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Weekly Strategy Update | 12 September 2013 – 2

increase car sales by 9% YoY, even though consumer confidence is still below average. If interest rates continued to rise, they could become a drag though.

With the labour market data firmly disappointing, the week ended on a weak note. At 169 000, the number of jobs created according to the payroll survey was below expectations. The previous two months’ data were revised lower by 74 000. In July, only 104 000 jobs were created. The average over the past six months is now 160 000, which is below the 2011 and 2012 averages. Thus, slow growth in the first half has affected the labour market. Other data were also weak. According to the household survey, employment fell. This survey can be volatile and had been strong in the previous four months. But the labour force shrank even faster, taking the unemployment rate down to 7.3%. This improvement is not for the right reason. The participation rate, the proportion of the working age population having a job or looking for one fell, to 63.2%, its lowest since 1978. This may be partly due to ageing, but there are more and more people no longer looking for jobs, on disability pay or staying at school longer.

Early this week, the NFIB index of confidence among small business owners fell unexpectedly, albeit marginally. This index has lagged the ISM index – which is tuned to large manufacturers – lately. Small business owners may be benefiting less from export growth but may also suffer more from uncertainty about fiscal policy.

The main question at the moment is what the Fed will do after all these data. We think the labour market data were not weak enough to keep the central bank from announcing the tapering of its asset purchases soon, possibly as early as after the 17-18 September policy meeting. Moreover, employment intentions in the ISM and the NFIB surveys were relatively strong and initial jobless claims have continued to fall. The drop in the unemployment rate may become a bit awkward for the

Fed. It has said it may start raising interest rates when the rate reached 6.5%, although that is a threshold, not a trigger, and it will also look at other labour market data. The Fed has said it expects to end asset purchases next summer with an unemployment rate at 7%.

So there are a few possibilities. One is that the Fed lowers its threshold, pointing to structural weakness in the labour market such as the low participation rate. Another possibility is that the participation rate stops declining. In that case, much higher job creation would be needed to lower the unemployment rate further. In fact, the rate could stabilise for a while or even rise, taking away the Fed’s problem. But that is not a given, so the most likely outcome is a modest start of tapering announced in September with some changes in the Fed’s numerical forward guidance on policy. As the September FOMC meeting will be accompanied by new economic projections and a news conference, this looks like a better option to change policy than in October. There is no meeting in November and for the Fed to wait until December, we think the labour market would have to weaken.

As for the growth outlook, the economy seems to be struggling to gain momentum so far in the third quarter, but leading indicators suggest a better second half than the first.

NO CHANGES FROM THE ECB

In the eurozone, all eyes were on the ECB last week. Improving confidence surveys seem to have taken away the need for any action by the ECB. In France, the INSEE index of producer confidence and the consumer confidence index rose in August. However, some real data have been disappointing lately.

Eurozone retail sales were up only marginally MoM in July and the YoY change actually fell deeper into

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90 92 94 96 98 00 02 04 06 08 10 12

US labour(%)

Unemployment (lhs) Particiation (rhs)Source: Datastream, BNPP IP

-22.5-15.0

-7.50.07.5

15.0

00 01 02 03 04 05 06 07 08 09 10 11 12 13

Industrial production(% YoY)

Germany France SpainSource: Datastream, BNPP IP

Weekly Strategy Update | 12 September 2013 – 3

negative territory. Industrial production was weak in July in several countries including Germany, France, the Netherlands, Ireland and Spain. In Greece and Portugal, it was not strong either. In Germany, manufacturing orders fell significantly in July due to a sharp decline in foreign orders. German exports fell unexpectedly in July. The French trade balance widened in July due to a larger increase in imports than in exports. Unemployment in France rose to 10.9% in the second quarter.

With real indicators on balance disappointing, but leading indicators pointing to improvements, the ECB did not change its monetary policy. It tried to sound dovish, pointing to a slow recovery this year and next and reiterating its forward guidance of an accommodative stance as long as necessary and its expectation that key interest rates will remain at current or lower levels for an extended period. The ECB marginally increased its growth forecast for this year to -0.4% YoY and lowered it marginally to 1.0% YoY in 2014. Risks to this outlook are to the downside, according to the ECB.

Rate cuts were discussed and could even be implemented if monetary conditions tighten, for example through rising bond yields. Another issue is the repayment of the three-year loans the ECB provided to the banking system in late 2011 and early 2012. These repayments have reduced excess reserves that banks have. At some point, lower excess reserves could lead to a rise in money market rates. Excess reserves are currently at around EUR 250 billion. In the past, ECB president Draghi has mentioned EUR 200 billion as a threshold at which market interest rates may start rising. However, Draghi now said the threshold was unclear and was between EUR 100 and 200 billion. The decline in reserves is not linear either and the pace has fallen lately. We would not rule out action by the ECB before the end of the year. We actually think that another round of long-term loans to the banking sector is more likely than a rate

cut. It would keep money market rates from rising and would address the transmission channel of monetary policy, which is still clogged in several ‘peripheral’ countries. Providing the loans at a fixed rate instead of a flexible rate as for the current loans would make them much more attractive. It would also be a sign of commitment to keep rates low for an extended period.

CHINA IMPROVING, JAPAN LOSING MOMENTUM

Data from China confirmed the economy is stabilising. Retail sales growth had slowed early this year, but improved from March onwards. In August, growth was unchanged at 12.8% YoY. Industrial production grew by 10.4%, the fastest pace since March 2012. Inflation came in at 2.6%, a notch lower than in July. Non-food inflation has been stable at around 1.5% for the past five months. Bank lending was strong in August. So far this year, it has increased at the fastest pace since 2009. This is too strong for comfort and poses a risk to future growth. The spike in interbank rates a few months ago, seen as an attempt by the authorities to lower credit growth, has not had a lasting impact. However, for now, growth looks stable, also with contributions from foreign trade.

The Japanese economy seems to be losing momentum. The Economy Watchers’ Survey – an important leading indicator – fell for the fourth straight month. Consumer confidence fell for the second month in a row. Losing momentum should not be a problem. Growth in the second quarter was revised up to 3.8% QoQ annualised after 4.1% in the first quarter. Consumption and government spending and exports have risen strongly in the first half. Business investment joined in in the second quarter. For the rest of this year, the economy could expand further. The real test could be next year when VAT may be increased, posing a risk of significant fiscal drag. But strong growth in the second half could even flatten the growth number for next year.

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Retail sales Industrial productionSource: Bloomberg, BNPP IP

Weekly Strategy Update | 12 September 2013 – 4

ASSET ALLOCATION: LONG DURATION CLOSED

Our long duration position in German Bunds was based on fundamental and more tactical factors. We still think the yield on these bonds is higher than fundamentals such as the growth and inflation outlook, monetary policy and the fiscal budget balance justify. Tactically, Bund yields struggled to stay above 1.8% for a long time. However, an improved economic outlook put upward pressure on the yield. A reduced need for investors to aim for a safe haven now that economies in the periphery have stabilised also played a role. We had thought ECB president Draghi would be more outspoken to keep yields from rising further. But as yields drifted higher after the ECB news conference, we closed the trade at a loss.

Equity markets hesitated after the weaker-than-expected US labour market report. At the margin, it lowered the chance of tapering in September. But early this week markets found the way up again after better-than-expected data from China. For US equities, the all-time highs set in early August may be a hurdle to pass. Furthermore there is uncertainty about foreign intervention in Syria, rising bond yields in the US, possible political bickering about raising the US debt ceiling and the sequester, while equity valuations in the US are relatively high. We underweight US equities, but globally, we are neutral on equities as the growth outlook has improved and we still see monetary policy and global liquidity as positive. Our overweight in Europe and emerging markets is strongly driven by attractive valuations. In Europe, we have become more positive on the growth outlook. We think the negative sentiment towards emerging markets is overdone. Economic growth is hovering at around 4.5% and the growth gap with developed economies is close to its long-term average. The earnings outlook is improving. So far in September, emerging equities have continued to outperform developed equities.

Within bonds, we prefer hard-currency emerging market debt, especially in the context of our overweight in emerging market equities, which gives us an effective overweight in emerging currencies.

We are underweight European investment-grade corporate bonds. We think downgrades by the rating agencies, tight lending conditions among banks and relatively high valuations are all downward risks. We think the currently low yields do not sufficiently compensate investors for these risks despite the relatively low default rates and generally healthy company fundamentals.

We are neutral high-yield credit, where quality generally is improving and valuations are less stretched in our view.

We are overweight global real estate due to our overweight in US real estate. We think that fundamentals such as growing employment, falling vacancy rates and low construction activity are positive. We are neutral European and Asian real estate.

We remain neutral on local currency emerging market debt, inflation-linked bonds, convertible bonds, commodities and cash.

We remain underweight the euro versus a basket of currencies, expecting a favourable interest rate differential to benefit the US dollar.

Joost van Leenders, CFA Investment specialist - allocation & strategy j+ www.bnpparibas-ip.com

-1012345

07 08 09 10 11 12 13

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ECB refi 2-years (Germany) 10-years (Germany)Source: Datastream, BNPP IP

Weekly Strategy Update | 12 September 2013 – 5

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