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#12 MONTHLY Cross asset investment strategy December 2016 Document fi nalised on 16 December 2016 Asset Allocation Trump-Reagan US public debt Disintermediation Private debt Monetary policies ECB QE Yuan Banks Regulation CRR /CRD IV /BRRD AWS Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 Executive summary Insights Asset Allocation: Amundi’s investment strategies What Donald Trump’s election changes... and what it doesn’t Page 4 The election of Trump does not dramatically change many of the themes of recent years but, that said, the influence of the future government on the direction of policy, particularly budgetary and fi scal policy, should not be underestimated. Although President Trump’s policy shifts will be fewer in number than what candidate Trump promised, they will be enough to change the pattern of the markets for a few months... at least. > FOCUS > Jobs Act: towards a new referendum in Italy? Risk Factors Page 10 Macroeconomic picture Page 15 Macroeconomic and financial forecasts Page 16 United States 1 Will Trump be the new Reagan? Page 17 Donald Trump is claiming, and being inspired by, Ronald Reagan’s legacy. But there is no comparison. In the early 1980s, the US economy was in stagflation. Absent the threat of recession, we should not expect a broad plan to stimulate the economy financed by a deficit. 2 5 key points to have in mind about the US public debt Page 20 Since Donald Trump won the presidency and the Republicans, a majority in Congress, the bond markets have priced in a steep rise in fiscal deficits. The issues of US debt and fiscal manoeuvring room will be key to the coming years. We focus here on several key points to have in mind about the US public debt. Europe 3 Disintermediation: a strong trend in Europe Page 24 Disintermediation has been a tangible reality in Europe for the last few years, aided by bank deleveraging and continued low interest rates. It has affected EU countries rather differently, but it is clear that investors, banks and corporate issuers are finding that their interests are converging as the trend continues. > FOCUS > Low interest rates and high cost of bank capital: a factor promoting disintermediation 2 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 Private debt 4 The many attractions of private debt markets Page 27 Beyond liquidity premiums, private debt markets make it possible to diversify credit exposure and benefit from protective credit documentation. Monetary policies 5 The ECB’s market presence will last for a long time Page 30 Very important decisions have been taken by the ECB governing council on 8 December. Many of them surprised the markets. The ECB will be present on the markets for a long time and speaking about the end of the ECB’s QE is definitely premature. These announcements are in favour of a steepening of the German yield curve. > FOCUS > What is the impact of rising political risk on financial securities? China 6 Chinese yuan: from crisis to normalisation Page 32 We believe that the Chinese yuan will be a currency stabiliser in 2017, a phenomenon that is still underestimated by the market. We also believe that the Chinese economy will stabilise in 2017, which is already partially priced in. We think that expectations for depreciation of the Chinese yuan have finally normalised away from crisis status. Banks 7 Banks: European Commission’s CRR/CRD IV and BRRD amendment proposal Page 35 The European Commission’s proposal to amend the banking regulatory framework is positive for the European Union’s banking sector. This is because it clarifies and sometimes eases regulation on aspects which were until now problematic from a credit standpoint. Sectorial highlight 8 AWS... The hidden face of Amazon Page 39 The world of IT infrastructure is currently experiencing an unprecedented revolution. The cloud-based infrastructure services (IaaS) offering enables companies to access enormous processing and storage capacity without the need to have their own server park and reduces to a minimum the time devoted to managing their IT infrastructure. Amazon is the champion of this transformation with its AWS offering. Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 3 # 12 December 2016 Finalised at December 1st 2016 Asset allocation: Amundi investment strategies What Donald Trump’s election changes... and what it doesn’t PHILIPPE ITHURBIDE, Global Head of Research, Strategy and Analysis The election of Donald Trump as President of the United States undoubtedly represents a major shift at the policy and diplomacy levels (the United States will certainly be less determined going forward by a logic of “the world’s police”, and more self-centred, if we are to believe the statements of Donald Trump) and on a purely economic level. The issue is whether economic policy will be sharply different, particularly fiscal and tax policies. We know that tax cuts and a revival of infrastructure spending are planned, and that the impact on the budget deficit can be very high, with the usual consequences on long rates, public debt… and monetary policy. Among other areas of uncertainty is the temptation of protectionism: we know that candidate Trump “promised” to impose prohibitive customs duties and renegotiate commercial treaties. We also know that the US Congress (even with a Republican majority) will not back the new President in these areas: it is certainly not enthusiastic about large budget deficits and is fairly pro-free trade. Having said that, even if the changes remain moderate compared to what was said on the campaign trail, not betting on substantial change would undoubtedly be a mistake. What will be the overall impact on long-term rates and on the equity markets? So many crucial questions remain unanswered in an environment which, since the financial crisis, has combined low interest rates, deleveraging and budget austerity. The victory of Donald Trump brings uncertainty on many points, and the risk of a major shift in economic policy, leading to a widening of deficits, is not marginal at this stage. However, we will have to wait at least a couple of months before getting answers to any of these questions (inauguration on 20 January, then negotiations with Congress). After reviewing what is not going to change with Trump’s election, we will run through a few major aspects of this shock of uncertainty. What people fear but what will likely never happen A wave of intimidating protectionism The US imports nearly USD 500 billion in goods per year from China, and nearly USD 300 billion from Mexico, which makes up about 35% of total goods imported, excluding petroleum products. Adopting a 45% tariff on Chinese imports and 35% on Mexican imports would increase the prices on all imported merchandise by about 15%. This increases all US consumer prices by nearly 3%, 18 months after the customs duty hike, in the Moody’s Analytics model. However, it is unlikely that such exorbitant tariffs would be levied on Chinese and Mexican imports to the United States. In fact, US lawmakers are allayed: 1) by China’s continued efforts to liberalise its currency, a process that began last summer, and 2) by the progress achieved in reducing illegal immigration at the Mexican border. China and Mexico would not enact any reprisals toward American products or services. Note that import duties could be extremely counter-productive: China may not be able to contain the depreciation of the yuan, with the consequences we can well imagine: an increase in volatility, the risk of a sudden and massive devaluation, a risk to financial stability, a sharp appreciation of the dollar… Donald Trump is not seeking any of this… quite the opposite. A sweeping anti-immigration plan The initial desire to send back more than 11 million undocumented immigrants to their country of origin is also unrealistic because they represent no less than 3.5% of the population and 5% of the labour force. All else being equal, doing so would also reduce the potential growth of the United States, which is not the intended goal. The essential The issue is whether US economic policy will be sharply different, particularly fiscal and tax policies. We know that tax cuts and a revival of infrastructure spending are planned, and that the impact on the budget deficit can be very high, with the usual consequences on long rates, public debt... and monetary policy. Among other areas of uncertainty is the temptation of protectionism. US Congress will not unconditionally back the new president on these subjects: it is certainly not enthusiastic about large budget deficits and is fairly pro-free trade. Having said that, even if the changes remain moderate compared to what was said on the campaign trail, not betting on substantial change would undoubtedly be a mistake. The victory of Donald Trump brings uncertainty on many points, and risk of a major shift in economic policy, leading to a widening of deficits, is not marginal at this stage. However, we will have to wait more than two months before getting answers to any of these questions (inauguration on 20 January, then discussions with Congress). In this article, we will review what will not change with Trump’s election and the elements of uncertainty in key areas, such as the impact on bond yields, the emerging markets and monetary policy. Having said that, even if the changes remain moderate compared to what was said on the campaign trail, not betting on substantial change would undoubtedly be a mistake The Trump roadmap has already been redrawn and the flow of immigrants will undoubtedly resume the pace observed during the Great Recession (500,000 per year). 4 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 A sharp deterioration in government deficits and national debt Inflationary pressures and the increased money supply that go along with a strong fiscal stimulus plan and tax cuts would (per standard model simulations) cause an abrupt rise in short- and long-term interest rates. A few simulations (such as Moody’s) show that candidate Trump’s programme could cause 10-year interest rates to rise by 200bp the first year and 460bp the second. Such a drastic change in interest rates seems very unlikely to us in the current economic climate for at least three reasons: Import duties could be extremely counter-productive for the US economy • First, because the output gap is still in negative territory according to the CBO’s estimates (which helps explain the weakness of current inflationary pressures); • Second, because the first signs of weakening aggregate demand appeared in 2016, calling a cycle downswing back to centre stage (investments and profits), with consumer demand as the sole driver of economic activity; • Lastly, because the programme will never be implemented. Congress is not hostile to tax cuts and fiscal reform, or to savings in non-military spending, but it is generally firm in its opposition to larger deficits. In other words, Congress will make counter-proposals to Donald Trump resulting in a more neutral impact on public finances. As a result, two-thirds of the tax cuts could be left on the floor (and more focused on the lowest income brackets), and the corporate income tax cuts could be smaller. What Trump’s election does not change If our predictions materialise (rejection of protectionism, no sweeping plan to send immigrants back to their countries of origin, no sharp deterioration in government deficits and the national debt), the inauguration of Donald Trump on 20 January will not change many of key factors that currently characterise the international business cycle and the financial markets. For example: • World growth is expected to remain above 3%, as has been the case for more than five years; • World trade is no longer a driver of global growth. Its decline is mainly due to the general reduction in investment and falling growth potential; • Investment too is in decline, both in the advanced countries and in many emerging countries; Congress will certainly make a few counter-proposals to Donald Trump, which will translate into a more neutral impact on public finances • Consumer spending is the main growth driver almost everywhere; • Budgetary and fiscal policies are now more expansionary, including in Europe (election year, phase-out of austerity measures, etc.); • The European political situation is complicated: several elections will take place in 2017 (including in Germany and in France) that may result in a change in leadership; • The ECB and the BoJ are going to continue their quantitative easing programmes; • Monetary policies remain accommodating overall. We note that in 2016, eight of the G10 countries furthered monetary easing; • Inflation is not a problem yet: of the world’s 120 principal countries, more than 80% have inflation below the targets established by their central bank, and in more than 15% of these cases, inflation is negative. Never since the financial crisis has this percentage been so high; • Fears of secular stagnation have not dissipated with the election of Donald Trump: demographics, productivity gains, and the debt burden are primarily the main reasons for these fears; • The Federal Reserve continues to maintain an attitude of extreme caution: even though the rate of inflation is close to its target, the conditions of growth, financial stability and the strength of the dollar are preventing it from implementing a fullblown cycle of monetary tightening on par with that of 2004-2006: during the last round of monetary tightening, the Fed raised the fed funds rate 17 times in three years (in 17 FOMC meetings). We are nowhere near this in the current pseudo tightening cycle; Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 5 # 12 December 2016 • Well before a programme addressing immigration in the United States was sketched out, there was lively debate on this issue in several countries, including some in Europe (immigrants, refugees, etc.). This is all the more important especially since many elections are set to take place and that this will inevitably be a hot campaign topic, including in France and in Germany; • The rise in populism (right-wing in core European countries and left-wing in the peripheral countries) is nothing new. There is no doubt, however, that Brexit and the election of Donald Trump have encouraged voters to cast aside their inhibitions on these matters. • We already know that the negotiations on the UK’s exit from the EU (Brexit) will be difficult and that they will spur European government to action; cohesion among Member States must be strengthened. Meanwhile, the United Kingdom may not be able to secure guarantees allowing it to access the Single Market (goods and services), pursue an independent immigration policy and an independent trade policy and no longer contribute to the European budget; • Despite fears of protectionism and higher interest rates in the United States, the improvement in the fundamentals of the emerging countries is patently obvious: Brazil and Russia are gradually climbing out of recession and China is efficiently stabilising its growth… • Last, the mismatch in the bond markets (the potential for lower yields is not as great as the potential for higher yields) was already a reality well before the election of Donald Trump. In terms of forecasting, many comfort zones did not vanish with the election of Donald Trump That being said, a few unknowns remain, such as Trump’s relationship with the Fed, the reaction of long rates and the reaction of the emerging markets. Three big questions remain unanswered Trump: for a hawkish or dovish Fed? It is surprising to see Trump complain about the Fed (which has not, he says, raised key interest rates enough), even though only intervention by the central bank could guarantee the “painless financing” of the measures he proposes. Furthermore, one can wonder whether Donald Trump would again be inclined to do an about-face once in office. Model simulations show that Trump’s policy would not be sustainable without the Fed’s support, i.e. without monetising the debt. How can you simultaneously expect higher growth, a weaker dollar and tighter monetary policy? This is all the more true given that, in half of cases (6 out of the last 12 times), since 1945, monetary tightening cycles have been followed by a US economic recession within two years. This is undoubtedly what the market is fearing in the event that the Fed moves too quickly and, in particular, too strongly. For the moment, the Fed is doing all it can to keep the dollar from appreciating (the Fed’s own models show that a 10% increase in the dollar’s real trade-weighted exchange rate is equivalent to 175bp in monetary tightening) and it is undoubtedly sensitive to rising long rates. Admittedly, the Fed is going to raise its rates, but it will remain moderate as it does so… just as it has done so far…. and that would definitely suit President Trump. The Fed will remain moderate as it raises rates, just as it has done so far... and that would definitely suit President Trump An unavoidable rise in long rates? In recent years, many have believed that the resumption of growth in the advanced countries, with the United States in the lead was, with the rise in price indices, a good reason to anticipate a rise in long rates. But that is underestimating key factors such as – the fear of – secular stagnation, the role and impact of QE, budget constraints in Europe (austerity), protracted deflationary pressures… The increase in long-term rates can come from five main sources: (i) a significant upturn in growth prospects, (ii) a reversal in interest rate policies, (iii) a complete taper of QE (not rolling over maturing bonds resulting in a rapid reduction in the Fed’s balance sheet), (iv) a resurgence in inflation, and/or (v) a reversal of budgetary and fiscal policies. In the case of the United States, the first will materialise at least in the short term, the next two sources are not really relevant, the fourth is not yet a concern (but a base effect is going to drive up price indexes in the coming months). Only the fifth is gaining momentum in the United States… and it will undoubtedly impact the first four. But be aware: sensitivity to long-term rates has increased with 6 Any rise in long-term rates is a hindrance to monetary policy and to the potential for higher interest rates Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 corporate releveraging (at a record high). It should also be noted that any rise in long-term rates is a hindrance to monetary policy and to the potential for higher interest rates. In order for it to be long-lasting, medium-term growth must increase. Nothing could be less certain at this stage. A lasting handicap for the emerging markets? The election of Donald Trump to the presidency of the United States is not extraneous to the downturn in the emerging markets. It must be said that the reading of his campaign platform had nothing to make these markets jump for joy: prohibitive tariffs, a very significant and negative effect on world trade, and a significant and negative impact on the US debt, public deficits and global growth. For emerging markets, two distinct scenarios can be distinguished: - Either the new US government causes deficits and recession, which will be extremely damaging for risk aversion, volatility and risky assets such as emerging country assets. - Or the new government is able to boost growth expectations, which will go hand in hand with a resurgence of some inflation expectations and a rise in long rates and fed fund rates. At first mixed for the emerging countries, this scenario of stronger growth should be favourable to them, and technical factors, fundamental factors and valuation aspects will return to the foreground. This is our central scenario. A simple reading of Donald Trump’s campaign platform had nothing to make emerging markets jump for joy Budgetary and fiscal policies: do not underestimate the magnitude of the future policy shifts in the United States Conclusion and consequences for asset allocation: Trump, Italy, Austria and other risk factors All in all, the election of Trump does not dramatically change many of the themes prevailing over the last few years but, that said, the influence of the future government on the direction of budgetary and fiscal policies should not be underestimated. Although President Trump’s policy shifts will be fewer in number than what candidate Trump promised, they will be enough to change the pattern of the markets for a few months… at least. This has already begun: the pick-up in long rates (less than 30% of the credit market is in negative territory compared to 50% just two months ago), the prospects for monetary policy tightening by the Fed and a steeper yield curve are just a few of the many reasons that make financials more attractive now than they were before. Note that for the first time in eight years, the Fed may well do what its own forecasts indicated it should do: three rate hikes in a little more than a year. However, it must be recognised that this can be done because it has considerably revised its own rate forecasts to the downside (dot plots) Regarding the fi xed income markets, the inauguration of Donald Trump is not the only uncertainty. European elections –the recent referendum in Italy as well as the Austrian presidential elections– have already prompted us to lower the risk budget in our portfolios, especially for eurozone peripheral countries (see Risk factors p. 10). We are maintaining this approach. We also forged ahead with reducing the overweighting of debt issues and the current configuration should gradually become more favourable for inflation-linked bonds and for financials. As to emerging debt: we are staying the course and maintaining our preference for dollar-denominated debt. We also favour US corporate bonds over their European counterparts. Turning to equities, we continue to prefer the US markets (growth repricing, domestic issues) a bit more than the European markets (currently unfavourable political backdrop) or emerging markets (the debate surrounding customs tariffs, higher rates, etc. does not totally offset the positive effect of the most recent OPEC meeting). As to sectors, in Europe we are overweight on pharma and energy stocks, with special emphasis on industrial stocks. We remain underweight on the automotive sector. We become a little bit more constructive on financial stocks. Regarding the forex market, we are maintaining our long position on the dollar, particularly relative to the euro, and our caution in the short term about emerging currencies. The GBP is expected to regain some colour in the short term but this trend is not sustainable due to the uncertainties linked to Brexit. Bonds: the political situation in Europe had already prompted us to lower the risk budget in our portfolios, especially for eurozone peripheral countries. We are maintaining this approach Equities: prefer US vs. Europe and emerging markets Forex: maintain a long position on the USD Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 7 # 12 December 2016 > Jobs Act: towards a new referendum in Italy? The largest Italian union (Confederazione Generale Italiana del Lavoro, CGIL) has collected enough signatures (more than 3 million) to call for a referendum to abolish global labor market reforms. These were introduced in 2014 by the Renzi Government (Jobs Act). The union wishes by referendum to restore the impossibility for the companies to dismiss the employees. If the idea is clear, the process is not that simple. Let us recall that there are two types of referendum in Italy: • “Confirmatory” referendums, which are intended to validate constitutional changes and do not require a quorum. However, they require the approval of at least two-thirds of the members of Parliament who voted; • “Abrogative” referendums requiring 500,000 signatures. The referendum on the Jobs Act would be an abrogative referendum. Before starting the procedure, however, there are 4 important prerequisites: • Prerequisite # 1: First of all, the Italian Constitutional Court must rule on the validity of the application. An abrogative referendum cannot relate to a Treaty (for example, a European Treaty) or to tax aspects (repeal of a tax law, for example). The Court will give reply on 11 January. If it validates the request, the referendum should take place between 15 April and 15 June. • Prerequisite # 2: This referendum can be held effectively ... unless there is an announcement of early elections. These would become priorities. • Prerequisite # 3: This referendum will also lapse if Parliament changes some elements of the current Jobs Act. In other words, if the new government wants to avoid a referendum, it simply needs to amend, even partially, the current Jobs Act. • Prerequisite # 4: An abrogative referendum requires a quorum of 50%. If less than 50% of voters mobilize, then the result of the referendum would be invalidated. It should be remembered that of the last eight referendums repealing, seven failed to obtain the necessary quorum of 50%. The strong participation in the last referendum (68.5%) nevertheless suggests that the outcome of a referendum on the Jobs Act would be likely to be validated. All in all, in the current context, it seems reasonable to consider that the 4 conditions mentioned above will not be met, and that there will be no referendum on Mr. Renzi’s “Jobs Act”. Building on changes in the Jobs Act seems credible to us. > Macro Hedging Strategies one-month change 0 Long US Treasuries Long Bunds Long USD Long JPY Long volatility Long cash USD The US elections have delivered their verdict. The election of Donald Trump is a real shock of uncertainty for economic policy, and fiscal and budgetary policy in particular. Repricing of economic growth goes hand-in-hand with a rise in (short and long) rates and an appreciation of the dollar. The post-Brexit stress fell, but we know that the UK is expected to trigger Article 50 before the end of March 2017. The forthcoming negotiations are sure to be difficult and will begin against an increasingly delicate European political backdrop (elections in several countries, including France and Germany). The ECB’s decision to continue, amend or stop its QE will be of paramount importance. Long Gold As such, we are maintaining some macro-hedging strategies (see table). Long US TIPS + ++ +++ The table above represents a short investment horizon of one to three months. The changes (column 2) reflect the outlooks expressed at our most recent investment committee meeting. The lines express our aversion to risk and our macro-hedging strategies. They should be viewed in relation to the asset allocation tables. A negative outlook in terms of asset allocation will not lead to hedging. A temporarily negative outlook (negative in the short term but positive in the medium term) may lead us to protect the portfolio, without affecting our long-term outlooks. The application of the strategy is expressed by a position (+), and the scale of the position is expressed by a graded scale (+/++/+++). These strategies are independent of the constraints and considerations concerning the construction of the initial portfolio subject to protection. These are overlay positions. 8 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 Asset allocation: multi-class outlooks and convictions 1 month-change ---0 + ++ +++ Equities/gov. bonds Corp. bonds/gov. bonds Equities/corp. bonds Duration Corporate bonds Oil Gold Cash EUR Cash USD The table above represents an investment horizon of six to 12 months. The changes (column 2) reflect the outlooks expressed at our most recent investment committee meeting. The lines express our multi-asset class outlook for a 6/12 month horizon. The outlooks, ch anges in outlooks and opinions on the asset classes reflect the expected direction (+/-) and the strength of the convictions (+/++/+++); they are independent of the constraints and considerations that concern the construction of portfolios. Asset allocation: relative outlooks and convictions by major asset class 1 month-change ---0 + ++ +++ US equities Japanese equities Euro equities UK equities Pacifi c excl. Japan EMG equities Gov. Bonds US bonds, short US bonds, long Euro core, short Euro core, long Euro peripherals UK bonds Japanese bonds Corp. Bonds US IG US HY EURO IG Euro HY EMG debt hard currencies EMG local debt FX USD EUR JPY GBP The table above represents an investment horizon of six to 12 months. The changes refl ect the outlooks expressed at our most re cent investment committee meeting. The different lines provide relative outlooks for each major asset class and absolute outlooks for forex and commodities. The outlooks, changes in outlooks and opinions on the asset classes refl ect the expected direction (+/-) and the strength of the convictions (+/++/+++). They are independent of the constraints and considerations concerning the construction of portfolios. Equities Portfolio type > Equity portfolios > Bond portfolios > Diversifi ed portfolios • Preference for US vs. Eurozone equities • US Sectors: - Overweight cyclicals, financials, small and mid caps, domestic plays - Underweight global trade plays • Emerging markets: globally cautious. Within EMG countries: - Overweight India, Thailand, Peru, Philippines, Russia - Neutral on Indonesia, Brazil, Turkey, South Africa - Underweight China, Taiwan, Greece, Malaysia, Korea • Long positions in EMG currencies drastically revised down • Underweight US govies • Overweight position in Euro credit reduced; overweight position in US credit increased • Short duration on US, GBP and JPY - Duration: globally neutral to short, with a short bias on negatively yielding segments • Emerging debt: - Still prefer hard currencies debt (long USD), but positions drastically reduced - Risk on local debt drastically reduced • Slightly long in GBP vs. EUR (tactical play) • Long USD vs. EUR • A few long positions in EMG commodity currencies • Global risk reduced • Portfolios globally neutral equities • Long positions reduced on Eurozone and increased on US equities • Globally neutral on Japanese equities • Stay overweight EMG equities • Keep overweight position on sovereign bonds of peripheral Eurozone countries (excl. Italy) vs. core (close to fair value, though) • Long US govies positions (carry + macrohedging purposes) drastically reduced • Corporate bonds: positive on HY and on IG • A few positions in EMG currencies, EMG debt and EMG equities Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 9 # 12 December 2016 Risk Factors PHILIPPE ITHURBIDE, Global Head of Research, Strategy and Analysis The table below presents 16 risk factors with probabilities assigned. It also develops the most credible market impacts. [RISK # 1] The perception of a significant change in the US policy-mix [PROBABILITY] 60% ANALYSIS The US elections resulted in a victory for D. Trump, who will be the 45th President of the United States. This election undoubtedly represents a great change in the philosophy of America, less determined now by a logic of «world policeman» and more self-centred, according to D. Trump’s statements. Beyond this major infl ection, the question is also now whether economic policy will be strongly altered, notably through fiscal and tax policy. How will monetary policy accompany these changes? These are all crucial questions. We know that tax cuts and a revival of infrastructure spending are planned, and that the impact on the budget deficit can be very high, with the usual consequences on long rates, public debt... and monetary policy. We also know that the American Congress (even if it is a Republican one) will not unconditionally back the new president on these subjects: it is indeed not favourable to large budget deficits. Having said that, even if the changes remain moderate with regard to the campaign promises, not betting on significant changes would undoubtedly be a mistake. MARKET IMPACT The victory of D. Trump brings uncertainty on many points: its international role, NATO, trade agreements, climate agreement, anti-migrant policy, trade policy, protectionism and possible tariffs ... Its future actions represent an additional risk for the financial markets (notably on the dollar, ambient volatility and long rates). The risk of a major shift in economic policy, leading to a widening of deficits, is not marginal at this stage, especially since it will take more than two months before These questions (taking office on 20 January, and then discussions with the Congress). [RISK # 2] Italy: a referendum on «Italexit», the next step? [PROBABILITY] 15% ANALYSIS Not surprisingly, the Italian referendum led to the resignation of Matteo Renzi. The appointment of a technical government (headed by Paolo Gentiloni) and the extension of the ECB’s asset purchasing program have reassured the Italian financial markets, but it is now a matter of reviewing the electoral law as the general elections take shape. Initially planned for February 2018, the financial markets fear on the one hand the holding of early elections which would lead to the taking of power of the party «populist» Five Stars, and on the other hand the holding of a referendum on the participation to the European Union (“Italexit”). The rise of populism (which is synonymous with rejection of the establishment, rejection of traditional parties, rise of protectionism, rejection of globalization, anger against rising inequalities, refusal of centralization, hostility to reforms of social systems, etc.) is also a reality in Italy. This would represent a major change after 5 years of political stability. This would undoubtedly be the worst case scenario, which could initially lead to political instability / crisis and undoubtedly lead to a period of stopping for reforms. Let us recall, however, that the five-star party is more an anti-establishment party than an anti-European party, but that the Italian people are among the countries of Europe the least enthusiastic about the euro. That is to say that a referendum on Europe, if it were to take place, carries lots of uncertainties. MARKET IMPACT The prospect of early elections - if that were to take place - would trigger a phase of political instability. This is bad news for this country, which is lagging behind in terms of economic growth (especially in comparison with Spain, its «comparable» market). Its debt is nevertheless protected by the ECB, which has just confirmed the extension of its QE, which makes it possible to attract investors (seeking yield and spread). In the event of a referendum on Italexit, the Italian bond market would represent a specific risk, and interest rate spreads would further deteriorate due to a «repricing» of the Italian risk. Political instability would also weaken - strongly - its equity and interest rate markets. [RISK #3] Misinterpretation of the Fed’s intentions... or misjudgement by the Fed [PROBABILITY] 30% ANALYSIS The election of D. Trump blurs the messages a little: it is doubtful that the new president confirms J. Yellen for a second term in 2018, and it is also known that he criticized the “complacency” of monetary policy. It is difficult to understand the message: how to have at the same time stronger growth, a weaker dollar and a more restrictive monetary policy? A misinterpretation of the intentions / decisions of the Fed was already a major risk factor. Since the elections, the situation has gotten worse. With GDP growth of around 2%, inflation close to 2% and a full-employment situation, the Fed funds rate should be, in a normal cycle, much higher than it is today. The Fed is technically «behind the curve». But this is all the more true given that, in half of cases (six out of the last 12 times), since 1945, monetary tightening cycles have been followed by a US economic recession within two years. This is undoubtedly what the market is fearing in the event that the Fed moves too quickly and, in particular, too strongly. For the moment, the Fed remains cautious. It is well aware that growth levels and the current cycle have not up until now warranted a significant increase in rates, and, that the reversal of an ultra-accommodating monetary policy that has been in place for eight years carries more importance than usual. In the Fed’s case, it is looking to keep the dollar from appreciating (the Fed’s models show that a 10% appreciation in the real effective dollar is equivalent to 175 bp in monetary tightening). Inflation indicators are now close to the Fed’s target, and the US central bank (J. Yellen and S. Fisher) has for several months prepared the markets for monetary tightening, by the end of the year. This may happen, but beware: Over the last 10 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 Risk Factors few weeks, long-term rates have risen again, and since the election of D. Trump, expectations of rate hikes have been postponed. The Fed must avoid any communication errors. Markets could react poorly if rates are increased prematurely, excessively or without a sound rationale, or in case of an important surprise. MARKET IMPACT If the Fed fumbles, we will have to count on a sharp downturn in equities and on contagion into the emerging markets, which have already been weakened. Such a situation would widen spreads and rates between Europe and the US, and further weakening the euro, two arguments in favour of European risky assets. [RISK # 4] A «hard landing» for China / the credit bubble bursts [PROBABILITY] 20% ANALYSIS China’s business model has changed in the past decade. Growth is not as export-led as it used to be, and domestic demand has become the key driver for growth. Such an evolution has some drawbacks: there are signs of excessive lending, debt is ballooning, industrial competitiveness has eroded and productivity gains are falling. In simple terms, potential growth is down. The question is not whether future and potential growth will be lower. That is already a given. Rather, it is whether growth risks falling sharply (and far) below its potential (5% at present vs. 10% 15 years ago). In other words, will China experience a large-scale economic crisis? A more severe contraction of Chinese growth would add to an already long list of global deflationary pressures. The most recent indicators have reduced this risk, with annualised GDP growth stabilising around 6.7% for the last three quarters. The introduction of 45% tariffs (as D. Trump promised during the campaign) would be conducive to the initiation of this negative spiral, but we do not believe at all in the adoption of a such a measure. MARKET IMPACT Such a scenario would have a very negative impact, and its cascading effects would be especially disastrous: vulnerability in the banking systems, vulnerability in the financial system, vulnerability from China’s public and private debt, impact on commodities and emerging countries, impact on the currencies of commodity-exporting countries, advanced countries, and emerging countries… The Fed would cut its «tightening cycle» short, and the ECB would pursue its QE. [RISK # 5] Collapse of global growth [PROBABILITY] 15% ANALYSIS A hard landing by the Chinese economy would mean a plunge in global growth, but other circumstances are possible. The continued decline in commodity prices and global trade, an excessively restrictive US monetary policy, and the structural weakness of European economic activity are all stirring fears of a decline in global growth. Until now, the slowdown in the emerging world has been a tangible reality, while the «advanced» world has been moving forward for four years now. Another slowdown in the “advanced world” could come from the secondary effect of the EMG countries (drop in exports), another dip in investment, jobs… in short, from domestic demand, at present the key driver for growth. MARKET IMPACT Putting aside the use of expansionist economic policies (especially the fi scal policy), we may fear the return of a currency war, among the emerging countries on the one hand, and between the advanced and the emerging world on the other. Expect a dramatic underperformance by risky assets, equities, and credit. [RISK # 6] A recession in the United States [PROBABILITY] 20% ANALYSIS We expect growth of 2% in 2017 (vs. 1.6% in 2016), followed by a slight acceleration in 2018 (2.2%). Growth is therefore likely to remain slightly above its potential over the next two years. At this juncture, a recession in the United States is not a possibility, but the Fed’s lack of room to manoeuvre is worrying. The current situation is totally different from 2004-2006. Over those two years, the Fed managed to hike interest rates 17 times—a total of 400 basis points—giving itself leeway, which it was quick to use once the financial crisis hit. Today that context is very remote. The Fed is behind in its economic cycle and financial stability, and to a lesser degree the US dollar, cannot afford such interest rate hikes. What is also worrying is the uncertainty about the future economic policy. The analysis and quantification of D. Trump’s campaign program leads to the anticipation of a recession: protectionism (and impact on Mexico and China in particular), anti-migrant plan (with a reduction in the labor force and the population, as well as an increase in the cost of labour), renegotiation of commercial treaties, etc. While this program is unlikely to be adopted as it stands, the uncertainty that is opening up is not favourable to the short term growth. MARKET IMPACT A recession in the United States would be catastrophic for the global economy, and Europe, despite being in better health, would not be spared the impact. Short rates would remain low for a very long time and the Fed, with no leeway in terms of conventional monetary policy, would have no choice but to go ahead with QE4. Do not expect a positive impact on risky assets. The initial impact will be negative, and the lack of credibility of central banks would certainly add volatility and stress. Expect further, and substantial, budget imbalances. [RISK # 7] Sharp devaluation of the yuan [PROBABILITY] 10% ANALYSIS For a few days in the middle of August 2015, China gave the impression that it was abandoning its exchange rate policy, Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 11 # 12 December 2016 Risk Factors preparing the markets for a major depreciation of the yuan (in 1994, it devalued the yuan by 30%). These same fears reared their heads again in early January. Until now, China has used monetary policy, budgetary policy, fiscal policy, and revenue policy as stimulus tools, careful not to use the exchange rate policy. Moreover, it promised the G20 it would not, and the yuan is now part of the SDR (and has been since 1 October). In 2016, China amended its foreign exchange system, and it is managing a gradual depreciation of the yuan. The implementation of a protectionist policy in the United States would be fatal, the Chinese authorities would be incapable and unwilling to pursue this FX policy, especially since the yuan is not notably undervalued. Beyond the very negative immediate consequences on the financial markets, an abrupt devaluation (of at least 10% in one day) would, without a doubt, be interpreted as an admission of weakness in terms of the economic policy as a whole. A very low risk, but with potentially very great harm, because China’s top challenge now is opening its capital account: attracting international investors means accepting a less-independent monetary policy, a more volatile exchange rate, different rules between the onshore market and the offshore market, more volatile capital flows, less easily administrated markets that are more dependent on international investors, greater transparency on the state of businesses, and, specifically, State-owned businesses… in short, a fairly radical change in governance. A strong devaluation of the yuan would be a very bad decision. MARKET IMPACT In this type of scenario, expect a widespread downward movement in the markets. A surprise devaluation would be the start of a more intense currency war, especially in Asia. Monetary policies would become extremely accommodating to keep currencies from appreciating. A blow to the euro, and to the European economy, because EMG currencies make up more than 70% of its effective rate. [RISK # 8] Continued slowdown in the emerging economies (commodity prices fall again) [PROBABILITY] 20% ANALYSIS Falling commodity prices, the dip in Chinese growth, and the coming shift in US monetary policy are all factors that, over recent years, have raised fears of a repeat of the 1997-1998 crisis (when emerging markets collapsed across-the-board). We should remember that emerging markets have been under stress since the US ended its QE programmes. Asia had been able to withstand that stress, driven by the strength of the Chinese economy and its ability to curb difficulties, and because it is essentially a commodity-consuming zone. Corporate defaults and leading activity indicators have occasionally put the markets on high alert, but the resources brought to bear by Chinese officials (cuts in interest rates and in mandatory banking reserves, injection of liquidities, fiscal and tax measures, maintaining currency policy, etc.) ultimately put everything right. The risk is that domestic demand will unravel and economic policies will become completely ineffective. This risk has nevertheless declined during recent months: the rise in oil prices (increased cohesion at OPEC) and the influx of capital (except for China) have, in particular, given these markets fresh colour. MARKET IMPACT Even though the drop in oil prices is, and has been, a plus for commodity-consuming advanced countries, it is hard to believe that these countries would be totally isolated. With the decline in commodity prices, we should count on the continued decline in EMG currencies as well as capital flows out of the EMG. Choose asset classes from the advanced countries, and safe havens. [R ISK # 9] The post-Brexit issue weakens the United Kingdom in a lasting way [PROBABILITY] 50% ANALYSIS “Brexit means Brexit, and we’re going to make a success of it”. Such was Theresa May’s position on the day she was appointed Prime Minister. «There will be [...] no second referendum,» she added. «There must be no attempts to remain inside the EU, no attempts to re-join it through the back door, and no second referendum. The country voted to leave the European Union, and it is the duty of the Government and of Parliament to make sure we do just that.» We now know a little more: the Prime Minister has announced that Article 50 will be triggered in the first quarter of 2017. According to estimates, the impact on the GDP would be significantly negative. The UK could “lose” between 2.5% and 9.5% of its GDP. Trade volume and costs would be affected, specifically in financial services, chemicals, and automobiles, all sectors that are highly integrated in the EU. The risk for the UK resides in its future capacity to trade freely on the single market, to acquire the desired independence without the EU’s constraints. It seems unlikely, and in any case that is what is at stake in the negotiations that will begin no later than the second quarter of 2017... and that could last two years (to find out more, read our report, «Post-BREXIT in a few questions and answers», Cross Asset Investment Monthly Strategy, Amundi, July 2016). Let’s be clear (fair) though: it is currently very difficult to say what will happen and even to be sure that the Brexit will really happen. The lack of any contingency plan in the UK, the lack of negotiations between the UK and the EU countries (pending the activation of Article 50), and the nature of the debate (which opposes pragmatists to ideologists of the Brexit) make the situation rather confused. Do not rule out holding a new referendum in one year. MARKET IMPACT In such a case, we would expect additional weakening of the pound sterling and long-term GDP of the British economy, two factors that could prolong the monetary status quo. Without a doubt, we would also see increased fragility in eurozone financial assets. [R ISK # 10] A new European crisis tied to Brexit [PROBABILITY] 20% ANALYSIS Brexit is unlikely to impact the EU too much, from a purely economic standpoint. Hardest hit would be those with close ties to the UK, especially Ireland, but also Luxembourg, Belgium, Sweden, Malta, and Cyprus, if we look at the nature of exports, 12 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 Risk Factors direct investment flows, and the financial sector. The risk is primarily a political one: that other European countries might extol a Europe “à la carte,” and/or demonstrate deep divisions in terms of how to handle the UK’s exit. The European institutions are regularly showing their limits because the “dogma of convergence” did not prepare them for such risk scenarios. The task was to respond to challenges like Europe’s governance deficit, the lack of coordination in budgetary policies, the failure of supervision of budgetary imbalances, competitiveness gaps between countries, the unfinished nature of the mechanism meant to support countries facing difficulty and the failure to appreciate the interdependence of member states (while the ECB’s anti-contagion mechanism has evolved significantly, the same cannot be said on the budgetary front). The recent UK referendum has added a new layer of uncertainty. Managing the UK’s exit from the EU is akin to managing the most complex divorce in history. One thing is sure: this is an important test of Europe’s capacity to (once again) manage a crisis, convince Europe that there is a plan for it, and remove any attempts at a Europe “à la carte” that could pop up here or there in the EU. A new European crisis, if it were to occur, could be fatal, unless there is a (highly unlikely) great leap towards federalism. Note that negotiations with the UK will come right in the middle of an election year in France and Germany, which is most certainly not an ideal political configuration. It will be necessary to reconcile the Europeans with the European idea, and in particular to reassure the Eurosceptics. It will not be easy. Before the Brexit and before the US elections, the European situation was already complicated. MARKET IMPACT The negative impacts are all too well known: widening of sovereign and credit spreads, rise of volatility—only this time it would certainly be accompanied by a severe weakening of the Euro. A new European crisis could very well confirm the scenarios of the zone breaking apart, or, at the very least, the weaker countries exiting it… unless the exit scenario tempts the most solid of them, which is highly plausible, because they will end up becoming tired – from a political standpoint – of economically and financially supporting the struggling countries. [R ISK # 11] Greater financial instability [PROBABILITY] 40% ANALYSIS Action by central banks has enabled fi nancial stability to return. Lower short- and long-term rates, reduced volatility and tighter credit spreads are all factors that have generated an environment of greater stability. However, beware. This stability has a contrived aspect that should not be underestimated. Central banks cannot resolve all of the problems by themselves (jobs, investment, growth, etc.) and, if the current conditions do not improve more significantly, a certain level of disillusion/disappointment may well set in, which could in turn become a source of instability. Moreover, monetary policies have reached their limits, both negative rates and QEs, and it is quite difficult to expect any more from them. The macroeconomic response would eventually come from fiscal and tax policies, and, traditionally, public spending has far fewer stabilising virtues for the financial markets than lower interest rates. MARKET IMPACT Greater fi nancial instability would lead to a rise in volatility and credit spreads, particularly in Europe, where the labour market is weaker and the political and social risks are greater. [R ISK # 12] Liquidity crisis [PROBABILITY] 20% ANALYSIS Aside from the risk scenarios outlined above, which could lead to the liquidation of positions and/or portfolios, it is worth recalling once again that the prevailing liquidity constraints call for additional caution. Since the 2008 financial crisis, the decline in investment banks’ inventories, the regulatory constraints that have led major players to buy and retain large volumes of bonds, the reduction in proprietary trading and market-making activities and the domination of central banks through QE programmes have all "drained" the fixed-income markets, and closing a position or portfolio now requires more time (seven times longer than before the financial crisis of 2008 if we are to believe the Bank of England). Even though bid-ask spreads have tightened since the financial crisis (due to the drop in interest rates), tradeable volumes are down sharply, as is the speed of execution, two major reflections of liquidity—or the absence thereof. Remember, the less liquid the markets are the less prices reflect fundamentals, the more they can be manipulated, the higher the risks of contagion are, the higher and more unstable volatility is, and the lower their capacity to absorb shocks. Not exactly reassuring. MARKET IMPACT This needs to be incorporated into investment decisions and should be taken into account in portfolio-building constraints and stress tests. Expect exit or macro-hedging plans for the less liquid portfolio segments or those that are likely to become less liquid in a crisis. [R ISK # 13] Banks collapse [PROBABILITY] 10% ANALYSIS This risk seems highly exaggerated to us. Still, we are not optimistic: negative rates are penalising the banks, the high cost of capital reflects the weight of past crises, fears of a new crisis, uncertainty over regulation, and the difficulty for investors to discriminate against banks and against banking systems are the primary factors in the banks’ underperformance – an underperformance that was amplified by the UK referendum precisely because it adds uncertainties over growth. Nor are we overly pessimistic. The banks of 2016 have nothing in common with the banks of 2008 or 2011: not only have they raised very large Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 13 # 12 December 2016 Risk Factors amounts of capital, but the ECB’s anti-crisis system is now well-established, with banking supervision and stress tests. Moreover, the ECB’s liquidity access facilities have drastically reduced specific risk and systemic risk for more than two years. However, it is easy to show the close link between the banks under-performing and long rates dropping into negative territory, and the question that arises is, in fact, how well the banks can contend with rates staying in negative territory. We do not anticipate a collapse, but rather continued pressures on profitability, increased by the issue of digitalisation, which is pushing the banks to reduce their debt and remain conservative on credit. MARKET IMPACT Among the factors causing fragility, the inability to discriminate is no doubt the most concerning: Deutsche Bank, bad news on Italian banks, all of it causes waves of stress, widening spreads, and plummeting bank securities. No need to go into detail on the implications on financial stability or the economies if there should be any bank failures. [RISK # 14] Geopolitical risks intensify [PROBABILITY] 70% ANALYSIS Geopolitically, the markets are now operating against a difficult backdrop: Syria, Islamic State, terrorist attacks and migrant flows are some of the forces weakening diplomatic ties among countries, especially in Europe. The United States officially entered this debate with the election of D. Trump and the anti- migrants plan (11.3 million if one believes in its program) and construction of a wall on the Mexican border. Do not expect these ongoing problems and conflicts to be quickly resolved. MARKET IMPACT There is no doubt that there will be regular spikes in tension and volatility. The current geopolitical risks are clearly identified and specific, but will this be enough to have zero impact on growth prospects or on the financial markets? Nothing is certain at this stage. [R ISK # 15] Political risks intensify (electoral calendar, populism, etc.) [PROBABILITY] 70% ANALYSIS Politically, the markets are now operating against a very difficult backdrop. In 2017, many elections will be held, and some are especially important: general elections in the Netherlands in March 2017, presidential elections (23 April and 7 May 2017) and legislative elections (11 June and 18 June) in France, and general elections in Germany in the autumn of 2017. What’s intriguing / concerning is the rise in extremist parties (far right-wing parties in Europe’s hard-core countries, and far left-wing parties in the peripheral countries) and populism, which is reflected in protectionist, anti-immigration, and pro-public-deficit issues. Inevitably, some parties will be tempted by these issues, to please an electorate increasingly sensitive to widening inequalities and the tax burden. Historically, such policies (especially protectionism) generally result in phases of very weak (or no) growth and higher inflation. These phases of economic stagnation and strong public deficits inevitably lead to periods of recession and political and financial instability. MARKET IMPACT The current political risks are clearly identified, but the prospect of major elections in Europe will lead to an increase in volatility and questions on the governance and future leadership of the EU. But will this have an impact on growth prospects or on the financial markets? The answer is yes. [R ISK # 16] A rise in European bond yields [PROBABILITY] 30% ANALYSIS Since the financial crisis, expectations on long rates have always wrong. At best, the anticipated decline was too low ... but many have also believed that the resumption of growth in the advanced countries, with the United States in the lead was, with the rise in price indices, a good reason to anticipate a rise in bond yields. Underestimating the key factors such as - the fear of secular stagnation, the role and impact of QEs, fiscal rigour in Europe (austerity), maintaining deflationary pressures ... In short, long rates not only continued to decline, but they have mostly entered into negative territory, driven by key negative short rates (Europe and Japan in particular) and impacting in the same way high-quality corporate bonds. The yield search in this ultra low or negative desert favoured three oases of spreads: emerging debt, private debt and high yield debt. What is the risk? The increase in long-term rates can come from five main sources: (i) a significant upturn in growth prospects, (ii) a reversal in interest rate policies, (iii) the end of QEs, (iv) a resurgence in inflation, or / and (v) a reversal of fiscal and fiscal policies. The first three are not materialized, the fourth is not yet a concern, only the fifth is gaining momentum in the United States... and it will undoubtedly impact the first four. This is why the current debate in the United States or in Europe on fiscal and tax policies is crucial for interest rates. MARKET IMPACT The risk of bond yields rising significantly in Europe is lower for historical reasons and in view of the European constraints caution in the case of the United States: sensitivity to long-term interest rates has risen with the rise of releveraging of corporates (now at its historical high). It should also be noted that any rise in long-term rates is a hindrance to monetary policy and to the potential for higher interest rates. 14 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 Macroeconomic picture DECEMBER AMERICAS UNITED STATES RISK FACTORS > Growth potential stunted Temporary rebound in H2: the election of Donald Trump opens a new chapter > The economy has rebounded in H2 under the impact of volatile components (inventories, for the foreseeable future ("secular stagnation") external trade, investment). > > The improvement in the labour market is continuing and wage tensions – albeit moderate ones Erosion of corporate margins – are appearing. > Donald Trump has promised stimulus measures (tax cuts, infrastructure spending), however, > Political risk (presidential election) he will only be able to implement part of this programme due to Congressional Republicans’ hostility towards increasing the defi cit. > The measures that are pushed through (probably at least the tax cuts) will have a stimulative (albeit unspectacular) impact on the economy, which will be more apparent in 2018 than 2017. > Trump’s election has also caused a number of new risks to come to light (particularly regarding his campaign rhetoric on immigration and international trade). BRAZIL > In terms of macroeconomic data, Q3 GDP came out at -2.9% yoy, compared to -3.6% in Q2. > Still ongoing political crisis Investment, which turned positive in Q2, contracted once more. > Downward pressure on the > Infl ation slowed considerably and the BCB began a cycle of monetary policy easing. However, exchange rate and rising this cycle remains moderate (two 25bp rate cuts), primarily due to the external risks that are inflation exerting pressure on the emerging markets and their currencies. > The Government submitted a proposal to reform the social security system to Congress which, if adopted, is expected to improve the current system. > The Government is continuing to move forward with its political reforms and anticorruption plans, with measures that have already been voted on in Parliament. EUROPE EUROZONE Slight slowdown in the recovery, impacted by the erosion of temporary factors and > Political risk (packed election calendar, rise of political risk > The recovery will continue, and will be underpinned by domestic demand. The positive credit anti-establishment parties, Brexit) and employment cycles will continue. > Contagion of the emerging > The support provided over recent quarters by the decline in oil prices and the euro will gradually world’s economic and/or dissipate, leading to deceleration. > The upcoming packed political calendar in the eurozone (elections in the Netherlands, France financial hardships and Germany in 2017, uncertain situation in Italy) and the uncertainty over Brexit may also encourage companies to defer certain investments. UNITED KINGDOM The economy is doing better than expected. However, political uncertainty will be a drag > Shock of uncertainty related to the Brexit in 2017 > The lack of visibility over the future framework for relations with Europe will be a weight on the > Public and foreign deficits economy. Despite encouraging activity indicators, activity will slow down in 2017. still very high > Private investment (corporate, real estate) and consumption will be impacted. In addition to uncertainty, they will suffer from the impact of rising inflation due to the depreciation of the pound. ASIA CHINA > Global economic stabiliser China: global economic and currency stabilisers in 2017 in 2017 > We think Chinese economic stabilisation is sustainable till end of 2017. > Reasons for Chinese economic stabilisation are both bottom up, where the private sector is > Global currency stabiliser showing green shoots, and top down where infrastructure investment will take a major lead in in 2017 stabilising the Chinese economy in 2017 during a political transition year. > We do not think China meets any of the six Chinese hard landing factors that we have defi ned, and that, relatively speaking, China would be most successful in delaying the problems by attempting to solve issues such as the global debt and property bubbles. INDIA > Indian growth is positioned India: a steady growth engine for Asia in 2017 to pick up > India is positioned on steady growth improvement but bottlenecks are keeping the country > Inflation moderation is from releasing growth potential as it should be along with current policy uncertainties. sustainable > Infl ation moderation is sustainable in 2017. > We continue to hold the view that the RBI will remain accommodative for longer than expected, and ease bigger than the market expects. JAPAN > Exposure to Chinese The recovery is continuing, with growth above potential. slowdown > The depreciation of the yen is expected to benefit the export sector. Consumption should remain underpinned by lower food prices and a rise in real wages. Combined with > Negative interest rate the stabilisation in China, the budget stimulus plan and the lower corporate tax rate are policy supporting factors. Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 15 # 12 December 2016 Macroeconomic and financial forecasts MACROECONOMIC OUTLOOK • United States: the recovery is continuing. After a trough early on in the year, the economy has rebounded in H2. The labour market remains robust and wage tensions are beginning to appear. Donald Trump’s plan includes stimulus measures (tax cuts, infrastructure spending) but these will likely not be completely implemented due to Congressional Republicans’ hostility towards increasing the budget deficit. The measures that are pushed through will have a stimulative impact on the economy, but more so in 2018 than 2017. • Japan: wage increases are the key to a lasting recovery, given the sluggishness of global trade and the appreciation of the JPY. Fiscal policy will remain a key growth driver. The BoJ’s new policy which aims to keep the 10-year rate at zero for the foreseeable future will give the government additional room for manoeuvre. It’s a situation worth watching. • Eurozone: the recovery is continuing. Domestic cyclical factors (improvements in employment and lending, in particular) are favourable, but the temporary drivers (decline in the euro and oil prices) are sputtering and risks (major political uncertainties in 2017) are significant. • Brazil: Q3’s GDP figure came out at -2.9% yoy, compared to -3.6% in Q2. The yoy growth carryover is now -3.2%. Trump’s election led to capital outflows and downward pressures on emerging market currencies, insofar as Q4 GDP is not expected to recover as much as we had projected. For 2016, GDP is expected to contract by at least 3%. However, this trend corroborates our scenario of a less severe recession in 2017 (-0.5%) than in 2016, but with a lag versus the consensus, which is forecasting a return to growth in 2017. • Russia: according to the Russian statistics institute, Q3 GDP is expected to come out at -0.4%, which is not as bad as Q2’s figure (-0.6%). We are maintaining our 2016 and 2017 GDP growth outlooks at -0.7% and 1%. Annual averages (%) Real GDP growth. % 2015 US 2.6 Japan 0.5 2.0 Eurozone Germany 1.7 France 1.3 Italy 0.8 Spain 3.2 UK 2.2 Brazil -3.8 Russia -3.7 India 7.6 Indonesia 4.8 China 6.9 Turkey 3.8 Developed countries 1.9 Emerging countries 4.1 World 3.2 2016 1.5 0.6 1.5 1.7 1.3 0.9 2.8 2.0 -2.5 -0.7 7.5 5.0 6.7 2.6 1.5 4.1 3.0 Inflation (CPI. yoy. %) 2017 2.0 0.7 1.3 1.4 1.2 1.1 1.3 0.5 -0.5 1.0 7.6 5.1 6.5 3.0 1.6 4.4 3.2 2015 0.1 0.8 0.0 0.1 0.1 0.1 -0.5 0.1 9.0 15.5 5.2 6.4 1.4 7.7 0.2 4.0 2.4 2016 1.3 -0.1 0.3 0.4 0.3 0.0 -0.4 0.7 6.8 10.0 5.4 4.5 1.2 7.5 0.8 4.2 2.7 2017 2.2 0.7 1.3 1.5 1.2 1.0 1.2 2.2 6.0 8.5 5.2 4.5 1.2 7.0 1.7 3.7 2.8 Source: Amundi Research KEY INTEREST RATE OUTLOOK FED: the Fed raised the fed funds target to 0.50-0.75%. The Fed should hike two other times in 2017. ECB: the ECB extended its QE until December 2017 at a reduced pace (€60bn/ month). Few changes have to be expected in the short-run. BoJ: after it announced it would target the long-end of the yield curve, it is likely that the BoJ will lower further the short-term rates. 16/12/2016 US Eurozone Japan UK 0.75 0.00 -0.10 0.25 Amundi Consensus Amundi Consensus + 6m. Q2 2017 + 12m. Q4 2017 1.00 1.00 1.25 1.30 0.00 0.00 0.00 0.00 -0.20 -0.10 -0.30 -0.10 0.25 0.25 0.25 0.25 BoE: the BoE cut its key rates to 0.25% and resumed its QE policy. It will be torn between the rise of inflation and the worsening of growth prospects. LONG RATE OUTLOOK United States: long-term rates rose significantly after the US elections, with the prospect of a fiscal stimulus boosting growth and with the rise of inflation expectations. Inflation base effects will be significant during the two first months of the year. This being said, they will go in the other way from March. Eurozone: the ECB announcements favor a steepening of the yield curve. The PSPP purchases will be redirected towards the short-end of the curve. United Kingdom: the potential for a rise UK yields is limited as the economic outlook is worsening and as BoE purchases will weigh on yields. Japan: the BoJ controls the long-end of the curve and is probably in favour of a decline of short-term bond yields. 2Y. Bond yield Amundi Forward 16/12/2016 + 6m. + 6m. 1.26 1.20/1.40 1.68 US Germany -0.80 -0.80/-0.60 -0.77 Japan -0.18 -0.40/-0.20 -0.10 UK 0.14 0.00/0.20 0.25 10Y. Bond yield Amundi Forward 16/12/2016 + 6m. + 6m. US 2.56 2.40/2.60 2.71 Germany 0.31 0.20/0.40 0.46 Japan 0.08 0 0.13 UK 1.44 1.40/1.60 1.63 Amundi Forward + 12m. + 12m. 1.60/1.80 1.96 -0.80/-0.60 -0.69 -0.40/-0.20 -0.03 0.00/0.20 0.46 Amundi Forward + 12m. + 12m. 2.20/2.40 2.83 0.20/0.40 0.58 0 0.18 1.40/1.60 1.77 CURRENCY OUTLOOK EUR: we expect a relative stability of the euro in effective terms in the coming months. The new ECB measures limit the upside for the euro during the coming semester. USD: the trade-weighted USD has risen sharply with the divergence between the US rates and that of other developed countries. This will be a limiting factor for the rise of long-term yields. The USD may appreciate slightly in the short-run but is now very expensive. JPY: the yen became undervalued again. With the BoJ’s yield curve control policy, a rise of US yields triggers a yen depreciation. GBP: the pound’s evolution will be dictated by political developments. A progression towards a ‘soft Brexit’ would be positive for the currency. 16 16/12/2016 EUR/USD USD/JPY EUR/GBP EUR/CHF EUR/NOK EUR/SEK USD/CAD AUD/USD NZD/USD 1.06 115 1.27 1.01 8.43 9.15 1.31 0.75 0.72 Amundi Consensus Amundi Consensus + 6m. Q2 2017 + 12m. Q4 2017 1.05 1.04 1.10 1.06 115 112 110 112 1.17 1.21 1.22 1.25 1.00 1.03 0.91 1.03 8.29 8.48 7.73 8.21 9.05 9.10 8.45 8.6 1.40 1.36 1.45 1.36 0.75 0.73 0.70 0.73 0.70 0.69 0.70 0.68 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 Finalised at 14 November 2016 1 Will Trump be the new Reagan? DIDIER BOROWSKI, Research, Strategy and Analysis Since Donald Trump was elected, US long rates have risen sharply, the dollar has appreciated significantly and equities have continued to climb. The explanation for this can mostly be found by looking more closely at fiscal policy expectations: a broad stimulus plan is expected, in line with candidate Trump’s promises. Implementing this (deficit-financed) plan in an economy that is already close to full employment opens up the possibility of simultaneous increases in growth and inflation in the United States. As such, many are starting to dream of a new cycle of expansion, with an economy reinvigorated, just as it was under Ronald Reagan, by tax cuts and military spending. However, this would not only ignore the conditions under which the Reagan administration implemented its policy, but also the economic environment, which has radically changed. It is useful to put the challenges faced by the two administrations into perspective. Donald Trump and Ronald Reagan clearly share a number of similarities. Reagan was an unorthodox Republican whose recommendations in terms of economic policy enjoyed far from unanimous support within his own camp. George Bush Sr, his main rival during the 1980 primaries, went as far as calling his proposals “voodoo economics”. Trump is controversial within his own party—or at least he was prior to his election. There are, however notable differences between the two: Reagan had already been Governor of California by the time he was elected, and therefore had extensive political experience, which cannot be said of Trump. Additionally, Reagan’s approach was less confrontational. In the run-up to the elections, he decided to join forces with the moderates by offering George Bush the post of VicePresident. By contrast, Trump remained in conflict with his party until the very end. Nonetheless, the appointment of Reince Priebus as White House Chief of Staff, as well as several other cabinet members (Treasury Secretary), shows that the President-elect is seeking an alliance with moderates from his own camp. Trump’s programme is openly inspired by Reagan’s 1980 stance on fiscal policy. Both advocate significant tax cuts, and public spending is slated to play a key role: The essential US interest rates rose sharply in the wake of Trump’s election, due to the anticipation of a highly expansionary budget policy (tax cuts, increased infrastructure spending). The continuation of this rise seems somewhat unwarranted in our view. Donald Trump is claiming, and being inspired by, Ronald Reagan’s legacy. But there is no comparison. In the early 1980s, the US economy was in stagflation. The recession and inflation required a combination of restrictive monetary policy and expansionary fiscal policy. Today, the situation is quite different: (1) the economy is at the end of the cycle (fiscal multipliers are lower in this situation); (2) inflation is much lower (the Fed can remain accommodating); (3) long-term rates are also much lower (less downside potential in the event of a shock); (4) companies are much more indebted now than they were in the early 1980s (less investment to be expected); (5) government debt is now more than twice as large as before (less room for manoeuvre). Absent the threat of recession, we should not expect a broad plan to stimulate the economy financed by a deficit. • Households: Reagan slashed the top marginal tax rate from 70% to 28%. Meanwhile, Trump proposes to cut it from 39.6% to 33%. • Businesses: Reagan cut the corporate tax rate from 48% to 34%. Trump proposes to reduce it from 34% to 15%. • Public spending: infrastructure rather than defence. Times have changed. Trump’s programme places a strong emphasis on broad infrastructure spending. By contrast, Reagan’s policy focused on increasing defence spending in a period dominated by international confrontation between the Soviet and Western-aligned blocs. That said, as Martin Feldstein recently wrote, defence spending will decrease from 3.2% to 2.7% of GDP over the next decade, its lowest level since the Second World War, which is not compatible with the United States’ security needs. As such, we could see military spending playing a key role. In the early 1980s, stimulus did not immediately benefit the US economy Nonetheless, it is hard to draw conclusions due to the vast differences in context. In the early 1980s, the economy was in the midst of “stagflation”. The second oil shock of 1979 combined with restrictive monetary policy had dragged the economy into a short-term recession (six months, from January to July 1980). When Reagan was elected president, the economic recovery was weak. Lasting only 12 months, it was followed by another recession, an episode known as “double-dip” recession. The second recession was both longer (16 months, from July 1981 to November 1982) and more severe, becoming the deepest recession since the 1930s. Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 17 # 12 December 2016 The deteriorated economic situation in the US helped Reagan overcome the opposition of some Republicans and to win over Democrats. Reagan went on to win the presidential election by a landslide, garnering more than 90% of the electoral vote and beating Jimmy Carter by more than eight million votes in the popular vote. The Republicans also wrested control of the Senate from the Democrats (53 Republican senators out of 100) for the first time since 1955. But the House of Representatives remained largely dominated by the Democrats, and it would stay that way during both of Reagan’s mandates. Budgetary and fiscal multipliers are lower when the economy is at the end of the cycle Furthermore, in 1980, the Republicans were opposed to policies that could derail public finances. Reagan had to intensely lobby Congress and use his talents as the “Great Communicator” to overcome the opposition. By July 1981, his economic programme had won broad public support. And Reagan managed to get enough Democrats on board to approve his plan. He promised he would later find additional spending cuts to balance the budget. The track record of the Reagan years still provokes debate. The policy mix is credited with putting an end to the damaging stagflation of the late 1970s. In retrospect, it is difficult to pin down how much of this was a result of fiscal policy and how much was down to the major military spending programmes. The only certainty is that both played a role. Having an absolute majority in both chambers, will Donald Trump be able to get his proposals passed more quickly? And if so, will his programme be able to lift growth? This is doubtful due to several factors. • The economy is at the end of its cycle. The level of growth expected for 2017 (2%) will struggle to keep going in 2018 without the support of fiscal policy. Growth potential has plunged since the Great Recession (slower increase in the active population, slowdown in productivity gains). Many studies suggest that fiscal multipliers are lower when the economy is in expansion than when the economy is in recession. US: Federal debt vs. federal budget balance (% of GDP) 1 4 80 2 60 0 -2 40 -4 -6 20 Federal budget (rhs) Federal debt (lhs) -8 -10 0 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 It is important to note that the expansionary fiscal policy did not immediately benefit the economy. The economy fell back into recession just as Reagan obtained a favourable vote in Congress. It is striking to note that the start of the second recession as dated by the National Bureau of Economic Research (NBER) coincides with the approval of the tax reduction plan by Congress (July 1981). All things considered, Reagan’s fiscal policy led to a substantial deterioration of structural deficits during his first mandate as well as a sharp rise in government debt. The impact on growth took time to materialise. Source: Datastream, Amundi Research • Companies are much more indebted now than they were in the early 1980s. The weak level of investment is not related to monetary conditions (real interest rates are very low, it is easy to access credit) or to lower profitability (the share of profits in value added is still much higher than its long-term average), but rather to weak expected demand, as the accelerator effect is absent at the end of the cycle. With regard to capital goods, the rate of investment in volume terms stands above its long-term average. That said, 2016 was a year of slumping investment and profits. Fiscal policy could therefore have a mild stimulating effect. • The cuts to spending advocated by the Republicans in Congress could have an immediate negative effect. Meanwhile, the promised infrastructure spending will take time to materialise. What is more, their financing is not assured. Trump proposes to finance infrastructure by combining tax credits to businesses (around $134 billion) with publicprivate partnerships. The goal is to be able to raise up to $1 trillion with a smaller contribution by the government. However, the expected returns on the renewal of public infrastructure are low and therefore unlikely to attract many private investors. Moreover, in Europe, the Juncker Plan has shown how difficult it is to mobilise private funding for new investment. The Republican Congress will be very reluctant to approve tax cuts without decreases in spending • The government debt is now more than twice as large. The long-term sustainability of the government’s debt requires either a sharp increase in tax revenues (assuming no change in spending) or deep cuts to spending programmes (assuming no change in taxes). From this perspective, the situation has changed radically in the past 35 years. It is not possible to 18 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 lower taxes and increase spending at the same time, at least not in the long term. Therefore, Congress will be very reluctant to approve tax cuts without a substantial decrease in spending, which would limit the stimulative effect. It is nonetheless likely that Republicans will use a procedure known as budget “reconciliation”1 in order to push through their tax cuts. • Inflation was 14% in 1980 compared to just over 2% today. Moreover, (core and headline) inflation is, based on the current cycle (which began in the spring of 2009) at its lowest level since the early 1960s. There is no genuine inflationary threat in the United States, although an accelerated rise in prices (excluding energy) is likely in 2017. Assimilating a period of reflation with a period of out-of-control inflation must be avoided. • Nominal interest rates are very low, while in the Reagan era they were very high. The risks are thus asymmetric for the American economy: there will be less leeway to hold back a potential recession through lower (short and long) interest rates. • In the early 1980s, the Reagan administration was in alignment with the Fed’s plan to defeat inflation. Reagan even reappointed Paul Volcker to the helm of the Fed in 1983. By contrast, the tension between the Fed and the new administration could become stronger under Trump. Janet Yellen is unlikely to be reappointed when her term expires in February 2018. In the meantime, hawks will probably be appointed to the FOMC. We should not expect a major infrastructure programme in 2017 2 Consumer prices: PCE vs. core PCE defl ators (% yoy, 7-year rolling mov. averages) 8,0 7,0 PCE Core PCE 6,0 5,0 4,0 3,0 • In 1981, the recession, high unemployment and inflation required a combination of restrictive monetary policy and expansionary fiscal policy. • In 2016, the enemy is not inflation, but excess savings (or lack of investment). On the one hand, it is not clear that lowering taxes will help boost investment by businesses, which are already highly indebted. On the other hand, the tax cuts target households who have a low propensity to consume. Finally, funding has not been found for infrastructure spending. The environment of high debt, both of the government and businesses, limits the feasibility and effectiveness of the announced fiscal policy. Absent the threat of recession, we should not expect a broad plan to stimulate the economy financed by a deficit. 2,0 1,0 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 In summary, while the recommended fi scal measures are similar at fi rst sight, the environment differs considerably. Source: Datastream, Amundi Research 3 US: nominal GDP trend growth vs. 10-year bond yield 14% 14% 12% 12% 10% 10% 8% 8% 6% 6% 4% 4% 2% Nominal GDP growth (10-y mov. avg, %) 10-y Treas. yield 2% 0% 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013 2016 0% Source: Datastream, Amundi Research 1 The so-called budget reconciliation procedure is an exceptional procedure that, under certain conditions, allows Congress to pass measures without having to endure the systematic obstruction of the other side of the House (by use of a fi libuster). While this procedure (created in 1974) was originally conceived as a way of implementing measures aimed at reducing the public defi cit, Congress has already used it to push through tax cuts that would temporarily increase the defi cit. The most well-known example is two pieces of Bush legislation (the 2001 and 2003 tax cuts). However, the budget rule known as the Byrd Rule allows senators to block a piece of legislation if it purports signifi cantly to increase the federal defi cit beyond a ten-year term. This explains the battles between Democrats and Republicans over the renewal of the Bush tax cuts in 2010 and 2012 (one year before they were due to expire). In practice, Donald Trump could therefore pass several measures without needing a super majority. Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 19 # 12 Finalised at 8 December 2016 December 2016 2 5 key points to have in mind The essential about the US public debt BASTIEN DRUT, Strategy and Economic Research Since Donald Trump won the presidency and the Republicans, a majority in Congress, the bond markets have priced in a steep rise in fiscal deficits. However, Congressional Republicans are traditionally opposed to deficits and the issue of public debt has led to recurring political crises in recent years. The issues of US debt and fiscal manoeuvring room will be key to the coming years. Since Donald Trump won the presidency and the Republicans, a majority in Congress, the bond markets have priced in a steep rise in fiscal deficits. While it is more or less clear that the new administration will cut taxes drastically, a question mark hovers over the extent of infrastructure spending and, indeed, if such spending will even be approved. Congressional Republicans are traditionally opposed to deficits and the issue of public debt has led to political (more than economic) crises in recent years with renegotiations of the debt ceiling (in 2011 and 2013). The issues of US debt and fiscal manoeuvring room will be key to the coming years, and this is therefore a good time to look more deeply into their many facets. While currently low interest rates are stemming the rise in US public debt, keep in mind that, as things currently stand, the debt-to-GDP ratio is expected to be driven up significantly in the coming decade by the ageing of the population. Against this backdrop, it is clear that policies that widens the primary deficit, combined with a more pronounced rise in yields, will rather rapidly expand US federal debt significantly. This will probably be the main focus of negotiations between President Trump and Congressional Republicans. How high is US public debt? US public debt can be split into two categories: • Marketable debt, which is raised on the markets. This is the debt that is traded on the markets each day, including T-bills, T-notes, T-bonds, floating-rate notes, and inflation-linked debt. As of November 2016, marketable debt amounted to $13,921bn, or 74.6% of GDP. • Non-marketable debt, which is raised from US governmental bodies. For instance, US law provides that tax receipts levied to fund the Social Security Trust Fund and the Medicare HI Trust Fund must be invested in US Treasuries, most of the time non-marketable US Treasuries. As of November 2016, non-marketable debt came to $5,481bn, or 29.3% of GDP. The debt ceiling applies – more or less – to the sum of the marketable and non-marketable debts, when the debt ceiling is not suspended (see below). Marketable debt consists of: • T-bills, of an initial maturity of 4 weeks, 3 months, 6 months or 12 months; • T-notes, of an initial maturity of 2, 3, 5, 7 or 10 years; The ageing of the population has become a fiscal reality that must not be understated • T-bonds, of an initial maturity of 30 years; • Floating-rate notes, of an initial maturity of 2 years (these were first issued in 2014); • TIPS, of an initial maturity of 5, 10 or 30 years. The US Treasury has several accounts that help it track revenues and outlays under certain programmes in particular. One fund, the Social Security Trust Fund, includes the Federal Old-Age and Survivors Insurance (OASI) and Federal Disability Insurance (DI). 20 6.5 60% 6.0 50% 5.5 40% 5.0 30% 4.5 20% Bills Bonds FRN 2017 2015 2013 3.5 2011 0% 2009 4.0 2007 10% 2005 Social Security pays benefits to employed workers when they retire or can no longer work. In October 2016, there were 66 million beneficiaries, including 68% retirees and 21% disabled persons. 70% 2003 Why Social Security is very important for US public debt Breakdown of US marketable debt vs average residual maturity (in years) 2001 The average maturity of the US marketable is approximately 5.2 years. It has been rising since 2014. The future Treasury Secretary, Steven Mnuchin, indicated in a recent interview that the new administration would “look at potentially extending the maturity of the debt because eventually, [the US] will have higher interest rates and that this is something that this country is going to need to deal with.” He mentioned the possibility to issue 50 or 100 yr bonds. 1 1999 More than 60% of marketable debt is T-notes. After falling precipitously in recent years (after peaking at 34% of marketable debt in 2008), the proportion of T-Bills is being driven back up by the reform of the US money markets (from 10% at and-2015 to 13% today). The expansion of the T-Bill market in 2017 will limit long-dated issuance. Notes TIPS Avg maturity (RHS) Source: Datastream, Amundi Research Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 2000 T-bills 1000 500 From the federal government’s point of view, having the Social Security Trust Fund buy Treasuries allows it to borrow less on the markets for its non-Social Security operations. What’s the latest on the debt ceiling? 0 3 2017 2015 2013 2011 32% CBO simulations 30% In 2011, as public debt approached its ceiling, the Republicans, who controlled the House of Representatives, demanded that President Obama agree to a deficit-reduction plan in exchange for raising the debt ceiling. The two sides reached an agreement to cut spending by $917bn over 10 years, two days before hitting the debt ceiling. 22% While the Congress majority and the president are both Republican, the evolution of the US public debt will probably continue to be subject to controversy very rapidly. The Senate majority leader, Mitch McConnell, said on December 12th that he considered the level of national debt “dangerous and unacceptable” and that he wanted “any tax overhaul to avoid adding to the deficit.” He also said: “What I hope we will clearly avoid, and I’m confident we will, is a trillion-dollar stimulus” while it was one of the cornerstones of the Donald Trump’s electoral campaign. US: old-age dependency ratio 34% 28% On 12 February 2014, the debt ceiling was suspended until 15 March 2015, and on 30 October 2015 it was suspended until March 2017. 2009 Source: Datastream, Amundi Research The debt ceiling has been subject to recurring controversy in recent years, particularly during the 2011 and 2013 crises. When the debt ceiling is reached, the Treasury uses “extraordinary measures” to allow the federal government to function before Congresses raises the ceiling. 26% 24% 20% 18% 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 2018 2022 2026 A new debt ceiling crisis occurred throughout 2013. Once again, the Republicans demanded spending cuts in exchange for raising the debt ceiling, which, technically, was hit on 31 December 2012. The debt ceiling was first suspended by President Obama until 18 May 2013. The reactivation of the ceiling at a slightly higher level, effective 19 May, forced the Treasury into new “extraordinary measures” before the temporary federal government shutdown, from 1 to 16 October. The crisis was resolved temporarily via a new suspension of the debt ceiling, this time until 7 February 2014. 2007 -500 2001 The amount of benefits to be paid is expected to rise steeply in the coming years as the population ages, and in particular as baby boomers retire, and as life expectancies grow longer. The dependency ratio (i.e., the ratio of the population older than 65 to persons aged 20 to 64) began to accelerate around 2010 and will do so even more in the next decade, according to CBO projections (see chart). The ageing of the population has become a fiscal reality that cannot be understated. According to CBO projections (“CBO’s 2015 long-term projections for social security: additional information”), under current laws, Social Security spending will outstrip its receipts by almost 30% in 2025 and by more than 40% in 2040.The ageing of the population will therefore automatically force the federal government to borrow more and more on the markets. T-notes & T-bonds 1500 2005 When Social Security Trust Fund receipts exceed its spending, the reserves rise and are invested in non-marketable Treasuries. When Social Security Trust Fund receipts are below its spending, the reserves are liquidated to pay benefits. Net issuance of T-bills, T-notes & T-bonds ($bn, 12 m. rolling sum) 2 2003 The Social Security Trust Fund is debited to pay benefits to Social Security recipients. Receipts from this fund come from employee and employer contributions earmarked for Social Security and from interest earned on accumulated reserves. US law states that Social Security reserves has to be invested only in Treasuries, most of them non-marketable securities. The value of these securities does not fluctuate and they may be redeemed at any time. The Social Security Trust Fund owns a little more than half of the US Treasury’s non-marketable securities. Source: CBO, Amundi Research 4 Social Security: tax revenues and outlays as % of GDP 7.0% 6.5% 6.0% 5.5% CBO simulations 5.0% 4.5% Outlays Tax revenues 4.0% 3.5% In Q3 2016, the US federal debt, excluding inter-governmental holdings, amounted to 75.9% of GDP (this does not correspond exactly to the marketable Source: CBO , Amundi Research 1985 1992 1999 2006 2013 2020 2027 2034 2041 2048 2055 2062 2069 2076 2083 What is the debt-to-GDP ratio? Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 21 # 12 December 2016 While fiscal policy will be a hallmark of the new administration, keep in mind that the debt-to-GDP ratio is expected to rise in the coming decade, even if the new administration takes no action. The fact that interest rates are so low compared to economic growth will make it impossible to counterbalance the increase in the primary deficit. Low interest rates are clearly good news for the debt-to-GDP ratio. As of the end of November 2016, the average interest rate paid on marketable debt was 1.96%, and the average interest rate paid on all marketable and non-marketable debt was 2.20%. As only about 15% of US debt is rolled over each year, this average interest rate paid on the debt will rise only slowly in the coming years, despite the recent steepening in the US yield curve. And this interest-rate level is below nominal GDP growth (at about 4%: 2% real growth and 2% inflation), which is helping to lower the debt-toGDP ratio. 5 US: debt limit vs debt subject to limit ($bn) 21000 Debt limit 19000 Debt subject to limit 17000 15000 13000 11000 9000 7000 5000 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 debt as some non-marketable securities are held by the public), up from about 35% prior to the Great Recession. While it is true that such levels of public debt not been seen since the immediate post-war period, the US’s debt-to-GDP ratio is not at all excessive compared to that of other developed economies. Source: Datastream, Amundi Research That said, even before the new US administration has taken office, the primary deficit is rising, driven mainly by the steady increase in Social Security and healthcare spending. 6% 4% 2% 0% -2% -4% Primary balance -6% Net interest outlays -8% -10% What about foreign holdings of US public debt? Source: Datastream, Amundi Research US public debt has not always been mostly held by non-residents. After the Second World War, foreigners held just 1% of all Treasuries. Foreign holdings did not truly take off until the 1970s, before levelling off at about 15% to 20% until 1995. It was about then, in the wake of the Asian crisis and the take-off in the Chinese economy that emerging economies began to pile up large currency reserves and, hence, US Treasuries. 7 60% In the first half of the 2000s, US long bond yields were lower than traditional models would suggest, due to massive Treasury purchases by foreign central banks, particularly Asian ones. The lower-than-expected long bond yields were called a “conundrum” by Alan Greenspan at a Senate hearing in 2005. One reason often put forth to explain this phenomenon is the steep rise in foreign holdings of Treasuries in the 2000s. The proportion of Treasuries held by non-residents peaked in 2008, at 53%. An IMF working document from 2012 (“Government Bonds and Their Investors: What Are the Facts and Do They Matter?”) on several developed economies estimated that a 10-percentage point rise in government bonds held by non-residents would lower long bond yields by 40 basis points. 50% One of the issues discussed most often within the Fed and academic circles has been: what would happen to long US bond yields if emerging economies were to reduce their current account surpluses and their international 0% 22 Share of the US marketable debt held by nonresidents 40% 30% 20% 2016 2011 2006 2001 1996 1986 1981 1976 1971 1966 1961 1956 1951 1946 10% 1991 In conclusion, and based on the CBO simulations, it is clear that policies that would widen the primary deficit, combined with a more pronounced rise in yields will expand US federal debt rather rapidly (when excluding inter-governmental holdings) to almost 100% of GDP within 10 years. Admittedly, this simulation is obviously flawed in that we cannot know what the growth impact would be of a fiscal stimulus plan; nor can we predict the timing and magnitude of a future US recession (which would raise the debt-to-GDP ratio drastically). Primary balance vs net interest outlays (as % of GDP) 6 Q1 1981 Q1 1983 Q1 1985 Q1 1987 Q1 1989 Q1 1991 Q1 1993 Q1 1995 Q1 1997 Q1 1999 Q1 2001 Q1 2003 Q1 2005 Q1 2007 Q1 2009 Q1 2011 Q1 2013 Q1 2015 Q1 2017 In August 2016, the Congressional Budget Office (CBO) forecasted that fiscal revenues as a percentage of GDP would level off in the next decade, even as outlays would rise gradually, due to increased spending on entitlements (i.e., Social Security and Medicare) and expectations of higher long bond yields (with the 10-year yield rising to 3.6% over time). On this basis, the CBO estimated that the debt-to-GDP ratio would be about 10 percentage points higher in 2026 (at 85.5% of GDP) than 2016. These estimates were made prior to the US elections. Source: US Treasury, Amundi Research Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 Domestic holdings Foreign - official Foreign - private Fed 5000 4000 3000 2000 1000 2017 2015 2013 2011 2009 2007 0 1999 • The decline in Treasury holdings by foreign official entities has been offset by the increase in Treasury holdings by foreign private investors. Low/ negative European and Japanese long bond yields have led, and continues to lead, investors in these regions to buy up US bonds massively. All in all, the decline in foreign holdings has been apparent since the start of 2015 but hasn’t been significant. 6000 2005 • Contrary to popular wisdom, Chinese international reserves do not consist merely of US Treasuries. As of end-September 2016, China held $1300bn in Treasuries, or about 9.5% of the stock of US marketable securities. Breakdown of US Treasuries’ holdings 2003 That said, the decline in Chinese international reserves probably contributed only modestly to the rise in long US bond yields, as: 8 2001 reserves? Some market observers have suggested that a reduction in Chinese international reserves would exert heavy upward pressures on long US yields. The renminbi’s depreciation vs. the dollar, which began in 2014, triggered massive capital outflow from China, leading to a significant decline in international reserves. Source: Datastream, Amundi Research The decline in Chinese international reserves probably contributed only modestly to the rise in long US bond yields Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 23 # 12 December 2016 Finalised at 4 December 2016 3 Disintermediation: a strong trend in Europe The essential PHILIPPE ITHURBIDE, Global Head of Research, Strategy and Analysis In Europe, bank deleveraging and the decline in bank lending have been two underlying trends since the financial crisis of 2008. Recent surveys by the ECB have shown at least two things: 1. Bank lending to large and mid-size companies recovered. In reality, the relatively small increase in bank lending conceals another reality, which is highly encouraging and positive for the economy. For several years, these businesses have been very active on financial markets, and have financed themselves through this channel. As a result, there are more than 300 new issuers in the past four years on the European high-yield segment. Conditions in that market are much more tempting than those offered on bank loans. 1. However, despite low rates and the end of the debt crisis, bank loans to small companies (mid-market corporates) have been declining for six consecutive years. This is one of the key problems of the eurozone. These businesses do not have access to financing through financial markets. They depend on the banks (more than 90% of their financing comes from financial institutions) and the European economy is highly dependent on these businesses (they have created more than 80% of net new jobs in the last 20 years). Disintermediation: where do we stand now? Historically, the European economy relies heavily on banks to fund businesses, unlike the US. As a consequence, immediately after the crisis, which led to bank deleveraging, in Europe there was no established capital market solution able to provide the necessary liquidity for mid-market corporates. The relative withdrawal of banks, continued low interest rates and the search for yield and spreads have given a major boost to disintermediation in Europe. The trend is not yet over. Non-banking fi nancial intermediaries still retain tremendous potential in the eurozone: 75% of the continent’s economy is financed by banks, versus 25% of the US economy. Historically, the European economy relies heavily on banks to fund businesses, unlike the US. As a consequence, immediately after the crisis, which led to bank deleveraging, there was no established capital market solution able to provide the necessary liquidity for mid-market corporates. The relative withdrawal of banks, continued low interest rates and the search for yield and spreads have given a major boost to disintermediation in Europe. Disintermediation is now a tangible reality in Europe, and the trend is not yet over. Admittedly, it has affected EU countries rather differently: for example, France and Belgium are ahead of countries like Spain, Germany, Greece, Denmark and Ireland. However, on the whole, investors, banks and corporate issuers are finding that their interests are converging as the trend continues. The various charts on the opposite page highlight four key features: - the relative role of bank lending in fi nancing compared to that of financial markets differs significantly on the two continents: 75%/25% in Europe, 25%/75% in the US; - disintermediation has gained ground in France (which nevertheless has the strongest banking system in Europe), Belgium and Italy, but not in other peripheral countries (Spain and Greece); Bank loans to small companies have been declining for six consecutive years - In Germany, the bulk of credit to corporates (84%) still comes from banks. Companies of all sizes rely on banks; - The size of corporates is crucial should we want to consider the dynamic of disintermediation. We have witnessed significant changes in disintermediation for large caps (less and less banks, more and more capital markets), but no major change for SMEs, which remain highly dependent on banks. When we look at funding flows (and not existing financing), the table is even more informative. Since the fi nancial crisis, companies have turned to market fi nancing more than bank lending. This makes continental Europe more similar to the United Kingdom. Of course, there are still strong disparities between countries, but on the whole Europe is becoming an increasingly “nonbank” system, rather than a “bank-dependent” system. Is disintermediation a sustainable trend? We believe this trend is sustainable because of the alignment of interests and because of the interest rate environment. Banks, investors and corporates are in it together. 24 After the crisis, which led to bank deleveraging, in Europe there was no established capital market solution able to provide the necessary liquidity for mid-market corporates Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 Banks have massively deleveraged following the financial crisis and they are increasingly restricted by local and international (Basel 3) regulations (increased cost of capital / resources). However, they need to maintain / develop customer relationships. They develop businesses with limited capital requirements and they need to increase net revenues. Regulation is a constraint, while negative interest rates and QE increase the gap between interest rates and cost of capital. Disintermediation can only continue in such an environment. Disintermediation affects large caps but not really SMEs, which remain highly dependent on bank financing > L ow i n t e r e s t r a t e s a n d h i g h c o s t o f b a n k c a p i t a l : a factor promoting disintermediation 80% 70% 60% 50% 40% 30% 20% 10% Bank loans Europe is becoming an increasingly ‘non-bank’ system, rather than a ‘bank-dependent’ system 2 Non fi nancial corporates funding: bank loans vs capital markets (2015) 100% • For their part, corporates will continue to look for non-bank lending: their fi nancing needs remain high (e.g. upcoming refi nancing, M&A financing, etc.). 90% • They look for additional diversification of funding. 70% • Capital markets complement traditional bank/loan offers, and offer more tailor-made solutions (format, terms and conditions, etc.). • Financing through the financial markets also gives some issuers an opportunity to communicate and thereby increase their profile. • Note that disintermediation for Corporates with limited access to DCM activities (Debt Capital Markets), i.e. unlisted, unrated companies and SMEs, has developed significantly. 26% 80% 60% 76% 50% 40% 74% 30% 20% 10% 24% 0% US According to a recent report (Grant Thornton), 80% of corporates view nonbank lenders positively or very positively. In other words, this style of financing is established and gaining popularity among corporates. UK France Belgium Sweden Portugal Poland Finland Euro Area Italy Netherlands Capital markets Source: Amundi Research The “abnormally” low level of interest rates and yield curves, with a direct impact on profitability and, hence credit supply. We could also add interest rate risk, which is now totally asymmetric. The more that banks believe that interest rates will remain low for a long time, the more they will be encouraged to dial back risk and ride against the tide of monetary policy. On the whole, we better understand why banks are taking less risk with their loans, a trend that has negatively impacted SMEs. To this we must add the investments banks must make in digitisation. We also better understand why many corporates prefer to raise funding on the market rather than approach banks. On the markets, their funding policy can be more flexible and they can obtain better financing terms. Several weeks ago, Sanofi issued a three-year bond with a -0.50% yield. No bank would have offered them that kind of funding. Ireland 0% Austria The market’s failure to make distinctions between different banking systems. In reality, the market doesn’t know how to make that distinction. As for the banks, the talk is still about systemic risks, interactions between banks, and contagion. None of that helps the interbank market function properly, and even undermines the weakest banks and thereby impacts the most solid banks through contagion! This vicious circle is encouraging deleveraging and domestic retrenchment more than fluid exchanges, pooling of risks, and the assumption of additional credit risk. 90% Denmark Regulatory uncertainty is also a factor behind the persistently high cost of capital. We don’t know what the contents of Basel 4 will be. The least that can be said is that regulation, which aims to prevent crises, does not spur growth. It brings us back to the usual debate about the pro-cyclical nature of regulatory measures. 100% Germany The fear of future crises: we know for a fact that the banking environment is still fragile in certain countries. In particular, we are thinking of Italy and its failure to create a “bad bank” due to the rejection of the European Commission when the other stakeholders, including investors and the ECB, looked upon its plan favourably. We are also thinking of the Portuguese and Spanish banking systems, and the direct consequences of recurring fears and rumours with respect to Deutsche Bank, and so on. Spain The weight of past crises: the return to normal never actually happened, as the 20112012 bank crisis left long-lasting traces; Non fi nancial corporates funding: bank loans vs capital markets (2015) 1 Greece The cost of capital has not really gone along with the downward movement on interest rates for several reasons: Banks Loans EU Capital Markets Source: Amundi Research Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 25 # 12 December 2016 Diversification, liquidity premium and the search for yield are the three reasons for investors to be interested in disintermediation. Following the 2008 crisis, a key outcome of the requirement for banks to hold more capital and tighten lending practices through regulations like Basel III (Europe applicable) and the Dodd Frank Act (US-centred), has been an increase in opportunities for institutional investors to help close the credit gap. Since 2012, asset managers have indeed jumped in to fill the gap (private debt, debt funds, direct lending, etc.), and this trend has continued strongly. The trend has also been exacerbated by the ECB’s monetary policy: Capital markets complement traditional bank/loan offers, because they offer more tailor-made solutions • Investors’ search for yield as rates / government bond yields trended towards zero and even into negative territory; • A key transmission mechanism of QE, emphasised by policymakers, has been the ‘portfolio balance’ channel (which the ECB calls the “balance shift portfolio”): investors shifted their portfolios away from government bonds towards risky assets. But portfolio rebalancing has been limited to corporate bonds and has not extended to equities. Overall, this trend has tightened credit spreads. For this reason, private debt and other forms of direct lending are becoming increasingly popular . In reality, institutional investors have long sought to invest in private debt, but until recently, the markets offered limited opportunities (size, issuers). Investors were interested in: • Gaining diversification (in comparison to public credit such as investment grade and high yield corporate bonds), Diversification, the liquidity premium and the search for yield are the three reasons for investors to be interested in disintermediation Disintermediation: strong divergences between corportates (%) 3 100 • Accessing a wider range of new issuers, • Capturing a liquidity premium, 35 2 7 Portfolio allocation around private debt is still evolving, some allocate within a fi xed income bucket, some within alternatives, private equity or even a hedge fund bucket. There is an increasing trend, particularly from large pension funds, to have an allocation specifi cally to private debt, which is particularly true of US schemes where the practice is more established. Private debt is perceived as having superior protections vs. traditional bonds and equity-like returns, and is increasingly perceived as a true asset class 58 22 47 38 20 0 ETI Loans Bonds Source: Amundi Research 60 14 2008 The current situation (regulation, negative rates, QE, etc.) has acted as an accelerator for the corporate bond market and for direct lending. Several European governments have also launched initiatives to boost direct lending to smaller companies since the financial crisis. For example, in 2012 the UK government introduced a scheme to lend £700 million of public money to smaller companies in partnership with asset managers. Better access to financing for SMEs is also one of the targets of the Capital Markets Union. 61 20 2014 • etc. 68 2008 • Being aligned with several European regulatory initiatives enabling trend shifts in capital to finance the real economy/assets (e.g. Insurance Code in France, Capital Market Union in Europe), 40 48 4 60 • Reducing the scarcity of assets for LT investors in a low-yield environment, • Accessing performing assets, 46 2014 • Improving the expected returns of portfolios, 31 SME 29 11 2014 80 2008 • Accentuating diversification of portfolios, Large Cap Other Regulation, negative rates, QE, etc. have all acted as an accelerator for the corporate bond market and for direct lending Conclusion Disintermediation has been a tangible reality in Europe for the last few years, aided by bank deleveraging and continued low interest rates. It has affected EU countries rather differently: for example, France and Belgium are ahead of countries like Spain, Germany, Greece, Denmark and Ireland. Investors, banks and corporate issuers are finding that their interests are converging as the trend continues. 26 Investors, banks and corporate issuers are finding that their interests are converging as the trend for disintermediation continues Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 Finalised at 8 December 2016 4 The many attractions of private debt markets The essential GUY LODEWYCKX, Deputy head of Private Debt Group An increasingly diverse asset class Private debt markets have changed a great deal in the past ten years. Whereas before, only the leveraged loan and real estate debt were generally known to end investors, a multitude of new asset classes are now available: corporate mid-cap debt, aircraft financing, infrastructure debt, and transport (shipping, rail, etc.). Analysing the growth of private corporate debt in euro reveals the factors at work in this development. First we note a slight increase in outstanding leveraged loans, issued as part of an LBO or its refinancing. This is a mature market, developed in the wake of its US counterpart, which regained its equilibrium after the 2007-09 crisis, although we are still quite far from the historic levels recorded in 2007, and where specialised players (fund or CLO managers) occupy a space that is structurally unappealing for banks. At the same time, we are seeing steady growth in the private corporate debt markets, issued for general corporate purposes, refinancing, development, and even acquisitions. There are two coexisting sectors: the Schuldschein, a German loan format, and the Euro PP, a French standard developed in 2011. This vigour is due primarily to a political desire to promote disintermediation. Take for example the favourable treatment of private debt under Solvency II (with a credit SCR close to that of a BBB); the French initiatives at creating the Euro PP market and implementing the «FPE» label; investments by the European Investment Fund in many local debt funds; the new option for funds in several European countries to grant loans... Of course, the need of companies to reduce their dependency on banks is also a driver. Finally, note that, while the banks’ reluctance to lend has been the main driver for this trend, today it is no longer the deciding factor. In fact, in most eurozone countries, the banks are showing renewed interest in these assets. So it is more and more common to see banks lending at longer maturities, in bullet (as opposed to amortising) formats, or accepting less stringent credit documentations. However, it should still be noted that the banks’ renewed appetite does not challenge the momentum of growth, which speaks of this market’s development. Each type of private debt has its own allocation approach Under the combined effects of the decline in interest rates and a political desire to promote disintermediation, end investors are allocating an increasing portion of their assets to the private debt markets. However, the logic underlying these investments is no longer optimisation within an envelope of illiquid assets. In fact, the successive market shocks in recent years have shown that liquidity was not a binary concept, and that yields on listed bonds sometimes underestimated the scope of that risk. Therefore, compensation for liquidity risk has become a theme across all asset classes. Consequently, the majority of private debt instruments are increasingly being compared to the bond markets. Thus they appear all the more attractive since they can allow investors to benefit from special protective mechanisms (restrictive covenants, financial covenants) and they offer many diversification opportunities on both businesses (acquisition, development, refinancing, general needs, etc.) and direct financing of real assets (aircrafts, real estate, infrastructure, etc.). From this viewpoint, private debt with the ISEs in the European Union can present value, because it offers an attractive risk /return pairing with high premiums (liquidity, origination, etc.) and protective credit documentation for investors. For the end investor, allocation on these different market segments usually comes from different approaches. For the leveraged loan, it’s absolute return that is of interest, as well as the capacity to diversify exposure inside an illiquid component that is, furthermore, exposed to private equity type assets. The approach is different for private corporate debt. The yield on this asset class and the type of risk place it closer to the investment-grade or high-yield bond markets. An allocation decision will typically be based on a comparative analysis of risk and yield on the private debt markets compared to listed bonds. Thus, this analysis must include the yield and liquidity aspects as well as the type of credit exposure, volatility, or quality of the credit documentation for the transactions. Liquidity risk - assumed but accounted for The most obvious difference between these two types of debt is, of course, liquidity on the secondary market. Bond markets organise this liquidity, but it remains uncertain, and the remuneration for this risk has often been questioned after prolonged dry spells on the secondary market (on securitisations, high yield credit, or certain specific names). Conversely, the private debt market demonstrates its relative illiquidity – even though there are still exit options in the secondary market – but offers a greater return than listed assets with comparable credit quality and maturity. By our observations, the median A multitude of new asset classes are now available: corporate mid-cap debt, aircraft financing, infrastructure debt, and transport (shipping, rail, etc.) Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 27 # 12 December 2016 liquidity premium is about 100 basis points. However, it can vary by time, because the rates of return on the public markets are more volatile than on the private markets. In fact, the price of a private investment is established during a several-weeks-long negotiating phase, and therefore reacts only marginally to day-to-day movements on the public markets. The median liquidity premium is about 100 basis points Multiple opportunities for diversifi cation Private debt also gives investors the opportunity to switch from the universe of issuers in the bond indices. Companies who use private debt are generally of a size that keeps them out of the bond markets and are almost always unrated. The trend is even toward an increasing share of ISEs on the primary market. Thus in 2014, 27% of private placements from French issuers are financed companies with less than €300 million in revenue (source: Amundi). This proportion rose to 37% in 2015 and the trend seems to have continued in 2016. For final investors, of course, this ability to access the ISE (even SME) market is an attraction in terms of diversifying issuer risk. It also allows national and supranational players to efficiently implement policies on direct financing of the economy by investing in local private debt funds. Controlled credit exposure Another key difference between listed bonds and private debt is access to information. On the public markets, information on issuers is easily accessible, and many analyses are also available: analyses and credit ratings published by rating agencies, sell-side research from investment banks, performance data and index volume data, etc. However, all these analyses are based on information that is limited by the rules on financial disclosure by public issuers. On the other hand, once a non disclosure agreement is signed, the potential investor in a private-debt instrument may have access to the issuer’s financial, accounting, or industrial data. It is common for the due diligence process to stretch over several weeks or even months and require a great deal of backand-forth with corporate officers. Thanks to the intensity of these discussions, investors can then get a very clear view of the issuer’s risk profile and potential development. 1 Euro Private Debt Issuance (€bn) 90 Euro PP 80 Schuldschein 70 Leveraged loan 60 50 40 30 20 10 0 2011 2012 2013 2014 2015 Source : Dealogic et Amundi (Euro PP), LPC Reuters (Schuldschein), S&P LCD (leveraged loan), Amundi Research Benefi ts of protective credit documentation This analysis is especially important because the private debt market’s flexibility makes it possible to negotiate the terms of the loan or bond agreement. In practice, credit documentation can provide guarantees, contain change of control clauses, negative pledges (prohibiting any new guarantees from being issued for other creditors), restrictions on any acquisitions or disposals, financial covenants, and more. All these contractual items create the framework for the credit profile over time. Therefore, it is important that these clauses reflect the results of due diligence. So a change of control clause will protect an investment in a sector that is consolidating, or a leverage covenant will provide confidence in the face of uncertainties over expansion plans. These credit documentation items can act as a put if the issuer’s credit profile worsens. In fact, the prospect of any of these contractual clauses being breached puts investors in the position of renegotiating the contract terms to their own advantage, or even demanding early repayment of their debt. These lender-protective clauses are not always included, however. The documentation’s content is determined by negotiation between issuer and investors. Yet investors have less negotiating power in a widely-distributed transaction where they will be in competition, than in a bilateral deal. So we find that credit documentation of ISE transactions is generally more protective than that of the major corporations. All these contractual items create the framework for the credit profile over time ISEs have the edge Within the corporate debt market, the ISE segment combines several advantages: attractive premiums, diversified issuer risk, and potentially protective credit documentation. 28 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 However, these features are not prevalent in all transactions. The benefits described above are usually seen in transactions with single or majority investors. While the asset class as a whole looks attractive to us, it is also important to select a manager who is prepared to find the best opportunities, analyse the issuers’ credit quality, negotiate credit documentation accordingly, build a consistent portfolio, and actively monitor it. Glossary • Euro PP (Euro Private Placement): a private placement standard promoted since 2011 by the Paris financial center in the “Euro PP Charter”. A Euro PP can take the form of a loan or bond. The ISE segment combines several advantages: attractive premiums, diversified issuer risk, and potentially protective credit documentation • Schuldschein: a German private placement format. Schuldscheine are loans. • Leveraged loan: debt from a company with high leverage (with net debt typically above 4x EBITDA), generally issued as part of an acquisition or for refinancing that operation. Financing is often “tranched” into senior and subordinate issues to optimise its cost. The senior issue usually comes with guarantees on the company’s assets (“senior secured loan”). • Direct Lending: transaction in which the investor negotiates the terms of the loan directly with the borrower, unlike “distributed” transactions in which one (or more) banks arranges the loan and then places it with investors. In practice, there is a whole gradation between these two extremes: for instance, a lead investor may co-arrange the transaction with a bank and thus influence the drafting of the credit documentation. Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 29 # 12 Finalised at 12 December 2016 December 2016 5 The ECB’s market presence will last The essential for a long time VALENTINE AINOUZ — BASTIEN DRUT Strategy and Economic Research Key decisions have been taken by the ECB governing council on 8 December. Many of them surprised the markets. In the midst of a heavy political agenda for the eurozone (the prime ministers of the number-two and -three economies resigned during that week), the ECB once again managed to surprise the markets on Dec. 8. We think that the ECB will be present on the markets for a long time and speaking about the end of the ECB’s QE is definitely premature. For now, the door is closed for the abandon of the capital key rule. The PSPP Purchases should be concentrated on the short-end of the curve for the German securities. These announcements are in favour of a steepening of the German yield curve. This is positive in the medium term for the fi nancial sector. The announced measures are the following: • QE extended by at least 9 months at a slower pace. While the markets expected the QE to be extended until September 2017 at a pace of €80 bn (€480 bn in additional purchases), the ECB extended this programme from March to December 2017 at a pace of €60 bn (€540 bn in additional purchases). We have no details on the QE’s distribution by programme (PSPP, CSPP, CBPP3, ABSPP). • Increase in the size and/or length of the QE, if the “outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment of the path of inflation,” 30 100 50 0 Source: Bloomberg, Amundi Research 2 Maturity below which PSPP purchases of German securities were impossible because of constraints 9 8 7 6 5 4 3 2 1 11-16 09-16 07-16 05-16 03-16 01-16 11-15 09-15 0 07-15 The door is closed for an abandon of the capital key rule. Extending the QE raised the issue of the lack of German PSPP eligible bonds. From then on, two options were possible: deviating dramatically from the capital key rule or modifying the QE parameters in order to enlarge the stock of German PPSP eligible assets. The fact that the governing council decided to modify the maturity constraint and to drop the yield constraint shows that they clearly chose the second option. This shows that the abandon of the capital key rule is set aside for a while. 150 05-15 Do not forget the circumstances of the decision to raise monthly purchases to €80 bn. After the 8 Dec. governing council, many ECB watchers interpreted the return to a pace of €60 bn per month as a kind of “tapering”. However, it is important to point out that the governing council decided on 10 March 2016 to go for €80 bn per month from April as long-term inflation expectations were free-falling, as there was a risk of euro appreciation, as equity markets were in turmoil and as inflation was back in negative territory. The decision to switch of 80 bn/month from 60 bn/month could be interpreted as an emergency measure. 200 1 to 2 2 to 3 3 to 4 4 to 5 5 to 6 6 to 7 7 to 8 8 to 9 9 to 10 10 to 11 11 to 12 12 to 13 13 to 14 14 to 15 15 to 16 16 to 17 17 to 18 18 to 19 19 to 20 20 to 21 21 to 22 22 to 23 23 to 24 24 to 25 25 to 26 26 to 27 27 to 28 28 to 29 29 to 30 30 to 31 This is not tapering! On the contrary, Mario Draghi’s message points to an even more sustained market presence for the ECB. He said that achieving 1.7% inflation in 2019 (the ECB’s forecast to that horizon) was “not really” the same as achieving a target. When Ben Bernanke evoked in May 2013 the idea to diminish the asset purchases done under the QE3 programme (the so-called ‘QE tapering’), it was with the idea to stop the asset purchases for good: that is very far from that point with regards to the ECB. Besides, the ECB reminded that maturing assets purchased under the APP will be reinvested “as long as necessary”. So, in addition to the QE itself (flow), the ECB holdings (stock) will continue to represent a very high share of the eurozone fixed-income markets for years : we are now at the end of 2016 and the Fed still has not reduced the amounts of its US Treasuries holdings while the QE3 ended in 2014. 250 03-15 • Removal of the yield constraint. Until now, the Eurosystem could only purchase securities with a yield above the deposit rate (currently at -0.40%). This constraint will not be applied anymore. This opens the door to possible PSPP-related losses for some national central banks, in particular for the Bundesbank. Breakdown of German public bond securities by maturity 1 DĂƚƵƌŝƚLJŝŶLJĞĂƌƐ • Change in the maturity constraint. While purchases made under the PSPP were on maturities of 2-31 years, they may now be between 1-31 years. at the time of purchases corresponding maturity on Dec. 12 Source: Bloomberg, Amundi Research Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 Purchases concentrated on the short-end of the curve for the German securities? At the end of November 2016, the Eurosystem held €290 bn in German PSPP securities. Assuming that programmes (PSPP, CSPP, ABSPP, CBPP3) will be uniformly reduced in size, the Eurosystem should purchase nearly €170 bn in German debt in 2017 (with net issuance close to zero). Yet PSPP-eligible German debt (central government, regions, agencies), respecting the issue share limit, is now close to €465 bn, including 80 bn for the 1 year – 2 years segment. It is particularly worth noting that purchases on this segment were very rarely the case since the start of the QE in March 2015. One can make the assumption that PSPP of German securities will be skewed on the short-end of the curve. The abandon of the capital key rule is set aside for a while > What is the impact of rising political risk on financial securities? 11 10 9 8 7 6 Germany France Italy Spain Supranationals Source: Datastream, Amundi Research The German banking system is particularly vulnerable to this environment. The German banking sector’s return on equity was only 2.6% during the first three months of the year, according to the EBA. This made it the third-worst performing country in the EU, ahead of only Greece and Portugal. However, low profitability was a problem well before the financial crisis. The source of German banks’ low profitability lies in the sector’s structure. The abundance of savings banks and cooperative banks means that Germany has the most fragmented banking system within the eurozone. In 2014, the five largest banks held only 32% of the system’s total assets. As a result: 1. The environment is highly competitive and drags down margins on consumer and business loans. 2. There is a high cost structure. According to the ECB, there was one bank employee per 166 people in the eurozone in 2014, compared to one per 127 people in Germany. Germany has the most fragmented banking system within the eurozone Negative rates have exacerbated the situation. According to analysts at Deutsche Bank, the ECB’s 0.4% deduction on surplus deposits will cost the German banking sector €787 million this year. These new measures are positive in the medium term for the financial sector because they lessen the pressure on the long portion of the German yield curve. The low-rate environment had heavily weighed down financial security performance: the Euro Stoxx banks lost more than 25% over the first nine months of the year. So, 45% of the euro fi xed-income market offered negative yield. With the recent rise in yields since September, the fi nancial sector has outperformed on the equity and credit markets. There is no possible parallel with 2008: banks’ solvency, liquidity, and fi nancing structure have increased significantly to meet with new regulatory constraints. Against this backdrop, its seems legitimate to once again emphasize that ultraaccommodative monetary policies are close to reaching their limits. Mario Draghi drove home the message more than usual about the importance of fiscal policy and structural reforms to support economic growth. The ECB is desperately seeking a partner to which it can pass the ball. Ultra-accommodative monetary policies are close to reaching their limits Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 31 11-16 09-16 07-16 05-16 03-16 01-16 11-15 09-15 5 07-15 The ECB could react to rising political risk by increasing the size of its QE programme. Mario Draghi specified that if the outlook were to become less favourable, the Governing Council would look to further increase the size of the programme. However, a very (or too) accommodative monetary policy would, to a certain extent, be counterproductive, because it would drag down banks’ profitability. As a reminder, the Euro Stoxx Banks index lost more than 25% over the first nine months of the year. This poor performance can be partly explained by the ultra-low-rate environment. The portion of the euro fixed-income market offering negative yields hit a new record of 45% in September. 12 05-15 The market doesn’t (usually) like political risk. However, in light of recent events, we must admit that investors are becoming relatively insensitive to this risk. Wall Street hit new record highs after Donald Trump was elected. The wide margin of victory by the “No” camp in the Italian referendum triggered only a moderate reaction on the markets. However, the story may move in a different direction in the event that doubt is cast on the cohesion of the eurozone in the wake of a populist party being elected. In this scenario (which is not very likely to happen), financial securities would be hit hard by rising risk aversion. Average maturity of PSPP purchases (in years) 3 03-15 Major elections will be taking place in late 2016 and 2017 in several major eurozone countries. To what extent could the return of political risk drag down performance of financial securities? # 12 Finalised at 30 November 2016 December 2016 6 Chinese yuan: The essential from crisis to normalisation MO JI, Strategy and Economic Research Why do we think the Chinese yuan will be a currency stabiliser in 2017? If we look at the currency movements both on the day of the US election, and also after the election, the situation is clear: 1. On election day in the United States (8 November), the rouble, yuan, pound and rupee became the most resilient currencies after Trump was unexpectedly elected, with the currencies’ intraday fluctuations at 0.0% for the Russian rouble, -0.1% for the Chinese yuan (–0.1%), +0.2% for the British pound and+0.3% for the Indian rupee, vs. +0.7% for the US dollar. 2. After the US election day until 30 November, the rouble, yuan, pound and rupee continued to show their resilience, with rouble fluctuating -2.1%, the yuan -1.4%, the pound +0.8% and the rupee -3.1%, vs. +3.1% for the US dollar. The reasons for the resilience are different between the yuan and the other three currencies, as the rouble (-77% in 2014, -24% in 2015, and +12% in 2016), pound (-16% in 2016) and rupee (-11% in 2015) had already substantially corrected before the US election, however the Chinese yuan (-3% in 2014, -5% in 2015, and -6% in 2016) was still following its regular depreciation route without any major previous corrections. With US dollar gaining much strength by appreciating +3.1% after Trump’s election, the Chinese yuan weathered the shock nicely by only depreciating 1.4%, i.e. a much smaller degree of depreciation vs. dollar appreciation, implying the relative hidden strength in the yuan. We believe that the Chinese yuan will be a currency stabiliser in 2017, a phenomenon that is still underestimated by the market. We also believe that the Chinese economy will stabilise in 2017, which is already partially priced in. We think that expectations for depreciation of the yuan have finally normalised away from crisis status. We also think the Trump government will only help to a minor extent in terms of expectations on two-way fluctuations of the Chinese currency. However, the increased impor tance of the petrorenminbi will bring a paradigm change to the global economy. Looking fur ther into the future, the larger and more open the Chinese economy becomes compared to the closed of f and smaller US economy, relatively speaking at least, will rewrite ever ything we currently know. As such, we believe that the yuan will be a currency stabiliser in 2017, and that the Chinese economy will also stabilise next year. China is contributing stability to the world economy and markets both in economic terms and also currency terms in 2017. This phenomenon remains underestimated by the market, especially the yuan’s role as a currency stabiliser. Currency Move on/after US Election Day, % change 10 8 US election day, Nov 8th 2016 8 After election day till now 6.3 7.1 6 3.1 4 2.1 0.8 1.4 0.2 0.1 0.0 2 3.1 3.6 3.7 1.8 0.7 0.3 0.5 1.7 0.8 0 -0.3 -4 -1.1 -3.5 -3.4 EUR -1.6 AUD -2 TRY BRL MYR JPY IDR DXY INR RUB CNY GBP -6 Source: Amundi Research Chinese yuan: a currency stabiliser in 2017! How has the yuan’s depreciation been normalised from crisis? We think the yuan has entered stage 4 where uncertainty over expectations for the yuan’s depreciation are significantly decreasing, and the yuan is finally moving forward along a normalised path of expected depreciation. 32 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 20 12.8 9 10 3. Stage 3: UK-related depreciation, the dollar appreciated more than the yuan depreciated (catch up depreciation). Markets were fairly relaxed given that the yuan was depreciating less and starting to show a normalisation trend; 5 4. Stage 4: US-related depreciation, the dollar appreciated more than the yuan depreciated, and the market virtually ignored the yuan’s depreciation despite its 1.4% move within three weeks, implying that the depreciation of the yuan has normalised. This means that the huge uncertainty coming from expectations for depreciation of the yuan have been largely eliminated. -5 We are putting forward the following reasons why expectations for depreciation of the yuan have normalised: (1) The yuan is proving its stability by moving to a lesser extent than the dollar; (2) The Chinese central bank (PBoC) is being proactive and successfully intervening in the onshore and offshore FX markets to stabilise the currency; (3) As we projected at the beginning of the year, capital outflows and FX reserve depletion will catch a break following repayment and hedging of foreign debt in the third quarter; (4) More capital control measures are expected to be adopted, including reducing the individual US$50,000 exchange quota, among others, to prevent potential new waves of capital outflow against the general backdrop of a tightening property market. 14 15 2.3 2 0 0 -8 -8 -11 -10 -12 -15 -16 2014 2015 DXY GBP -20 AUD -10 -2 -6 -5 EUR 2. Stage 2: US-related depreciation, the dollar appreciated less than the yuan depreciated (marked in light purple); the market felt unease which culminated in a crisis; DM Currency Move, % change (Vs USD) 1 JPY 1. Stage 1: Sudden direction change with depreciation (marked in light green). The dollar depreciated more than the yuan, as a result of which the market experienced turbulence which culminated in crisis; 2016ytd Source: Bloomberg, Amundi Research Chinese Yuan Normalization Stages Time Event USDCNY DXY Stage 1 Aug 11th 2015 ~ Aug 25th 2015 CNY sudden depreciation -3.33% -4.7% Stage 2 Nov 1st 2015 ~ Jan 8 th 2016 Before and after Fed rate hike -4.39% 1.30% Apr 1st 2016 ~ Jul 11th 2016 After US names China as currency manipulator -3.76% 1.50% Jun 24th 2016 ~ Jul 13 th 2016 After Brexit GBP depreciation over 13% -1.80% 3.50% Sep 30 th 2016 ~ Oct 27th 2016 After GBP sudden 7% depreciation -1.58% 2.56% Nov 8 th 2016 ~ Nov 30 th 2016 After Trump elected US president -1.42% 3.14% Stage 3 Stage 4 Expectations of the yuan’s depreciation have finally normalised! EM Currency Move, % change (Vs USD) 2 Source: Bloomberg, Amundi Research 100 To what extent will a large Trump administration help expectations of two-way fluctuations in the yuan? Whether and when the Trump administration will label China as a currency manipulator are still uncertain to the market. In our view, the Trump administration is unlikely to bring up this currency manipulator topic with China anytime soon, for the following reasons: (1) under our central scenario, the yuan fluctuates in a narrower range than the dollar; (2) the Trump administration is unlikely to prioritise its trade negotiations with China. As such, we expect the yuan to be more of a global currency stabiliser in 2017, and the chances of the yuan being labelled as a currency manipulator are very low. Current market expectations are still for one-way depreciation of the yuan. The rhetoric from the Trump administration, likely in 2018, about labelling China as a currency manipulator, will to some extent help China to stabilise the expectations for two-way fluctuations in the Chinese currency, but we 2014 77 2015 80 2016ytd 60 49 40 24 23 20 35 6 254 7 11 3 13 2 0 -3 -20 -12 -15 Source: Bloomberg, Amundi Research Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 33 # 12 December 2016 think it will only be to some minor extent. This is because of the overall relative dollar strength given the mild economic recovery in the US, the Fed’s rate hiking cycle; and the weakening – albeit currently stabilising – Chinese economy, are all more conducive to depreciation of the yuan than appreciation. Will the petrorenminbi era arrive earlier than market anticipated? We think one very interesting development in the global FX market in 2017 will be whether the petrorenminbi has the potential to replace the petrodollar? And if so, how soon it will be achieved? This will bring fundamental change to the global currency and systems, and thereby introduce a new order of the world economy. The impact would be far beyond our expectations, as market is not pricing in this scenario at all at the moment. This is something happening fast, on which the market has not started to focus. The impact would be much more profound than any of us can currently imagine. What has happened? The petrorenminbi will induce a paradigm change 1. Russia settles oil exports with China using RMB-denominated prices, and China pays Russia in gold. That is why we have seen a gold reserve depletion in China over the last year. 2. Saudi Arabia is also considering the same thing, so China is also trying to build its gold reserve in anticipation. 3. Given the RMB’s inclusion in the SDR currency basket, and the newly set up AIIB and NDB, yuan usage is becoming freer, hence the chances of petrorenminbi entering the market are increasing more quickly than expected. This is one area that we should not lose sight of, and one to which the markets are still unaware. If this happens quickly, dollar shortage would no longer be the fundamental key reason behind several current phenomena. If we look much further, China is becoming much bigger and more open, whereas, relatively speaking, the US is becoming much smaller and more closed off. If this is the case, the fundamental logic behind our analysis of the world economy has completely changed. In this scenario, the US will then never be the source of global recovery or slowdown, but China will be. A Chinese hard landing will certainly lead to a global hard landing, but this may not be true in the event of a US hard landing. Conclusion We believe that the Chinese yuan will be a currency stabiliser in 2017, a phenomenon that is still underestimated by the market. We also believe that the Chinese economy will stabilise in 2017, which is already partially priced in. We think that expectations for depreciation of the yuan have finally normalised away from crisis status. We also think the Trump administration will only help to a minor extent in terms of expectations on two-way fluctuations of the Chinese currency. However, the increased importance of the petrorenminbi will bring a paradigm change to the global economy. Looking further into the future, the larger and more open the Chinese economy becomes compared to the closed off and smaller US economy, relatively speaking at least, will rewrite everything we currently know. 34 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 Finalised at 30 November 2016 7 Banks: European Commission’s CRR/CRD IV and BRRD amendment proposal STÉPHANE HERNDL — DUNG ANH PHAM, Credit Analysis In late November 2016, the European Commission (EC) made proposals to amend the Capital Requirement Regulation (CRR), Capital Requirement Directive (CRD IV) and the Bank Recovery and Resolution Directive (BRRD), which are key regulatory documents within the European Union. The proposals still need to be approved by the European Parliament. Overall we believe that the EC’s proposals are positive for the European banking sector, as they aim to clarify and sometimes ease regulation on aspects which were until now seen as problematic from a credit standpoint. We take comfort in the fact that while the proposals are softer than what had been anticipated, the EC does not intend to relax the overall level of capital required or its quality, which we believe is a key driver underpinning the creditworthiness of most European banks. Most of the measures affecting subordinated instruments were long expected. The creation of a new senior instrument class was also anticipated, although the timing for implementation is tighter than what we would have thought, which is positive. With this proposal, the EC is also showing it is willing to take a more supportive stance towards the EU banking sector. This stance still needs to be confirmed on key discussions at the Basel committee, most notably on mortgage risk weight floors. The essential The European Commission’s proposal to amend the banking regulatory framework is positive for the European Union’s banking sector. This is because it clarifies and sometimes eases regulation on aspects which were until now problematic from a credit standpoint. Most of the measures were anticipated. Still, the EC is showing it is willing to take a more supportive stance towards the European banking sector. There remain uncertainties on key regulatory developments, chiefl y the evolution of risk weights on home loans. We highlight here the main key proposals. • The Commission confi rmed the split of the Pillar 2 capital requirement into a pillar 2 requirement (P2r) and a Pillar 2 guidance (P2g). The P2r will be disclosed to the market while the P2g will not. The P2r will be based on each issuer’s specific risk and has to be 75% comprised of Tier 1 capital, 56% of which has to be CET1. This proposal will improve the “distance to Maximum Distributable Amounts” (MDA), i.e. the cushion above the capital level at which discretionary payments on dividends, Additional Tier 1 (AT1) coupons and senior staff bonuses, would be constrained. This distance is to be increased due to the aforementioned split of the Pillar 2 but also the broader eligibility to P2r. • The EC also proposed to introduce a dividend and senior bonus stopper mechanism, whereby in case of breach of the Combined Buffer Requirement (CBR), the amount that institutions will be allowed to distribute would be allocated in priority to service AT1 coupons. Dividend payments to shareholders and senior staff bonus payments would be allowed only after full payment of AT1 coupons. This feature comes as a surprise as we would have expected this to be difficult to introduce into EU law. It is a new supporting driver for the AT1 space. • The EC did not mention a possible harmonization of the calculation of Available Distributable Items (ADI). The lack of consistency in the way ADIs are calculated (local GAAP vs. IFRS, consolidated vs. solo accounts) is a key weakness for the AT1 sector. The lack of visibility on ADI reserves calculation underpins our long-standing view to invest preferably in AT1 instruments of those banks where ADIs are sufficient to withstand a severe stress. • With a view to harmonising national bank insolvency law and facilitating banks’ compliance with TLAC/ MREL requirements, the EC proposed to create a new senior debt class, the Non-Preferred Senior debt (NPS). This proposal is drafted along the lines of the French senior non preferred debt. NPS debts will rank junior to the existing senior unsecured debt but above the T2 and AT1 subordinated securities. NPS instruments will need to have an initial maturity equal to or greater than one year and have no derivative feature. The proposal, if adopted will have to be enacted into national laws by June 2017 and applied in July 2017. This will be positive for existing senior debts The Commission confirmed the split of the Pillar 2 capital requirement into a requirement and a guidance. This proposal will improve the cushion above the capital level at which payments on Additional Tier 1 coupons would be constrained Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 35 # 12 December 2016 which would benefit from a greater cushion of more subordinated instruments. It is also seen as positive for banks in Spain and the Netherlands, where the public debate on the introduction, at a national level, of such a new debt layer were stalling.1 We now expect this solution to gain momentum locally, under the impetus of the EC’s proposal and tight deadline for implementation. 1 Since July 2015, Spanish banks are allowed to issue subordinated “Tier 3” instruments, which rank statutorily junior to senior unsecured debt, but senior to Tier and Tier 1 instruments. Thus far, none of them has issued such debt, though we are of the opinion that a pan-European harmonization of insolvency laws could be a game changer. In the Netherlands, some banks have publicly indicated their preference for the NPS approach, but the offi cial sector seems to be in favour of a European harmonization as a fi rst step. Overview of the revised MDA framework SREP requirement Reported capital excess over SREP SIFI/syst. buffer Combined (1) buffer requirement CCyB (2) (CBR) (a) CCB - 2.5% P2r - T2 (3) P2r - AT1 (3) P2r - CET1 (3) Capital requirement P1 - T2 - 2% P1 - AT1 - 1.5% P1 - CET1 - 4.5% Capital below SREP requirement triggers MDA restrictions Loss Shortfall vs. SREP Excess over capital requirement (b) (b)/(a) quartile >100% [75%-100%] [50%-75%] [25%-50%] [0%-25%] 1 2 3 4 distribution factor unconstrained 60% 40% 20% 0% MDA (4) = net profit (5) x distribution factor Distributable amount allocated to (6): - AT1 coupon first, then - Dividends and senior staff variable remuneration, for the remainder (1) set individually for each issuer. Has to be comprised of CET1. (2) set individually for each country. Applicable only to the banks' exposures to the buffer’s country of reference. Has to be comprised of CET1. (3) Pillar 2 requirement, the Pillar 2 component which will be made public, as opposed to the Pillar 2 guidance which will likely remain confi dential. While under CRR/CRD IV, credit institutions have to fi ll Pillar 2 exclusively with CET1, under the proposed new rules, 75% of P2r has to be in the form of Tier 1 capital, 75% of which has to be CET1 (i.e. 56,25% = 75% x 75%). (4) maximum distributable amount, the maximum amount an issuer is allowed to pay in case it fails to meet its CBR. The greater the shortfall, the lower the distributable amount, to slow the pace of capital depletion. MDA restrictions impact discretionary payments, including optional AT1/legacy T1 coupons, dividends and senior staff variable remuneration. (5) net profi t since last distribution. The defi nition remains vague and subject to interpretation. However, in case of net loss, no AT1 coupon will be paid (per EBA). (6) effectively a dividend and senior bonus stopper whereby - in the event of an MDA breach - shareholders and senior staff would get their payment only after full payment of coupons on AT1s. Note: SIFI/Syst. Buffer : the maximum of the Global Systemically Important Financial Institution, the Other Systemically Important Financial Institution and the systemic risk buffers. Generally between 0% and 3% of risk weighted assets. CCyB: countercyclical buffer, to raise capital cushion ahead of cyclical downturns (meant to be raised during boom periods, notably on home lending). CCB: capital conservation buffer: minimum cushion a bank should maintain over its capital requirements, to prevent a risk of becoming non-viable. Source: Amundi Credit Research, European Commission, European Banking Authority. 36 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 • For European Globally Systemically Important Institutions (EU G-SIBs), the MREL requirement will be closely aligned with the TLAC term-sheet: the leverage ratio will be set at 6.75% by 2021 (6% by 2019) and the risk-weighted requirement at 18% of RWAs by 2021 (16% by 2018). Instruments that count towards MREL now have to be subordinated to excluded liabilities (e.g. deposits, secured funding, etc), much like in the TLAC term-sheet. • For other institutions, the EC proposed to set the leverage ratio at 3% while the level of MREL (Minimum Required Eligible Liabilities) will be determined by the national Resolution authorities on a case by case basis. The calculation of MREL also converges to that of TLAC, i.e on a risk weighted basis. • The application of IFRS 9 will be phased in over a period of fi ve years instead of being fully implemented on 1 January 2018. This is another positive development given how unprepared the banks appear and given the implications this new standard may have on provisioning levels and volatility in the P&L. The EC proposed to create a new senior debt class, the Non-Preferred Senior debt, which will rank junior to existing senior unsecured debt, but above the Tier 2 and Tier 1 subordinated securities • The risk weight on the SMEs / infrastructure loans will be lowered for a transition period. The aim of this is likely to encourage banks to finance real economy. • The EC proposes to strengthen the framework for market risks, much along the lines of what is being discussed at the Basel committee level. However, the EC proposed to cap the new requirements to 65% of what these should be under the new rules, over a multi-year period, and to conduct an impact assessment at the end of the period. • No mention has been made about the risk weight fl oor on mortgages, which is still a key variable for EU banks. • The EC proposes to require non-EU Member State banks operating in the EU to set up an intermediate holding company with bail-in-able instruments, when their EU balance sheet exceeds EUR30 billion. This requirement is drafted along the lines of what the Fed requires for foreign banks operating in the US with a balance sheet above USD50 billion. This is consistent with the need for the EU to manage contagion and systemic risk in case one of these banks were to fail. It is arguably also to the benefit of EU banks, as it will ensure a level playing field with their non-EU competitors (in terms of cost of funding). We highlight that this is another hindrance for UK banks to continue to operate within the EU, after the UK leaves the union (the other hindrance being the issue of whether they will be able to continue to operate under the EU single passport). Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 37 # 12 December 2016 Current proposals to adapt local insolvency laws to comply with TLAC Current BRRD (EU’s official text) Germany Italy Spain France and new EC’s NPS proposal effective as of 01.01.2016 effective as of 01.01.2017 effective as of 01.01.2019 effective as of 01.07.2015 draft law all banks in the EU all banks incorp. in the country all banks incorp. in the country all banks incorp. in the country all banks incorp. in the country / the EU Secured funding Secured funding Secured funding Secured funding Secured funding Preferred deposits / structured notes / operational liabilities Preferred deposits / structured notes / operational liabilities Preferred deposits / structured notes / operational liabilities Preferred deposits / structured notes / operational liabilities Preferred deposits / structured notes / operational liabilities Corp. Deposits / retail dep. >100k€ / derivatives Corp. Deposits / retail dep. >100k€ Senior unsec. / Schuldscheine Senior unsec. (incl. sold in the retail network) / derivatives Senior unsec.* Senior unsec. Corp. Deposits / retail dep. >100k€ Corp. Deposits / retail dep. >100k€ Senior unsec. Corp. Deposits / retail dep. >100k€ T3 Senior unsecured unpreferred T2 T2 T2 T2 T2 AT1 AT1 AT1 AT1 AT1 CET1 CET1 CET1 CET1 CET1 * senior unsecured holdco debt’s proceeds downstreamed as an intragroup subordinated loan, which ranks junior to opco senior unsecured debt, but senior to opco Tier 2 and Tier 1 debt. 38 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 Finalised at 12 December 2016 December 2016 8 AWS... The hidden face of Amazon The essential LUC MOUZON, Financial analysis The advent of AWS as a dominant player in the cloud-based IT infrastructure In the space of five years - the value of the Amazon Inc. group has multiplied sixfold - the American group that initially positioned itself as the champion of e-commerce and logistics now has a market capitalisation of USD 400 billion. While the group is seen as a pioneer in the online retail revolution, a large part of its growth and profits now come from its AWS division, far less known to the public. Initially launched in 2006, AWS - Amazon Web Services - is an online IT (‘cloud’) capacity provider. At the outset, the target clients were start-ups in the internet sphere that wanted to deploy their services online without having to invest in their own capacities in terms of servers and hard drives. AWS services matured over time, and many technology groups have launched in the wake of Amazon, offering their services, such as IBM, Microsoft, and Google. The Infrastructure as a Service (IaaS) market has industrialised and thereby become accessible to a wider field of clients. Owing to the available IT tools and their increasingly easy implementation, IaaS has now become a baseline for any IT department head. Investing in one’s own data centres and servers makes less and less sense in light of the alternative offered by IaaS suppliers. There are many advantages: extreme flexibility - adjustment of required capacities in real time - rapid integration of advances in technology and a security level that cannot be replicated without colossal internal resources. In practice, the technology transfer has already begun. More than 70% of Fortune 500 companies now use IaaS solutions for a growing portion of their IT infrastructures. Size of the IaaS market (US dollar) and the advantages Faster time to market Entreprise 3.4 trillion No need for CapEx True Elastic capacity Cloud Computing 127 billion The IT infrastructure world is undergoing an unprecedented revolution. With the ser vices offered by the Amazon group (AWS), businesses have access to enormous processing and storage capacity without having to invest in their own data centres or own their own ser vers, and the time spent managing their IT infrastructure is reduced to a minimum. There are many advantages, including fully elastic capacity that meets their development needs in real time; costs that are reduced and stretched to fi t actual use; and continuous hardware and software upgrades, especially for cybersecurity. Initially popular with new companies in the internet sphere, adoption of AWS-type services is growing and has now spread to large, established corporations. Players like Netflix are going so far as to base their entire IT architecture on the one offered by Amazon. AWS is so successful that this little-known division has become a huge growth engine for the group in terms of revenue. Most significantly, it now makes up more than half of operating profits for the undisputed e-commerce champion. In the medium term, the issue of Amazon’s dominance on this market may legitimately be raised even as alternatives like IBM and Microsoft ramp up. IaaS 40 billion Pay for what you use Focus on core competency Source: Gartner 2015, Amazon AWS 2016, Amundi Research Infrastructure services is one of the IT expense segments that offers the most growth with cybersecurity, according to expert consultants like Gartner. From the viewpoint of IT managers, the equation is very simple. For businesses, traditional solutions involve significant Capex plus (often oversized) and financially cumbersome maintenance schemes. Growing complexity and increased security issues also come into play. The use of capacities leased in the cloud brings drastic cost cuts on a comparable basis. IT service players like Atos and Cap Gemini, which help businesses transform their IT, emphasise the net gain offered by cloud-based solutions. Compared to those combining own investment and the associated operating expenses, making the change means cutting TOC by a factor of four or five, potentially, over a period of two to three years. The financial equation is beyond dispute. The trickier point is that most businesses have pre-existing systems they cannot immediately discard. However, the basic trend is there, and we expect that decisions made in favour of switching to IaaS type solutions will accelerate over the coming years. Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 39 # 12 December 2016 Within 10 years it is possible to consider an IT world in which IT capacities are wholly purchased or leased like a service - just like electricity or water. Own investments in hardware will be limited to work consoles and IP networks. For large corporations, the most critical or heavily regulated data centres will be kept in-house. But the majority of the market, and SMEs, will naturally turn to outsourced capacities. Using cloud-based IT infrastructure (Iaas) can lower investment and maintenance costs by a factor of 4 The natural consequence can already be seen today in the financial markets - the value of the big names in traditional infrastructure, like IBM and HP, has collapsed over the past five years. This is especially ironic since IBM was the first to launch on the IaaS market with pilot solutions in the 1970s - but at that time, the network speeds were entirely inadequate. Emergence of IaaS - what exactly are we talking about? IaaS is Infrastructure as a Service - in concrete terms, clients are renting servers with the processing and storage capacity and all the network connectivity associated with the service. A natural extension of the market Netflix is probably one of the most advanced IT architectures for streaming videos around the world. In 2008, the group suffered serious database disruptions and could not deliver its customers anything for three days. That’s when the group decided to transform its architecture by switching to AWS. The top reasons given were: looking for greater reliability, the ability to operate on a massive industrial scale, and fully distributed systems available anywhere on the planet through the cloud. 350000 300000 250000 200000 150000 100000 50000 Amazon 2016 2015 2014 2013 2012 2011 2010 2009 0 2008 While the basic service is still virtually unchanged - basic AWS is, in concrete terms, a virtual PC with 1.7GB of power, a single 32-bit CPU, and 160GB of memory. The service is (almost) infinitely configurable with the addition of virtual machines. This means that players like Netflix and DropBox can rely almost entirely on AWS for the bulk of their services. Market Cap (Million USD) 2007 Today, the AWS platform offers much more than simple data storage - the solution has transformed spectacularly in recent years, from computing and processing capacities and, now, into special software applications. AWS offers integrated applications like database management and messaging services. 1 2006 The starting point for the service was to store and archive data - in a secure environment, accessible online in the form of remote servers. Amazon started from a simple basis with its Simple Storage Service (S3) - almost 10 years ago. Amazon’s initial stroke of genius was to use its own infrastructure, dedicated to its e-commerce activity, as the technical medium for its IaaS. The initial investment was minimal. AWS’ profitability has literally exploded since 2014, once the effects of scale kicked in. In 2016, AWS posted an operating margin of 25%, and will contribute more than the half of operating income for the current year (Amundi AM estimates). IBM Source : Amundi Research Netflix – an IT architecture moslty based on Amazon AWS CONTENU ARCHITECTURE IT Séries TV / Films & autres ARCHITECTURE IT DE DISTRIBUTION Rediffusion multi-appareils Open Connect PLAYBACK Roku – Apple TV Smart TV Appareils iOS & Android Consoles de jeux PC The Netflix group entirely rebased its IT architecture on Amazon’s IaaS offering at the beginning of 2016 Global CDN Partners tv Stockage sur S3 Transcodage sur EC2 ScaleScale 40 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 2 The main advantage, according to Netflix’s CTO, is, again, the elasticity of resources, with the option for the AWS client to add on (virtual) servers and millions of GB in storage in the space of a few hours. This, on the scale of 130 countries in which Netflix’s subscription video services are available. Overall, Netflix maintains control of the bulk of the technology through its own content delivery network (CDN) and control of its subscribers’ base, but its physical architecture is completely remoted to Amazon. Others 0% Source: Amazon, Amundi Research 80% 3 70% 2,5 60% 2 50% 1,5 40% 30% 1 20% 0,5 10% Q3 2016 0% Q2 2016 0 Q1 2016 30% 90% 3,5 Q4 2015 70% 60% AWS revenues per quarter - in USD bn (left) and y/y growth (right) 3 Q3 2015 Configuring and orchestrating IaaS tools 40% Amazon’s AWS offering is gradually moving from infrastructure to software applications Q2 2015 Managing the core business 20% Q1 2015 Managing IT infrastructures on site and maintaining legacy installed base 33% Source: Amundi Research Q3 2014 Infrastructure IT IaaS / Cloud based Managing the core business 12% Amazon Demand for IaaS, and client motivations, are changing over time. While actual operating costs are the primary motivation, flexibility and simplicity have become strong criteria for adopting IaaS. Amazon is taking over the traditional constraints of IT that eat up time and human resources. For an IT department head, this means that operating system updates and hardware renewal (servers, HHD/SSD rack, networks) are completely taken care of. IT Infrastructures on premise 8% Microsoft Back to the Future Time allocated to manage IT infratructures 5% IBM The lines between infrastructure-specific services and application domain services are beginning to blur. Software players are increasingly involved in areas connected to AWS’ own business. Conversely, AWS is developing a series of applications for cybersecurity, database, and other BI fields that have been dominated until now by Oracle, SAP, and the like. The question now is the risk of Amazon’s absolute domination. Given the size required to operate on this market and the platform effect that Amazon achieves by pooling costs with its retail business, competitors will have a tough go of it. The HP group has had to throw in the towel. More barriers to entry pop up every day. Just as IBM and HP dominated the server market in the 2000s (x86), Amazon is poised to dominate the IaaS market. The size of Amazon’s (IaaS) market could reach USD 150 billion by 2020, according to Forrester and IDC, compared to the USD 13 billion in revenue estimated for Amazon AWS over 2016. 42% Google AWS is the dominant player in the IaaS world, and the revenue the group draws from this market is projected to grow by more than 50% over FY 2016. Gartner projects 40% average growth per year for the ‘cloud’ infrastructure target market until 2020. Amazon’s estimated market share is now above 30%. The group requires investments and price pressures that are quite significant for its followers. And yet the competition is increasing - particularly from IBM and Microsoft. IBM is still quite active on traditional architectures, branding itself on hybrid solutions that are used to set up private clouds and partial use of third-party (public cloud) solutions. Microsoft is relying on the linchpin of its software solutions - Office - with Office 360 and its Azure platform. IaaS - market share by vendor - 2016 est. Q4 2014 The migration actually took seven years and, as of January 2016, Netflix became now 100% cloud-based - which means there is no longer any proprietary data centre in the group’s hands for the video-streaming service. Source: Amundi Research What could change the game for AWS in the medium-long term? Moore’s Law is still a restoring force for any IT infrastructure Amazon is subject to Moore’s Law, which dictates that overall processing power for computers will double every 18 months. So AWS must invest perpetually to retain its rank and Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 41 # 12 December 2016 provide its clients with the top-performing technology. In concrete terms, the group must have the most powerful servers, the best storage solutions, and, even more critically, the best network infrastructure. One of the key points for the future of IaaS will remain network efficiency, because clients are moving toward zero tolerance of lag times. The implicit idea of using externalised infrastructure is still that lag times are non-existent and that end users cannot tell the difference between local servers in their offices and outsourced capacities. The maturity of solid state hard drives (SSD) - i.e. storage drives based on NAND-type chips - should lead to another upgrade in the architecture of large data storage centres. The advent of SSD should generate a wave of substantial investments for players in the cloud infrastructure market, where the bulk of current storage capacity is based on standard hard drives. The next revolution for IT infrastructure will come from software architecture - particularly the tools for orchestrating and integrating software-defined networking (SDN) functions. To put it simply, software tools are evolving very quickly and providing simplified IT architecture management (particularly through virtualisation). Eventually, businesses will be able to allocate their processing and storage capacity requirements based on the best solutions available in the cloud. Switching from AWS to Google infrastructures will be much simpler for IT department heads. Changing IaaS suppliers will take a few hours or even a few minutes. Most consultants now predict that cloud brokerage activities will break into the market - allowing companies to choose, in real time, the best prices offered by IaaS providers in terms of computing and/or storage capacity. As these technologies reach maturity, price pressure will increase, eventually leading to accelerated commoditisation of the IaaS market. This is a distinct difference from the software (SaaS) markets, where the model is designed to lock in the client relationship after a few years and impose price increases after the fact. The game in the IaaS market seems more open. 42 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry # 12 December 2016 NOTES Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 43 # 12 December 2016 Publications récentes Amundi Research Center Top-down Asset Allocation Bottom-up Corporate Bonds Fixed Income Working Papers The Reactive Covariance Model and its implications in asset allocation EDUARDO ABI JABER — Quantitative Analyst – ENSAE ParisTech — DAVE BENICHOU, Portfolio Manager, HASSAN MALONGO — Recherche Quantitative On the stationarity of dynamic conditional correlation models JEAN-DAVID FERMANIAN — Professor of Finance & Statistics, CREST/ENSAE — HASSAN MALONGO — Recherche Quantitative Asset Allocation under (one’s own) Sovereign Default Risk DIDIER MAILLARD, Professor — Cnam, Senior Advisor Designing a corporate bond index on solvency criteria LAUREN STAGNOL — Recherche Quantitative Discussion Papers Series Coal extraction and mining: sector exclusion or greater selectivity? 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While industrial economic MY DOCUMEN ADD TO BASTIEN DRUT, MO JI — Research, Strategy and Analysis, PHILIPPE ITHURBIDE — Global Head of Research, Strategy and Analysis, ÉRIC TAZÉ-BERNARD — Chief Allocation Advisor % 1.5 11.03.201 14.03.201 MOST REA OF THE DAY onomic indicators news since Macro-ec tion of good widespre ad The accumula 2013 confirms onomic climate. of summerent in the macro-ec improvem MY DOCUMEN ADD TO MY DOCUMEN ADD TO TS Endocrine disruptors in ESG Analysis NAVARRE MARIE, RENARD AURÉLIE — ESG Analysis TS u ALL ARTICLES IORP2: A New Regulatory Framework for Pensions TS LING-NI BOON, MARIE BRIÈRE — Research, Strategy and Analysis Foreign Exchange Money Markets Equities Find out more about Amundi research team Low/negative interest rate environment, secular stagnation… implications for asset management PHILIPPE ITHURBIDE — Global Head of Research, Strategy and Analysis Special Focus Banks: the weak link in the European recovery VALENTINE AINOUZ — Strategy and Economic Research, YASMINE DE BRAY — Financial Analysis South Africa: is the political climate responsible for the growth decline? 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