Euro zone recovery stronger than most expectEUR strength is here to stay!

Vasileios Gkionakis, Global Head of FX Strategy, UniCredit Group

May 2014

2

The themes that will dominate markets in the rest of 2014…

More risk normalization: our 2013 story of risk normalization played out very well; we expect it to continue for most part of 2014

Fed tapering: the Federal Reserve will continue with its gradual withdrawal of asset purchases; we expect this will conclude in 3Q14

Eurozone: the recovery in the Euro zone will be stronger than most expect on the back of domestic demand improvement

China: the gradual structural slowdown will continue

BoE: we expect the Bank of England to start a gradual hiking cycle in 4Q14, earlier than consensus

EM: as interest rates rise differentiation among EM will be a key theme this year

3

…and implications for the FX market in 2014

EUR: our out-of-consensus call for EUR-USD is at 1.45 by year-end. We expect the common currency to trade firm on the back of a stronger European recovery, an increasing C/A surplus, more demand for EUR-denominated reserves and inflows to Euro zone risk assets

USD: the US recovery and rising interest rates should support the US dollar against a number of currencies including JPY, CHF and SEK, on account of divergent monetary policies

JPY: the continuation of risk normalization alongside potentially further monetary policy easing by the BoJ should put downside pressure on the yen

CHF: as risk premia across the periphery of Europe compress further, the SFr should finally start to weaken as Swiss international portfolio investment returns to long term averages

CEEMEA: PLN should continue to outperform due to spill over from a strong German growth and domestic demand picking up; the HUF is likely to be the underperformer amidst measures that erode the carry further; TRY should benefit from high carry and improvements in the external account

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2014 FX Themes: EUR to appreciate further; USD to strengthen against a number of currencies; Yen and SFr to weaken

Stronger growth in the US (we forecast 2.8% yoy for 2014)

Stronger growth in the Euro zone (we forecast 1.5% yoy for 2014)

Stronger growth in the UK (we forecast 3.2% yoy)

Yields in major developed countries will move higher (we forecast US 10Y at 3.5%; Bund 10Y at 2.2%; and Gilt 10Y at 3.6% by year-end)

These movements will impact currency pairs – although several other idiosyncratic factors will play a crucial role

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EUR-USD: it is all about growth prospects!

1.20

1.25

1.30

1.35

1.40

1.45

1.50

42

44

46

48

50

52

54

56

58

Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13

EZ CompositePMI, 3M MA

EUR-USD (RS)

Correlation = 0.83

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%-10

-5

0

5

10

15

20

25

30

35

40

EA: Change inCredit Stds forBus Loans: Past3M: Overall(0+=tightened)QoQ Euro zoneGDP growth rate(RS)

Sources Haver, Bloomberg, UniCredit Research.

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C/A surpluses should provide additional support to the common currency

Source: Markit, UniCredit Research

C/A as % of GDP is recording record high surplus…. …and it is not only about the core!

-7.00

-6.00

-5.00

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00M

ar-9

9

Mar

-00

Mar

-01

Mar

-02

Mar

-03

Mar

-04

Mar

-05

Mar

-06

Mar

-07

Mar

-08

Mar

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Mar

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Mar

-11

Mar

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Mar

-13

Euro zone UK US

Record high C/A as % of GDP

-20

-15

-10

-5

0

5

10

Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12

Spain ItalyPortugal GreeceIreland

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…and consumer confidence is registering multi-year highs!... which should drive inflation higher in the near future

Sources: Bloomberg, UniCredit Research.

-1

0

1

2

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5

-40.00

-35.00

-30.00

-25.00

-20.00

-15.00

-10.00

-5.00

0.00

Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14

EC Consumer Confidence

EZ CPI, yoy, %, lagged by 6M (RS)

8

Reserve managers have significantly increased their holdings in safe haven FX mostly at the expense of EUR…this is likely to correct as

perception of sovereign risk for Europe normalizes further

Source: IMF, UniCredit Research

25.5%

8.2%

164.2%

46.6% 43.9%

-0.5%

71.4%

14.4%

-20%

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

USD EUR JPY CHF

2Q10-2Q13 Growth in FXreserves

Average 12Q growth in FXreserves between 1999 -2010

17%

18%

19%

20%

21%

22%

23%

24%

25%

26%

Mar-99 Mar-02 Mar-05 Mar-08 Mar-11

EUR as % of allocated reserves, const x rateTrend until 2Q10

Evidence of a turn in the latest data

9

Eurozone equities have underperformed excessively their US counterparts…with sovereign risk now normalizing European equities are

likely to see significant flows which will support the EUR further

Source: Bloomberg, UniCredit Research

60

80

100

120

140

160

180Ja

n-04

Jan-

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Jan-

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Jan-

08

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10

Jan-

11

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12

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14

EuroStoxx 50 (Jan 04 = 100)

S&P500 (Jan 04 = 100)

Massive underperform

ance

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

Jan-

05

Jan-

06

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14

12M rollingcorrelation betweenSX5E and EUR-USD monthlyreturnsAverage for theperiod

10

There is little the ECB can do to prevent EUR appreciation in the medium term!

Verbal intervention is rarely successful in the medium term when not backed by a high probability of actual intervention…something the ECB has not done in the past!

The ECB could deliver another symbolic cut to the refi rate and/or announce a "Funding for Lending" scheme, in order to address the problem of fragmentation. These two measures could weaken the EUR in the short term but are unlikely to have a lasting impact

The only measure that could deliver a serious blow to the currency would be a full-blown QE (purchases of government bonds). However, this is highly unlikely in our view, because:

The central bank cannot engage in QE as a response to currency appreciation

Economic recovery is preceding better than most expected Inflation has shown signs of having bottomed in March should start

gradually picking up… ….in other words, the "bar" for initiating a QE programme is very high

in our view

11

The Euro zone recovery is having positive spill over effects to Central and Eastern Europe

30

35

40

45

50

55

60

65

Poland

Hungary

CzechRepublicTurkey

Russia

Manufacturing PMIs, 3M MAWith the exception of Russia, all trend-PMIs are firmly above the break-even level of 50…

…and more is to come!...given the historical correlations with the improving Euro zone PMI

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

CzechRepublic

Poland Russia Hungary Turkey

Correlations with EZ Manufacturing PMI

Source: Markit, UniCredit Research

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Poland stands to benefit the most

PLN: the rebound in domestic activity and spill-overs from German growth should benefit Poland the most in the region and result in PLN outperformance. We forecast EUR-PLN at 4.05 by year-end

HUF: the worsening net international investment position, the large foreign ownership of domestic bonds which is subject to reversal on the back of Fed's tapering and the increased domestic liquidity that erodes the carry further should pose some headwinds for the HUF, which we think will underperform in CEE. We forecast EUR-HUF at 308 by year-end

TRY: we expect further improvement in Turley's C/A balance to around -4.8% of GDP this year; this, alongside the high carry should provide cushion to the Turkish Lira

RUB: we have pencilled in just 0.5% of annual growth in GDP. Russia will have problems managing the slowing of domestic demand, high inflation rates and the potential acceleration of capital outflows

13

Croatia: looking for growth drivers

We forecast a contraction of 1% in GDP yoy for this year; this is largely driven by declining private demand and cuts in government spending, although the recovery in the Euro area will have some partial offsetting effects

Downside risks exist to this scenario given the country's current credit rating

Fiscal consolidation has made steps in the right direction but more structural reforms are needed

Adoption of the EUR is still some years away; the current contraction in the economy makes meeting the convergence criteria more difficult; at the same time, Croatia needs to have the currency flexibility to become more competitive

The ratings outlook poses a challenge for the short-to-medium term. Only accelerated efforts toward addressing key structural economic and budgetary challenges can lead to an upgrade in rating