eric chaney's blue book, july 24, 2014

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Eric Chaney

Chief Economist, AXA Group

Head of Research, AXA IM [email protected]

July 2014 (Update 24 July, 2014)

Tracking the global recovery Global growth re-accelerated in Q2

US ahead of Europe; China boosted by stimulus

Emerging markets: benefiting from liquidity

Central banks: Fed-ECB resolutely dovish

Euro area: risk of persistent low inflation

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(logo placé à 2/3X du bord; X =

logotype) 2 Eric Chaney, Chief Economist AXA Group, Head of Research, AXA IM 2

The global macro outlook

Global GDP recovered in Q2 – 2014 forecast stable at 3.3%

► Global GDP growth accelerated in 2Q – US manufacturing up 7% (saar) in 2Q

► Stimulus in China has quickly boosted GDP growth to 7.5%Y (8.2% saar)

► Europe is diverging from the rest of the world (yet, mind weather related distortions)

Fed: perceived as more dovish under Yellen than under Bernanke

► The new Chair is focused on the labour market, more than on financial stability

► Some FOMC members are ready to let inflation overshoot after having undershot

► Yellen is not worried by market valuations and believes that rates aren’t the right tool

The recovery in Europe is too sluggish to fully offset deflationist forces

► Weak and uneven, the cyclical recovery lost steam in 2Q; yet, a recession is unlikely

► The ECB has delivered an easing package; targeted liquidity injection is the new plan

► Absent QE (unlikely), bank restructuring is a necessary condition to the recovery

Emerging markets: net capital inflows and market sentiment again positive

► Tapering being fully priced, the Fed’s dovish stance is –again- positive for EMs

► Country-specific political risks made things worse. They look less acute now

► The good news: emerging markets have proved resilient to capital flows gyrations

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logotype) 3 Eric Chaney, Chief Economist AXA Group, Head of Research, AXA IM

Main macro risks

Short term (3 to 6M):

Stalemate in Eastern Ukraine; Russia proves more defiant than currently thought

Impact of Russian recession negative for Western Europe; energy supply may be at risk

Political instability in the Middle East sending crude oil prices through the roof

Two conflicts are yet unresolved: Israelis vs. Palestinians and Sunnis vs. Shias

Markets challenging the Fed on its very dovish policy stance

Yellen’s Fed has become ever more dovish. A rise in inflation may question this stance

Political instability in Europe caused by votes on independence or EU membership

The rise in eurosceptic votes shows that tensions within the EU are building up

Medium to long term:

Very low inflation becoming entrenched in the euro area if bank restructuring is too slow

Following a large debt build-up, excessively low inflation would raise solvency issues

Policy mistake in China causing a sharp but temporary slowdown

With housing prices falling, NPLs will rise. Tighter financial regulation may backfire

Further French / German growth and fiscal divergence, markets testing France

France is now moving toward supply side reforms – at a snail pace

Ill designed ‘exit strategies’ by big central banks (Fed/BoJ/BoE)

Inflating monetary bases to prevent deflation was easy. The opposite won’t be

Mismanagement of the rise of China as regional superpower

From India to Japan through Philippines and Vietnam, tensions are rising

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What equity markets say

Equities: supported by Fed benign neglect policy

Source: MSCI, AXA IM Research

Equities have performed better than expected

so far this year, led by the US and EMs

The real global MSCI index is standing 1 s.d.

above trend, and markets have recently become

more nervous to bad news

Despite alluding to ‘stretched’ valuations, the

Fed continues to encourage overall risk taking

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2.3Log (MSCI - World Equity Index*, inflation adjusted), 1=1970

*: Total return

Red line: real trend (non recursive HP filter, lambda = 10^11)

Dotted lines: +/- 1 standard deviation of

deviation from mean

Deflator interpolated from US PCE deflator

As of: 24/07/2014

World US EMU (€) EU ($) EM ($)

-40.3% -37.1% -44.3% -46.1% -53.2% Through 2008

30.8% 27.1% 28.7% 36.8% 78.7% Through 2009

12.3% 15.4% 3.3% 4.5% 19.2% Through 2010

-5.0% 2.0% -14.1% -10.5% -18.2% Through 2011

16.2% 16.1% 18.0% 18.7% 18.5% Through 2012

27.4% 32.6% 24.4% 26.0% -2.3% Through 2013

7.4% 8.7% 6.0% 5.1% 9.9% Since 01 Jan 2014

1.2% 1.7% -0.3% 0.0% 3.8% Last four weeks

MSCI total return indexes (source MSCI)

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9MSCI World Equity

Index*Annualized real rate of return

*: Total returnAnnualized rate of growth of smoothed (non recursive HP filter, lambda = 10^11) inflation-adjusted total return index.Deflator interpolated from US PCE deflator

Long-term average

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What our models say

Equities: Risk Appetite Barometer neutral

Our in-house ‘Risk Appetite Barometer’ has moved from “moderately positive” to “neutral”

Its cyclical component (Surprise Gaps) is neutral, good news from US being offset by €-area. Also:

* The 3M momentum component has declined and is now neutral

* The average pair-wise correlation of US stocks is rising, a worrying signal (herd behaviour coming back)

* The low vs. high credit quality spread remains record high: investors continue to see a (US) recession as

highly improbable

Rescaled weighted

average of four scores

(AXA IM surprise

gaps, Corporate bond

spread of spreads,

Average pair-wise

correlation of stocks &

3-month equity price

momentum)

Cyclical risk: first

score /

Systematic risk:

weighted average of

the last three scores

Sources:

Bloomberg,

Datastream,

Reference

document:

Market sentiment

indicators: less is

more – Mathieu

L’Hoir – AXA IM

Research

– May 24th 2012

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2009 2010 2011 2012 2013 2014

Risk appetite

Risk aversion

Weekly Risk Appetite Barometer (RAB)

Systematic risk appetite

Cyclical risk appetite

Risk Appetite Barometer (RAB)

Latest Data:

17/06/2014

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What bond markets say

Bonds boosted by dovish talk; € decoupled from US

Markets see the first Fed hike in mid/late 2015, followed by 25bps hikes every two other FOMC meetings.

Despite strong job data, the bond market remains directionless

By contrast, markets are incrementally raising the probability of a Japanese scenario in the euro area.

Our belief: markets will eventually raise the term and inflation premia and reconsider the timing of rate hikes

In the euro area, a Japanese scenario is a serious possibility. Yet, it is much too early to conclude that the

ECB’s strategy has failed. The pivotal year will be 2015.

Source: Datastream, AXA IM Research

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USA

Germany

US trend

Japan

Main benchmark 10Y bonds, annual yields%

All time lows:US Treasuries: 1.40% on 24 July, 2012Bunds: 1.15% on 31 May, 2012JGBs: 0.43% on 13 June, 2003

Latest data:

24 July 2014

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USA Germany

US trend Japan

%

First hint at

'imminent' tapering

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What bond markets say

Forward curves: US / euro area divergence

UST curve: Since end 2013, medium-long-term forwards have fallen by up to 70bps, while shorter forwards

were stable, as if markets were pricing slower long term growth or a lower duration risk premium

The first speeches of Fed chair Janet Yellen have confirmed that she is on the dovish side re interest

rate policy. She is convinced that the slack is significantly wider than suggested by unemployment at 6%

German curve: over the same period, the whole forward curve went down

Markets now envisage different long term future for the euro area and the US, as testified by the record

level of the spread between 5/5Y forward rates


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1Y ...in 1Y ...in 2Y ...in 3Y ...in 4Y ...in 5Y ...in 6Y ...in 7Y ...in 8Y ...in 9Y

Euro curve, 18-Jul-14

US curve, 18-Jul-14

US curve, 27-Dec-13

Euro curve, 27-Dec-13

US and Germany1Y forward rates derived from zero coupon curves%

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US Treasuries

German Bunds

5Y in 5Y yield, US and Germany

(extracted from zero-coupon curves)

US-German 5/5Y spread, basis

points for 1pp of US yield, RHS

% bps

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What real bond markets say

Inflation futures: stabilisation

Medium term (5Y) expectations have marginally increased in the US and Japan and declined in the euro area, where they are now below peers (@ 1.22% on July 21)

Longer term (5Y in 5Y) expectations are broadly stable in the US, between 2.75 and 3.0%, and in the UK, around 3.5%. They have declined to 2.0% in the €-area . If extended, this downward trend would challenge the ability of the ECB to “anchor long-term inflation expectations”.

With Fed, BoE and BoJ sailing in unchartered waters, investors may ask for a higher long term inflation premium, at some point in time. The longer exit strategies are postponed, the higher the premium.


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UK 5Y in 5Y US 5Y in 5Y

EUR 5Y in 5Y Japan 5Y in 5Y

Inflation swaps (breakevens), 5Y in 5Y

Latest data: 21/07/2014

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UK 5Y US 5Y

EUR 5Y Japan 5Y

Inflation swaps (breakevens), 5Y

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What commodities markets say

Commodities: Chaos in Iraq is a longer term issue

Base metal prices are rising, on the back of good news from China. The deceleration of headline growth in China together with sluggish recoveries in developed economies and ‘end of QE’ headwinds for emerging economies kept base metal prices at bay. These structural factors will not disappear.

Crude oil (Brent): supply disruptions fears caused by the civil war in Iraq seem to have vanish: Iraq exports did not fall, and shale oil from North America has provided a powerful buffer. Yet, long term futures have not declined significantly: markets are losing faith in Iraq as a “swing producer”

Source: Datastream AXA IM Research

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2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Brent, US$/bblHWWA Index

Brent

LME index

LME Metal Index

HWWA Agriculture Raw Materials Index -RHS

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Crude oil futures, ICE Brent contracts

Spot Dec-2014

Dec-2016 Dec-2018

US$/bl

Latest data point: 15/07/2014

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What FX markets say

Currencies: € overvalued vs. ¥ and $, £ rising fast

Since Mr. Abe election, the JPY has fallen by 30%

BoJ is likely to expand further its monetary base

The ECB is concerned by deflation. Followed by action, it

is EUR negative. If action fails, deflation is EUR positive

End of QE should be USD positive. A stronger than

expected recovery in the US too.

Source: Federal reserve, ECB, BoE, AXA IM Research

Nominal TW rate: Deviation from average(1999-2013)As of: UK £ Euro JP Yen Swiss franc US $

24/07/2014 -6.0% 1.9% -3.7% 24.7% -9.6%

US$ real bilateral rate: Deviation from(1999-2012)As of: US$ /Yen US$ / CHF US$ / UK£ US$ / €

24/07/2014 17% -17% -6% -8%

Euro real bilateral rate: Deviation from(1999-2012)As of: € / Yen € / US$ € / UK £ € / CHF

24/07/2014 29% 9% 2% -7%

JPY real bilateral rate: Deviation from(1999-2012)As of: JPY/€ JPY/US$ JPY/UK£ JPY/ CHF

24/07/2014 -24% -16% -23% -29%

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2007 2008 2009 2010 2011 2012 2013 2014

CHF

JPY

EUR

USD

GBP

Average1999-2012

Nominal trade-weighted exchange rate, 100 = average (99-13)

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€ / JPY € / US$ € / UK £ € / CHF

Euro bilateral exchange rate, adjusted for inflation trends100 = average (99-13)

Str

ong

euro

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ak e

uro

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What real economic indicators say

Global trade: roller coaster, weak underlying trend

Global trade retraced in May, after a robust rebound in April

The underlying trend (circa 3.5%) remains significantly weaker than the longer trend (6%)

Unless trade sharply rebounds in the coming months, global trade growth will disappoint again in 2014

The elasticity of trade relatively to global growth has fallen from 1.5 before the global financial crisis to

less than 1 since then. Is this a structural shift? If it is, growth models based on exports would suffer.

Source: CPB, AXA IM Research

Volume

Price in US$

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Volumes (s.a.)

Prices / unit values in US$

May 2014

-21%

100 = 2005

Global trade in US$, 2008/06 to 2009/04: -32.5%

-15%

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Inflation/deflation balance: deflation wins (but in Japan)

Japan, the UK and a handful of emerging economies are operating above recent trends, by a significant margin. China is close to potential, Brazil and Russia much below trend.

Most of Europe is at or below trend, but the UK, now on a fast catching-up track

Short term, risks are still tilted toward disinflation but slightly more balanced than 3M ago

Bear in mind that the global component of inflation explains 70% of local inflation (*)


(*): More precisely, the share of inflation variance explained by a measure of global inflation is 71%, on

average, for Oecd economies. This share ranges from 60% for Germany to 68% for the US and 89% for

France. Source: Ciccarelli and Mojon, Global Inflation in The Review of Economics and Statistics, 2010.

Trend GDP is estimated with a non-recursive

HP filter, with lambda set at 10,000

(industrialised) or 5,000 (emerging)

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Irela

nd

Japan

UK*

Mala

ysia

Hungary

Denm

ark

Austr

alia

Canada

Indonesia

Germ

any

Turk

ey

US

Chin

a*

Sw

eden

Kore

a

Rom

ania

Sw

itzerland

Chile

Mexic

o

Fra

nce

Belg

ium

Taiw

an

Italy

Pola

nd

India

Port

ugal

Spain

Bra

zil

Neth

erlands

Thailand

Russia

Arg

entina

Gre

ece

Output Gaps, 1Q 2014 (* = 2Q 2014)

Actual minus trend GDP as % of trend GDP

Operating above trend Operating close to trend

Risk of deflationOperating below trend

1.0% < OG -1.0% < OG < 1.0%

-2.5% < OG < -1.0%

OG < -2.5%

-3.8

-2.6

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Divergences within developed economies widening

Source: National Accounts, AXA IM Research

Since the bottom of the 2009 recession, recoveries in the developed world have been heterogeneous.

Canada, Switzerland and Sweden, all wide open economies, are doing better than others.

Among larger developed economies, the US is leading, followed by Germany. The UK is catching up fast

Japan has overtook France, where unemployment is still rising. Yet, mind the payback in 2Q

Along larger economies, Italy remains the most worrying case, with GDP still 9% below the 2008 peak

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2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Canada US Germany

France Japan UK

Italy

Real GDP index100 = average 3 quarters around peak

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2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Sweden Switzerland

Belgium Netherlands

Ireland Spain

Portugal Greece

Real GDP index100 = average 3 quarters around peak

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China: stimulus has boosted growth without lag

China’s GDP accelerated in 2Q (7.5%Y, 2.0%Q vs.1.4% in 1Q 2014),

while industrial production is entering Q3 with a 9% momentum

In contrast with developed economies, the ‘targeted stimulus’ decided by

the government has quickly boosted domestic demand. Risk to our 2014

forecast (7.2%) is now on the upside

Headwinds related to the housing market are here to stay, but a hard

landing is unlikely in the short-medium term.

Car sales have somewhat slowed (12%Y on trend), but remain robust.

Source: NBS, Datastream, AXA IM Research

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Smoothed series

Raw series

China: vehicles production (volume index - log scale)

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Real YoY

Real GDP quarterlyannualised (SAAR)

Trend growth (HP, λ = 400)

China - actual and trend real GDP growth

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China: NBS PMI and industrial value added 12M % change

PMI index

Long term relationship between growth and PMIOutput % = -28 + 0.8*PMIBreakeven around 35PMI at 50 consistent with circa 10% growth in the long run

IP growth, June 2014

PMI, June 2014

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Chinese exports fell from a cliff in February (-45% MoM), without any ‘economic’ rationale. Imports fell

much less (-22%), thus generating a trade deficit (=China exporting growth). Since then, exports have

recovered faster than imports; yet the current trend is puzzlingly flattish.

This is why a limited fiscal stimulus was decided, together with a cut in the reserve requirement rate

The message from the PBC was loud and clear: with financial liberalization coming, RMB/USD will no

more be a one-way bet. Note that the currency is now back on the 2.5% p.a. appreciation line.

Source: NBS, Datastream, AXA IM Research


China: sluggish exports, RMB stabilised

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Average annual rate: +6%

100 yuan = … US $

2.5 to 5%

per

annum

21 J

uly

, 2005

25 J

uly

, 2008

21 J

une,

2010

End of the 5% p.a. de facto FX policy

New leadership

Trading

range

widened to

+/- 2.0%

Latest data: May - 2014

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USD Bn USD Bn

Exports (monthly, USD Bn)

Imports (monthly, USD Bn)

Trade balance (smoothed)

China: Trade flows

?

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US: manufacturing production up 7% in Q2

Manufacturing production was up 7.0% (saar) in Q2, vs. 1.4% in Q1. GDP is likely to surprise on the upside

a mirror image of Q1. Yet, trend growth remains around 2%, which makes the Fed uneasy.

The June ISM index (speed component) was stable but still 2% below its 4Q 2013 average. The Surprise

Gap (acceleration component) rose further, hinting at a likely acceleration of the US economy in 2Q/3Q

This is consistent with a more benign fiscal drag (-0.75% vs. -1.75% in 2013), more confident consumers

and companies likely to spend more on equipment goods

Source: ISM, AXA IM Research

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0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Surprise Gap, smoothed

Surprise Gap (Production - previous orders), normalised

Production component

March 2009

US Surprise Gap: Current production minus new orders 3 months agoSource: ISM (ex-Napm) survey

Recession warning Recovery signal

US Surprise Gap Index

February 2010

May 2011

August 2013

December 2007June 2012

Dec. 2011Feb. 2013

October 2008

February 2014

July 2009 June 2014

-20

-10

0

10

20

30

40

50

60

70

80

90

100

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Production (lhs)

Aggregate hours (lhs)

Index - 100 = 2007

US Manufacturing production

3M / 3M annualised rate, %

Production growth (rhs)

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US: Q1 pothole passed, fundamentals improving

Corporate investment (x-structures) is growing slower than in the first phase of the recovery(2.5% on trend

vs. 10% in 2010-11), despite improving fundamentals. It is likely to accelerate in the course of the year.

More worrying and uncertain is the outlook for housing investment, which contributes to explain why the

Fed wants to check bond yields and mortgage rates.

As growth accelerates, the participation rate will rise, thus slowing the unemployment decline. Interestingly,

the perceived unemployment rate is not declining as fast as the measured one. In its forward guidance, the

Fed will assess the labour market through a broader set of variables than the sole unemployment rate.

Source: BEA, , Department of Commerce, Conference Board, AXA IM Research

45

50

55

60

65

70

75

80

85

90

95

100

105

110

115

120

125

130

135

45

50

55

60

65

70

75

80

85

90

95

100

105

110

115

120

125

130

135

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Corp. Invest.,equipmentsoftwares andintangibles(10%)

Privateconsumption(68%)

GDP (100%)

Gov't spending(19%)

Residentialinvestment(3%)

Volume indexes; 100 = average (2001-2007)

US GDP and demand components

1

2

3

4

5

6

7

8

9

10

11

1

2

3

4

5

6

7

8

9

10

11

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

'Perceived' unemployment rate Actual unemployment rate

Actual: extrapolated trend 'Perceived': extrapolated trend

10.8%

7.8%

Subjective unemployment = 5.8+ 0.06 * (balance of opinion on current jobs - Conference Board)OLS, 1978-2013, R2=0.83

10.0%

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US Consumers: the return of wealth

As long as the personal saving rate rises, consumer spending could not but disappoint. This is what

happened until 3Q 2010. As wealth rises and net debt declines, the savings rate may decline –again.

Based on 1Q net wealth data, the personal savings rate could fall by another 1 pp during the year, thereby

boosting consumer spending

The stabilisation of the debt/income ratio (at end-2002 level) is consistent with the wealth-based analysis

Source: BEA, AXA IM Research. Latest data: 1Q 2014 (NIPAs revised from 1929)

0

2

4

6

8

10

12

14

40

50

60

70

80

90

100

110

120

130

140

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

Household total credit market debt Debt trend

Gross saving rate (smoothed) Gross saving rate

Debt, % of disposable income Saving, % of disposable income

Debt trend (1975-1999)

Debt overhang: between 9% and -7%% of income,

as of Mar. 2014

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

19

61

19

63

19

65

19

67

19

69

19

71

19

73

19

75

19

77

19

79

19

81

19

83

19

85

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

20

03

20

05

20

07

20

09

20

11

20

13

CORRELATION = - 0.71

Personal gross savings rate, % of personal disposable income (left

hand scale)

Ratio Net wealth / annual disposable income (right hand scale)

Consistent with 3.0% savings rate

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logotype) 19

What monetary indicators say

US Fed: money gap positive, money multiplier declining

The Fed’s obsession: do not repeat the mistakes of 1930 Former chairman Bernanke was the first scholar to demonstrate that Milton Friedman, not JM Keynes, was right about

the cause of the 1930 depression: it was the contraction of money supply, not fiscal austerity

When QE3 ends, the monetary base will have increased 5 times compared to pre-Lehman

The test will come when the money multiplier, so far low and stable, starts rising. Then, the Fed will have to

shrink its balance sheet accordingly. This is not (yet) part of the official exit strategy of the Fed.

Eric Chaney, Chief Economist AXA Group, Head of Research, AXA IM Source: Federal Reserve Board, AXA IM Research

8.6

8.7

8.8

8.9

9.0

9.1

9.2

9.3

9.4

2

3

4

5

6

7

8

9

10

Jan

-04

Jul-

04

Jan

-05

Jul-

05

Jan

-06

Jul-

06

Jan

-07

Jul-

07

Jan

-08

Jul-

08

Jan

-09

Jul-

09

Jan

-10

Jul-

10

Jan

-11

Jul-

11

Jan

-12

Jul-

12

Jan

-13

Jul-

13

Jan

-14

US: Broad money and money multiplier

Money multiplier (left hand scale)= M2 / Monetary base,

Ln (M2), right hand scale

Ratio log (US$ bn)

6%

Long term trend (5.5% p.a.)

0

2,000

4,000

6,000

8,000

10,000

12,000

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

Jan-0

4

Ma

y-04

Sep

-04

Jan-0

5

Ma

y-05

Sep

-05

Jan-0

6

Ma

y-06

Sep

-06

Jan-0

7

Ma

y-07

Sep

-07

Jan-0

8

Ma

y-08

Sep

-08

Jan-0

9

Ma

y-09

Sep

-09

Jan-1

0

Ma

y-10

Sep

-10

Jan-1

1

Ma

y-11

Sep

-11

Jan-1

2

Ma

y-12

Sep

-12

Jan-1

3

Ma

y-13

Sep

-13

Jan-1

4

Ma

y-14

Sep

-14

US: Monetary base and broad money

Bank reserves (left hand scale)

Monetary base (left hand scale)

US$ bn US$ bn

Monetary base:+$ bn

i.e. +

Broad money (M2):

+ 42%

M2 (right hand scale)

Lehman Bros bankruptcy

End o

f Q

E s

imula

tion

3,050

348%

Latest data: 01/05/2014

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Japan: Capex reviving, outlook uncertain

Master piece of Abenomics, the BoJ decision to double its monetary base and reach 2.0% inflation has

weakened the yen, boosted equity prices and raised companies as well as consumers’ expectations.

GDP growth took off in 1Q (6.7% annualised growth), as consumers tried to beat the 3pp tax hike. A

payback is due in 2Q, but the Tankan-based Surprise Gap is consistent with a re-acceleration in 3Q. Even

pricing in a 3.5% GDP dip in 2Q, our 1.7% GDP growth forecast for the full year looks reasonable.

Corporate investment (capex) was re-ignited by Abenomics: capex was up 11.6% in the last 12M. We

expect 1.7% GDP growth in 2014, after 1.5% in 2013.

Source: MoF, AXA IM Research

-15

-10

-5

0

5

10

15

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Manufacturing production,

(quarterly growth, %, RHS)

Tankan based Surprise Gap(standard deviation, LHS)

Japan: Manufacturing production and Tankan based Surprise Gap

Tankan based Surprise Gap(Smoothed), LHS)

60

70

80

90

100

110

120

130

140

80

85

90

95

100

105

110

115

120

20012002200320042005200620072008200920102011201220132014

Gov't consumption (20%), LHS Consumption (60%), LHS

GDP (100%), LHS Fixed investment (20%), LHS

Exports (15%), RHS

Japan: GDP and final demand componentsVolume indexes; 100 = average (2001-2007)

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What central banks say

Japan: QE likely to extend into 2015

Abe’s second arrow (fiscal stabilisation – 3pp rise of consumer tax in 2014/04, possibly another 2pp in

2015) and third arrow (reform agenda, including energy and medical sector deregulation, farmland

reform, special economic zones “tokku”) is now in place

Therefore, the BoJ is likely to support further the government policy by extending its purchases of

assets into 2015 and, probably into 2016. Bond yields will not rise any time soon.

Source: Gov. Kuroda

at Jackson Hole, 24

August 2014

Beyond 2014: AXA IM

estimates

0

50

100

150

200

250

300

2007 2008 2009 2010 2011 2012 2013 2014

BoJ JGB holdings

Monetary base

Introduction of QQE

Bank of Japan balance sheet and QE, in ¥tn

End-2013 ¥200tn

End-2013 ¥141tn

End-2014 ¥270tn

End-2014 ¥190tn

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Europe: diverging from US and China

€ area manufacturing production was up 0.8% (saar) in 1Q but is likely to have contracted in 2Q

A triple-deleveraging (banks/consumers/governments) weighs on domestic demand. Southern economies

are struggling with a credit crunch. More neutral fiscal policies should prevent a relapse into recession.

Germany, which benefits from a strong competitive position and negative real interest rates, will remain

the powerhouse of Europe. Spain has bottomed out and could surprise on the upside.

Events in Ukraine are the wild card for the euro area, especially for Germany.


65

70

75

80

85

90

95

100

105

110

65

70

75

80

85

90

95

100

105

110

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Germany

France

Italy

Spain*

Manufacturing productionIndexes, 100 = 2007

* Total industrial production

75

80

85

90

95

100

105

110

75

80

85

90

95

100

105

110

€-area

US

Manufacturing productionIndexes, 100 = 2007

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€-area manufacturing: sluggish recovery

The €-area Surprise Gap (SG) has weakened on trend over the last few months but is still broadly neutral,

supporting the scenario of a weak manufacturing recovery

Optimism on demand is rising no more in Germany and has fallen in France for two straight months

The €-area is more sensitive than the US to the escalation of the Ukrainian crisis or to a oil price spike

Sourc

e: If

o, In

see,

Ista

t, IN

E, C

BS

, B

NB

, A

XA

IM

Researc

h

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

May 2009

April 2008

Euro Area Surprise Gap Index

EA Surprise Gap: Current production minus production plans 3 months ago

Recession warning Recovery signal

December 2008 : -2.4

August

2013

May 2011

Feb 2012

May 2012June

2014

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What the markets say

€-sovereigns: yields and spreads down

The GDP-weighted 10Y €-yield has declined sharply (1.8% as of 21 July), exactly in line with nominal GDP growth in 1Q. Investors see a growing risk of deflation and rush to harvest yields

Markets see Italian and Spanish sovereign debts as substitutes, despite Spain being more advanced in terms of reforms and cyclical recovery.


1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

2008 2009 2010 2011 2012 2013 2014

Spain

Italy

Synthetic

€-area

France

Germany

10Y yields on benchmark government bonds

Latest data 21/07/2014

Periphery banks keep buying their sovereign bonds, despite warnings from ECB, in order to reap the carry trade and benefit from zero capital charge. The resulting spread compression is not really explained by the credit quality of the sovereign.

Spread compression is reversible: political risks may rise, especially once the size of bank recapitalisation needs is known. In addition, the ECJ ruling may undermine the credibility of OMTs.

Last, non core €-area bonds might be tested when the first Fed hike gets closer, like other liquidity supported markets.

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What € bond markets say

€-Spreads: convergence at the long end? not quite

Consistent euro politics (LTROs + €-Summit + threat of OMTs) have reversed the dynamics of spreads, in

favor of Ireland, Spain and Italy, especially for short durations.

5Y in 5Y spreads have been declining on trend since July 2012. They are around 230 bps for Italy and

Spain. A significant credit risk and/or a smaller euro club in the longer term are still priced in.

Warning: the German Constitutional Court may cast doubts about the credibility of OMTs, depending on

its reaction to the European Court of Justice decision (expected later this year)

Source: Bloomberg, Datastream, AXA IM research

0

100

200

300

400

500

600

700

800

0

100

200

300

400

500

600

700

800

Spain

Italy

Belgium

France

Austria

Netherlands

2Y spreads vs. German bonds

25 Nov. 201124 Jul. 2012

0

100

200

300

400

500

600

700

800

900

0

100

200

300

400

500

600

700

800

900

Spain

Italy

Ireland

Belgium

France

Finland

Netherlands

5Y in 5Y spreads vs. German bonds

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logotype) 26


ECB: flat money supply hints at deflation risk

The ECB is struggling to boost money supply M3 is almost flat: +0.8% 3M/3M annualized in May 2014 (0.8% too on a 3M vs. 3M previous year basis)

Against its long term trend, M3 is running 21% below. The ECB’s monetary base has fallen below its pre-crisis trend

The purpose of the upcoming TLTRO (targeted LTRO) is to boost credit to companies, thus, hopefully, money supply

‘Pure’ QE is very unlikely: high political costs vs. low and uncertain reward The ECB may opt for other assets (ABS for instance); this is unlikely to be large enough to kick start money supply

The most promising channel is the restructuring of the banking system, but this might take years

Source: ECB monthly bulletin Eric Chaney, Chief Economist AXA Group, Head of Research, AXA IM

8.2

8.4

8.6

8.8

9.0

9.2

9.4

9.6

5

6

7

8

9

10

11

12

13

14

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

€ area: M3 and multiplier (M3/monetary base)

Money multiplier= M3/monetary baseLeft hand scale

Ln (M3), right

hand scale

Ratio log (€ bn)

Ln(M3) trend01/1999 to 12/2011[6.7% p.a.]

- 21%

(€ 2.6Tn)

0

100

200

300

400

500

600

700

800

900

1,000

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

01/2

00

1

01/2

00

2

01/2

00

3

01/2

00

4

01/2

00

5

01/2

00

6

01/2

00

7

01/2

00

8

01/2

00

9

01/2

01

0

01/2

01

1

01/2

01

2

01/2

01

3

01/2

01

4

01/2

01

5

Monetary base, left hand

Deposit facility, right hand scale

€ bn € bn

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ECB: challenged by credit decline and acting

Sources: ECB, AXA IM Research

-50

-40

-30

-20

-10

0

10

20

30

40

50

60

70

-50

-40

-30

-20

-10

0

10

20

30

40

50

60

70

Jan-9

9Jul-9

9Jan-0

0Jul-0

0Jan-0

1Jul-0

1Jan-0

2Jul-0

2Jan-0

3Jul-0

3Jan-0

4Jul-0

4Jan-0

5Jul-0

5Jan-0

6Jul-0

6Jan-0

7Jul-0

7Jan-0

8Jul-0

8Jan-0

9Jul-0

9Jan-1

0Jul-1

0Jan-1

1Jul-1

1Jan-1

2Jul-1

2Jan-1

3Jul-1

3Jan-1

4Jul-1

4Jan-1

5

Bns EUR, Monthly flows Loans to non-financial corporations

May 2014

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

35

40

45

50

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

35

40

45

50

Jan-9

9Jul-9

9Jan-0

0Jul-0

0Jan-0

1Jul-0

1Jan-0

2Jul-0

2Jan-0

3Jul-0

3Jan-0

4Jul-0

4Jan-0

5Jul-0

5Jan-0

6Jul-0

6Jan-0

7Jul-0

7Jan-0

8Jul-0

8Jan-0

9Jul-0

9Jan-1

0Jul-1

0Jan-1

1Jul-1

1Jan-1

2Jul-1

2Jan-1

3Jul-1

3Jan-1

4Jul-1

4Jan-1

5

Billions EUR, Monthly flows

Loans to households

May 2014

The endless decline of new loans to companies is a serious cause for concern

With the GDP weighted 10Y average government bond yield at 2.0%, vs. nominal GDP running at

1.8%Y (1Q 2014), monetary policy action aiming at lowering bond yields would be futile

The first wave of TLTROs (in 2014) will have little impact on credit supply, because of its weak

conditionality. On the other hand, it will contribute keeping bond yields low by subsidizing banks

After the publication of the stress tests, the restructuring of the banking system will accelerate and the

conditionality of the next wave of LTROs will be hardened. If all goes as planned by the ECB (as

supervisor and monetary authority), credit supply should start accelerating in the course of 2015.

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Central banks: a tentative calendar for exits

Bank of England: end 2014 / early 2015

Federal Reserve: second half 2015

European Central Bank: 2017

Bank of Japan: 2018

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Baseline 2014-18: quantitative scenario (1)

Sourc

e: IM

F, D

ata

str

eam

, A

XA

IM

Researc

h

As of: 25-Jul-2014

2007 2008 2009 2010 2011 2012 2013 2014f 2015f 2016f 2017f 2018f

World GDP (PPP) 5.3 2.7 -0.4 5.2 3.9 3.5 3.2 3.3 3.3 3.3 3.3 3.3

World GDP (market FX rate) 3.9 1.5 -2.1 4.1 3.0 2.6 2.8 2.9 3.0 3.0 3.0 3.0

USA 1.8 -0.3 -2.8 2.5 1.8 2.8 1.8 1.8 2.5 2.7 2.7 2.7

Euro area 3.0 0.3 -4.4 1.9 1.6 -0.6 -0.4 1.1 1.4 1.4 1.4 1.4

UK 3.4 -0.8 -5.2 1.7 1.1 0.3 1.4 3.3 2.7 2.5 2.4 2.4

Japan 2.2 -1.1 -5.5 4.7 -0.4 1.4 1.8 1.7 1.4 1.4 1.4 1.3

China 14.2 9.6 9.2 10.4 9.3 7.7 7.7 7.4 7.0 6.8 6.7 6.5

Rest of Asia 7.6 4.0 5.5 8.7 5.8 5.2 5.0 4.5 4.3 4.2 4.1 4.0

RoW 4.3 2.5 -2.4 4.7 3.9 3.5 3.2 3.0 3.0 3.0 3.0 3.1

Global trade (manuf. goods) 6.6 2.3 -12.6 14.6 6.1 1.9 2.7 2.8 4.9 5.0 5.0 4.9

Inflation

US 2.9 3.8 -0.3 1.6 3.1 2.1 1.5 1.8 2.0 2.1 2.1 2.2

Euro area 2.1 3.3 0.3 1.6 2.7 2.5 1.4 0.5 1.4 1.5 1.75 2.0

UK 2.3 3.6 2.2 3.3 4.5 2.8 2.6 1.7 1.8 2.0 2.0 2.0

Japan 0.0 1.4 -1.1 -0.7 -0.4 -0.5 0.0 2.5 2.0 1.9 1.9 1.8

Crude oil (Brent), US$/bbl 72.6 97.3 61.7 79.9 111.6 112 109 108 109 110 113 115

% change 10.6 33.9 -36.6 29.5 39.7 0.4 -2.8 -1.2 1.0 1.5 2.0 2.0

Interest rates, FX (end of period)

US

Fed funds (actual / target)- O/N 4.24 0.16 0.20 0.20 0.15 0.17 0.09 0.10 0.50 1.50 2.50 3.50

10Y Treasuries yield 4.03 2.25 3.84 3.31 1.88 1.80 3.01 2.8 3.3 3.8 4.1 4.4

Euro area

EONIA 3.86 2.49 0.39 1.0 0.63 0.13 0.17 0.05 0.05 0.05 0.5 1.0

10Y Bund yield 4.33 2.94 3.38 2.89 1.83 1.43 1.94 1.25 1.7 2.2 2.6 3.0

€1 = …US$ 1.46 1.35 1.46 1.34 1.33 1.33 1.38 1.30 1.30 1.29 1.29 1.28

Japan

Overnight call rate 0.47 0.46 0.11 0.0 0.10 0.09 0.10 0.1 0.1 0.1 0.1 0.50

10Y JGB 1.50 1.17 1.28 1.12 0.99 0.79 0.74 0.5 0.9 1.2 1.6 1.9

US$1 = … JPY 110 95 87 85 78 76 105 105 103 101 99 97

€1= … JPY 161 128 127 114 104 115 145 137 133 130 127 124

UK

BoE base rate 5.5 2.0 0.50 0.50 0.50 0.50 0.50 0.75 1.25 2.00 2.75 3.50

10Y gilt 4.50 3.09 4.11 3.51 1.98 1.96 3.03 3.0 3.5 4.0 4.3 4.6

€1= … GBP 0.73 0.95 0.89 0.85 0.86 0.81 0.83 0.79 0.75 0.76 0.76 0.77

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Baseline 2014-18: quantitative scenario (2)

Sourc

e: IM

F, D

ata

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h

5.3

2.7

-0.4

5.2

3.9

3.53.2 3.3 3.3

3.3 3.3

3.3

-15

-10

-5

0

5

10

15

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

2007 2008 2009 2010 2011 2012 2013 2014f 2015f 2016f 2017f 2018f

World GDP and trade (manufactured), % growth

World GDP

Global trade

GDP scale Trade scale20

40

60

80

100

120

140

-1

0

1

2

3

4

5

2007 2008 2009 2010 2011 2012 2013 2014f 2015f 2016f 2017f 2018f

CPI Inflationannual change, %

US (left)

Euro area (left)

Crude oil (Brent, US$/bl)

Crude oil(right)

0

1

2

3

4

5

0

1

2

3

4

5

2007 2008 2009 2010 2011 2012 2013 2014f 2015f 2016f 2017f 2018f

Policy interest rates, %, end of year

Fed funds target

ECB(Eonia)

BoE base rate

0

1

2

3

4

5

0

1

2

3

4

5

2007 2008 2009 2010 2011 2012 2013 2014f 2015f 2016f 2017f 2018f

Benchmark 10Y Bonds yield, %, end of year

US Treasuries

German Bunds

JGBs

UK Gilts

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Interest rates 2014-20 scenario: US


0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

2014 2015 2016 2017 2018 2019 2020

Fed funds target - O/N

5Y Treasury yield

10Y Treasury yield

US rates: baseline scenario

US Fed rate policy: first hike in late 2015, followed by 100bp increases in 2016 and 2017; long-term

neutral short term rate: 4.0% (consistent with 2.5% LT potential growth and 2.0% inflation target)

Note that this is consistent with Larry Summers statement to the WSJ: “I suspect unless circumstances

change fed funds rates may well average less than 3% over the next decade”

US Treasury curve: steady normalization of the term premium, converging toward 120bps, lower than

before the crisis because of Fed’s holdings of Treasuries.

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

2014 2015 2016 2017 2018 2019 2020

Term Premium

Average expected 1Y rates

1Y Treasury yield

US rates: baseline scenario

Term premium

US, end of... 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

O/N 0.10% 0.50% 1.50% 2.50% 3.50% 3.75% 3.75% 3.75% 3.75% 3.75% 3.75%

1Y 0.30% 1.00% 2.00% 3.00% 3.63% 3.75% 3.75% 3.75% 3.75% 3.75% 3.75%

5Y 1.95% 2.73% 3.37% 3.81% 4.05% 4.17% 4.26% 4.35% 4.35% 4.35% 4.35%

10Y 2.80% 3.33% 3.79% 4.14% 4.40% 4.59% 4.77% 4.95% 4.95% 4.95% 4.95%

30Y 3.62% 3.95% 4.26% 4.53% 4.77% 4.99% 5.20% 5.42% 5.42% 5.42% 5.42%

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Interest rates 2014-20 scenario: EUR


0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

2014 2015 2016 2017 2018 2019 2020

Refi / Eonia

5Y Bund yield

10Y Bund yield

ECB / German rates: baseline scenario

ECB rate policy: first hike in 2017, followed by 50, then 75bps increases in 2018-2020; long term neutral

short term rate: 3.3% (consistent with 1.5% LT potential growth and 2.0% inflation target)

German Bund curve: steady normalization of the term premium, converging toward 60bps, lower than

before the crisis because German Bunds continue to benefit from a safe haven premium

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

2014 2015 2016 2017 2018 2019 2020

Term Premium


1Y Bund yield

German rates: baseline scenario

EUR, end of... 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

O/N = Eonia 0.05% 0.05% 0.05% 0.50% 1.00% 1.75% 2.50% 3.00% 3.30% 3.30% 3.30%

1Y 0.05% 0.05% 0.28% 0.75% 1.38% 2.13% 2.75% 3.15% 3.30% 3.30% 3.30%

5Y 0.35% 0.82% 1.41% 2.04% 2.61% 3.06% 3.35% 3.51% 3.60% 3.60% 3.60%

10Y 1.25% 1.71% 2.17% 2.60% 2.99% 3.32% 3.57% 3.75% 3.90% 3.90% 3.90%

30Y 2.12% 2.43% 2.75% 3.06% 3.35% 3.62% 3.86% 4.09% 4.30% 4.30% 4.30%

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Interest rates 2014-20 scenario: JP and UK


Japan BoJ rate policy: QE extended into 2015 / mid-2016, then tapering; first rate hike in 2017, then

gradual rise toward neutral rate (2.5%, consistent with 1.2% LT potential growth and 1.5% inflation)

JGB curve: yields capped below 1.0% by BoJ until 2016, then gradual rise toward 3.0%, which

assumes a 50bp term premium, explained by the large size of the BoJ’s holdings of JGBs

UK BoE rate policy: first rate hike toward the end of 2014 or early 2015, then very gradual rise toward

neutral rate (4.0%, (consistent with 2.5% LT potential growth and 2.0% inflation target)

Gilts curve: steady normalization of the term premium, converging toward 100bps, lower than before

the crisis because of BoE’s holdings of Gilts. If the BoE opted for sales of its portfolio, a higher premium

would be warranted

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

2014 2015 2016 2017 2018 2019 2020

O/N = base rate

5Y

10Y

Japan rates: baseline scenario

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

2014 2015 2016 2017 2018 2019 2020

O/N = base rate

5Y Gilt yield

10Y Gilt yield

UK rates: baseline scenario

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Alternative ‘low yield’ scenarios - rationale


What could keep bond yields low in the longer run?

1. Structural economic changes, such as lower long term potential GDP growth. LT growth depends

on demography, relative return on capital (negatively related to relative productivity level) ruling capital

accumulation, total factor productivity (linked to innovation, infrastructures...), efficiency of institutions

2. Perceived changes in monetary policy fundamentals, such as a different reaction function

-200

-100

0

100

200

300

400

500

600

700

-200

-100

0

100

200

300

400

500

600

700

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Bn US$Bn US$ Demand and Supply of 'safe and liquid assets'

Proxy for Demand (C/A surplus of China, HK,UAE, Saudi Arabia)

Free supply of safe and liquid asset (proxied bynet issuances of US Treasuries, German Bundsand UK Gilts net of Fed and BoE purchases)

Free Float supply, smoothed

Proxy for Demand, smoothed

3. A permanently lower term

premium (duration risk). Linked

to uncertainty on future

monetary policy but also to

consumers’ risk aversion (the

higher, the lower the term

premium)

4. Market failure. Strong

demand from price-insensitive

raises the price of bonds other

things equal. Quantitative

easing do that on purpose. The

scarcity of safe and liquid

assets needed by FX reserve

managers too, although the

resulting price distortion is not

on purpose.

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Low yield alternative scenario: US


US Fed rate policy: first hike in 2016, followed by 75bp

increases in 2017-18-19; long-term neutral short term rate:

3.5% (consistent with 2% LT growth and 2.0% inflation target).

US low yield scenario Main case

LT trend GDP growth 2.0% 2.5%

Inflation target 2.0% 2.0%

LT FFR equilibrium rate: 3.5% 3.5% 4.0%

LT 10Y term premium 0.8% 1.2%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

2014 2015 2016 2017 2018 2019 2020

Fed funds target - O/N

5Y Treasury yield

10Y Treasury yield

US rates: alternative scenario

US Treasury curve: steady normalization of the term premium, converging toward 80bps, much lower

than before the crisis because of Fed’s holdings of Treasuries and a higher risk aversion for consumers.

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

2014 2015 2016 2017 2018 2019 2020

Term Premium


1Y Treasury yield

US rates: alternative scenario

Term premium

US, end of... 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

O/N 0.10% 0.10% 0.75% 1.50% 2.25% 3.00% 3.50% 3.50% 3.50% 3.50% 3.50%

1Y 0.10% 0.43% 1.13% 1.88% 2.63% 3.25% 3.50% 3.50% 3.50% 3.50% 3.50%

5Y 1.03% 1.74% 2.44% 3.01% 3.42% 3.68% 3.81% 3.90% 3.90% 3.90% 3.90%

10Y 2.58% 3.00% 3.39% 3.71% 3.95% 4.12% 4.22% 4.30% 4.30% 4.30% 4.30%

30Y 3.44% 3.71% 3.97% 4.21% 4.42% 4.61% 4.78% 4.93% 4.93% 4.93% 4.93%

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Low yield alternative scenario: EUR


ECB rate policy: first hike in 2018, followed by 50bp

increases in 2019-22; long-term neutral short term rate: 2.5%

(consistent with 1% LT growth and 2.0% inflation target).

German yield curve: steady normalization of the term premium, converging toward 30bps, much lower

than before the crisis because of a permanent premium on Bunds and large scale QE by the ECB.

EUR, end of... 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

O/N = Eonia 0.05% 0.05% 0.05% 0.05% 0.50% 1.00% 1.50% 2.00% 2.50% 2.50% 2.50%

1Y 0.05% 0.05% 0.05% 0.28% 0.75% 1.25% 1.75% 2.25% 2.50% 2.50% 2.50%

5Y 0.33% 0.58% 0.93% 1.37% 1.82% 2.18% 2.44% 2.59% 2.65% 2.65% 2.65%

10Y 1.14% 1.42% 1.70% 1.99% 2.25% 2.46% 2.62% 2.74% 2.80% 2.80% 2.80%

30Y 2.47% 2.64% 2.81% 2.99% 3.15% 3.29% 3.42% 3.54% 3.63% 3.63% 3.63%

0.0%

1.0%

2.0%

3.0%

4.0%

2014 2015 2016 2017 2018 2019 2020

Refi / Eonia

5Y Bund yield

10Y Bund yield

ECB / German rates: alternative scenario

0.0%

1.0%

2.0%

3.0%

4.0%

2014 2015 2016 2017 2018 2019 2020

Term Premium


1Y Bund yield

German rates: alternative scenario

EUR low yield scenario Main case

LT trend GDP growth 1.0% 1.50%

Inflation target 2.0% 2.00%

LT refi equilibrium rate 2.5% 3.30%

LT 10Y term premium 0.3% 0.60%

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logotype)

Theme: Central Banks exit strategies

The shadow of Milton Friedman

“The quantity of money in the United States fell by one-third in the course of the

contraction. And it fell not because there were no willing borrowers -not because

the horse would not drink. It fell because the Federal Reserve System forced or

permitted a sharp reduction in the monetary base, because it failed to exercise the

responsibilities assigned to it in the Federal Reserve Act to provide liquidity to the

banking system. The Great Contraction is tragic testimony to the power of

monetary policy -not, as Keynes and so many of his contemporaries believed,

evidence of its impotence.”

“The Role of Monetary Policy”, Milton Friedman

The American Economic Review, Vol. 58, No. 1 (March 1968), p. 3

37 Eric Chaney, Chief Economist AXA Group, Head of Research, AXA IM

Source: AXA IM Research – Manolis Davradakis

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logotype)


Central bankers heard Friedman’s call...

From March 2007 to March 2014, the BoE increased its balance sheet by 408%,

the Fed by 386%, the BoJ by 113% and the ECB by 85%


0

5

10

15

20

25

30

35

40

45

50

03

/20

07

08

/20

07

01

/20

08

06

/20

08

11

/20

08

04

/20

09

09

/20

09

02

/20

10

07

/20

10

12

/20

10

05

/20

11

10

/20

11

03

/20

12

08

/20

12

01

/20

13

06

/20

13

11

/20

13

04

/20

14

Central banks balance sheets - % of GDP

ECB

Fed

BoJ

BoE

0

5

10

15

20

25

30

35

40

45

03

/20

07

08

/20

07

01

/20

08

06

/20

08

11

/20

08

04

/20

09

09

/20

09

02

/20

10

07

/20

10

12

/20

10

05

/20

11

10

/20

11

03

/20

12

08

/20

12

01

/20

13

06

/20

13

11

/20

13

04

/20

14

Monetary base - % of GDP

ECB

Fed

BoJ

BoE

Source: Central Banks – AXA IM Research

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-100

-50

0

50

100

150

5 10 15 20 25 30

Ch

ange

in 1

0Y i

nfl

atio

n e

xpe

ctat

ion

s (s

wap

s), 2

014/

2009

Change in CB balance sheet (% of GDP), 2014/2007

JP

UK

USEUR

Source: Markit – AXA IM Research


... With some impact on inflation expectations

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Theme – Central Banks exit strategies

US Fed: targeting 2.0% inflation, or a price level path?

Sources: US Dpt of Commerce, AXA IM Research

In January 2012, the FOMC translated its mandatory price stability objective into a more concrete target,

namely, a “longer-run goal for inflation” of 2 percent*.

A possible interpretation of the commitment to achieve a 2% inflation rate in the “longer-run” is that the

Fed is actually targeting a 2%-sloped price path, instead of a mere 2% rate at any point in time

The average inflation rate observed from 1991until today has been 2.0%, supporting this interpretation

FOMC member Narayana Kocherlatova has recently expressed its interest for this option (May 2014)

(*) “The inflation rate over the longer run is primarily

determined by monetary policy, and hence the Committee

has the ability to specify a longer-run goal for inflation. The

Committee judges that inflation at the rate of 2 percent, as

measured by the annual change in the price index for

personal consumption expenditures, is most consistent over

the longer run with the Federal Reserve's statutory mandate.

Communicating this inflation goal clearly to the public helps

keep longer-term inflation expectations firmly anchored,

thereby fostering price stability and moderate long-term

interest rates and enhancing the Committee's ability to

promote maximum employment in the face of significant

economic disturbances.”

Board of Governors – Press release

January 25, 2012

-1

0

1

2

3

4

5

6

7

8

9

50

60

70

80

90

100

110

120

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

PCE price index (100 = 2009) PCE trend (1991-2013, slope: 1.97%)

PCE inflation (average: 1.98%) PCE inflation, smoothed

US Personal Consumption Expenditure Price Index(The inflation gauge targeted by the Fed)

Why this matters: if inflation stays below 2%

for a significant period of time, the Fed might

want to deliver inflation above 2% over a

significant period of time, and vice-versa.

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Theme – Central Banks exit strategies

ECB: targeting 1.99% inflation, or a price level path?

Sources: Eurostat, AXA IM Research

The primary mission of the ECB is to ‘maintain price stability: safeguarding the value of the euro’*

At the outset of the €, the interpretation of the Governing Council (GC) was ‘positive inflation below 2%’

Later on, it became ‘to maintain inflation below, but close to, 2% over the medium term’**

More recently, some members of the GC said that, practically, the target is 2.0%

Since this target is ‘over the medium term’, it is legitimate to ask whether the ECB is actually targeting a

2%-sloped price path, instead of a mere 2% rate at any point in time (see slide on the Fed)

The facts:

1/ average inflation since 1998 (creation of

the European Monetary Institute) is 2.00%

2/ the trend over the same period (2008-

2013) has a 2.08% slope

Why this matters: if inflation stays below

2% for a significant period of time, policy

makers should aim at delivering a higher

than 2% inflation rate during a significant

period of time, and vice-versa.

(*) in The Mission of the European Central Bank

ECB website

(**) Jean-Claude Trichet – Foreword to the 2011 edition of

‘The Monetary Policy of the ECB’

-2

-1

0

1

2

3

4

5

6

7

8

60

70

80

90

100

110

120

Eurozone HCPI (2005=100) HCPI trend (1998-2013, slope: 2.08%)

HCPI inflation (average: 2.00%) HCPI inflation, smoothed

Eurozone Harmonized Consumer Price Index

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logotype)


Unconventional policies raise long term risks

Risk #1: Fiscal dominance (Japan – US – UK)

Blowing up balance sheets was politically easy; deflating them won’t be. The

risk is monetary policy becoming an instrument of debt management

Among QE champions, only the BoE has alluded to sales of assets

Risk #2: Asset price detached from fundamentals (everywhere, including EMs)

If ‘low-flation’ has structural causes other than a lack of aggregate demand,

liquidity injections may inflate asset prices instead of real demand

Bubbling markets? US High Yield, €-periphery bonds, UK housing

Risk #3: Japan-isation (€-area)

In highly intermediated regions (€-area) flooding banks with liquidity may delay

restructuring and therefore keep the economy in a slow growth, very low

inflation and bond yields trap*

(*) “Zombie lending and depressed restructuring in Japan”, Ricardo Caballero, Takeo Hoshi and Anil

Kashyap, American Economic Review 2008, 98:5, 1943-1977


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Theme – Europe is not out of the woods

What to make of EU elections?

The rise of eurosceptic votes is so a large extent linked to the recessions that have hit most

euro zone countries post 2008. Yet, once this factor is controlled, not all countries are equal

Ireland

Finland

AustriaGermany

BelgiumNetherlands

Spain

France

Greece

Portugal

Italy

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

0% 10% 20% 30% 40% 50%

Ch

ange

in r

eal

GD

P p

er

cap

ita

20

13

/20

07

Percentage of eurosceptics MPs elected to European Parliament in 2014

Linear regression: Eurosceptic vote = 14.3% - 1.04*GDP loss (R2 = 0.37)

Correlation: -61%

-20% -10% 0% 10% 20%

France

NL

Austria

Greece

Italy

Germany

Ireland

Finland

Spain

Portugal

Belgium

Share of eurosceptic vote not explained by GDP

change since 2007

Sources: EU Parliament, AXA IM Research

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Theme – Europe is not out of the woods

Recessions are political bombs

Whatever the reasons for the recessions endured by several euro area countries (GDP previously

artificially inflated by a credit bubble or by unsustainable public spending, or fiscal restriction), their

amplitude is, in several countries, dramatic enough to fuel anti-euro or nationalistic political reactions.

Which countries are better off,

compared to where they stood

before EMU? We look at real

GDP per capita.

Average growth at or above

1.0% p.a. from 1998 to 2013:

* Ireland (2.01%)

* Finland (1.47%)

* Austria (1.33%)

* Germany (1.30%)

Average growth below 1.0%:

* Belgium (0.92%)

* Netherlands (0.90%)

* Spain (0.81%)

* France (0.75%)

* Greece (0.34%)

* Portugal (0.23%)

* Italy (-0.14%) Source: Eurostat, AXA IM Research

95

100

105

110

115

120

125

130

135

140

145

150

95

100

105

110

115

120

125

130

135

140

145

150

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Ireland

Finland

Germany

Belgium

Netherlands

Spain

France

Greece

Portugal

Italy

Gross domestic product per capita at constant pricesIndexed, 100=1998

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Biography

Eric Chaney

Chief Economist AXA Group

Head of Research, AXA Investment Managers

Member of the Executive Committee, AXA

Investment Managers

Eric Chaney is chief economist for the AXA Group since 2008. His mission is

to provide a vision on the most likely scenarios for the global economy in the

medium to long term, as well as an assessment of the main macroeconomic

risks, for the group and its main entities.

Within AXA Investment Managers, Eric leads the Research and Investment

Strategy team and promotes a multidisciplinary approach of Research,

directed toward quality and helping investment decision. Eric has launched the

AXA IM Symposium (Paris 2010, London 2011 and 2012, Paris 2013) which

featured prominent speakers such as Stephen Roach, Francesco Giavazzi,

Jacques de Larosière, Charles Goodhart, Sushil Wadhwani, P.O. Gourinchas,

Stephen Li Jen, Thomas Huertas, Richard Koo, Tim Tacchi, Thomas

Kirkwood.

From 2000 to 2008, Eric Chaney was Chief economist for Europe at Morgan

Stanley, which he had joined in 1995. Previously, he headed the economic

forecasting unit of the French statistical office (INSEE). Before that, he was

responsible for global forecasts and analysis at the French Treasury.

He has been associate professor at the French School of Administration

(ENA). Since 1997, Eric has been a member of the French Economic Council

of the Nation, which advises the Minister of finances. He is an independent

member of the French Tax Council since 2010. He sits on the Scientific boards

of the AXA Research Fund and of the Autorité des marchés financiers (AMF),

the French financial market watchdog.

A former professor of Mathematics and editor of a mathematical journal of the

University of Strasbourg, Eric also holds a Master’s Degree in economics and

econometrics from the Paris Graduate School of Economics, Statistics and

Finance (ENSAE ParisTech).

Eric lives in Paris, is married and has five children.

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logotype)

Glossary

Backwardation: situation whereby future commodity prices are lower than spot prices

Breakeven: expected inflation extracted from inflation-proof bonds (also called linkers)

Contango: situation whereby future commodity prices are higher than spot prices

Convertibility risk: refers to the possibility that a country member of the euro club would leave the club

Credit risk: for a bond, risk of default by the issuer (coupon or principal)

Fair value: econometric estimate of the price of an asset, given economic fundamentals. Despite its name, the ‘fair

value’ is not intrinsic, since it is model-dependent

Forward rate: expected future short term interest rate (1Y for instance) derived from the yield curve

Log (MSCI): looking at the logarithm of an economic indicator allows to see whether its growth rate is constant (straight

line), accelerating (upward curved or concave) or decelerating (downward curved or convex)

OMT: Outright Monetary Transaction, a name invented by the ECB to qualify potential purchases of government bonds

of a country having required financial help from the European Stabilisation Mechanism (ESM). Has never been used.

Risk premium: premium on top of the price of a financial asset asked by investors to compensate for uncertainties

about the future (default, liquidity condition, counterparty risk, stock market crash...)

Term (risk) premium: risk premium investors are asking to compensate for the uncertainty on future monetary policy,

given the path of short term interest rates that they anticipate. Comes on top of the geometric average of expected rates

Surprise gap: A reversal indicator extracted from business surveys (Ifo, Insee, ISM, Tankan...). As for European

surveys, computes the difference between the assessment made by companies on current production growth with the

expectations they were expressing three months earlier, on harmonised data (z-score)

Yield curve: curve showing the yields of same nature bonds of various maturities, traditionally from 3M to 10Y.

Zero coupon (yield) curve: for any bond paying annual or semi-annual coupons, it is possible to calculate the price of

an equivalent zero-coupon bond. Doing so all along the yield curve gives a fairer idea of market expectations, especially

in terms of forward rates.

Z-score: normalised time series: (x-m)/s, where x is the original variable, m its mean and s its standard deviation. The

unit is thus 1 standard deviation.

5Y in 5Y: five-year yield in five-year extracted from 10Y and 5Y yields of similar bonds (for instance zero-coupon

bonds), considering that the 10Y yield is the geometric average of 5Y and 5Y in 5Y yields. Using both nominal bonds

and inflation proof bonds, it is possible to extract 5Y in 5Y inflation expectations.


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logotype) 47 Eric Chaney, Chief Economist AXA Group, Head of Research, AXA IM 47

Recent research from AXA IM

AXA IM research documents are available on: http://www.axa-im.com/en/research

France: not yet out of the woods 17/07/2014

France has weathered the crisis better than most of its peers. But the recovery remains sluggish and feels nearly as painful as the recession.

Russia: quo vadis? 03/07/2014

The purpose of this note is to delve into the structural weaknesses of Russia and shed light on the likely future path of its economy.

Euro area equities: some margin for margins 19/06/2014

In this article, we review in turn the various costs that are critical to understanding the dynamics of marging and conclude with our expectations for European corporate margins in the next 12-18 months.

The important thing is to participate 28/05/2014

In this article, we start by exploring the broad set of labor market indicators that the Fed is looking at to evaluate the recovery in the job market.

China: continue the economic miracle 22/05/2014

We develop a 2-part report that investigates China's past growth, current problems, and future prospects.

Credit spreads tight, be selective 30/04/2014

Corporate credit fundamentals remain solid and technical supply demand imbalance remains supportive for credit in both the US and EUR IG space. However, returns are getting squeezed and, as we continue to tighten in what sometimes feels like a relentless grind to the bottom, the reality is that returns will be weaker this year than

in the past two years. Japan: one year on, still in midstream 24/04/2014

We review the effects of the "shock and awe" strategy implemented by the government since it took office and lay out our expectations for the short and medium term.

US monetary policy expectations and emerging credit growth 17/04/2014

Credit growth in Emerging Asia is more sensitive to expected changes in US monetary policy, since Emerging Asia receives the lions' share in US portfolio flows.

China: debunking the shadow banking system 03/04/2014

This note on Chinese shadow banking is designed to provide a holistic view of the sector by discussing the structural factors propelling its rise, and how the system

functions and what it contributes to China's overall financial reform.

Japanese equities and the yen - An almost 2-for 1 relationship 20/03/2014

The yen has fallen by close to 25% against the US$ since January 2013, with Japanese equities up by 60% over the same period.

Portfolio diversification and the return of leveraged loans 13/03/2014

Having essentially disappeared during the height of the sovereign crisis, leveraged loans are also making a return in Europe as investors warm to the potential return

and relative protection they offer in a world of rising rates.

US yield curve: a change on the horizon? 27/02/2014

Our view is that a bear steepening bias will come first, followed by a mild bear flattening to emerge already in the latter part of 2014

http://www.axa-im.com/en/research



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This document is used for informational purposes only and does not constitute, on AXA Investment Managers Paris part, an offer to buy or sell, solicitation or investment advice. It has been established on the basis of data, projections, forecasts, anticipations and hypothesis which are subjective. Its analysis and conclusions are the expression of an opinion, based on available data at a specific date.

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Editor : AXA INVESTMENT MANAGERS PARIS, a company incorporated under the laws of France, having its registered office located at Cœur Défense Tour B La Défense 4, 100, Esplanade du Général de Gaulle 92400 Courbevoie, registered with the Nanterre Trade and Companies Register under number 353 534 506, a Portfolio Management Company, holder of AMF approval no. GP 92-08, issued on 7 April 1992.

eric chaney's blue book, july 24, 2014

Economy & Finance

axa group head of research

chief economist axa

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