Important disclosures and certifications are contained from page 9 of this report. www.danskeresearch.com

Investment Research — General Market Conditions

We expect euro-area GDP growth to be above consensus in 2015 despite our

view of deflation in 2015.

The euro area will, in our view, experience deflation during most of 2015, but it

will mainly be due to the low oil price, which boosts private consumption.

In addition to stronger growth in private consumption the recovery should also

follow as a result of fading headwinds to economic activity.

First, exporters will benefit from the depreciation of the effective exchange rate,

which should continue to weaken as a result of further easing from the ECB.

Secondly, the expansion of the ECB’s balance sheet should improve credit to the

private sector as banks’ supply conditions have improved. Related to that lower

costs of borrowing also support business investments and private consumption.

Finally, the headwind from fiscal tightening continues to fade, while European

politicians are likely to support the recovery through an investment project.

The market factors in low future growth and inflation and forward rates are

consistent with the ECB not lifting its key rates the next five years.

The market is in other words pricing in a Japanese scenario as the EUR swap

curve is now lower across all tenors compared with Japan in the 1990s.

Fading headwinds imply we expect the recovery to strengthen in 2015

Source: ECB, OECD, Danske Bank Markets.

Note: All changes are permanent and the impact on GDP is one year after the shock

Easing headwind/tailwind Impact on economic activity Rule of thumb

Rate cuts

Oil price declineLower inflation, higher real wage growth and thus increasing private consumption

10% oil price decline lifts GDP by 0.08%

Effective euro depreciationImproved price competitiveness hence higher exports and lower imports

10% euro depreciation lifts GDP by 0.7%

Higher real money supply

Can result in more credit to the private sector and thus support investments and private consumption

Real money supply growth of 7% y/y cor-responds to GDP growth of 0.5% q/q

Improved credit supply conditions

Demand for credit gives more bank lending which increases investments and private consumption

A credit impulse of 0.2 corresponds to GDP growth of 1.5% y/y

Lower cost of borrowingLower financing costs support investments and private consumption

A decline in the Eonia rate of 0.16pp lifts GDP growth by 0.12pp

Less fiscal tightening Higher growth in public comsumptionIncrease in public expenditures of 1% of GDP lifts GDP by 0.8%

12 January 2015

Senior Analyst Pernille Bomholdt Nielsen +45 45 13 20 21 perni@danskebank.dk

Senior Analyst Lars Tranberg Rasmussen +45 45 12 85 34 laras@danskebank.dk

Assistant Analyst Lars Sparresø Merklin mer@danskebank.dk

Research papers

1. Recovery despite deflation

12 January

2. Short-term weakness fades

13 January

3. Deflation but the good kind

14 January

4. ECB will buy government bonds

15 January

5. Impact of broad-based QE

16 January

Euro-area outlook for 2015

Recovery despite deflation

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Euro-area outlook for 2015

Deflation in the euro area, but we still look for stronger growth

Our outlook for the euro economy in 2015 deviates considerably from consensus both in

terms of activity and inflation (see table). First, we expect the recovery to gain

momentum as private consumption is supported by the oil price drop, business sentiment

has started to improve as uncertainty has lightened, while a number of headwinds are

fading mainly due to policy initiatives. Based on this we expect GDP growth will be 1.5%

in 2015 and 2.1% in 2016, which is above the Bloomberg consensus of 1.1% and 1.5%,

respectively. (In this paper, we consider the fading headwinds, while in paper #2 we will

look at the specific growth drivers).

At the same time, we look for falling prices during most of 2015 primarily as a result of

the sharp decline in the oil price but also as core and food price inflation are low in a

historical perspective. In 2015, we expect average inflation will be negative at -0.1%,

which is much below consensus expectations that prices will increase by 0.6%. In 2016,

inflation should rebound as the oil price is set to increase. Core inflation should also

slowly increase as stronger growth supports wage pressure and reduces second round

effects. (We will analyse the inflation outlook in our paper #3).

We expect the euro recovery to gain momentum in 2015... ... although inflation is set to be negative during most of 2015

Source: Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets

In our view, negative inflation is not contradicting a stronger recovery as long as the

falling prices are driven by lower commodity prices. Hence, our expectation of stronger

activity and falling consumer prices is consistent because we expect deflation to be driven

by the sharp drop in the oil price, which is growth supportive as it boosts private

consumption through higher real wage growth.

Deflation is mainly driven by lower commodity prices Real wage growth is boosted due to the drop in the oil price

Source: Eurostat, Danske Bank Markets Source: ECB, Eurostat, Danske Bank Markets

Non-consensus view on growth and

inflation

Source: Bloomberg, ECB, European Commission,

OECD, Danske Bank Markets

GDP HICP GDP HICP

Danske Bank 1.5 -0.1 2.1 1.6

Consensus 1.1 0.6 1.5 1.3

ECB 1.0 0.7 1.5 1.3

Commission 1.1 0.8 1.7 1.5

OECD 1.1 0.6 1.7 1.0

Euro area

forecasts

2015 2016

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The low oil price has reduced gasoline prices with a very short lag, thus consumers

already experience higher purchasing power and looking ahead we expect real wage

growth to increase further due to an even lower inflation rate.

The contribution to inflation from energy prices has fallen from +1pp in mid-2012 when

the oil price started to trend lower to -0.6pp at end-2014 and, based on our forecast, it will

decline down to -0.9pp. This gives a direct impact on real wage growth of close to 2pp

and given the propensity to consume, it boosts growth in private consumption by 1.7pp.

This consumption estimate does not include supply-side effects, which should lead to

higher employment and wages as the decline in the oil price reduces production costs and

leads to higher investments. On the other hand, it also excludes any second-round effects

where wages follow inflation lower as a result of indexation and lower inflation

expectations. The ECB has estimated this and concludes that a 10% permanent rise in the

oil price increases consumption by 0.3% after three years.

The sharp decline in the oil price has reduced gasoline prices Private consumption to strengthen further

Source: Bloomberg, European Commission, Danske Bank Markets Source: Eurostat, Danske Bank Markets

The case of an economic rebound after having experienced deflation has been observed

before. Ireland had deflation in 2009-10 and consumers’ real wage growth was negative

in 2012-13. Nevertheless, the Irish recovery is gaining pace and for 2014 we look for the

strongest growth rate since 2007. Likewise, Spain has balanced around the deflation limit

since end-2013, but in 2014 GDP growth is set to be the strongest since the financial

crisis kicked in. One reason behind the strong growth in 2014 has been that private

consumption increased as consumers had positive real wage growth for the first time

since end-2009. This occurred despite consumer expected zero inflation since end-2012.

Strong Irish activity although wages declined in 2012-13 Spanish economy improving despite deflation expectations

Source: Central Statistics Office Ireland, ECB, Eurostat Source: European Commission, Eurostat, Markit PMI

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Euro-area outlook for 2015

Continued monetary easing to support the recovery

An important argument behind our expectation that the recovery will gain momentum in

2015 is that a number of headwinds to economic activity in previous years are fading.

Some of the most significant fading headwinds are related to the already announced

monetary easing from the ECB together with our expectation that the ECB will expand its

balance sheet further through a broad-based QE programme (see more in our paper #4).

One of the headwinds which is fading is the impact from the depreciation of the euro,

which will support economic activity as it improves price competitiveness and benefits

exporters. The effective euro has depreciated around 7% since the ECB in May clearly

signalled it would ease monetary policy.

Looking ahead, we expect the weakening to continue on a six month horizon as the ECB

is expected to continue its accommodative monetary policy and announce QE in January.

This should imply, that the effective euro will weaken around 10% before it slowly starts

appreciating. The impact on growth and inflation is estimated to be seen after around a

year and including our view of the continued weakening, this should give a boost to GDP

of 0.7% and support inflation by around 0.3pp in 2015 and 0.7pp in 2016.

The effective euro has weakened during 2014 This is supportive for higher growth and inflation

Source: Bloomberg, Danske Bank Markets Source: OECD, Danske Bank Markets

Another sign of the monetary easing is that money supply is increasing at a faster pace.

Real M1 growth is a good leading indicator for activity on a nine-month horizon and the

current pace of increase suggests GDP growth will pick-up to around 0.5% q/q in H1.

Looking ahead, real money supply should improve further as nominal money supply will

increase faster and the real rate is lifted by lower inflation.

Higher real money supply suggests stronger GDP growth The balance sheet expansion should affect economic activity

Source: ECB, Eurostat, Danske Bank Markets Source: ECB, Danske Bank Markets

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The higher nominal money supply should follow as the expected boost to the ECB’s

balance sheet will result in an increase in the monetary supply if the money multiplier is

constant. This was not the case in 2011-12, when the liquidity from the 3Y LTROs

increased the balance sheet as the liquidity did not feed through to more credit to the

private sector. Nevertheless, a pass-through is more likely this time, as banks have

reported they predominantly aim to employ the TLTRO funds for granting loans.

Related to that the headwind to the recovery from very weak bank lending has started to

fade as credit supply conditions have improved. An important constraint for bank

lending in 2012-13 has been the ECB’s ongoing Asset Quality Review and stress tests,

which implied banks focused on reducing and restructuring their balance sheets instead of

lending out. But there has been some relief after the ECB took its snapshot of banks’

balance sheets in December 2013 and even more so after the comprehensive assessment

released in October 2014 showed a limited capital shortfall, see ECB comprehensive

assessment: Capital shortfall less than expected. Added to this, the ECB’s ABS

purchases will take credit risk from banks’ balances and thus support an improvement in

the lending potential for banks which are still capital constrained.

Improved lending after ECB’s comprehensive assessment Demand for credit crucial for higher bank lending

Source: ECB, Danske Bank Markets Source: ECB Bank Lending Survey, Danske Bank Markets

In light of this, supply side restrictions on lending should play a smaller role and

increasing demand for credit is instead crucial for higher loan growth and thus for

stronger economic activity. In terms of impact on GDP growth, it is the change in credit

growth, which is important, and it currently suggests GDP growth around 1.5% y/y.

Moreover, we estimate that the credit gap accounts for around half of the total euro output

gap, hence an improvement in credit growth is important for the gap to narrow.

Credit growth accounts for around 50% of the total output gap The credit impulse indicates higher GDP growth

Source; ECB, Eurostat, Danske Bank Markets Source: ECB, Eurostat, Danske Bank Markets

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Importantly, more credit to the private sector is coming at a lower cost of borrowing.

The ECB’s Bank Lending Survey shows that banks in 2014 eased price terms on loans to

enterprises for the first time since the financial crisis kicked-in. Similarly the composite

cost of borrowing have declined since the ECB eased in June. In Spain and Italy, the costs

of borrowing to non-financial corporations have also declined, which is also likely to

reflect a transmission of the significant decline in sovereign bond yields. A lowering of

the policy rate, which lower the Eonia rate by 0.16pp is estimated to increase GDP

growth by close to 0.18pp after around two years.

Banks ease price terms for the first time since the crisis Lower cost of borrowing after the ECB eased monetary policy

Source: ECB Bank Lending Survey, Danske Bank Markets Source: ECB, Danske Bank Markets

Fiscal headwind fading

Fiscal policy tightening has also been a significant headwind to economic activity in

previous years, but in 2014 it faded and in 2015, the European Commission estimates that

fiscal policy will be slightly expansionary. Although this could turn out to be a bit too

optimistic, as it only includes measures that have already been approved, the headwind in

2015 should be much smaller compared to the situation in 2011-13.

Added to this, European politicians are likely to strengthen the recovery through a

EUR315bn investment project. The plan is to carry out infrastructure projects without the

use of money from taxpayers, but instead using a small amount of EU funds as a

guarantee to raise new private cash in the capital markets. The investments will start in

mid-2015 and are scheduled to be completed in 2017. According to the European

Commission, the investment plan could potentially add 0.3-0.4% to GDP.

Small fiscal headwind compared to previous years Investments boosted by policy initiatives

Source: Eusopean Commission, IMF, OECD, Danske Bank Markets Source: Eurostat, Danske Bank Markets

-5

-4

-3

-2

-1

0

1

2

2010 2011 2012 2013 2014 2015

Impact on growth Change in cyclically adjusted primary balance

%-points of GDP Fiscal headwind

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The market price in a Japanese scenario

European fixed income markets have performed in recent years as growth has been weak

and inflation low and declining. The ECB has pushed down shorter-dated rates through

lowering its key policy rates and adding liquidity to the markets to enhance the growth

outlook. However it has helped little and consequently the long-end rates have fallen,

which reflects that the market factors in lower future growth – i.e. flatter 2/10 and 10/30

slopes in EUR swaps. In fact, as the chart below shows the EUR swap curve is now lower

across all tenors comparing with Japan in the 1990s. Further, it is in line with the current

Japanese curve, which is not really pricing in future rate hikes in any significant way.

Japanese zero coupon yield curve on selected dates EUR swap curve on selected dates

Source: JPN Ministry of Finance (Govies), Danske Bank Markets

Note: We have used government yields in order to have data back to the 90s

Source: Danske Bank Markets

Zooming in on the EUR forward curve, we can derive the following conclusions. Forward

rates are consistent with the ECB not lifting its key rates the next five years. Measured

from the point in time when the first rate hike is priced in, only one rate hike of 25bp per

year is discounted in the following four years. In fact, one could argue that the curve is

not pricing in any rate hikes at all since the upward sloping curve could just be viewed as

a term premium. In other words, the market does not believe that growth and inflation

will return in the next ten years. (In our paper #2, we will look at how the market is likely

to respond once growth returns).

Eonia curve consistent with the ECB on hold next for five years 10Y EUR swap below 1%

Source: Danske Bank Markets Source: Danske Bank Markets

-0.20%

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

06

Feb

15

07

Jul1

50

7D

ec1

50

6M

ay1

60

7O

ct1

60

7M

ar1

70

7A

ug1

70

5Ja

n1

80

7Ju

n1

80

7N

ov1

80

5A

pr1

90

6S

ep1

90

7Fe

b2

00

7Ju

l20

07

Dec

20

07

May

21

07

Oct

21

07

Mar

22

05

Au

g22

06

Jan

23

07

Jun

23

07

Nov

23

05

Ap

r24

06

Sep

24

07

Feb

25

07

Jul2

50

5D

ec2

5

1M Eonia forwards

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Euro-area outlook for 2015

Lessons from Japan: Cost of moderate deflation is not high

Before comparing the euro area to Japan, it is important to remember that from a cyclical point of view Japan has in the past decade done much better than its bad reputation. The recovery in Japan in the wake of the financial crisis has actually been stronger than in the US if it is adjusted for the population growth. Additionally, the unemployment rate in Japan is now back at its level before the financial crisis. Based on this, the lesson from Japan seems to be that the impact on GDP growth of having deflation, which we expect for the euro area during most of 2015, is not that harmful, although the costs are larger compared to having positive inflation. Despite moderate deflation Japan experienced its longest post-war recovery from 2002-07. The private non-residential investment ratio has also been higher than in Germany and the US, underlying that moderate deflation did not weigh substantially on business investments. A cost of deflation is that it is hard to reduce the debt burden, but in Japan this was compensated for by lower real rates. Like in Japan the output gap in the euro area is set to remain very large despite our expectations of a recovery. In isolation, this suggests substantial risk of slipping into broad-based deflation. (We will analyse the inflation outlook in our paper #3). Moreover, the euro area faces some of the same structural challenges that Japan faced in the 1990s and particularly the demographic development will be a challenge going forward. Nonetheless, potential growth in the euro area should not slow as fast as it did in Japan. An important factor behind the weakness in Japan in 1990 was also the banking sector, which was not recapitalised before 1999. In light of this, the capital improvements in the euro area during 2014 and the limited capital shortfall among banks which was revealed in the ECB’s comprehensive assessment should be important for a stronger recovery, as we have also concluded above.

Source: Macrobond, Danske Bank Markets Source: Macrobond, Danske Bank Markets

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Euro-area outlook for 2015

Disclosure This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske

Bank’). The authors of the research report are Pernille Bomholdt Nielsen, Senior Analyst, Lars Tranberg

Rasmussen, Senior Analyst, and Lars Sparresø Merklin, Assistant Analyst.

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See the front page of this research report for the date of first publication.

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Euro-area outlook for 2015

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