CROSS ASSET THEMATIC RESEARCH October 2011

THE NEW WORLD ORDER

Fiscal austerity: sectors in the line of fire

Véronique Riches-Flores

Phone: +33 (0)1 42 13 84 04

Societe Generale (“SG”) does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that SG may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE APPENDIX AT THE END OF THIS REPORT FOR THE ANALYST(S) CERTIFICATION(S), IMPORTANT DISCLOSURES AND DISCLAIMERS AND THE STATUS OF NON-US RESEARCH ANALYSTS.

THAT WILL BE FOLLOWED BY MAJOR CHANGES IN THOSE COUNTRIES’ FISCAL POLICIES Already in 2006.we have no chance to see our future income improving substantially in the long run . S&P was arguing that ageing populations would cause most OECD countries to lose their investment grade status by 2040 Abstract from our report “After the central banks who will buy our government bonds?” June 09 S&P 2006 long-term baseline scenario – sovereign debt ratings Australia Canada AAA AAA AAA AAA France AAA A Non-IG Non-IG Germany AAA AAA A Non-IG Italy AA A Non-IG Non-IG Japan AA Non-IG Non-IG Non-IG S.e.with weak potential GDP. WHY? » OUR ECONOMIES ARE MATURE .WE ARE ALL GREEKS! NO ONE CAN CLAIM TO BE IMMUNE FROM A GREEK-STYLE SPIRAL. especially post the financial crisis » WE ARE AGEING . FAILURE OF AN OECD STATE – IS AN ELECTROSHOCK FOR THE COMMUNITY OF INDUSTRIALISED NATIONS. SG Cross Asset Research 25/10/2011 2 . Korea A A Non-IG Non-IG Spain AAA AAA BBB Non-IG Sweden AAA AAA A Non-IG UK AAA AAA A Non-IG USA AAA BBB Non-IG Non-IG 2005 2020 2030 2040 AAA AA BBB Non-IG Source: S&P 2006. our savings capacities are shrinking and our health and pensions spending is increasing THE REAL-LIFE STRESS TEST OF GREECE – i.

00 20.00 30.THE LONG ROAD TOWARDS FISCAL CONSOLIDATION THE BILL IS HUGE. IT WOULD STILL REQUIRE THREE YEARS TO STABILISE THE DEBT RATIO » THE FISCAL CONSOLIDATION REQUIRED – RETURNING TO 60% OF GDP WOULD TAKE A MINIMUM OF 10 YEARS ACCORDING TO THE OECD.00 Consolidation required to stabilize debt at 2010 levels Consolidation needed to bring government debt to 60% of GDP by 2026 Source : OECD.00 15.00 25. 20 YEARS ACCORDING TO THE IMF… Effort required on primary balance to stabilise or return to debt level of 60% of GDP by 2026. THE LEVEL OF PUBLIC DEBT IS UNSUSTAINABLE » AT 100% OF OECD’S GDP. according to the OECD. EVEN IF THE PRIMARY DEFICIT DISAPPEARED AS OF TODAY.00 10. % of potential GDP 35.00 0. SG Cross Asset Research 25/10/2011 3 . BUT THAT IS NOT THE ISSUE. AND THERE IS A SIGNIFICANT RISK THAT EFFORTS WILL ULTIMATELY BE ABSORBED BY LASTING WEAK ECONOMIC AND INFLATION GROWTH.00 5.

Over these 107 periods .5 percentage points. Authors identified 107 episodes of fiscal adjustmen ts between 1970 and 2007 (91 episodes of stimuli ). SG Cro ss Asset Research Alesina and Ardagna define fiscal adjustment episodes as the years during which the cyclically adjusted primary balance (public balance exc. 35% Expansionary episodes Contractionary episodes Exp. 25/10/2011 4 .5 % of GDP. 4 lasted three years but one only lasted over four consecutive years (Denmark from 1983 to 1986). An episode of fiscal adjustment is qu alified as “expansionary” if the average growth rate of GDP gap with the G7 in the first year of adjustment and the two following years significantly exceeds the same variable in all episodes of fiscal adjustment. 135% Revenue 66% Exp. 2009. SUCH AN ADJUSTMENT WOULD BE MADE BY EFFORTS TO REDUCE SPENDING » OF THE 107 EPISODES OF FISCAL ADJUSTMENTS OBSERVED IN THE PAST 40 YEARS THE MOST EFFICIENT IN TERMS OF FISCAL RESULTS AND LEAST COSTLY IN TERMS OF GROWTH HAVE BEEN THE ONES BASED ON SPENDING DRAG RATHER THAN TAX INCREASES Typolog y and efficiency of fiscal consol idation episodes between 1970 and 2007 in OECD countries Repartition of the 107 episodes of fiscal adjustment by d uration Contribution of expenditure and revenue items to fiscal adjustment and impact on growth 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 3 4 Duration (years) Contribution of expenditure and revenue items to fiscal adjustment and impact on primary deficit 160 140 120 100 80 60 40 20 0 -20 -40 -60 70 60 50 40 30 20 10 0 Number of episodes by duration Revenue 14 Revenue 65% Exp. 34% Revenue -35% Successes Failures 1 2 Source: Alesina et Ardagna.WHAT’S NEXT? “IDEALLY”. interests) improves by at least 1. They are qualified as “successful” when th e cumulative reduction of the debt to GDP ratio three years after the beginning of the fiscal adjustment is greater than 4. 65 lasted only one year. 86% Exp. 13 lasted two years.

SG Cross Asset Research 25/10/2011 5 . none of them dealt with as many economies as are involved today The success of a fiscal adjustment is much more uncertain over the long haul (when it repeatedly affects a growing number of economic agents and causes a reassessment of the role of public authorities) Austerity measures may find differing levels of acceptance among population Their impact on the behaviour of agents is largely unpredictable and may notably cancel out much of the effects initially targeted (see Greece) SPENDING CUTS THAT HAVE LARGELY CHARACTERISED BUDGETARY POLICY IN 2010 WILL BE DIFFICULT TO CONTINUE IN THE LONG TERM Expenditure versus revenue-based measures in fiscal consolidation plans of 2010 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Expenditure Revenue Source : OECD. HOWEVER Fiscal austerity efforts are more accessible when they are carried out in isolation (their depressive effects can be offset by growth in the rest of the world) 60% of the past episodes of adjustment lasted less than one year.THE CURRENT SITUATION IS FAR MORE COMPLEX.

096*u-0.657+0.53*g R2=0. exp/GDP ratio .OECD d=1.789 Actual d= one year change in public spending/GDP ratio -1 -2 2 0 -2 Residuals u= one year change in the unemployment rate g= one year change in reral GDP growth 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 0 1 2 3 4 5 6 7 8 9 10 Source : SG Cross Asset Research 25/10/2011 6 .GROWTH CONSTRAINTS THE CURRENT CONTEXT OF SLOW GROWTH AND A STUBBORNLY HIGH UNEMPLOYMENT RATE CONSIDERABLY REDUCES THE PROBABILITY OF A SUBSTANTIAL CUT IN PUBLIC SPENDING 80% OF THE CHANGE IN THE RATIO OF PUBLIC SPENDING/GDP HAS RESULTED FROM THE COMBINATION OF GDP GROWTH AND UNEMPLOYMENT RATE OVER THE LAST 40 YEARS! 4 3 2 1 0 Fitted Implicit imp of pact SG economi c forecasts Change in pub.

Those that offer the least protection may be faced with the need to increase their social action.BEWARE THE SOCIAL/POLITICAL CONSTRAINTS… THE SOCIAL COST OF THE ONGOING CRISIS WILL LIMIT THE SCOPE OF PUBLIC SPENDING CUTS Average replacement rate of revenue during initial phase of unemployment based on six family types – level 1 of earnings (from 67% to 150% of national average wages) Countries with the highest protection level will have very limited room for manoeuvre to reduce their spending. 90 80 70 OECD average 60 50 40 AUS NZL KOR GBR TUR USA POL IRL JPN EST SWE GRC AUT FIN HUN ITA BEL ESP CAN SVK NOR CZE DNK DEU NLD SVN FRA ICE CHE PRT LUX 20 Gap to average 10 0 -10 -20 AUS NZL KOR GBR TUR USA POL IRL JPN EST SWE GRC AUT FIN HUN ITA BEL ESP CAN SVK NOR CZE DNK DEU NLD SVN FRA ICE CHE PRT LUX Source: From OECD. SG Cross Asset Research 25/10/2011 7 . Tax-Benefit Models.

0 25.0 30. public sector investment is likely to bear the brunt of the spending cuts Easier to cut or postpone than other forms of expenditures.PUBLIC INVESTMENT IN THE FIRING LINE Eventually.0 15.0 35.0 20.0 5. SG Cross Asset Research 25/10/2011 8 . 2009 45. in the end.0 As a % of total investment As a % of total public expenditure Source: OECD. less political/social conflict A substantial part of public spending (10% of OCDE public spending) Sometimes poor economic efficiency BUT A LONG-TERM ECONOMIC COST Public investment account for 1/5th of total investment in OECD countries Lasting underinvestment in the public sector has always come at a cost in terms of infrastructure efficiency and.0 40.0 10.0 0. productivity (see UK or German experiences) Weight of public investment among OECD members.

80000 1981 France 70000 60000 50000 40000 Income level. nat. cur. SG Cross Asset Research 80000 Marginal tax rate. 1981 at 2010 prices 2010 USA 30000 20000 10000 0 400000 350000 300000 250000 200000 1981 1981 at 2010 prices 2010 0 10 20 Greece 30 40 50 60 Marginal tax rate. % Income level. nat. 150000 100000 100000 120000 1981 1981 at 2010 prices 2010 50000 0 0 20 40 60 80 60000 40000 20000 0 0 Source: OECD. nat. cur.HIGHER TAX AND MORE PROGRESSIVITY AHEAD Income level. cur. % 25/10/2011 9 . % 10 20 30 40 50 60 70 Marginal tax rate.

$PPP 20000 25000 30000 35000 40000 45000 50000 25000 0 15000 Public expenditure/cap.) GDP/cap.-) 25000 Public revenues/cap. 2009.. 2011. 20000 FIN FRA ITA OECD GBR GRC 10000 POL 5000 PRT KOR JAP ESP DNK SWE OE BEL DEU CAN IRE AUS NDL CHE USA 15000 The preservation of nationally preferred models may be hit by the fiscal consolidation Tax revenues/capita relative to GDP/capita for main OECD countries and probable trend (..SG Cross Asset Research GDP/cap. PPP 20000 25000 30000 35000 40000 45000 50000 25/10/2011 10 . DIFFERENT OUTCOME Public spending per capita relative to GDP per capita for the main OECD countries and probable trend (.....SAME PROBLEMS. 20000 SWE DNK OE NDL BEL IRE FRA GBR CAN ITA GER OECD AUS SP FIN JAP PRT POL 5000 KOR 15000 GRC 10000 USA CHE 0 15000 Source: OECD “Governments at a glance”. 2009. $.

0 -37. % change from 2009 30.0 -10.300.0 -20.0 Source: OECD. within OECD average.0 30. 20.INCREASING INCOME TAX OR REDUCING EXPENDITURE? 40.0 12. % change from 2009 25. the US would actually have to increase government revenues by 33% (or $4.) France would have to decrease both its revenues and expenditure by PPP $ 2.0 -10.5 -50.) and to p increase public expenditure by 10% (or $1.0 Restriction 20. SG Cross Asset Research 25/10/2011 11 .0 Restriction needed to bring gvt expenditure/cap.700/cap.5 -25. % change from 2009 Restriction To bring its fiscal situation in line with the OECD average.100/cap.0 -30.280/cap.0 Restriction Overall restriction per capita. within OECD average.5 0.0 10.0 Restriction needed to bring gvt revenue/cap.0 0.0 -20.0 10.2.0 0.0 -12.0 -30.

CORPORATE TAXATION: POTENTIALLY VERY DIFFERENT SITUATIONS IN THE US AND EUROPE Corporate income tax rate. % 60 THE US IS POTENTIALLY MORE EXPOSED TO AN INCREASE IN SOCIAL CONTRIBUTIONS THAN EUROPE (potentially negative for US labour-intensive industries) BUT IT IS IN EUROPE THAT THE RISK OF HIGHER INCOME TAX SEEMS THE MOST ELEVATED (the US corporate income tax is among the highest in the OECD) Adjusted top statutary tax rate on corporate income 55 50 45 JAP 40 USA 35 FRA ITA 30 DEU ESP 25 GBR 20 1995 1997 1999 2001 2003 2005 2007 2009 2011 Source: EUROSTAT. SG Cross Asset Research 25/10/2011 12 .

CROWDING-OUT EFFECTS DRAIN ON REVENUES/weaker economic growth Higher risk premium UNSTABLE TAX AND REGULATORY ENVIRONMENT /negative for investment Structural decline in P/E CONSUMER TAXATION Negative on consumption outlook CORPORATE TAXATION Negative on investment and corporate performance WHICH ARE THE MOST EXPOSED SECTORS? 25/10/2011 13 .

0 -2.0 0.0 3.0 -2.0 5.0 -3.0 0.0 1.MULTI-CRITERIA* EXPOSURE OF THE VARIOUS EUROPEAN SECTORS TO AN INCREASE IN TAXATION Tobacco Utilities Overall exposure Most profitable sectors are highly exposed Telecommunication Services Semiconductors & Semiconductor Equipment Pharmaceuticals Beverages Real Estate Media Low taxed Cies are highly exposed Oil & gaz extraction Food Products Metals & Mining Textiles.retail Hotels Restaurants & Leisure IT Services Commercial Services & Supplies Labour intensive Cies may be relatively protected Source: SG Cross Asset Research.0 -4.0 25/10/2011 14 .0 4. Apparel & Luxury Goods Energy Equipment & Services Chemicals Electrical Equipment Construction Materials Labour intensity EBIT margins Payout ratio Effective tax rate Aerospace & Defence Machinery Software Automobiles & Components Specialty Retail . *All indicators are normalised and rebased to zero.0 2.0 -1.0 6. -4.0 2.0 4.

THE EUROPEAN FISCAL HIT LIST Exposure of the various sectors to tougher fiscal conditions for companies in Europe The most exposed sectors Tobacco Utilities Telecoms Semiconductors S i d t Pharmaceuticals Real estate Media Beverages Oil & Gas Neutral sectors Agrifood Metals & Mining Textiles. apparel & Luxury goods Energy equipment & S i E i t Services Chemicals Electrical equipment Construction & Materials The most protected sectors Commercial services Hotels. restaurants & leisure Specialised distribution Automobile & E i A t bil Equipment makers t k Software & IT services Machinery Aerospace & Defence Source: SG Cross Asset Research 25/10/2011 15 .

S. firms or entities. act as market-makers or advisers. firms or entities mentioned in this document and may be represented on the board of such persons.DISCLAIMER FOR DISCLOSURES PERTAINING TO COMPENDIUM REPORTS OR RECOMMENDATIONS OR ESTIMATES MADE ON SECURITIES OTHER THAN THE PRIMARY SUBJECT OF THIS RESEARCH REPORT. SG is under no obligation to disclose or take account of this document when advising or dealing with or on behalf of customers. and derivatives in particular. Analyst Disclosure: The name(s) of any non-U.. U. SG does not provide any tax advice. 25/10/2011 16 . The non-U. An option may become worthless by its expiration date. Estimates of future performance are based on assumptions that may not be realized. or a solicitation of an offer to buy or sell. The value of securities and financial instruments is subject to currency exchange rate fluctuation that may have a positive or negative effect on the price of such securities or financial instruments.278.S. SG does. profit from. SG does not accept any liability whatsoever arising from the use of the material or information contained herein. analysts who contributed to this report and their SG legal entity are listed below. The financial instrument discussed in this report may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein. of persons.com/compliance. Past performance is not necessarily a guide to future performance. SG does. counterparty default and liquidity risk. This research document is not intended for use by or targeted to retail customers. investors must review the "Characteristics and Risks of Standardized Options" at http://www. information presented in this report and is under no obligation to ensure that such other reports are brought to the attention of any recipient of this report.S. hold.6000 in the U. public appearances and trading securities held in the research analyst(s)’ account(s): Véronique Riches –Flores (Société Générale. Should a retail customer obtain a copy of this report he/she should not base his/her investment decisions solely on the basis of this document and must seek independent financial advice. Prior to buying or selling an option. including. addition. or is based upon. from. trade in. from time to time. any securities and has been obtained from. act as a principal trader in debt securities that may be referred to in this report and may hold debt securities positions. sources believed to be reliable but is not guaranteed as to accuracy or completeness. as it is a depreciating asset. may not be associated persons of SGAS and may not be subject to the FINRA restrictions on communications with a subject company. Trading in options involves additional risks and is not suitable for all investors. may from time to time have a position in or hold any of the investments or related investments mentioned in this document.rha or call +1 (212).jsp. among others.com/publications/risks/riskchap. Paris) IMPORTANT DISCLAIMER: The information herein is not intended to be an offer to buy or sell..S. or individuals connected to them. especially for options of unhedged positions. Non-U.sgresearch. To the maximum extent possible at law. Investments in general. market. or derivatives thereof. analysts are employed by SG Americas Securities LLC. PLEASE VISIT OUR GLOBAL RESEARCH DISCLOSURE WEBSITE AT http://www. deal. Option ownership could result in significant loss or gain. brokers or bankers in relation to the securities. The views of SG reflected in this document may change without notice In addition SG may issue other reports that are inconsistent with and reach different conclusions from the notice.S. with. Employees of SG. involve numerous risks. a portion of which are generated by investment banking activities.1. The analyst(s) responsible for preparing this report receive compensation that is based on various factors including SG’s total revenues.optionsclearing. analysts are not registered/qualified with FINRA. and investors in securities such as ADRs effectively assume this risk.APPENDIX . from time to time.

The Branch certifies that this document has been elaborated with due dilligence and care. Accredited Investors. Hong Kong Branch which is licensed by the Securities and Futures Commission of Hong Kong under the Securities and Futures Ordinance (Chapter 571 of the Laws of Hong Kong) ("SFO"). The Branch is supervised by the Polish Financial Supervision Authority and the French ”Autorité de Contrôle Prudentiel”. person wishing to discuss this report or effect transactions in any security discussed herein should do so with or through SGAS. Tokyo Branch. 110 (“FAA”): (1) the exemption in Regulation 33 of the Financial Advisers Regulations (“FAR”).K.com. Notice to Canadian Investors: This document is for information purposes only and is intended for use by Permitted Clients.DISCLAIMER Important European MIFID Notice: The circumstances in which material provided by SG European Fixed Income (Credit) & Forex Research. and under no circumstances should it be forwarded to any third party. London Branch . This report is intended for institutional investors only. a broker-dealer registered with the SEC and a member of FINRA. fair and not misleading. Cap. Tokyo Branch.S. However. 236651 issued under the Corporations Act 2001 (Cth) ("Act"). (2) the exemption set out in Regulation 34 of the FAR. and (3) the exemption set out in Regulation 35 of the FAR. Any U. BCSC. 1221 Avenue of the Americas. SG Commodity Research. please be informed that in SG's dealings with you.. and made available only to. or in connection with. as defined under National Instrument 45-106. 289. expert investors and institutional investors. Société Générale is a French credit institution (bank) authorised and supervised by the Autorité de Contrôle Prudentiel (the French Prudential Control Authority). as defined by the Financial Instruments and Exchange Law in Japan and only for those people to whom it is sent directly by Societe Generale Securities (North Pacific) Ltd. as defined in the Act on trading in financial instruments.. This document does not constitute a solicitation or an offer of securities or an invitation to the public within the meaning of the SFO. which exempts SG from complying with Section 25 of the FAA on disclosure of product information to clients. This report is to be circulated only to "professional investors" as defined in the SFO.sgcib.K. SG Americas Securities LLC (“SGAS”) takes responsibility for this research report. as defined in Section 4A of the Securities and Futures Act. which is regulated by the Financial Services Agency of Japan. which exempts SG from complying with Section 36 of the FAA on disclosure of certain interests in securities. because of reporting or remuneration structures or the physical location of the author of the material) that it is not appropriate to characterize it as independent investment research as referred to in the European Markets in Financial Instruments Directive and that it should be treated as marketing material even if it contains a research recommendation (“recommandation d’investissement à caractère promotionnel”). Singapore Branch in respect of any matters arising from. professional clients and eligible counterparties (as defined in the FSA rules) and should not be relied upon by any other person or party. Investors: This publication is issued in the United Kingdom by or through Société Générale ("SG"). the document. Oddzial w Polsce (“the Branch”) with its registered office in Warsaw (Poland) at 111 Marszałkowska St. Notice to Polish Investors: this document has been issued in Poland by Societe Generale S. Notice to Australian Investors: This document is issued in Australia by Société Générale (ABN 71 092 516 286) ("SG"). which exempts SG from complying with Section 27 of the FAA on recommendations. (212)-278-6000. Copyright: The Société Générale Group 2011.A. Notice to Singapore Investors: This document is provided in Singapore by or through Société Générale ("SG"). If you are an accredited investor or expert investor. Notice to U. Notice to Japanese Investors: This publication is distributed in Japan by Societe Generale Securities (North Pacific) Ltd. SG is relying on the following exemptions to the Financial Advisers Act. it must be made clear that all publications issued by SG will be clear. The information and any advice contained herein is directed only at. This report is addressed to financial institutions only. Singapore Branch and is provided only to accredited investors. NY 10020. The products mentioned in this report may not be eligible for sale in Japan and they may not be suitable for all types of investors. All rights reserved. 25/10/2011 17 . This document is intended only for the Specified Investors. Notice to French Investors: This publication is issued in France by or through Société Générale ("SG") which is authorised and supervised by the Autorité de Contrôle Prudentiel and regulated by the Autorite des Marches Financiers. Notice to Hong Kong Investors: This report is distributed in Hong Kong by Société Générale. as defined under National Instrument 31-103. SFSC and NBSC Orders http://www. SG Convertible Research and SG Equity Derivatives Research have been produced are such (for example.APPENDIX .S. Cap. Details of the extent of SG's regulation by the FSA are available from SG on request. This publication may not be reproduced or redistributed in whole in part without the prior consent of SG or its affiliates. SG is regulated by APRA and ASIC and holds an AFSL no. New York. Accredited Counterparties as defined under the Derivatives Act (Québec) and "Qualified Parties" as defined under the ASC. Société Générale is subject to limited regulation by the Financial Services Authority (“FSA”) in the U. The information contained in this document is only directed to recipients who are wholesale clients as defined under the Act. Notice to U. For more details please refer to SG’s Policies for Managing Conflicts of Interest in Connection with Investment Research posted on SG’s disclosure website referenced herein. Recipients of this document are to contact Société Générale. Investors: For purposes of SEC Rule 15a-6.

SG LEADER IN GLOBAL CROSS ASSET RESEARCH Macro & Strategy Fixed Income 2011 #1 Overall Trade Ideas #1 Global Strategy #1 Multi Asset Research #2 Global Economics #2 Pan-Euro Economics #1 Credit Research Team #1 Overall Credit Strategy #1 in Sovereigns #1 in 4 sector teams 2011 Commodities Equity 2011 #3 Research in Power and Gas #4 Research in Oil #4 Research in Base Metals #5 Research in Precious Metals #1 Equity Quant #1 Index Analysis 10 sector teams in the Top 10 25/10/2011 18 .