The oil price; US tax policy; US inflation and monetary policy; The Italian economy and banks;

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1 What should we monitor in 7? January 7 - We believe economists and investors should closely monitor these variables or developments in 7 because of their importance for economies and financial markets: The oil price; US tax policy; US inflation and monetary policy; The Italian economy and banks; The Bank of Japan s balance sheet and the yen; Capital outflows from China and the RMB. Patrick Artus Tel. ( ) CORPORATE & INVESTMENT BANKING INVESTMENT SOLUTIONS & INSURANCE SPECIALIZED FINANCIAL SERVICES Distribution of this report in the United States. See important disclosures at the end of this report..

2 Six key factors for economies and financial markets In this Executive Summary we look at economic and financial developments, not geopolitical developments (diplomatic tensions, protectionism, advancement of Brexit, etc.), and we select those likely to have the greatest impact on inflation, monetary policies and financial markets (government bonds, equities, credit). We are now seeing a rise in equity markets (Chart A) and in long-term interest rates (Chart B), an appreciation of the dollar (Chart C), and a tightening of credit spreads (Chart D). To what extent could a number of shocks in 7 change these trends? We look at six important factors Chart A Stock market indices (: = ) Chart B Interest rate on -year government bonds (as %) S&P Euro Stoxx FTSE Nikkei,, United States Germany United Kingdom Japan,,,,,,,, 9 9,, 7 Jan- Apr- Jul- Oct- Jan-7 7, -, -, Jan- Apr- Jul- Oct- Jan-7, -, -, Chart C Exchange rates Chart D High yield credit spread (asset swaps, in bp) Dollar/euro (EUR = USD..., LHS) Yen/dollar (USD = JPY..., LHS) RMB/dollar (USD = RMB..., RHS),9, 7 United States United Kingdom Euro zone 7,7, Sources: Datastream, Natixis Jan- Apr- Jul- Oct- Jan-7,, Jan- Apr- Jul- Oct- Jan-7 First important factor: The oil price The financial markets expect a very moderate rise in the oil price (Chart A), consistent with the rapid growth in global demand for oil (Chart B) due to the announced reduction in OPEC and Russian production (Chart C).

3 Chart A Oil prices* (Brent, in USD/bbl) (*) From September, futures oil prices Chart B Global oil demand In absolute terms (in million bbl/day, LHS) Y/Y (as %, RHS) 9 9 Jan- May- Sep- Jan- 7 Sources: Oil Market Intelligence, Natixis Chart C Oil production (million bbl/day) OPEC United States Russia Sources: Datastream, OIM, Natixis If this moderate rise in the oil price materialises, inflation will rise above the Federal Reserve's target, but not above that of the ECB (Charts A and B). Chart A United States: Inflation (CPI, Y/Y as %) Chart B Euro zone: Inflation (CPI, Y/Y as %) Inflation Underlying inflation* (core* PCE deflator) - (*) Excl. energy and food Sources: Datastream, BLS, Natixis forecasts Sources: Datastream, Natixis forecasts But we can imagine: - A smaller rise in the oil price, which would reduce pressure on the Federal Reserve, if the agreement on production cuts is not applied; - A sharper rise in the oil price, which would force, for example, the ECB to exit its expansionary monetary policy, if the increase in the oil price gives rise to a large speculative long position (Chart ).

4 Chart Long oil futures position (non-commercial, in thousands of contracts) Sources: Datastream, CFTC, Natixis Second important factor: US tax policy Financial markets currently expect the Trump administration to drastically reduce taxes on US companies profits (a cut in the tax rate from % to % would increase net profits by %, Chart A) and introduce incentives to repatriate profits kept abroad to the United States, which could bring USD, billion in profits back to the United States and lead to a sharp increase in dividends paid out and share buybacks (Chart B), leading to a sharp rise in share prices. Chart A United States: Taxes on corporate profits and profit after tax, interest and dividends (as % of nominal GDP) Taxes on corporate profits Profits after tax, interest and dividends Chart B United States: Dividends paid and net share issuance by non-financial corporations (as % of nominal GDP) Net share issuance Dividends paid by non-financial corporations (as % of nominal GDP) Sources: Datastream, BEA, Natixis Sources: Datastream, BEA, Natixis If the Trump administration did not implement these measures, this would lead to a sharp fall in share prices and a widening of credit spreads. Third important factor: US inflation and monetary policy Chart A above shows our inflation forecasts for the United States. The rise in inflation is due both to the rise in the oil price and the acceleration in labour costs as a result of the return to full employment (Chart ).

5 - Chart United States: Unit labour cost and unemployment rate Unit labour cost (Y/Y, as %, LHS) Unemployment rate (as %, RHS) Sources: Datastream, BLS, Natixis Despite this marked rise in inflation, financial markets expect a limited rise in short-term (Charts 7A and B) and long-term interest rates (Chart 7C) in the United States. We believe investors should closely monitor the Federal Reserve s behaviour: the rise in short-term interest rates that financial markets expect seems very low relative to the expected rise in inflation. A sharper rise in interest rates in the United States would drive up interest rates in the rest of the world (Chart 7D). Chart 7A Eurodollar contract (-month) December maturity December 7 maturity December maturity,, Chart 7B United States: Interest rate on -year Treasuries (as %),,, Jan- Jul- Jan- Jul- Jan-7, 7 9 7,, Chart 7C United States: Interest rate on -year Treasuries (as %) -year interest rate -year interest rate in year -year interest rate in year,, Chart 7D Interest rate on -year government bonds (as %) United States United Kingdom Germany Emerging countries as a whole excl. China,,,,,, Jan- May- Sep- Jan- May- Sep- Jan-7,, - Jan- Apr- Jul- Oct- Jan-7 -

6 Fourth important factor: The Italian economy and banks The Italian economy is caught in a dangerous vicious circle: - Problems for banks (Chart A) and decline in business loans (Chart B); - As a result, weak investment, leading to low productivity, rising production costs (Chart C) and market share losses (Chart D); - And therefore, lastly, sluggish growth (Chart E) that increases default rates (Chart F) and reinforces the 9 7 Chart A Italy: Unprovisioned non-performing loans As % of total loans (LHS) In EUR bn (RHS) Sources: Datastream, IMF, FSI, Natixis Chart B Italy: Bank loans to companies (Y/Y as %) Sources: Datastream, Bank of Italy, Natixis Chart C Italy: Productive investment and productivity (: = ) Productive investment (in volume terms) Per capita productivity Chart D Italy: Global trade and exports (in volume terms, : = ) Global trade Italy: exports Sources: Datastream, Istat, Natixis Chart E Italy: Real GDP : = (LHS) Y/Y as % (RHS) Sources: Datastream, Istat, Natixis Chart F Italy: Household default rate and number of corporate defaults Household default rate (as %) (LHS) Number of corporate defaults (in thousands per year) (RHS) Sources: National sources, Natixis ,,,, 7,,,, To prevent Italy from sliding into a deep crisis, which would have a very negative impact on European equities, the European credit market, and peripheral euro-zone bonds, there is

7 therefore a need to fix (clean) the banks' balance sheets and to jump-start investment and growth. Fifth important factor: The Bank of Japan s balance sheet and the yen The Bank of Japan has decided to switch to a policy of targeting long-term interest rates (at %, Chart 9A), which will require it to buy a rapidly increasing quantity of bonds and to considerably increase the size of its balance sheet (Chart 9B). The Bank of Japan s situation will probably be made even more difficult by the rise in interest rates in the United States (Chart 9A) which is likely to trigger substantial short-term and long-term capital outflows, in the same way as from to (Charts 9C and D), leading to bond sales by domestic investors that will force the Bank of Japan to buy increasing quantities of bonds. If there are capital outflows from Japan combined with a very marked increase in the size of the central bank's balance sheet (the money supply), there is reason to fear a steep depreciation of the yen in the future (Chart 9E). Chart 9A Interest rate on -year government bonds (as %) Japan United States Chart 9B Japan: Monetary base In JPY trillion (LHS) As % of nominal GDP (RHS) Sources: Datastream, BoJ, Natixis Chart 9C Japan: Net purchases of foreign assets* by residents** (as % of nominal GDP) (*) Equities + bonds (**) Outflows = < Chart 9D Japan: Net open position in the yen (in thousands of contracts: long-short) Sources: Datastream, BoJ, Natixis Sources: Bloomberg, Natixis

8 Chart 9E Japan: Exchange rate against the dollar (USD = JPY...) Sixth important factor: Capital outflows from China and the RMB's exchange rate At the end of, capital outflows from China are once again becoming very significant (Chart A), still fuelled by acquisitions of companies abroad (Chart B) and also by speculative capital outflows linked to the fresh depreciation of the RMB against the dollar (Chart C). Chart A China: Annualised capital flows* (in USD bn) Chart B China: Direct investment outflows (in USD bn per quarter) (*) = x (month-on-month change in foreign exchange reserves - trade balance for the month) Sources: Datastream, IMF, Natixis Sources: Datastream, SAFE, Natixis 7 9 7, Chart C China: Exchange rate against the dollar (USD = RMB...),,, 7, 7, 7, 7,,,, 7 9 7, There is here a risk of a pronounced depreciation of the RMB, which the Chinese authorities are trying to prevent by curbing capital outflows (by making it more difficult to obtain approval for acquisitions abroad, etc.). A significant depreciation of the RMB would create tensions between China and other countries that could affect equity markets, as in -.

9 Conclusion: The worst-case and the best-case scenarios Based on the above, we can imagine the worst-case scenario for economies and financial markets: - Sharp rise in the oil price; - Leading to higher inflation than the target: the Federal Reserve raises its interest rates faster than expected and the ECB is forced to stop the quantitative easing programme, which it has just extended until the end of 7; - The sharp rise in interest rates worsens the Italian economy, leading to the threat of a debt crisis and to a marked decline in the yen and the RMB. But we can also see the best-case scenario: - Significant reduction in the tax burden on US companies; - Moderate rise in the oil price; - A continued quite expansionary monetary policy in the United States and a very expansionary one in the euro zone; - Sharp rise in equity and credit markets; - Limited exchange-rate fluctuations. 9

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