US Economics. State of the Union Growth, rates, and equities NORTH AMERICA. In a nutshell. Our key views on growth, policy, and rates

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1 NORTH AMERICA In a nutshell The US expansion is poised to continue Near-term data may surprise on the upside and show an economy expanding at an underlying 2.5% pace Longer-term growth should decelerate as full employment is reached The Fed rate hike cycle should be gradual and cautious. We anticipate liftoff in September Our longer-term forecasts for the Fed Funds rate and the 10-year yield remain well below the consensus Equity markets can make strong gains within this context Cyclicals are likely to outperform defensives through year-end Seek companies with exposure to US domestic growth over those with exposure to global growth 28 July 2015 Macquarie Capital Markets Canada Ltd. State of the Union Growth, rates, and equities The US expansion should continue, with real GDP growing at an underlying pace of ~2.5% for the next year. Following this it may slow to below 2% as full employment is achieved and the pace of payrolls gains moderates. Alongside this, the Federal Reserve should gradually hike its Fed Funds rate target commencing in September. Despite this, the 10-year Treasury yield should increase only modestly as the yield curve flattens. Interest rates are likely to prove structurally lower in the current expansion with the Fed Funds rate only rising to 2% (cons. 2.9%) and the 10-year yield to 2.7% (cons. 3.7%) at end-17. Within this context, our work suggests equities can continue to make strong gains. Joint work with our Quant team (LINK) suggests this occurs leading into and during gradual rate hike cycles that involve a flattening yield curve and that cyclical sectors tend to outperform defensives. As our global team s outlook (LINK) is for weakness in EM economies, we prefer companies with more exposure to domestic US growth than those exposed to global growth. Our key views on growth, policy, and rates I. Near-term growth outlook. Consumer spending and residential construction should be sources of strength as fundamentals in the labour and housing markets remain robust. Seasonality trends that have existed since 2010 suggest near-term data strength can continue (Fig 1). Notably, a broad indicator of activity, vehicle miles travelled, has accelerated YTD (Fig 2). II. Labour market. Fundamentals here remain the strongest in over a decade. As full employment is neared, the pace of employment growth may moderate, but this should be accompanied by a faster pace of wage gains. III. Long-term outlook. When full employment is reached, the pace of real GDP growth may moderate to slightly less than 2.0%. This is enough to maintain full employment as: i) demographics imply a pace of labour supply growth of 0.5%, and ii) productivity growth has trended in the 1% to 1.5% range. IV. Recession risks low. The economic expansion should continue for at least the next two years and potentially much longer. With investment, the cyclical component of GDP still low relative to GDP, a downturn is unlikely. V. Fed rate hike cycle. The FOMC is likely to embark on a gradual and cautious rate hike cycle in September. Rate hike cycles have historically lasted 2 years or less we believe this should mean the Fed Funds rate only rises to 2% in the current expansion, well below the consensus of 3.5 to 4%. While the FOMC has been reluctant to embrace this view, a recent paper authored by San Francisco Fed President John Williams lends support for our thesis. VI. Lower Equilibrium 10-year yield. A 2% equilibrium Fed Funds rate will limit the potential upward movement in the 10-year Treasury yield. Our work suggests the 10-year yield may only rise to 2.7% by end-17. VII. Flatter yield curve. Typically when the Fed tightens, the yield curve has not moved out in parallel fashion, but has rather flattened. We anticipate this to continue through the current period. Please refer to page 9 for important disclosures and analyst certification, or on our website

2 I Near-term growth outlook underlying pace of 2.5% to continue Strength from consumer spending and residential construction is likely to continue. Business investment may face headwinds from global growth challenges and ongoing weakness in the energy sector. While data has generally been below market expectations in 2015, this is starting to turn, in line with a seasonal pattern that has existed since 2010 (Fig 1). One indicator that has proved particularly robust is vehicle miles travelled, which has accelerated in 2015, in contrast to what occurred during previous large oil price declines in 1986 and 1998 (Fig 2, 3). Fig 1 Seasonality suggests continued upside data surprises lie ahead Fig 2 Vehicle miles travelled growth accelerating Fig 3 and not just due to lower gasoline prices 4% US - moving 12 month total vehicle miles traveled, % change YoY 5% YoY % change in 12 month total vehicle miles traveled 3% current level 4% 2% 1% 3% 0% 2% -1% -2% 1% -3% % Source: US Dept of Transportation, Macquarie Research, July 2015 Source: US Dept of Transportation, Macquarie Research, July July

3 II Labour market fundamentals remain strong As outlined in Believe it. Full employment is around the corner, the labour market remains strong with several measures showing slack has rapidly diminished (Fig 4). The pace of payrolls growth remains nearly the strongest in 15 years (Fig 5). This may moderate in the quarters ahead, but this development should be accompanied by stronger wage growth, where there are already signs of improvement over the past several months (Fig 6). Fig 4 Measures of slack suggest full employment is just around the corner 11% Unemployment rate 10% 9% 8% 7% Macquarie estimate (accounts for returnees to labour force) 6% 5% u-3 FOMC estimate of stuctural unemployment = 5.1% 5.3% 5.9% 4% Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Source: Bloomberg, Bureau of Labor Statistics, Macquarie Research, July 2015 Fig 5 Payrolls growth is strong, but should moderate Fig 6 while wage growth should accelerate further US 4% nonfarm payrolls growth - six month % change annualized 6Wage growth measures are trending higher 2% current level = 1.8% 5 0% 4-2% The pace of jobs gains is close to the strongest in 15 years, but is likely to moderate in the months ahead 3 Atlanta Fed individual wage growth tracker, % change YoY -4% -6% 2 1 Employment Cost Index, % change YoY 0-8% Source: BLS, Bloomberg, Macquarie Research, July 2015 Source: Atlanta Fed, BLS, Bloomberg,Macquarie Research, July July

4 III Long-term growth and lower potential output In the longer-term we believe the economy is on a lower growth trend and that once the output gap is closed and full employment is reached a pace of less than 2% is likely to be the underlying trend in real GDP growth. This is more subdued than that in previous cycles (Fig 7), but is driven largely by demographics causing a low pace of labour supply growth (Fig 8). Productivity growth has also been relatively weak (Fig 9) a phenomenon our work suggests is at least partially due to shifts in the demographic profile, a topic we discussed in Demographics, productivity, and wage growth. Fig 7 Low growth track compared to previous cycles 5.5 United States Real GDP (1970 = 0) % line Macq. forecast 3.0 Actual GDP Source: Bureau of Economic Analysis, Macquarie Research, July 2015 Fig 8 Labour force growth has decelerated Fig 9 while productivity has remained subdued Labour 4.0% force growth YoY change in twelve month moving average US 5.0 annual productivity growth estimates (% change) 3.0% % avg. = 2.2% 2.0 % avg. = 1.5% 0.0% % Source: Bureau of Labor Statistics, Macquarie Research, July 2015 Source: Bureau of Labor Statistics, Macquarie Research, July July

5 IV Recession risks remain low One of the silver linings of a lower growth cycle is that the lack of a swift acceleration makes a recession unlikely for the timing being. Indeed, prior to each recession since 1970: i) investment became elevated as a share of GDP (Fig 10); and ii) construction became elevated as a share of total employment (Fig 11). These measures remain well below those levels today, suggesting that a recession is unlikely and providing some assurance that the economic expansion may continue for at least another 2 3 years and potentially much longer. Fig 10 Investment as a share of GDP remains below previous peaks 22 Gross private domestic investment as share of GDP Q79 1Q81 2Q00 2Q Q73 1Q89 +1 STDEV Average STDEV Source: Bureau of Economic Analysis, Bloomberg, Macquarie Research, July 2015 Fig 11 Construction employment as a share of total also has a long ways to run 5.8% Construction employment as share of total employment 5.6% % 5.2% 5.0% % 4.6% 4.4% 4.2% 4.0% Source: Bureau of Labor Statistics, Bloomberg, Macquarie Research, July July

6 Fed funds rate V Pace of rate hikes to be gradual and to a lower end-level We anticipate the FOMC to embark on a gradual and cautious tightening cycle commencing in September. Our projected pace of increases (100 bp per year) is consistent with the FOMC s forecast and is a pace that would be the most gradual since the mid-1950s (Fig 12). Given this gradual pace and that the length of rate hike cycles since 1950 have been two years or less (Fig 13) we anticipate the Fed Funds rate will only rise to 2% in the current expansion. Members of the FOMC have been reluctant to embrace this outlook thus far, but have begun to move in this direction over the past twelve months (Fig 14). Recently, the FRBSF President, John Williams, published an article, The natural rate of interest, which suggested the natural real rate of interest may be just 0%, a level consistent with a 2% nominal Fed Funds rate. Fig 12 The forecasted pace of increase would be the most gradual cycle since the 1950s Annualized pace of Fed Funds rate hikes in bp (all rate hike cycles of four months or longer since 1955) Source: Federal Reserve, Bloomberg, Macquarie Research, July 2015 Fig 13 Rate hike cycles typically last <2 years Fig 14 we project 2% as the equilibrium level 2.5 Length of rate hike cycles in years Median FOMC member projections for longer-run Fed Funds rate (ex-three most hawkish estimates) 4.5% % 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 3.8% 3.8% 3.8% 3.5% 3.5% 3.5% % 2.5% 2.0% 2.0% % % Jan-12 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 MQG forecast Timing of projection Source: Federal Reserve, Bloomberg, Macquarie Research, July 2015 Source: Federal Reserve, Macquarie Research, July July

7 VI The 10 year yield has likely peaked for the current expansion A lower equilibrium Fed Funds rate should also result in a lower ten-year Treasury yield. We believe the longer-run level will be ~2.7%, well below the consensus estimate of 3.5 to 4%%. Our work described in The neutral rate structure, inflation, and equities is based on how the 10-year Treasury yield has typically performed following rate spikes such as the one experienced during 2013 (Fig 15). The trajectory since that time appears to have followed a similar path to previous instances (Fig 16). Fig 15 Previous rate spikes have proved to be self-containing United 18 States 10 year government bond yield (month end values) Before 2013, there were six dramatic moves in the government ten year bond from cyclical lows since 1980 These led to a 35 to 75% increase in the government 10 year bond yield Based on the upper end of this range, Month end lows of 1.5% in the summer of 2012 would have implied a move to ~2.6%, a level that was temporarily breached in late In 2014 & 2015, however, the moderation in yields has pushed yields back below the expected level of 2.6% Fig 16 The mid 2013 experience seems to be following the same path year bond yield at date of 100 bp move = Max (prior 6 periods) Current Median Min 0.4 trading days from spike trigger point July

8 VII Yield curve should flatten as rate hikes commence A gradual tightening cycle from the FOMC can lead to sharp upward movements at the front end of the yield curve as the 2-year yield should push higher. Contrary to conventional wisdom, rather than moving up in parallel fashion, the 10-year yield tends to trend sideways to only modestly higher when rate hikes commence as the yield curve flattens (Fig 17). In 2014, the 10-yr/2-yr spread crossed through 180 bp. If the 10-year yield follows a similar path from this point as what occurred in the past two expansions, it is likely to remain contained below 3% and trend around 2.5% for the most part (Fig 18). Fig 17 The yield curve typically flattens during tightening cycles US year yield less 2 year yield (%) 3.0 Dec-13 (taper commences) Feb-94 (rate hike cycle) Jun-04 (rate hike cycle) 1.5 current level 0.5 Jun-99 (rate hike cycle) QE2 resteepens curve QE3 resteepens curve Mar-15 FOMC Fig 18 During yield curve flattening, the 10 year yield only moves modestly higher year yield paths from dates where 10 yr less 2 yr spread falls below 180 bp Max from 1990s and 2000s cycle= 2.97% Dec-14 to present Jun-93 to Jun-96 path Jul-04 to Jul-07 path 1.75 Min from 1990s and 200s cycle= 1.91% 1.50 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec July

9 Important disclosures: Recommendation definitions Macquarie - Australia/New Zealand Outperform return >3% in excess of benchmark return Neutral return within 3% of benchmark return Underperform return >3% below benchmark return Benchmark return is determined by long term nominal GDP growth plus 12 month forward market dividend yield Macquarie Asia/Europe Outperform expected return >+10% Neutral expected return from -10% to +10% Underperform expected return <-10% Macquarie First South - South Africa Outperform expected return >+10% Neutral expected return from -10% to +10% Underperform expected return <-10% Macquarie - Canada Outperform return >5% in excess of benchmark return Neutral return within 5% of benchmark return Underperform return >5% below benchmark return Macquarie - USA Outperform (Buy) return >5% in excess of Russell 3000 index return Neutral (Hold) return within 5% of Russell 3000 index return Underperform (Sell) return >5% below Russell 3000 index return Volatility index definition* This is calculated from the volatility of historical price movements. Very high highest risk Stock should be expected to move up or down % in a year investors should be aware this stock is highly speculative. High stock should be expected to move up or down at least 40 60% in a year investors should be aware this stock could be speculative. Medium stock should be expected to move up or down at least 30 40% in a year. Low medium stock should be expected to move up or down at least 25 30% in a year. Low stock should be expected to move up or down at least 15 25% in a year. * Applicable to Asia/Australian/NZ/Canada stocks only Recommendations 12 months Note: Quant recommendations may differ from Fundamental Analyst recommendations Financial definitions All "Adjusted" data items have had the following adjustments made: Added back: goodwill amortisation, provision for catastrophe reserves, IFRS derivatives & hedging, IFRS impairments & IFRS interest expense Excluded: non recurring items, asset revals, property revals, appraisal value uplift, preference dividends & minority interests EPS = adjusted net profit / efpowa* ROA = adjusted ebit / average total assets ROA Banks/Insurance = adjusted net profit /average total assets ROE = adjusted net profit / average shareholders funds Gross cashflow = adjusted net profit + depreciation *equivalent fully paid ordinary weighted average number of shares All Reported numbers for Australian/NZ listed stocks are modelled under IFRS (International Financial Reporting Standards). Recommendation proportions For quarter ending 30 June 2015 AU/NZ Asia RSA USA CA EUR Outperform 46.23% 58.36% 47.27% 44.20% 60.65% 43.01% (for US coverage by MCUSA, 9.68% of stocks followed are investment banking clients) Neutral 37.67% 25.65% 29.09% 49.29% 34.19% 40.93% (for US coverage by MCUSA, 5.53% of stocks followed are investment banking clients) Underperform 16.10% 15.99% 23.64% 6.52% 5.16% 16.06% (for US coverage by MCUSA, 1.38% of stocks followed are investment banking clients) Company-specific disclosures: Important disclosure information regarding the subject companies covered in this report is available at Analyst certification: The views expressed in this research reflect the personal views of the analyst(s) about the subject securities or issuers and no part of the compensation of the analyst(s) was, is, or will be directly or indirectly related to the inclusion of specific recommendations or views in this research. 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