19 August 2013 Economics Research

http://www.credit-suisse.com/researchandanalytics

European Economics
Research Analysts Christel Aranda-Hassel +44 20 7888 1383 christel.aranda-hassel@credit-suisse.com Steven Bryce +44 20 7883 7360 steven.bryce@credit-suisse.com Violante Di Canossa +44 20 7883 4192 violante.dicanossa@credit-suisse.com Neville Hill +44 20 7888 1334 neville.hill@credit-suisse.com Axel Lang +44 20 7883 3738 axel.lang@credit-suisse.com Giovanni Zanni +44 20 7888 6827 giovanni.zanni@credit-suisse.com

Investing in the future

The euro area has reached an inflection point. Euro area Q2 GDP grew by 0.3%, after six quarters of recession, driven by a solid pick-up in domestic demand (private consumption in particular) in the core and an attenuation of the domestic demand recession in peripheral Europe. For once, the euro area was not a drag on global activity as also suggested by some moderation in net external trade dynamics. Investors focus may now begin turning to how the euro area could surprise to the upside. That might be premature and our central scenario is one of muted recovery in the coming quarters but optimists should look into investment dynamics, in our view. Investment, we believe, could provide a key source of upside risk. There are several reasons for this: Investment is a high beta element of the business cycle, and depends on businesses expectations of future economic activity. If these start to surprise to the upside, also thanks to the reduction of political and policy uncertainty, so could investment. Investment as a percent of GDP has fallen markedly. Based on 2013 forecasts from the European Commission, the 2008-2013 decline in investment as a percent of GDP will be higher in the euro area than in the UK or the US. Net investment is at around 2% of GDP, compared with 6.7% in the pre-08 period. This suggests very modest increases in the capital stock. Profit growth rates appear to be on the verge of recovering, and investment growth has been weaker than profit growth in the past years. Non-financial corporates In the euro area are in financial surplus, meaning that investment projects could be funded internally. In addition, the external funding cost has fallen. This could provide an incentive to undertake the marginal investment project. As usual, there are also potential downsides. Corporate indebtedness, particularly in certain euro area countries is high, so companies may want to use their financial surplus to pay down debt rather than to invest. In addition, after several consecutive negative shocks to expectations, firms may remain slow to encompass better news into their decision-making process. A fragile confidence backdrop that could be upset next year by the negotiations on the banking union credit and product & labour market rigidities could also slow down the reallocation of resources and consequently the recovery in investment expenditure. These are key concerns, and mean that we envision a steady recovery in investment and more generally in activity, rather than a rapid one. Our current forecasts for investment are -2.9%yy in 2013, and 3.7%yy in 2014 consistent with our GDP growth expectations of -0.5% this year and 1.2% next.

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19 August 2013

Steven Bryce +44 20 7883 7360 steven.bryce@credit-suisse.com Giovanni Zanni +44 20 7888 6827 giovanni.zanni@credit-suisse.com

Investing in the Future

Euro area GDP posted a slight upside surprise in Q2, growing 0.3%qq after falling a cumulative 1.5% between Q3 2011 and Q1 2013. The country breakdown was also positive. While the core countries continued to be the main growth engine, as might be expected, the peripheral economies showed that they have reached a turning point. We estimate that Greek GDP was flat on the quarter, ending 13 consecutive quarters of contraction, and Portugal posted a quarter-on-quarter growth reading of 1.1%. The larger peripheral economies while still contracting, posted smaller contractions than in previous quarters. Overall, we believe that this is consistent with the story in higher frequency data and survey indicators, namely that the euro area has reached a turning point in the business cycle, and is now on the threshold of we believe sustained expansion. As such, investor sentiment is now shifting from the question, when will the euro area economy stop contracting? to how quickly could the euro area economy expand? Our central view is that the pace of recovery will be modest. Business and consumer confidence has been severely hit, and will take time to return. In addition, deleveraging dynamics and structural changes could present a headwind to growth in the medium term. Nonetheless, we do not think all risks are on the downside and we believe there is a chance that euro area could also surprise on the upside. If we consider where the source of this upside surprise could be, investment stands out as a key candidate.

Exhibit 1: EA GDP
Index, Q1 2008 = 100

Exhibit 2: EA country dispersion, Q2 13

Growth qq%

100 99 98 97 96

1.2 1.0

0.8
0.6 0.4 0.2 0.0

95
94 08 09 10 11 12 13
Source: Credit Suisse, Eurostat

-0.2

-0.4
IT NL ES GR EA17 FR BD PT
Source: Credit Suisse, Eurostat

Compared to the other components of GDP, investment appears to be the likely source of any upside risk. On the external front, further contractions in imports (which would act to support GDP) are probably consistent with poor domestic demand not expansion. The behavior of exports in the medium term is more dependent on the international business cycle than other factors. While we believe that government spending will stop as a significant headwind to growth going forward, the scope for this to begin positively contributing to GDP is limited. Household consumption could be a source of upside surprise in some countries. However, the scope for upside risk to euro area consumption in the near term is limited. Several of the peripheral economies are likely to face substantial headwinds to consumption in the near term. While part of the rebalancing process would be for Germany to expand its level of consumption which could outweigh these headwinds from the periphery there is limited evidence that such large-scale rebalancing is under way.

European Economics

19 August 2013

This leaves investment as a potential source of upside risk, and we do see reasons to be positive on the investment outlook. Exhibit 3 shows the difference in investment as a percent of GDP between 2008 and 2013 (using EC forecasts for the full 2013 year). The fall in investment as a percent of GDP in the euro area is forecast to be larger than in the US and the UK (although in absolute level terms, the UK has been weak), and the fall in some of the peripheral economies has been particularly large.

Exhibit 3: Fall in investment

As percent of GDP, 2008 to 2013, EC forecast

Exhibit 4: In levels terms

2008 = 100, US is private GFCF

5 4

Spanish fall was 11.1%

100
95 US

UK 90
EA17

3
2 1

85

80
75

0
ES EA 17 IT UK US FR BD
Source: Credit Suisse, AMECO database

70
08 09 10 11 12 13
Source: Credit Suisse, national statistics offices

To be sure, some of these declines in investment in the peripheral economies are likely to be permanent. Spain and Ireland in particular experienced unsustainable construction bubbles, and so the level of investment as a percent of GDP in these economies is likely to be persistently lower in the future. Nonetheless, there is an argument that some of this decline could be filled by the German construction sector and more in general by stronger overall investments in that country, stimulated by exceptionally low nominal and even more real interest rates. For the euro area in aggregate, construction investment as a share of GDP appears low, even when considering long-term series (Exhibit 5) so it is unlikely to drag on an investment rebound. In addition capacity utilisation, while at a relatively low level, has begun to increase. This should therefore be a decreasing headwind to investment expansion in coming quarters.

Exhibit 5: Investment ratio as % GDP

13 12

Exhibit 6: Capacity utilization rate manufacturing

85 83

11
10 9 8 7

construction

81 79 77 75 73 Historical

non-construction 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

71 69

Whole sample series average

6
Source: Credit Suisse, AMECO, Eurostat

85 87 89 91 93 95 97 99 01 03 05 07 09 11 13
Source: Credit Suisse, European Commission

European Economics

19 August 2013

The charts in Exhibit 7 and Exhibit 8 also suggest that investment has seriously undershot in the current cycle. Net investment in the euro area is at historical lows, around 2% compared to a 6.7% historical average. This suggests that the capital stock in the euro area is hardly growing. An upward revision of firms expectations for output could stimulate investment as businessmen seek to ensure that they can reach expected new levels of demand in the future. Exhibit 8 shows annual gross investment growth in the euro area over the past 50 years. It demonstrates that growth is now at long-term lows.

Exhibit 7: Net investment

% GDP

Exhibit 8: Gross investment growth

Growth yy%, 5y moving average, euro area 12

8 7

6
4

6
5 4 Net capital formation as % GDP historical Net capital formation as % GDP forecast Average 1995 to 2007

2 0 -2

3
2 1 0 1995

1999

2003

2007

2011

2015

-4 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: Credit Suisse, AMECO

Source: Credit Suisse, AMECO

The cyclical nature of investment also means that it stands out as a candidate for an upside surprise to GDP. As Exhibit 9 shows, gross fixed capital formation has a beta with GDP, that is much higher than household consumption. In other words, as economic activity picks up, there is a risk that investment rises quickly.

Exhibit 9: Beta of expenditure component with GDP

3.0
2.5 2.0 1.5 1.0 0.5 0.0 Gment cons HH cons GFCF Imp Exp
Source: Credit Suisse, Eurostat

Exhibit 10: Change in past cycle

%

international correlation of the business cycle

-2

-7 Q1 2008 - Q2 2009 -12 Q2 2009 to Q3 2011 Q3 2011 to Q1 2013 -17

GDP
Source: Credit Suisse, Eurostat

HH cons

Gment cons

GFCF

European Economics

19 August 2013

This relationship with GDP has been broadly on the downside, rather than the upside over the past five years. Exhibit 10 shows the performance of various components of GDP during the three stages of the post-2008 economic environment in the euro area. Stage 1 (Q1 2008 to Q2 2009) is the decline in GDP that followed the financial crisis. Stage 2 (Q2 2009 to Q3 2011) is the upswing that followed. Stage 3 (Q3 2011 to Q1 2013) is the downswing associated with the euro area sovereign crisis. This chart shows that while investment has performed very negatively in the downswing elements of the cycle, it was actually rather weak during the upswing. In fact, GDP was broadly supported by net trade during the Q2 2009 to Q3 2011 period, rather than investment. If this behavior were to continue it would argue for a weaker profile for investment. Exhibit 11 and Exhibit 12 show simulations for profiles of future investment based on historical experience. These profiles show how year-on-year investment growth would look if investment followed the same approximate profile for growth following the trough in previous cycles. The dotted blue line in Exhibit 11 assumes instead that investment will return to its peak percentage GDP over the same time frame as occurred in the 2002 cycle (that is, sixteen quarters). This is much stronger than the other simulations, and would probably be consistent with a sharp rebound in business confidence.

Exhibit 11: Simulation based on previous EA

Exhibit 12: and US experience

Private US GFCF

10

10

0 Historical 2002 recovery 2010 recovery -10 Based on GFCG % GDP 2002 recovery 1980's recovery 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
Source: Credit Suisse, Eurostat

-5

-5

Historical US 2003 recovery

-10

US 2010 recovery
-15 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
Source: Credit Suisse, Eurostat

-15

While we think that gross fixed capital formation could provide some upside, we see less the case for an inventory-led cyclical rebound. As Exhibit 13 and Exhibit 14 show, the inventory cycle has not reached the level of destocking that it did during 2008-2009. As such, there is unlikely to be much rebound from the companys additional inventory demand. This provides some support for the view that the next phase of recovery in the euro area could be somewhat modest.

European Economics

19 August 2013

Exhibit 13: Inventories from the PMIs

Stocks of finished goods

Exhibit 14: Inventories from national accounts

Four month sum, bn, estimated from the national accounts

52 50

80 60 40 20
Stocks of finished goods 1998 to present average

48
46 44 42 40

-20
-40
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Source: Credit Suisse, Eurostat

Source: Credit Suisse, Markit

The behavior of investment surveys and profits are consistent with some improvement in the investment outlook, but do not yet suggest significant shortterm expansion. Exhibit 15 shows the relationship of the euro area economic sentiment indicator with investment. The sentiment indicator is now increasing, but is still consistent with negative rates of investment growth at least in year-on-year terms. Exhibit 16 shows the relationship between profit growth and investment for non-financial corporates in the euro area, along with an estimate for Q2 this year based on the GDP growth figure. Again, the profit rate is still consistent with a fall in investment. However, profit growth is on the verge of positive growth. In addition, investment has fallen much more sharply than profits in the latest downturn. This could be due to the extreme shock to business confidence. As confidence returns, in line with market and survey evidence, it is possible that investment could grow at a faster rate to fill this gap.

Exhibit 15: Investment surveys

10
110

Exhibit 16: Profits and investment

Non-financial corporates, blue square is Q2 estimate

10 5 0 -5 Profit growth yy% -10

80

5
100

0
90 EA17 GFCF, yy%, l.h.s.

-5

-10

EA17 Economic Sentiment Indicator, r.h.s. 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

-15
70
-20

Nominal GFCF growth yy%

-15
Source: Credit Suisse, European Commission, Eurostat

00 01 02 03 04 05 06 07 08 09 10 11 12 13
Source: Credit Suisse, ECB

European Economics

19 August 2013

The remaining key element is funding costs and credit availability. Credit standards have stopped tightening (Exhibit 17), meaning again that a headwind to growth in investment at the aggregate level has been reduced. Significant cross-country dispersion, especially in the case of SMEs, remains a key issue. It can be argued that some form of credit crunch is at play for small and medium-sized companies in the euro area periphery (Exhibit 18), although recent measures, such as the payment of arrears by governments and support to lending via the EIB and other special schemes should ease credit conditions for those companies as well in the coming months.

Exhibit 17: ECB bank lending survey

Standards applied by banks

Exhibit 18: Dispersion of financial conditions

Weighted percentage of responses

70 60

60 50 40 30 20

50
40 30 20 10

did not apply due to expectation of rejection received only limited amount costs too high application rejected

0
-10 -20
Source: Credit Suisse, ECB

Credit standards past three months

10 0 EA GER FRA ITA SPA IRE POR

Source: Credit Suisse, ECB

Creedit standards next three months

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Nonetheless, for those firms that do have access to credit the terms can be favourable. In the core economies funding costs are at low levels, as suggested by Exhibit 20. Such low rates should encourage firms to undertake marginal investment projects, as the required rate of return for these projects to break even is lower than it would otherwise be. In the periphery, certain rates are punitive, particularly for small firms. However, as the macroeconomic environment improves and government bond yields fall, this may help lower funding costs for corporates. Indeed, the Credit Suisse LEI index suggests that yields on the most liquid bonds of industrial companies and utilities in the periphery have fallen in the past 18 months. Again, this could support investment activity in the periphery.

Exhibit 19: Government bond rates

5 year, government bond rates

Exhibit 20: Lending rates

Interest rate on small, short-term new loans to non-financial corporates

7 6 5 4

Periphery

3
2 Core Periphery

1
0

Core
05 06 07 08 09 10 11 12 13

00

01

02 03 04

3 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Credit Suisse, ECB

Source: Credit Suisse, Thomson Reuters Datastream

European Economics

19 August 2013

Finally, firms (in aggregate) may not need to turn to external financing to fund investment for now. Exhibit 21 shows that euro area non-financial corporates are now in financial surplus, meaning that they could fund projects internally. Some of this surplus may be due to a precautionary motive, and so it is possible that firms would be willing to run a lower net surplus as economic sentiment and confidence improves. However, as Exhibit 22 shows, non-financial corporates, particularly in certain peripheral economies, are highly indebted. These firms may wish to use their financial surplus to run down debt, not to spend. Nonetheless other countries, particularly Germany, could be in a position to invest further. The German non-financial corporate financial account surplus is 3% of GDP. Overall, we see a compelling case for a rebound in investment, especially in core countries (and in Germany in particular), but also for the euro area aggregate as a whole. A rebound in investment might be the best chance for GDP to surprise on the upside, although given the points we highlighted below evidence is more consistent with expectations of a modest acceleration in investment and, more generally, in GDP growth.

Exhibit 21: Net lending/borrowing

Non-financial corporates % GDP

Exhibit 22: Distribution of debt to GDP

Non-financial corporates

2 1 0 -1 -2

200

150

100

50

-3
-4 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Source: Credit Suisse, ECB

0 GR BD IT NL EA17 FR ES PT IR
Source: Credit Suisse, ECB, Eurostat

European Economics

GLOBAL FIXED INCOME AND ECONOMIC RESEARCH

Dr. Neal Soss, Managing Director Chief Economist and Global Head of Economic Research +1 212 325 3335 neal.soss@credit-suisse.com Eric Miller, Managing Director Global Head of Fixed Income and Economic Research +1 212 538 6480 eric.miller.3@credit-suisse.com

US AND CANADA ECONOMICS

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LATIN AMERICA ECONOMICS AND STRATEGY

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Paulo Coutinho, Associate +55 11 3701-6353 paulo.coutinho@credit-suisse.com Brazil

EURO AREA AND UK ECONOMICS

Neville Hill, Managing Director Head of European Economics +44 20 7888 1334 neville.hill@credit-suisse.com Axel Lang, Associate +44 20 7883 3738 axel.lang@credit-suisse.com Christel Aranda-Hassel, Director +44 20 7888 1383 christel.aranda-hassel@credit-suisse.com Steven Bryce, Analyst +44 20 7883 7360 steven.bryce@credit-suisse.com Giovanni Zanni, Director +44 20 7888 6827 giovanni.zanni@credit-suisse.com Violante di Canossa, Vice President +44 20 7883 4192 violante.dicanossa@credit-suisse.com

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JAPAN ECONOMICS AND STRATEGY

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NON-JAPAN ASIA ECONOMICS

Dong Tao. Managing Director Head of NJA Economics +852 2101 7469 dong.tao@credit-suisse.com China Michael Wan, Analyst +65 6212 3418 michael.wan@credit-suisse.com Singapore, Philippines Robert Prior-Wandesforde, Director +65 6212 3707 robert.priorwandesforde@credit-suisse.com Regional, India, Indonesia, Australia Weishen Deng, Analyst +852 2101 7162 weishen.deng@credit-suisse.com China Christiaan Tuntono, Vice President +852 2101 7409 christiaan.tuntono@credit-suisse.com Hong Kong, Korea, Taiwan Santitarn Sathirathai, Vice President +65 6212 5675 santitarn.sathirathai@credit-suisse.com Regional, Malaysia, Thailand

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Investment principal on bonds can be eroded depending on sale price or market price. In addition, there are bonds on which investment principal can be eroded due to changes in redemption amounts. Care is required when investing in such instruments.
When you purchase non-listed Japanese fixed income securities (Japanese government bonds, Japanese municipal bonds, Japanese government guaranteed bonds, Japanese corporate bonds) from CS as a seller, you will be requested to pay the purchase price only.