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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
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# 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
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# 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.
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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
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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;
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• 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
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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
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> 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
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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
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# 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
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# 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,
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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,
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# 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
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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.
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# 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.
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# 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
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# 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.
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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
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# 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.
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# 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
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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?
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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
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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
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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
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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
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# 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
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# 12
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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.)
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# 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
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# 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.
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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
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# 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
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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
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# 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
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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
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# 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
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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
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• 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).
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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
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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.
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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
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# 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
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# 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
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NOTES
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Contributors
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– PHILIPPE ITHURBIDE
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Deputy-Editors
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MO JI – Hong Kong, STÉPHANE TAILLEPIED – Paris
Support
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DISCLAIMER
Chief editor: Pascal Blanqué
Editor: Philippe Ithurbide
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