FINANCIAL FORECASTS ECONOMIC RESEARCH. January No. 1. What will be the characteristics of euro-zone financial markets in 2016?

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1 ECONOMIC RESEARCH January - No. What will be the characteristics of euro-zone financial markets in? We believe investors will be faced with the following characteristics in euro-zone financial markets in : Persistently very low interest rates, thanks to the ECB s action, the low level of inflation and the small wage increases; Interest-rate convergence between euro-zone countries thanks to quantitative easing; Growing abundance of liquidity to invest, given the ECB s inability to push up inflation; Appeal of European equities - whose valuation remains low - due to the low interest rates, the cyclical economic recovery, the abundance of liquidity, the improving corporate profitability, the depreciation of the euro and the fall in commodity prices; Variable volatility of asset prices (high volatility of volatility) and fluctuating risk aversion, due to the abundance of monetary liquidity in a situation where market liquidity is limited; Effects of the cyclical lag and the monetary policy divergence between the and the euro zone; they may trigger high variability of the dollar/euro exchange rate, probably divergent trends of equity markets and credit markets in the and the euro zone, and the risk of contagion from the deterioration in these markets in the to the euro zone. The objective would therefore be to be able to take advantage of the good performance of European equities while hedging against the volatility of volatility and against contagion from the. Author: Patrick Artus

2 Six specific characteristics of euro-zone financial markets in Very low long-term interest rates; Chart D Euro zone: Real GDP growth (Y/Y as %) The continuation of quantitative easing until 7 (Chart A), the small increases in labour costs and the low inflation (Charts B and C), at the most % in, and the modest improvement in growth (Chart D) add credence to the view that long-term interest rates will remain very low in the euro zone in (Chart E). - - Chart A Euro zone: Monetary base (in EUR bn) - Sources: Datastream, ECB, forecasts Chart E Interest rate on -year government bonds (as %) Germany Euro-zone countries as a whole excl. Greece Sources: Datastream, ECB, 7 9 Chart B Euro zone: Nominal per capita wage and unit labour cost (Y/Y as %) Nominal per capita wage Unit labour cost Sources: Datastream, 7 9 Sources: Datastream, Eurostat, Chart C Euro zone: Inflation (Y/Y as %) Inflation (CPI) Underlying inflation (core* CPI) (*) excl. energy and food - () Ongoing interest-rate convergence between euro-zone countries The ECB s ongoing purchases of euro-zone government bonds (Chart A) de facto continue to transform government bonds into eurobonds. The reason is that when the ECB buys a euro-zone country s debt, this country s sovereign risk is neutralised since, in the event the ECB incurs a loss on this debt, it will be recapitalised by all euro-zone countries. This means that the continuation of quantitative easing should lead to continued convergence of long-term interest rates between eurozone countries (Charts B and C). Chart A Euro zone: Outstanding government bonds held by the ECB (in EUR bn) Sources: Datastream, Eurostat, Sources: Datastream, ECB, 9

3 7,,,, Chart B Interest rate on -year government bonds (as %) Germany France Spain Italy Portugal 7,,,, 7 Chart B Euro zone: Private sector debt* (as % of nominal GDP) (*) households + companies 7 7, 7,,,,, Sources: Datastream,, 7 9, Sources: Datastream, ECB, 7 9 Chart C Interest rate on -year government bonds (as %) Germany France Spain Portugal Italy Chart C Euro zone: Lending to the private sector* (Y/Y as %) (*) households + companies - - Sources: Datastream, Jan-Apr- Jul- Oct-Jan-Apr- Jul- Oct- Sources: Datastream, ECB, () Growing abundance of liquidity to invest The ECB s expansionary monetary policy cannot have any noticeable effect on euro-zone inflation. The high unemployment rate (Chart A) is leading to a continued slowdown in labour costs; due to the still high debt level, the credit recovery is modest (Charts B and C); wealth effects are very weak in the euro zone; the depreciation of the euro is having only a temporary effect on inflation (Chart D). 9 Chart A Euro zone: Unemployment rate (as %) 9,,,,,, Chart D Euro zone: Exchange rate, import prices and inflation (Y/Y as %) Exchange rate against the dollar (EUR = USD..., LH scale) Inflation (CPI, Y/Y as %, LH scale) Import prices (Y/Y as %, RH scale) Sources: Datastream, Eurostat, -, 7 9 This means that the stance of monetary policy will remain very expansionary, and therefore that the liquidity to invest will remain very abundant Sources: Datastream, Eurostat, () Appeal of European equities As a result of: The low interest rates (see above); The economic recovery in the euro zone (Chart A); The abundance of liquidity (see above);

4 The wage restraint (Chart B) and the rising corporate profitability in the euro zone (Chart B); The depreciation of the euro (Chart D above); The fall in commodity prices (Chart C); The modest level of the initial valuation of European equities (Chart D); European equities are definitely an attractive asset for investors in. Chart A Euro zone: PMI (index) Manufacturing PMI Non-manufacturing PMI Chart D Euro Stoxx: Equity risk premium and forward PER Sources: Datastream, Forward PER Equity risk premium 7 9 Sources: Datastream, Markit, 7 9,,,,,, Chart B Euro zone: Profits after tax, interest and dividends (as % of nominal GDP) Sources: Datastream, Eurostat, 9, 7 9 Chart C Commodity prices Oil prices (USD/bbl, LH scale) Non-precious metals ( =, RH scale),,,,,, 9, 7 European credit is benefiting from the same positive factors, except that the credit market is still relatively expensive despite the recent repricing (Chart E). Chart E Euro zone: Credit spreads (asset swaps, in bp) () High volatility of volatility 7 7 In a situation where the liquidity created by central banks is very abundant and where market liquidity is low, small shocks and insignificant news create very large capital flows from one asset class to another. This explains the rapid alternation of periods of volatility and high risk aversion, which we have already seen in (Charts A and B). BBB High Yield Sources: Datastream, Chart A VSTOXX stock market index equity volatility (as %) Sources: Datastream, 7 9 Sources: Datastream, 7 9

5 Chart B risk perception index Interest rates (Charts C and D); Share prices, which is already noticeable in (Chart E); Credit spreads (Charts F and G). Chart C Interest rate on -year government bonds (as %) Germany Source: () Cyclical lag between the and the euro zone The is currently at the end of an expansion period, while the euro zone is at the start of an expansion period (Charts A and B). Chart A Real GDP growth (Y/Y as %) Euro zone Sources: Datastream, Chart D Interest rate on -year government bonds (as %) Germany Sources: Datastream, BEA, ECB, Chart B Composite ISM or PMI (index) Euro zone Sources: Datastream, Chart E Stock market indices (: = ) S&P Euro Stoxx Sources: Datastream, BEA, ECB, 7 9 Sources: Datastream, 7 9 This explains the divergence of monetary policies (gradual tightening in the, continuation of stronger expansion in Europe), and therefore the divergence of:

6 9 7 Chart F BBB credit spread (asset swaps, in bp) Euro zone Sources: Datastream, iboxx, 7 9 Chart G High Yield credit spread (asset swaps, in bp) 9 7 Chart I High Yield default rate (as %) Euro zone Sources: Moody s, 7 9 Chart J Dollar/euro exchange rate (EUR = USD...) Euro zone,,,,,, 7 9 This unprecedented situation of divergence between the and the euro zone raises several questions: Sources: Datastream, Merrill Lynch, We expect the situation of financial markets in the to deteriorate, given the end of the expansion cycle, the decline in corporate profitability (Chart H) and the rise in default rates (Chart I). The first question is whether this deterioration will spread to European markets or whether there can be a significant decoupling between US and European markets; We expect high volatility in the dollar/euro exchange rate (Chart J), due to the uncertainties created by the cyclical divergence between the and the euro zone. Chart H Profits after tax, interest and dividends (as % of nominal GDP) Euro zone, Conclusion: What objective for investors? The above shows that investors should try: To take advantage of the likely strong performance of European equities (low interest rates, abundance of liquidity, rising profitability, weak euro and low commodity prices); Sources: Datastream,, 7 9,, But while hedging against volatility of volatility, i.e. against drastic downward market corrections; And hedging against a possible contagion from the US equity market, which is likely to be in a more difficult situation as the expansion period in the is drawing to an end. Sources: Datastream, BEA, Eurostat,

7 Equity Markets Equity indices // // // Main indices (end of period) Mar- Jun- Sep- Dec- Mar-7 S&P 9 nc QoQ Growth % % % % nc EURO STOXX nc QoQ Growth % % % % nc DAX nc QoQ Growth % % % % nc CAC 7 7 nc QoQ Growth % % % % nc Sources: Bloomberg, US Equity Market (S&P) European Equity Market (Eurostoxx ) Observé Observed Observé Observed Corporate Credit Spreads Credit Spreads // // 7// EUR Spreads (bp, end of period) Mar- Jun- Sep- Dec- Mar-7 Investment Grade 9 99 nc High Yield 7 9 nc U.S. Spreads (bp, end of period) Investment Grade 77 9 nc High Yield 7 9 nc Sources: iboxx, Merrill Lynch, Note: Investment Grade spreads are non-financial corporates EUR spreads are expressed against sw ap, US spreads are option-adjusted spreads Investment Grade EUR spread High Yield EUR spread Observed Observé Observed Observé Sources Sources : : Sources :, Datastream

8 Bond & swap Markets : United Kingdom, Japan & Switzerland United Kingdom // // // Swap rates (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 -year,9,9,,,,,,, Fwd - - -,,,,,, -year,,9,,,7,,9,, Fwd - - -,,,7,79,,9 -year,,,9,,,,,, Fwd - - -,9,,,9,,7 -year,,,9,,,,,,7 Fwd - - -,,,,,, Y - Y 9 7 Y - Y Y - Y 9 7 Gilts // // // Yields (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 Y Gilt,7,9,,9,,,,, UK Y sovereign interest rate UK -Y swap slope (bp) Observed Observé Forward Observed Forward Observé Forward Japan // // // Swap rates (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 -year,,,,,,,7,, Fwd - - -,,,,,, -year,,,,,,,,, Fwd - - -,,,9,,,7 Y - Y JGB // // // Yields (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 Y JGB,,7,,,,,,, Japan Y sovereign interest rate Japan -Y swap slope (bp) Observed Observé Forward Observed Observé Forward,,,,,,,,,,,,,,, Sources :, : Bloomberg,,, - Sources Sources ::,, Bloomberg Bloomberg - Switzerland // // // Swap rates (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 -year -, -, -, -,7 -,7 -,7 -,7 -, -, -year,,,,,,,,, Sources: Bloomberg,

9 US bond & swap Markets // // // Sovereign yields & spreads (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 -year,,,,,,,,, Fwd - - -,,,,9,,9 -year,,7,7,,,,,, Fwd - - -,,97,7,,7, -year,7,7,,,,,7,,9 Fwd - - -,,,,,, -year,7,,99,,,,,, Fwd - - -,,,9,,,7 Y - Y Y - Y 9 7 Y - Y Sovereign spreads // // // Y spreads, in bp (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 TNotes - Bund TNotes - Gilt 7 US Y sovereign interest rate US -Y slope (bp) Observed Observé Forward Observed Observé Forward 7 7 Sources ::, Bloomberg Swap rates // // // (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 -year,9,,,,,7,,, Fwd - - -,,,,,77, -year,7,7,9,,7,,,,7 Fwd - - -,7,,9,,, -year,,,,,,,7,,9 Fwd - - -,,,,9,,7 -year,,,,,9,,,, Fwd - - -,,,7,,7,7 Sources: Bloomberg, US swap curves -M -M, -M -M, -Y -Y Aujourd'hui Today,,,,,, US Y swap spread (bp) Observed Observé Forward - - Swap spreads // // // in bp (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 -year,,, -year, -, -, 7 -year, -, -, - -year -, -9, -, Sources: Bloomberg, 9

10 European bond & swap Markets Germany // // // Sovereign yields & spreads (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 -year -, -, -, -, -, -, -, -,, Fwd , -, -,9 -, -, -, -year, -, -,7 -, -,,,,, Fwd ,,,7,,, -year,,,7,,,7,,9, Fwd - - -,,,9,7,77, -year,9,9,,,,,,, Fwd - - -,,,7,,, Y - Y 7 Y - Y Y - Y Sovereign spreads // // // Y spreads, in bp (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 OAT - BUND BTP - BUND Germany Y sovereign interest rate Germany -Y slope (bp) Observé Observed Forward Forward Observed Observé Forward Sources Sources :, :, Bloomberg Bloomberg - - Sources Sources :, :, Bloomberg Bloomberg - - Swap rates // // // (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 -year, -, -, -, -,,,,, Fwd ,,,,9,, -year,,,,,7,,,7, Fwd - - -,,,,,, -year,,,9,9,9,,,9,9 Fwd - - -,,,,7,, -year,,,7,9,,,,7,7 Fwd - - -,,,,,,7 EUR swap curves -M -M -M -M,, -Y -Y,, Aujourd'hui Today,,,,,,,, Sources Sources :, :, Bloomberg 9 7 EUR Y swap spread (bp) Observed Observé Forward 9 7 Swap spreads // // // in bp (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 -year 9 -year -year year 7 7 Sources: Bloomberg,

11 Economic Forecasts January- The picture in a nutshell: In our central scenario we expectthe Fed toraise rates fourtimes this yearby a quarterpointeach time. But given the latestdisappointingu.s. figures, we will particularly pay attention todevelopments inthe labormarketand the Services ISMas well as in spreads forthe US High Yield energy sector. In particularnfps of less than / K (versus K on average overthe last six months) wouldcall ourfed scenario into question. Our central assumption is thatthe Brentwill trade at USD by the end of the year. In this case, the ECB is expectedtomainta in the status quo. Butshouldthe Brent trade durablybelow USD this year, inflation wouldturn negative again bythe midof the yearand would force the ECB to furtherstimulus. GDP (YoY) Inflation (YoY) Fiscal balance (% of GDP) 7 7 7,,,,,9, -, -, -,7 Latin-America -, -, -,,9,7, -,9-7, -, Brazil -, -, -,,9 7,, -,9 -, -, Mexico,,,,7,, -,9 -, -,9 Argentina,,,,, 7, -, -, -, United Kingdom,,,,,7, -, -, -, Euro Zone,,,,,9, -, -,9 -, Germany,,,,,9,7,,, France,,,,,9, -, -, -, Italy,7,,,,, -, -,9 -, Spain,,9, -,,7, -,9 -, -, Netherlands,,,9,,, -, -, -, Central Europe *,,, -,,, -, -, -, Turkey,,7, 7, 7,, -, -, -, Russia -, -,,, 7,, -, -, -, China,9,7,,,9, -, -, -, Japan,,,,,, -, -, -, Asia excluding China and Japan**,,,7,9,, -, -, -, India(FY) 7,, 7,,9,, -, -,9 -, Korea,,7,,7,,7 -,,, Developed economies,9,9,,,, Emerging economies,,7,,9 7,, World GDP,,,,,7, World (PPP),9,, * Poland, Hungary, Czech Republic ** Korea, Thailand, Malaysia, Singapore, Hong-Kong, Indonesia, Philippines, India, Taiw an, Vietnam Money Markets Official Rates / Eonia, Euribor & Libors déc.- // Mar- Jun- Sep- Dec- Mar-7 Jun-7 FED rate,,,7,,,,7, M Libor $,,,9,,,,9, Forward,7,9,,,, ECB rate,,,,,,,, M Euribor -, -, -, -, -, -, -, -, Forward -,7 -,9 -, -,9 -,7 -, Eonia -, -, -, -, -,9 -, -, -, Forward -, -, -, -, -, -,9 BOE rate,,,,,7,,, M Libor,9,9,,,9,,, Forward,,,7,,9,9, BOJ rate,,,,,,,, M Libor,,,,,,,, Forward,,,,,, SNB rate -,7 -,7 -,7 -,7 -,7 -,7 -,7 -,7 M Libor CHF -,7 -,7 -,7 -,7 -,7 -,7 -,7 -,7 Forward -,7 -, -, -, -,7 -,7

12 Foreign exchange rates // // // G (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 EUR/USD,,9,,,,,,, EUR/GBP,7,7,7,7,7,7,,9,7 EUR/CHF,,9,9,,,,,, EUR/SEK 9, 9,7 9, 9, 9, 9, 9, 9, 9, EUR/NOK 9, 9, 9, 9, 9, 9, 9, 9,, GBP/USD,,7,7,,,,,, USD/JPY 9,,,,,,, USD/CNY,,9,,7,,9,9 7, 7, Sources: Bloomberg, EUR/USD EUR/GBP Observé Observed,7,7,,,,,,,,,,,,,7,,,,,,, Observé Observed,,,9,9,9,9,,,,,7,7,7,7,,,,,,,9,9,9,9,,,,,7,7,7,7,,,, // // // (end of period) Mar- Jun- Sep- Dec- Mar-7 Jun-7 USD/KRW USD/INR,,,, 7, 9,,,, USD/BRL,,9,,,,,,,7 USD/MXN, 7, 7, 7, 7, 7,,,, USD/CAD,,,,,,9,7,, AUD/USD,,7,7,,7,,,, NZD/USD,7,,,,,,,,9 Sources: Bloomberg, USD/JPY USD/BRIC Observé Observed Observé Observed

13 Commodity markets // // // Energy prices mars- juin- sept.- déc.- mars-7 juin-7 Brent spot 7,,, 7 9 Future,,,,, 7,7 WTI spot, 7,, Future,9,,,,, Brent prices ($/bl) Brent curve Observé Observed Futures 9 Aujourd'hui Today -M -M -M -M -Y -Y Sources :, : Bloomberg - Sources Sources :, :, Bloomberg Bloomberg - // // // Metals Mar- Jun- Sep- Dec- Mar-7 Jun-7 Gold,9, 7, Gold-Oil ratio Observed // // // Cross indicators mars- juin- sept.- déc.- mars-7 juin-7 Gold-Oil ratio (vs Brent),7 9, 9,,,,9 9, 7, 7, Sources: Bloomberg,

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