Euro area fundamentals #1 Potential growth important for bond yields

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1 Investment Research General Market Conditions 1 June 2015 Potential growth important for bond yields Bond yields have been driven by ECB flows in 2015 and it seems evident that fundamentals have had a limited effect in market developments so far. However, with an expected sharp rise in inflation in Q4 and very low potential GDP growth in the euro area, focus could soon turn to whether the ECB could start tightening its monetary policy sooner rather than later. In this series of research papers we consider the fundamental drivers of the euro area economy aimed at giving our view on the ECB s future monetary policy. We show that potential GDP growth is crucial for where long-term interest rates should be, when the ECB will start normalising its monetary policy and thus when bond yields should be driven by fundamentals rather than flows. We expect potential growth to increase very slowly due to the very muted productivity growth, headwind from employment growth and modest investment outlook. In our upcoming papers, we discuss whether the ECB will end its QE programme before September 2016, whether it will hike policy rates immediately after the end of the QE programme and what the outlook for long-term interest rates is. Euro area fundamentals Potential growth important for bond yields The output gap will close quickly implications for the ECB Fundamentals to keep bond yields low Outlook for drivers of potential GDP growth Drivers of potential GDP growth > Expectations Technology Potential productivity Edudation To improve marginally Organisation of workers Hours worked Potential employment Population age Activity rate To continue to be a headwind NAIRU Capital accumulation Investments Depreciations To be slightly supportive Source: Danske Bank Markets Senior Analyst Pernille Bomholdt Henneberg perni@danskebank.dk Senior Analyst Anders Vestergård Fischer afis@danskebank.dk Important disclosures and certifications are contained from page 8 of this report.

2 Different drivers of long-term interest rates Following the ECB s QE announcement early this year, bond yields have to a large extent been driven by flows rather than fundamentals both in the post-qe decline and the following correction, see Strategy: Bond yields to go higher in coming months but don t expect a long bear market on the sell-off in April/May. However, as fixed income markets have stabilised, the questions are what is a fundamental fair value for bond yields and which drivers will dominate in the future. To determine this, we consider three different approaches: 1. The ECB monetary policy is set according to a standard Taylor rule 2. A classic macroeconomic model, where savings equal investments 3. A micro-economic founded model, where rates equal marginal return on capital The first fundamental way to consider interest rates is to assume they are determined by the ECB s monetary policy set according to a standard Taylor rule,. The Taylor rule signals the ECB should hike its policy rate by around 10bp at end-2015, see chart 1. This follows, as inflation is expected to increase sharply at the end of this year, see Euro inflation research #1: Inflation to increase sharply this year. However, we do not think the Taylor rule represents the ECB reaction function very well (note how it failed to explain the recent policy move of asset purchases), as there will still be a large output gap and core inflation will remain very low at end Therefore, we expect the ECB will remain on hold for longer than suggested by the simple Taylor rule, see chart 2. We will discuss our expectations of ECB monetary policy in our upcoming paper about the ECB s reaction function. Chart 1: Taylor rule suggests higher policy rate at end-2015 Chart 2: A large output gap will keep ECB on hold Source: ECB, Eurostat, Danske Bank Markets Source: ECB, Eurostast, Danske Bank Markets A classic macroeconomic setup where aggregate demand equals aggregate supply also provides a fundamental determination of the interest rates. Here, the equilibrium interest rate is determined by the level where investments equal savings. This is consistent with real GDP growth equalling its potential plus an adjustment for long-term inflation expectations,. Finally, in a micro-founded macroeconomic model based on rational choice the interest rate equals the marginal return on capital again adjusted for long-term inflation expectations,. In equilibrium GDP equals its potential, hence the only difference compared to the expression above, is that potential GDP is set relative to the capital accumulation, and then adjusted by a constant. 2 1 June

3 Chart 3: Lower inflation expectations during 2014 Chart 4: Potential GDP growth is crucial for bond yields Source: Bloomberg, ECB, Danske Bank Markets Source: Bloomberg, ECB, European Commission, Danske Bank Markets Both macroeconomic perspectives will thus point to the decline in inflation expectations in 2014 to explain why bond yields have declined, see chart 3. However, the actual level of interest rates is still far from what can be justified from a fundamental perspective, see chart 4. Regardless of which of the above perspectives we use, the outlook for the ECB and potential GDP growth are crucial for where long-term interest rates should be. Thus we first need to understand the drivers of potential GDP growth aimed at being able to come up with an outlook for bond yields. The rest of this piece is focused on the drivers of potential growth, while paper #2 focuses on the output gap, inflation developments and the ECB s monetary policy. Paper #3 draw upon the conclusions in its long-term outlook for interest rates. Chart 5: Drivers of potential economic growth Chart 6: Weak potential growth only set to improve slightly : Potential productivity - Technology - Education - Organisation of workers : Capital stock - Investments - Depreciation : Potential employment - Hours worked - Population age - Activity rate - NAIRU Source: Danske Bank Markets Source: European Commission, OECD, Danske Bank Markets Potential growth has weakened and will stay low Potential economic growth is determined by the development in potential productivity growth, potential employment growth and capital accumulation, see chart 5. Potential GDP growth has weakened in recent years and the slowdown intensified with the financial crisis as capital accumulation worsened. But notably the slowdown started before the crisis kicked-in as potential productivity and employment growth weakened beforehand. Looking ahead, the European Commission, the OECD and the IMF expect the downtrend in potential growth to be reversed, but the outlook is for a modest 3 1 June

4 increase seen from a historical perspective, see chart 6. Below we look into the drivers of potential growth and consider the outlook for each of the components. Potential productivity growth to improve marginally Potential productivity growth is affected by the technological development, education or human capital accumulation and organisation of workers within sectors, see chart 5. Productivity growth averaged 1.5% in the period , when it was strongly supported by innovations in information technology. At the beginning of 2000 the rapid pace proved to be temporary and productivity growth weakened to an average of 0.8% in the period running up to the financial crisis, see chart 7. Chart 7: Productivity growth slowed before the crisis started Chart 8: Low productivity seen in lower unemployment rate Source: ECB, Danske Bank Markets Shortly after the crisis productivity growth rebounded, but since then it has remained very low. The declining unemployment rate since mid-2013 illustrates this, as the rate had declined at a time when economic activity had been very modest. Based on the historical relationship, GDP growth has actually suggested the unemployment rate should have continued to increase slightly also at the beginning of 2015, see chart 8. Looking ahead, we expect productivity growth to show some convergence towards the pace of increase running up to the financial crisis. This should follow as a stronger recovery should imply there will be 1) less substitution of workers away from the relatively more productive industrial sector to the service sector, see chart 9, 2) more investments in the procyclical research and development and 3) the reforms to boost competition and enhance wage and price flexibility should have increased productivity especially in the periphery countries. However, seen in a historical perspective productivity growth should still remain modest around 0.5% in the coming years. This should follow as 1) human capital accumulation is expected to slow down as the marginal return to additional education decreases, see chart 10, and 2) as innovations in information technology are not expected to reach the same level as in June

5 Chart 9: Substitution of workers to the industry sector Chart 10: Marginal return of additional education declines Source: Eurostat,Danske Bank Markets Potential employment growth will continue to be a headwind Potential growth in employment is determined by demographic changes, while longlasting cyclical trends can also become structural. Structural employment growth peaked already in 2000 as the demographic development with a declining population and a larger share of older age workers became a headwind long before the financial crisis, see chart 11. The cyclical downturn following the crisis contributed to an additional weakening of potential employment growth, see chart 12, but this should be less of a headwind going forward. Chart 11: Potential employment growth will remain very low Chart 12: Long-lasting cyclical trends can become structural Source: Eurostat, OECD, Danske Bank Markets Source: BLS, Eurostat, European Commission, Danske Bank Markets Going forward, the demographic development should remain negative for potential employment growth. According to estimates from the United Nations, growth in the working age population should decline further after it turned negative in 2012, see chart 13. Added to this, the older age share of the working population is estimated to increase further, which is also a headwind, as people older than the prime working age have a lower propensity to participate in the labour force. However, the negative impact is reduced as the activity rate among people older than the prime working age has increased, see chart June

6 Chart 13: The working age population is declining Chart 14: Higher share of older age workers Source: United Nations, Danske Bank Markets Added to this, there is a risk that the long-lasting slowdown following the financial crisis has a permanent structural impact. But in our view the risk is relatively limited. First of all, there has been a structural improvement as women have entered the labour force and the participation rate has increased despite the crisis, see chart 15. This has dominated a cyclical decline in the participation rate among prime age men, likely reflecting workers, who are discouraged from searching for a job due to the high unemployment rate. On the other hand, there is a risk of hysteresis effects, where the unemployed are excluded from the labour market, as the employed bargain for higher wages instead of more employed when the economy gets better. The current high share of long-term unemployment increases the risk as these workers typically have more trouble in finding regular work. Nevertheless, the labour and product market reforms implemented during the crisis should reduce wage mark-ups and structural mismatch in the labour market, thereby limiting the hysteresis effects somewhat. Chart 15: Higher participation rate due to female workers Chart 16: Risk of hysteresis because of high unemployment Capital accumulation to be slightly supportive going forward Capital growth declined when the financial crisis kicked-in and despite some rebound in 2010, the investment rate has remain low, see charts 17. Tighter lending standards from banks are likely to have limited investments in productive capital in recent years. However, after years where banks have built up capital, there should be more focus on lending out as already reflected in easier credit conditions and lower cost of 6 1 June

7 borrowing, see chart 18. Nevertheless, regulation in the financial sector will still be a headwind to investments. Chart 17: Business investments remain low Chart 18: Bank tightening was a headwind to investments Source: ECB, Danske Bank Markets Another factor behind the weaker capital growth is uncertainty among businesses following the crisis. There still seems to be a degree of post-traumatic stress among companies, as they are now much more cautious than they were before the crisis. But the strong growth in private consumption should support business investments going forward. Where to go from here? The table below brings together the drivers of potential growth and our expectations going forward. Looking ahead, we expect potential growth to increase slowly due to the very modest productivity growth, headwind from employment growth and modest investment outlook. We will use these findings about potential growth in our assessment of the outlook for the output gap in our upcoming paper. This will help us answer the questions below: Will the QE programme end before September 2016? Will interest rate hikes follow immediately after the end of the QE programme? What is the outlook for long interest rates giving the above answers? We will assess these questions in the following two papers. Outlook for drivers of potential GDP growth Drivers of potential GDP growth > Expectations Technology Potential productivity Edudation To improve marginally Organisation of workers Hours worked Potential employment Population age Activity rate To continue to be a headwind NAIRU Capital accumulation Investments Depreciations To be slightly supportive Source: Danske Bank Markets 7 1 June

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