ASSESSING INFLATION STATUS IN A TURNING POINT FOR CENTRAL BANKS For Professional Investors Marketing Communication PATRICK BARBE London, 2 October 2017

CONTENT Eurobond market performance Main themes concerning inflation US case analysis Growth and overall situation FED policy changes Focus on Euro situation Growth outlook ECB strategy Outlook for Euro inflation 10/11/2018

The eurobond market: remarkable resilience The ECB’s very accommodative policy has kept yields at their lowest level Index Universe Performance 2015 in % Performance 2016 Performance 2017 in % as at end August 2017 Barclays Euro Corporate EMU Corporate Bonds All Maturities -0.56 4.73 1.97 Barclays Euro Aggregate EMU Bonds Aggregate All Maturities 1.00 3.32 0.51 Barclays Euro Treasury EMU Government Bonds IG all maturities 1.65 3.23 0.08 Barclays Euro Treasury AAA EMU Government Bonds AAA All Maturities 0.36 3.99 -0.60 Eurozone main bond indices: performance Source: Barclays Capital as at end August 2017 Fading political risk (France, etc.) has led to eurobond country spread normalisation 10/11/2018

Structural inflation themes (follow-up since LED March) The structural issues weighing on inflation: It can take a long time, a decade, to recover from such a ‘once-in-a-century’ crisis: The real estate bubble burst and affected housing and financial markets as well as households and banks Reducing households’ and banks’ excess debt levels Global disinflation due to excess industrial production capacity: a globalisation issue! Pressure on margins and wages due to the ‘GAFA’* generation: the ‘uberisation’ world Ageing population in many developed countries and/or a change in consumption behaviour Wealth losses due to the crisis, impacting household confidence * GAFA = Google, Apple, Facebook and Amazon Source: Barclays Capital as at end of August 2017 10/11/2018

Synchronised global economic growth for the first time since the crisis All regions and their main countries are experiencing growth at the same time Source: Markit, BNP Paribas as at end August 2017 Red improving growth Blue declining growth 10/11/2018

Economic activity was already accelerating before the US election The US economic picture changed when the industrial soft patch ended in 2016 Step-by-step, all growth engines are contributing to increased activity in 2017: Strong trend for both job creation… … and real-estate activity Job openings reached a new high during the summer and leading indicators announced an acceleration: The real-estate sector is again a pillar of US growth: prices are back to their pre-crisis levels Source: BNPP AM, Bloomberg as at end of August 2017 Source: BNPP AM, Natixis as at end of August 2017 Economic activity was already accelerating before the US election 10/11/2018

The Trump reflation policy was so strongly expected that it became a ‘game changer’ Such a strong rebound in confidence lead to ‘animal spirits’ behaviour… boosting activity by itself Domestic companies expect a lot from Trump’s policies: capex rebound since Trump election Jump in consumer confidence: household perception of financial situation Source: Census, Haver Analytics, DB Global market Research Source: BNPP AM, Bloomberg as at end of August 2017 Such confidence can accelerate the pace of growth to a high level 10/11/2018

Thus the Fed should remove its accommodative policy Since the election, the Fed and the market have been concerned about the declining rate of inflation… This is temporary, as shown by leading indicators for wage increases: Last year’s low productivity explained low wage increases: but unable-to-be-filled positions reached a new high A key leading wage increase indicator is also back to a high level Source: BLS, Macrobond, BNP Paribas as at end June 2017 Source: Census, Haver Analytics, DB Global market Research as at end August 2017 Scale in % The Fed announced its balance sheet reduction to exit from a non-accommodative policy 10/11/2018

The new US policy for reflation is a game changer Many uncertainties remain but an asset reflation objective is clear The challenge for the new president is to get his Party’s agreement on each reform The most probable measures would be focused on a consensual Republican topic: tax reform for corporates & the middle class, to boost domestic demand Cutting taxes raises the funding issue without the revenues of the too-complex border tax on imports The repatriation tax should bring some revenues to fund a small tax cut plan A context of steady global growth implies increasing pressure on prices of goods, in turn implying a rise in the risk premium - which explains Fed cautiousness The inflation rate should start to rise smoothly as the output gap closes: Source: IMF / OECD Official figures as at end August 2017 10/11/2018

The Fed just announced its balance sheet reduction The Fed recently announced its portfolio reduction process: First three months: USD 6 billion of Treasury reimbursement non- reinvested and USD 4 billion of MBS Then every three months, the cap should be increased by USD 6 billion of Treasury reimbursement non- reinvested and USD 4 billion of MBS One year after activation, the maximum amount of Treasury reimbursement non-reinvested should be USD 30 billion, and for MBS, USD 20 billion Source: CBO, Bloomberg, BNP Paribas Asset Management as at end August 2017 This should result in the yield curve steepening at more than a bearish trend level, as long as inflation is stable 10/11/2018

Improved eurozone growth (1) Supported by: a weak currency, very low yields, the fall in commodity prices and the end of fiscal austerity…thanks primarily to household credit and consumption: Private credit is now growing in most countries except Spain, thanks to consumption Consumption rebounded as real wages increased… thanks to lower energy prices Source: Deutsche Bank, ECB, Haver Analytics / Credit consistent with DB domestic growth projections as at end March 2017 Source: Macrobond, Eurostat, BNP Paribas as at end March 2017 The ECB’s accommodative monetary policy is starting to work: it will take time to reverse the effects of the last six years, especially if energy prices or long-term yields rebound 10/11/2018

Improved eurozone growth (2) Since the start of 2017, corporates in all sectors except construction have been contributing to the acceleration in economic growth Corporate confidence is on a bullish trend thanks to the US and French elections Strong rebound in investment: at risk by the year end? GSK % Balance / diffusion index Source: BNPP AM as at end of August 2017 Source: Eurostat, Bloomberg, BNP Paribas Asset Management, Juillet 2017 Eurozone growth acceleration would be at risk should EUR/USD rise back to 1.30 10/11/2018

The ECB is focused on currency and asset prices The impact of QE on currency has ended, reducing inflation risk Real exchange rate is back to its pre QE level despite a negative deposit rate: Because of the large balance account surplus Core inflation rate should stay around 1%-1.5% Source: Bloomberg, BNP PAM as at end August 2017 Source: Bloomberg, BNP PAM, as at end August 2017 No issue for the ECB in terms of inflation: unchanged policy for 2017 and just tapering in 2018 10/11/2018

The ECB’s strategy: asset reflation QE extension to Q3 2018 to ensure protracted support for monetary policy transmission: a ‘tapering’ process due to bond scarcity but conditional upon economic data Risk of implicit tightening: currency rebound and then risk premium No key rate increase soon New rules could be implemented to be able to extend QE purchases up to 2018: More flexibility in the capital key rules, maturity band or sector allocation Its CSPP programme of EUR 5-7 billion per month supports credit market: Corporate bonds offer negative returns on short-term maturities! The ECB purchasing programme’s impact on the market should remain significant in 2018 because of bond reinvestment (EUR 10 billion a month), despite tapering: Estimated net sovereign flows for 2017 of EUR -315 billion Source: BNP Paribas CIB, as at end of December 2016 10/11/2018

The euro inflation outlook A rise toward the ECB’s target in 2018 Euro inflation market expectations are stable, at around 1.6% (5Y/5Y forward rate) Rising global growth and commodity prices should support a core CPI rate rising toward 1.5%-2% The higher level should only be reached if wages increase toward 3% So no reason for the ECB to exit its accommodative policy soon Source: BNPPAM, Bloomberg end of August 2017 10/11/2018

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