03 19 2015 the divergence theme

The Divergence Theme

Jonathan Basile Head of Business Cycle Research AIG Global Economics 212-770-5228 jonathan.basile@aig.com March 19, 2015

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Factor 1: The Oil Price Shock The supply-side decline in oil prices boosts global growth, with asymmetric effects across countries.  It represents a massive shift in wealth and income from producers to consumers of oil even as economies have become less “oil-intensive”.  A floor for oil prices will emerge, as layoffs and investment curtailment take place.

Crude Oil Futures ($/barrel)

Sources: EIA; AIG Global Economics 2

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Market Impact: The USD rises as oil prices decline

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… And deflation fears set in

Sources: Haver; AIG Global Economics 4

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Factor 2: The ECB’s QE ECB picks up QE baton from Fed

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Market impact: Competitive devaluation Euro

Yen

CHF

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… And massive rally in sovereign bonds

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Factor 3: The Fed’s Lift-Off Strong employment report…

… Prompted a re-thinking of the Fed’s policy moves

Sources: Haver, Bloomberg, AIG Global Economics

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Market impact: Inflation Expectations Bouncing off Lows

Market-based inflation expectations Core inflation: More stable

Sources: Haver; AIG Global Economics

Sources: Haver; AIG Global Economics 9

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… And the flattening of Yield Curves: 2 Year-10 Year Yield Spread US Treasuries

UK Gilts

German Bunds

Japanese JGBs

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Global monetary policy is coalescing around three blocks: The Americas…

Latin America (Latam): Can’t afford to fight the Fed:  Portfolio-flow financed current account deficits in some countries limit the central bank’s ability to cut rates, as does moderate level of dollarization across the financial system.  Some Latam countries have either started to raise policy rates, or will have to over 2015 in line with rising shortterm and long-term rates in the US, as preventing capital outflows becomes more important than maintaining currency competitiveness.

Currencies (vs US$) are adjusting to the weaker outlook

Foreign currency debt means following the Fed

Sources: Oxford Economics, Fitch, Haver, AIG Global Economics

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… Emerging Europe Emerging Europe: Can’t afford to fight the ECB  Poland’s central bank rate cut is linked to the potential gains of the currency and ensuing financial stability risks (i.e., bond bubble).  Russia has started an easing cycle, following the aggressive tightening (650bps) in December, as the ruble has stabilized.  Turkey is more influenced by USD financing. It faces adverse dynamics of high inflation, a large current account deficit, dependence on confidence-driven capital flows and, therefore, a volatile currency.

Currencies reacting to the ECB

Currencies (vs US$) lose ground

Sources: Oxford Economics, Fitch, Haver, AIG Global Economics

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… And Non-Japan Asia Non-Japan Asia: An eye on the BoJ and the Fed; dovish central banks amidst intensified dis-inflation and restrictive fiscal policies.  China: Looser monetary conditions are aimed at countering the tightening caused by capital outflows.  South Korea, Indonesia, Singapore and Thailand are all seeing more dis-inflation with faster pass-through effect of lower gasoline prices, against the backdrop of modest domestic demand.  Thailand’s baht and the Philippines’s peso are regional outperformers on strong current account position and FDI inflows.  India: The switch to inflation targeting makes aggressive cuts less likely.

Currencies (vs US$) are adjusting to the weaker outlook

Foreign currency debt means following the Fed

Sources: Haver, AIG Global Economics

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The outcome: Developed economies outperform emerging markets Volatility in the currency markets, capital outflow pressures and broken growth models are factors that will continue to weigh on EM growth.

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The US lead-dog to global growth  US GDP growth of close to 3% in 2015 should turn out to be the best year of expansion since the end of the Great Recession.  The main reason: broad-based acceleration in private domestic demand dominated by households. Stronger domestic demand will widen the trade gap as import growth outpaces export growth for the first time in five years.  We expect both disposable income and consumer spending to post the strongest annual growth since 2009. A tighter labor market should benefit households through strong job gains and moderately faster wage growth.

We expect above trend growth in 2015

Shift from producer to consumer

5

4 3

3.1 2.5

2

2.3 2.2 2.4 1.6

1 0

-1 -2 -3

Real GDP, YoY % Average growth rate b/t 1Q10 and 3Q14 @ 2.2%

-4 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15F Sources: BEA; BLS; Haver; AIG Global Economics

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The oil price windfall for the US consumer  Uncertainty about the US growth outlook goes up in the short run because the news is negative for producers. But the drop in gasoline prices from June to present is equivalent to about $200bn in additional income and to a 1.5% tax cut.

• But it takes time to harvest the redistribution to consumers because demand for energy in the very short run usually doesn’t change. It takes time (months) for household and business behavior to change from the positive oil price shock.

• One way we illustrate this is by looking at US consumer spending on gasoline in dollars (light blue) and volume (dark blue). The negative price effect is more direct on dollars spent (light blue) and it took longer for the volume (dark blue) to get a boost. The price drop has to stick for the volume to move up materially and for more trips to be taken.

• Green shoots have emerged: Auto sales have picked up pace and miles traveled have broken through 2007 highs.

Americans are paying Less at the Pump…

…And Driving More Places

Sources: Autodata; BEA; Federal Highway Administration; AIG Global Economics 16

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The oil price windfall for the US consumer (continued) The cumulative effect of the gasoline price drop over the last seven months: The savings have been spent: • Discretionary (green) spending • Nondiscretionary (light blue and red) spending (defined as food/beverages, energy, clothing/footwear, and housing).

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Euro Area: More near-term upside Balance of Risk: Tilting to the upside, with emerging green shoots to the consumer and export sector  The Euro Area (EA) economy has shown more upside momentum recently, despite being constrained by on-going deleveraging in some of the peripheral countries and by the lack of support from fiscal policy on a broader basis.  Consumer spending benefits from lower oil prices and rebounding confidence, especially in countries with lower household debt burdens.  Weak investment remains an entrenching theme across the EA, though drivers differ in each country.  The recent decline in the currency driven by the ECB’s QE has helped the export sector, contributing to continued improvement in the current account.  Headline deflation will more likely stay for most of the year in the region, although core inflation will stabilize with the support of stronger growth.  Winner industries: Autos, consumer discretionary and consumer goods exporters

Real GDP Growth (%, YoY)

Current Account Balance (% of GDP)

5.0

12 9

4.0

6

3.0

3 2.0

0 -3

1.0

forecasts -6

0.0 GERMANY

FRANCE

ITALY

NETHERLANDS

IRELAND

-1.0 2014

2015

2016

SPAIN

Germany Netherlands Spain

-9 -12 Dec-06

Dec-08

Dec-10

Dec-12

France Italy Ireland Dec-14

Dec-16

Sources: AIG Global Economics Baseline Forecast 18

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Euro Area PMI: Pickup in activity Germany PMI

France PMI

80

70 60 50 40 30

Italy PMI

70

70

65

65

60

60

55

55

50

50

45

45

40

40

35

35

30

30

25

25

20

20 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Manufacturing

20 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Manufacturing

Manufacturing New Order

Netherlands PMI

Manufacturing New Order

65

60

55

60

55

55

50

50

45

40

45

40

40

35

35

35

30

30

30

25

25

25

20

20

50 45

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Manufacturing

Manufacturing New Order

Manufacturing New Order

70

65

60

Manufacturing

Spain PMI

Ireland PMI

65

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

20 2006 2007

2008

2009 2010

Manufacturing

2011 2012 2013

2014 2015

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Manufacturing New Order

Manufacturing

Manufacturing New Order

Sources: Haver, Markit, AIG Global Economics

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Appendix 1: Global Growth forecasts

World North America United States Europe Euro area Germany France Italy Spain United Kingdom Japan Asia ex Japan China India EMEA Russia Turkey South Africa Latin America Brazil Mexico

PPP weighted share of world GDP (2014) 100.0 17.8 16.3 17.4 12.0 3.4 2.4 1.9 1.4 2.3 4.5 34.2 16.5 6.8 17.6 3.3 1.4 0.6 8.5 2.9 2.0

2013 3.3 2.2 2.2 0.2 -0.4 0.5 0.3 -1.9 -1.2 1.7 1.5 6.1 7.7 5.0 2.9 1.3 4.1 1.9 2.7 2.5 1.1

2014 3.3 2.4 2.5 1.4 0.9 1.6 0.4 -0.4 1.4 2.6 0.1 6.0 7.4 5.6 2.5 0.5 2.7 1.5 1.2 0.0 2.1

Growth Rates 2015 3.4 3.0 3.1 1.7 1.4 1.7 1.0 0.3 2.1 2.6 1.0 5.9 6.8 5.8 2.2 -3.6 3.6 2.6 1.1 -1.1 3.1

2016 3.8 2.8 2.8 1.9 1.6 1.5 1.5 1.0 2.2 2.5 1.2 5.9 6.5 6.2 3.6 0.2 3.8 3.0 2.7 0.6 4.0

2017 4.0 2.8 2.8 2.0 1.7 1.6 1.5 1.0 2.4 2.6 0.8 5.8 6.3 6.6 4.2 2.0 4.2 3.2 3.6 2.7 4.1

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Appendix 2: Global Inflation forecasts

World North America United States Europe Euro area Germany France Italy Spain United Kingdom Japan Asia ex Japan China India EMEA Russia Turkey South Africa Latin America Brazil Mexico

PPP weighted share of world GDP (2014) 100.0 17.8 16.3 17.4 12.0 3.4 2.4 1.9 1.4 2.3 4.5 34.2 16.5 6.8 17.6 3.3 1.4 0.6 8.5 2.9 2.0

2013 4.0 1.4 1.5 1.5 1.4 1.6 1.0 1.3 1.5 2.6 0.4 4.3 2.6 9.5 7.8 6.8 7.5 5.8 7.4 6.2 3.8

2014 3.9 1.6 1.6 0.6 0.5 0.9 0.5 0.2 -0.2 1.5 2.8 3.6 2.0 7.3 7.2 7.7 8.9 6.1 10.5 6.3 4.0

2015 3.4 0.7 0.6 0.0 -0.1 0.1 0.0 -0.2 -0.9 0.5 1.2 3.0 2.0 5.5 7.1 9.1 6.0 5.5 11.2 7.0 3.2

2016 3.6 2.5 2.5 1.3 1.1 1.2 1.0 0.7 1.0 1.8 1.0 3.1 1.6 6.4 6.1 6.1 6.5 6.2 8.6 5.6 3.3

2017 3.5 2.5 2.5 1.7 1.5 1.8 1.4 0.9 1.1 2.0 2.0 3.3 2.1 6.3 5.7 5.1 6.1 6.2 6.2 4.9 3.2

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