China Merchants Securities 2015 Overseas Macroeconomic Outlook

8/10/2019 China Merchants Securities 2015 Overseas Macroeconomic Outlook

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Annual Report

Macro ReportDecember 1, 2014 Monday

China Merchants Securities (HK) Co. LtdHong Kong Equity Research

To access our research reports on the Bloomberg terminal, type CMHK 1

Gradual global recovery process to face

increasing risks and challenges in 20152015 Overseas Macroeconomic Outlook

On a whole, we expect the big developed economies to see growth edge up in2015, but downside risks have risen. We expect the recovery will likely remainmodest and uneven as economies continue to struggle to restore growthdynamism following the crisis years. Challenges remain significant and weremain cautious on the overseas macro environment moving into 2015.

US: moderate recovery to accelerate, striving for escape velocity Main focus in the US will remain on monetary policy normalization; weexpect a hike of 25 bps in mid-2015 , and we expect multiple hikes in 2015,forecasting rate at 1.0% in 2015.

At this point, the recovery may not be at escape velocity, or strongenough to be self-sustained despite external headwinds, meaning the USrecovery may still be subject to external shocks.

Improving labor and housing markets, still accommodative policy, andlessened fiscal drag should bolster economic growth moving into 2015.

We view the US most positively of developed economies, forecasting2015 GDP growth at 2.9% YoY and for the dollar to strengthen further.

Eurozone: recovery to remain lukewarm, rising downside risks Downside risks prevail in the region, as deflationary pressures andunemployment continue to weigh on consumption and activity.

Eurozone countries performances are likely to vary moving forward.We view Germany, Spain and other countries which pursued structuralreforms more favorably, while France and Italy may continue to struggle.

The ECB has exhausted its conventional monetary tools to little effect,may introduce full-fledged QE; we identify March/July as a possible QE timing.

The Eurozone is set to return to positive YoY growth in 2014, as theregion continues its slow recovery from the debt crisis and austerity. Overallfor the region we expect growth to remain steady at 0.9% YoY in 2015. It islikely we will see the Euro dip further in 2015.

Japan: stimulus & trade to buoy 2015 growth, long term risks big Japans core story remains the same, short term growth fueled byaggressive stimulus, while long term issues loom on the horizon. Rate of stimulus to slow after Oct. 31 st BoJ stimulus, but BoJ andgovernment will remain ready to support the economy further if needed.

Impact of the stimulus, a more favorable trade outlook, a delayed salestax, and the base effect may accelerate growth from 2Q15 onward, and we

expect growth to edge up slightly to 1.1% YoY in 2015. Long term risks tied to government debt and lack of structural reformremain significant, we remain bearish on Japan for the medium to long term.

Lynn SONG+852 3189 [email protected]

Dr. Cliff Zhao, CFA +852 3189 612 6 [email protected]

Dr. David Xie

+86 755 [email protected]

U.S.% 14E 15E

GDP 2.3 2.9

CPI 1.7 1.8Unemployment 5.8 5.6Current Account /GDP -2.4 -2.3Fiscal balance /GDP -2.9 -2.6Policy rate 0.25 1.00Dollar index 88.5 93.0Eurozone% 14E 15E

GDP 0.9 0.9

CPI 0.5 0.8Unemployment 11.5 11.3Current Account /GDP 2.3 2.5Fiscal balance /GDP -2.5 -2.3Policy rate 0.05 0.05EUR/USD 1.25 1.15Japan% 14E 15E

GDP 0.8 1.1CPI 2.8 1.5Unemployment 3.6 3.4Current Account /GDP 0.1 0.9Fiscal balance /GDP -8.0 -7.8Policy rate 0.1 0.1USD/JPY 118.0 121.0Source: Bloomberg CMS(HK)

Key forecasts
mailto:[email protected]:%[email protected]:%[email protected]:%[email protected]:%[email protected]:%[email protected]:%[email protected]:[email protected]


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2014 12 1 ( )

: CMHK 2

2015

2 15

2015

2015

2015 25

2015 1.0%

2015

2015 GDP2.9%

2015 3 7

2014 GDP 2015

0.9% 2015

2015

10 31

20152015 1.1%

+852 3189 [email protected]

, CFA+852 3189 612 6

[email protected]

+86 755 83295524

[email protected]

% 14E 15E

GDP 2.3 2.9

CPI 1.7 1.8

5.8 5.6

/GDP -2.4 -2.3

/GDP -2.9 -2.6

0.25 1.00 88.5 93.0

% 14E 15E

GDP 0.9 0.9

CPI 0.5 0.8

11.5 11.3

/GDP 2.3 2.5

/GDP -2.5 -2.3

0.05 0.05

/ 1.25 1.15

% 14E 15E

GDP 0.8 1.1

CPI 2.8 1.5

3.6 3.4

/GDP 0.1 0.9

/GDP -8.0 -7.8

0.1 0.1

/ 118.0 121.0
mailto:[email protected]:%[email protected]:%[email protected]:%[email protected]:%[email protected]:[email protected]


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December 1, 2014 Monday


Table of Contents

1. US to continue moderate recovery: is the economy at escape velocityyet?

5

1.1 Policy may gradually tighten in 2015, but overall still accommodative;we expect rate hike in mid-2015

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1.2 Dollar likely to maintain upward climb in 2015 and lead to more capitalinflow

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1.3 Consumption should continue to drive growth on labor marketimprovement, but rate hike may create headwinds

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1.4 Investment growth may continue to edge up on improving housingmarket and replacement of capital stock

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1.5 Net exports may drag growth slightly amid stronger dollar and weakexternal outlook

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1.6 Key risks in 2015 remain tied to monetary policy and externalenvironment

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2. Eurozone recovery to remain lukewarm, with rising downside risks 20

2.1 Policy direction in the EU to remain highly accommodative 22

2.2 Euro may weaken further, with potential capital outflow from the regionin 2015

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2.3 Limited upside potential for recovery of Eurozone domestic demandamid continued job market weakness

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2.4 Investment remains significantly below long term potential, may staydownbeat in 2015

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2.5 External demand situation should benefit from weaker Euro, but impactmay be modest as trade partners economies moderate

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2.6 Risk outlook is balanced to the downside: deflation, reform fatigue, andgeopolitical risks remain significant

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3. Japans 2015 growth may rise on aggressive stimulus and external tradebalance improvement, but long term concerns remain serious

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3.1 Japan policy stance likely to push for continued aggressive easing, butspace for further support may be limited

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3.2 Consumption will remain subdued unless real wage growth risessubstantively

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3.3 External trade balance may be more positive for growth in 2015 onenergy developments

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3.4 Further downside pressure on Yen will persist, but pace of depreciationmay slow or stabilize in 2015

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3.5 Key risks remain centered on huge government debt and lack of

structural reform

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4. Conclusion 42


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US Macroeconomic Forecast Table

Eurozone Macroeconomic Forecast Table

Japan Macroeconomic Forecast Table

Sources: Bloomberg, CMS (HK)

% 2008 2009 2010 2011 2012 2013 2014F 2015F

GDP -0.3 -2.8 2.5 1.6 2.3 2.2 2.3 2.9

CPI 3.9 -0.4 1.6 3.2 2.1 1.5 1.7 1.8

Unemployment 5.8 9.3 9.6 8.9 8.1 7.4 5.8 5.6

Current Account / GDP -4.7 -2.6 -3.0 -3.0 -2.9 -2.4 -2.4 -2.3

Fiscal balance / GDP -4.6 -10.2 -8.5 -8.1 -6.6 -0.3 -2.9 -2.6

Policy rate 0.25 0.25 0.25 0.25 0.25 0.25 0.25 1.00DXY 81.3 77.9 79.0 80.1 79.8 80.0 88.5 93.0

% 2008 2009 2010 2011 2012 2013 2014F 2015F

GDP (% YoY) 0.4 -4.4 2.0 1.6 -0.7 -0.5 0.9 0.9

CPI inflation (% YoY) 3.3 0.3 1.6 2.7 2.5 1.5 0.5 0.8

Unemployment 7.6 9.6 10.1 10.2 11.4 12.3 11.5 11.3

Current Account / GDP -1.6 -0.2 0.0 0.1 1.4 1.5 2.3 2.5


Policy rate 2.5 1.0 1.0 1.0 0.8 0.25 0.05 0.05

EUR/USD 1.40 1.43 1.34 1.30 1.32 1.35 1.25 1.15

% 2008 2009 2010 2011 2012 2013 2014F 2015F

GDP (% YoY) -1.0 -5.5 4.7 -0.6 2.0 1.7 0.8 1.1

CPI inflation (% YoY) 1.4 -1.3 -0.7 -0.3 0.0 0.0 2.8 1.5

Unemployment 4.0 5.0 5.0 4.5 4.2 4.0 3.6 3.4

Current Account / GDP 3.3 2.9 3.7 2.0 1.0 0.9 0.1 0.9


Policy rate 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1

USD/JPY 90.6 93.0 81.1 76.9 86.8 105.3 118.0 121.0


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1. US to continue moderate recovery: is the economy at escape velocityyet?

The US economy has shown encouraging signs of recovery in 2014, and we currently view theUS most favorably among the major developed economies. In particular, unemploymentrecovered notably faster than initially expected, and despite some remaining pockets ofweakness, was a driver for the recovery.

Although a weak 1Q14 from extreme weather conditions is likely to drag growth for the year asa whole, growth gained traction starting in 2Q14, and we expect the current trajectory ofaccelerating growth to carry forward into 2015.

Chart 1: US GDP bounced back strongly after weak 1Q14, set to accelerate furtherin 2015


The key catalysts for growth remain in a virtuous cycle of continued labor market recoverystimulating consumption, the housing market, and hopefully economic investment, as well asfrom capital flow entering the US economy. These factors should outweigh what should beslightly less accommodative monetary and fiscal policies in 2015. A downside risk to keep inmind would be the possibility of contagion, if economic activity slows in the other major global

economies, it may also create a headwind on US growth. At this point, the recovery may notbe at escape velocity, or strong enough to be self -sustained despite externalheadwinds, meaning the US recovery may still be subject to external shocks.

In the US, we identify the following as some of the key issues to watch for in 2015:

1. When will the Fed start to raise interest rates? What frequency and scale will the rate hikeshave? What will the impact be on the real economy and the markets?

2. Can the improvement of the labor market continue into 2015 and drive consumption?

3. Will a potential moderation of other major global economies drag US growth?

4. With a newly elected Republican -controlled Congress, will policy gridlock be exacerbated or

eased? Impact will likely be seen more in 2016 fiscal budget. 5. Will another polar vortex causing extremely cold weather drag 1Q15 growth again?

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US GDP growth (% YoY) US GDP growth (% QoQ SAAR)

Forecast ->1Q: 2.5% YoY2Q: 3.0% YoY3Q: 3.0% YoY4Q: 3.2% YoY


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We continue to view the US most favorably among the major developed economies. Overall, weforecast 2015 GDP growth to rise to 2.9% YoY.

1.1 Policy may gradually tighten in 2015, but overall still accommodative; we expect ratehike in mid-2015

The US is entering a phase of policy normalization following an extended period of veryaccommodative policy; this is a sugarcoated way of indicating upcoming policy tightening. Themost important event for the US in 2015 is the timing of the first interest rate hike.

In accordance with the amendment of the Federal Reserve Act of 1977, the Fed has two coregoals, known colloquially as their Dual Mandate: the two goals are to achieve maximumemployment, and stable prices. With the labor market steadily recovering, highlighted byunemployment falling to 5.8% in October, and with inflation forecasted to edge up further towardthe 2% target in 1H15, we expect a series of rate hikes to likely begin in mid -2015.

Chart 2: Job market has entered a stage of recovery, withunemployment falling to 5.8%

Chart 3: Inflation below target but may escalate to exceed2% in 1H15

Sources: Bloomberg, CMS (HK) Sources: Bloomberg, CMS (HK)

In our view, there is likely to be a series of rate hikes (2 -3) in succession to boost the FedFunds Target Rate to 1.0% by the end of 2015 , but there will likely be a time gap between

each, with the gap between the first and second likely to be the longest to allow for the Fed toobserve the impact of the hike. It is also possible later rate hikes may be by a larger scale if theeconomy strengthens enough. We expect as economic conditions allow, the Fed will eventuallytry to steer rates to 3 -4%, as evidenced by their long -term projections, but it is likely to takeseveral years to reach that range.

The impact of a series of rate hikes will be significant, as the first true move oftightening (QE taper is merely a smaller stimulus rather than an actual tightening) in therecent era of extraordinarily accommodative monetary policy. We view that monetarypolicy normalization is likely to cause significant ripples in the financial markets andsome modest headwinds on the real economy, but given a well -planned and carefulcommunications strategy by the Fed, cautious incremental moves to allow for themarkets to process moves in a gradual and calm manner, and continued improvement ineconomic fundamentals, these spillover effects should not be destabilizing.

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Chart 4: Interest rate hikes set to begin after long periodof near zero rates

Chart 5: Federal reserve balance sheet ballooned afterQE programs


Over the last several years, QE programs caused the Fed balance sheets to more thandouble in size. It is possible that the Fed will also cease reinvestment of asset purchasesin late 2015, which will passively reduce its balance sheet. As the goal of policy

normalization is to increase long term interest rates, ceasing reinvestments may be amethod of pushing long term interest rates higher.

With that said, we expect the Fed will not be in a hurry to cease reinvestment, remainingcautious amid a weak external environment.

In the meantime, the Fed has already started using less scrutinized tools such as theovernight reverse repos (ON RPP) and the term deposit facility (TDF) to control liquidityand impact short term market rates.

The Feds announced USD 300 bn reverse repo program to be conducted in December2014, which will also test the impact of draining liquidity on the market and economy. Thegoals of the policy were to test the effects of widening spread between the ON RPP rate and the

interest on excess reserves rate on money markets and the effectiveness of an ON RRP facilityin providing a floor for money market rates during policy normalization. ON RPPs are a form oftemporary open market operations (QE, for example was a permanent OMO) which involvesthe Fed Trading Desk selling a security under an agreement to repurchase that security in thefuture, and can be used to temporarily affect the size of the Federal Reserve System'sportfolio and influence day -to -day trading in the federal funds market.

The term deposit facility (TDF) is another tool used to manage the aggregate quantity ofreserve balances held by depository institutions. By increasing the term deposit facility, theFed removes bank reserves from the system, and drains liquidity; the 7 day TDF is usuallyseveral basis points above the interest rate on excess reserves. The Fed has already beenquietly testing out the newest rounds of TDFs since 2013.

Thus far, these tools seem to have a limited impact on short term money rates, as the scale isstill smaller and designed for technical purposes. Moving forward, it is likely these tools maybe expanded to influence short term money rates.

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It should be noted that monetary policy conditions will still remain quite accommodative relativeto historical levels, and the Fed is likely to be cautious with monetary policy normalization, as it

is very much possible that tightening policy too rapidly would take the wind out of the recovery.Furthermore, we would like to emphasize that the Fed will tighten monetary policy only due tostrength in the economy; should the data suddenly show significant deterioration, there is roomfor the Fed to reverse direction on policy at their discretion.

Moving on to fiscal policy, the US growth has been dragged by fiscal policy in the past severalyears following the 2013 sequester. As 2015 is the second year of the two -year budget dealbrokered for FY 2014 -2015, the fiscal drag should be similar to 2014 . Overall, we view thatboth public and private investment growth to date still remains below the long term trend.

Chart 6: FY 2015 budget expenditure breakdown Chart 7: Interest rate payments are expected to balloon in

coming years, rate hikes to increase interest burden

Sources: US OMB, CMS (HK) Sources: US OMB, CMS (HK)

There is also hope for the new Congress to be able to reach more bipartisan agreements andpass more fiscal policy measures than the current Congress, which has been noted as one ofthe least productive Congresses in US history. If the incoming Congress is able to come to alonger term fiscal agreement (likely involving entitlement reform), there is a potential for anupside risk of a streamlined or relaxed budget which would lead to increased fiscal spending inthe short term. With that said, we currently do not expect policy gridlock to disappear; theRepublican policymakers will likely be emboldened by the results of the midterm elections, butwith the president maintaining veto powers, significant policy changes are unlikely in 2015.

1.2 Dollar likely to maintain upward climb in 2015 and lead to more capital inflow

Monetary policy divergence widening occurred earlier than expected, as the BoJ stimuluspolicies at the end of October as well as the ECB rate cuts and ABS purchases came monthsbefore people had expected. This has led to a faster than expected rise of the dollar in 2014 inthe later months of the year.

We expect the appreciation momentum of the dollar to continue in 2015, as we expect themonetary policy normalization process, as well as the continued improvement of economic

Pensions19%

Health Care20%

Education16%

Defense13%

Welfare8%

Protection4%

Transportation5%

GeneralGovernment

3%

OtherSpending

7%

Interest5%

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Net Interest Estimate (USD bn)


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fundamentals will help boost the dollar via capital inflow. In our view, the pace of appreciationmay be slower in 1H15 before accelerating in 2H15, or approximately around when the series of

US rate hikes is likely to begin.Chart 8: Dollar index has traditionally moved closely with interest rates


Rate hikes will also influence capital flow across the world, particularly those which relied on aninterest rate differential between the US to attract capital flow. This effect may be magnified as

the worlds major central banks experience divergence in their monetary policy, with the USbeginning normalization while the ECB and BOJ ease policy further; the US benchmark rate of0.25% is already higher than that of the Eurozone (0.15%) and Japan (0.1%), while just a shadebelow the UKs (0.5%). If a series of rate hikes are made in relatively quick succession, this willput the US benchmark rates significantly above most of its developed economy peers, meaningdeveloped market focused funds will find the US relatively attractive, and emerging economiesmay also become significantly less attractive.

In the charts below, we can see that the capital flow into the US from mutual funds and ETFshas a strong positive correlation with the strength of the dollar, and conversely, emerging marketcapital flow data showed some negative correlation with the strength of the dollar.

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Chart 9: Strength of dollar has highly correlated withcapital inflow

Chart 10: Emerging markets may face capital outflow withrising USD, historical data showed negative correlation

Sources: EPFR, Bloomberg, CMS (HK) Sources: EPFR, Bloomberg, CMS (HK)

Capital flow has already been returning to the US despite rates remaining at record lows,particularly after the sheen on the emerging markets wore off over the past several years amid aslowdown in China and political instability in the ASEAN region. This is a trend that is likely tocontinue in our view: with Europe still mired in a weak and unsteady recovery, Japan attemptingto ward off stagflation with aggressive but short -sighted stimulus, and Chinas growth trajectoryslowing, the US is a relative bright spot in the major global economies. Expectedappreciation of the dollar will also add to the attractiveness of US assets.

Examining historical data over the past 25 years, we can see that the relationship betweeninterest rates and capital flow is not linear, but does show a loose correlation. As capital flowdata is far too volatile on a monthly basis, we chose a 6 month moving average to present thisdata. During this recent era of low rates, net capital flow has correlated more closely with theimplementation of QE, as seen in the chart below.

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Chart 11: Higher relative interest rates may lead to greater capital inflow, buthistorical data is inconclusive


Regardless, between improving economic fundamentals and a series of impending rate hikes, itis likely that capital flow will continue to return to the US, which should continue to benefit theUS financial markets and to a lesser extent the real economy.

1.3 Consumption should continue to drive growth on labor market improvement, but ratehike may create headwinds

Overall, consumption has been relatively solid in 2014, slightly accelerating on a year on yearbasis from 2013, but remaining below 2012 levels. We view that consumption should continueto grow in 2015 for two main reasons. Firstly, continued improvement of the job market shouldcontinue to support US consumption, and secondly, a stronger dollar will also make importedgoods cheaper for consumers. These factors should offset a likely drag coming from a rate hikein 2015.

The US labor market improved at a faster than expected pace in 2014, with the headlineunemployment rate dipping below 6%, and nonfarm payroll data surging to recovery highs. 2014was mostly a recovery at the level of quantity rather than quality. While there are still someweaknesses in underlying labor market data, overall the trend is positive, and should continueinto 2015. We expect a slower recovery of the headline numbers, but a gradual improvement ofunderlying data to show a gradual improvement of job quality as well as job quantity.

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Chart 12: Nonfarm payrolls rebounded strongly whileunemployment dipped to lowest since July 2008

Chart 13: Underemployment remains a consideration, asgap between U6 and headline shows quality of jobs

remained lackluster


Improvements in the labor market and also improvement in households balance sheets will leadto more supportive conditions for consumption.

Chart 14: Household debt burden declining and rise of disposable income growth

may boost consumption


The USD has been on an upward trend as monetary policy divergence continues in most of theworlds major central banks. A stronger dollar will decrease the cost of imported products,encouraging additional consumption.

With this said, the likely impending series of rate hikes will also take some of the wind out of theconsumption recovery. Big ticket discretionary spending which is traditionally installment based(such as cars, high end electronic appliances, etc.) is the most likely to be significantlyimpacted, as a rate hike will also likely spillover to make installment based purchases costlier.

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Our analysis of past periods of rate hikes has indicated that the effect on retail sales is likely tocome with a slight lag of roughly 2 -4 months, meaning that the US retail sector and companies

relying on sales to US consumers may begin to face headwinds in 4Q15 or so if the rate hikeprocess starts around the middle of the year.

Chart 15: Retail sales growth has been negatively correlated with benchmarkinterest rate historically


Households may be influenced to save more if real interest rates rise, which will furthercompound the headwind effect on consumption. As seen in the chart below, historically since1980, household savings rates have been very closely correlated with real interest rates. Therecent few years may be the only clear exception where savings rates showed major volatilitydespite declining real interest rates, which is likely explained by a more conservative outlookfollowing the financial crisis.

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Chart 17: Historically investment has positively correlated with interest ratemovements


In previous periods of rate movements, we have seen that private investment growth hashistorically positively correlated with the benchmark rate, indicating that economic fundamentalsare a better predictor of investment than the benchmark interest rate, as rates are typically hikedin times where fundamentals are strong and vice versa. A downside risk would be a situationwhere the US economy is dragged by contagion and headwinds from monetary policynormalization further hurt sentiment, which may lead to the opposite effect of a drop ofinvestment.

Chart 18: Home sales on recovering trend, but still belowpre-bubble levels

Chart 19: Improving confidence has led to an increase ofhousing starts in 2014, may pick up further in 2015


On residential investment, recent improvement in the housing market has increased thelikelihood of further upward momentum of residential investment. As seen from the chartsabove, recent housing market data including the National Association of Home Builders (NAHB)

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confidence index and housing starts and sales data, the recovery of the housing market is on anupward trajectory and this has translated into a higher number of housing starts in 2014, though

the pace of improvement remains gradual. With that said, we expect that a series of rate hikesand the subsequent impact on mortgages will act as a headwind on the housing market, andlimit residential investment growth to modest levels.

Non -residential investment should continue on an upward trend, and may gain some steam in2015. One major reason is that as companies have put off replenishing capital stock over thepast several years, and a combination of necessity and improved confidence should lead toadditional investment.

Overall, investment growth should continue to edge up and contribute to growth, but thepace is likely to be modest.

1.5 Net exports may drag growth slightly amid stronger dollar and weak external outlook

Trade is a less significant driver of growth compared to consumption and investment in the US,as the US persistently runs a current account deficit as a net importing country. We view severalkey points to note regarding trade.

While global activity is likely to improve overall in 2015, there are likely some continuedheadwinds for global trade for the US. Outside of continental North America, the othermajor export destinations for the US such as the EU, China, ASEAN, and Japan are notlikely to see a significant bump in domestic demand in 2015, meaning in turn it is unlikelythat demand for US exports will rise significantly.

The USD may appreciate further in 2015, which would also impact the competitiveness ofUS exports, acting as a further drag on exports. We expect net exports as a whole toslightly drag GDP growth in 2015.

In contrast, the recent shale gas development has vastly decreased US energy imports,and in terms of trade structure may decrease the import burden of the US economy.

Chart 20: US trade deficit widened in 2014, stillsignificant

Chart 21: US export breakdown by region (2014 ytd)


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1.6 Key risks in 2015 remain tied to monetary policy and external environment

There are also some notable downside risks, mostly from potential contagion impacting tradeand financial markets. The Fed and the IMF warn that risks have not been adequately priced inby the financial markets, and there is a risk of some correction if sentiment sours, similar to howthe Eurozone sentiment abruptly turned in 2H14.

We view that risks associated with monetary policy may escalate in 2015. US QE tapering, oneof the biggest perceived risks of the year, was carried out without much difficulty, concludingasset purchases in October on schedule. However, while QE tapering was tightening in thesense of reducing the pace of easing, in absolute terms the Fed was still injecting money intothe financial system as asset purchases continued.

2015 will mark the first real tightening with the first benchmark interest rate hike since 2006,and ending an era of near zero interest rates. We view a rate hike will have a larger impact on

financial markets than on the real economy of the US.Historically, we have observed brief periods of stock market downturns after a rate hike, but theimprovement of economic fundamentals usually outweighed the impact of a rate hike and thehistorical correlation is actually positive rather than negative. Given the current unique situationof divergent monetary policy direction from the major central banks, the downside risk may bebigger than it was in the past. With that said, we believe the improving economic fundamentalsof the US will limit the downside risk.

Chart 22: S&P 500 historical performance vs benchmark rate


US treasuries historically closely tracked the benchmark rate, but in the latest era of near zerointerest rates, the government bond yield has begun to move with QE instead. As a series ofrate hikes begins, we expect bond yields (particularly the 2 year bond yield) may move closelywith the rate, but any escalation of risk may push yields down as safe haven flows are likely toflow to the US first and foremost. .

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Chart 23: Treasury yields have correlated strongly with the benchmark ratehistorically, with 2 year yield most sensitive


Another concern for the US is if a slowdown of other economies will have a spillover effect onUS growth. While from the perspective of economic fundamentals the US looks to gainmomentum in 2015, it is possible a general downturn of sentiment globally may also createheadwinds on growth. At the moment, the Fed does not view possible contagion as a major

threat; FOMC minutes acknowledged a weaker external outlook, but viewed external situationimpact on domestic economy to be quite limited .

A special point to note in the US case may be potential downside risks stemming from therecent decline in crude oil prices. Historically, a downward dip of crude oil prices would be awelcomed trend for an energy importing country such as the US, but now presents some risks.One factor which has been big in the recent US resurgence has been the shale gas industry,and more affordability of crude oil may impact the shale gas industrys competitiveness; ifshales price competitiveness is diminished, it could reduce the viability of the industry and lowerinvestment which previously contributed to the US recovery.

Separately, according to meteorologists, initial signs of another polar vortex in 2015 leading to a

colder winter have emerged. 1Q14 growth was heavily dragged by the polar vortex, as anunusually harsh winter led to less consumption and construction activity. If this factor emergesagain in 2015, 1Q15 growth may once again start off sluggish.

1.7 Conclusion

Though economic fundamentals look to be strengthening, downside risks to the scenario bothtied to domestic policy normalization and external headwinds remain a consideration. At this

juncture, we cannot confidently say the US has fully reached escape velocity yet, but amoderate recovery is in progress, and we expect it to continue in the next several years.

We reiterate that of the developed economies, we view the US most favorably, as recoveringlabor and housing markets as well as still accommodative (if turning toward tightening)monetary and fiscal policy should combine to buoy growth further. Our 2015 GDP growthforecast is 2.9% YoY.

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Chart 24: US Macroeconomic Forecast Table


% 2008 2009 2010 2011 2012 2013 2014F 2015F

GDP -0.3 -2.8 2.5 1.6 2.3 2.2 2.3 2.9

CPI 3.9 -0.4 1.6 3.2 2.1 1.5 1.7 1.8

Unemployment 5.8 9.3 9.6 8.9 8.1 7.4 5.8 5.6

Current Account / GDP -4.7 -2.6 -3.0 -3.0 -2.9 -2.4 -2.4 -2.3


Policy rate 0.25 0.25 0.25 0.25 0.25 0.25 0.25 1.00

DXY 81.3 77.9 79.0 80.1 79.8 80.0 88.5 93.0


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2. Eurozone recovery to remain lukewarm, with rising downside risks

The Eurozone economy disappointed the markets lofty expectations in 2014, but is still set tofinish the year with weakly positive YoY growth, particularly after a weak 2Q14 was revisedupward and a 3Q14 GDP slightly exceeded market forecasts.

Chart 25: Eurozone GDP growth returned to positive YoY growth in 2014, ytdperformance in line with our forecast


As we saw during the year, the market consensus forecasts were repeatedly revised downwarduntil roughly in line with our start of the year forecast. The main reason was both domestic andexternal demand failed to live up to lofty expectations. Within the Eurozone itself, theemergence of deflation as a significant threat has dragged consumption via inflationexpectations. Externally, initial projections were overly optimistic, as US growth was dragged bya weaker than expected 1Q14, and as Japans recovery momentum faded following theconsumption tax hike.

A weak and uneven recovery should still continue in the Eurozone, mostly reflecting a gradualrecovery in Spain and the periphery countries and continuing relative outperformance ofGermany. Several countries have also shown signs of improvement from the austerity process

which heavily drained growth in 2012, and as structural reforms have improved thecompetitiveness of various European economies.

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Chart 26: Germany moderated in 2014, but remains thekey driver of Eurozone growth

Chart 27: Spain showed signs of recovery with hopes ofmaintaining growth into 2015


As seen from the charts below, France and Italy have both grown at low levels in 2014. Weemphasize that despite a rebound of Frances GDP in 3Q, this was driven by an accumulation ofinventories, while consumption and investment remained negative. The continued struggles inFrance and Italy, as well as a potential relapse of select periphery countries present potentialdownside risks.

Chart 28: France GDP surprisingly rebounded in 3Q14,but underlying data showed continual weakness

Chart 29: Italy GDP has failed to reach positive levelssince 1H11, may remain near zero moving forward


Low bank lending has been a symptom of lackluster economic activity across Europeancountries. In the region as a whole, borrowing demand is improving slowly but remains

lackluster despite very favorable conditions set up by the ECBs rate cuts and TLTRO program,and banks continue to struggle to find qualified borrowers to lend to.

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The Eurozone 3Q14 bank lending survey published at the end of October illustrated this trendclearly; the indicator measuring credit standards for loans eased -2% (marking negative net

tightening, i.e. eased credit conditions) across the Eurozone, but the improvement for loandemand has consistently undershot expectations. By country, the survey showed that borrowingdemand is slowly recovering in Germany, France, and Spain, but deteriorating further in Italy.

Chart 30: Weak lending continues to drag the economy, but signs of lendingdemand gradually recovering


Moving forward in 2015, we believe the key points to watch for in the Eurozone include:

1. Divergent performances of various Eurozone countries is likely to continue, as countriessuch as Germany and Spain may show improvement while France and Italys outlooksremain bleak.

2. Will the deflation threat remain a major threat or will deflationary pressures decline in 2015?

3. Growing possibility of full -fledged QE in 2015, what will be the impact and timing of apotential full -fledged QE?

4. Will there be a fiscal policy push to match aggressive ECB support? If so, risks forexacerbating the debt crisis may resurface down the line.

5. Risks in the region have also risen, with downside risks prevalent. Will risks topple theEurozone back into recession?

Overall, we expect growth to remain steady in the Eurozone for a GDP growth of 0.9% YoY in 2015, lower than current market expectations.

2.1 Policy direction in the EU to remain highly accommodative

Deflation emerged as a more considerable risk in 2014, as inflation dipped to just above 0 in theEurozone, with several countries already falling into deflation. Despite initially dismissingdeflation as a legitimate concern, the ECB ended up easing policy by more than expected at thestart of the year. While it still remains to be seen if the latest round of stimulus measures willboost the economy as its effects gradually emerge, policymakers have become significantlymore downbeat, downgrading present and future growth forecasts.

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The ECB has led the charge in the most recent series of policy actions to fend off deflation andboost growth, cutting rates twice in 2014, restarting a new TLTRO program, and starting asset

purchases of covered bonds and ABS in a preparatory step for full -fledged QE.Chart 31: ECB cut rates twice in 2014, including a cut topush deposit rates to negative levels

Chart 32: TLTRO program started in September


In terms of monetary policy, ECB president Mario Draghi has stated repeatedly the ECBswillingness to act to prevent deflation, and has backed up his words with action. While weexpect this willingness to continue, the ECBs remaining tools are very much limited, with thebenchmark interest rate down near the zero bound. We have also observed that some of themeasures taken so far are not overly strong; the ECB has stated it would like to return balancesheets to around 2012 levels; as of the start of November 2014, ECB balance sheets wereroughly EUR 940 bn smaller than the average level of 2012.

Chart 33: ECB targets returning monetary base to 2012levels, indicating over EUR 900 bn expansion to come

Chart 34: ABS market remains too small for ECBpurchases to provide a significant impact


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As deflationary pressures may persist with weak commodity prices dragging down headlineinflation, and weak consumption keeping core inflation low, the general market expectation is for

the ECB to eventually to start a full -fledged QE program of government asset purchases in2015, overriding German opposition. The odds for such an action have increased significantlyover the past year, as the Eurozone remains near deflation and growth remains weak. With thatsaid, we do not necessarily believe QE will solve all of the Eurozones ills, particularly givenJapans renewed struggles despite aggressive QE. We view that the impact of keeping thepossibility of QE as a potential policy support may actually be more useful thanimplementing QE itself.

With that said, we can speculate on the possible timing for QE announcements. we identifyMarch 2015 as a possible month for such a program to be forced through, as the firstmonetary policy meeting is likely to be spent debating the impact of earlier policy measures.Due to the ECBs rotating vote system, if the vote is not passed in March, July would be

the first time Germany does not have a vote in 2015. If the discussions on the topic arecontentious, July may be more likely, as Germanys Bundesbank President Jens Weidmann (themost vocal dissenter against QE) does not have a vote.

The ECBs voting system is made on a rotating basis, with the central bank presidents from thelargest five countries (Germany, France, Italy, Spain, and Netherlands) in one group (1 omittedeach month), and the other Eurozone countries central bank presidents in another rotatinggroup (3 omitted each month).

Chart 35: ECB voting rights rotation will leave Germany without a vote in July


Even in the case of QE being successfully initiated, the impact on the real economy may not beoverly significant. As any potential QE program would have to be split by the size of the country(namely the contribution to the ECB), the lions share of the purchases would be in Germanyand France, which already have relatively low yields. While asset prices may climb followingQE, this may not necessarily translate to real economic growth, as seen by the Eurozonesperformance in 1H14.

2015 Group 1 country without a vote Group 2 countries without a vote

Jan Spain Belgium, Ireland, Greece

Feb France Ireland, Greece, Cyprus

Mar Italy Greece, Cyprus, Lithuania

Apr Netherlands Cyprus, Lithuania, Latvia

May Germany Lithuania, Latvia, Luxembourg

Jun Spain Latvia, Luxembourg, Malta

Jul France Luxembourg, Malta, Austria

Aug Italy Malta, Austria, Portugal

Sep Netherlands Austria, Portugal, SloveniaOct Germany Portugal, Slovenia, Slovakia

Nov Spain Slovenia, Slovakia, Finland

Dec France Slovakia, Finland, Belgium


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With that said, monetary policy will likely remain as accommodative as possible in 2015 andshould remain a support to growth. We currently expect Draghi to ultimately win the power

struggle and embark on QE, and it is possible that smaller incremental measures such asfurther LTROs to boost lending may also be taken.

The Eurozone fiscal policy outlook is complex, as fiscal policy remains fragmented in lieu of afiscal union. Currently, the ECB, IMF, and various bodies are calling for increased fiscal policysupport from countries with the capacity to do so, with Germany as the most obvious and mostsignificant choice. We view that the fiscal drag may continue to grow smaller as the fiscalconsolidation processes ease.

Chart 36: Debt to GDP ratio remains at elevated levels, still rising overall in region


With that said, the governments with room to elevate spending are also those who were morefiscally responsible and less likely to engage any in stimulus spending. Given government debtlevels remain very escalated and given the debt crisis is still fresh in the minds of policymakers,it is unlikely we will see a significant fiscal push in 2015.

On the policy side, Eurozone policy should remain supportive for growth. We expectsignificant support from monetary policy to continue with odds of QE increasing, and forthe fiscal drag to be diminished further in 2015.

2.2 Euro may weaken further, with potential capital outflow from the region in 2015

In terms of the Euro, after persisting at high levels at the start of the year, the Euro declinedstarting in 2Q14 as economic data persistently underperformed expectations and sentimentexperienced a downturn after early optimism.

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Chart 37: Euro fell against the USD and GBP starting in2Q as sentiment soured

Chart 38: Euro down significantly against most majorcurrencies in the year to date (as of Nov 27)


We expect a continued depreciation of the Euro in 2015, primarily reflecting several keyreasons:

Disparity of economic fundamentals may widen in 2015 as the US recovery may

accelerate at a faster pace than the Eurozones. Existing ECB measures such as the ABS/covered bond purchase program, the TLTRO

program will continue to expand the ECB balance sheet, and there is also an increasingpossibility for additional easing such as QE in the Eurozone.

The US is very likely to hike rates in 2015, further widening the monetary policy divergenceand strengthening the dollar vs the euro. It is quite likely there will be a series of rate hikes.

The depreciation of the Euro and very cheap borrowing costs may also lead to some carrytrade from Europe, though Japan may remain a more favorable environment to conductcarry trade.

With that said, we do not expect the pace to be as rapid as in 2014, as many of these factorsshould have already been priced in. Our expectation is for the EURUSD to dip further to 1.15 in2015.

2.3 Limited upside potential for recovery of Eurozone domestic demand amid continued job market weakness

In the long term, revitalizing domestic demand is essential if the Eurozone is to fully recover itsgrowth. Consumption in the Eurozone has taken a battering due to a combination of austerity, aweak job market and labor reforms, as well as a heavy downturn of sentiment. Most recently,deflationary concerns have become another factor dragging consumption. We expect inflationto remain at low levels in 2015, which may trigger continued pressure on the ECB topush out QE.

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Chart 39: Eurozone retail sales growth showedconsumption picture remained downbeat

Chart 40: Eurozone hovering near deflation in 2014,pressure may ease slightly in 2015


On a YoY basis, we saw that Eurozone retail sales had indeed picked up in 2014, illustratingthat the turning point had been crossed and a weak recovery is in progress. Consumersentiment skyrocketed in 1H14, returning to near pre -crisis levels as strength in the financial

markets as well as real economy buoyed sentiment. With that said, the level of improvement foractual consumption was less than what many had hoped for previously; sentiment had run toofar ahead of actual performance, and moderated sharply in the middle of the year.

Chart 41: Eurozone consumer sentiment surged before falling sharply mid-year


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Deflation pressure will also drag investment, as companies are more likely to hold on to cash ifthey anticipate deflation. With the ECB still struggling to prevent deflation (and as various

periphery countries are already in deflation), this is likely to remain an issue in 2015. Additionally, the downturn of sentiment will also weigh on investment. While it is impossible toaccurately predict how sentiment will shift in 2015 as surveys are subjective, with the exceptionof QE, there are limited upside catalysts for sentiment apparent at this stage, while variousdownside risks exist.

A less favorable base effect will further limit the YoY growth figures for gross fixed capitalformation in 2015; 2014s growth looks to be weakly positive on a YoY basis, partly skewed by2013s negative growth. This effect will phase out in the coming quarters, which may pressureYoY growth figures.

One potential support for investment growth would be increased fiscal spending; while overall

we expect fiscal consolidation to continue region -wide, governments such as Germany withrelatively healthy balance sheets and a need to upgrade infrastructure may increase investmentslightly in 2015. With that said, just several years removed from the debt crisis, countries arehighly unlikely to be aggressive with fiscal stimulus and risk a relapse.

Overall, we envision a mixed picture for Eurozone investment in 2015, but overall thepace of recovery should continue to be slow.

2.5 External demand situation should benefit from weaker Euro, but impact may bemodest as trade partners economies moderate

A combination of stronger growth in the US as well as a likely weaker Euro should provide somelevel of support for exports in 2015. Analyzing the export breakdown of the Eurozone wouldindicate that the US as the largest export destination should provide the bulk of the support forEurozone exports in 2015, particularly as the Euro is set to hover at weaker levels against thedollar in 2015 than 2014.

While there may be a positive boost from the US, any improvement in external demand from theother trade partners is likely to be limited relatively limited, particularly for countries such asJapan which are also devaluing their currencies, and for countries such as China which areexperiencing growth moderation.


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Chart 44: Mixed picture for Eurozone export destinations,as Euro weakens but geopolitical tensions threaten trade

Chart 45: Historically export growth has negativelycorrelated with strength of Euro


As an energy importing region in general, the drop in oil prices should reduce import costs. Withcrude oil prices dipping sharply and likely to remain at lower levels in 2015, we expect importcosts may decline and improve the Eurozones current account balance slightly. The overallimport breakdown of EU countries showed the imports of petroleum fuels took up approximatelya fifth of total imports.

The geopolitical tensions with Russia, as well as the current turmoil in the Middle East on theborder of Turkey may also be a potential catalyst for trade. In the case of tensions beingresolved in Russia, sanctions may be lifted, providing some relief for European agricultureexports; current Russian bans on European produce have hurt various farmers across theregion. Turkey may also represent a downside risk; if the conflict with ISIS is exacerbated in2015, regional stability may be threatened and may impact trade.

2.6 Risk outlook is balanced to the downside: deflation, reform fatigue, and geopoliticalrisks remain significant

The key risk in the Eurozone is currently deflation, with the biggest concern being the Eurozonemay fall into Japanization, a prolonged period of low to negative inflation and minimal growth.On the plus side, the ECB is cognizant of this risk and has acted aggressively to avert it;aggressive monetary policy may stave off deflation but inflation is likely to remain atrelatively low levels for the foreseeable future . On the negative side, they are running out oftools to deal with the threat. Demand remains lackluster amid stagnant wages and highunemployment, dragging price pressures downward, and inflation expectations have alsodipped.

Fiscal policy also presents a risk moving forward, policymakers may soon be forced into a lose -lose scenario. After the ECBs supportive measures are largely exhausted, Eurozoneconstituent countries face a choice of bolstering growth or continuing fiscal consolidation. Either

choice has potential risks; if countries choose to bolster growth with fiscal stimulus, they risk arelapse into the debt crisis, and if they choose fiscal consolidation they may risk returning torecession.

US18%

Switzerland8%

China10%

Russia6%Turkey

5%

Others53%

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EUR/USD, LHS Export Growth (% YoY), R HS


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Reform fatigue and stagnation is another risk. The Eurozone has been through an extendedperiod of sluggish growth from the global financial crisis, and with many families living

standards declining amid a poor job market, there is a general sense of fatigue and lesspatience for further reform bringing short term pain for long term gain. Some countries such asItaly and France have failed to even fully start this process, and a lack of structural reform(particularly in the labor market) will drag on their competitiveness. There is some risk that withimpatience, governments may choose to unravel the progress made with shortsighted policiesto boost growth or appeal to the populace. A general sense of reform fatigue would also drageconomic sentiment downward and discourage investment.

As mentioned earlier, geopolitical risks also remain a concern, primarily the situation with Russiaand Ukraine. Tensions remain elevated and there is a downside risk the situation willdeteriorate, leading to further sanctions or possibly even armed conflict. Furthermore,independence movements in Spain and Italy may provide further downside risk.

In particular, Eastern Europe may be facing additional risk in 2015. Firstly, it faces risks to bothits external trade as well as its energy supply due to the Ukraine conflict. Secondly, a possibleslowdown in Germany will also have a spillover effect on these countries, as Germany is notonly a major trade partner but also heavily invests in Eastern European countries. Thirdly, asemerging economies, Eastern Europe may be susceptible to a negative impact of capitaloutflow caused by a US rate hike.

2.7 Conclusion

In sum, the Eurozone countries are experiencing a degree of divergence, with Germanyand Spain likely to outperform France and Italy in 2015. The recovery should remainmodest, and with few positive catalysts foreseeable, risks remain balanced toward thedownside.

We forecast the region to remain in a state of weak positive growth in the baseline scenario, andexpect 2015 GDP growth to remain relatively stable at 0.9% YoY.

Chart 46: Eurozone Macroeconomic Forecast Table


% 2008 2009 2010 2011 2012 2013 2014F 2015F

GDP (% YoY) 0.4 -4.4 2.0 1.6 -0.7 -0.5 0.9 0.9

CPI inflation (% YoY) 3.3 0.3 1.6 2.7 2.5 1.5 0.5 0.8

Unemployment 7.6 9.6 10.1 10.2 11.4 12.3 11.5 11.3

Current Account / GDP -1.6 -0.2 0.0 0.1 1.4 1.5 2.3 2.5


Policy rate 2.5 1.0 1.0 1.0 0.8 0.25 0.05 0.05

EUR/USD 1.40 1.43 1.34 1.30 1.32 1.35 1.25 1.15


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3. Japans 2015 growth to edge up on aggressive stimulus and currentaccount balance improvement, but long term concerns remain serious

Japan returned to recession in 2014 as growth in the middle of the year was draggedsignificantly by the consumption tax hike in April as well as the beneficial effects from the earlierstimulus policies phasing out. Furthermore, despite an uptick of inflation created by aggressivemonetary policy, wage growth remained muted, which has further limited consumption appetite.

Chart 47: Japan slipped back into recession after the tax hike in April 2014, butshould see growth edge up in 2015


Japans growth outlook weakened as 2014 progressed and it was clear the first round ofstimulus measures had failed to produce sustainable growth. However, two major measureswere announced in 4Q14 which should bolster 2015 growth and prevent growth from slowingmuch further. The first was the aggressive expansion of monetary policy stimulus by the BoJ,and the second was the announcement the scheduled consumption tax hike from 8% to 10% inOctober 2015 would be delayed to 2017.

For 2015, we identify some major points to watch for in Japan:

1) Is Abenomics running out of time to set the Japanese economy on a sustainable long term

growth path?

2) Will the BoJ and government continue to push aggressive stimulus in 2015 or are theyrunning out of room to ease further?

3) Can policymakers successfully boost real wages on a sustainable basis?

4) Will Japans external trade situation change direction after dragging growth in 2013 and2014?

5) What impact will the delaying of the scheduled October 2015 tax hike have?

Overall, we expect growth to register at 1.1% YoY in 2015 upon a more favorable policy andtrade outlook, with growth likely peaking in the middle of the year upon the base effect.

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Japan GDP growth (% YoY) Japan GDP growth (% QoQ SAAR)

Forecast ->1Q: -1.0% YoY2Q: 2.5% YoY3Q: 1.6% YoY4Q: 1.2% YoY


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3.1 Japan policy stance likely to push for continued aggressive easing, but space forfurther support may be limited

The first two arrows of Abenomics, aggressive monetary easing and fiscal stimulus, have beenthe biggest catalysts for the Japanese economy since Abe entered office at the end of 2012.Despite some mixed results and serious questions about exacerbating long term issues,aggressive supportive policy has been useful in boosting financial markets and growth in theshort run. The aggressive stimulus has kept Abe in office for the longest tenure of any Japaneseprime minister since Junichiro Koizumi (April 2001 -September 2006).

Regarding monetary policy, the BoJs policy will remain accommodative but is likely to be lessaggressive in 2015, after further expanding its stimulus earlier than expected on October 31 st .Currently, the BoJ is set to expand the monetary base by JPY 80 tn per year, as well aspurchasing JPY 80 tn of government bonds, JPY 3 tn of Japanese ETFs, and JPY 90 bn ofJapanese REITs per annum. The most recent voting breakdown showed division within the BoJcommittee, with 5 votes for and 4 votes against the measures, indicating there is some internalresistance to further stimulus building. Consequently, the possibility for further aggressive policyexpansion has diminished in 2015; but we view that if circumstances dictate it is necessary, theBoJ will continue to act aggressively.

In terms of fiscal policy, the biggest consideration is the delay of the scheduled consumption taxhike. At this juncture, after 3Q14 GDP significantly disappointed market forecasts, as publicsentiment turned against the tax hike, and as Abes approval ratings dipped, the Japanesegovernment chose to delay the unpopular but necessary tax hike until April 2017. This willimprove 2015s growth outlook, but exacerbate long term fiscal problems.

Though the odds of massive fiscal stimulus declined after the delaying of the tax hike, there still

may be further fiscal stimulus packages to provide further support to the economy if necessary. As the government delayed the sales tax hike, we expect a stimulus package smaller than theJPY 5.5 tn fiscal stimulus implemented in 2014, with a JPY 2.5 -4 tn range possible. It is alsopossible that there will be increased public investment on infrastructure as we draw closer to the2020 Olympics.

Regarding the third Abenomics arrow of structural reform, 2014 confirmed our negative bias.Despite some measures such as increasing the quota for foreign workers, there was littleprogress in achieving meaningful structural reform in other areas. With Abe seemingly mostlyfocused on his own re -election and political goals, he appears willing to put off fiscalconsolidation to boost short term growth and his own approval ratings at the expense of longterm fiscal sustainability.

Abes goal to mitigate the government debt situation by increasing tax revenues via revitalizingthe economy will be a difficult challenge, as debt grows faster while growth has yet to pick upon a sustainable basis.

3.2 Consumption will remain subdued unless real wage growth rises substantively

The main reason consumption remains downbeat is that real household income remained tooweak to drive growth. A gradual relaxation of immigration policy for professionals in December2013 also increased the supply of cheaper foreign labor, further dragging overall wage levels.Despite Japanese companies reporting favorable earnings, this has not translated to any

significant increases of wages, and the economy has not entered a virtuous cycle.


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