April 2011 - N°04 › ... · Equity markets: Diversify to mitigate rising risks page 18 Credit:...

For professional use only

April 2011 - N°04

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20Bank stress tests redux

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19Equity markets: Diversify to mitigate rising risks

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Credit: “Corporate America”, don’t stop on the road towards improved credit metrics, as shown by the Fed’s latest data

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Currencies: What can movements in assets held abroad tell us about currency trends?

Box 4: Asian currencies: nominal or real appreciation?

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Impact of the global geopolitical crises: Despite being geographically close to Africa and the Middle East, the direct impact is limited for European companies

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14The Japanese crisis: The market has already discounted the short-term effects

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13How will the Japanese disaster affect the global economy?

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10Japan: The economic and market outlook following the earthquake

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Euro sovereign debt: A multi-track Europe

Box 1: Decisions in March

Box 2: Questions about the ECB’s reaction function

Box 3: Defaults – debt restructuring…what does history teach us?

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Euro sovereign debt: a multi-track Europe . Although the countries of Europe did not resolve all of their problems at the end of March, the markets appreciated the progress made and Spain performed the best over the month. Portugal, on the other hand, joined Greece and Ireland as a sovereign pariah. This is mainly due to the political situation and the initial rejection of any external aid.

Japan: the economic and market outlook following th e earthquake. The 2011 GDP forecasts were revised downwards and the 2012 forecasts upwards. Comparisons with the Kobe earthquake have little relevance as the current situation is far more serious. The serious problems affecting supply chains and demand for raw materials will be far-reaching. The bond market should remain solid, whereas volatility is to be expected on the equity markets.

How will the Japanese disaster affect the global ec onomy? The Japanese tragedy should have a very limited impact on the global economy due to the current momentum and Japan's relatively low weight in the global economy. Reconstruction should later benefit export companies, led by companies in Asia, and raw material exporters such as Australia and Brazil. Any repatriation of capital, which is unlikely, would favour the yen's rise against other currencies.

The Japanese crisis: the market has already discoun ted the short-term effects. Note that European companies have only limited exposure to Japan, usually amounting to less than 5% of their turnover. Some believe that the US and emerging economies are likely to offset the shock from Japan. According to others, the shock is temporary enough to be easy to absorb.

Impact of the global geopolitical crises: despite b eing geographically close to Africa and the Middle East, the direct impact is limited for E uropean companies. The sectors monitored have very little exposure to these two regions. Across all sectors, the turnover generated in Africa and the Middle East is between 0% (real estate, financial institutions, food distribution and semi-conductors) and 7% (capital goods, defence, consumer staples andpharmaceuticals). Some companies have a large presence in these two regions, however.

Currencies: what can movements in assets held abroa d tell us about currency trends?Forex traders often focus on flows of goods and services and capital, and fail to analyse trends in country's net foreign assets. But ultimately these are what count when assessing a country's needs. Looking at the net international investment positions of the G3 nations shows (1) that the dollar does not have a greater need to fall than the euro and (2) that the yen may need to remain strong long term…

Credit: “Corporate America” don’t stop on the road t owards improved credit metrics, as shown by the Fed’s latest figures. The debt/cash flow ratio of US companies was at its lowest level in Q4 2010, while cash is continuing to build up. In the wake of rising profits, corporate spending has greatly increased, and this is probably only the beginning.

Equity markets: The increase in exogenous risks, li nked to factors such as geopolitics, climate and radioactivity, does not dim the appeal of equity investments, but it does call for diversification. Our main themes are energy (both cyclical and structural), the US market (the price to be paid for a defensive choice) and the euro area market (a diversified “value” play).

Bank stress tests redux. After passing the tests, Irish banks needed considerable recapitalisation, which damaged the tests' credibility. The European Banking Authority is responsible for the next round (H1 2011), on a different basis. Its goal is to assess the resilience of the EU's banking system and the sensitivity of each bank to extreme events. Previous tests, and those underway, have a seriously failing: despite identifying banks with fairly low capital ratios (but that remain within the regulatory framework), there is no mechanism in place to enforce their recapitalisation.

Sent to press on 8 April 2011

2For professional use only

April 2011 - N°04

ASSET CLASS INVESTMENT THEMES and OUTLOOK Amundi INVESTMENT STRATEGIES

Asset allocation

• Despite the recent turmoil on the financial markets, we are heading towards a normalisation of growth and inflation around the world. Prefer risky assets – especially equities – over government bonds.

• Tactically speaking, the main cause for concern remains on-going tension in the Middle East and North Africa. A spike in oil prices could dampen consumption. This risk needs to be hedged in a diversified portfolio.

• Monetary policy normalisation could affect risky assets, as investors fear a faster-than-expected tightening in monetary policy. Volatility is set to remain unsettled.

• In equities, we are marginally lowering beta by reducing the long bias on euro zone equities (we prefer the US to the euro zone). We are also raising exposure to commodity equities to hedge against rising oil prices.

• In bonds, we still have a clear preference for credit, and are overweight in high-yield and emerging public debt.

Money markets

• As expected, the ECB raised interest rates by 25bp on 7 April. The phrase “strong vigilance” has been dropped, which seemingly implies that the ECB will not raise rates again in May. We still expect two more hikes by year-end (probably one during the summer), but the timing is uncertain. The ECB may want to take time out with the arrival of its new President in November. We expect the repo rate (currently 1.25%) to reach 3.0% by the end of 2012. Given cyclical differences within the euro zone, the ECB has little room to raise interest rates more aggressively. Euribor rates are still climbing slowly but surely…

• In the United States, the Fed’s minutes show intense debate about whether or not QE2 should beended early. We expect the Fed will complete its purchases of $600 billion in Treasury notes – the amount initially announced. It cannot start raising interest rates until QE2 ends. The Fed will probably want to wait to see the impact on long-term bond yields before it removes the sentence that says it will keep rates unchanged “for an extended period”.

• As the sovereign debt crisis intensifies in Greece, Ireland and Portugal, exceptional liquidity operations could keep the Eonia low for longer than expected… it should nonetheless move closer to the repo rate in the months ahead.

• In the United States, the Fed is likely to change its tone … Meanwhile, surplus liquidity (banks’surplus reserves with the Fed) has reached a record high and is maintaining pressure on the effective Fed Funds rate (which fell below 0.10% on 8 April).

Bond markets

• We still expect a “classic” monetary policy normalisation. This generally causes a flattening in the yield curve, with the short end rising more than the long end. The German yield curve is already well along in this process. However, the curve is still very steep in the US and will only begin to flatten with a significant shift in tone from the Fed.

• For now, food and energy prices are driving up headline inflation on both sides of the Atlantic. Core inflation remains subdued. However, real interest rates are negative and it is thus becoming necessary for central banks to start normalising monetary policy.

• In the United States, regulations and deleveraging mean that a greater portion of assets is being held in the form of Treasury bonds (by commercial banks, pension funds, households, etc.). These investments had fallen to very low levels. US residents can absorb Treasury note issues, which should eventually stave off a bond market crash.

• Despite the sharp rise in core euro zone countries’ short-term rates, we are maintaining our bear flattening position.

• Yields are likely to continue moving up this year in both the United States and Germany.

• The spread in short-term rates between Germany and the United States is unlikely to widen further. The 2-10 year segment now has less flattening potential in core euro zone countries than in the US.

Credit

• Credit outperformed government bonds in March, too, notwithstanding a wide combination of headwinds from recent events. The picture is still credit friendly. Key factors include low interest rates, low inflation, significant corporate deleveraging, cash accumulation, still-attractive credit spreads, very low default rates, and a strong rebound in profits.

• Stay overweight in high-yield versus investment-grade credit and in financials vs. industrials.

• Performance should be satisfactory in 2011, but not up to the levels of the last two years.

Equities

• Risks are on the rise but the environment still favours equities.• Classic risks: monetary policy normalisation in developed countries while emerging countries have

not finished tightening and commodity prices are still rising.• External risks: climate (impact on food prices), geopolitical (oil), radioactivity (uncertainty over the

timing of Japanese reconstruction).• Positive factors: liquidity remains abundant, earnings growth will remain in double digits over the

next 12 months, market valuation is not excessive.• Given the risks that may persist and the exogenous nature of some of these risks, we are reducing

our portfolios’ cyclical exposure, though without adopting a defensive stance.

• Overweight the US (a bit expensive, but defensive) and the euro zone (a diversified value market). Japan has temporarily become a speculative market.

• Neutral on emerging markets. EMEA countries need to continue to benefit from their exposure to the oil, gas and gold sectors.

• On European sectors, we are downgrading our opinion on luxury goods from positive to neutral (exposure to Japan, while valuations are tight and the euro is rising).

Emerging markets

• Emerging economy assets navigated the recent period relatively well. Emerging equities were in the black at the end of March and the credit risk premium on emerging market sovereign debt has been stable since the start of the year. This confirms that these assets have further reinforced their defensive status.

• Domestic inflation is the main area in which these economies remain vulnerable.

• Until the positive impact of the current monetary tightening shows up in these countries, underexposure is recommended on both emerging equities and debt.

Commodities

• Oil prices are likely to remain on a rising trend as long as the political situation in the Middle East and North Africa remains under pressure.

• Reconstruction spending in Japan will push up metals prices. Gold is benefitting from growing risk aversion and possibly from inflation expectations.

• Overweight on the energy sector. • Overweight on the gold mining sector. • Long on soft commodities as supplies remain

very tight (risk of a food crisis).

Currency markets

• The euro continued to ride the widening in the 2-year yield spread between Germany and the US, which is linked to monetary policy expectations. The euro will remain strong as long as the Fed does not shift its tone, and that could take several more months…

• The dollar is likely to remain under pressure, particularly vs. Asian currencies (countries having heavy current account surpluses and inflation under control). The yen is likely to be an exception, especially as the BoJ will do all it takes to reduce any upside pressure caused by capital repatriation like in the aftermath of the Kobé earthquake of 1995. Yield spreads are likely to continue to play in favour of the dollar/yen.

• Prefer emerging currencies, particularly in Asia, given the expected gradual rise in the RMB.

• Commodity currencies will remain strong, even though they are already overvalued.

• The dollar offers good protection against a worsening of the sovereign debt crisis.


April 2011 - N°04

An earthquake, a tsunami, a nuclear alert and an armed conflict… this is what the month of March held in store for us. In addition to the human cost, the accumulation of four major

Introduction: an earthquake, a tsunami, a nuclear alert, and an armed conflict … how do we deal with four “black swans” in one month?

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Even so, the environment is favourable to risky assets

exchange rates may be marked by changes in the amount of foreign-held equity (see section 6).

So what are we to make of the events in Japan, tens ions generated by the crisis that is still affecting euro zone sovereign debt, or the Middle East crisis?

There is no point in recalling that neither Three Mile Island, nor Chernobyl, nor the Indian Ocean tsunami, nor Hurricane Katrina triggered the slightest global recession. And there is no reason at all for the events in Japan to do so this time around (see section 3).

That said, the events in Japan will obviously not b e without economic repercussions , and our Tokyo-based research team rapidly took the measure of the growth impact in its sharp revisions to its 2011 forecasts (see section 2). It is always tempting to compare the current disaster with the 1995 Kobe earthquake. While the market’s reaction was identical (equity markets dropped, the yen rallied sharply on anticipations of capital repatriation, etc.), the comparison ends there.

VIX index (implied volatility on the US equity market)

Central bank rate: ECB vs Fed

EUR/USD vs 2y. govies spread Germany-US

Four “black swans”in March

events – four black swans, some might say – has heightened uncertainty on all financial markets. However, even this was not enough to make radical changes to our base-case scenario, which, remember, is based on four major themes:

“”

� First, the conviction that economic growth in the US and in euro zone core countries is increasingly well balanced. True, the lack of rebound in investment is keeping economic activity from accelerating, but the solidity of consumption is keeping hopes alive in this area.

� Next, even though inflationary fears seem premature in advanced economies, price trends are becoming a major problem in certain developed economies, which has been exacerbated by oil and food prices in recent months.

� There are still wide economic divergences in euro zone countries; some countries are on a more solid standing in their public finances, and enjoy lower interest rates and other competitive advantages, while other countries are being forced into fiscal consolidation that is undermining growth, while credit downgrades are sending yields up and handicapping economies that are already under-competitive.

� Central banks will soon have to begin normalising their monetary policies: after long quarters of highly accommodating monetary policies, the Fed plans to set aside quantitative easing in June, while the ECB has flagged a first rate hike in early April (on the 7th).

All in all, the context is favourable to risky assets, equities most of all. The tightening cycle (in both short and long rates) does not appear to have been changed radically by recent events. In other words, the current uncertainty, which is something of a spur to risk aversion and flight to quality, is not able enough to undermine our scenario of a rise in long-term yields and a flattening in the yield curve. Movement in foreign

“

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Japan: much worse than the Kobe earthquake

This time, not only have more regions been affected (four prefectures in 2011, just one in 1995), but the tsunami has been much more destructive than the 1995 earthquake. The nuclear alert skews the comparison even more.

“”

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30

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02-1

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03-1

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04-1

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Source : Datastream, Amundi Strategy

Earthquake in Japan

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1%

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7%

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09-0

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12-0

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03-0

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06-0

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09-0

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12-0

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03-1

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05-1

1Source: Datastream, Amundi Strategy

ECB (repo rate)Fed funds rate

1.2

1.25

1.3

1.35

1.4

1.45

1.5

1.55

1.6

04-0

8

08-0

8

12-0

8

04-0

9

08-0

9

12-0

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04-1

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04-1

1

Source: Datastream, Amundi Strategy

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100EUR/USD2y. spread (R.)


April 2011 - N°04

The commodity prices evolution :

Price of brent barrel depending on the currency (100 = july 2008 peak)

All other things being equal, the two first risk factors give pause on commodity prices, an increase in which runs the risk that this will "bite" into growth, especially through US consumers, and trigger a recession. These three risk factors tend to increase market volatility and flight to quality. It is without doubt useful to diversify within equity to confront increasing risk (see section 8).

Euro sovereign debt: will governments be able to reassure investors once andfor all?

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It is no easy task to predict whether tensions will spread to other exporting countries, with an impact on supply … or to predict what type of political region will replace the regimes that fall –assuming that they do fall. The biggest uncertainty of all is over oil prices and on the scale of the impact on European companies (section 5).

Middle East:complete uncertainty over oil

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As for the euro-zone sovereign debt crisis (see sec tion 1) , the various meetings in March cleared up some shadowy areas, particularly as concerns solidarity between European countries, but there are still some fears over the extent of the crisis in certain countries (Greece and Ireland), the political situation in others (Portugal and Ireland), and the agency downgrades of two sovereign issuers that are currently in the eye of the hurricane (Spain and Portugal), as well as a portion of their banking systems (see section 9 for a new version of the banking stress tests).

”

Based on initial estimates, damage is two times worse than in 1995. Even so, it is reasonable to believe that the impact on other countries will be neutral or even positive in certain cases. Global growth will suffer a limited hit, as Japan accounts for just 9% of the world’s GDP (vs. more than 18% in 1994) and just 8% of global market capitalisation (vs. 50% in the 1980s). Note that the markets have already priced in the short term effects of the Japanese crisis (section 4).

Reconstruction will nonetheless boost countries that already export to Japan (remember that, at cruising speed, Japan is already the country that spends the most on infrastructure). It’s a good bet that the loss of almost 25% of Japan’s nuclear power capacity will boost oil and gas imports, that reconstruction will spur commodities demand and that the food alert will probably push food prices up. Some countries could be big beneficiaries, including producers of gas, iron ore (Brazil and Australia are the main iron ore exporters to Japan, which is the world’s largest steel producer) and other basic materials. As in 1995, reconstruction of devastated areas will stimulate growth, probably in late 2011 and in 2012.

As for the Middle East, the situation looming on the horizon is hardly any simpler. After Tunisia, Egypt… After Egypt, Libya … And after Libya… who’s next?

Impact Japan European debt Middle East crisis

Persistently high spreads for certain countries

Solvency vs. liquidity

Bull market not at risk (in the rest of the world)

Advanced economies vs. emerging countries

(oil, commodities, food, inflation, etc.)

Eurozone: expect a recovery in peripheral

countries

A peak in divergences

Flight to quality

A heavier impact on emerging economies, Asia

in particular… overweight EMEA

Higher oil prices (impact on trade balances)

Higher gold prices

Economic growth

Impact on growth through higher oil and

commodity prices… A heavier impact on

emerging economies, Asia in particular if the

crisis drags on

Bond markets

Watch out for Japan … very narrow manoeuvring

room but exceptional measures are inevitable

(monetisation of debt)

Euro zone: cost of fiscal consolidation,

particularly in peripheral countries

Core countries enjoying solid growth and low

rates

Flight to quality … limited

Spectre of stagflation if crisis drags on

Japan: Weaker activity in H1 2011, revised

upward for 2012

US and euro zone: negligible impact

Equity markets

CommoditiesExpect a sharp run-up in demand from Japan (oil,

aluminium, etc.)No impact

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1600Crude Oil price$/barrel (Lhs)

Gold Price$/ounce (Rhs)

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07-1


GBP EUR USD JPY


April 2011 - N°04

EMU countries are struggling to find solutions to the debt crisis and to reassure the financial markets completely that the crisis will have a happy ending. Even so, the situation now looks clearer. Although stubborn divergences within the euro zone continue to disrupt the markets, European countries clearly took some big steps throughout the month of March, on the one hand by expanding the capacity of the European Financial Stability Facility (EFSF) and, on the other, with regard to the permanent European Stability Mechanism (ESM) set to replace the EFSF in 2013. True, Finland, which is currently in an election campaign, has requested a postponement in the signing of these agreements.

Euro sovereign debt: a multi-track Europe

A greater cause of concern was the fact that the failed vote in late March occurred at a time when one country, Portugal, was weakening both politically and in financing its debt. Just to make matters worse, ratings agencies downgraded Portuguese and Spanish debt during the month, along with five Portuguese banks and 30 Spanish banks (La Caixa, BSCH and BBVA were spared this credit event). While the European decisions satisfied holders of Spanish debt (the top performer in the euro zone in March), political instability moved Portugal closer to those countries suffering clear solvency problems (Greece and Ireland).

Dispersion in the Eurozone: interest rates, economic cycles and equity markets

10 yr interest rate spread with Germany

10 yr interest rate change over the month (April 8th 2011)

This is not in itself a cause for concern but it does not completely meet the expectations – and demands – of financial markets who want quick answers. Clearly, the markets do not march at the same pace as European governments. Let’s admit that the markets’ impatience is justified (given the lack of fiscal federalism, the EMU is incomplete and therefore fragile) and they are

The markets do not march at the same pace as European governments

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“forcing” European governments to quickly address legitimate fears. To mitigate the lack of fiscal federalism, several solutions are possible:

� A shared tax pool based on economic activity

� The creation of a richly endowed European monetary fund

� The creation of a European government

� Setting up a pan-European debt market to replace the fragmented markets in place.

The path envisioned by European countries is not simple and all this takes time, but what is currently happening in managing the European debt crisis is without a doubt much more important and tangible than the various political and economic moves made in the last 15 years. As is always the case in European construction, it is in crisis situations that problems – even those that were predictable – are analysed and resolved.

”

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� 11 March announcement: the EFSF’s capacity should be expanded from €255 bn to €440 bn.

� 15 March: curbs on spending growth (below medium-term GDP growth), debt constraints, new sanctions (inadequate for the ECB).

� 24-25 March: The European Council confirmed to establish a permanent crisis mechanism –the European Stability Mechanism (ESM) to replace the EFSF. The ESM - with an effective lending capacity of €500 bn - will have a total subscribed capital of €700 bn (80bn in the form of paid-in capital provided by the eurozone member states and 620bn of committed callable capital and guarantees). It will raise funding and provide loans under strict conditions to eurozone states threatened by severe financing problems, to safeguard the stability of the eurozone. It may also exceptionally intervene in the debt primary market under the same conditionality.

Box 1: Eurozone sovereign debt – decisions in March

We might add that Portugal faces two other challenges: on the one hand, its refusal – at the beginning – to request assistance from the European Union and the IMF is not reassuring, and on the other hand, its major sovereign debt maturities in April (not less than €4 bn in

Portugal is distressed“”sovereign bonds are due, along with €1 bn in sovereign coupon payments and €1 bn in

bank debt) and in June (€5 bn in sovereign debt about to mature, €2 bn in sovereign coupons and €1 bn in banking debt about to reach maturity.

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1

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98 99 00 01 02 03 04 05 06 07 08 09 10


10-year sovereign yield

Economic sentimentEquity markets (12-m rolling)

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04-1


GREECEIRELANDPORTUGALSPAINITALY

-75 -50 -25 0 25 50 75 100

IRELAND

SPAIN

ITALY

GREECE

BELGIUM

FRANCE

AUSTRIA

FINLAND

GERMANY

NL

PORTUGAL

Yield Change

SpreadChange


April 2011 - N°04

Ratio CDS spreads Peripherals against AAA countries

10 yr interest rate spread with Germany: AAA countries

10 yr interest rate spread with Germany: peripheral countries

The euro zone now has a multi-track bond market, with one group suffering solvency problems (Greece and Ireland), one group that is solvent but vulnerable to liquidity crises and, hence, even higher spreads (Spain) – Portugal is hovering between these two groups; it is solvent (like Spain), but is suffering liquidity problems and serious political difficulties (like Ireland back when) – and, finally, one group with narrower spreads vs. Germany (Italy and France in particular).

Economic history shows (see Reinhart and Rogoff (2010) on this point) that international banking crises generally touch off sovereign debt crises and that sovereign debt crises occur at the weakest links in the global economy. It happens that on the issue of sovereignty, federalism, governance and fiscal coordination, the euro zone is seen as a week structure. Fortunately, the financial markets can tell the difference between solvent and insolvent. The other countries include “healthy” countries and countries facing financing issues. In other words, regardless of the mechanism adopted, it will be hard for insolvent countries (Greece and Ireland) to avoid debt restructuring.

The debt crisis has ultimately turned out the same as the currency crisis. With no adjustment possible via monetary policies and short-term interest rates, and with no adjustment possible t h r o u g h e xc ha n g e ra t es , and wi t h no coordination of fiscal policies within the euro zone, it is long bond yields that adjustment is taking place, and credit spreads represent the EMU’s “breathing zone”. It is striking to see how

The current debt crisis and the 1990s currency crisis: have we been down this road before?

“

”dispersion has evolved over time. In the 1980s dispersion was apparent in economic cycles and especially in the equity markets. Dispersion is now apparent on fixed-income markets. In fact, sovereign spreads are similar to those that prevailed before the EMU was set up, which, in some ways, points to the gaps in European construction.

The existence of sovereign credit spreads is not surprising in light of the differences between the countries… what is surprising is the de facto lack of spreads for almost 10 years. Following the heady phase of economic, monetary and f inancial convergence, spreads between sovereign issuers had narrowed considerably until they stabilised at minimal levels, without the

Sovereign spreads will never return to their pre-crisis levels

“

”slightest questioning of these levels. The recent awakening has been brutal. True, some countries have admitted falsifying public accounts and others have ridden on the coattails of the euro zone’s core countries … but the financial crisis has levelled the playing field, and credit spreads are indeed the expression of economic divergences. From now on this will be recurring: in other words, credit spreads will never return to their pre-crisis levels, but one that is not necessarily dangerous, as long as there are adjustment constraints and a stabilisation mechanism. Constraints do exist (or, at least existed) in the form of the growth and stability pact. And penalties do exist (or, at least existed), but the pact was violated in 2004 and 2005 by both Germany and France, which cost it a great deal of credibility.

Peripheral countries … A quick refresher

Greece

Greece is the worse one off of this lot and the Greek government will have difficulty lowering its very high debt burden in the face of low economic growth prospects and low competitiveness of the economy. The reason for the Greek problem goes back for decades and combines a weak and uncompetitive economic base with low growth prospects, reckless fiscal behaviour and high tax evasion and poor tax collection capacity. These characteristics have manifested themselves in high fiscal and current account deficits, a growing and very large public debt burden, and very high external debt. While the financial crisis and accounting mistakes aggravated the Greek situation, the economic and structural precedents were already there.

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Italy - SpainGreece - Ireland - Portugal

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5

619

90

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010


Finland

France

Austria

Netherlands

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1990

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1994

1996

1998

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GreeceIrelandPortugalSpainItaly


April 2011 - N°04

Portuguese budget yoy, %

2010 Budget balance reduction, %GDP

Conclusion: despite the EUR 110 bn EU/IMF rescue package put in place in 2010, debt levels near 150% of GDP are unsustainable for Greece and we see an orderly debt restructuring as the only solution to stabiliz e and reduce the debt to GDP ratio. A haircut is probably inevitable for Greece, but th e haircut would probably not exceed 30%. Note that a debt restructuring can also occur without haircut, through an extended payback period and/or lower interest ra tes paid. In fact, it is important to keep in mind that there are many ways for a nati on to restructure its debt.

Ireland

In the case of Ireland, which had low public debt and low current account deficits, the problem came from a real estate bubble resulting from excessive credit growth and a bloated and highly indebted banking sector. The Irish banking sector relied largely on external wholesale funding. When the real estate bubble burst the banks found themselves with growing non-performing loans and recapitalization needs. The government had to come to the rescue of the private sector banks, which increased the public debt burden by around 40% of GDP, hence causing a large and sudden increase in the public debt burden from 44% of GDP in 2008, to 64% in 2009 to 95% in 2010.

Thus in the case of Ireland, a private sector problem became a public sector one. While Ireland had to have recourse to a EU/IMF rescue package in November 2010 similar to Greece for EUR 85 bn, Ireland is in a slightly better position than Greece in terms of its public debt being lower and its economy more dynamic, flexible and competitive.

Conclusion: Ireland has chances of coming out of this difficu lt situation without a debt restructuring and stabilizing its debt burden, especially if an orderly restructuring of bank senior bank debt is put in pl ace as discussed by Fine Gael –the party which heads the new coalition. This would shift part of the burden of debt/ losses from the sovereign to private investors hold ing senior bank debt.

Portugal

Portugal had neither had a real estate boom nor a banking crisis. However, Portugal is among the poorer members of the Euro zone, and its growth has been lagging the behind the rest due to structural weaknesses in the economy, such as low productivity, lack of competitiveness and a very low domestic savings rate. These shortcomings are reflected in large current account deficits – as in Greece - not financed by foreign direct investment inflows, and a growing external debt burden.

Public finances are also increasingly in bad shape because of large structural deficits, and debt to GDP has increased rapidly from 64% of GDP in 2006 to an estimated 85%-90% in 2011, albeit remaining well below Greek and Irish levels. Domestic credit to GDP remains high and the private sector is relatively indebted. The banking sector is highly reliant on external wholesale funding and as such has had large liquidly problems and has been using access to the ECB liquidity facility extensively. In addition, the government has not been very adamant in taking fiscal and structural measure of significant depth.

Conclusion: at five-year bond yields at over 7%, and refinanc ing burden both in April and June, it is expected that Portugal needs an EU/IMF type of rescue package.

Spain

Spain, similar to but a bit milder than Ireland, also had a real estate boom and bursting of the bubble. The Spanish banks, especially the savings banks were very exposed to the construction and real estate sectors. The severe recession that followed, expansionary fiscal policies, combined with bank restructurings and recapitalizations also increased the Spanish government’s debt burden from 53% of GDP in 2009 to more than 70% (approximately) in 2011.

The Spanish government has taken measures to restructure and recapitalize the savings banks the number of which has been reduced from 45 to 17. We believe that even though there may be further capitalization needs in the banking sector, these needs remain manageable and moderate relative to GDP – of the order or 4-5% of GDP maximum. In addition, structural budgetary measures have been adapted to put public finances on a more stable and viable path.

Conclusion: as a result, pressure on Spain has subsided and i t is unlikely that Spain will need a rescue package, as was the case for Ire land and Greece on one hand, and Portugal on the other hand.

-25

-20

-15

-10

-5

0

5

10

15

20

25

02 03 04 05 06 07 08 09 10Source: DGO, Amundi Strategy

Public revenues

Public spending

-6

-5

-4

-3

-2

-1

0

Por

tuga

l

Italy

Spa

in

Gre

ece

Fra

nce

Ger

man

y

Eur

o (1

2)Source: Datastream, Amundi Strategy


April 2011 - N°04

"Standard" core inflation vs "persistent" core inflation

Modelling of ECB's reaction function

Italy

Italy -a rich economy with a diversified economic and export base and a stable macroeconomic environment - neither had a real estate boom nor a banking crisis. The current account deficit to GDP and external indebtedness ratios are low compared to other countries in difficulty. Household and private sector indebtedness is moderate and the banking sector sound and liquid. Due to conservative practices of the banking sector and the lack of a real estate boom, government support to the banking sector has been minimal with no contingent liabilities expected. Thanks to a solid retail funding base, Italian banks fare better than their peers in terms of liquidity and have made minimal use of ECB funding.

However, a very high general government debt burden only surpassed by that of Greece in the Euro zone is the main problem facing the Italian economy. Among other weaknesses, we can mention structural rigidities in the economy, loss of competitiveness manifested by gradually widening external imbalances, and low potential GDP growth. On the positive side Italy has had the ability to deal with a large debt burden for over two decades thanks to sophisticated debt management and the effort required to stabilize the debt burden is minimal compared with some other peripheral European peers. Debt to GDP ratio is expected to peak at 119% in 2011, stabilize and decline thereafter. As such Italian five year CDS is the lowest in peripheral Europe, reflecting a lower level of risk relative to peers.

Conclusion: in any case, Italy will avoid a restructuring and will not be forced to accept (or ask for) a rescue package

Financial markets sometimes react with amazement to the monetary policy decisions of the European Central Bank. Clearly, the ECB does not use a standard Taylor rule, which links the bank’s policy rate to the inflation rate and the economy’s position in the cycle. As mentioned in our March edition, one of the big difficulties with this kind of modelling is to determine the type of inflation that central banks are modelling. They customarily track the underlying inflation rate, (i.e. inflation minus the volatile food and energy components) because it supposedly gives a better reading of long-term inflation. With the ECB, however, several factors suggest that alternative indicators of underlying inflation are being used.

Inflation is general measured by monitoring the price of a “basket” of goods and services, weighted according to their share of consumption. But an ECB study* argues that these components ought to be weighted according to the persistence of their price developments, meaning how long the price trend lasts. This concept of so-called “persistent” underlying inflation seems to bear out the monetary policy decisions taken by the ECB since its inception. As Chart X shows, the reaction function predicated on persistent underlying inflation is historically must closer to policy rates than a function based on the conventional measure of underlying inflation. This sheds new light on the 25bp rate hike in July 2008 and, more importantly, explains why Jean-Claude Trichet recently stated implicitly that the ECB would start raising rates in April. While underlying inflation in the euro zone has been stable in recent months and does not point to a rate hike, persistent inflation has risen sharply. And since persistent inflation has moved more closely in step with total inflation than with standard underlying inflation, the ECB may have given the impression that it was targeting the headline rate. It is on this score that the approach is open to criticism: because the persistent inflation rate tracked by the ECB is fairly volatile, policy rate changes are bound to be frequent.

* Bilke L. and L. Stracca, 2008, “A Persistence-Weighted Measure of Core Inflation in the Euro Area”, ECB Working Paper No. 905.

Box 2: Questions about the ECB’s reaction function

-2%

-1%

0%

1%

2%

3%

4%

5%

01-9

9

01-0

1

01-0

3

01-0

5

01-0

7

01-0

9

01-1

1


Difference"Standard" core inflation"Persistent" core inflation

-1%

0%

1%

2%

3%

4%

5%

6%

01-9

9

01-0

1

01-0

3

01-0

5

01-0

7

01-0

9

01-1

1

So urce: Datastream, A mundi Strategy

ECB repo rate"Non conventional" modelling


April 2011 - N°04

Defaults can occur with low and different debt/GDP ratios

Share of peripheral countries' public debt held (abroad) by foreign banks

Public debt has returned to the forefront following the financial crisis, which forced a substantial number of governments to increase their public deficits, provide bailouts to their banking systems and fiscal excesses, etc. Furthermore, this occurred during a period when activity levels were dropping sharply, causing debt-to-GDP ratios to increase sharply. Four questions quickly come to mind:

Question 1: Are public debt ratios a determining fa ctor in sovereign crises or sovereign defaults? Honestly, not really. Debt crises and defaults occur over extremely variable debt levels. Over the last twenty years, countries have experienced sovereign debt crises with low debt-to-GDP ratios – less than 60% for Ecuador in 1998, just over 40% for Mexico (1994) and Argentina (2000), around 30% in Russia and even less in Ukraine (1998). In more than 50% of cases, the debt crisis occurred with a debt-to-GDP ratio of less than 40% and more than two-thirds occurred with a ratio under 60%. In contrast, other countries with higher debt ratios have managed to avoid such debt crises: Japan is currently running a debt-to-GDP ratio of more than 200%, Lebanon (over 160% in 2003), Belgium, Italy, etc. In fact, there is no limit to public debt as long as deficits are monetised. The United States is a fine example of this – US debt is directly monetised by the Fed, which purchases debt securities. In Europe, monetisation is mainly performed by the ECB, which refinances commercial banks that have purchased debt securities. Furthermore, many banks also purchase debt securities in light of their soaring foreign exchange reserves. Japan’s case is different: Japanese public debt has increased from 60% of GDP in the early 90s to its current level of more than 200%, without creating the slightest tension on the interest rate markets. In fact, banks purchased JGBs (with bank deposits) while benefiting from the BoJ’szero-interest rate policy. These deficits, which are almost exclusively financed by domestic savings, have not caused any pressure on the yen.

Question 2: At what level does debt begin to “erode ” growth? A study by C. Reinhart and K. Rogoff addresses this question. In their opinion (the result is contested because it is deemed to be too systematic), the 90% barrier is crucial. These authors demonstrate that, below 90%, there is no impact on GDP. In contrast, above 90%, median growth rates dip by 1%. It is interesting to note that this result applies to both advanced and emerging economies. The correlation with inflation seems to be tighter in emerging countries, which experience stronger inflation when debt is higher, which is not the case in advanced economies.

Question 3: Is there a debt threshold which causes a risk of bankruptcy? In contrast to a company, a country will never find itself under financial administration. A country does not go bankrupt; it “only” defaults on its debt, which leads to default charges, debt renegotiation and novation (increasing debt maturities, altering interest rates, etc.) or simply renouncing the full repayment of the debt. In order to measure the critical nature of debt, it is appropriate to analyse the debt service ratio, notably in terms of tax revenues. A debt service/tax revenues ratio of 33% would be a “critical” threshold. F. Dedieu et al. (2010) had the idea of calculating this ratio for a number of countries, assuming that no effort would be made in this area and that these countries would continue to go into debt at the same rate as they did between 2006 and 2010. According to their calculations, in early 2010, it was estimated that Pakistan would go bankrupt in 2012, Ireland in 2013, Romania in 2016, Malaysia in 2017, Greece in 2018, Poland in 2019, Spain in 2021, Lithuania in 2022, Russia in 2024, Egypt in 2026, Latvia in 2028, Mexico and the United Kingdom in 2029, the Czech Republic in 2032, Australia in 2038, the United States and Netherlands in 2039, France in 2043, China in 2054, Portugal in 2065, Colombia in 2068, Japan in 2075 and finally Germany in 2078. This exercise is purely theoretical, since several initiatives have been launched over the last two years or so. For certain countries, despite these efforts, their ratios have deteriorated. Greece has already exceeded the 33% threshold. Moreover, such a ratio is not characteristic in the beginning of a severe debt crisis; the crisis often occurs long before the ratio reaches the 33% threshold.

Question 4: When a default occurs, what do investor s recover from their bond? There have been numerous cases of defaults throughout history: 13 defaults/debt restructures for Spain since 1500 (a record, but there have been no defaults for over a century), nine for Ecuador and Venezuela, eight for France, Germany Mexico and Uruguay, seven for Brazil, six for Portugal, five for Greece, etc. Since the beginning of the 80s, defaults have mainly occurred in emerging countries. Central and South America have provided several cases (Bolivia, Dominican Republic, Ecuador, Uruguay, Argentina, Brazil, Venezuela), as has Africa (Angola, Côte d’Ivoire, Senegal, Ethiopia, Sierra Leone, Kenya, Zimbabwe, Belize, Nigeria, Rwanda, Guinea). There have been fewer cases in Asia (Pakistan, Thailand) and Europe (Russia, Ukraine, Croatia, Bulgaria). Credit spreads tend to widen during debt renegotiation phases, but what occurs in terms of the recovery rate is without doubt more important. This rate varies between 30% and 100%, with an average of 54% between 1983 and 2007, and 65% between 1998 and 2007.

Box 3: Defaults – debt restructuring… what does histo ry teach us?

0% 25% 50% 75% 100%

Germany

France

Italy

Other EMU

Total EMU

UK

Japan

US

Rest of the World

Source: BIS, Amundi Strategy

*(% of total)

0

20

40

60

80

100

120

140

160

180

Source : Amundi Strategy

Countries w ith debt crisis betw een 1994

and 2005

Countries w ithout debt

crisis


April 2011 - N°04

1. GDP forecasts are likely to be revised down for 2011 and up for 2012

The earthquake and tsunami that struck with such tragic force on March 11 wreaked havoc in terms of the number of fatalities and level of destruction. The bond, currency and stock markets responded appropriately but are now trying to price in the damage, both material and psychological, still being inflicted by a seriously damaged nuclear power station.

The earthquake most seriously affected four prefectures which together account for about 6.4% of GDP. The government is estimating the physical damage at ¥16 trillion, leaving room to increase this figure to ¥25 trillion in the worst case scenario, which clearly exceeds the \9.9 trillion in destruction inflicted by the Kobe earthquake in 1995.

The 1st chart is the comparison of our GDP forecasts before and after the disaster. Our estimate takes into account the contribution from recovery spending in the affected region and the effect of power shortages due to damage done to a nuclear power plant in Fukushima. However, it is necessarily tentative.

First of all there is the impact of rolling power cuts in the Kanto region and the prefectures of Shizuoka and Yamanashi. The affected area, which accounts for 36.8% of output, has been divided into five blocs which are in turn subjected to blackouts. Assuming that each bloc has 3 hours down time per day, that each day has 12 hours of production time, and that the blackouts continue until April, we can provisionally assume that the maximum impact on national output will be:

Japan: the economic and market outlook following the earthquake

Amundi Japan’s GDP forecast

Equity Markets - Nikkei 225: Kobe (1995) vs March 2011

steel and aluminum production and freight transportation into and out of the affected areas. All in all, in CY2011, the disaster could deduct a maximum of 5 percentage points from the economy.

In addition, Japanese households do not have the financial underpinning they had in 1995, and it seems unlikely that consumer spending will be able to rise. Illustrating the problem is the fact that consumer sentiment even before the recent earthquake was at a lower level than it was before the Kobe earthquake in 1995 (42.7 against 46.9). Similarly in employment, where the environment has deteriorated over the same period: there were only 57 jobs per 100 applicants in the more recent period against 65 jobs before the Kobe earthquake.

Since the private sector is in no position to offer significant help, the Bank of Japan has increased its budget for buying assets to ¥10 trillion, and will include ETFs and stocks owned by banks. In addition, we expect the central government to put together supplementary budgets of around ¥10 trillion (compared to Kobe’s ¥3.8 trillion), a vast majority of which, in our view, will ultimately be monetized by the central bank.

The recovery is unlikely to be as rapid as was the case after the Kobe earthquake. In fact, until September the fall in private sector demand is likely to exceed the demand created by recovery efforts, with recovery demand then achieving ascendancy. Our new (but tentative) GDP growth is outlook shown below:

2

36.8% * 3 hours / (12 hours / 5 blocs) = 1.8%

This is the maximum impact on national output because some areas, such as central Tokyo, will be exempted from the blackouts, and because there will be a certain amount of replacement production filling the 1.8% shortfall. However, with scant hope for a quick recovery in electric power provision, the Tokyo Electric Power Co. is calling for additional power cuts during the active summer. This prolonged constraints spoils

The recovery is unlikely to be as rapid as was the case after the Kobe earthquake

“

”

For CY 2011: +1.2% →→→→ +0.7％％％％ (FY2011: +1.6% →→→→ +1.1％％％％)

For CY 2012: +1.7% →→→→ +2.8％％％％ (FY2012: +2.4% →→→→ +2.6%)

-3,0

-2,0

-1,0

0,0

1,0

2,0

3,0

4,0

5,0

6,0

7,0

T1

2010

T3

2010

T1

2011

T3

2011

T1

2012

T3

2012

Source: Amunid Japan

Q/QAR%

DifferenceRevised forecastsPrevious forecasts

Forecast

70

75

80

85

90

95

100

105

01-9

5

02-9

5

03-9

5

04-9

5

05-9

5

06-9

5

07-9

5

08-9

5

09-9

5

10-9

5

12-9

5Source : Datastream, Amundi Strategy

Nikkei 225 (Kobe, 1995)Nikkei 225 (mars 2011)


April 2011 - N°04

11

April 2011 - N°04

� Also a semiconductor production base for Micro Computer Unit for autos, which has 40% of global market share, damaged badly and it will impact auto shipments. Autos are reported to contain 20,000 - 30,000 parts, so are particularly vulnerable in the event of a breakdown in the supply chain.

� Our original forecast of FY2010 domestic auto production was 9.55 million units but this is likely to decline 400,000 to 9.15 million units due to the suspension of the production in March since the earthquake. Also our revised new forecast for auto production in FY2011 is 7.7 million units, down 14% yoy. The breakdown of this figure is, 2.2 million units only in the first half (April – September), which represents more than a 70% yoy decline in the first quarter (April – June), and 5.5 million units in the second half (October 2011 – March 2012). This is a provisional forecast but this level of double digit decline seems to be reasonable.

� Steel and other manufacturers seem to have suffered relatively less damage, but will be affected by supply bottlenecks elsewhere.

� Retail will be affected by falling propensity to consume in the affected areas, but since such consumption is about 4% of the total nationwide the impact on total sales should be limited. However, margins will be affected by power cuts and higher freight costs.

� In finance, we expect the banks of the Tohoku region to face higher credit costs. Non-life insurance companies will face a short-term excess of liabilities to reserves. Both life and non-life insurers are believed to be sufficiently well capitalized, and neither will have to resort to big sales of securities holdings to fund payments to beneficiaries.

The economic weakness implicit in these numbers is much less than that which followed the Lehman shock. In early 2009 industrial output fell briefly by almost 40% and GDP fell some 8% from its peak and, at that time, global demand was said to be evaporating. Itmay not apply to this case, and it is the partial supply and domestic demand sentiment issues that are dominating as far as economic activity is concerned. These figures suggest that the recent earthquake has had a relatively smaller impact on GDP than the Lehman shock.

2. Impact on industry: serious problems affecting s upply chains

High-tech industries account for about 7% of industry in the affected areas. However, the products of such industries can be very specific and difficult to replace, and reconstruction of damaged facilities can take a long time. So the impact of loss of production on, for example, the auto sector, may be very great. Power cuts also have a bigger impact on the high-tech sector than was suggested above because, in many cases, plants require continuous operation, especially in semiconductor or material industries.

Before the disaster, Amundi’s bottom-up research on our universe of large-caps excluding financials posited pre-tax profit growth for FY 2010 of 56%, and for FY 2011 of 13%. This would have brought profits back to 86% of what they were prior to the Lehman shock. We do not as yet have the necessary data to update this forecast but it seems that, with supply chain bottlenecks, damaged infrastructure and poor consumer sentiment, a fall in corporate profits cannot be avoided at least in the first half (April to September) of FY2011.

Our analysts are particularly concerned about the following areas:

� Production facilities for large-bore silicon wafers for semiconductors have sustained damage and 30% of global production has been halted. This will eventually impact semiconductor output.

� Production of plastic packaging for mobile phones has fallen sharply, affecting 80% of global output with obvious consequences later for mobile phone output.

Breakdown in the supply chain could reduce auto production by double digit in 2011

“

”

Amundi Japan's recurring (pretax) profit forecast (yoy, as of quarter end)

Amundi Japan's recurring (pretax) profit forecast (yoy, as of quarter end)

Comparison of industrial production in the significant demand shocks

21,3%

-0,1%

-9,9%-14,4%

10,4%

45,2% 49,2%

57,8%

55,7%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

09-0

8

12-0

8

03-0

9

06-0

9

09-0

9

12-0

9

03-1

0

06-1

0

09-1

0

12-1

0

Source: A mundi Japan

Estimation ex. 2009(04-2009/03-2010)

Estimation ex. 2010(04-2010/03-2011)

65

70

75

80

85

90

95

100

105

110

-t (6) -t (3) t (0) t (3) t (6) t (9) t (12) t (15)

Source: M ETI, Amundi Japan

t(0)=100

NortheasternearthquakeLehman shock

Kobe earthquake

Note: t(0) represents a month before the demand shock

Forecast


April 2011 - N°04

12

April 2011 - N°04

Average PBR of TOPIX

Mid-2011: Despite hopes for a recovery in demand, the effects of the disaster are clearly weighing on the economy. News flow could well be negative, underlying corporate performance will be difficult to divine, and investors could retire to the sidelines. JGBscould rally. Rising prices in the US and policy tightening in the NIEs (Newly IndustrialisedEconomies). Possible peak-out of the global economy. Market could be encouraged by extending QE2 or by additional asset buying by BoJ.

10-year JGB yield range: 1.15 ％％％％ - 1.35%

Nikkei range: ¥9,000 - ¥10,000

H2 2011: While the effects of recovery are becoming apparent, corporates will resume postponed capex projects. Risk aversion will wane and renewed outflows from Japan will weaken the yen. The stock market will be firm, driven by developments in the US and Chinese economies and by inflationary expectations. BoJ will put policy on hold, which will help bonds (but payments to insurees may force insurance companies to sell, or refrain from buying. Yield curve could steepen).


Nikkei range: ¥10,000 - ¥11,500

3. Outlook for markets

The bond market is not expected to fluctuate significantly, remaining basically firm.

The equity market may be volatile, but the book value per share (BPS) 8,700 points for the Nikkei 225 or 810 points for the TOPIX may be considered as the bottom resistance level. And they are expected to remain in the zone or return to a growth trend as follows:

From Spring: The size of the supplementary budgets for FY 2011 will put pressure on JGB’s, but will support equities. Following the relatively small first supplementary budget, the government is likely to deliberate 2nd and 3rd ones in the next 12 months. The bond market is wary of the scale of disaster restoration. In the meantime the BoJ may hold back on additional measures as earlier decision to double the size of its asset purchase funds will be in effect until June. The main concern coherent to the market is the state of the earthquake-crippled nuclear plant and dispersal of radiation. Fears of a higher radiation level could vex the equity market from time to time.


Nikkei range: ¥9,500 - ¥10,500

The size of the supplementary budgets will put pressure on JGB’s, but will support equities

“

”M a r.03

1.21

M a r.111.09

0,5

1,0

1,5

2,0

2,5

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

(Y ear)S ourc e: Tok yo S toc k E xc hange

BP S o f N ikke i 225 = 8,700 po in ts le ve lBP S o f TO P IX = 810 po in ts le ve l

Japan: Nikkei vs USD/JPY in 1995 (Indexes, 100=the day before the earthquake)

70

75

80

85

90

95

100

105

110

09-9

4

11-9

4

01-9

5

03-9

5

05-9

5

07-9

5

09-9

5

11-9


Nikkei 225USD/JPY


April 2011 - N°04

In terms of the economic impact alone, the cost of the disaster in Japan should come to more than $200 billion. The Kobe earthquake, which caused 6,000 fatalities, is often used as a yardstick for calibrating this estimate. According to the IMF, the damage from that 1995 disaster amounted to 2.5% of Japan’s GDP. Industrial output had declined in January only, before taking off again in the next three months, boosted by reconstruction and the demand for durable goods. This time, the earthquake was stronger – 8.9 on the Richter scale versus 7.2 – and it was compounded by a tsunami and a nuclear accident. The number of fatalities is much higher (more than 20,000) and the threat of leaking radioactivity has yet to be overcome. This has compromised economic recovery and it is necessary to know how the situation at the Fukushima powerplant plays out in order to grasp the extent of the impact on Japan. It is hard to quantify this impact at present, but the potential consequences for global economic growth seem to be somewhat limited since Japan is no longer a driving force.

Japan’s average contribution to global growth over the last ten years stood at only 0.1%, for a total of 3.6%. Deflationary spirals in Japan following the bursting of financial and real-estate market bubbles hobbled domestic demand growth. At the time, Japan’s trade balance showed a large structural surplus, with few clear opportunities for its trading partners’ exports. This did not prevent emerging Asian countries from enjoying strong growth, however. Tragic as the disaster has been in human terms, Japan’s recent earthquake should not have a marked impact on global growth.

How will the Japanese disaster affect the global economy?

Japan: Industrial production m/m, %

Contribution to the global economy

Net purchases by foreigners of US bonds and notes

Nonetheless, Japan is a key link in the global production chain. It has the third largest economy in the world and it produces 6% of global GDP (in PPP) and it accounts for 4.5% of world trade. The disaster on 11 March involved the destruction of infrastructure in many activity sectors. Furthermore, Japan’s economy is still at the forefront of innovation. Japan’s exports are made up of machinery (20%), The automotive

The disaster in Japan is ultimately more of a supply shock than a demand shock for the global economy

“

and electronics industries seem to be particularly vulnerable to disruption of their production circuits, even through the full impact also depends on how much output can be shifted to other units. Finally, the disaster in Japan is likely to have an impact on countries that export the raw materials used by Japanese factories (fuels and extractive industry products account for 34% of Japan’s imports).

The disaster in Japan is ultimately more of a supply shock than a demand shock for the global economy. Further effects may also be felt in the financial sphere. Japan’s structural trade surplus has enabled it to build up large reserves, standing at $1,062 billion at the end of 2010 and it has claims on many countries. Deflation in the domestic economy led Japanese investors to seek out areas with stronger growth that provide higher returns. Because of the earthquake, this capital may have to be brought home to compensate the victims and to finance reconstruction. This does not reflect our central scenario (see previous section); and just in case it happens, this could put pressure on certain assets, with a rise in the value of the yen and the sale of foreign securities – Japan holds some $800 billion in US Treasuries. The leading central banks have already taken joint action to ease the pressures driving up the value of the yen. In the coming months, investors will have to pay very close attention to Japanese capital flows, since the financial channel is bound to be one of the major routes for transmitting the Japanese crisis to the global economy.

”

3

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

m-3 m-2 m-1 m m+1 m+2 m+3

Kobé - january 1995 march 2011


date of im pact11/03/2011

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Japa

n

US

Eur

o Z

one

Em

ergi

ngec

onom

ies

Em

ergi

ngA

sia

Latin

Am

eric

aE

urop

ean

Uni

on

0%

0,5%

1%

1,5%

2%

2,5%

3%Global GDP Share Global grow th share

mean, on the past decade (2001-2010)

Source: IM F, Amundi Strategy

-150

-100

-50

0

50

100

150

200

250

300

350

02 02 03 04 04 05 06 06 07 08 08 09 10 10

Europe without U.K.ChinaJapan

So urce: TICS, A mundi Strategy

12-month trend (Bns $)


April 2011 - N°04

Recent events affecting Japan, the world’s third largest economy, have led equity analysts to determine the potential impact on each sector on the basis of direct and indirect exposures at different time horizons. In the short term, pending a recovery driven by the reconstruction of its domestic economy, Japan’s GDP could contract and some sectors, such as the Aerospace Industry, are correlated to GDP. Reconstruction could have a positive impact – or at least offset the negative effects of the disaster – in sectors such as Mining and Metals.

European companies have little exposure to Japan, which generally accounts for less than 5% of their sales. The main topics are:

� Some European companies’ sales have been directly affected by the Japanese disaster. For example, Luxury share prices were hit hardest, shedding about 9% during the first trading session after the earthquake. But companies exposed to the Japanese market recently released more reassuring outlooks that are much less pessimistic than investors’very gloomy expectations in the days immediately after the disaster in Japan. These outlooks are based on the fact that very strong demand from the United States and China could offset the decline in sales to Japan. In our view, companies are understating the potential negative effects of the disaster. That is why Amundi is neutral on the Luxury

sector, but without being negative.

� Other sectors, such as Semi-conductors, will also suffer because they rely so heavily on Japanese suppliers, whose production will be disrupted by electricity outages for several weeks, or even months and quarters to come. It should be noted that Japan accounts for 15% of global output in the electronics sector. It is also a leading player, though to a lesser extent, in the Chemicals sector, especially for chemicals used in the petrochemicals and agriculture sectors.

� Some European companies are likely to see their profits squeezed in the first half-year owing to the immediate impact of the disaster. In some extreme cases, such as that of the automotive industry, there are shortages of certain electronic components. Problems with supplies for some production lines could disrupt the Technology, Telephony, Chemicals and Automotive sectors, but for the time being, investors see these problems as merely creating a lag in sales. There is no scenario calling for a decline in sales figures in 2011. Peugeot was the first to communicate on this issue, but other European companies are likely to be affected in the short term. The harmful effects of European companies’difficulties in getting supplies from Japanese producers cannot be fully measured until the existing inventories of electronic components run out in the next month or two.

� By contrast, in reaction to the questions that are likely to be raised about the use of civil nuclear energy, we have seen Energy prices rise (coal by 10%, gas by 7%, CO2 by 10%) with the loss of some 10 to 11 megawatts of nuclear-powered generating capacity in Japan.

In the first week following the disaster in Japan, the market reacted negatively to two factors: first, the exposure of various sectors to Japan, with the major relative underperformance of Luxury and Insurance shares for example, and second, to Japan’s excessive weight in certain industries, which caused Medical Equipment, Automotive, Pharmaceutical, IT services and Telecom Equipment shares to underperform the rest of the market.

Subsequently, investors took a more constructive approach, considering that the problems caused by the disaster were merely temporary, which led Semi-conductor, IT services, Automotive, Luxury and other shares to outperform the rest of the market. This optimistic view, which assumes that the decline in sales for European companies as a result of the Japanese disaster will be very small or inexistent, looks set to prevail in the short term.

The Japanese crisis: the market has already discounted the short-term effects

MSCI Sectors PerformanceBetween March 11 and March 18, 2011

MSCI Sectors PerformanceBetween March 18 and March 25, 2011

4

-8,5%-7,5%

-6,8%-6,4%-6,2%

-5,2%-5,0%-4,9%-4,9%-4,7%

-4,1%-3,9%-3,9%-3,8%-3,7%-3,6%-3,5%-3,2%

-2,7%-2,4%

-1,4%-0,8%-0,6%

CONS. DURABLE & APP.HEALTHCARE

AUTOM OBILESSOFTWARE &

INSURANCEDIVERSIFIED

TECH HARDWAREAERO/DEFENCE

CHEM ICALSPHARM

TELECOM SERVICESM EDIA

CAP GDSUTILITIES

M SCI EUROPEFD/BEV/TOBFOOD RETAILREAL ESTATE

RETAILINGBANKS

ENERGYSEM ICONDUCTOR

M ET & M IN

Source: Equity Research Amundi

0,91%1,35%

2,79%2,80%2,80%

3,17%3,31%3,36%3,37%3,37%

3,57%3,68%3,78%3,85%3,91%3,98%4,12%

4,39%4,68%4,79%

5,37%5,48%

6,02%

M EDIAFOOD RETAIL

PHARMBANKS

UTILITIESAERO/DEFENCE

REAL ESTATETECH HARDWARE

HEALTHCAREINSURANCE

M SCI EUROPEDIVERSIFIEDCHEM ICALS

FD/BEV/TOBTELECOM SERVICES

CAP GDSENERGY

M ET & M INCONS. DURABLE & APP.

AUTOM OBILESSOFTWARE & SERVICES

SEM ICONDUCTORSRETAILING

Souce: Equity Research Amundi


April 2011 - N°04

Recent events in Africa and in the Middle East have prompted financial analysts to examine the potential impacts that such an upheaval could have on the earnings of European companies.

This analysis shows that the sectors we follow have very little exposure to these two geographical regions. Across all European sectors, Africa and the Middle East account for between 0% (real estate, financial institutions, food distribution, semiconductors) and 7% (capital goods and equipment, defence, consumer staples and pharmaceutical products) of sales. However, there are some companies with a significant presence in these two regions, namely:

� CFAO (retail sales sector) is by far the company with the greatest exposure, with 79% of its revenue generated in Africa (of which 19% is in the Maghreb and 6% is in Côte d’Ivoire);

� These regions account for 55% of the sales of Hikma, a company doing business in the healthcare sector (generics drugs) (35% in the Middle East and 20% in Africa, respectively) and 75% of this company’s profits (47% in the Middle East and 28% in Africa);

� Beverage producers (notably SAB Miller, Diageo and Heineken) via their African exposure (37%, 12% and 12%, respectively) and tobacco manufacturers (notably BAT and Imperial Tobacco), also via their African exposure (16% and 18% of sales, respectively) do a substantial amount of business here (with the notable exception of Pernod Ricard and Remy Cointreau);

� Capital goods and equipment (Alstom, ABB, Atlas Copco, Sandvik, Vallourec and Schneider) and civilian/defence transport players (BAE, EADS and Thales) are also firmly established in these countries;

� ENI is far and away the oil company with the heaviest investment in Africa (Libya accounts for 14% of its total production);

� Vivendi, through its majority interest (53%) in Maroc Telecom, is heavily dependent on earnings generated in Morocco, which accounts for approximately 20% of its gross profit and other figures;

Impact of the global geopolitical crises: despite being geographically close to Africa and the Middle East, the direct impact is limited for European companies

Brent oil price evolution in 2011

Variation of Aluminium, Copper and Steel price (basis 100 at January 1st, 2011)

5

EURO STOXX

260

265

270

275

280

285

290

295

300

31-D

ec

4-Ja

n

6-Ja

n

10-J

an

12-J

an

14-J

an

18-J

an

20-J

an

24-J

an

26-J

an

28-J

an

1-Feb

3-Feb

7-Feb

9-Feb

11-F

eb

15-F

eb

17-F

eb

21-F

eb

23-F

eb

25-F

eb

1-M

ar

3-M

ar

7-M

ar

9-M

ar

11-M

ar

15-M

ar

17-M

ar

21-M

ar

23-M

ar

25-M

ar

January, 10th 2011 : Huge demonstration

against Ben Ali in Tunisia

February, 19th 2011 : Some insurgent rebelled against Kadhafi in Libya.

The army repression is condemned by the Lybian association of Human rights.

March, 9th2011 : Question of developed countries on a potential

Lybian intervention.

March, 11th 2011 : Japan Earthquake

EuroStoxx evolution since the beginning of 2011

Source: Datastream, Amundi Equity Research

90

95

100

105

110

115

120

28-0

3

21-0

3

14-0

3

07-0

3

28-0

2

21-0

2

14-0

2

07-0

2

31-0

1

24-0

1

17-0

1

10-0

1

03-0

1

Source: Datastream, Amundi Equity Research

+15%

90

95

100

105

110

03-0

1

17-0

1

31-0

1

14-0

2

28-0

2

14-0

3

28-0

3

So urce: Datastream, A mundi Equity Research

Aluminium Copper Steel


April 2011 - N°04

Disconnexion between gas and crude oil prices (2007 = 100 basis)

Net foreign assets (% of GDP)

� France Telecom, which derives 7% of its sales and earnings from Africa, has high exposure to Egypt (3% of sales and profits);

� Sociéte Générale (present in Algeria, Egypt, Tunisia, Morocco and Côte d’Ivoire) and Crédit Agricole SA (77% stake in Crédit du Maroc, 60% in CA Egypt and 31% in Saudi Fransi) are two active operators in this region (close to 5% their profits).

On the other hand, there is a greater likelihood of an indirect impact of these geopolitical events (as reflected in the recent spike in the price of natural gas, coal and electricity, in particular in Germany), potentially leading to structurally higher energy costs (an imbalance between a nearly stagnant oil supply and growing demand, motivation for oil-producing countries to plan for higher equilibrium prices due to a likely increase in public spending in these countries to avoid social upheaval and its unpredictable consequences; some doubts over nuclear power in the short and medium terms, etc.) on stock markets (given the under-performance of consumer-related sectors) than any direct impact on European companies doing business in these two geographical regions.

Japan: Current account(12-month rolling sum, % of GDP)

Japan is the world’s top creditor, ahead of China

Currency markets usually focus on flows of goods and services, and capital between countries, while often overlooking trends in countries’ net foreign assets held, even though this is what counts the most in estimating countries’ needs.

In the US, foreign debt levels evolve naturally as a function of cumulative current accounts deficits, as well as shifts in the valuations of assets owned. However, the amount of foreign assets held by Americans rose from 30% of GDP in the early 1980 to 130% in 2009! Valuation therefore plays a bigger role today. Slight shifts in valuations (due to changes in exchange rates of the prices of the assets) lead to changes in net wealth, which can offset or reinforce the financing needs incurred by current transactions. This is exacerbated by the nature of the foreign debt held by US residents and the nature of the debt they owe to the rest of the world. For US residents mostly hold equities and foreign direct investment (FDI), both of which offer returns that are higher than their cost of debt (which is made up mainly of debt securities (government bonds and agency or corporate debt) that offer relatively low coupons). All in all, as of the end of 2009, the US’s external net position (i.e., the difference between credits and debt) under “equities and FDI” was positive by about $3000 bn, while the net position under “debt securities” was negative by about $5000 bn!

Note, finally, that most of the foreign debt held by the US is denominated in foreign currency whereas the debt it owes is denominated in dollars. As a result, rising global equity prices and the falling dollar generate powerful valuation effects that partly offset the worsening in the US current accounts balance. When excluding the impact of valuation, the US’s net external debt – i.e., resulting from the accumulation of past current accounts deficits – would today be above 50% of GDP. But, in reality, it came to just 19% of GDP in 2009 and will very probably decline in 2010 given the gains in equity prices.

Currencies: What can movements in assets held abroad tell us about currency trends?

6

Remarkably, the euro zone’s net external debt was close to 18% in 2009, i.e., only slightly below that of the US, even though its current accounts deficits are much lower. Based on external accounts, the dollar is no weaker than the euro! All other things being equal, the two currencies should depreciate to stabilise their net assets.

The euro zone’s net foreign debt is similar to that of the US

“

”

0

50

100

150

200

250

300

01-0

7

07-0

7

01-0

8

07-0

8

01-0

9

07-0

9

01-1

0

07-1

0

01-1

1


Crude Oil WTI

Natural Gas

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

86 88 90 92 94 96 98 00 02 04 06 08 10

So urce: Datastream, Amundi Strategy

JapanEurozoneUnited States

-2

-1

0

1

2

3

4

5

88 90 92 94 96 98 00 02 04 06 08 10

So urce: Datastream, A mundi Strategy

Current account = (1)+(2)+(3)Goods (1)Services (2)Income and current transfers (3)


April 2011 - N°04

Two scenarios about the USD/JPY PPP model

Japan: real effective exchange rate(100= average on the period 1970-2010)

USD/JPY equilibrium rate according to our fundamental fair-value model (BEER)

On another level, the yen’s gains since mid-2007 are also due to the Japan’s accumulation of foreign debt. Japan’s position as a creditor contrasts with the net debtor position of the US and the euro zone. All other things being equal, the stabilisation of their net external debts required an upward adjustment in the yen vs. the dollar. Studies on the dynamics of the net

Rebalancing net external debt requires a “strong” yen

“

”

Japan, however, is a different story altogether. Valuation plays a lesser role there than in the US. Japan’s net foreign assets have more than tripled since 1995, hitting a record of almost 57% du GDP in 2009. Unlike the US, the dynamics of debt accumulation by Japan is due mainly to the increase in past current accounts surpluses. And contrary to popular wisdom, it is not Japan’s trade surpluses that cause its current accounts surplus. Income on investments made abroad generated an income balance surplus that has risen constantly in the last 10 years, offsetting the dip in the trade balance (see chart).

What is the right level for the yen?

Shortly after the tsunami, the yen’s nominal exchange rate spiked, peaking on 17 March at a level unheard of since the Second World War (76.6 per dollar), as speculators tried to get the jump on the massive repatriation of capital by the Japanese that they anticipated. This is what happened after the Kobe earthquake in January 1995, when a wave of speculation pushed the yen up by 23% to the dollar in less than three months. However, and strikingly, in real terms the yen remains far below its 1995 peak vs. the dollar. The yen in 1995 was massively overvalued. The USD/JPY exchange rate in PPP terms was above 130 then, and the dollar had fallen to 80 yen (see graph). We see a similar message when looking at real effective exchange rates. After the Kobe earthquake the yen surged by almost 15% in terms of real effective exchange rates, reaching a historic peak in April 1995. Today the yen’s real effective exchange is close to its 40-year average (see graph). In other words, its current level is no danger for exporters.

For, since 1995, deflation has been at work. The cumulative inflation gap – whether based on consumer prices or producer prices – currently justifies a level of about 88 yen per dollar. Based on PPP, the yen is currently only slightly overvalued. What about the years to come? The recent disaster will probably end up having a disinflationary impact in the short term, thus allowing the yen’s “equilibrium” parity to continue appreciating. To cite one example, if prices continued to move in the US and Japan at the same pace as in the 10 past years (scenario 1, see graph), that would mean that the yen’s PPP equilibrium rate vs. the dollar would gain more than 2% annually. In less than five years, the PPP rate of the Japanese currency would then move beyond the 80 yen per dollar barrier. That said, any assumption that prices will move as they have over the past 10 years is probably wrongheaded (scenario 2, see graph), as inflationary pressures will re-emerge in Japan in coming years, especially if is economy’s output potential has taken a long-lasting hit from the recent disaster.

external debt have provided evidence for correction dynamics such as these. For example, the work of W. Cline and J. Williamson[1] concluded in summer 2008 that the yen was likely to continue rising (to as high as 78 yen per dollar!) in order to stabilise the net external debts of Japan and the United States. Without imposing a stabilisation of net assets in their calculations, the same authors found an equilibrium exchange rate of about 90 to 95 yen per dollar, which is close to the findings of PPP models (at that time).

This would eventually seem to suggest a “sustainably strong” yen vs both the dollar and the euro. The concerted intervention on the FX market by the G7 countries, a few days only after the tsunami, has been successful in discouraging speculators. The yen has fallen appreciably, back to its end-2010 level. Moreover the normalisation of monetary policies of the Fed and the ECB, coupled with a lasting status quo from the BoJ, are likely to continue weakening the yen in 2011. However, taking into account the high level of net foreign assets, a substantial decline of the yen is unlikely to occur.

[1] “New Estimates of Fundamental Equilibrium Exchange Rates”, W. Cline and J. Williamson, Peterson Institute for International Economics, July 2008.

70

90

110

130

150

170

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014


Nominal ratePPPScenario 1Scenario 2

70

80

90

100

110

120

130

140

150

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10Source: Datastream, Amundi Strategy

Kobe earthquake

60

70

80

90

100

110

120

1990

1992

1994

1996

1999

2001

2003

2005

2008

2010


Equilibrium Rate Exchange RateEq. +/- 1 std dev


April 2011 - N°04

GRAPH 1 BOX 4

Asian countries: inflation and nominal appreciation against USD in 2010

GRAPH 2 BOX 4

China: nominal and real trade-weighted exchange rates of the RMB

Asian currencies, particularly the yuan, are the subject of heated debate. For a number of years, trade balances in emerging Asia have witnessed substantial surpluses (around 20% of GDP for Singapore in 2010!), while the United States is running a significant deficit. As a result, emerging Asian countries are accumulating large amounts of assets abroad, which is a strong argument in favour of appreciation of their currencies.

Moreover, the Balassa-Samuelson effect, where the real exchange rate of a country appreciates as it develops economically, also argues for an appreciation of Asian currencies. However, although the real exchange rate in Asian countries should appreciate, we must not lose sight of the fact that this may happen in different ways. Real currency appreciation can take place through two channels: the appreciation of the nominal exchange rate and/or domestic inflation which is higher than inflation abroad. Currency brokers often focus on the first channel; however, it seems that the second one is running at full steam. Inflation in Asian countries is much higher (almost 10% in India and 5% in China) than in developed countries (2% in the United States). For example, since the beginning of 2010, the Chinese currency has appreciated more than 6% in real terms but less than 1% in nominal terms (see graph). It would therefore be a mistake to only pay attention to the increase in the nominal exchange rate. Furthermore, it is remarkable that the Asian countries that have witnessed the highest inflation over recent months are the ones whose currencies have appreciated the least against the dollar (see graph). The correction of the major global imbalances, i.e. Asian surpluses and the US deficit, will therefore not necessarily lead to a sharp nominal appreciation in Asian currencies.

Box 4: Asian currencies: nominal or real appreciati on?

2009 2010 2009 2010

Singapore 17.9 19.3 Thailand 8.3 4.5

Malaysia 16.5 12.0 Japan 2.8 3.6

Chinese Taipei 11.3 8.7 South Korea 5.1 2.8

China 5.9 5.2 Indonesia 2.0 1.0

Philippines 5.3 4.8 India -2.1 -2.6

Current account balance in % of GDP

On March 10 the Fed published its quarterly set of aggregated microeconomic data called the flow of funds: the latest updates relate to Q4-2010. In this section we outline the main findings of our analysis of the credit metrics of US non-financial companies.

As underscored in our previous monthly reports, “corporate America” entered one of the strongest profit recovery phases in 2010 after devoting the previous year to repairing balance sheets and reducing debt. The fourth quarter was no exception and further confirmed the ongoing favorable trends seen in previous quarters.

Debt coverage and funding strategies

Let’s first take a look at the main indicator of credit risk, or the debt coverage ratio, namely the ratio between debt levels and cash flow generated by US companies. This ratio fell to lower levels in the last three months of 2010, moving to 1.16x compared with 1.19x in the previous quarter: this change follows the positive trend seen in H1-2010, with net debt

Credit: “Corporate America”, don’t stop on the road towards improved credit metrics: as shown by the Fed’s latest data

7

falling from 1.26x to 1.25x and 1.21x corporates’internal funds. Admittedly, net debt growth was back in positive territory for the first time in quarters, confirming the end of the repair phase: gross debt less liquid assets in fact grew by 3.7%, up from f lat and negat ive growth respectively in the previous two quarters. Companies ' renewed use of short -term instruments for funding over the last quarters is another posit ive sign of normalization of financing strategies on the liabilities’ side.

The ratio between debt levels and cash flow fell to lower levels in Q4-2010

“

”

China

Indonesia

Thailand

South Korea

M alaysia

India

Chinese Taipei

Philippines

Japan

Singapore

0%

2%

4%

6%

8%

10%

12%

0% 2% 4% 6% 8% 10%Inflation in %

App

reci

atio

n ag

ains

t US

D in

%

95

100

105

110

115

120

125

130

01-0

0

01-0

1

01-0

2

01-0

3

01-0

4

01-0

5

01-0

6

01-0

7

01-0

8

01-0

9

01-1

0

01-1

1Source: BIS, Amundi Strategy

RealNominal


April 2011 - N°04

Debt coverage ratio improved further

Peak on the liquidity over short-term debt

M&A and share buybacks recovered

Corporates rate bonds remained an important funding channel in Q4, but data show a recovery in bank loans and other financing means typically used by companies to cover their renewed inventory cycle, increased spending in investments, M&A activity and share buy backs.

Liquidity

Interestingly, holdings of cash rose further, hand-in-hand with higher short-term liabilities, a sign of a controlled or cautious attitude towards financial strategies and liability management, and liability management, preventing net debt from growing too much. The liquidity ratio or the ratio of liquid assets to short-term liabilities therefore increased to an all-time high, at 50.7%, up from previous levels of 49% and 47% (see graph 2).

Holdings of cash rose further, hand-in-hand with higher short-term liabilities

“

”Spending

Sustained by growth in profits, companies’ spending had rebounded from very low levels. Still, the spending cycle looks to be in its early stages. Notwithstanding the very cheap cost of financing, companies are likely to resist the temptation to rapidly embark on aggressive re-leveraging given the low growth environment. The crisis days where bank loans were massively replaced by bonds are over, but in any case companies benefited from strong demand for bonds in 2009 and 2010, increasing the overall duration of their liabilities and therefore reducing their refunding risk.

The investment cycle started two years ago, in March 2009 for developed countries and in November 2008 for emerging countries. Corporate earnings growth has now peaked; the profits of MSCI World companies were up by 40% in one year, which is 2 standard deviations more than mean growth over the last 20 years. This is bound to be followed by a slowdown.

At this point, cyclical factors alone are enough to cause us to question our strategy, especially since monetary policies are bound to return to normal as pressure on commodity prices grows. The answers to these classic questions are somewhat reassuring. First, cash is still abundant. Second, MSCI World companies' earnings are expected to grow in double digits (16% according to Ibes, 10% to 15% according to our estimates). And third, market valuations are not too rich. Indeed, the global PER stood at 14.1 over the last 12 months, compared with 14.6 at the last earnings peak in May 2008.

Equity markets: Diversify to mitigate rising risks8

However, investors today must make decisions to cope with exogenous risks that cannot be wished away. 1) Geopolitical risk in North Africa and the Middle East: if oil prices reach $140 or $150/bbl this summer, they will have doubled within a year, which points to a recession in the United States, 2) weather risk: soft-commodity

Increasing exogenous risks call for caution

“prices soared (the S&P GSCI Spot Softs index rose 95% over one year) following the huge fires that destroyed Russian wheat fields in June 2010. These pressures are likely to subside in the second half-year compared with the previous year. All hope for a return to calmer markets rests with the crops planted in America this spring. Better harvests in the autumn should help to reduce inflation pressure in the emerging countries. But this depends on the weather. 3) Nuclear risk: this is a key difference compared to the Kobe earthquake in January 1995. It increases uncertainty about when Japan’s economic activity will take off again and could pose a threat to industries operating with just-in-time supply chains. It could even raise questions about the value of certain contaminated assets.

”

0.8

0.9

1

1.1

1.2

1.3

1.4

03-9

0

03-9

2

03-9

4

03-9

6

03-9

8

03-0

0

03-0

2

03-0

4

03-0

6

03-0

8

03-1

0

Source: Fed, Amundi Strategy

Net debt to internal funds ratio

15

20

25

30

35

40

45

50

5503

-90

03-9

2

03-9

4

03-9

6

03-9

8

03-0

0

03-0

2

03-0

4

03-0

6

03-0

8

03-1

0Source: Fed, Amundi Strategy

Liquidity ratio (%)

-200

0

200

400

600

800

1 000

1 200

03-9

9

03-0

0

03-0

1

03-0

2

03-0

3

03-0

4

03-0

5

03-0

6

03-0

7

03-0

8

03-0

9

03-1

0

Source: Fed, Amundi Strategy

Dividends InvestmentsAcquisitions Share Buyback


April 2011 - N°04

MSCI World - 12M Trailing EPS (% YoY)

USA: 12M forward PERrelative to MSCI World

EMU: 12M forward PERrelative to MSCI World

Equities’ appeal is not in doubt, but wisdom suggest s diversification

The first reflex is to turn to oil assets in an effort to hedge a surge in energy prices. We even recommended investing in the EMEA countries in these pages last month, before the disaster in Japan. The main alternatives to nuclear power for electricity generation, which is now in disfavour, are thermic coal and, more especially, gas, which produces less pollution. Russian firms, such as Gazprom, are in a strong position to benefit. We therefore renew our positive opinion on EMEA. With regard to the energy sector as a whole, investors can benefit from the procyclical profile of suppliers and substantial dividends from the leading integrated stocks. Admittedly, the market was quick to respond and valuations have risen somewhat. In Europe, for example, energy stocks have only been cheaper since 1973 in 16% of the cases. Even so, the current situation is conducive to further rises and energy is one of our favourite sectors.

Japan has become a speculative market in the short term. The United States and the euro zone are still our preferences in the developed world. They have very different strengths, which makes them a good fit.

The US market is still a defensive choice if extreme risks materialise, especially since the authorities would be quicker to respond to support the economy. But this defensive choice carries a price. On the basis of earnings over the last 12 months, the American market PER compared to the PER of MSCI World is 8% higher than the mean for the last 10 years, which is nearly 2 standard deviations. The only other time over this period it has been higher was when Lehman Brothers collapsed, which was another extreme event.

On the other hand, the euro zone would not withstand a shock so well, especially if a recession were to occur. Such an event would aggravate fiscal constraints and drive down domestic demand. European corporate earnings are more cyclical on average than US earnings and they would be affected. But there is no certainty that the worst will happen. The euro zone will probably manage to find a political solution to its sovereign problem, with the decisions taken in March paving the way. Bear in mind, too, that Europe derives greater benefit than the USA from emerging-market growth. Furthermore, euro zone stocks are cheap. Indeed the MSCI EMU is trading at less than 10 times forward earnings for the next 12 months, i.e. lower than the mean for the last 10 years relative to the rest of the world, despite the recent dip in the Japanese market.

For anyone who tries to assess the creditworthiness of banks, stress test has become a familiar world. Indeed, since the US SCAP (Supervisory Capital Assessment Program) stress test in 2009 to last week Irish PCAR (Prudential Capital Assessment Review), such exercises have been common tools in supervisors' attempts to restore confidence in the market. The next big event will be the European stress test currently under way, which will reveal the capital position of banks in the 27 European Union countries. Given the current shaky context regarding European sovereigns, this stress test is a hot topic for the market. The process started early March and is due by next June; nonetheless, below are the available information and what expectations we can derive from these at the current time.

2010 Stress Tests

In July 2010, the Committee of European Banking Supervisors (CEBS) published a series of stress tests on European Banks (including non-Eurozone countries). The official objective of the stress tests was “to provide policy information for assessing the resilience of the EU banking system to possible adverse economic developments and to assess the ability of banks in the exercise to absorb possible shocks on credit and market risks, including sovereign risks”.

Thus it differed from the US stress tests published in May 2009 whose purpose was to determine the level of capital to be raised by each US bank under review in the midst of the financial crisis.

Bank stress test redux9 0,9

0,95

1

1,05

1,1

1,15

1,2

03-0

1

03-0

3

03-0

5

03-0

7

03-0

9

03-1


Standard Deviation

+2

+1

-1

-2

0,7

0,75

0,8

0,85

0,9

0,95

1

03-0

1

03-0

3

03-0

5

03-0

7

03-0

9

03-1

1


+2Standard Deviation

-2

-1

+1

-40

-20

0

20

40

60

07-8

7

07-9

0

07-9

3

07-9

6

07-9

9

07-0

2

07-0

5

07-0

8


mean

Standard Deviation

+2

+1

-1

-2


April 2011 - N°04

The 2010 stress test outcome for major European banks

What value in the stress tests? The 2010 results for Greek, Irishand Portuguese banks

In practice the opportunistic nature of those tests had a different purpose. It sought to reassure the financial markets on the viability of the European banking system during the ongoing sovereign crisis.

The target of the stress-tests was to cover Europe’s largest banks in EU country, so as to cover at least 50% of the European banking system’s assets. However each country was allowed to designate additional banks beyond the 50% thresholds – so that in total 65% of the EU banking system’s assets were covered.

The stress tests were run over a 2-year time horizon and the starting point was the bank’s Tier ratio as at 31/12/2009 (core Tier 1 was not considered due to a lack of a common EU definition of that metric). Banks were required to forecast their cumulative operating profitability over the relative period with constant balance sheet under a benchmark scenario (in line with EU macro forecasts). A stress scenario was then applied, with detailed GDP growth assumptions by geographies, assumptions on real estate prices, etc.. An additional sovereign shock was applied, which consisted mainly in stress on the Market-to-Market (MTM) sovereign exposure in the trading books and the indirect effect on the real economy of this sovereign stress test in the banking book.

The Results

Passing the test meant reaching at least a 6% Tier 1 ratio in the worst case scenario (adverse scenario together with a sovereign shock). Out of the 91 banks – only 7 did not pass the test – with €3.5bn of aggregated capital needed for all banks to reach the 6%threshold and €30bn to reach 8%. Total cumulated losses under the worst-case scenario amounted to €566bn over the 2-year period, compared to about €1,400bn in aggregate Tier 1 capital.

Market reaction

The response by the markets to the publication of the stress-tests was mixed. On the one hand there was relief that the European banking system was overall, sound with no hidden skeletons.

On the other hand, there was a view, given that only 7 banks out of 95 had failed, that the tests had not gone far enough and that the 6% threshold was too low. But the greatest criticism concerned the treatment of banks’ sovereign exposure in their Hold-to-Maturity (HTM) portfolio which had not been stressed tested.

In response to this criticism, the CESB argued that as the European Union (EU) had put in place a sovereign support plan at avoiding a sovereign default within the EU – with the full backing of its members, the default of a EU country was not considered realistic enough to be included in a stress scenario.

Notwithstanding the criticisms, the market reaction seemed to be positive, with banks’credit spreads rallying substantially during the summer of 2010. This move was nevertheless also--and perhaps more vigorously - helped by a coincident update on the Basel III proposals which boosted sentiment.

By the fall, sentiment had changed dramatically with the IMF/EU rescue package for Ireland put together essentially as a result of the near collapse of its banking sector. At the time, investors questioned how it was that Irish banks which had passed the stress tests (albeit at a low level) in July, had to be essentially recapitalized in November?

The 2011 Stress Tests

When the 2010 stress tests were released, the CESB had suggested that stress test would take a greater part in the supervisory process and those common stress tests could take place on a regular basis.

Given that, the European Banking Authority (EBA) which took over from the CEBS in January this year, announced that it is conducting a stress test on a comparable wide sample of banks in the first half of 2011 with the objective of assessing the resilience of the EU banking system, and the specific solvency of individual institutions to hypothetical stress events under certain restrictive conditions imposed by supervisors.

2%

4%

6%

8%

10%

12%

14%

Source : CEBS, Amundi Credit research

31/12/2009 sovereign shock6% thresho ld 7% thresho ld8% thresho ld 4% regulato ry

2%

4%

6%

8%

10%

12%

14%

Source : CEBS, Amundi Credit research

31/12/2009 sovereign shock6% thresho ld 7% thresho ld8% thresho ld 4% regulato ry

1

Financial Stress: US vs Eurozone

-1

0

1

2

3

4

5

01-1

0

03-1

0

05-1

0

07-1

0

09-1

0

11-1

0

01-1

1

03-1

1

05-1

1

Source: Amundi Strategy calculations

EurozoneUS


April 2011 - N°04

Contributions to the eurozone financial stress index

Senior loan officer survey:Credit conditions to firms by size*

Euro zone: Firms' credit conditions

The EBA indicates that in the design and conduct of the 2011 exercise “the EBA took into account areas where improvements compared to the 2010 exercise were deemed necessary as a result of a “lesson learnt” analysis conducted by the EBA and all the involved authorities”

The 2011 stress test will include all capital initiatives and restructuring plans set up by banks until April of this year, therefore taking into consideration the ongoing reshaping of the Spanish banking system (which provided the bulk of the contingent of banks not passing the test last year). Nevertheless, the stress test covering a two-year period up until will not include the Basel III reform--which will take effect in early 2013.

What is different

The scenarios and tests have been fine tuned but for the time being we remain cautious as to their impact. The definition and target of the Core Tier 1 have not been defined. As in the previous tests, the sovereign shock test will only apply to the trading book. However, banks will be required to break down the sovereign exposure by accounting portfolios(AFS, HTM,HFT), by maturities and specific country. The liquidity risk will not be assessed, instead, the tests will focus on the cost of funding and how it will be impacted by rising interest rates as well as the impact of a sovereign crisis on funding costs generally.

The scenarios published by the EBA also raise questions regarding their credibility. While the stresses applied in the crisis scenario are tougher in general compared with last year's test, the starting point is often higher (i.e. a more benign basecase scenario), which results in pretty similar final stressed assumptions. Regarding the sovereign exposures, some of the haircuts to be applied are lower than those used in last year's exercise--although the environment can be seen as much harsher. In addition, some proposed haircuts are less negative than what the market currently prices, and who knows how the situation will be in three month time…

Sentence now, verdict later

This stress test is certainly welcome, as is what seems to be a principle of regular testing of the European banking system. It is clear that bank stress tests do provide useful tools to investors to assess their creditworthiness and allows them with the information disclosed to run their own stress tests. Information is key in a period of volatility, and the design of stress test at the EBA level also helps comparability among banks in 27 different jurisdictions.

However we still see a friction point which will likely undermine the impact of the stress test on market sentiment. The key weakness of the previous test and we suspect with the current one is that having identified banks with weak capital ratios (albeit within regulatory guidelines) there is no real mechanism to force banks to recapitalize. The 6% threshold then used was generally considered low by market participants and it was suggested that regulators expected the market to exert pressure on bank that passed the test with only moderate leeway to raise their capital level. The European situation contrasts with what took place in the US in 2009 when most banks had to increase their capital, even if it was deemed unnecessary. As a result, with the failure of Irish banks, despite the 2010 tests, still in people’s minds, the market will only be satisfied once some of the banks widely recognized as having capital needs have been forced, by regulators, to undertake recapitalization exercises that are perceived as sufficient.

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

01-1

0

03-1

0

05-1

0

07-1

0

09-1

0

11-1

0

01-1

1

03-1

1

Source: Amundi Strategy

OthersBanking sector stressSovereign stress

-70-60-50-40-30-20-10

010203040506070

03 04 05 06 07 08 09 10 11

Source: ECB, Amundi Strategy

-20

-10

0

10

20

30

40

50

60

70

Realised Expected in 3 months

<0 Easing

>0 Tightening

-70

-50

-30

-10

10

30

50

70

90

90 92 94 96 98 00 02 04 06 08 10

Source: Federal reserve, Amundi Strategy

Large and medium

Small

* % Net o f domestic responds

For professional use only

April 2011 - N°04

Chief editor: Pascal BlanquéEditor: Philippe IthurbideThis document may not be reproduced, fully or partly, or communicated to third parties without our authorisation.Published by Amundi a joint stock company (société anonyme) with a registered capital of 578 002 350 euros. An investment management company approved by the French Securities Authority (Autorité des Marchés Financiers - “AMF”) under No.GP04000036. Registered office: 90, boulevard Pasteur 75015 Paris - France. 437 574 452 RCS Paris.The information contained in this document is not intended for distribution or use by any person or entity in a country or jurisdiction where such distribution or use would be contrary to legal and regulatory provisions, or which would require Amundi and its affiliated companies to comply with the registration procedures of said countries.All of the products and services may not be registered or authorized in all countries or available to all clients. The data and information in this document is provided solely for information purposes. None of the information contained in this document constitutes an offer or appeal by any member of the Group Amundi to provide investment advice or services or to buy and sell financial instruments. The information contained in this document is based on sources that we deem to be reliable, but we cannot guarantee that it is exact, complete, valid or relevant, nor should it be considered as such for any purpose whatsoever.

DISCLAIMER

EditorPhilippe Ithurbide - Head of Research, Analysis and Strategy+33 1 76 33 46 57

ContributorsMarc-Ali Ben Abdallah - Global Allocation - ParisSergio Bertoncini - Credit Strategy - MilanDidier Borowski - Head of Strategy and economic research - Paris Richard Butler - Head of Credit Analysis - ParisBastien Drut - FX & Fixed Income Strategy - ParisDelphine Georges - Global Allocation - ParisXavier Got - Credit Analysis - ParisJames Hegarty - Equity Research and Strategy -TokyoPhilippe IthurbideMasanaga Kono - Equity Research and Strategy -TokyoRémy Lambinet - Global allocation Strategy - ParisLaureline Martin - Equity analysis - ParisEric Mijot - Head of Equity Strategy - ParisJulien Moussavi - FX & Fixed Income Strategy -ParisShizuko Ohmi - Equity Research and Strategy -TokyoAnne-Charlotte Paret - Macroeconomics - ParisFlorian Roger - Head of Macroeconomics - ParisStéphane Taillepied - Head of Equity analysis -ParisSosi Vartanesyan - Credit Analysis - ParisIbra Wane - Equity Strategy - ParisAkio Yoshino - Equity Research and Strategy -Tokyo

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