EFTA Document EFTA01437704

Amercias Edition March 2016 The limits of monetary policy: Are central banks losing their magic touch? Marketing Material EFTA01437704 The limits of monetary policy Amercias Edition I March 2016 2 The limits of monetary policy: Are central banks losing their magic touch? Letter to investors Central bank policy intervention has dominated the investment landscape for the last eight years. As some monetary policy was certainly helpful — at least from a financial market perspective - more and more questions come up where do we go from here? Opinions differ about whether it is a help or a hindrance. With economic growth still stubbornly low in many regions, skepticism has grown about how effective it can be - as have concerns about its possible long-term side effects. This special report should help to understand the limits to central bank policy intervention and the implications for investment. It explains why quantitative easing can be a powerful medicine, it is one which is only very imperfectly understood and which relies as much on investor belief as well as rational calculation to work. The report also spells out why such intervention can have unexpected and possibly negative consequences, for example through the encouragement of capital misallocation and asset class bubbles. But, with central banks likely to persevere with this uncertain cure, we will all have to learn to live with the consequences for some time to come. Uncertainty, of course, will create opportunities as well as risks. You might still navigate around this uncharted investment world in a potentially profitable way. But given the likely background of varied asset class returns, coupled with high levels of volatility, you may need to keep an open mind as to how you invest. To make your portfolio appropriate to your needs, I would suggest focusing on four issues. 1. Returns expectations should be appropriate. Some investors may find it appropriate to lower their returns expectations, given their circumstances, but others will not. The structure of portfolios must reflect this. 2. Risk comes in many forms. For those seeking to maintain returns expectations, increasing risk budgets might be an appropriate approach, especially of if you have a longer-term perspective. In such uncertain times, constructing "airbags" to protect EFTA01437705 portfolio returns may be wise if you are targeting normal or high returns. Remember that while protection has its costs, it may help you sleep better at night. And naturally, higher risk is no promise of higher returns, especially not short- term. 3. Diversify, but flexibly. Whilst I believe the old correlation patterns between asset classes will continue to change, a more flexible approach to diversification might still benefit portfolios. A well-diversified investor, ready to be flexible, can benefit from currency and other trends. You may want to consider investing in alternative assets to help you meet your return targets, but always with due regard to your risk profile. 4. Knowledge is still king. In an increasingly uncertain world, deep local knowledge of the world is also important, to identify structural trends early on and select assets accordingly. I am not suggesting that investing in this environment, with central banks still feeling their way, will be easy or uneventful. But I believe that as an organization we have the skills to help you do it. Past performance is not indicative of future returns No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. Christian Notting Global Chief Investment Officer for Deutsche Bank Wealth Management, Managing Director EFTA01437706 The limits of monetary policy Amercias Edition I March 2016 3 Are central banks losing their magic touch? When markets worry about central banks, they are really fretting about two distinct things. On the one hand, there is the real economy. On the other hand, and usually of much more immediate interest is the question of how central-bank moves will impact financial markets. For much of the period since equity markets bottomed out in 2009, those two questions have been intertwined. Not so long ago, the prices of risky assets, such as equities, seemed like a one-way bet. Bad economic news, such as lackluster U.S. job creation, led markets to expect further monetary stimulus and boosted financial assets. Meanwhile, good economic news also boosted prices of risky assets. Solid job figures, for example, suggested that the economy was healing nicely, but, given the depth of the slump, financial markets rightly expected it would still take a long time for interest rates to return to more normal levels. This cozy era came to a close in 2015, and probably ended for good with the first U.S. Federal Reserve Board (Fed) interest-rate hike last December. Major equity markets began this new age with their worst start of the year since the 1930s, amidst growing concerns that central banks have lost their magic touch. In recent months, financial markets have increasingly seen central banks less as saviors and more as part of the problem. What next? Of course, the range of the federal funds rate at 0.25 to 0.50% remains extraordinarily low by historic standards. What has changed, however, is the balance of risk from a market perspective. Strong U.S. economic figures are now a mixed blessing, while weak figures really are bad news. The pain caused by weakness in U.S. manufacturing, for example, is tangible enough, but the potential gain from more Fed action for now looks distant. The stakes are particularly high for the European Central Bank (ECB) and the Bank of Japan (BOJ), amidst growing concerns that they are running out of options. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The EFTA01437707 information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437708 The limits of monetary policy Amercias Edition I March 2016 4 Central-bank moves and market-mood swings 8,500 9,000 9,500 10,000 10,500 11,000 11,500 12,000 12,500 in index points ECB announces QE China devalues the yuan ECB lowers interest rate, however markets are disappointed Global monetary policy action has been the key driver for equity markets Dax 01/2015 03/2015 05/2015 07/2015 09/2015 ECB hints at further loosening 11/2015 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 01/2016 03/2016 The past year has seen many mood swings in financial markets, as illustrated here by the German Dax. When the ECB announced the large-scale purchase of assets through quantitative easing (QE), that gave equities a boost. The Dax lost steam, once the ECB actually started its QE program. Global equities fell sharply in the summer, after China devalued the Yuan. In fall, it was again the expectation of further loosening that helped equities, while the actual decision disappointed. But why, precisely, are markets worried? To answer this question, we suggest that a EFTA01437709 closer look at the role of central banks is warranted, by considering: 1. The role central banks see for themselves — and how it falls short of what markets have come to expect; 2. The limits of how much extra help central banks can and will provide. Next, we take a more detailed look at: 3. The potential consequences for investors; 4. The specific challenges ahead for the ECB, the Fed and the BOJ The report concludes by presenting some tentative solutions to the dilemma investors currently face from a multi-asset perspective. 1. The role of central banks Sixteen years ago, Mervyn King of the Bank of England (BoE) suggested that "a successful central bank should be boring — rather like a referee whose success is judged by how little his or her decisions intrude into the game itself."1 That's a far cry from what central bankers have been up to in recent years. Ever since the financial crisis of 2009, markets have looked to them for salvation. The main tool used was quantitative easing — buying assets to stimulate money creation. In many market segments, this has turned central bankers from neutral observers to dominant players. But are markets right to have such high expectations of central banks? That reflects a basic misunderstanding of what central banks can, and cannot do. And to see why, think back to what monetary policy was like not so long ago. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. 1 "Monetary Policy: Theory in Practice", Address given by Mervyn King, Deputy Governor of the Bank of England, 7 January 2000 EFTA01437710 The limits of monetary policy Amercias Edition I March 2016 5 Not so long ago, central banks had a clear, but limited task. To be sure, there were small variations in terms of the mandate of central banks around the developed world. But essentially, monetary policy was a decision on when to adjust interest rates — ideally raising them before economic overheating and cutting them in time to mitigate or avoid a looming slump. How quickly an economy would grow in the longer term, though, was largely determined by other factors. That last insight is important. We should remember that there may not be much central banks can do to boost potential growth. Perhaps we need to realize that potential output growth is lower than it used to be. Blaming the Fed for lackluster potential growth is a bit like blaming a referee for the lack of sporting prowess you see among the players on the field. To be sure, a central bank can mitigate the lasting impact of a slump by trying to keep recessions brief, being mindful of the fact that workers who are unemployed for prolonged periods lose some of their skills. When young people struggle to find a job to begin with it can also hurt their prospects for many years to come. This has been a perennial problem in other parts of the world, and may be one of the root causes of economic stagnation in Southern Europe.2 Arguably, the ECB made matters worse, when it prematurely increased interest rates in 2011. By contrast, U.S. unemployment has more than halved since peaking in 2010, thanks in large part to decisive Fed action. Unfortunately, this translated into a mere 2.4% of growth in gross domestic product (GDP) for both 2014 and 2015, according to the latest estimates of the Bureau of Economic Analysis. For 2016, we now forecast 1.8%. Potential U.S. growth is probably quite a bit lower still. The same is true in other developed markets that embraced QE early on. At 2%, growth remains disappointingly slow in the United Kingdom, if judged by historic standards. However, unemployment has fallen to 5.1 %, suggesting there is little slack left in the labor market. It appears that the United Kingdom, just as the United States, is no longer able to sustain the sort of growth rates familiar from previous EFTA01437711 cycles, without triggering inflation. 2 Blanchard, Olivier J., and Summers, Lawrence H., Hysteresis and the European Unemployment Problem, NBER Macroeconomics Annual 1986, Volume 1, pp. 15 — 90. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437712 The limits of monetary policy Amercias Edition I March 2016 6 Since 2009, monetary-policy rates were mostly stuck near zero... 7 6 5 4 3 2 1 0 2007 2009 2011 2013 2015 2005 2007 2009 2011 2013 2015 in % Fed Funds Target Rate ECB Main Refinancing Rate BoE Official Bank Rate BOJ Result Unsecured Overnight Call Rate ... while unemployment swiftly started to decline. 10 11 12 13 3 4 5 6 7 8 9 in % (seasonally adjusted) United States Eurozone United Kingdom Japan Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 What can anyone do? Well, all U.S. monetary policy can do is to wait for the EFTA01437713 economy to heal — and hope that potential growth will eventually pick up again. Over the medium term, we would still expect potential growth to edge a bit higher, as some of the lingering effects of the crisis continue to fade, and productivity and labor-force growth recover a bit. By contrast, there are plenty of things governments (as opposed to central banks) could do. Boosting spending on education, liberalizing labor and product markets, improving incentives in tax and entitlement systems, amongst other measures, come to mind. Talking about "structural reforms" may sound trite, but they remain extremely important. Implementing reforms is easier said than done — just look at Japan and the Eurozone. Politics frequently gets in the way. This has arguably been the story behind the Eurozone debt crisis and Japan's malaise. Japan is now in the 26th year of what was at first called its lost decade. Many of the problems in both Japan and the Eurozone are structural. Monetary policy is hardly the most obvious way of tackling them — as the BOJ itself argued for much of the initial lost decade. Fiscal policy would be a more obvious bet — especially if the money is spent on the sort of infrastructure projects that will actually boost potential growth, rather than on bridges to nowhere. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437714 The limits of monetary policy Amercias Edition I March 2016 7 Central balance sheets as percentage of GDP in % of GDP BOJ 100 120 20 40 60 80 0 2006 2008 2010 2012 2014 2016 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 All of which makes it rather odd that so many hopes should still rest on central banks. After all, Japan already tried QE from March 2001 to March 2006. According to most empirical studies, this was of limited help in either boosting output or inflation. Indeed, it may even have strengthened the performance of Japan's weakest banks — further delaying the necessary clean-up of bank balance sheets. Markets were fairly unimpressed. Japan's initial dose of QE simply seems to have acted as a sedative. One down-side of loose monetary policy — and not just in Japan — is that it can reduce the pressure for reforms. 2. The limits of central banking. So far, we have seen that there is little monetary policy can do to boost long-term growth potential. At most, it might provide breathing space for structural reforms (but with the caveat noted above). For investors, however, a more immediate question is whether central banks are also losing their ability to cheer up markets. Here, the evidence is mixed — and to see why, look no further than at Japan's previous attempt at QE. Japan's structural problems are real enough, but they only tell half of the story. The other half is one of monetary impotence to do even the limited work central banks are usually charged with: making sure that actual economic growth is in line with EFTA01437715 potential growth rates. Central banking can prove tricky enough in normal times. As Rudiger Dornbusch quipped in 1997, "None of the U.S. expansions of the past 40 years died in bed of old age; every-one was murdered by the Federal Reserve."3 at least, central banks have plenty of historic data to rely on. But By contrast, economists looking at Japan since the early 1990s had to go back to the Great Depression to find anything remotely similar. Japan appeared stuck in a liquidity trap, the traditional bogeyman of central banking (see box). Much of the policy response in the rest of the world since 2009 can best be understood as an attempt to avoid such a fate. Central bank balance sheets as percentage of GDP have ballooned BoE BOJ forecast BoE forecast ECB ECB forecast Fed Fed forecast Throughout the developed world, central banks have taken ever more assets onto their balance sheets. Initially, this reflected such programs as the Fed's Term AssetBacked Securities Loan Facility (TALF) in the United States, intended to boost consumer lending in the aftermath of the financial crisis. Similarly, the Eurozone debt crisis caused the ECB's balance sheet to expand, well before the formal adaption of QE. In recent years, balance sheet growth has been strongest in Japan, reflecting its increasingly aggressive use of QE policies. 3 Dornbusch, Rudiger. 1997. "How Real Is U.S. Prosperity?" Column reprinted in World Economic Laboratory Columns, Massachusetts Institute of Technology, December. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to EFTA01437716 change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437717 The limits of monetary policy Amercias Edition I March 2016 8 Liquidity traps, monetary policy and QE Liquidity traps describe a situation where conventional monetary policy has lost its potency. Remember how monetary policy normally boils down to changing interest rates in a timely fashion? Technically, this means buying short-term bonds from the banking sector, reducing short-term rates and paving the way for money creation. By promising to keep buying short-term bonds until the economy has regained its footing, moreover, the central bank will also put pressure on yields of longer-term government bonds. This ideally translates into lower interest rates when a firm was looking to fund risky, longer-term investments, such as building a new factory. Note that a central bank only firmly controls the first step of this process. The rest partly depends on others. Even in normal times, it is rather like a very impressive conjurer's trick, which works best when the audience is willing to play along. In a liquidity trap the central bank loses control even over that first step — short-term interest rates. Since the late 1930s, most economists felt that this was a theoretical, but fairly remote possibility. A liquidity trap requires several unusual things to happen at the same time. First, you need a severely depressed economy — an ailment central banks would normally be able to cure by waving their interest-rate wand. And second, inflation needs to be very low to begin with. That too, should normally not be much of a challenge — in fact, central banks usually worry more about the opposite problem, of inflation being too high. Take both things together, though, and you have every reason to worry. A central bank that has already cut nominal interest rates to zero must face up to the problem that the interest rate wand no longer works. Its first instinct might be to do more of the same, that is to keep on buying more bonds. The trouble is that once nominal interest rates hit zero, households and firms will already have plenty of cash — probably far more than they need for their planned purchases of goods and services. So, if you try to buy even more bonds from them, they will take the cash and simply hold onto it as a store of value. Under these conditions, money becomes a perfect substitute for short-term bonds. At the first glance, it is not clear how printing more money will help in this situation! Why would an economy get so depressed? Well, for one thing, you might find yourself in a vicious circle. Falling prices and weak consumer demand EFTA01437718 discourage investment. This, in turn, means that real interest rates would need to fall for firms to invest in new factories. But with inflation turning more and more negative, zero nominal interest rates will translate into real interest rates actually rising, discouraging investment even more. This, in turn, might make households want to consume less (and save even more).4 Alternatively, the initial source of the problem might be households, who expect real incomes to be lower in the future, due to, for example, an aging population. This appears to have been part of the problem in Japan, where a shrinking working population has existing disinflationary and, increasingly, deflationary pressures. 4 This is broadly the argument of John Maynard Keynes, esp. chapters 15 and 23 of "The General Theory of Employment, Interest and Money.", 1936, Palgrave Macmillan. His followers took a narrower view, looking at liquidity traps mainly by focusing on the zero lower bound of nominal interest rates. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437719 The limits of monetary policy Amercias Edition I March 2016 9 Most recent discussions take a highly accessible paper by Noble laureate Paul Krugman as their starting point.5 The implication of his model is that there is indeed little that conventional monetary policy can do in the here and now. Printing more money to buy more bonds makes no difference. There is a way, however, that a central bank might still work its magic, namely through expectations. This means convincing households and firms that you will not just expand money supply today, but continue to do so tomorrow. If it succeeds, inflation expectations will rise, allowing real interest rates to fall and stimulating investment. Of course, this only shows that monetary policy might work, not that this is the best option, or even a particularly good path out of the liquidity trap. Once interest rates are at zero, short-term bonds and money are close to perfect substitutes. Conventional monetary policy loses much of its potency. Even if a central bank somehow succeeds in pushing nominal interest rates on bank deposits into negative territory (an option section 2 looks at), this would simply make cash even more attractive than bonds as a store of value. So, if a central bank keeps on buying short-term bonds, we would still have the same problem — it would keep on buying, without those purchases having any impact. But what if the central bank starts buying longer-duration government bonds? Couldn't this help by reducing the term premium? And surely, QE might squeeze spreads, either by central banks buying corporate bonds directly or by pushing private investors into higher risk assets? And finally, all this should reduce funding costs for companies building new factories, should it not? Also, might the rise in asset prices of all sorts not make households feel wealthier, boosting consumption? Well, a resounding "Maybe" to all of the above. Something along these lines has happened in practice. Central banks used to be lenders of last resort. Increasingly, they have instead become the buyer of last resort. This certainly worked in terms of reducing longer-term government bond yields — ballooning central bank balance sheets coincided with falling bond yields. EFTA01437720 5 Krugman, Paul R. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap." Brookings Papers on Economic Activity, 1998, 29(2), pp. 137-205. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437721 The limits of monetary policy Amercias Edition I March 2016 10 ECB balance sheet and 10-year Bund yields 3,500 3,000 2,500 2,000 1,500 1,000 500 2006 2008 2010 2012 2014 2016 in billion euros in % 0 Yield 10-year Bunds (right axis, inverted) ECB balance sheet (left axis) 1 2 3 4 5 6 Fed balance sheet and 10-year Treasuries 6,000 in billion U.S. dollar 5,000 4,000 3,000 2,000 1,000 0 2006 2008 2010 2012 2014 2016 Yield 10-year U.S. Treasuries (right axis, inverted) Fed balance sheet (left axis) in % 0 1 2 3 4 5 6 EFTA01437722 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 For such a widely used tool, it is surprising how hard it is to make QE work in theory.6 The trouble is that any such framework must take its longer-term impact into account. Fortunately, central banks not much keener than stage magicians to let you in on the inner workings of their latest creations. As a result, it is fairly easy to figure out what is known — and, more worryingly, what even central banks do not know. We know from empirical studies in the United States, the United Kingdom, and, in recent years, the Eurozone and Japan, that QE "works" in the short term in terms of moving markets, and perhaps, even increasing lending. We have some ideas on why this might be so. It remains unclear, however, how QE will impact inflation, economic activity and asset prices across the economic cycle. From a theoretical perspective, we know that households and firms will try to anticipate future central-bank actions — which risks offsetting much of what the central bank is doing through the channels described above in the here and now. To take the example of the wealth effect, let's say that the Fed buys 30- year bonds today, drives down nominal market rates and thereby increases the nominal value of the longer maturity bonds I hold in my portfolio. On paper, this makes me wealthier. If I am rational, though, I will know that returns on any additional bond investments I make to save for my retirement will be lower. Moreover, if and when QE does its job in restoring full employment, interest rates will increase, so I will face losses in the future. My real wealth, over my remaining life-time, has not really gone up, and there is little reason why I should boost my consumption. Instead, I might even decide to save more! Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, EFTA01437723 opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. 6 As a useful starting point for figuring when central-bank openmarket operations do and do not impact the private sector, see Wallace, N. (1981). A ModiglianiMiller theorem for open-market operations. American Economic Review, 71(3):267-74. EFTA01437724 The limits of monetary policy Amercias Edition I March 2016 11 For QE to have much of an impact, you need to create somewhat ad-hoc assumptions. Translated into plain English, this means coming up with stories for why private investors will not fully adjust their portfolios to reflect recent and anticipate future actions by the central bank. Generally, such stories boil down to different assets not being perfect substitutes for different types of investors. Insurance companies or pension funds, say, might face regulatory restrictions on which assets they can hold. There might be differential information and transaction costs for retail investors. Some investors might invest in certain ways simply out of habit. All of which might be true, but ideally, you would want to have a lot more data before betting economies worth trillions of dollars on it. To his credit, Ben Bernanke, the Fed's chair throughout much of the crisis, has freely acknowledged as much in speeches and in his earlier academic work.7 We would argue that part of the reason the Fed was relatively successful with this policy, was markets were ready — indeed eager — to play along. It is less clear that QE will be as helpful going forward, either in the United States or elsewhere. As the balance sheets of central banks have ballooned, private-sector debts have also been mounting, from emerging markets borrowers to U.S. corporates. In the search for yield, some of the money that actually did find its way into lending will inevitably turn out to have been misspent — perhaps sowing the seeds of the next crisis. 7 See, for example, Bernanke, Ben, "Monetary Policy since the Onset of the Crisis", Presented at the Federal Reserve Bank of Kansas City Economic Symposium, "The Changing Policy Landscape," Jackson Hole, Wyoming, August 31, 2012; http://www. federalreserve.gov/newsevents/ speech/bernanke20120831a.pdf Despite monetary easing, Eurozone lending remains subdued year-on-year change in % 20 EFTA01437725 15 10 5 0 -5 2006 2008 2010 2012 2014 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 2016 Eurozone loans to non-financial corporations Eurozone loans to households Lending never really recovered from the crisis Despite all the efforts by the ECB, loans to the business sector of the Eurozone remain weak. In part, this probably reflects the fact that troubled banks, especially in Southern Europe, are not fully transmitting monetary loosening to their clients. A bigger problem is probably demand for business loans remains weak, reflecting subdued growth in several Eurozone economies. Loans to households are slowly rising. Overall, however, QE has not proven very effective in improving lending. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437726 The limits of monetary policy Amercias Edition I March 2016 12 And, we are hardly alone in this assessment. As Stephen Williamson, Vice President at the Federal Reserve Bank of St. Louis, noted in a recent review, taking a broader historic perspective: "The theory behind QE is not well-developed ... Evidence in support of Bernanke's view of the channels through which QE works is at best mixed... Much of the work on the quantitative effects of QE consists of event studies, whereby researchers look for effects on asset prices close to the date of an announced QE intervention. ... All of this research is problematic, as it is atheoretical. There is no way, for example, to determine whether asset prices move in response to a QE announcement simply because of a signaling effect, whereby QE matters not because of the direct effects of the asset swaps, but because it provides information about future central bank actions with respect to the policy interest rate. Further there is no work, to my knowledge, that establishes a link from QE to the ultimate goals of the Fed —inflation and real economic activity." 8 Given such doubt, it is no wonder that the Fed is hoping for a return of more normal times — when it could count on well-understood tools to do the job. 3. Consequences for investors In 1976, the economist Robert Barro argued that an activist monetary policy gains much of its effectiveness from confusing people, clouding signals to market participants. That can secure tranquility for a while and perhaps provide a temporary boost to output. However, that stability comes at the cost of even greater variance later on.9 Eventually, you might expect inflation, GDP and also financial markets to become more volatile. Given how much QE appears to have relied on market expectations, it is hard to say if such a tipping point has already been reached. Over the past year, the investment environment has clearly been getting trickier. In the past, correlations across different asset classes were generally such that you could reap decent returns without taking too much risk, using diversification effects to mitigate the downside risks. Now things are different. EFTA01437727 This is especially true if we compare the period between 2010 and 2015 with the recent market turmoil. Lately, many unusual correlations have cropped up that you might not have expected. For example, major equity indices have tended to move in sync with the oil price. This might seem justifiable for the S&P 500 Index, but is less understandable for the German Dax, which does not include a single major oil producer. In any case, correlations between oil and the S&P 500 Index have historically tended to be negative, which also makes more economic sense. Worse still, many old correlations have been swept aside. Volatility is increasing. 8 Williamson, Stephen D., "Current Federal Reserve Policy Under the Lens of Economic History: A Review Essay", Federal Reserve Bank of St. Louis Working Paper Series, Working Paper 2015-015A, pp. 8-9. https://research.stlouisfed.org/ wp/2015/2015-015.pdf 9 Barro, Robert J.: Rational Expectations and the Role of Monetary Policy. Journal of Monetary Economics; pp. 1-32, January 1976; Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437728 The limits of monetary policy Amercias Edition I March 2016 13 Historical relationship between the Dax and government bonds Correlation Daxl vs. Bunds2 -1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0 8 1 0 2000 2002 Dax Price Index 2 2004 (monthly data, 12 month rolling) Old correlations are breaking down Until recently, investors could count on returns from equities to be negatively correlated with returns on government bonds for most of the time. As the chart comparing the German Dax and 10-year Bunds illustrates, this relationship was not stable, but the tendency was clear. In recent months, by contrast, correlations have turned positive This meant that adding government bonds to an equity portfolio has become a much less effective tool to reduce the overall risk profile. 2006 2008 2010 BofA Merrill Lynch 7-10 Year German Government Index 2012 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 1 2014 2016 These are early signs that QE euphoria has come at a cost. It may have assisted generating high returns in financial markets in recent years, but investors should expect leaner times ahead. In the meantime, there are likely to be dramatic swings — in both directions. Over the medium term, it appears likely that confidence in the ability of central EFTA01437729 banks to stabilize financial markets will continue to erode. Just because this is likely to happen eventually, however, does not mean we are quite there yet. Central banks still have options — and willingness too, it would seem, to creatively use any readily available tool remaining. However, betting on their magic touch is getting riskier. Look at how last December, the ECB caught investors on the wrong foot. Markets had grown used to its President Mario Draghi over-delivering. Instead the ECB underwhelmed in the short term. It only tinkered on the edges of its existing QE program, focusing instead on cutting (its already negative) deposit rate further in the wake of similar decisions in several smaller European economies. Sweden, Denmark and Switzerland have increasingly relied on negative interest rates to discourage capital inflows (see box). Beyond the zero bound Negative interest-rate policies (NIRP) have always been controversial in the academic community, and even less systematic research has been done on their effectiveness than with respect to QE. We believe, their growing use raises at least three issues: 1. What's the point of negative nominal interest rates? The answer to this question should be clear from section 2. If they can be implemented without too many detrimental side-effects, NIRP offer a neat way out of the liquidity trap. Monetary policy regains its power to push real interest rates lower, even in a low-inflation environment. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437730 The limits of monetary policy Amercias Edition I March 2016 14 However, things get somewhat messy when you think about the practicalities. So far, negative interest rates are only charged on balances of commercial banks with the central banks. Commercial banks have been reluctant to pass this cost on to their clients, so most of the private sector, including practically all individual savings accounts, is not charged. This, in turn, means two things. First, households are shielded, so lower interest rates will not have an impact on household behavior (encouraging current consumption, say, by discouraging saving, or prompting households to purchase riskier assets). Second, bank profitability will suffer. 2. What's the evidence so far on the impact on banks? In Sweden, Denmark and Switzerland banks have coped reasonably well with negative interest rates, in part because their domestic banking markets are quite concentrated." This allowed the top two or three key players to make up for the shortfall by pushing up profits on other products. For example, Swedish banks have been able to protect their net interest margin by increasing mortgage loan rates to offset charges on deposit. The problem is that, first, this means that the NIRP results in tighter, rather than looser financial conditions. Second, it would not work in other, less concentrated markets. And third, and perhaps most troubling for the ECB, it means NIRP will have a differential impact in different Eurozone countries, depending on the degree of concentration in the local banking market. 3. How low can central banks go? Therein lies another problem. After all, there was a reason why most economists were doubtful of attempts to push interest rates below zero. Reduce the interest rates too much, and the private sector might simply withdraw their bank deposits and hold the money in cash. Of course, there are some costs to storing cash, with some estimates at 20 basis points (bps), and some a bit higher. However, the ECB is already in the lower range of such estimates. Moreover, comparisons with credit-card charges of several hundred bps are somewhat flawed: a large chunk of cash deposits are probably held as a store of value, rather than with any immediately looming payments in mind. To implement negative deposit rates anywhere near that level, you would probably have to introduce a time-varying fee of some sort on (physical) cash of the sort initially proposed by the German merchant Silvio Gesell 100 years ago. No country has since tried to implement 'Gesell money' and political obstacles look EFTA01437731 sizeable. The evidence so far suggests that when they work, the effect from NIRP is mainly from driving down exchange rates rather than by stimulating lending. For small open economies, this might even be part of a "foolproof way" to escape the liquidity trap and deflation. The idea was for the central banks to give a commitment to higher future price levels, concrete action, such as a currency's sharp depreciation, to demonstrate that commitment, and an exit strategy of when and how to get back to normal.10 In a small open economy, such as Sweden, a currency devaluation can go a long way in rekindling inflation. Unfortunately, using devaluation is a lot harder to manage in large economies, such as Japan and the Eurozone. 10 Svensson, Lars E.O. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others." Journal of Economic Perspectives, Fall 2003, 17(4), pp. 145-66 Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437732 The limits of monetary policy Amercias Edition I March 2016 15 Again, it is Japan that provides the most cautionary tale on monetary impotence. In January it took markets by surprise by implementing a NIRP of minus 0.1%. The system was structured in three tiers, to reduce the impact on bank profitability, but nevertheless hit bank share prices hard and reinforced broader market weakness. This, in turn, put upward pressure on the yen, precisely the opposite of what the BOJ had been aiming for. NIRP has suddenly brought home one implication of unconventional measures for households: it is supposed to work, in part, by depressing the future value of their savings. To a trained economist, there might not seem to be much of a difference whether that wealth transfer takes place through inflation eroding nominal returns or NIRP. To households and companies, it probably does — which risks further eroding confidence in central banks being able to "fix" the problem. Asset-class implications: 1. Currencies: Expect more currency volatility, sometimes in surprising directions, that defies what policy makers have had in mind. The underlying driver of this volatility remains divergence in monetary policy between the Fed, wanting to get back to normal, and others, particularly the BOJ and the ECB relying on increasingly unfamiliar tools, such as NIRP. We believe eventually, this should translate into a strengthening U.S. dollar. 2. Bonds: QE has pushed an ever growing number of sovereign bonds into negative territory. Effectively, this has destroyed positive, nominal returns on "safe" government bonds, a key element which diversified investors have long been able to rely on. This means risk-free rates can no longer serve as a portfolio cushion in a diversified portfolio. For sovereign bonds, it is worth keeping in mind that these too are far from risk-free. If you think that QE will eventually succeed in boosting inflation, rates have to go up. Holders of longer maturity bonds therefore face significant duration risk. Against this background, we believe investment- grade debt and also high yield are probably among the more attractive alternatives. EFTA01437733 3. Equities: For U.S. equities, most recent concerns have centered around recession fears. However, this is no longer the only risk. Continuing solid U.S. economic performance, resulting in swift further interest-rate increases, would also be worrisome. Either way, U.S. margins have probably peaked. U.S. strength would probably be reflected in consumer spending holding steady on the basis of rising wages and continuing employment growth. This could put pressure on earnings. More broadly, the above discussion suggests that further monetary adventures in other parts of the world, such as negative interest rates, come with risks attached — both in terms of their direct impact (on bank profitability, for example) and by increasing the scope for policy errors. Risk premia might rise. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437734 The limits of monetary policy Amercias Edition I March 2016 16 4. Policy challenges ahead Eurozone: Following the latest meeting of the Governing Council of the ECB, the ECB announced on March 10th that it would reduce its deposit rate (on money deposited by Eurozone banks by 10 bps to minus 0.4%. Its other key rates were cut by 5 bps, with one on the main refinancing operations (MRO) now at 0% and on marginal lending facility at 0.25%. As many market participants had hoped, it also expanded QE, increasing the monthly purchases under the asset purchase program by €20bn to €80bn starting in April. More significantly, the scope of assets eligible to be included in the list of assets for regular purchases will include investment grade euro- denominated bonds issued by non-bank corporations from now on. In our view, this will somewhat alleviate one of the issues the ECB has faced, namely the growing scarcity of government bonds of some countries, such as Germany. It comes at the risk, amongst other issues, of losses on these private sector bonds and will no doubt prove controversial. However, the alternatives would probably have been even less palatable. In order to increase the QE program without including new sets of assets, the ECB could instead have changed its capital key, allowing it to purchase more bonds from more highly indebted countries such as Italy. Or it could have given up the deposit rate as a hurdle rate when it buys government bonds. However, this would have effectively resulted in an arbitrage opportunity for banks, with the ECB locking in losses with each purchase of bonds from the banking sector (which could then deposit the proceeds at a less negative rate with the ECB. Finally, the ECB announced a new series of targeted longer-term refinancing operations (TLTRO). These are designed to stimulate lending to the real economy, by allowing banks to borrow on attractive terms from the ECB. These will now be very attractive indeed — from now on, borrowing conditions in these operations can be as low as the interest rate on the deposit facility, or minus 0.4%. This will depend, however, on the banks actually lending. The more banks lend, the closer the rate will fall to the deposit rate. In our view, the package illustrates the growing ECB concerns about the potential EFTA01437735 impact on bank profitability from cuts in its deposit rate. This impact will be alleviated somewhat by the benefits bank will get from TLTRO II. Nevertheless, we would expect minus 0.5% to be the lower limit of how much further the ECB will cut the deposit rate, which will probably be reached at the next meeting. All of which sounds quite impressive. However, stocks eroded their gains within hours, and the euro reversed its initial weakening, after Mario Draghi indicated during the press conference that he expected no further cuts. In the following trading days, equities strengthened again, as investors took a closer look at the package. The volatile market reaction showed three things. First, the ECB still has some options to move markets Second, it now takes a very comprehensive set of Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437736 The limits of monetary policy Amercias Edition I March 2016 17 measures, far beyond what would have seemed possible six months ago to have much of an impact. And third, there will be more beneficiaries form QE, in this case investment grade bonds, as investors swiftly try to reshuffle their portfolios. United States: Despite the concerns outlined above, we would stress that the U.S. economy also has several strengths. Thanks in part to QE and the temporary relief it brought, both the banking sector and households are on a more solid footing than they were a decade ago. The labor market continues to heal. Against this background, our view is that the Fed is likely to continue on its current course. The Fed has made it clear that its decision making will be data- dependent. We expect this to translate into interest rates remaining low and increases to be slow in materializing. Our central case is a 25 bps increase in 2016 and another one early in 2017. With financial conditions highly volatile, there are risks to this view, of course. However, it should be kept in mind that financial markets are more vulnerable to some of the recent shocks than the real economy, due to, for example, the heavy weighting of the energy sector in the S&P 500 Index. Japan: Most concerns on the limits of monetary policy will continue to center on Japan. Its current program, known as Quantitative and Qualitative Monetary Easing (QQE), is distinctive in not just the size of its purchases but also their composition. At an annual 80 trillion yen (700 billion U.S. dollars) or 16% of GDP, it dwarfs attempts by other central banks. The BoJ has also been buying a broad mix of assets. In January 2016, it added negative deposit rates to the mix. Part of its challenge was the very negative market reaction, when it took markets by surprise in January, by implementing a negative interest rate of minus 0.1%. Negative interest rates also risk a further destabilization of the banking sector. The system is structured in three tiers, similarly to what we envision for the Eurozone. EFTA01437737 Having caused bank shares to fall by 28% and the broader market by 17% in the two weeks following the announcement, we doubt the BOJ has much appetite for further cuts. Japan cannot simply turn its back on QE, because the result could be too destabilizing. But relying increasingly on currency depreciation is risky with growth in the rest of the world weakening. Part of the problem is that there are simply not enough bonds left that the private sector is willing to sell. The BOJ could buy equities, after already dipping into Exchange Traded Funds last year, and, basically, anything else they can get their hands on. By contrast, the scope for fiscal policy looks limited, given already high levels of public debt. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437738 The limits of monetary policy Amercias Edition I March 2016 18 Central bank holdings 50 in % of total debt 40 30 20 10 0 Fed ECB BoE Sources: Bloomberg as of 03/16 Meanwhile, it ineffective in terms of its impact on the real Japan's previous experience with QE. In fact, surprised when digging deeper into the data Disappointing inflation data partly reflects falling harsh statistical treatment of rental cost. inflation has picked up in recent years. Partly, sales tax, but it also reflects falls decades ago. Wage growth finally appears to be improving. While most jobs created are relatively lowly paid and part-time, even for full-time workers, unemployment rate has fallen, and labor participation has improved over the last few years. In Japan, at least, QQE appears to be working — but at what cost? 5. Assessing the problem from a multi-asset perspective With confidence in monetary policy at lower levels than it used to be, central banks are finding it increasingly hard to manage turn, makes surprises in both directions more likely. with hefty doses of volatility and event risk. banks are as much part of the problem, as part of the solution. Even if you knew when the BOJ or the ECB will announce a new surprise move and what that move will be, you would still be left guessing how markets will react. Part of the difficulty of government bonds in % of total outstanding debt Finance L.P., Deutsche Asset Management Investment GmbH; is worth pointing out that QQE has not been quite as economy as you might think, based on a casual newspaper reader might be on recent price and wage trends. energy costs, as well as the somewhat Strip out these factors, and core this was on the back of Japan's increased in unemployment to levels last seen two market expectations. This, in Subdued returns will probably come In that sense at least, central EFTA01437739 would be in figuring out how other market participants have positioned themselves. The bigger difficulty, however, is that it is getting ever harder to figure out which moves would be seen as decisive shows of strength — and which ones would simply be interpreted as signs of desperation. The ability of central banks to prevent periods of turbulence and mitigate sharp declines in financial-market valuations certainly looks more limited than ahead of previous crises. This is due not so much to central banks running out of options Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. BOJ Current (2015) End 2017 (forecasted) QE has turned central bankers into major buyers of government bonds Under QE programs, the Fed and the BoE have bought large amounts of domestic government debt. In recent years, the ECB and the BOJ have followed suit, while the programs in the United States and the United Kingdom have expired. The problem that the BOJ in particular increasingly faces is that it already holds 30% of all outstanding debt of the Japanese government. The BOJ is finding it increasingly hard to find willing sellers. EFTA01437740 The limits of monetary policy Amercias Edition I March 2016 19 per se. Already, measures once considered outlandish, such as various versions of helicopter money, are once again doing the rounds. These would no doubt face practical, legal, and, in many instances, constitutional concerns. However, in recent years we have already seen that policy makers are willing to take extreme measures, if times get sufficiently desperate. The real problem is that the longer-term implications of the remaining tools are even less well-understood than QE. Recent market turbulence in the wake of Japan's implementation of negative deposit rates should serve as a cautionary tale that more monetary action no longer necessarily equates with better financial- market outcomes. They also reinforce doubts on how much good monetary policy could do, if things go wrong (either as a result of a new shock, or because of policy errors). Already, many investors have shifted their focus from seeking gains to merely wanting to preserve their existing wealth. Gold is just one example of an asset benefitting from its apparent safe-haven appeal. Given the concerns outlined above, it makes sense for risk-averse investors to attempt to limit the downside potential of their portfolio, while maximizing its ability to capture upside moves in markets. Even if we imagine a relatively benign outcome to the current growth and policy uncertainty, we expect future returns to be lower, for any given amount of risk. When it comes to risks and rewards, we have already entered a new investment world Allocation 15% 2004 85% Total Return 4% 2015 50% 50% 11% 2% Volatility Equitiesl Bonds2 EFTA01437741 0% 2% 4% 6% Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 1 Dax 2 iBoxx Euro Germany Sov 1-3 8% 10% 12% This has already started to happen. Take a portfolio held in 2004, with an expected return of 4%. Looking at the historical data, a portfolio comprised of 15% equities and 85% bonds would have delivered just that, with volatility of just 2%. Fast forward to 2015, however, and you would have needed to allocate 50% to equities to generate the same 4% in total return. Volatility would have been 11%. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437742 The limits of monetary policy Amercias Edition I March 2016 20 For a multi asset investor, we would suggest focusing on the following four key points. First: be realistic about your returns expectations and how you can achieve them. Lowering returns expectations as part of a desire to better align asset allocation with investment objectives might make sense for some investors (such as those already approaching retirement). Depending on your personal circumstances, the lower expected returns from most financial assets may tempt you instead to some consumption opportunities. Keep in mind, after all, that part of the whole point of QE is to make you spend more in the here and now. But note also the ECB and other central banks' increasing focus on getting QE to work through revitalising the credit channel in economies: increased lending will support economies and help create investment opportunities too. For most investors, the main issue will remain on how to generate acceptable levels of returns with acceptable levels of risk. Second: remember that risk comes in many forms. As we have outlined above, current central bank policy will have a tendency to increase risk in part because lower yields on lower-risk assets can alter investor behavior. In search of higher yielding investment they are forced to buy riskier assets, both in the fixed income space and equities or alternatives. In this way, loose monetary policy can increase the risk of misallocation of capital and bubble formation in financial assets. This is true for fixed income as well as equities. The valuations side of the equation can come into particular focus as investors are willing to take more risk, even if earnings are not able to keep pace with valuations As always, bear in mind, assuming greater risk is no assurance of greater returns. At the same time as investors are looking for higher returns, multi asset investors are also trying to establish what might be percieved current investment "safehavens". Effective safe-havens vary over time and between crises and no investment is without risk. Gold, for example, may have proved a good safe EFTA01437743 haven in some periods in the past, but has been a less effective one in recent years In other words, the correlations between safe havens and risk assets are not stable and history does not always repeat itself. So, as noted above, some risks accompany holding Treasuries (or Bunds) in an interest rate up-cycle, they do not always lose their appeal. It is also worth remembering that "safe havens" may not be confined to those traditionally perceived as such (e.g. Treasuries, cash and, perhaps, gold). In the current environment, currencies might be seen as a key part of any safe- haven strategy. And, linked to the currency issues, some regions' equities may also offer temporary safe haven status. When considering risk and safe-havens, it is also worth distinguishing between overall market risks and those which are countryspecific — emerging markets provide a good example of this. Investors, of course, also need to look beyond seeking higher risk and safe havens and take an overall approach to their own risk profile. As noted above, accepting only as much risk as one has historically budgeted for is likely to result in returns below historical averages. For some people, a better solution might be to increase their risk budgets, especially if they want to take a longer-term perspective, but any increase in risk must be in line with your personal risk composure. Further, you may want to endeavor to limit the downside risk in your portfolio with an appropriate Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. • EFTA01437744 The limits of monetary policy Amercias Edition I March 2016 21 protection strategy. You might also want to take a broader look at the assets you really have in your investment portfolio and in particular take your human capital in to account, when thinking about risks and rewards. Already, we are seeing clear signs that the advantages from taking a world-wide perspective when making investment decisions are once again growing. For example, a few individual emerging markets have performed quite well in recent months, after years of disappointing returns. Benefitting from such reversals requires a strong grasp of the trends shaping the global economy. To well-diversified investors, the increasingly volatile currency movements we are expecting are presenting opportunities, not just risks and it may be appropriate to integrate these into the portfolio decisionmaking process. At a time when yields on traditional asset classes can be so low, currency investments may in some cases help generate added returns, as they will be directly affected by central banks' policy. Handling such sophisticated diversification however requires consideration of the fourth point below. Third: diversify but flexibly. Traditionally, the main idea of a multi asset approach has been to reduce portfolio risk through diversification But if monetary policy is determining the overall risk sentiment of investors, affecting all conventional asset classes, traditional diversification effects (e.g. through combining equity and fixed income in a portfolio) are unlikely to contribute much to a portfolio's performance. But this is not to suggest that would argue that will need to broaden and with regard to other investments, Fourth: knowledge is king. Paradoxically, in such an uncertain particularly important. We would distinguish two deep local knowledge of what is happening identify structural trends early on, and select managers, we diversification no longer has a part to play: instead we it can still be extremely important, but to make it so, investors their investment horizon both regionally, within asset classes e.g. alternatives/illiquids. world, specific knowledge becomes types of in knowledge here. First, you need different regions of the world, to assets accordingly. As wealth EFTA01437745 fully intend to help our clients make the best of what has no doubt become a more difficult investment environment. Second, you need a data-driven understanding of what is going on at an overall investment level, so you can separate out the reality of what is going on from general perception. Only with this knowledge can you, for example, look deeper into concepts such as valuation, equity selection and risk. The environment will change and you need to be able to judge the likely implications for your own personal situation. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437746 The limits of monetary policy Amercias Edition I March 2016 22 Glossary Here we explain central terms. A balance sheet summarizes a company's assets, liabilities and shareholder equity. The Bank of Japan (BOJ) is the central bank of Japan. One basis point (bp) equals 1/100 of a percentage point. Bunds are issued by Germany's federal government, most frequently with a maturity of 10 years, and are the German equivalent of U.S. Treasury bonds. The Bureau of Economic Analysis is a U.S. government agency which produces economic statistics that enable government and business decision makers to follow and understand the performance of the nation's economy. Core inflation is a measure of inflation that excludes certain items that face volatile price movements, such as energy and food products. Correlation is a statistical measure of how two securities move in relation to each other. The Dax is a blue-chip stock-market index consisting of the 30 major German companies trading on the Frankfurt Stock Exchange. Deflation is a sustained decrease in the general price level of goods and services. The deposit rate is the rate banks receive when they make overnight deposits with the ECB. In relation to currencies, depreciation refers to a loss of value against another currency over time. Devaluation is the forced reduction of the value of a currency against other currencies. Disinflation is a decrease in the rate of inflation. Diversification refers to the dispersal of investments across asset types, geographies and so on with the aim of reducing risk or boosting risk-adjusted returns. Duration is a measure of the sensitivity of the price of a fixedincome investment to a change in interest rates and is calculated on the basis of present value, yield, coupon, final maturity and call features. The ECB's main refinancing operations or MROs are one-week liquidity-providing operations in euro which serve to steer shortterm interest rates, to manage the liquidity situation and to signal the monetary policy stance in the euro area. The European Central Bank (ECB) is the central bank for the Eurozone. The Eurozone, also called the euro area, is a monetary union of 19 of the 28 European Union (EU) member states which have adopted the euro as their common currency. The Federal Reserve System or Fed, which serves as the U.S. central bank, was established in 1913, consisting of the Federal EFTA01437747 Reserve Board with seven members headquartered in Washington, D.C., and twelve Reserve Banks located in major cities throughout the United States. The federal funds rate is the interest rate at which banks actively trade balances held at the Federal Reserve. Through fiscal policy, the government attempts to improve unemployment rates, control inflation, stabilize business cycles and influence interest rates in an effort to control the economy. Government bonds are issued by a government to support government spending, mostly in the country's domestic currency and are backed by the full faith of the government. The Great Depression was the deepest and longest-lasting economic downturn in the history of the Western industrialized world. The gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period. Headline inflation is the raw inflation figure based on the consumer price index (CPI) and not adjusted for seasonality or for the often volatile elements of food and energy prices. Helicopter money refers to a large sum of money being directly or indirectly distributed to the public by the central bank in order to stimulate the economy. High yield (HY) is often used as a shorthand for high-yield bonds. Inflation is the rate at which the general level of prices for goods and services is rising and, subsequently, purchasing power is falling. EFTA01437748 The limits of monetary policy Amercias Edition I March 2016 23 An investment-grade (IG) rating by a rating agency such as Standard & Poor's indicates that a bond has a relatively low risk of default. Lender of last resort refers to a central bank, which offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse. Liquidity trap describes a situation where conventional monetary policy has lost its potency. Lost decade refers to Japan's dismal economic performance in the 1990s after the burst of the country's real-estate and equity asset price bubbles. Monetary policy focuses on controlling the supply of money with the ultimate goal of price stability, reducing unemployment, boosting growth etc. (depending on the central bank's mandate). A mortgage is a debt instrument, secured by the collateral of specified real-estate property, that the borrower is obliged to pay back with a predetermined set of payments. A negative interest-rate policy (NIRP) is an unconventional monetary policy tool whereby nominal target interest rates are set below zero. Potential growth of gross domestic product (GDP) is defined as the rate of output growth that an economy can produce at a constant inflation rate. Although an economy can temporarily produce more than its potential level of output, that comes at the cost of rising inflation. Quantitative and qualitative easing (00E) aims at increasing the monetary base by both buying a wide range of assets as well as extending the maturities held by the central bank. Quantitative easing (QE) is an unconventional monetary policy in which a central bank purchases securities in order to lower interest rates and increase the money supply to promote increased lending and liquidity. The real interest rate is the nominal interest rate adjusted for inflation as measured by the GDP deflator. The risk premium is the expected return on an investment minus the return that would be earned on a risk-free investment. The S&P 500 Index includes 500 leading U.S. companies capturing approximately 80% coverage of available U.S. market capitalization. The spread is the difference between the quoted rates of return on two different investments, usually of different credit quality. The ECB's targeted longer-term refinancing operations (TLTROs), announced in June 2014, are designed to enhance the functioning of the monetary-policy transmission mechanism by supporting bank lending to the real economy. The Term Asset-Backed Securities Loan Facility (TALF) was a funding facility provided by the Fed from 2009 onwards and intended to boost lending to households and small businesses by EFTA01437749 supporting the issuance of asset-backed securities (ABS). Treasuries are fixed-interest U.S. government debt securities with different maturities: Treasury bills (1 year maximum), Treasury notes (2 to 10 years), Treasury bonds (20 to 30 years), and Treasury Inflation Protected Securities (TIPS) (5, 10 and 30 years). The United States dollar (USD) is the official currency of the United States and its overseas territories. Volatility is the degree of variation of a trading-price series over time. The wealth effect is the change in spending that accompanies a change in perceived wealth (also known as the wealth channel). Yield is the income return on an investment referring to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value. Yuan refers to the Chinese yuan (CNY). EFTA01437750 Important information Deutsche Bank Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries. Clients will be provided Deutsche Bank Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. Deutsche Bank Wealth Management offers wealth management solutions for wealthy individuals, their families and select institutions worldwide. Deutsche Bank Wealth Management, through Deutsche Bank AG, its affiliated companies and its officers and employees (collectively "Deutsche Bank") are communicating this document in good faith and on the following basis. This document has been prepared without consideration of the investment needs, objectives or financial circumstances of any investor. Before making an investment decision, investors need to consider, with or without the assistance of an investment adviser, whether the investments and strategies described or provided by Deutsche Bank, are appropriate, in light of their particular investment needs, objectives and financial circumstances. Furthermore, this document is for information/discussion purposes only and does not and is not intended to constitute an offer, recommendation or solicitation to conclude a transaction or the basis for any contract to purchase or sell any security, or other instrument, or for Deutsche Bank to enter into or arrange any type of transaction as a consequence of any information contained herein and should not be treated as giving investment advice. Deutsche Bank AG, including its subsidiaries and affiliates, does not provide legal, tax or accounting advice. This communication was prepared solely in connection with the promotion or marketing, to the extent permitted by applicable law, of the transaction or matter addressed herein, and was not intended or written to be used, and cannot be relied upon, by any taxpayer for the purposes of avoiding any U.S. federal tax penalties. The recipient of this communication should seek advice from an independent tax advisor regarding any tax matters addressed herein based on its particular circumstances. Investments with Deutsche Bank are not guaranteed, unless specified. Although information in this document has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness, and it should not be relied upon as such. All opinions and estimates herein, including forecast returns, reflect our judgment on the date of this report, are subject to change without notice and involve a number of assumptions which may not prove valid. EFTA01437751 Investments are subject to various risks, including market fluctuations, regulatory change, counterparty risk, possible delays in repayment and loss of income and principal invested. The value of investments can fall as well as rise and you may not recover the amount originally invested at any point in time Furthermore, substantial fluctuations of the value of the investment are possible even over short periods of time Further, investment in international markets can be affected by a host of factors, including political or social conditions, diplomatic relations, limitations or removal of funds or assets or imposition of (or change in) exchange control or tax regulations in such markets. Additionally, investments denominated in an alternative currency will be subject to currency risk, changes in exchange rates which may have an adverse effect on the value, price or income of the investment. This document does not identify all the risks (direct and indirect) or other considerations which might be material to you when entering into a transaction. For certain investments, the terms will be exclusively subject to the detailed provisions, including risk considerations, contained in the Offering Documents. Review carefully before investing. This publication contains forward looking statements. Forward looking statements include, but are not limited to assumptions, estimates, projections, opinions, models and hypothetical performance analysis. The forward looking statements expressed constitute the author's judgment as of the date of this material. Forward looking statements involve significant elements of subjective judgments and analyses and changes thereto and/or consideration of different or additional factors could have a material impact on the results indicated. Therefore, actual results may vary, perhaps materially, from the results contained herein. No representation or warranty is made by Deutsche Bank as to the reasonableness or completeness of such forward looking statements or to any other financial information contained herein. We assume no responsibility to advise the recipients of this document with regard to changes in our views. No assurance can be given that any investment described herein would yield favorable investment results or that the investment objectives will be achieved. Any securities or financial instruments presented herein are not insured by the Federal Deposit Insurance Corporation („FDIC") unless specifically noted, and are not guaranteed by or obligations of Deutsche Bank AG or its affiliates. We or our affiliates or persons associated with us may act upon or use material in this report prior to publication. DB may engage in transactions in a manner inconsistent with the views discussed herein. Opinions expressed herein may EFTA01437752 differ from the opinions expressed by departments or other divisions or affiliates of Deutsche Bank. This document may not be reproduced or circulated without our written authority. The manner of circulation and distribution of this document may be restricted by law or regulation in certain countries. This document is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction, including the United States, where such distribution, publication, availability or use would be contrary to law or regulation or which would subject Deutsche Bank to any registration or licensing requirement within such jurisdiction not currently met within such jurisdiction. Persons into whose possession this document may come are required to inform themselves of, and to observe, such restrictions. Past performance is no guarantee of future results; nothing contained herein shall constitute any representation or warranty as to future performance. Further information is available upon investor's request. All third party data (such as MSCI, S&P & Bloomberg) are copyrighted by and proprietary to the provider. Availability of alternative investments is subject to regulatory requirements, and is available only for "Qualified Purchasers" as defined by the U.S. Investment Company Act of 1940 and "Accredited Investors," as defined in Regulation D of the 1933 Securities Act. Alternative investments may be speculative and involve significant risks including illiquidity, heightened potential for loss and lack of transparency. Please refer to the disclaimer page at the end of this presentation for important risk considerations. Certain strategies may be available to Eligible Contract Participants only as defined by the Commodity Exchange Act. The services described are provided by Deutsche Bank AG or by its subsidiaries and/or affiliates in accordance with appropriate local legislation and regulation. Certain products and services may not be available in all locations or to all Deutsche Bank Wealth Management clients. Wealth-management services are offered through Deutsche Bank Trust Company Americas (member FDIC) and Deutsche Bank Securities Inc. (member FINRA, NYSE, SIPC), a registered broker-dealer and registered investment adviser that which conducts investment banking and securities activities in the United States. Deutsche Bank has published this document in good faith. This document has been prepared without consideration of the investment needs, objectives or financial circumstances of any investor. Before making an investment decision, investors need to consider, with or without the assistance of an investment adviser, whether the investments and strategies described or provided by Deutsche Bank, are appropriate, in light of their particular EFTA01437753 investment needs, objectives and financial circumstances. Furthermore, this document is for information/discussion purposes only and does not constitute an offer, recommendation or solicitation to conclude a transaction and is not investment advice. EFTA01437754 Deutsche Bank AG is authorised under German Banking Law (competent authority: European Central Bank and the BaFin, Germany's Federal Financial Supervisory Authority) and by the Prudential Regulation Authority and subject to limited regulation by the Financial Conduct Authority and Prudential Regulation Authority. Details about the extent of our authorisation and regulation by the Prudential Regulation Authority, and regulation by the Financial Conduct Authority are available from us on request. Risk Warning Investments are subject to investment risk, including market fluctuations, regulatory change, possible delays in repayment and loss of income and principal invested. The value of investments can fall as well as rise and you might not get back the amount originally invested at any point in time. Investments in Foreign Countries - Such investments may be in countries that prove to be politically or economically unstable. Furthermore, in the case of investments in foreign securities or other assets, any fluctuations in currency exchange rates will affect the value of the investments and any restrictions imposed to prevent capital flight may make it difficult or impossible to exchange or repatriate foreign currency. Foreign Exchange/Currency - Such transactions involve multiple risks, including currency risk and settlement risk. Economic or financial instability, lack of timely or reliable financial information or unfavorable political or legal developments may substantially and permanently alter the conditions, terms, marketability or price of a foreign currency. Profits and losses in transactions in foreign exchange will also be affected by fluctuations in currency where there is a need to convert the product's denomination(s) to another currency. Time zone differences may cause several hours to elapse between a payment being made in one currency and an offsetting payment in another currency. Relevant movements in currencies during the settlement period may seriously erode potential profits or significantly increase any losses. High Yield Fixed Income Securities - Investing in high yield bonds, which tend to be more volatile than investment grade fixed income securities, is speculative. These bonds are affected by interest rate changes and the creditworthiness of the issuers, and investing in high yield bonds poses additional credit risk, as well as greater risk of default. Hedge Funds - An investment in hedge funds is speculative and involves a high degree of risk, and is suitable only for "Qualified Purchasers" as defined by the US Investment Company Act of 1940 and "Accredited Investors" as defined in Regulation D of the 1933 Securities Act. No assurance can be given that a hedge EFTA01437755 fund's investment objective will be achieved, or that investors will receive a return of all or part of their investment. Commodities - The risk of loss in trading commodities can be substantial. The price of commodities (e.g., raw industrial materials such as gold, copper and aluminium) may be subject to substantial fluctuations over short periods of time and may be affected by unpredicted international monetary and political policies. Additionally, valuations of commodities may be susceptible to such adverse global economic, political or regulatory developments. Prospective investors must independently assess the appropriateness of an investment in commodities in light of their own financial condition and objectives. Not all affiliates or subsidiaries of Deutsche Bank Group offer commodities or commodities-related products and services. Investment in private equity funds is speculative and involves significant risks including illiquidity, heightened potential for loss and lack of transparency. The environment for private equity investments is increasingly volatile and competitive, and an investor should only invest in the fund if the investor can withstand a total loss. In light of the fact that there are restrictions on withdrawals, transfers and redemptions, and the Funds are not registered under the securities laws of any jurisdictions, an investment in the funds will be illiquid. Investors should be prepared to bear the financial risks of their investments for an indefinite period of time. Investment in real estate may be or become nonperforming after acquisition for a wide variety of reasons. Nonperforming real estate investment may require substantial workout negotiations and/ or restructuring. Environmental liabilities may pose a risk such that the owner or operator of real property may become liable for the costs of removal or remediation of certain hazardous substances released on, about, under, or in its property. Additionally, to the extent real estate investments are made in foreign countries, such countries may prove to be politically or economically unstable. Finally, exposure to fluctuations in currency exchange rates may affect the value of a real estate investment. Structured solutions are not suitable for all investors due to potential illiquidity, optionality, time to redemption, and the payoff profile of the strategy. We or our affiliates or persons associated with us or such affiliates may: maintain a long or short position in securities referred to herein, or in related futures or options, purchase or sell, make a market in, or engage in any other transaction involving such securities, and earn brokerage or other compensation. Calculations of returns on the instruments may be linked to a referenced index or interest rate. In such cases, the investments may not be suitable for persons EFTA01437756 unfamiliar with such index or interest rates, or unwilling or unable to bear the risks associated with the transaction. Products denominated in a currency, other than the investor's home currency, will be subject to changes in exchange rates, which may have an adverse effect on the value, price or income return of the products. These products may not be readily realizable investments and are not traded on any regulated market. 0 March 2016 Deutsche Bank AG, Taunusanlage 12, 60325 Frankfurt am Main, Germany. All rights reserved. 023536 032216 EFTA01437757