EUROPE AND GERMANY NEWSLETTER

Mar. 20, 2015

Aureliano Gentilini Head of Research

“The progress of rivers to the ocean is not so rapid as that of man to error.”

– Voltaire (1694-1778)

EUROPE AND GERMANY NEWSLETTER

WHILE A GOLDILOCK ECONOMY ON THE OTHER SIDE OF THE ATLANTIC CELEBRATES A DOVISH MONETARY GUIDANCE BY THE FED, EUROPEAN MARKETS RALLY, FUELED BY ABUNDANT LIQUIDITY ECB ACTION.

Markets shrugged off early concerns that the US

Fed might tighten too much too quick, redirecting

on an upward trajectory. Traders now bid up a

58% probability that the Fed will increase interest

rates in October. Chances of a September increase

dropped to 38% from 61% prior to the meeting.

» While markets celebrate a cautious stance in the Fed monetary guidance, creeping risks of a prolonged standoff between the European Union (EU) and Greece mount. It was only one month ago that the Greek government secured a four-month extension of an EU bailout loan (the "Master Financial Assistance Facility Agreement"). Greece is running out of cash and needs an injection of fresh money to avoid bankruptcy. Late-night crisis talks on Thursday appeared to mutually reconcile diverging opinions between the Greek Prime Minister and EU creditors on budget measures and economic reforms required to unlock cash. EU institutions released a statement early Friday stating: “Within the framework of the Eurogroup agreement of 20 February 2015, the Greek authorities will have the ownership of the reforms and will present a full list of specific reforms in the next days.” Should the standoff between the EU and Greece prolong with adverse outcomes, volatility spikes might be observed in the markets. On the other hand, Mr. Draghi has already clarified, and he is expected to stress again that Greece cannot rely on the ECB to raise a limit on the issuance of short-term debt. Given Greece is expected to run out of cash by the end of March, one funding option would be to raise a 15-billion-euro cap on issuance of Greek short-term debt. The cap has already been reached, and the ECB has a

veto over raising it. ECB is concerned that the Greek banking system will indirectly finance short-term government needs, ramping up purchases of T-bill as they get access central bank funding via T-bill purchased on a previous instance. Worrying signs about lack of confidence in the outlook of financial institutions and the broader country perspectives mount among Greek bank depositors. Similarly to what happened with Cyprus, should financial stress worsen due to an average daily loss of EUR400 mln in bank deposits, Greece might consider introducing capital controls to limit cash withdrawals. » The ECB system massive purchase program is expected to continue creating distortion in the debt market. Subdued inflation projections and negative interest rates in the short- to medium-end segments of the Eurozone government benchmark yield curve continue to drive demand for longer-dated bonds. In the Mar. 18 auction, Germany sold EUR3.298 bln 10-year Bund at a record low average yield of 0.25%, with a bid-to-cover ratio of 2.4. At the previous 10-year auction in February, the bid-to-cover ratio was lower at 1.4, and the auction was priced at an average yield of 0.37%. On March 20 at 1:00 pm CET, yields on 10-year Bund stood at 0.189%. Also, as government bond yields grip on the entire term structure, the hunt for yield can break the traditional risk aversion thresholds for more conservative categories of investors. » Fueled by the ECB asset purchase program, risky assets continue to edge higher. European stocks climbed to fresh multi-year record highs on Thursday Mar. 19 and are poised to trend higher. The STOXX Europe 600, the EURO STOXX 50, and the DAX 30 returned 2.20%, 1.99%, and 4.37%, respectively, month to date at Mar. 19 close. In particular, the STOXX Europe 600 closed up 0.55% at 400.83 points on Mar. 19, just five notches below its all-time high recorded on Mar. 6, 2000 at 405.495 points. Interest-rate sensitive sectors of the STOXX Europe 600, such as financials

EUROPE AND GERMANY NEWSLETTER

(+0.98%) and consumer services (+1.08%) gained in the trading session following the FOMC statement. At the same time, more defensive sectors, such as Utilities (+1.64%) and Health Care (+1.85%) posted healthy returns as anticipated changes in the economy and interest rates are expected to have a muted impact on the revenue and earnings of companies within the sectors. The STOXX Europe 600 Oil and Gas Sector Index came in stronger (+2.87%) as crude oil rallied. The DAX eased from the all-time record high posted on Mar. 16, 2015 at 12,167.72 as profit taking drivers took a toll after think tank ZEW published its monthly survey of economic sentiment, which showed an increase to 54.8 in March from 53.0 in February. Nonetheless, the reading was below a Reuters consensus forecast of 58.2. The reading pointed to the fact that a lack of progress in the Greek debt standoff and Ukraine crisis was dampening market sentiment. A separate gauge of current economic conditions for Germany climbed to 55.1 from 45.5 in February, exceeding a consensus forecast of 50.0. March’s reading was the highest since July 2014. » At the same time, market sentiment regarding economic expectations for the Eurozone showed signs of improvement, fueled by ECB asset purchase program. ZEW's indicator of economic sentiment for the Eurozone surged 9.7 points in March to a reading of 62.4, after posting 52.7 in February. February marked the highest reading since June last year. Also, increasing 11.8 points in March, the indicator for the current situation in the Eurozone has reached a value of minus 36.6 points, up from minus 48.4 in February. » In the FX market, the US dollar almost pared down the sharp 2.53% decline recorded against the euro on the day of the FOMC statement. At Mar. 19 close, after trading above USD1.09 during the session, the euro ended at USD1.0659, 1.90% below the previous day reading. We expect the euro to head toward the parity level against the US dollar last seen in November 2002 as the ECB system

keeps buying significant amount of bonds on a daily basis and the Greek debt standoff appears far from being resolved in full. The Norwegian crown gained 2.82% on Mar. 19 against the euro, its biggest daily appreciation since Oct. 23, 2008, after Norway's central bank kept interest rates on hold, countering market expectations of a rate cut. Norway’s central bank maintained its 2015 outlook unchanged, stating that crude oil glut has had only a modest impact on the economy, while house prices have continued to trend higher. It appears that the economic downturn that last December’s rate cut was aimed at preventing is far from materializing. The Swiss franc appreciated 0.71% against the euro on March 19 as Switzerland's central bank maintained unchanged its negative interest rate of 0.75% for some cash deposits and its target range for three-month interbank rates at -1.25% to -0.25%. On the same day, the U.S. dollar rose 1.20% against the Swiss franc to 0.9899 franc, after depreciating 2.78% on the day of the FOMC statement. Swiss exports declined 3.1% on a working days adjusted basis in February. Sales of drugs and pharmaceutical ingredients, machinery and electronic equipment were impacted significantly by Switzerland’s central bank decision to abandon the cap against the euro earlier in January. At the same time, the Swiss National Bank cut its economic growth forecast for the current year to +0.9% and +1.8% for 2016, from previous +2.1% and +2.4% estimates, respectively. Also, consumer prices are forecast to decline 1.0% for 2015 and start rising again by 0.3% in 2016. Previous forecasts for Swiss inflation were at +0.2% for the current year and +0.4% for 2016. The pound sterling posted significant losses (-1.53%) against the US dollar on Mar. 19 as investors pushed back expectations of an interest rate hike sometime in mid-2016, from previous anticipations of an interest rate increase in early 2016. The FX market factored in revised expectations following the publication of the

EUROPE AND GERMANY NEWSLETTER

minutes of latest meeting of Bank of England's monetary policy committee, in which members flagged the impact of a strengthening pound on inflation. » Banks loaded up more than twice the amount of ‘TLTRO’ (Targeted long term refinancing operation) from the ECB on Mar. 19. Banks took EUR97.848 bln of ‘TLTRO’. Higher-than-expected bids appear to suggest a growing appetite to lend, although historical evidence shows that in the past, increased money supply remained locked in the financial sector without flowing to the real economy. It should be seen whether the high take-up will rather be used to pursue carry trade strategies, as banks use cheap funding to buy government benchmarks and lock in profits. Italian banks, in particular, which are burdened by EUR186 bln of bad loans, might have taken about 34% of the ‘TLTRO’ overall amount. » Recent data point to a healthy labor market in Germany. The number of employees in manufacturing increased by 1.2% (or 61,000 persons ) year on year at the end of Jan. 2015. The number of hours worked in Jan. 2015 decreased 3.4% from a year earlier, reaching 674 million, although it should be taken into account that there was one working day less than in Jan. 2014. Earnings rose 3.0% year on year in Jan. 2015, corresponding to an overall amount of EUR20.5 bln. At the same time, labor costs per hour worked in the industry and the service sectors rose by 1.7% year on year in 2014 on a calendar adjusted basis. Compared with the same quarter a year earlier, labor costs in the fourth quarter of 2014 increased by 2.0% in calendar adjusted terms. Quarter on quarter, the seasonally and calendar adjusted increase was 1.0%. » Labor costs readings for the European region show a mixed scenario.

In the Eurozone, labor costs for the fourth quarter of 2014 rose 1.1% compared with the same quarter a year earlier. For the same quarter, in the broader European Union (EU28), the rise in labor costs amounted to 1.4% year on year. In the third quarter of 2014, hourly labor costs increased by 1.4% in the Eurozone and by 1.5% in the EU28. In the fourth quarter of 2014, the largest annual increases in hourly labor costs for the whole economy were observed in Romania (+7.9%), Estonia (+6.5%), Latvia (+6.1%), Lithuania (+5.7%) and Slovakia (+5.1%). Conversely, decreases were registered in Portugal (-8.8%), Cyprus (-2.2%), Croatia (-0.5%), Italy (-0.3%) and Ireland (-0.1%).

LIGHT AND SHADOWS – DAX CONSTITUENTS

» HeidelbergCement strives for significant improvements in sales, operating income and adjusted net profit in 2015, in light of strong demand in its core markets, a weaker oil price and euro and efficiency measures. » BMW’s fourth-quarter results showed that the profit margin for the car division had decreased to 8.2%, from 9.2% a year earlier, despite posting a new record for sales of premium sports cars. As critical markets such as China are expected to lose momentum, the company confirmed its commitment to put greater emphasis on quality of sales and profits, rather that absolute volumes. Such strategy should pay off in the long run, according to the company. At the same time, investment spend for new technologies is seen eroding profit. BMW is investing in technologies such as electric and hybrid drivetrains with the goal to cut average vehicle fleet emissions to 95 grams per kilometer in Europe by 2021, from a current average of 130 grams. » Data from the Association of European Carmakers (ACEA) showed new car registrations in Europe rose

EUROPE AND GERMANY NEWSLETTER

for the 18th month in a row by 7% month on month in Feb. 2015, driven by double-digit sales growth in Italy (+13.2%), Spain (+26%), and United Kingdom (+12%). Volkswagen held the top spot in the car sales ranking, recording in February a 12.8% rise in registrations to 105,942 passenger cars. » LANXESS, the German chemicals group, unveiled additional cuts of about 140 jobs in rubber production, as it copes with harsh competition. » Lufthansa’s pilots confirmed to be on strike for the third day in a row on Friday and are expected to continue their disruption for a fourth day on Saturday, hitting long-haul flights. The strike aims to put pressure on Lufthansa’s management in a protracted dispute over early retirement benefits and cost cuts. » French media group Lagardere said it is selling its stake into Deutsche Telekom, corresponding to 2.84 million Telekom shares, for EUR45 million, with the sale taking effect in Jun. 2016. The media group has owned the shares since it sold Club Internet to T-Online International in early 2000. On a separate note, T-Mobile US Inc., controlled by Germany's Deutsche Telekom, unveiled cellular and data plans for business customers aiming to increase its penetration into a lucrative market segment long dominated by larger rivals AT&T Inc. and Verizon Communications Inc. » In the latest iteration of stress tests, called Comprehensive Capital Analysis and Review, the US Federal Reserve has rejected the capital plans of the US branch of Deutsche Bank. The test failure prevents the US branch of a given foreign bank from distributing capital to its parent company.

“THE PROGRESS OF RIVERS TO THE OCEAN IS NOT SO RAPID AS THAT OF

MAN TO ERROR.”

– Voltaire (1694-1778)

EUROPE AND GERMANY NEWSLETTER

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Mar. 20, 2015

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