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Five Macro Themes for 2017 Chief Analyst Allan von Mehren +45 45 12 80 55 [email protected] Senior Analyst Pernille Bomholdt Henneberg +45 45 13 20 21/+44 20 7410 8157 [email protected] Senior Analyst Mikael Olai Milhøj +45 45 12 76 07 [email protected] 1 December 2016 Investment Research www.danskebank.com/CI Important disclosures and certifications are contained from page 24 of this report. Five Macro Themes for 2017 1. Synchronised recovery 2. Reflation 3. European policy uncertainty 4. Trump – what policies and when? 5. ECB policy - tapering or not? 1 1. Synchronised recovery 2017 starts with recovery across the regions of the world The global economy is entering 2017 with synchronised recovery Strongest global recovery since 2013 First synchronised recovery since 2009 We look for global growth at 3.5% in 2017 2017 2018 % y/y D a ns k e B a nk C o ns e ns us D a ns k e B a nk C o ns e ns us USA 2.2 2.2 2.8 2.2 Euro area 1.5 1.3 1.5 1.5 Japan 0.8 0.8 0.7 0.7 China 6.6 6.4 6.3 6.0 Global 3.5 3.4 3.6 3.4 Source (all charts): Macrobond Financial, Danske Bank Markets 3 Investments to drive recovery as drag from energy investments fades Investment growth to recover from weak levels US economy hit by falling investments Investments have been the weak link since the crisis Drag on the US from oil investments is easing now Source (all charts): Macrobond Financial, Danske Bank Markets 4 In this part of the business cycle equities and US yields increase Leading indicator 1 2 100 3 Equities move higher in the Blue phase 4 We are currently in the Blue phase of the business cycle, which is characterised by global growth recovery with negative output gap So do US bond yields Source (both charts): Macrobond Financial, Danske Bank Markets, Bloomberg 5 2. Reflation Reflation case is strong in the US – less so in the euro area Reflation case is strong in the US – less so in the euro area The US can tick all the boxes on the reflation check list currently – the euro area still has slack left Rise in US inflation towards 2% is persistent. Euro area inflation mainly higher on commodities. Will fall back to just above 1% Source (both figures): Macrobond Financial, Danske Bank Markets 7 US output gap almost closed – euro area has more slack Wage inflation up in US – but not in the euro area Both US and euro area recovering, but the output gap has closed in the US – not in the euro area Core inflation to rise in US – stay low in euro area Source (all charts): Macrobond Financial, Danske Bank Markets 8 Rising commodity prices pushing up inflation Change in oil price drives most of short-term change in inflation. To push up inflation in next 6 months Metal prices rising at strongest pace since 2011. Likely to push up producer prices. Rise driven by recovery of China construction and infrastructure Source (both charts): Macrobond Financial, Danske Bank Markets 9 Fed leans towards letting the economy run a bit hot ‘Fed’s 2% inflation target is not a ceiling’ ‘The natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a ”high-pressure economy,” with robust aggregate demand and a tight labor market’ Fed Chairman, Janet Yellen, October 2016 William Dudley, November 2016 Fed Vice-chairman ‘I see benefits to trying to engineer policy to allow for the strong possibility of inflation overshooting its target’ Charles Evans, October 2016 Chicago Federal Reserve Source: Federal Reserve, Bloomberg 10 The Fed taking a dovish twist in 2017 – we look for only two hikes 2016 Hawkish Neutral Dovish Vacant Lacker Lacker Richmond George George Kansas city Mester Mester Cleveland Rosengren Rosengren Boston Harker Harker Philadelphia Lockhart Lockhart Atlanta Williams Williams San Francisco Powell (B) Powell (B) Board S. Fischer (B) S. Fischer (B) Board, Vice chair Kashkari Kashkari Minneapolis Kaplan Kaplan Dallas Yellen (B) Yellen (B) Chairman Tarullo (B) Tarullo (B) Board Evans Evans Chicago Dudley Dudley New York Bullard Bullard St. Louis Brainard (B) Brainard (B) Board Vacant (B) Vacant (B) Board Vacant (B) Vacant (B) Board Voting member Source: Federal Reserve, Danske Bank Markets 2017 7 out of 10 voters in 2017 will be doves – only one hawk left with voting rights (B) Board Member 11 3. European policy uncertainty EU-sceptic parties to acquire power, not control – the recovery continues with political uncertainty Political uncertainty the main euro theme in 2017 Time for anti-establishment parties to gain power: • EU-sceptic parties are likely to acquire some power in 2017 after having gained in opinion polls, but we do not expect them to take control of the euro area. EU-sceptic parties have gained in polls DE: Alternative for Germany FR: Front national IT: Five Star SP: Podemos NL: Dutch Freedom Party • It is hard to imagine further euro area integration in coming years, but we believe the UK will be the only country to leave the EU, while the euro will not lose any members. • The growing EU scepticism has so far had limited economic impact, but more actual power to anti-establishment parties could result in postponed investments and consumption decisions. On the other hand, it could boost fiscal spending, but at the same time threaten fiscal sustainability. BE: Vlaams Belang AT: Austrian Freedom Party FI: Finland's Finns Party GR: Syriza GR: Golden Dawn PT: Left Bloc IE: Sinn Fein UK: UK Independence Party SE: Sweden Democrats DK: Danish People's Party 0% Latest polls (Oct-Nov) 10% 20% Last national election 30% EP 2014 40% EP 2009 Source: Danske Bank Markets 13 Italian referendum – market reaction dependent on political path Referendum on Italy’s constitutional reform ‘ YES’ ‘NO’ Initial positive market reaction Initial negative market reaction Renzi continues growth reforms. Work on new electoral law Within the next week, the first major political event in the euro area will take place with the Italian constitutional referendum • In our base case, the Italians vote ‘No’ and PM Renzi steps down but without it resulting in ‘Italexit’ or a major sell-off in Italian government bonds • There is broad political support in favour of changing the new electoral law – ‘Italicum’ – into being less beneficial for a single party like the antiestablishment Five Star Movement (M5S) before calling snap elections • A revised electoral law makes a coalition government most likely, which should limit M5S power given its opposition to forming coalitions Renzi stays PM Renzi steps down President Mattarella rejects Renzi’s resignation Strong support for Renzi government Election in 2018 based on revised Italicum Weak support for Renzi’s government New government/coalition serving as placeholder until election in 2018 Focus on new electoral law. No reform progress Renzi gets second term with more government power Positive market reaction. No/little uncertainty about Italy’s future in euro / EU Source: Danske Bank Markets Renzi is not likely to take part in new government President Mattarella accepts Renzi’s resignation Care-taker government and snap election Snap election in H2 2017 based on revised Italicum Coalition government The Five Star Movement emerges into power Snap election in H1 2017 based on current Italicum Strong reform progress. Work on new electoral law Negative market reaction. Uncertainty about Italy’s future in the euro / EU 14 French presidential election – are opinion polls unreliable? Presidential election (by universal suffrage in two stages of voting) Front National: Marine Le Pen Socialist candidate Independent candidate Emmanuel Macron The Republicans: Francois Fillon First round (absolute majority necessary to win) Deeply unpopular, unlikely to enter run-off Unlikely to enter run-off Second round run-off between two top candidate in first round (simple majority sufficient to win) Polls show Fillon winning run-off against Le Pen with 67% against 33% Risks to our base case that Marine Le Pen will not become the next French president: • In the past, voters have united to prevent the far-right from winning, but nothing can be ruled out given the current populist, anti-establishment mood in Europe and the high degree of uncertainty around opinion polls • With his socially conservative and liberal reform programme, Francois Fillon lacks the broad appeal to both voters on the right and left and may struggle to unite them against Le Pen. Source: Danske Bank Markets 15 4. Trump – what policies and when? Trump’s fiscal easing to support reflation case but his overall policy remains a risk factor The political and economic consequences of the Trump presidency Donald Trump as US President Possible regime shifts in US policies but actual policy changes should be more modest than proposed due to likely Overall political resistance from Congress even within the Republican party. However, Trump's room for manoeuvre is larger as the Republican party will also control Congress outlook Uncertain how he will act as President as he has no political background. Overall economic outlook Q4 16-Q3 17: The election to be broadly neutral for US growth, which we expect at around 2.25% annualy Q4 17 - 2018: More expansionary fiscal policy to boost GDP growth from late 2017 to nearly 3% annually. 2018+: More uncertain, but the negative effects from more protectionism and a tougher immigration policy may outweigh possible positive effects from less regulation, lower taxes and infrastructure spending. Hence structural growth may fall. Fiscal policy Short to medium term: large tax cuts and infrastructure spending; in sum, fiscal easing of up to 2.2% of annual GDP Long run: worsen public financial sustainability as net debt will rise dramatically. Trade policy More protectionist, risking a global trade war. Withdrawal of the US from TPP Renegotitate the NAFTA to get 'a lot better terms', otherwise withdraw from it. No comments on TTIP but given Trump's protectionist stance does not bode well. Tougher line against China. Protectionism will lower US potential growth. We expect that the Fed will hike rates in December and twice a year afterwards, i.e. a total of five hikes from now until Monetary policy year-end 2018. We expect Fed to only partly offset Trump's expansionary fiscal policy. Trump to replace Fed chair Yellen in 2018 and likely appoint more hawkish Governors in 2017. Foreign policy Immigration Trump has more power on foreign policy. Very uncertain how he will act but has hinted at a significant regime shift. Has said that China is the enemy, not Russia. Wants NATO countries to contribute more. Trump has softened his tone but is likely to be substantially more hawkish than previous administrations on immigrants. Will likely take measures to reduce illegal immigration and send criminal immigrants home. Anti-immigration could lower US potential growth. Source: Donald Trump’s speeches, Danske Bank Markets 17 Trump to boost growth through infrastructure spending and tax cuts Increasing infrastructure spending Estimated multipliers in the range [0.5 ; 2.5] over several quarters Higher employment Estimated multipliers in the range [0.3 ; 1.5] over several quarters Lower corporate taxes Higher consumer saving Higher disposable income Personal tax cuts Firms increase employment and investments Higher consumer spending We expect the Fed to only partly offset growth impact through rate hikes (tighter monetary policy lowers multiplier effect) Multiplier effect Source: Danske Bank Markets 18 Biggest growth impact in 2018 due to policy lags There is a lag before fiscal policy affects the economy Q1 17 IDEA Q2 17 DECISION Comprehensive and permanent economic plan? Smaller and more temporary economic plan? Takes time for the politicians to pass the necessary legislation – Trump probably needs to make compromises with Republican members of Congress Q3 17 IMPLEMENTATION Takes time to implement the policy (projects may not be ‘shovel-ready’ so projects have to be defined and designed first) GROWTH IMPACT Earliest from late 2017 Infrastructure: Longer policy lag but bigger growth impact Tax cuts: Smaller policy lag but smaller growth impact Q4 17 2018 Biggest growth impact in 2018 Source: Danske Bank Markets 19 5. ECB tapering or not? Premature to price ECB hiking cycle and discuss tapering – we look for (at least) one QE extension ECB set to continue QE as inflation is not on a sustainable path Inflation above 1.0%, but due to the oil price • We expect the ECB to extend its QE programme by six months and maintain the EUR80bn monthly purchases as inflation is not on a sustainable path towards 2%. • Prominent ECB members have expressed concern about the lack of upward pressure on underlying prices, which together with a considerable downward revision to the ECB’s core inflation projection should convince enough ECB members that it is too early to discuss tapering. • We believe it is premature to price rate hikes from the ECB and see a more than 50% likelihood that QE purchases will be extended again next year, which is not consensus. Source: ECB, Macrobond Financial, Danske Bank Markets 21 Lack of upward trend in core inflation is a concern to the ECB Core inflation is far from the ECB’s forecast Philips curve: ECB’s wage forecast is hopeful ECB 2018 Wages: 2.2% Unemp: 9.6% ECB 2017 Wages: 1.8% Unemp: 9.9% Core inflation on a downward trend during 2016 – no longer support from a weakening euro Source: ECB, Eurostat, Danske Bank Markets ECB 2016 Wages: 1.2% Unemp: 10.1% Source: ECB, Eurostat, Danske Bank Markets 22 ECB end-of-easing is wrong – QE extension becoming more likely ECB action in December - extension and minor PSPP tweaks (hawkish wording) Trump sell-off has reduced tapering risks - not increased due to: - Two-sided risk to inflation - and pricing still very, very low - Higher real rates - Periphery spread widening - QE restrictions not binding in the near term - Increased political risk in Europe - Higher protectionism (US repatriation) - (Not weaker effective euro) The market has gone from ‘cut’ to ‘hike’ in 2m 10 bp ECB dated Eonia swaps (assuming neutral Eonia is 5bp above deposit rate) 6.1 5.0 5 3.8 2.7 ECB extension (and possible tapering options) 6 month EUR80bn extension (tapering options) - We expect the ECB to announce a six month QE extension in December - No pre-announcement of QE tapering, but a reiteration that QE will not exist forever - The programme’s end date will remain dependent on the inflation outlook - The first ECB rate hike will not follow until ‘well past the horizon of the QE purchases’ - (Risk of some form of tapering: 1) EUR80 bn will include reinvestment of redemptions; 2) 'Tapering' in countries that hit restrictions (Germany, Finland, Portugal & Ireland); 3) Step-down to EUR60bn per month; 4) EUR5bn or EUR10bn reduction per month) 0.2 0.3 0.4 0.3 0.3 0.9 1.7 0 0.0 -0.2 -0.2 -0.2 -0.3 -0.3 -0.1 -5 -10 PSPP tweaks (also important for exit strategy) - Allowing some deviation from Capital Key - but NOT introducing a new buying scheme (enough German Bunds are eligible for a 36M extension - but if market rally German/Finnish purchases will More PSPP flexibility still be reduced as is already the case with Ireland/Portugal) needed if core FI rally again (not - IF buying below depo is allowed actual buying will be quite low really needed at current yield (ECB will buy Schatz down to -80bp) level) - Lifting issue/issuer limit is possible, but actual buying in ISINs with holdings above 33% will be quite low. We see risk tilted towards ECB rather reducing longer dated purchases as holdings in longer dated German bonds approach the limit -15 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 ECB ECB ECB ECB ECB ECB ECB ECB ECB 28/11/2016 29/09/2016 Source: ECB, Eurostat, Danske Bank Markets 23 Disclosures This research report has been prepared by Danske Research, a division of Danske Bank A/S (‘Danske Bank’). The authors of this research report are Allan von Mehren, Chief Analyst, Pernille Bomholdt Henneberg, Senior Analyst, Mikael Olai Milhøj, Senior Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst’s personal view about the financial instruments and issuers covered by the research report. 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