By Arnab Das, Invesco Fixed Income (Atlanta) OECD Money growth & inflation %YOY. Source: Macrobond, as at 31 December 2017.

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1 In recent years, European monetary policy, particularly that of the European Central Bank (ECB) and Bank of England (BoE), have directly contributed to domestic financial stability, economic recovery and global risk appetite. The QE to QT bull/bear debate: the special case of Europe February 2018 This marketing document is exclusively for use by Professional Clients, Financial Advisers in Continental Europe (as defined in the important information) and Ireland as well as by Qualified Investors in Switzerland. This document is not for consumer use, please do not redistribute. Please read the Risk Warnings that appear on page 5. Indeed, the BoE s post-brexit referendum policy gave rise to easier financial conditions in Thus, the start of the ECB s quantitative easing (QE) program tapering and the initial BoE rate hike must be considered when assessing how the unwinding of emergency monetary policies large-scale asset purchases and negative rates will impact the global economy and financial markets. By Arnab Das, Invesco Fixed Income (Atlanta) A shift in Europe towards Quantitative Tightening (QT) may undermine global risk appetite. It will be enough Issues specific to the Eurozone (EZ) and UK include the threat of euro disintegration and of a Brexit-led trade/investment shock. These deserve special consideration as these risks threatened the global economy following the Global Financial Crisis (GFC). ECB QE was instrumental in stabilising risk premia across the Eurozone, and thereby containing the Eurozone financial crisis (EFC) and preventing the disintegration of the euro. The ECB initially succeeded where EZ governments had failed thanks to ECB President Mario Draghi s verbal commitment...to do whatever it takes [to save the euro] and... it will be enough. OECD Money growth & inflation %YOY CPI all items: OECD [c.o.p. 1 year] Broad Money (M2 or M3) [c.o.p. 1 year] /00 07/02 01/05 07/07 01/10 07/12 01/15 07/17 Source: Macrobond, as at 31 December

2 The BoE s August 2016 rate cuts and increased QE, following the June 2016 Brexit referendum, significantly eased financial conditions in the UK. The BoE has already begun shifting its policy stance back in the direction of normalisation, with its first rate hike in a decade in 2017, reversing the post-brexit cut. Even so, this new round of stimulus was global even though it was initiated in response to the specific idiosyncratic threat of Brexit. It seems to have delayed or mitigated a UK slowdown in response to Brexit-driven uncertainties, rather than prevented it. Thus, a shift in Europe towards Quantitative Tightening (QT) may undermine global risk appetite. Here we provide a regional bull/bear discussion of the investment challenges posed by the end of ECB QE and the recent BoE rate hike. Bear case: higher growth and higher bond supply means higher bond yields The global effect of ECB QE tapering in 2018; balance sheet reduction in 2019; and potential future rate hikes will be significant even if there is no rapid adjustment. The ECB is arguably undergoing the greatest policy shift of all major central banks from a backdrop of negative interest rates and multi-pronged QE across the Eurozone, to one of tapering (via balance sheet stabilisation) leading to future policy rate hikes. This is a bigger shift than the Fed, which neither took nominal policy rates below zero nor bought credit whether corporate or municipal debt. In the future, large private investors will have to purchase bonds that the ECB would otherwise have bought. These investors will likely demand higher yields for a host of reasons. Growth is above almost all estimates of potential, which means the output gap is closing even if slowly. In a scenario in which private demand for Eurozone government bonds remained unchanged, an increase in the supply of these bonds from the public to the private sector would imply lower bond prices. Even if private demand increased for no particular reason, this would probably only partly offset the pressure of higher growth and firming inflation on bond yields. After all, a key purpose of QE was to depress real bond yields below market-clearing levels to pressure private investors to seek yield and duration elsewhere in long-dated or higher risk credit, equity or real estate assets. Rising bond yields and normalising monetary policies might raise refinancing risks for highly leveraged firms or zombies. Will we see more risk-aversion? This deliberately excessive easing of financial conditions was ultimately aimed at inducing growth by lowering the cost of credit and increasing its availability in the real economy. Now that this goal has been reached, the role of monetary policy normalisation would be to restore policy rates, financial conditions and therefore bond yields to their more normal levels, curve slopes and trajectories all of which are higher than at present. In a more negative scenario, any major increase in private-sector demand for European government bonds as perceived safe assets would very likely be associated with rising risk aversion and allocations to the ultra-low-yielding Eurozone core. Such a scenario in turn would likely be associated with a shift out of the periphery and probably out of risky assets globally. Falling bond yields would be associated with rising risk premia. 2

3 The ECB will need to exit with caution, with as much forewarning as the Fed, if not more so. Credit spreads might usually hold or even tighten in such a scenario during a normal cycle but in this one, emergency monetary policies have pushed both yields and spreads to exceptionally rich levels. But now, rising bond yields and normalising monetary policies might raise refinancing risks for highly leveraged firms or zombies that have been given an extended, cheap lease of life by easy policies. Such developments might also cause a reassessment of fair value in credit spreads generally because the same issues might well affect various companies in various sectors and economies. Bull case: bond yields hinge on inflation and financial conditions, which are supportive, and growth The key risk for the markets would be a sudden shift in central bank policy or rhetoric away from forward guidance and gradualism towards a significantly more hawkish stance. This was the key lesson of the so-called taper tantrum. Today, however, growth is being generated mainly out of income rather than credit growth except in a few cases such as China (where policy is now tightening and taking the growth impetus away from excessive and shadowy credit growth). In most other parts of the world, credit growth has been relatively weak. Thus, the key risk for ECB policy, as with any other major central bank, would be any significant shift in inflation or inflation expectations: a string of upside inflation surprises could make the ECB and BoE tighten more significantly than is priced in. Comeback of cash-is-king? Any such inflation-driven tightening would call for a re-pricing of policy and would be a challenge for both risk-free and risky asset classes to absorb. In a replay of the taper tantrum bonds, credit and equity would suffer all at once, driving investors into a cash-is-king mentality. The threat of higher inflation must be born in mind given how strong the global growth cycle is. However, high inflation is not likely to become a central scenario anytime soon, in our view, because many of the underlying drivers of inflation are restricted. History suggests that accelerations in inflation are associated with rising growth in money and credit aggregates (chart below). At present, inflation is firming and credit is starting to grow, but remains weak relative to history, and, if anything, is slowing across many important economies. Finally and perhaps most important of all, the ECB has the hindsight of the Fed s experience. The taper tantrum itself stands as a cautionary tale of the dangers of a policy shock in a global economy that is still recovering from the trauma of the first global, systemic financial crisis in generations. This lesson is compounded for the ECB as the most effective guardian of both price stability and the euro s integrity that has now restored financial stability mandates of major central banks. As such, we would expect the ECB to maintain its current approach of carefully telegraphed policy change and well communicated policy debate. The ECB is far from tightening policy Like the Fed, the ECB also has every interest in sustaining the recovery, while maintaining price and financial stability. And indeed, it is precisely because the ECB went so much further than the Fed, into negative rates and corporate bond purchases, that it will need to exit with caution and with as much forewarning as the Fed, if not more. After all, the Eurozone Financial Crisis (EFC) was an even more profound threat than the Global Financial Crisis (GFC), even though it was contained before the financial system collapsed. The threat to the very existence of the euro could have led to cascading defaults and devaluations across the Eurozone. The effects were very serious, even though a crisis did not materialise capital flight out of Europe and a withdrawal of foreign funding directly affected banks and their sovereigns. Thus, although the ECB has begun normalisation, it is likely very far from tightening policy. A slow, well-communicated process should sustain both economic growth and risk appetite in a low-yield world. 3

4 Convergent policy normalisation can take place in an environment of continued economic recovery and financial stability. Conclusion: support of risky assets The Eurozone recovery and gradual convergence of ECB policy towards Fed policy implies that the euro will likely strengthen against the dollar, which is a crucial source of easy global financial conditions. US dollar-euro is the most important single bilateral exchange rate in the world, and the prime mover in the impact of major currencies and central bank policy differentials on global financial conditions. With global growth recovering and global policies starting to converge gradually, the dollar has peaked, as in many previous cycles. All of this argues that convergent policy normalisation can take place in an environment of continued economic recovery and financial stability, which should support risky assets through gradual repricing in bonds. 4

5 Contact Amsterdam Brussels Frankfurt Madrid Milan Paris Vienna Zurich Risk Warnings The value of investments and any income will fluctuate (this may partly be the result of exchange-rate fluctuations) and investors may not get back the full amount invested. Important Information This marketing document is exclusively for use by Professional Clients, Financial Advisers in Continental Europe (as defined below) and Ireland as well as by Qualified Investors in Switzerland. Data as at , unless otherwise stated. This document is not for consumer use, please do not redistribute. By accepting this document, you consent to communicate with us in English, unless you inform us otherwise. This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities. Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. Further information on our products is available using the contact details shown. This marketing document is not an invitation to subscribe for shares and is by way of information only, it should not be considered financial advice. As with all investments, there are associated risks. This document is by way of information only. Asset management services are provided by Invesco in accordance with appropriate local legislation and regulations. For the distribution of this document, Continental Europe is defined as Austria, Belgium, Luxembourg, Finland, France, Germany, Greece, Italy, Portugal, the Netherlands, Spain, Sweden and Switzerland. Germany, Austria and Switzerland: This document is issued in Germany by Invesco Asset Management Deutschland GmbH, An der Welle 5, D Frankfurt am Main. This document is issued in Austria by Invesco Asset Management Österreich Zweigniederlassung der Invesco Asset Management Deutschland GmbH, Rotenturmstrasse 16 18, A-1010 Wien and in Switzerland by Invesco Asset Management (Schweiz) AG, Talacker 34, CH-8001 Zurich. Belgium, Finland, France, Greece, Italy, Luxembourg, Netherlands, Portugal, Spain and Sweden: This document is issued by Invesco Asset Management S.A., rue de Londres, Paris, France. Ireland: This document is issued in Ireland by Invesco Global Asset Management DAC, Central Quay, Riverside IV, Sir John Rogerson s Quay, Dublin 2, Ireland. Regulated in Ireland by the Central Bank of Ireland. EMEA1482/2018 Read more articles from the Euro Zone News: Centrally or locally? Finding an optimal mix will be the winning formula for Europe s future in a fractured world, says Bernhard Langer. Investor or owner? As ESG gains ground, active ownership is the engine that drives responsible investment stewardship. Out with the old? Taking a deep look into the notes on ECB Governing Councils can be worthwhile, observes Jeff Taylor. How long can this go on? There is reason to think the strong economical development of the Eurozone will continue, says Paul Temperton. Are investors ignoring the balance of risks? The risks to the consensus view of Eurozone inflation are increasing, observes Mark McDonnell. 5