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UBS Asset Management November 2016 Investing in 2017 Protection, politics, populism Introduction "In this world, global institutions will need to make way for more regional ones." 2016 may very well go down as the year in which governments, particularly those in developed economies, came to the realisation that they failed in their duty to ensure the benefits of growth are spread evenly across their electorates. Instead of focussing on ensuring the long term productive capacity of the economy, governments for too long were focussed on austerity. The over-reliance on monetary policy as the sole tool to address the post-financial crisis malaise propelled the trend in rising income and wealth inequalities within economies even further. As a result of this neglect, potential growth rates have fallen. Ironically, while governments around the world have realised that they have left voters behind in their efforts to lift postcrisis economic growth, they have become powerless to do anything about it. The fragile state of many coalition governments that are made up of parties at extreme ends of the political spectrum has depleted political capital. The exception to this is the US where the Republicans control both Congress and the White House. There is still considerable uncertainty surrounding the extent to which Congress will support the more extreme policies of President-elect Trump, however. With little political capital remaining, governments are increasingly tilting toward protectionist policies as an easy solution. This tilt was given a substantial push following the outcome of the US presidential election. In this world, global institutions will need to make way for more regional ones. Trade agreements will become more preferential. Multi-national corporations will shrink and cross-border political collaboration will be more difficult to achieve outside of the region. In 2017, multi-asset investors will need to re-price risk to reflect national differences between sovereigns and between regions. From a strategic perspective, this will likely benefit developed markets more than emerging markets. Within emerging markets, however, the fundamentally more sound Asia region will benefit over the less sound Latin America. Between asset classes, more expansionary fiscal policy and more protectionist trade policy suggests bond yields will be pressured higher. This may not be to the detriment of equities, however, if growth supports earnings expansion. Tracey McNaughton Head of Investment Strategy 3 The Great Fed Debate Nearly ten years on from the financial crisis and after unprecedented amounts of monetary stimulus, economies around the world are still struggling to generate sustainable growth. A realisation is dawning within central banks and among government authorities that economies are hamstrung by structural challenges that cannot be addressed with cyclical tools alone. Just how much downward pressure these structural issues are having on growth is the subject of much debate. A great debate is currently taking place inside the US Federal Reserve. The issue: just how expansionary is the current setting of monetary policy? This seems a simple enough question to answer, especially since those trying to answer it are the ones setting monetary policy. The problem is the line in the sand that delineates expansionary from contractionary policy is firstly, not directly observable and secondly, may have moved in recent years. With the Fed now in tightening mode, knowing where you are in relation to a neutral policy setting is pretty important, especially given how low the starting point is. There is little room for error to the downside if policy is tightened too much or too quickly. Recovery of sorts It is clear there has been a recovery in global growth since the 2008 financial crisis. However, the recovery has been disappointing. Using data from the International Monetary Fund (IMF), in the last three years world growth has averaged less than 3 percent. This is below what would be considered trend growth of 3.5 percent. The real median wage earned by men in the US is lower today than it was in 1969. This comes despite unprecedented levels of monetary accommodation. There have been no fewer than 670 interest rate cuts globally since the 2008 financial crisis. This equates to around one rate cut every three working days. Interest rates have been pushed to record lows. Around 489 million people now live in countries where the official interest rate is negative. In addition, the major central banks have expanded their balance sheets by over $US12 trillion. As a result, asset prices have surged – the world stock market capitalisation has increased from $25.5 trillion in March 2009 to $65.4 trillion today1. Non-financial corporate profits in the US have increased by 72 percent since the financial crisis trough. At the same time, US household net worth has increased by $33.7 trillion. Despite the expansiveness of the stimulus, the US economy is experiencing its weakest recovery in the postWorld War II era (chart 1). The average rate of growth in GDP during the current expansion has been just 2.1 percent. This compares with the average of the previous ten expansions since 1949 of 4.7 percent. Despite ranking the fourth longest expansion, the economy has only managed to increase in size by a total of just 15.5 percent, compared to an average of 24.9 percent over the past expansions (chart 2). Has monetary policy lost its potency? The concept of secular stagnation was first put forward by economist Alvin Hansen in the 1930s but was given 1 Data as at 31/10/16 from Bloomberg Chart 1: Average annual change in GDP, by expansion (%) Chart 2: Length of expansions since 1949 (years) 8 12 7 10 6 8 5 6 4 4 3 2 2 1 Source: US Commerce Department, at 31 October 2016 Q2 2009 – Q2 2016 Q4 2001 – Q4 2007 Q1 1991 – Q1 2001 Q4 1982 – Q3 1990 Q3 1980 – Q3 1981 Q1 1975 – Q1 1980 Q4 1970 – Q4 1973 Q1 1961 – Q4 1969 Q2 1958 – Q2 1960 Q2 1954 – Q3 1957 Q2 2009 – Q2 2016 Q4 2001 – Q4 2007 Q1 1991 – Q1 2001 Q4 1982 – Q3 1990 Q3 1980 – Q3 1981 Q1 1975 – Q1 1980 Q4 1970 – Q4 1973 Q1 1961 – Q4 1969 Q2 1958 – Q2 1960 Q2 1954 – Q3 1957 Q4 1949 – Q2 1953 Source: US Commerce Department, at 31 October 2016 4 Q4 1949 – Q2 1953 0 0 prominence by Lawrence Summers in a speech at the IMF in 2013 as a reason for why the post-crisis US recovery has been weaker than its predecessors. The concept of secular stagnation rests on the idea that there is structurally too much saving in the system and too little investment. The imbalance puts downward pressure on real interest rates. A further three years on from when Summers first gave his speech, and with the recovery still stuck in the slow lane, the hypothesis that this is more than a cyclical problem that requires more than a cyclical solution is even more compelling. If the US, Europe and Japan are indeed stuck in a period of secular stagnation, as argued by Summers, the malaise cannot be fixed by record low interest rates alone. Government fiscal policy and structural reform needs to become part of the fix. The US Federal Reserve has now recognised that the decline in the neutral rate, the interest rate that is neither stimulative nor restrictive for the economy, is something that is more than a temporary reaction to the financial crisis. Ageing populations, slower productivity growth and a reluctance around the world for business to invest have propelled many developed economies into a state of secular stagnation. The implication of this structurally lower growth state is a lower neutral interest rate. Currently, the Federal Reserve’s estimate of this neutral interest rate is 2.875 percent (chart 3). While this rate has steadily been revised lower it is still a long way from the markets 1.5 percent estimate. There is still a clear disconnect between the market and the Fed. Chart 3: Fed policy makers' median longer-run Fed Funds rate projection Prior to the financial crisis. it could be argued that the neutral rate was closer to around 5 percent made up of 2.0 percent inflation and 3.0 percent potential growth (made up of 1.5 percent population growth and 1.5 percent productivity growth). Today, it can easily be argued that all three components are lower. The Fed‘s estimate of around 3 percent can be seen to be a combination of 1 percent inflation and 2 percent potential growth. This is consistent with a recent Fed paper that suggested potential growth had fallen by around 1.25 percentage points2. Why is it so important to know where the neutral rate is? First, because the effective operation of monetary policy hinges on it. If the neutral rate is too low, it is very difficult to get to a monetary policy setting that is considered expansionary. This is why nominal rates have had to go negative in Japan, Europe, Sweden Switzerland and Denmark and why there is now $13 trillion worth of bonds that have a negative yield. Second, a lower neutral rate means that each Fed tightening will pack a much greater punch than in the past. It would suggest that monetary policy is not as expansionary as we thought and so the path back to neutral will be short with the need to raise interest rates less urgent. Fed Chair Janet Yellen accepts this saying in the press conference following the September Federal Open Market Committee (FOMC) meeting that the current stance of monetary policy is “only modestly accommodative”. On the flipside, it also means unconventional monetary policy is likely to be needed again at the next downturn since this tightening cycle is likely to be modest. Time to get fiscal Market discussion has now turned to the effectiveness of monetary policy. Monetary policy can boost asset prices but it can do very little to boost an economy’s potential growth rate (and by inference lift the neutral interest rate). For this we need the government to step in with structural reform and productivity-lifting fiscal policy. 4.35 4.15 3.95 3.75 As the next article will discuss, if we are to address what truly ails the global economy, that is a structural excess of saving over investment, then the central bank cannot be the only game in town. 3.55 3.35 3.15 2.95 Source: US Federal Reserve, at 31 October 2016 Jun 16 Sep 16 Dec 15 Mar 16 Jun 15 Sep 15 Dec 14 Mar 15 Jun 14 Sep 14 Dec 13 Mar 14 Jun 13 Sep 13 Dec 12 Mar 13 Jun 12 Sep 12 Mar 12 2.75 2 “Understanding the new normal: The role of demographics”, Gagnon, et al 2016. 5 Central banking, no longer the only game in town Economies around the world are stuck on a structurally lower growth path. Ageing populations, weak investment spending, and shrinking workforces are putting downward pressure on the potential growth rates of both developed and emerging economies. Having spent too much of the past decade in balance sheet repair mode, governments must now focus on addressing the longer-term structural issues that are inhibiting the productive capacity of their economies. The chorus of voices calling for government policy to step in and give central banks a hand in fixing the global economy is getting louder. Until now, the solution to lifting global growth post the financial crisis has been to ease monetary policy through both conventional and unconventional means. Governments meanwhile have for the most part been focussed on repairing their crisisbattered balance sheets. It is now apparent this combination is not only not working, it is actually making the situation worse. Fiscal austerity is depleting economies of their productive capacity, sending potential growth rates lower, increasing debt-to-GDP ratios, and making the task of creating an expansionary monetary policy even harder. Chart 4: Deteriorating global infrastructure quality (1–7 score, 7 = best) 6.8 Productivity growth has declined around the world. The need for new infrastructure has failed to keep pace with the growth in emerging markets while developed market economies have failed to keep pace with the deterioration in the quality of its infrastructure (chart 4). In the US, non-farm business productivity growth has averaged just 0.9 percent per annum during the current expansion, less than half the average from the previous cycle. Weak productivity growth, driven by underinvestment in both capital and labour, coupled with slowing population growth and declining worker-to-retiree ratios, translates into more stress on social safety nets and hence higher fiscal deficits. From a monetary perspective, it puts downward pressure on the neutral interest rate (the interest rate that is neither expansionary nor contractionary for an economy) and therefore impedes the effective operation of monetary policy. 6.6 6.4 6.2 6.0 5.8 5.6 5.4 5.2 5.0 Germany Japan US 2006-07 UK 2014-15 Source: IMF, Bank of America Merrill Lynch, at 31 October 2016 6 Three broad determinants of a country’s potential growth are population, productivity, and participation in the labour force. Increasing any or all of these factors will have a positive effect in lifting the potential growth rate of an economy. The ability of monetary policy to have any effect over any of these factors is limited. Monetary policy operates with just one tool that being the price of capital via its influence over the level of interest rates. Korea It is clear, in order to raise the potential growth rate of an economy, government support is needed. Specifically this may include measures such as infrastructure investment, investments in research and development, programs designed to improve the skill set of the workforce, reforms designed to increase the size of the workforce including policies designed to encourage skilled migration, incentives to make self-employment easier and policies to reduce the barriers to workforce entry or re-entry for females and older workers. The evidence Fiscal policy will likely be positive for developed economy growth next year for the first time since 2010 (chart 5). Japan and Canada have already announced stimulus programs. Japan’s Government announced a supplementary budget worth ¥28.1 trillion within which ¥4.7 trillion (0.9 percent of GDP) is new spending. The Canadian Government has pledged C$60 billion of new infrastructure spending over the next decade, double the previously planned amount. The focus for the spending is on public transport, housing and water systems. The UK has indicated it would slow down the pace of fiscal tightening as a result of the expected impact on growth from the Brexit decision in June. The May Government, by setting up a new Economy and Industrial Strategy Cabinet Committee, has signalled a desire to combine fiscal easing with a new industrial strategy aimed at investing in the economy’s long-term growth potential. In the US, President elect Trump has proposed tax cuts, infrastructure, defence and health spending. There is no coordinated fiscal push in Europe, rather a fiscal fillip is happening more by circumstance than by design. The refugee inflow, the rise in border security, and the rise in terror-related activity will require a considerable lift in government spending. In the fourth quarter of 2015, the fiscal impulse on growth was the largest since 2010. For the most part, the program of fiscal austerity in Europe is now over. Elections are looming in France, Germany, Netherlands and Hungary next year and possibly Italy. This will no doubt add impetus to the fiscal impulse next year. Already Germany has announced a €264 billion infrastructure package to be spent on roads, railways, roads and waterways by 2030. In addition, there is likely to be a more concerted push on investing the €315 billion currently earmarked in the centrally coordinated infrastructure fund called the Juncker Plan. Among emerging economies, fiscal dynamics are more varied. Fiscal policy is expansionary in Asia, especially in China, South Korea and India, but contractionary in Latin America and other commodity producing countries like Russia and South Africa where the fall in commodity prices has severely impaired fiscal balance sheets. While some steps have been made by some governments toward lifting the productive potential of their economies, more needs to be done. The longer it takes to realise this, the longer the period of low growth, low returns and low interest rates will be with us. Importantly, the longer it takes governments to realise change is necessary, the more difficult it will become to implement that change. As the next article will show, electorates around the world are becoming increasingly disenfranchised with their governments and so are gravitating toward minority or fringe parties. The end result is weakened mandates and a depletion in the political capital needed to drive structural change and reform. Chart 5: Fiscal contribution or subtraction to growth 2.0 1.5 Projections 1.0 0.5 0.0 -0.5 In July the European Commission elected not to punish Spain and Portugal for breaching their deficit-reduction targets. Even in Germany the government is becoming less austere. The Finance Minister Wolfgang Schauble has promised more than $2 billion worth of tax cuts and increased child benefits in 2017 and $7 billion of tax cuts in 2018. -1.0 -1.5 -2.0 -2.5 2010 2011 2012 Japan 2013 Europe 2014 US 2015 2016 2017 UK Source: JP Morgan, at 31 October 2016 7 Unconventional monetary policy meets unconventional politics Ironically, just as governments around the world are coming to the realisation that large portions of their populous have been left behind as a result of rising income and wealth inequality, the political capital needed to do anything about it has been depleted. Voters around the world are increasingly turning to non-mainstream parties who promote a more nationalistic agenda. With so many disparate parties winning support, the formation of a stable, effective government has become more difficult. Globalisation, free trade, large scale immigration programs, and free market ideologies in general have produced the most rapid progress in living standards that the world has ever seen. Millions have been raised out of poverty. Life expectancy has increased as new technologies are shared. Wealth has been created at a scale that our ancestors could not have imagined. And yet, a growing number of citizens in Europe, North America, and the Middle East blame globalisation for unemployment, rising inequality and terrorism. The evidence There is little disagreement that globalisation in general has been a benefit across countries. The share of the global population defined as “poor” — those making less than $2 per day — have fallen since 2001 by nearly half, to 15 percent (chart 6). Overall, the world has become “wealthier” in the 10 years between 2001 and 2011. Notably, those in the middle-income bracket making between $10 and $20 per day have nearly doubled their global presence, from 7 to 13 percent. Indeed, according to IMF data, global inequality has declined consistently since 1990. Chart 6: Global population by income group 60% 56% 50% 50% 40% 30% 20% 29% 15% 13% 10% 7% 7% 9% 6% 7% 0% Poor Low Income 2001 Middle Income 2011 Source: World Bank, at 31 October 2016 8 Upper-Middle Income High Income So why the discontent? While inequality has fallen across countries, within countries it has increased. In particular, income inequality has risen dramatically since the 2008 financial crisis. The top 1 percent of earners in the US for example have received 95 percent of the growth in income since the crisis. This is compared to an average of 54 percent for 1979–2007. In 34 of the 83 countries monitored by the IMF, income gaps had widened since 2008, with incomes of the richest 60 percent rising more quickly than those of the poorest 40 percent. This trend highlights two important risks that come with globalisation. The first relates to spill-over effects of a globalised world onto other countries which can be both positive as well as negative. The second is the risk that certain industries get left behind by globalisation. Since 2008, these two risks have come to the fore in accentuating the widening in income and wealth inequality within economies. The over-reliance on monetary policy as a result of global deflation trends has boosted the wealth levels of asset owners (physical and financial) but has done little to boost aggregate demand in the real economy. Meanwhile, government policy to address the hollowing out of industries as a result of globalisation has been notably absent. In the post-financial crisis world, governments have been more focussed on reducing debt levels than on providing investment in re-training, education and industry vocational programs. As a result, income and wealth inequality within countries has increased as has support for anti-establishment political parties whose policies are based more on nationalism, populism, and demagogy. The antithesis of what globalisation represents. Support for these nonmainstream parties has meant coalition and minority governments are on the rise around the world. In some countries, elections have failed to produce a result at all. A national election in Spain in December last year failed to give any party a majority. A second election held in June this year produced the same result. An agreement to form a coalition government was only resolved in October of this year, some 10 months after the first election. Similarly, recent elections in Iceland left no party with an outright majority and at the time of writing no coalition government had been formed. In May 2016, Europe came within 31,000 votes of electing its first far-right head of state since 1945 when the Freedom Party of Austria, founded in the 1950s by ex-Nazis, lost the election by the smallest of margins. The result was declared invalid by the constitutional court after faults in postal ballot procedures. A new election is set for 4 December 2016. The far-right Sweden Democrats took 13 percent of the vote in elections in 2014. The resulting minority government under the Social Democrats collapsed after just two months. Formal coalitions between the two biggest parties now rule in Germany, the Netherlands, Finland, and Ireland, among other countries. In 1955, 96 percent of the British electorate voted Conservative or Labor. Last year, barely two-thirds voted for either. The same trends are evident in Australia. In 1975, 95 percent of the vote went to the Coalition or to Labor. In 2013, one-quarter of the electorate voted for minority parties. The issue is that coalition governments are increasingly reliant on the support of a number of different minor parties that at times can sit at opposite ends of the political spectrum. This makes such a government unstable, fragile, and ineffective. Europe is by far where the greatest amount of political risk lies next year. Since the UK vote to exit the European Union in June, anti-establishment parties in France, Germany, the Netherlands, Italy and Austria have called for referendums on EU membership. The Italian constitutional referendum on 4 December 2016 threatens to turn into a political crisis with Prime Minister Renzi threatening to step down on a “no” vote to change the constitution to make it easier to pass legislation. Italy’s anti-establishment Five-Star Movement, advocating for a referendum on EU membership, is currently polling at 30 percent. National elections are coming up next year in France (May/June), Germany (September), the Netherlands and Hungary. In all four, far-right, non-mainstream, political parties are growing in popularity. In France, President Hollande suffers from the worst approval rating of any president in modern French history. Marine Le Pen’s National Front Party is currently polling 27 percent of the vote. In Germany, the Alternative for Germany Party won 25 percent of the vote in state elections in March. The three mainstream parties in the Netherlands are set to win just 40 percent of the vote at the next election, roughly what any one of them might have gotten previously. The Party for Freedom, currently leading in the polls, wants a referendum on EU membership. In Hungary, the far-right Jobbik party is the second strongest party with 21 percent of the vote. 2017 will be a defining year for global politics. The concerns of electorates in many countries who feel left behind by the solutions put forward to address weakened post-crisis economic growth are reflected in the rapidly growing support for political parties that advocate increased trade barriers, reductions in immigration, and greater national control over the marketplace. 9 Rise in protectionism What was a tentative tilt away from globalisation has now been given a significant push following the election of Donald Trump as President of the United States. Political culture is contextual. The euphoric benefits of globalisation as China ascended onto the world stage some 15 years ago have given way to the ugly truth for those left behind by governments who failed to re-train, re-educate, and reform affected industries. This political new normal will require investors to re-price the sovereign risk they take. From an economic perspective globalisation is the great equaliser, at least across countries if not within. Allowing the free flow of labour and capital means price differentials are bid away, resources are more efficiently distributed and overall welfare is lifted. A move away from globalisation means this equaliser will not work as efficiently. Globalisation does appear to be slowing. In the 60 years before the financial crisis, trade typically expanded at twice the rate of output or GDP. Between 1960 and 2015, world trade increased at an average annual rate of 6.6 percent, while output grew at an average annual rate of 3.5 percent. Between 2008 and 2015, however, average annual growth of world trade slipped to 3.4 percent in real terms, while world output grew at 2.4 percent. The IMF believes part of the reason for the decline in global trade is the rise in protectionism driven in turn by a popular uprising against income and wealth inequality. Globalisation does cost jobs, at least in the initial phase when unproductive domestic industries make way for imports produced by more productive industries offshore. Most economists would argue, however, that the benefits of globalisation are not in the number of jobs it creates but in the rise in productivity it produces. Higher productivity and cheaper imports lifts living standards and helps to keep inflation and therefore interest rates in check. Broader job creation is a secondary benefit that comes about indirectly via faster economic growth. 10 It is true the benefits of globalisation are not spread evenly within a country. Middle-class wages in the US stopped rising more than 30 years ago. It is here where government policy has a role to play in ensuring those most adversely affected by globalisation are not left behind. In the decades leading up to the financial crisis, the rising tide of strong economic growth globally lifted all boats, obscuring the rise in inequality within countries. After the financial crisis, when the tide was no longer rising, or rose less fast, the relative differences between income and wealth cohorts within countries become more obvious. Some governments have responded to the political pressure posed by this inequality by raising trade barriers or imposing trade restrictions. According to the Global Trade Alert (GTA), 2015 saw a 40 percent rise in protectionist activity, the worst outcome since the global financial crisis3. According to GTA, 50 to 100 protectionist measures were implemented around the world in the first four months of each year between 2010 and 2015. In 2016, the total exceeded 150. Protectionism is about shutting out an economy from international competition. The agriculture industry is one of the most heavily protected industries in the world reflecting the particular place of agriculture in the political economy of most countries. Food security has become a major political issue. 3 Global Trade Alert Annual Report, 2016. The tendency to protect agriculture more than manufacturing is more prevalent among developed economies. Rich countries tax their agricultural imports on average 6.7 times more than manufacturing4. Interestingly, Japan is at least as bad as the EU when it comes to subsidised farming. The average Japanese farmer, for example, is 66 years old and tills 1.9 hectares of land. In 2010, Japanese farmers added 4.6 trillion yen in value to the economy but consumed 4.6 trillion yen in subsidies, meaning the net benefit to the economy was zero. Protecting an industry hardly equates to an efficient use of an economy’s resources. The UK’s new Conservative Prime Minister, Theresa May, appears to be signalling an end to Britain’s free-market economic liberalism of the past. As a way of responding to the will of the people following the Brexit result, May is implementing an interventionist industry policy to promote certain industries the government deems to have value. In a nod toward a more protectionist stance, May is also introducing a new system to vet foreign investment deals into the UK. Governments are notoriously bad at asset allocation. Political bias and the election cycle too often get in the way. This is one of the reasons why many developed market central banks are independent of the government (although the UK was late to this party asserting the independence of the Bank of England as recently as 1997). This independence may come under strain in a world where government plays a more interventionist role in the economy as appears to be the case in the UK under Theresa May. Not only are trade barriers rising, but the number of free trade deals being successfully negotiated is falling (chart 7). The fate of the most ambitious arrangements, the Trans-Pacific Partnership (agreed, though not ratified) and the Transatlantic Trade and Investment Partnership (very far from agreed), remains quite uncertain. The Trans-Pacific Partnership has been six years in the making and potentially ties together 40 percent of the world‘s economy and eliminating 18,000 tariffs. The election of Donald Trump as the new President of the United States leaves the fate of this deal seriously in doubt. largely because it required the agreement to be ratified by all 28 EU parliaments. The difficulty in getting all 28 EU parliaments to agree raises questions about the ability of Europe to fulfil one of its fundamental objectives – to break down trade barriers. Emerging markets are most affected by trade. Emerging market economies within the G20 have around 27 percent of their GDP exposed to exports. Since peaking in 2009, the growth differential between emerging and developed markets has been narrowing. Part of the reason for this is the slowdown in global trade. The implication for investors of a less open global trade environment is that sovereign risk must take into account more idiosyncratic risk. In a globalised world, inefficiencies are bid away and global collaboration supports the broader good. In a less globalised world, inefficiencies remain and national interests are put first. This must be priced by financial markets accordingly. This can be seen in how the UK pound has reacted to the Brexit decision. If the UK is going to become less integrated into the EU, then its sovereign risk must be priced accordingly. Given the UK has the second highest current account deficit in the G20, this implies either a higher risk premium for its bonds and or a weaker currency. For investors, we are now in a far more volatile, uncertain environment. The shift in political ideology (away from globalisation) that is now shared by the leaders of the US and UK, means a re-pricing of risk premiums to reflect national differences. For discerning investors, this may present opportunities. At the very least, we may now be reverting to a world where risk is more appropriately priced. Chart 7: Number of free trade agreements – by year of signature 45 40 35 30 25 20 15 10 4 “A picture of tariff protection across the world in 2004”, Houssein Boumellassa, David Laborde, Cristina Mitaritonna 5 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 The trade deal between the European Union (EU) and Canada was seven years in the making Source: IMF, at 31 October 2016 11 Economic outlook for 2017 For the most part, economic growth and inflation appear to have past their lows. Moves to support growth with more accommodative fiscal policy, as well as monetary policy, will be positive for global growth in 2017. With less excess capacity in the system than at any stage since the global financial crisis, deflation fears will make way for rising inflation pressures in 2017. 13 Australia The Australian economy is on track to record its world record-breaking 26th year of uninterrupted growth in 2017. Overall, growth will be supported by accommodative monetary policy with interest rates expected to remain unchanged at 1.5% through most of next year. Growth will be reasonably broad-based with consumer spending supported by further gains in employment and an expected decline in what is by historical standards a high saving rate. A partial recovery in commodity prices, particularly coal and iron ore, will provide a lift in the terms of trade and support income growth. The pipeline of residential construction work will provide another key source of support next year while state and federal government budgets imply ongoing growth in public investment. Chart 8: Australia GDP and CPI The Australian dollar remains over-valued relative to commodity prices and is likely to experience some downward pressure in 2017 as the US dollar strengthens and rates there rise. A weaker dollar will improve the competitiveness of our export sector and will assist domestic industries such as tourism, education and financial services. Offsetting this to some extent is the expectation that the Trans Pacific Partnership agreement will not be ratified under a Trump Presidency. Source: Bloomberg, at 31 October 2016 14 5 Bloomberg forecast 4 3 2 1 0 06 07 08 09 10 11 GDP (yoy%) 12 13 CPI (yoy%) 14 15 16 17 China Economic growth in China is expected to edge down slightly in 2017. Large-scale infrastructure spending will only partly make up for slowing business investment as overcapacity is being worked off in several industries including coal and steel. The property market is cooling, but housing inventories remain sizeable. Consumption is projected to stay buoyant. The reduction in excess capacity will ease the downward pressure on producer prices, but consumer price inflation will remain low. Corporations need to deleverage as slowing growth heightens credit risks. Fiscal policy is being eased significantly, potentially crowding out of private investment and building up imbalances. The pace of structural reforms will continue to influence short-term outcomes, the challenge being to keep up sufficient momentum to reduce imbalances while avoiding overly abrupt adjustments that might trigger a crisis. The potential implications of a Trump Presidency for China mainly centre around trade and political relations. Trump said he would name China a currency manipulator on day one of his Presidency raising the risk of a currency war. A rise in US protectionism and trade tariffs on China that materially affect Chinese exports and hence growth, can expect to be met with an increase in fiscal policy support from the Chinese government. Chart 9: China GDP and CPI 16 Bloomberg forecast 14 12 10 8 6 4 2 0 (2) 06 07 08 09 10 11 GDP (yoy%) 12 13 CPI (yoy%) 14 15 16 17 Source: Bloomberg, at 31 October 2016 15 Japan Growth in Japan is expected to remain muted in 2017 despite low unemployment, ultra-loose monetary policy and government fiscal stimulus measures. The impact of the consumption tax hike planned for 2017 will weigh on consumer spending, and the slower growth outlook for China (which accounts for a quarter of Japan's exports) and other Asian countries will impact exports as will any further strengthening in the yen. Japan's trade prospects will likely take a further hit if, as expected under the new US President, the Trans Pacific Partnership falls over. Offsetting this to some extent is record-high corporate profits supporting business investment and employment. Despite the tightness of the labour market, labour shortages have risen to their highest levels in 25 years, wage gains have been frustratingly slow to materialise. Chart 10: Japan GDP and CPI 6 Bloomberg forecast 4 2 0 (2) (4) (6) 06 07 08 09 10 11 GDP (yoy%) 12 Source: Bloomberg, at 31 October 2016 More than three years have passed since the Bank of Japan introduced the surprisingly aggressive monetary policy of quantitative and qualitative monetary easing. The introduction of negative interest rates in February 2016 reaffirmed the Bank's commitment to its 2% inflation target. Despite this, core inflation is expected to remain close to zero. 16 13 CPI (yoy%) 14 15 16 17 US Growth remains on a moderate trajectory sustained by mutually-reinforcing gains in employment, income and household spending. Business investment has been lacklustre, in part due to the decline in drilling and mining investment due to the low oil price. The policy environment will be supportive next year. The clean sweep outcome of the US election, with the Republicans not only retaining control of Congress but also winning the White House, is positive for economic growth. Assuming he has the backing of his own party on most measures, President Trump's policies of higher infrastructure spending, lower corporate taxes, and higher defence spending will lift GDP growth. Lower corporate taxes may also give a boost to business investment spending. The negative consequence of this policy stance is higher budget deficits and higher inflation. Chart 11: US GDP and CPI 4 Bloomberg forecast 3 2 1 0 (1) (2) (3) 06 07 08 09 10 11 GDP (yoy%) 12 13 14 15 16 17 CPI (yoy%) Source: Bloomberg, at 31 October 2016 The policy shift away from free trade is likely to have a neutral effect on net exports as higher tariffs on imports are likely to be met with a retaliatory move of higher tariffs on US exports. The end result is likely to be higher inflation and therefore higher interest rates and a higher US dollar. A more protected economy, however, will support employment growth in import-competing industries. 17 Europe The ongoing moderate recovery in Europe is expected to continue in 2017 albeit at a slightly lower pace. Sustained monetary stimulus and low oil prices will support domestic demand, but the slowdown in emerging market economies will weigh on exports. The decline in unemployment should also continue at a modest pace, but differences across euro area countries will persist. Continued cyclical slack and some second-round effects from cheaper energy will hold inflation under the ECB’s target of just below 2%. Monetary policy should remain accommodative through most of the year while fiscal policy is projected to be slightly expansionary. A busy political calendar is coming up for Europe in 2017 with national elections scheduled for France, Germany, the Netherlands and Hungary. Europe will also be negotiating the exit of the UK from the Union. The farright movement that is already polling strongly in Austria, France, Italy, Hungary, and Poland would have received a fillip from the outcome of the US Presidential election. As a result, we see the greatest risk for Europe being a rise in anti-union sentiment next year. 18 Chart 12: EU GDP and CPI 4 Bloomberg forecast 3 2 1 0 (1) (2) (3) (4) (5) 06 07 08 09 10 11 GDP (yoy%) 12 13 CPI (yoy%) Source: Bloomberg, at 31 October 2016 14 15 16 17 UK The outlook for the UK economy hinges on the Brexit negotiations. The near 20% fall in the pound over the past year reflects a growing realisation that the UK’s long-run growth potential has deteriorated since the 23 June referendum result. While the lower currency will put upward pressure on inflation, it is unlikely to give much of a boost to exports given the limited pass-through of a cheaper currency by UK exporters to foreign buyers. The upside to this is that UK exporters will benefit from higher margins. The net export impact on GDP will still be positive as consumers substitute away from the higher priced imports. Consumers are likely to feel the pinch from the squeeze on real incomes as a result of higher inflation. Heighten business uncertainty resulting from Brexit may also hinder business investment spending. Despite this, a recession will likely be avoided in the UK next year as any weakness from will be offset by the wealth effects from a strong housing market and more accommodative fiscal policy with plans to step up public investment spending. While interest rates have been cut and quantitative easing has expanded post-Brexit, any further monetary easing is likely constrained by the rise in inflation pressure. Chart 13: UK GDP and CPI 6 Bloomberg forecast 4 2 0 (2) (4) (6) 06 07 08 09 10 11 GDP (yoy%) 12 13 14 15 16 17 CPI (yoy%) Source: Bloomberg, at 31 October 2016 19 If you would like further information, please contact our Client Services Team: Phone: 1800 023 043 Email: [email protected] www.ubs.com/am-australia © UBS Group AG 2016. The key symbol and UBS are among the registered and unregistered trademarks of UBS. 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The opinions expressed are a reflection of UBS Asset Management’s judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. You are advised to exercise caution in relation to this document. The information in this document does not constitute advice and does not take into consideration your investment objectives, legal, financial or tax situation or particular needs in any other respect. Investors should be aware that past performance of investment is not necessarily indicative of future performance. Potential for profit is accompanied by possibility of loss. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. Source for all data and charts (if not indicated otherwise): UBS Asset Management. © UBS 2016. The key symbol and UBS are among the registered and unregistered trademarks of UBS. 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