Asset Prices and Debt - Impact on the Global Outlook

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Director, Global Economics 6 Wall Street New York, New York 15 Tel: 212 25 2155 Torsten.Slok@db.

Data is sourced from Deutsche Bank and subject companies.

1 Asset Prices and Debt - Impact on the Global Outlook May 21 Torsten Slok, Ph.D. Director, Global Economics 6 Wall Street New York, New York 15 Tel: Torsten.Slok@db.com Deutsche Bank AG/London All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 16/5/29

2 The importance of balance sheets Household, financial, non-financial, and government balance sheets are important for the outlook Assets are more volatile than liabilities. Falling asset prices puts pressure on balance sheets and raises risk premiums, i.e. the cost of borrowing increases. Will now look at balance sheets and their impact on the outlook 1

3 Household Sector 2

4 With household wealth back to pre-bubble highs, saving rate may not need to rise much further Ratio Personal saving rate (rs) Wealth-to-income ratio (ls) % of DPI Pessi mistic Optim istic Baseline 2-2 Source: BEA, FRB, DB Global Markets Research 3

5 Nominal home prices are down 29% from their peak Index 11 Case-Shiller composite 2 home prices, Jul-6=1 OFHEO house prices, Q2 7=1 Index Source: OFHEO, S&P, DB Global Markets Research 4

6 Even a 2bps rise in mortgage rates would still result in housing affordability being above the levels seen in the 199s Index Housing affordability index Index Level of mtg rate: 2 Housing affordability (at different mortgage rates) 2 Current % higher % higher % higher Source: Univ. of Mich. NAR & DB Global Markets Research 5

7 Consensus expects US home prices to bottom in 21H1 % 3 25 When will home prices (Case-Shiller) stop declining? 25% 27% % % % 8% 8% % 2% Q2 Q3 Q4 Q1 Q2 Q3 Q or later 5 Source: WSJ Survey, DB Global Markets Research 6

8 Home foreclosures have soared % Homes in foreclosure (ls) Foreclosure started (per qtr, ls) Numbers of housing units in foreclosure (rs) mln Source: MBA, Datastream, DB Global Markets Research. 7

9 Shadow inventory potentially high but being dampened by improvements in labor market and the fact that home prices are no longer declining Number of mortgage loans outstanding and delinquency rates Number of loans (mlns) 6+ day delinquency rate Current data Loans delinquent 6 + days (mlns) Total % 5.5 Subprime % 2. Prime % 3.6 Agency % 2.4 Alt-A %.7 Jumbo %.2 Option Arm %.2 Source: LoanPerformance, DB Global Markets Research 8

10 Many option ARM and subprime borrowers are underwater Current LTV distribution of non-agency mortgages Share of total mortgage balance outstanding CLTV >12 Non-agency 6% 41% 13% 13% 18% 15% Prime Alt-A 8% 23% 13% 14% 21% 28% Subprime 7% 19% 13% 15% 22% 32% Option ARM 3% 5% 5% 8% 21% 6% Source: LoanPerformance, DB Global Markets Research 9

11 Geographical distribution of housing boom/bust Source: NY Fed, DB Global Markets Research 1

12 Temp hiring sending a strong signal m/m chg, Thous., 3-m MA Temporary help services (3m lead, ls) Total nonfarm employment (rs) m/m chg, Thous., 3-m MA Source: BLS, DB US Economics Research -8 11

13 ISM employment index sending a strong signal Total nonfarm employment (ls) % y/y ISM employment index (mfg.+non mfg.) 6m lead (rs) Correlation= Index Source: BLS, ISM, DB US Economics Research

14 Jobless claims sending a strong signal Thous. 4 wk 7 MA Initial claims (ls) Unemployment rate (rs) % Source: BLS, DOL, DB Global Markets Research 2 13

15 Financial sector 14

16 Significant excess reserves in the banking system $ bln Total reserves $ bln Required reserves Excess reserves Source: FRB, DB Global Markets Research 15

17 Senior Loan Officer Survey leads lending by 6 quarters % y/y 3 25 Banks C&I lending (ls) FRB Sr. officers survey: banks tightening C&I -2 loans to large firms (rs, inverted axis, 6 qtr lead) Source: FRB, DB Global Markets Research %

18 US loan charge-off rates about to come down % of total loan Residential real estate Commercial real estate % of total loan 7 6 Commercial & industrial Consumer IMF forecasts Source: Fed, IMF & DB Global Markets Research -1 17

19 US Balance Sheets in a Global Context 18

20 Three headwinds in most OECD countries 1) Coming out of a housing bubble 2) Household leverage/vulnerability 3) Fiscal situation 19

21 The US housing bubble was smaller than in many other OECD countries 2 = House price / income ratio US Japan Germany France Denmark UK Canada Australia Euro Area 2 = Source: OECD, DB Global Markets Research.6 2

22 US households in reasonable shape % Household debt as a share of disposable personal income* ITA FRA DEU FIN JPN CAN USA ESPSWE GBRAUS CHE NOR IRL NLD DNK * averages are unweighted % Source: OECD, DB Global Markets Research 21

23 Government balance sheet 22

24 The public debt problem smaller in emerging markets % of GDP Public debt: GDP weighted (baseline) % of GDP Developed markets Emerging markets Forecasts Source: DB Global Markets Research 23

25 Big US deficits are a recent phenomenon % of GDP 4 Government budget balance (adv. countries) Forecast % of GDP Australia Canada France Germany -12 Greece Italy Japan Spain -16 UK US E U Source: IMF WEO, DB Global Markets Research 24

26 Percent of public debt held abroad 9 8 External debt as a % of total government debt Austria Belgium France Germany Greece Italy Japan Portugal Spain UK US 25

27 Government interest payments Government interest payments as a % of GDP To domestic lenders To foreign lenders Austria Belgium France Germany Greece Italy Japan Portugal Spain UK US 26

28 Many countries in bigger fiscal trouble than the US The public debt stress ranking was created by combining public sector debt levels, public sector deficits, and public sector net interest payments as a % of GDP into a single measure by taking the ranking of each country for each measure and summing them to get an aggregate country risk indicator 27 27

29 Total net borrowing need of the sovereign sector % of GDP Euro Area U.S. U.K. % of GDP average 29 21E 211E Source: National sources, IMF & DB Global Markets Research 28

30 Investment implications 29

31 Impact of rising sovereign risk Unsustainable fiscal scenario => higher government bond risk premia Government needs to react Significant fiscal belttightening, overall leading to deflationary environment or Financial regulation/controls to keep real interest rates low or Allow high inflation for an extended period or Debt restructuring or debt default U.S. looking better on a relative scale, likely to benefit Creates flight-to-quality leading to fall in bond rates for relatively safer countries Unlikely for all countries to default at the same time 3 3

32 Rates driven by three forces Our model of 1-year Treasuries is useful for understanding what is going on: i 1Y = F(Inflation expectations, Output gap, Government debt/gdp) Currently, investors are worried about supply but they want to see more evidence that the recovery is sustainable. The ultimate evidence that the recovery is sustainable is when the Fed begins to signal that they will remove the extended period language. Once Fedspeak - esp from Bernanke - starts to communicate the intention to remove extended period the entire yield curve will probably shift up and flatten significantly. Likely to happen over the summer. 31

33 A big unknown in the outlook is if the Fed sells securities. Recent Fed event study shows that Fed mortgage purchases had a significant impact across fixed income assets bps Cumulative interest changes on baseline events set days 2y UST 1y UST 1y Agy Agy MBS 1y TP 1y Swap Baa Index bps Source: NY Fed, DB Global Markets Research 32

34 Fed normally waits until well after unemployment has begun to decline % 12 6 months 2 months 12 months 12 % Fed funds target rate Unemployment rate Source: BLS, FRB, DB Global Markets Research 33

35 A timeline for the Fed s exit Discount rate hike/reduction of maximum maturity of disc. window loans Closure of TAF Supplementary Financing Program End MBS purchases Term deposits and reverse repos when Fed hike is imminent Remove Extended period language Closure of TALF Raise interest on excess reserves and the Fed funds rate Selling securities 34

36 Any New Normal discussion has to include a discussion of demographics % Labor force growth (age 15-64) China Japan Korea US Europe % Source: UN Population Division, DB Global Markets Research 35

37 Still room for more urbanization in EM Urbanization rate 25 (%) 215 (%) World Northern America Latin America Europe Oceania Asia ex CN & ID China Africa India Source: UN World Urbanization Prospects, DB Global Markets Research 36

38 Core inflation is driven by four factors Unemployment Inflation expectations The big question is how flat the Phillips curve is Core inflation This is all about central bank credibility Oil price Import prices/ Exchange rate Source: DB Global Markets Research 37

39 Bottom line Stresses at the moment are in government balance sheets Governments must convince markets that they have a plan for dealing with debt problems The 75bn European plan will work, but fiscal adjustment is needed European recovery likely to be slower than US recovery High inflation is unlikely requires a regime change and substantial loss of central bank credibility 38

Torsten Slok, Ph.D. Director, Global Economics Deutsche Bank Securities, Inc. Torsten Slok joined Deutsche Bank Securities in the fall of 25 and is a senior member of the Global Economics Team.

40 Torsten Slok, Ph.D. Director, Global Economics Deutsche Bank Securities, Inc. Torsten Slok joined Deutsche Bank Securities in the fall of 25 and is a senior member of the Global Economics Team. Prior to joining the firm, Mr. Slok worked at the OECD in Paris in the Money and Finance Division and the Structural Policy Analysis Division. Before joining the OECD he worked for four years at the IMF in the Division responsible for writing the World Economic Outlook and the Division responsible for China, Hong Kong, and Mongolia. Mr. Slok studied at University of Copenhagen and Princeton University. He has published numerous journal articles and reviews on economics and policy analysis. 39

41 Deutsche Bank Appendix 1 Important Disclosures Additional Information Available upon Request For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Torsten Slok 4

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44 Risks to Fixed Income Positions Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates these are common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options in addition to the risks related to rates movements. 43

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The Fed s experience with forward

The Fed s experience with forward guidance and asset purchases December 2014 Torsten Slok, Ph.D. Chief International Economist Managing Director 60 Wall Street New York, New York 10005 Tel: 212 250 2155