EUROPEAN MARKETS

THE NEED FOR HIGHER GROWTH AND LENDING ACTIVITY

October 2014

Miroslav FrayerSenior economist

Economic & Strategy Research

Tel.: +420 222 008 567

miroslav_frayer@kb.cz

2October 2014

CONTENT

1. The EMU's macroeconomic environment

2. The European Central Bank's monetary policy

3. Impact on financial markets (EUR/USD, market interest rates)

MACROECONOMIC ENVIRONMENTIn the shadow of low inflation and weak growth

4October 2014

SLOW AND UNEVEN RECOVERY

Economic recovery is slow, fragile and heterogeneous among countries: The EMU saw GDP growth of +0.2% qoq in Q114 and 0.0% in Q214

Low capacity utilisation rate and weak global demand point to a modest recovery in capex

Household consumption hit by a high unemployment rate and weak wage growth

A weak housing sector

The slowdown in global trade is also affected by rising geopolitical risks

Source:: Datastream, SG Cross Asset Research/Economics

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

1999Q1 2001Q3 2004Q1 2006Q3 2009Q1 2011Q3 2014Q1

Business investment grow th rate, % yoy

Euro area Germany France Spain Italy

A persisting weak investment picture Leading indicator (manufacturing PMI)

46

51

56

Aug-13 Dec-13 Apr-14 Aug-14

Diffusion index

Euro area Germany FranceItaly Spain

5October 2014

THE UKRAINE CRISIS IS TAKING A LARGER TOLL

Sanctions imposed to date will have a 0.3pp impact on GDP growth over 2014-15To date, just under 10% of euro area exports to Russia have been affected

Mechanically, this would reduce full-year euro area GDP by around 0.1pp

In addition to direct impacts, we also consider secondary confidence effects among business managers

GDP growth revised from 1.3% to 1.0% for 2015 (0.8% for this year)

Source:: Datastream, SG Cross Asset Research/Economics

Real GDP (% yoy) Contribution to GDP growth (% qoq)

6October 2014

NO RETURN OF WAGE-DRIVEN INFLATION YET

Wages have been relatively sticky throughout the 2007 crisisGrowth of an average 2% pace since Q107

A slowdown to 1.2% yoy in Q114 despite the rise in the unemployment rate by nearly 3.8pp during the same period

The drivers of sticky compensation growthPent-up wage deflation

Wage negotiation

Sources:Eurostat; SG Cross Asset Research/Economics

1.0

1.5

2.0

2.5

3.0

3.5

4.0

6

7

8

9

10

11

12

13

1999 2002 2005 2008 2011 2014 2017

Unemployment rate (%)

Compensation per employees (% yoy), RHS

SG forecast

Sticky wage growth in a context of soaring unemployment

99

101

103

105

107

109

111

2000 2002 2004 2006 2008 2010 2012 2014

Real wages per employee

Productivity

Rebased Q1 2000 = 100

7October 2014

INFLATION WILL NOT EXCEED 1.5% THROUGH 2018

HICP inflation printed at 0.4% yoy in August, down from 2.0% in January 2013; the

inflation rate should gradually exceed the 1.0% threshold starting in mid-2015Higher energy prices owing to euro depreciation Stabilisation of food pricesGradual recovery of core prices

For this year, the inflationary forecast was revised downward from 0.8% to 0.6%

Source:: Bloomberg, SG Cross Asset Research/Economics

Low inflation but no outright deflation No inflationary pressures due to negative output gap

MONETARY POLICYLots of work ahead

9October 2014

WHAT HAS THE ECB DONE SO FAR? ...

An unfavourable inflation outlook has forced the ECB to act:Double rate cuts

− refinancing rate stands at 0.05%− deposit rate at -0.20% − marginal lending facility rate at 0.30%

End of the sterilisation of the SMP programmeA series of six quarterly TLTROs granted from September 2014 to June 2016, all maturing in September 2018 Launch of a private sector assets purchase programme covering ABS and covered bonds

-0.30-0.20-0.100.000.100.200.300.400.500.600.700.80

Jan-14 Mar-14 May-14 Jul-14 Sep-14

refi rate deposit rate MLF rate%

Source:: Datastream, Bloomberg, SG Cross Asset Research/Economics

ECB interest rates reach the „lower bound“ Monetary conditions

10October 2014

THE ECB’S OBJECTIVES

The goal is to inflate the ECB’s balance sheet back toward 2012 levels: Today, the ECB balance sheet totals EUR 1988bnIn 2012, it averaged EUR 2750bn and rose to EUR 3100bn by mid-2012 Adjusted for non-monetary policy posts, this would suggest the ECB is targeting a EUR 425-825bn increase in its balance sheet, including TLTROs

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2007 2009 2011 2013 2015 2017

%

Source:: Bloomberg, SG Cross Asset Research/Economics

Decreasing ECB balance sheet The first rate hike in 2017

11October 2014

UPCOMING EVENTS

The ECB's meeting in October: More details on its ABS and covered bond purchase programmes

Comprehensive assessmentPrior to taking full responsibility for supervision under the Single Supervisory MechanismTwo main pillars:

− An asset quality review

− A stress testGoals of the comprehensive review

− Transparency

− Repair

− Confidence buildingResults are expected by the end of October

− We expect the need for major listed banks to raise equity capital as a result of the stress test will be very limited

− Three areas of concern: Italian mid-cap banks, Portugal and the unlisted sector

FINANCIAL MARKETSFocus on interbank interest rates and EUR/USD

13October 2014

FINANCIAL MARKETS WILL NOT REMAIN UNTOUCHED...

The main aims of the ECB's relaxed monetary policy To prevent the economy from falling into deflation

To halt or at least lower fragmentation on the European interbank market

To support lending in the economy, especially for small and medium enterprises

Source: ECB, SG Cross Asset Research/Economics, Datastream

Lending rate on loans to NFCs, 1Y rate Monetary and credit growth (%, yoy)

14October 2014

LONG-TERM PERIOD OF LOW INTEREST RATES AND YIELDS...

Yields and rates close to record minimums The ECB's monetary policy, low inflation and weak growth will keep rates down

No significant increase in rates in the near future for short-term or long-term yields

Pressure on a decline in yields in peripheral countries (Italy, Spain, etc.)

Source: Bloomberg, KB Economic & Strategy Research

Declining European swap rates (%) Deeper decline in long-term rates (10-2Y, %)

15October 2014

EURO SUFFERS FROM STRONG SELLING PRESSURES ...

Finally, the euro is on its way to weaker levels Huge capital inflow to European equity and bond funds in 2013 and the beginning of 2014 led to

a strong exchange rate for the euro

Different approaches to monetary policy by the Fed and the ECB should push the euro down

EUR/USD at 1.21 on the one-year horizon

Source: Bloomberg, KB Economic & Strategy Research

Cumulative capital inflow to EU funds (USDm) Market expectations of weakening EUR

THANK YOU FOR YOUR ATTENTION

17October 2014

DISCLAIMER

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