Fixed Income in the Euro Zone

11 October 2014 Fixed Income in the Euro Zone The quarterly fixed income newsletter of Allianz Global Investors Editorial A pall suddenly descended on the economic and financial environment recently, triggering sharp adjustments in all asset classes. In the wake of the mid-october capitulation it is worth asking: where do we go from here? FRANCK DIXMIER CIO FIXED INCOME EUROPE The reversion of volatility somewhat closer to its historical mean is no surprise. All monetary policy transitions as is occurring in the United States with the end of tapering¹ generate uncertainties. But this time the confusion surrounding the Fed s² discordant communication is troubling and a source of concern. When a central bank loses its bearings, don t be surprised when investors do the same! In the euro zone, the recent avalanche of bad macroeconomic news confirmed that flat secondquarter growth was no accident but, rather, a harbinger of the significant slowdown that we saw in the third quarter, particularly in Germany. The extent of revisions of 2015 forecasts by all major economic study institutes was a surprise and confirmed the weakness of future growth. In a challenging environment, it is important to fall back on a few clear convictions: l advanced economies are slowing down; they re not collapsing; l the central banks should take control by guiding market expectations with greater clarity; l in the euro zone in particular, quantitative easing (QE) has become considerably more likely and, in any case, we will be in a low-interest-rate environment for some time to come. Against this backdrop, we are keeping our bond portfolios structurally positioned to tap into a rally that is still possible on the Bund (long on calls); in the event of a significant widening in spreads we will raise our exposures to risky assets, which, in a low-interest-rate environment and once the dust has settled, should benefit from renewed investor interest. In the meantime, expect our convictions to be put to the test by moody markets. In a storm you have to keep a tight grip on the rudder! 1 Tapering refers to the reduction of the Federal Reserve s quantitative easing, or bond buying programme. 2 Federal Reserve

Key macro trends & Investment strategy Europe: 30% Possibility of Recession in Q4 Growth momentum in the Eurozone continues to worsen particularly in Germany, where August factory orders declined more than consensus, posting a -5.7% mom drop. The Eurozone Manufacturing PMI have declined since the beginning of the year followed now also by the Service Index. In our opinion, despite the significant downward revision of consensus growth which took place in last weeks, the potential for negative surprises remains elevated. The present trend in leading indicators and hard data have increased the risk for a continuation of weak growth. We estimate the probability of Europe falling into a recession by the end of this year has now risen to 30%. European Central Bank (ECB): Announcement of new measures. On September 4 th, the ECB unexpectedly lowered the refi rate by 10 bps to 0.05%, the marging lending facility (MLF) to 0.30% and the deposit rate to -0.20% (technical adjustment). In addition, the ECB announced to start an ABS (Asset Backed Securities) and a covered bond purchase programme in October 2014. The decisions on the new measures were not unanimous. The objective is to stimulate lending and get credit flowing especially in the peripheral countries where it is urgently needed which is evident in the following chart. Stock of loans to non-financial corporations and households Source : Eurostat and Jefferies International Sept.2014 The Draghi-led ECB is much more pragmatic and willing to react than it was used to be before. The slowdown in growth as well as the low prints in inflation clearly made the ECB nervous. The worsening of the economic outlook for the Eurozone forced the ECB to introduce new measures to support the economy and fight the decrease in inflation expectations (5yr5yr forward Inflation now well below 2%). As the first round of Targeted Longer Term Refinancing Operations (TLTRO) has attracted lower than expected demand, market expectations for public sector Quantitative Easing (QE) has increased, as that seems the only way to reach the target of the prior early 2012 ECB balance sheet size (i.e. an increase of somewhere between 700bn and 1 trn Eur from current levels). Quantitative Easing a clear possibility. Mr Draghi latest comments on fiscal policies in the Eurozone may strengthen the idea of a grand bargain between ECB and the Eurozone governments that implies more support (in the form of QE) in exchange for a more decisive move into the structural reforms field; structural reforms need time, and the ECB is going to provide the time needed to implement them. The fact that ECB has explicitly mentioned the 5yr5yr forward inflation expectations, as if that was a policy target, has put the ECB somewhat in a corner; unless this measure starts to rise, the ECB 2

will be forced to deliver more actions, or risk losing its credibility. Central Bank Balance Sheets Peripheral debt should remain well supported. The take-up of the first TLTRO came in below market consensus. While still not our base case, the likelihood for QE which includes sovereign bonds has further increased. ECB s tolerance for negative inflation surprises is low data dependency. The hope for the eventual delivery of QE should keep the peripherals market supported, especially if the economic/inflation pictures should be deteriorate. Investors appear to hold overweight positions in risky assets (peripherals included), as consensus already discounts some sort of QE sooner or later. Investments banks have started to include government bond buying or Q.E. in their base-case scenarios (e.g. Barclays) if the economy deteriorates. Overall front end rates expected to remain at very low levels for an extended period. Anchoring of rates extended beyond front end. Consequently, fixed rate bonds should be preferred over floating. The Euro has fallen in anticipation of an expansion of the ECB s balance sheet. The ECB is willing to depreciate the euro, even if it is not a stated target in order to create export jobs and raise the inflation rate. The last ECB s study on the impact of EUR exchange rate on headline inflation is that a 10pp change will swing the inflation in the opposite way by about 0.5pp after two years. It is important to remember that the ECB is the only Central Bank whose balance sheet has shrunk in the past BOJ: Bank of Japan - PBOC: People s Bank of China Source : AllianzGI Bloomberg, 09/2014 2 years (see chart below) which contributed to a rise in the Euro (decrease in supply of Euros). USA: Timing of Federal Reserve (FED) Rate Hikes Dependent upon Labor Market & Wages The most recent Fed Minutes were dovish which is in contrast with the hawkish dot-charts. Qualitative forward guidance remains unchanged, with no urgency to start hiking rates. The attention of market participants has shifted to the timing of an initial rate hike. In our view, the Federal Open Market Committee (FOMC) risks to overestimate the slack in the labour market and underestimates the outlook for inflation. Real wage growth will most probably become the focus of market participants regarding the timing of a first rate hike. We believe the risk is tilted towards an earlier tightening in Q2 2015 vs. current market expectations for the second half of 2015. The front end of the US yield curve is vulnerable as USD Libor rates should edge higher. The September US Non-Farm Payrolls report proved to be solid in all components apart from Average Hourly earnings that remain capped at 2% yoy growth. Nonfarm payroll (NFP) increased +248k with an upward Aug. revision of +38k. The Unemployment rate declined to 5.9% vs. 6.1% posted in August. These numbers confirm that the labor market in the U.S. remains in good shape even if some structural weaknesses such as low earnings growth and a low participation rate show no signs of reversing. We have debated how and if the unemployment rate level decline will trigger a Fed active response as the Non-Accelerating Inflation Rate of Unemployment (NAIRU) estimate is believed to be between 5.2%-5.5%. We believe that the lack of wage growth will cause the Fed to maintain a dovish stance but that the Fed will nonetheless hike rates earlier than current market consensus. Why? Historically, the Fed typically started to tighten monetary policy long before full employment levels were reached. 3

Japan and Emerging Markets: Risks Remain Elevated The Chinese economy appears to have lost momentum in August as industrial output weakened since the global financial crisis to a five year low. Industrial profits in the first eight months of the year slowed to a 10% increase from 11.7% in the first seven months. Weak demand and falling factory prices were among the main drivers. So far, the government is reluctant to implement new easing measures but may be forced to in order to maintain the 7.5% growth target. In Japan, the Bank of Japan kept its monetary policy unchanged at the October meeting, in line with market expectations and downgrading its assessment on Industrial Production, but maintaining a moderate positive outlook concerning future path of the economy. We believe that risk for negative surprises in Japan and emerging markets remains elevated. Credit: The summer High Yield sell-off appeared to be high valuation meeting a confluence of risk-off circumstances: significant outflows from the US High Yield (more benign in Europe), Geopolitics (Russia-Ukraine crisis, Middle-East ), increase in idiosyncratic risk (Argentina, BES ). Regarding high quality credit, inflows remained however steady and very robust in Investment Grade space. Within this environment of ultra-low yields, the credit market is still attractive relative to other fixed income asset classes. Investors just realized over the past few weeks that the illusion of unlimited and infinite liquidity may come to an end (tapering talk and wondering about the FED turning more hawkish ). Macro and micro fundamental factors are back on stage and should progressively play a bigger part as a valuation component. Over the coming quarter, the market should navigate with caution between the accommodative stance from the ECB and a more aggressive FED. In so far as our strategy is concerned, we remain constructive within this low yield/low volatility environment and pay attention to liquidity. We stick to quality, rely on our disciplined investment process to pick the optimal risk/return opportunities in the market and preserve the carry. The year-end total return expectation of 5 to 6% is still in sight. Euro High Yield Year-to-Date Performance (Total Return January-September 2014 in price) Message: Quality pays-off higher quality BB-rated issuers outperform significantly the lowest-rated issuers (CCC and below) Despite Investment Grade corporate bond spreads being optically low, they are still higher than the pre-crisis level prior to 2008 Source : AllianzGI Bloomberg, 09/2014 4 Source : AllianzGI - Bloomberg - Sept.2014

FX 1 Views The dovish ECB surprise in September, together with the monetary easing decisions at the June meeting are EUR-negative. Recent remarks from Draghi at Jackson Hole suggest that further easing cannot be ruled out. While we acknowledge the solid fundamentals of the EURO, namely the positive balance of payments, we remain convinced, that the focus will remain on monetary policy divergence. The Fed/ECB divide will become dominant into 2015 and the current account won t matter once the Fed starts raising rates. The technical picture deteriorated recently, as EUR/USD made new lows of the year. We continue to expect a grind lower of the EUR (towards 1.25 this year and 1.20 next), but not a sharp fall, unless the ECB goes for outright sovereign QE. The strengthening of the lower for longer case in Europe makes the EUR attractive as a funder for carry trades. Longer-term we still expect a stronger USD against most G10 currencies, due to a relative growth advantage, monetary policy, improving current account, attractive valuation. EUR/USD: Monetary policy divergence argues for further EUR/USD weakness Source : AllianzGI - Bloomberg - Oct.2014 JPY 2 : We remain bearish The JPY weakened sharply over the last two months (-6% vs. USD), mainly due to: l expectations of a more hawkish Fed, and a USD positive increase in short-term interest rate differentials l Rising Japanese appetite for offshore assets. We remain bearish on the JPY, due to the very loose monetary policy and a wider Japanese trade deficit. As soon as US front-end yields move higher, USD/JPY will rise further. Bank of Japan (BoJ) Governor Kuroda mentioned the possibility of additional Quantitative and Qualitative Easing (QQE), which contrasts the Fed exiting QE in October. GBP 3 to strengthen further l Sterling benefits from the notion that the BoE will probably be the first G4 central bank to hike rates. We expect further GBP strength as a function of the relative growth advantage especially compared to the Eurozone. This economic strength will likely support capital inflows, which would offset the large current account deficit. 1 Forex 2 Japanese Yen 3 British Pound 5

Glossary Breakeven: See inflation expectations. Bund: German Treasury bond. Unless otherwise indicated, with a residual life of 10 years. Covered bond: A bond issued by a bank and this is backed by collateral, or a guarantee, most often mortgage loans. Duration: Average life span of a bond or a bond portfolio, including all related flows, i.e., coupons and partial or full repayments. The more a 10-year bond pays out high coupons and makes partial repayments, the shorter its duration. The lower its coupons and the closer its repayments are to maturity, the longer, or higher, its duration. Eonia (Euro OverNight Interest Average): Average euro zone overnight (see this term) money-market rate. Euribor: Benchmark money-market rate for terms ranging from one week to two years. Haircut: A haircut is a percentage that is subtracted from the market value of an asset that is being used as collateral. The size of the haircut reflects the perceived risk associated with holding the asset. Inflation expectation: This is the spread between the bond market yield on a certain duration and the real rate (ex-inflation) as results from the market value of a bond linked to inflation of the same duration. Inflation-linked bond: Bond whose principal is indexed regularly to inflation of the issuing country or the euro zone. The remuneration rate, which is based on the principle plus inflation, therefore offers a real remuneration (ex-inflation). Investment approach: In each region (US, euro zone, and emerging markets) we review the following variables over the medium and long term: growth potential, inflation risk, monetary policy, long bond yield potential, and risk appetite. Money market: Cash market. Banks place their short-term cash on this market or go to it to borrow the funds they need on a short-term basis. See also Eonia, Euribor, overnight rate. Overnight rate: Refers to a 24-hour loan that may be rolled over indefinitely. OAT: French Treasury bond. Unless otherwise indicated, with a residual life of 10 years. Spread: The difference in yield between two bonds with the same maturity, with the former often offering greater risk than the latter. Treasuries: US Treasury bonds. Unless otherwise indicated, with a residual life of 10 years. Variable: See investment approach. All data provided in this document come from the following sources: Datastream, Reuters, Boursorama. The variation listed are calculated from one month to the other. It concerns the indexes established by assessment organism commonly recognized unless stated otherwise (INSEE, IFO - Institut für Wirtschaftsforschung, ZEW - Zentrum für wirtschaftsforschung, GFK - Gesellschaft für Konsumforschung, etc.). The weekly variations of equity indices, the 10-year rate and the exchange rates mentioned in this article are computed or recorded on the last business day of the previous week. 6 Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Bond prices will normally decline as interest rates rise. The impact may be greater with longer duration bonds. High-yield or junk bonds have lower credit ratings and involve a greater risk to principal. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. 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