Global Economics & Markets

Rob Carnell Chief International Economist

June 2012

May 2012

Eurozone - what else could go wrong?

LTRO impact fades Portugal debt restructuring Popular backlash against fiscal austerity

AAAs downgraded

Greece leaves euro

Eurozone depression

IMF resources not expanded

EU17 bailout fund not expanded

Fiscal compact fails

Run on banks

May 2012

Eurozone: Greece - the mad guy in the lift?

Give me the money Or I shoot the puppy

Greece realises finally that it has bargaining power

But the rest of Eurozone is playing tough guy Who is going to blink first? Dont let logic blinker your analysis
2

May 2012

Presidential and parliamentary elections

Netherlands snap parliamentary election Italian general election Apr 2013 Portuguese parliamentary election 2015

Greek re-run parliamentary election 17 June 2012

12 Sep 2013

2012

2013

2014

2015

2016

French Parliamentary elections 10-17 June

German federal election US presidential and senate election 6 Nov 2012 27 Aug 27 Oct 2013

Greek presidential election 2015

Portuguese presidential election 2016

May 2012

Greecethe troika plans doomed

To succeed, everything needs to go 100% right Privatisation receipts Tax implementation, and co-operation

Public sector spending cuts

GDP growth returns and central banks make up some shortfall with profit donation And then it still falls short of the target

May 2012

No plan B
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The logistics of a new currency

Assuming Greek notes were all burned then what can be done? Each euro note has a serial number with a letter code so it could work off this: X (pictured) = Germany P = Netherlands U = France Y = Greece De La Rue 4 months to print enough Euro for Greece But notes have moved across borders check your wallets & purses

May 2012

Bank runs?
Czechoslovakia style stamping?
5

A new Greek drachma: Hello and good-bye

FX performance after failed FX regimes
120 Mexico 1994 Thailand 1997 Indonesia 1997 Korea 1997 Russia 1998 Brazil 1998 Turkey 2000 120

100

100

80

Jan 1st of crisis year = 100

80

A Greek exit and a return of the Drachma is now on the table The implementation challenge is huge On arrival we would expect it to fall up to 80% against the EUR. .generally at the lower end of performances of failed FX regimes

60

60

40

40

20

20

0 1 51 101 151 201 251 301 351 401 451 501

Days after January 1st of crisis year

May 2012

The result of failure: catastrophe

If only Greece were to leave, it would suffer the most, but others would not be immune Under a total break up, output could fall by 10%+ in the first two years
Output effects of Eurozone break up
Cumulative o utput lo ss 201 2-201 (% relative to base) 4 Greece Ireland Spain Italy P o rtugal . B elgium Netherlands France Germany -1 4 -1 2 -1 0 -8 -6 -4 Greek exit To tal break-up -2 0

Real GDP projections in breakup scenario

1 05 Real GDP (201 = 1 1 00) 1 05

1 00

1 00

95

95

90

90

85 05 06 07 08 Germany 09 1 0 1 1 1 2 1 3 1 4 1 5 1 6

85

NL, AUT, FIN, LUX

Southern -Europe (GIPS)

the losses to even Germany would dwarf the effects of the Lehman brothers bankruptcy
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May 2012

Slow motion Euro deposit flight

Bank deposits* in selected Eurozone countries
120 115 110 105 100 95 90 85 80 Jun-2010 = 100 75 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11

France Germany NL Italy Spain Ireland

Greece
Sep-11 Dec-11 Mar-12

Source: ECB
May 2012

* Excluding deposits held by MFIs and central government

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European bailout fund not big enough

Peripheral Eurozone debt maturities Euro bn
600

500

Portugal Ireland Greece

400

Spain Italy

300 Source: Reuters

200

100

1-2Yr

2-3Yr

3-4Yr

4-5Yr

6-7Yr

7-8Yr

8-9Yr

<1Yr

9-10Yr

10-15Yr

15-20Yr

20-25Yr

25-30Yr

5-6yr

30Yr+

May 2012

Spanish & Italian banks - LTRO carry trade

Commercial bank net purchases of govt securities

60 50 40 30 20 10 0 -10 -20

Cumulative in Dec-11 & Jan-12 (EUR bn)

SP IT IR LU GR AS PT BE FR DE NL

Far from solving the Eurozones problems, LTRO may have made them worse

May 2012

10

ECB reluctant lender of last resort

Securities Markets Program
ECB bond buying (bn)
25 Weekly bond purchases (lhs) 20 Cumulative total (rhs) 240 220 200 180 160 140 120 100 80 60 40 20 0 Apr- Jun- Aug- Oct- Jan- Mar- May- Aug- Oct- Dec- Mar10 10 10 10 11 11 11 11 11 11 12

15

10

Italian Draghi - SMP is temporary and limited

In reality it will probably become permanent and unlimited

11

May 2012

but still trails behind the Fed & BOE

Central Bank asset purchases (% of GDP)

24 22 20 18 16 14 12 10 8 6 4 2 0 Bank of England Federal Reserve Bank of Japan ECB LTRO QE still to come

ECB started off with the sovereign market program, which was fully sterilised - NOT QE ECB reluctant to do QE so lent 1trn to the banks to do it - >90% of which has ended up back on deposit with the ECB The BoE has done 325bn of QE and the Fed has done over $2trn Scaling up ECB bond buying to Fed & BoE levels would amount to around 1.8trn- 2trn more than the entire Italian bond market!

May 2012

12

Fiscal austerity FOREVER!!

14 12 10 8 6 4 2 0 -2 -4 -6 -8
Germany Italy Netherlands Greece UK Spain France US

Cyclically adjusted primary balance required for sustainable debt

(% of GDP)

If fiscal policy is going to be so tight then monetary policy will have to be ultra loose to compensate Low rates and bond yields forever = currency to depreciate versus emerging market growth engines
13

2010 2020-2030

2020-2030 including age related spending

May 2012

Population demographics bad for Europe

Growth rates of populations of working age
160 140 120 2010-2030 100 80 60 40 20 0 -20 -40
North America Asia Latin America Europe Oceana World Africa

(% change)

2010-2050

Europe will soon see its population shrink making a drive for exports all the more important Europes working age population will fall even more quickly

meaning the fiscal pain will be even greater

May 2012

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How can we get out of this mess?

1. Relax austerity countries meant to have deficits less than 3% by 2013, so delay this until 2016 Talk down the euro to boost competitiveness shouldnt be hard

2.

3.

ECB rate cuts, LTRO3, possible QE will also feed through into weaker euro but ECB must be prepared to take losses Lower oil prices Saudi oil minister says oil should be $100/bbl
Common Euro-bond?
15

4.

5.
May 2012

Competitiveness still to be addressed

Jan 2001= 1 00 200

Relative unit labour costs

1 80

GER SPA

FRA NLD GRE

ITA BEL POR

1 60

IRE

1 40

The likes of Portugal, Spain, Italy, and Greece still have a mountain to climb in terms of competitiveness but it can be done Ireland did it, and now runs a current account surplus

1 20

OECD: Manufacturing Unit labour costs - sa

1 00

80

60 00 01 02 03 04 05 06 07 08 09 1 0 1 1

May 2012

16

Shale Gas Race to the bottom

index $ per unit
200 1 80 1 60 1 40 1 20 1 00 80 60 40 20 0 08 09 1 0 1 1 1 2
Technically Recoverable Resources Tcf

Natural Gas - relative price

Europe US Henry Hub

Recoverable shale gas deposits are widely distributed

Shale Gas Reserves

US Natural Gas prices are their lowest in yearsthanks to the growth of shale gas production this has only just taken off in other regionsthough we can expect a similar price reduction in time elsewhere
May 2012

Australasia, 396 Asia, 1404

US, 862 Other North America, 1069

Africa, 1042 Europe, 624

South America, 1225

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Oil shock: Israel vs Iran

Prospects for a Middle East clash uncertain Iranian or Hezbollah retaliation? Oil at $200/bbl? Mining the Straits of Hormuz?
Crude oil prices

$/bbl 1 60 1 40 1 20 1 00 80 60

Brent crude 40 20 0 Jan 07

WTI

Jan 08

Jan 09

Jan 1 0

Jan 1 1

Jan 1 2

May 2012

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Impact of fuel shock

Potential cost of US Fuel
oil price in US$ 100 110 120 130 140 150 160 170 180 190 200 pump price average cost 1 car ($c/gall) ((13 gallons per week ($)) 297 322 347 372 397 422 447 472 497 522 547 38.94 42.22 45.50 48.78 52.05 55.33 58.61 61.89 65.17 68.44 71.72 avg annual cost 1 car 4050 4390.91 4731.82 5072.73 5413.64 5754.55 6095.45 6436.36 6777.27 7118.18 7459.09 % median after tax income 4.1 4.4 4.7 5.1 5.4 5.8 6.1 6.4 6.8 7.1 7.5 2 cars 8100 8781.818 9463.636 10145.45 10827.27 11509.09 12190.91 12872.73 13554.55 14236.36 14918.18 % median after tax income 8.1 8.8 9.5 10.1 10.8 11.5 12.2 12.9 13.6 14.2 14.9

May 2012

At current prices - $120-$130/bbl, gasoline consumption is costing a 2 car household about 9.5-10% of annual income. At $200/bbl, this increases to about 15% Of course, if you drive an SUV double all the figures above!
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SPR 30m barrels = about $0.50-$1.00 3m

SPR Drawdowns
750000 Hurricane Katrina 1 m b 1 700000 Arab Spring 30m b

450 400 350 300

In recent history, there have been three instances of an SPR drawdown The resulting fall in retail gasoline prices was about $0.50 - $1.00, though the counterfactual is unclear Is few cases, was the impact sustained for more than 3m Moral: Dont overestimate the price effect of the SPR

650000 low distillate levels in NE 30m b 600000 1 50 1 00 Strategic petroleum Reserve, lhs Retail gasoline prices, rhs 500000 99 00 01 02 03 04 05 06 07 08 09 1 0 1 1 50 0 250 200

550000

May 2012

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EUR/USD the known unknowns

High

US elections/ protectionism

PROBABILITY

Fed QE3 Eurozone hard-landing Early Fed tightening Chinese hard landing Iran Conflict Greece leaves EMU

EUR/USD

Positive factors

Negative factors

Eurozone breaks up

Low 0% Low
May 2012

15% IMPACT

30% High
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Monetary Shocks policy error?

% 5

Fed member assessment for appropriate interest rate

0 201 2 201 3 201 4 Lo nger run

The Feds proposed first rate hike by no sooner than late 2014 seems difficult to take seriously Markets are registering their doubt through Eurodollar and Fed fund futures contracts Fed taking a chance with inflation bond yield spike later in 2012?
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May 2012

US is not immune to the Eurozone

EURtr

Ultimate country risk exposure

2 1 .8 1 .6 1 .4 1 .2 1 0.8 0.6 0.4 0.2 0 B anking secto r P ublic secto r GIIP S Other UK to tal

Exposure of US banks to Europe through deposits, loans etc amounts to about $1.8tr (inc UK)
EUR tr

0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

Country and CDS

Other Euro zo ne

May 2012

and exposure through CDS written amounts to a further $2.2tr If the crisis does re-ignite then the US will not be immune to Eurozone developments

Be lg iu Fr m a G nce er m an y Lu Ita xe m ly b N et ou he rg rl a nd Au s st r G ia re ec Ire e la Po n d rtu ga Sp l ai n U K

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US fiscal policy tightening set to bite

GDP % 4 3 US 2 1 0 -1 -2 -3 2009 201 0 201 1 201 2 201 3 201 4 Euro pe

US growth has been helped by the fact the government has been quicker to loosen and slower to tighten fiscal policy than has the Eurozone this is beginning to change Bipartisan politics mean more sunsetting of stimulus from 2013, and more fiscal drag
24

Tax-mageddon

May 2012

Debt burden still very heavy

($) 180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 52 56 60 64 68 72 76 80 84 88 92 96 00 04 08 * debt per person of working age

The US debt burden*

($) 180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0

Federal & local government debt Household Average salary

Household debt has fallen mainly due to debt default But overall burden still extremely high three times average individual salaries Likely to weigh on consumer spending growth for years
25

May 2012

China avoiding a hard landing?

index

Exports and Export PMI

YoY%

70 65 60 55 50

60 50 40 30 20 10

Export growth has been slowing

but some of the lead indicators for exports are not too bad
and in any case, wasnt China supposed to be moving to a more domestically oriented growth model?

45
Export orders PMI

0 -10 -20 -30 -40

40 35 30 25 31/01/2005

Exports, rhs

31/01/2007

30/01/2009

31/01/2011

May 2012

26

Key currency attributes in 2012

Safety
JPY CHF GBP

Liquidity

USD
CNY

EUR CAD

NOK AUD SEK NZD

Year-to-date vs. USD (% chg) NZD GBP NOK CAD CHF SEK AUD EUR JPY -6 -4 -2 0 2 4 6

ASIA ex CNY

LATAM

Return

EMEA INR

Very few currencies demonstrate all the attributes of safety, liquidity and return
May 2012 27

Global FX valuations to impact returns

Currency pain thresholds
Brazil Russia Australia China Singapore Canada Switzerland Indonesia NZ Thailand South Africa Malaysia Norway India Turkey Hungary Sweden Japan Mexico Eurozone South Korea US UK -15 -10 -5 0 5 10 15 20 25 30

Percent of REER index above/below 10-year average

May 2012

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Summary
The best case, is for ongoing, prolonged, low level risk aversion and weak growth from the G-10 Assuming no Euro break up: fiscal tightening, credit constraints, and deleveraging will weigh on economies and assets for year (decades?) to come The worst case is for massive economic and market disruption in the event of Eurozone break up The rest of the G-10 will not be immune to the fallout Choosing between a number of binary outcomes (Greece in or out for example), makes forecasting almost impossible

Adding politics to the arguments makes logic irrelevent

Most of the arguments point to further euro weakness. And also to low(er) rates and bond yields (for core Europe, and non-Europe)

May 2012

29

Forecasts
Forecast summary
2011 US GDP CPI EZ GDP CPI EUR/USD UK GDP CPI GBP/USD Japan GDP CPI USD/JPY China GDP CPI USD/CNY 1.7 3.2 1.5 2.7 1.30 0.7 4.5 1.55 -0.7 -0.3 77 9.2 5.4 6.32 2012 2.2 2.1 -0.4 2.4 1.15 0.2 2.7 1.53 1.9 0.2 85 8.2 3.0 6.24 2013 2.0 2.4 0.9 1.7 1.2 2.0 2.0 1.56 1.3 -0.1 95 8.4 3.0 6.18 2014 2.3 2.5 1.2 1.8 1.25 2.7 2.3 1.56 1.2 0 110 8.4 3.0 6.18

All figures annual averages, except for exchange rates, which are year end

May 2012

30

Disclaimer
All charts sourced from EcoWin or Bloomberg unless stated otherwise.
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May 2012

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