Global Economic Outlook: Next Quarter vs Next Decade

Global Economic Outlook: Next Quarter vs Next Decade Samantha Azzarello, Economist October 2014 1

Investment advice is neither given nor intended The research views expressed herein are those of the author and do not necessarily represent the views of CME Group or its affiliates. All examples in this presentation are hypothetical interpretations of situations and are used for explanation purposes only. This report and the information herein should not be considered investment advice or the results of actual market experience. 2

Risks of trading futures and swaps Neither futures trading nor swaps trading are suitable for all investors, and each involves the risk of loss. Swaps trading should only be undertaken by investors who are Eligible Contract Participants (ECPs) within the meaning of Section 1a(18) of the Commodity Exchange Act. Futures and swaps each are leveraged investments and, because only a percentage of a contract s value is required to trade, it is possible to lose more than the amount of money deposited for either a futures or swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles and only a portion of those funds should be devoted to any one trade because traders cannot expect to profit on every trade. 3

Additional disclosures The Globe Logo, CME, Chicago Mercantile Exchange, and Globex are trademarks of Chicago Mercantile Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago, Inc. NYMEX, New York Mercantile Exchange, and ClearPort are trademarks of New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. CME Group is a trademark of CME Group Inc. All other trademarks are the property of their respective owners. The information within this presentation has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Although every attempt has been made to ensure the accuracy of the information within this presentation, CME Group assumes no responsibility for any errors or omissions. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME, CBOT and NYMEX rules. Current rules should be consulted in all cases concerning contract specifications. 4

Seven global game-changers 1. Global growth edging upward in 2015, China still decelerating into the 2020s 2. Commodity price weakness for how long? 3. A Fed rate-rise decision on the horizon? 4. Corporate earnings, low inflation, and equity market volatility 5. ECB bank stress tests and asset purchases 6. FX markets in motion 7. Political risks in play 5

Global growth in 2015 Scenario #1 (70%) US labor markets continue to improve, Europe starts to grow slowly after ECB stress tests, China s deceleration continues but growth still close to 7%, India and Brazil see modestly better growth. Commodity prices stabilize at lower levels. Global growth picks up modestly. Fed raises its federal funds rate target range. Scenario #2 (30%) Geo-political tensions and uncertainties take their toll. Commodity prices continue to weaken. Europe maintains fiscal austerity despite IMF and ECB calls for fiscal assistance. Gridlock in the US Congress keeps fiscal policy tight. Global growth slows. Fed delays raising rates, sending a negative lack of confidence message to equity markets. 6

China by the decades -- decelerating Annual Average Real GDP Growth 12% 9% 6% 3% 0% China: Real GDP Growth Rates by Decade 2.02% 7.30% 9.69% 9.96% 10.48% 6.74% Estimated 4.25% 1960s 1970s 1980s 1990s 2000s 2010s 2020s Source: World Bank Real GDP Index from the Bloomberg Professional (WRGDCHIN). Estimates by CME Economics Research. 7

Three reasons why China is decelerating (it is a natural process) Diminishing returns from new infrastructure development China posted three decades of 10% annual average real GDP growth based on a rapid modernization program with massive infrastructure spending. Diminishing returns are now occurring for any new investments. Rural to Urban Migration China has experienced a massive migration of 15 million people a year moving from rural to urban areas. This migration supports GDP growth, but as it slows in the next decade the lift the economy gets from this factor will eventually disappear. Aging Demographic Pattern The one-child policy stopped population growth, but it also created a evolution toward a higher average age. As the percent of people over 65 increases, consumption demand per person slows in every sector but health care. 8

Brazil, Russia, and India better in 2015 Weighted Average of Annual Real GDP Growth 10% 8% 6% 4% 2% 0% -2% 2000 2001 Brazil, Russia, India -- Real GDP 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: World Bank Real GDP Data provided through the Bloomberg Professional. 2014-15 estimated by CME Economics Research. Estimated 2014 2015 9

Global perspective: 2010-2014 difficult years after the Great Recession Average Annual Real GDP Growth: 2010 through 2014 China 8.5% India 6.4% Brazil US Russia Japan UK 3.0% 2.3% 2.1% 1.7% 1.5% Euro-Zone 0.3% 0% 2% 4% 6% 8% 10% 12% Source: World Bank Annual GDP Data from Bloomberg Professional and CME Economics Estimates for 2014. 10

Commodity price weakness Supply Higher prices from the 2001-2008 growth years along with technological advances, has brought more supply. We may have entered a period of secular price weakness in a broad selection of commodities. Demand Slower global growth in 2013 and 2014, especially from a weak Europe and decelerating China, has exacerbated the supply-driven weakness in commodity prices. Global Growth A healthy US economy, leading to incrementally improving global growth with only mild further deceleration in China suggests the possibility of commodity prices stabilizing at lower levels in 2015. 11

Gold: No fears of inflation or financial crisis $2,000 Spot Gold Price US Dollars per Ounce $1,600 $1,200 $800 $400 $0 Source: Bloomberg Professional (GOLDS) 12

Copper stagnant without stronger growth $5 COMEX Copper Nearby Futures Price Nearby Copper Futures (HG / 100) $4 $3 $2 $1 $0 Source: Bloomberg Professional (HG1) 13

Crude oil has recently moved to the bottom end of its 4 year trading range $120 WTI Crude Oil Spot Price $110 US$ per barrel of oil $100 $90 $80 $70 $60 Source: Bloomberg Professional (USCRWTIC) 14

Scenarios for US oil and natural gas are diverging Oil US oil production continues to rise, while consumption falls with more fuel efficient vehicles (oil is used 70% for transportation). The result is less US imports of crude oil and more US exports of refined petroleum products. While in Europe, demand is falling with a weak economy, and North See production is declining. The market impact is to erase the premium of Brent over WTI, and to put downward pressure on oil prices globally despite geo-political tensions. Natural Gas Production growth may decelerate. Consumption demands appear to be accelerating, including more electrical generation from natural gas and increased exports. Large price differentials with Europe and Japan remain. Longer-term fundamentals suggest the potential for natural gas prices to rise relative to crude oil prices, which (if it happens) would reduce the energy efficiency advantage of natural gas over oil. 15

US crude oil production is booming 700,000 US Crude Oil Production U.S. Field Production of Crude Oil (Thousand Barrels per Month) 600,000 500,000 400,000 300,000 200,000 100,000 0 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Source: US Energy Information Administration, Sourcekey MCRFPUS1. 16

US refined petroleum consumption is declining with transportation efficiencies U.S. Product Supplied of Petroleum Products (Thousand Barrels per Month) US Oil and Petroleum Product Consumption 700,000 600,000 500,000 400,000 300,000 200,000 100,000 0 1982 1986 1990 1994 1998 2002 2006 2010 2014 Source: US Energy Information Administration, Sourcekey = MTTUPUS1. 17

More exports and less imports have helped reconnect US oil to global markets Barrels of Petroleum Products Per Month 500,000,000 400,000,000 300,000,000 200,000,000 100,000,000 US Oil Petroleum Products: Imports and Exports Imports Exports 0 1981 1985 1989 1993 1997 2001 2005 2009 2013 Source: US Energy Information Administration, Sourcekeys MTTIMUS1 (Imports) and MTTEXUS1 (Exports). 18

Rising consumption, decelerating production = possible new natural gas price dynamics 35,000,000 US Natural Gas Production & Consumption MMcf 30,000,000 25,000,000 20,000,000 15,000,000 Production Consumption 10,000,000 5,000,000 0 1949 1957 1965 1973 1981 1989 1997 2005 2013 Source: US Energy Information Administration, Sourcekeys N9140US2 (Consumption) and N9010US2 (Withdrawals). 19

Near-term production growth depends on expansion in the Marcellus field MMcf at Annual Rate Regions of Expanding Natural Gas Production 16,000,000 12,000,000 8,000,000 Texas, Oklahoma, Louisianna, Arkansas, New Mexico 4,000,000 Pennsylvania, Ohio, New York, West Virginia Bakken 0 1998 2000 2002 2004 2006 2008 2010 2012 Source: US Energy Information Administration, Natural Gas Gross Withdrawals by State. 20

US natural gas production the declining regions are important, too 6,000,000 Regions of Declining Natural Gas Production MMcf at Annual Rate 4,000,000 2,000,000 Alaska Sum of Other Smaller Regions Wyoming & Colorado Offshore Gulf of Mexico 0 1998 2000 2002 2004 2006 2008 2010 2012 Source: US Energy Information Administration, Natural Gas Gross Withdrawals by State. 21

Energy (BTU) price gap 600,000 BTUs per US$1 by US Energy Source BTUs of Energy per 1 US Dollar 500,000 400,000 300,000 200,000 100,000 Natural Gas WTI Oil 0 2002 2004 2006 2008 2010 2012 2014 Source: Bloomberg Professional for prices (USCRWTIC, NGUSHHUB), CME Economics Research for BTU conversion. 22

When will LNG connect global gas markets? US Dollars per Million BTUs of Natural Gas $20 $18 $16 $14 $12 $10 $8 $6 $4 $2 $0 Natural Gas Prices: US, Germany, Japan Japan Germany US Source: Bloomberg Profressional (NGUSHHUB, NGIMGEP2, LNGJLNJP) 23

Scenarios for Fed decision to raise rates and possible bond market reactions Scenario #1 US labor markets continue to improve while core inflation remains below the Fed s 2% target rate. Fed pushes short-term rates higher in 1H/2015 halting the rate rise by year-end at 1% federal funds rate. Since no inflation pressure, the yield curve flattens. (60%) Scenario #2 US labor markets continue to improve and core inflation rises above 2% year over year rate, and inflation expectations rise for the years ahead. Fed pushes short-term rates higher. With some inflation pressure, the Fed is perceived as being behind the game, and the yield curve rises in parallel across the maturity spectrum. (20%) Scenario #3 Global economy hits a rough patch and slows US growth and reduces global inflation expectations with some fears of deflation for Europe and Japan. The Fed stays on hold. US Treasuries may rally and yields move lower. (20%) 24

US Fed ends quantitative easing in Q4/2014, then comes the rate decision $5 Composition of Federal Reserve Assets $4 US$ Trillions $3 $2 MBS $1 $0 Short & Medium Term Treasuries Long-Term Treasuries Source: Federal Reserve Bank of St. Louis FRED Database 25

It only takes about 7% GDP in terms of Fed assets to run the banking system Assets as Percent of US Nomimal GDP 30% 25% 20% 15% 10% 5% 0% Federal Reserve Assets as a Percent of US Nominal GDP Source: Bloomberg Professional (GDP CUR$ and CERBTTAL) 26

The main post-recession drag on jobs was the sharp drop in government sector jobs 23,500 US Federal, State, and Local Government Jobs 23,000 Census Workers (2010) Jobs in Thousands 22,500 22,000 21,500 About 850,000 government jobs were lost between April 2009 and July 2013. QE was never going to 21,000 help state and local governments get their budgets in order. 20,500 2003 2005 2007 2009 2011 2013 2015 Source: St. Louis Federal Reserve Bank FRED Database (USGOVT) 27

Once drag from lost government jobs ended, job growth has been robust Monthly Change in Thousands 400 300 200 100 0 US Nonfarm Employment: Monthly Change Once government jobs stopped disappearing in mid-2013, the pace of monthly job gains increased to over 200,000 per month. Source: St. Louis Federal Reserve FRED Database (PAYEMS) 28

US unemployment rate projected to decrease to 5.5% by Mid-2015 12% US Unemployment Rate 9% Percentage 6% 3% 0% 5.9% Over the last 40 years the average unemployment rate has been 6.5%, and two-thirds of the time the reading has been inside a range from 5% to 8%. Source: St. Louis Federal Reserve Bank FRED Database (UNRATE) 29

Fed Debate 7% 6% Are Negative Real Short-term Rates Still Appropriate for a Growing Economy? Annual Percentage Rafe 5% 4% 3% Core Inflation Rate 2% 1% Fed Funds Rate 0% 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 Source: Federal Reserve Bank of St. Louis FRED Database. 30

Inflation path is key to bond market reaction to a Fed rate rise decision 15% US Treasury 10-Year Yield & Core Inflation: December 1982 - August 2008 12% 9% 6% 10-Year Treasury 3% 0% PCE Core Inflation Source: Bloomberg Professional (USGG10YR & PCE CORE) 31

Inflation path is key to bond market reaction to a Fed rate rise decision 4% 3% 2% US Treasury 10-Year Yield & Core Inflation: September 2008 - October 2014 10-Year Treasury Note Fed Maturity Extension and QE Programs 1% PCE Core Inflation 0% Source: Bloomberg Professional (USGG10YR & PCE CORE) 32

Why has a $4.5 trillion Fed balance sheet not led to more inflation? (#1 of 2) What is Money? With credit cards, check-writing on asset management accounts, interest on bank checking accounts, e-commerce, electronic payments and transfers, there is no longer a definition of money that reliably correlates with inflation as it did in the 1950s, 1960s, and 1970s. Credit Channel has structurally changed As financial institutions have become more sophisticated in their risk management and also more highly regulated, the link from the Fed s balance sheet to credit expansion has been structurally broken. Deleveraging after the Great Recession The financial panic in 2008 was due in no small part to a burden of too much debt in the US, UK, and Europe. The postrecession deleveraging process meant that central bank policies were not effective at encouraging more growth or inflation, even if they did help prevent a deeper recession. 33

Why has a $4.5 trillion Fed balance sheet not led to more inflation? (#2 of 2) Commodity Price Weakness The emerging market boom that ended after the Great Recession led to higher commodity prices, which brought forth a new era of greater supply, leading to a secular decline in a broad-based selection of commodity prices. Global Competition Intense competition from emerging market countries, as well as a newly invigorated US manufacturing sector based on the energy boom have help keep inflation pressures low. Lack of FX interaction The inflationary 1970s saw a weak US dollar, and strong US dollar in the early 1980s help create disinflation. Since 2008, with all major central banks at near-zero shortterm rates, there have not been FX trends to magnify and inflation differentials. 34

Scenarios for US equity markets for 2015 Scenario #1 US economy continues to improve, but with no inflation pressure, no pricing power for corporation, so earnings growth decelerates. S&P500 suffers a 10% correction but ends up positive on the year. (60%) Scenario #2 M&A activity and solid US economy propel S&P500 Index to new highs, up 15% or more on the year, give or take. (20%) Scenario #3 US economy hits a rough patch, (possibly due to international causes) and equities swoon, for a 20% bear market downturn, then a rally, but not enough to end the year in positive territory. (20%) 35

Earnings levels experienced a quick recovery from the recession US$ Billions, Annual Rate $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 US Corporate Profits (After Tax, GDP Basis) $0 2003 2005 2007 2009 2011 2013 2015 Source: St. Louis Federal Reserve (CP). 36

However, the growth rate of earnings is decelerating Percentage change, Trailing 12 months compared to one year ago. 50% 40% 30% 20% 10% 0% -10% -20% -30% US Corporate Profits (After Tax, GDP Basis) Source: St. Louis Federal Reserve (CP). 37

FX Markets, more than most, historically embraced the trend is my friend The lack of persistent and strong trends in major FX markets since September 2008 is directly related to the zero rates from the US Fed, ECB, Bank of England, and Bank of Japan. Until rate policies diverge among the big four central banks, persistent trends in those key currency pairs are unlikely. A consequence of the lack of persistent price momentum has been reduced trading profits at prop shops, FX funds, and bank trading units focusing on FX markets. A number of formerly very large FX desks and shops have closed their doors. The lack of meaningful short-term interest rate differentials among the big four currencies has led to an increase in political or policy statement event risk causing very temporary price shocks. Event risk environments may favor options trading over futures. 38

Scenarios for new dynamics in FX depend heavily on central bank divergence Scenario #1 US and UK economies perform well enough to lead to expectations of rate rises in 2015, while Euro-Zone and Japan hit economic rough patches. USD and GBP outperform EUR and JPY. (60%) Scenario #2 Creeping inflation in the US and UK versus deflation fears in Europe and Japan magnify country differences. (20%) Scenario #3 US, UK, Euro-Zone, and Japan all disappoint on economic growth. Zero rates remain in all countries. No trends, not much volatility. (20%) 39

UK & US improving Growth, Japan and Euro-Zone still struggling Annual Average Real GDP Growth Rate 4% 2% 0% -2% Real GDP Scenarios 2011 2012 2013 2014 Source: Data from Bloomberg Professional, Projections from CME Economics. UK US Japan Euro-Zone 40

Bank of Japan remains committed to massive government bond purchases 300,000 Bank of Japan Assets 250,000 Billions of Japanese Yen 200,000 150,000 100,000 Other Loans 50,000 Japanese Government Securities 0 1997 1999 2001 2003 2005 2007 2009 2011 2013 Source: Bank of Japan (www.boj.or.jp) 41

Alone -- ECB balance sheet has shrunk but asset-backed purchases are coming 3,500 European Central Bank Assets 3,000 2,500 Euro Billions 2,000 1,500 1,000 500 0 2000 2002 2004 2006 2008 2010 2012 2014 Source: European Central Bank Monthly Bulletins 42

Yen fell 20% to 100 per US$ with Abe s Election, stabilized, then recently weakened 125 Japanese Yen per US Dollar JPY per USD 115 105 95 Prime Minister Abe Wins Election and Promises Monetary Expansion Policy 85 75 Dec-2007 Jun-2008 Dec-2008 Jun-2009 Dec-2009 Jun-2010 Dec-2010 Jun-2011 Dec-2011 Jun-2012 Dec-2012 Jun-2013 Dec-2013 Jun-2014 Dec-2014 Source: Bloomberg Professional (JPY) 43

Euro regained ground after the debt crisis eased, but is now weakening. 1.40 Euro US Dollars per Euro 1.30 1.20 1.10 ECB vows to do whatever it takes to preserve the single currency. Threat of deflation in EU, no growth, worry over bank stress tests, more ECB stimulus vs possibility of a US raterise in 2015. Source: Bloomberg Professional (EUR) 44

Five geo-political risks that are in play 1. US Congressional elections: Does the Republican Party gain control of both the Senate and the House of Representatives? 2. Will the Brazilian election bring a period of less uncertainty regardless of who wins? 3. Despite the Scottish No vote, will the rise of nationalism in Europe bring more political risks? 4. Russia wins its wars in the winter. Will the battle of the economic sanctions escalate? 5. Will tensions in the Middle East hit oil prices? 45

Seven global game-changers 1. Global growth edging upward in 2015, China still decelerating into the 2020s 2. Commodity price weakness for how long? 3. A Fed rate-rise decision on the horizon? 4. Corporate earnings, low inflation, and equity market volatility 5. ECB bank stress tests and asset purchases 6. FX markets in motion 7. Political risks in play 46

Thank you. CME Economic Research: www.cmegroup.com/research CME s Chief Economist Blu Putnam: www.cmegroup.com/putnam 47

The Interplay of Geo-Politics and Economics: Market Drivers for 2014 Samantha Azzarello, Economist, CME Group October 21 st, 2014

Disclaimer Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All references to options refer to options on futures. Swaps trading is not suitable for all investors, involves the risk of loss and should only be undertaken by investors who are ECPs within the meaning of section 1(a)12 of the Commodity Exchange Act. Swaps are a leveraged investment, and because only a percentage of a contract s value is required to trade, it is possible to lose more than the amount of money deposited for a swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. Any research views expressed are those of the individual author and do not necessarily represent the views of the CME Group or its affiliates. CME Group is a trademark of CME Group Inc. The Globe Logo, CME, Globex and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago, Inc. NYMEX, New York Mercantile Exchange and ClearPort are registered trademarks of New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. All other trademarks are the property of their respective owners. The information within this presentation has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Additionally, all examples in this presentation are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official Exchange rules. Current rules should be consulted in all cases concerning contract specifications. Copyright 50

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Samantha Azzarello Samantha Azzarello has served as an Economist at CME Group since 2012. In this role, she is responsible for conducting macroeconomic research and analyzing domestic and global economic developments that impact the company s business. Azzarello earned her bachelor s degree from the University of Toronto where she studied Economics and Mathematics. She holds a master s degree in economics from New York University where she focused on econometric forecasting. 54