The Big Picture. Global economy still on a roll. Highligths

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1 The Big Picture Investment Research 4 December 17 Global economy still on a roll Highligths Global expansion is set to continue in coming years Driven by continued strong consumer spending and a robust investment recovery Inflation is set to stay fairly muted, with central banks only very gradually withdrawing stimulus Important disclosures and certifications are contained from page 3 of this report.

2 Danske Bank / The Big Picture Analysts Editor-in-Chief: Jakob Ekholdt Christensen Head of International Macro and Emerging Markets jakc@danskebank.com Macroeconomics: Bjørn Tangaa Sillemann Japan bjsi@danskebank.com Aila Mihr Euro area amih@danskebank.com Vladimir Miklashevsky Emerging Markets vlmi@danskebank.com Mikael Olai Milhøj US and UK milh@danskebank.com Allan von Mehren China alvo@danskebank.com Editorial deadline: 1 December 17 Economics Research This publication can be viewed at Where no other source is mentioned statistical sources are: Danske Bank, Datastream, Macrobond, OECD, IMF and other national statistical institutes as well as proprietary calculations.

3 Danske Bank / The Big Picture 3 Contents Global overview 4 Global recovery set to continue Japan Strong but very globally-dependent economic upturn US 8 High optimism but politics still a hot topic China 4 Slowing down Euro area 1 Gradual ECB exit amid robust expansion Emerging markets 8 Solid growth outlook UK Brexit uncertainties dominating theme Follow us on Twitter to get the latest macroeconomic and financial market Visit our YouTube channel for video interviews on our latest research reports The Big Picture is a semi-annual analysis focusing on the outlook for the global economy. Read about the prospects for, and the most important risks to, the global economy. The publication Nordic Outlook presents our expectations for the Nordic economies. Important disclosures and certifications are contained from page 3 of this report.

4 4 Danske Bank / The Big Picture Global overview Global recovery set to continue 17 is set to be the best year for the global economy since 11 with growth of 3.6% and all regions of the world contributing. We expect the expansion to continue in 18, although a slowdown in China would put a small dent in the global business cycle. Continued strong consumer spending and a robust investment recovery in advanced economies are the main pillars of the global expansion. We look for inflation to stay fairly muted and central banks to withdraw stimulus only very gradually. Risks to our forecast are fairly balanced, though the uncertainty posed by the Italian election and NAFTA agreements could weigh negatively on the growth outlook.

5 Danske Bank / The Big Picture A strong 17 is coming to a close A very strong year is coming to an end in the global economy. Corporate profit growth has been robust, business and consumers are the most upbeat in many years and the expansion has had plenty of breadth, with most regions and sectors enjoying rising growth. Strong support from monetary policy and the first year in many years with no negative shocks hitting the world have paved the way for an acceleration in the global economy. Fears of a US-China trade war or military conflict on the Korean Peninsula have not materialised. The strengthening global activity, notably investments, has raised global trade, which is now growing at the strongest pace since the financial crisis. Can the global economy keep up the pace? Yes... The question arising is increasingly: how long can this go on? We are optimistic that the global expansion has more legs in the coming years. First, although the recovery is getting older, we also started from a place of very high unemployment and plenty of slack in most economies,and the subsequent recovery has had many bumps in the road and structural headwinds leading to more muted growth rates than in a normal recovery. We do not see that any big imbalances have built up in either the US or Europe. There are no overinvestment or housing bubbles that need to be corrected (Sweden may be the exception). On the contrary, if anything, investments still have pent-up demand in some areas after a long period of weak capex spending. The main global imbalance is in our view to be found in China, where investment growth is still too high and needs to adjust lower still. We do expect Chinese investments to slow down, but China has tools to manage the slowdown to avoid it becoming a hard landing. Second, inflation pressures still appear to be muted, leaving scope for just a gradual withdrawal of monetary accommodation. Central banks do not have to step on the brakes due to inflation running away. We are of the view that wage inflation will continue to be quite moderate despite the decline in unemployment seen in most countries as inflation expectations have come down. The Fed will probably continue raising rates in 18 but we look for only -3 hikes which historically is a very gradual pace (in 4-6 the Fed hiked eight times per year and called it a measured pace ). Finally, there are no obvious big risk factors looming to derail the global economy (more on this below). but the acceleration phase is over... Hence, overall we look for global growth to continue at a decent pace in 18, holding up at 3.6% (similar to 17 and in line with consensus), with investments in the US and the euro area growing at a decent rate and consumers seeing further support from robust real wage growth, gains in employment and rising housing wealth. We are particularly optimistic on the growth outlook in the euro area, where economic growth momentum has taken hold, although the stronger euro may weigh on net exports compared with 17. Record-high business confidence is driving capex recovery in advanced economies Index OECD capex (rhs) OECD business confidence (lhs) Source: OECD, Macrobond Financial, Danske Bank % q/q, ma, AR Higher capex investment is driving recovery in global trade World trade growth in volumes OECD capex Source: OECD, CBP, Macrobond Financial, Danske Bank Not yet any overinvestment - on the contrary there is still pent up demand in capex % of GDP % of GDP Euro investment US private investment Euro average (9-7).. US average (9-7) Source: Eurostat, BEA, Macrobond Financial, Danske Bank

6 6 Danske Bank / The Big Picture While we look for the global expansion to continue, we believe the acceleration we saw in 17 is behind us. Policy tightening in China is increasingly feeding through to a cooling of the housing market, which we expect to send Chinese growth lower to 6.3% in 18 from 6.8% in 17. A moderation in Chinese growth would weigh on commodity markets as China consumes around % of global metals. This would cause some headwind for commodity exporters. In our view, the tailwind from monetary policy in the US and Europe will also ease a bit in 18. Hence as we move through 18, we expect global growth and PMI indices in most countries to come down gradually. China set to weigh on the global economy Z score PMI manufactoring, standardised Z score and political risks are looming, notably in Italy The risks to our growth forecast are seen as broadly balanced. Downside risks to our favourable euro area outlook stem primarily from the Italian elections in early 18. Italy remains the most fragile among the big eurozone countries due to a combination of banking sector weaknesses, a high public debt burden combined with a weak growth outlook and political risks. A government led by the euro-sceptic Five Star Movement could quickly derail the current market complacency and bring concerns about Italian debt sustainability and a possible euro exit back to the forefront of investors minds. Furthermore, more mainstream parties are becoming more EU sceptical. On the other side of the Atlantic, the risk of a breakdown in NAFTA negotiations could impact US growth negatively. Our base case is that Trump will not pull-out of the free trade arrangement (very unpopular among businesses) and instead will get some concessions on e.g. rules of origin, but Trump risks becoming a lame-duck president if the Democratic Party wins either the House or the Senate. In such an event, he would be more likely to press harder on foreign and trade policy issues, where he can act without Congressional support. On the other hand, a more pronounced tax reform than assumed could lift US economic growth by more than we expect. Another risk is a faster rise in inflation than we project in our baseline. Financial markets and ourselves expect major central banks only gradually to exit their accommodative monetary policies given the fairly subdued inflation outlook. Should inflation surprise on the upside, this could lead to a fairly aggressive repricing of monetary policies in advanced economies, leading to higher interest rates especially in the short end of the curve. Higher interest rates and a possible fall in asset prices would have a negative bearing on investment and private consumption, leading to slower economic growth. - High uncertainty about future Italian government composition, as no clear majority in sight % Italy opinion polls % Mar World China incl. forecast May 1 Five Star Movement Centre left coalition (PD, Popular Alternative & MDP) Centre right coalition (Forza Italia, Lega Nord & Brothers of Italy) Centre right-left coalition (Forza Italia & PD) Source: Macrobond Financial, Danske Bank 14 Source: IHS Markit, Macrobond Financial, Danske Bank Jul 17 Sep Nov

7 Danske Bank / The Big Picture 7 GDP forecasts - Global overview Danske Bank Consensus Danske Bank Consensus Danske Bank Consensus Global Developed markets USA Euro area Japan UK Emerging Markets China India Russia Brazil Turkey South Africa ASEAN Middle East and NA 1, Sub-Saharan Africa (ex SA) LatAm (ex Brazil) NA is North Africat. IMF WEO October 17 projections Source: Bloomberg, IMF, Danske Bank

8 8 Danske Bank / The Big Picture US High optimism but politics still a hot topic Growth has accelerated and optimism remains high, suggesting the expansion will continue in coming years. Republicans are likely to deliver tax cuts, but we do not expect a big boost to growth. President Trump has not made the big shifts in US foreign and trade policy that he promised, which is good news. The midterm election in 18 is a joker in the pack. Jerome Powell is likely to replace Janet Yellen as Fed chair but will stick to the current monetary policy strategy with gradual hikes.

9 Danske Bank / The Big Picture 9 Growth has accelerated in H 17 After a weak first half of the year, growth has accelerated in the second half to around 3% q/q annualised and it seems that hard data have partly caught up with the strong soft indicators. We have been surprised that confidence among both businesses and consumers has stayed extremely high, despite President Trump not having been able to pass major legislation yet. High confidence means that growth will probably also remain strong in 18, which is the main reason we have become more upbeat on the economic outlook for the US next year. The good news is that growth is no longer driven only by private consumption, as non-residential investments have rebounded since the downturn caused by the oil sector after the oil price collapsed. Growth has become more balanced, driven by both consumption and investments and we expect this to continue. It is good news that business investments have begun to increase, as the slower real wage growth limits how fast private consumption can grow. It is also good for productivity growth, which has been very weak in this cycle. Optimism remains high despite Trump not passing any major legislation yet Index NFIB small business optimism (lhs) Conference board, consumer confidence (rhs) Source: Conference board, NFIB, Macrobond Financial Trump victory 1 14 Index We forecast GDP growth of.4% next in 18, up from.% in 17, significantly above potential GDP growth of around 1.7-.%. We expect GDP growth to slow to.1% in 19, which, however, is still above potential. Above-trend growth means the labour market continues to tighten and we expect the unemployment rate to reach 3.7% by the end of 19. One big question is how much slack is left in the labour market and, if the expansion continues, whether we may see some of the discouraged workers returning to the labour force. After many years of decline, the participation rate has stabilised around the current level of 6.7%. Despite the expansion lasting for several years, inflation pressure remains modest and the Fed has missed its % target for several years now. While there may be some truth in the argument that PCE core inflation is pulled down by transitory effects right now, we think the drop in inflation expectations has become self-fulfilling in the sense that wage growth demand and price increases are modest. We expect PCE core inflation to move higher but to remain below the % target. Growth now driven by both consumption and investments Private consumption (rhs) Non-residentiel investment (lhs) Source: BEA, Macrobond Financial It is natural to ask how much further it can go and whether the economy may soon be heading for a downturn. First, remember that expansions do not die of old age, meaning that just because the expansion has lasted for a long time, a crisis does not have to be just around the corner. Second, if we look at the expansion, it has been more gradual than previous expansions. Right now, we think there are only a few big triggers for a downturn out there, but a few to mention are higher US yields, the Chinese debt situation and political uncertainty. PCE core inflation set to move higher but stay below %.. 1. Fed s % target,, 1, Republicans to deliver tax cuts It is our expectation that the Republicans will deliver tax cuts, as they are afraid of losing the midterm election in November 18. That said, it is not a given that tax cuts will actually increase support for the Republicans, as corporate tax cuts are not especially popular with the US population ,,, Tax reform has become more likely but is definitely not certain and there is still a risk that the whole thing could backfire, as was the case with Obamacare. We expect tax reform to end up PCE core inflation PCE inflation Source: BEA, Macrobond Financial, Danske Bank

10 Danske Bank / The Big Picture as a watered down version of what is currently on the table, not least since there is some heavy lobbying against some of the revenue raisers. Notice it costs USD1,bn to cut the corporate tax rate to % by itself. We do not expect a big economic boost from tax reform, although it is slightly positive, as (1) income tax cuts target mainly high income earners (partly as low income earners already pay little or no tax), who generally have a low marginal propensity to consume; and () investments may not increase significantly despite the possibility of deducting investment costs, as credit has been cheap and easy in recent years. Overall, tax reform is more likely to boost investments than consumption, which is also what we have pencilled in. According to estimations made by the Committee for a Responsible Fiscal Budget (CRFB), public debt is set to increase from around 77% currently to 99% over years (compared with 91% under current law). Although US public finance is already unsustainable in the long-run to begin with, we are not extremely worried, as interest payments as a percentage of GDP are low due to the low rates, and the US economy is in good shape. Still, we think it is the wrong time to make fiscal policy more expansionary, as the economy is operating close to full employment and there is a risk of overheating. Trump remains a topic next year Trump remains a theme for the next year, not only due to tax reform. President Trump has not made the big changes on US foreign and trade policy that he talked about and right now the probability of a trade war with China is low, as the working relationship between the two countries has been better than feared. We do not know what will happen with respect to NAF- TA yet, but our base case is that Trump will not pull out of the free trade arrangement (very unpopular among businesses). It is also worth mentioning that the midterm election is likely to be an election for or against Trump, and if the Democrats win either the House or the Senate, Trump in reality becomes a lame duck in the sense that there would be gridlock between the White House and Congress. If so, he may start to deliver on his promised changes to foreign and trade policy, as the US President has more power here, even without Congressional support. Fed set to continue its hiking cycle under Powell As expected, President Trump decided not to reappoint Janet Yellen as Fed chair. However, her monetary policy strategy with gradual hikes and shrinking the balance sheet is likely to remain unchanged, as the next Fed chair Jerome Powell is a Republican version of Yellen. As the expansion is set to continue and we do not expect inflation to accelerate a lot, we expect the Fed to hike two to three times next year, with two hikes being our base case. In our view, inflation and/or wage growth have to accelerate next year in order for the Fed to step up its current hiking pace. Note that there are still many vacant seats on the Fed Board of Governors, meaning it is still uncertain whether we will see at least a slight move in a more hawkish direction in coming years. Deficit-financed tax reform leads to higher debt % of GDP Source: CBO, Committee for a Responsible Federal Budget, Macrobond Financial Source: CBO, Macrobond Financial We expect the Fed to continue its hiking cycle % Fed funds rate 1 14 CBO projection (current law) CRFB estimate of tax plan US interest payments as a percentage of GDP are low due to low rates despite higher debt % of GDP US government expenditures, interest payments % of GDP % of GDP % Source: Federal Reserve, Macrobond Financial, Danske Bank

11 Danske Bank / The Big Picture 11 Macro forecasts - US Calendar year average % change q/q AR Q1 Q Q3 Q4 Q1 Q Q3 Q GDP Private Consumption Private Fixed Investments Residential , Non-residential Change in inventories Public Consumption Exports Imports Net exports Unemployment rate (%) Inflation (CPI) (y/y) Core inflation (CPI) (y/y) Public Budget Public Gross Debt Current Account Fed funds rate Contribution to annualised GDP growth. Pct. of GDP (CBO and IMF) 3. Upper limit, end of period Source: CBO, IMF, Danske Bank

12 1 Danske Bank / The Big Picture Euro area Gradual ECB exit amid robust expansion We expect the euro area economy to expand by.% in 18 and 1.8% in 19 driven by stronger domestic demand, while net exports will become a drag. Risks to the growth outlook loom from the Italian election in 18. Despite the narrowing output gap and continued employment gains, we expect wage growth to stay below average due to significant slack in the labour market. In our view, muted wage growth and euro appreciation will contain underlying inflation pressures in 18. We expect inflation to pick up in 19, but stay below target without further lift from energy prices. We think the ECB will end its QE programme in 18, before embarking on a gradual hiking cycle starting in Q 19.

13 Danske Bank / The Big Picture 13 Solid growth continues, but political risks still loom With growth accelerating to.3% in 17 according to our projections, we expect another year of solid GDP growth of.% in 18 in the euro area (up from 1.6% previously), driven primarily by a more favourable outlook on private consumption and investments. In Q3, the euro area economy expanded by.6% from the previous quarter, likely to have been driven by both domestic and external demand. Going forward, we see investments driving growth to a larger extent than previously, as they are supported by favourable financing conditions, high business confidence in light of increasing capacity utilisation as well as new orders and pent-up demand. The combination of high consumer optimism, low borrowing costs and continuing employment gains means that we are now more optimistic on the outlook for private consumption in the euro area in 18. However, going forward, we believe it is unlikely that the eurozone economy will remain immune to the loss of momentum in China and we expect some weakness to spill over via the trade channel in coming quarters. Additionally, we expect the headwind from the stronger euro to dampen export demand, while imports will accelerate driven by stronger domestic demand, meaning that the contribution from net exports to GDP growth will turn negative in 18 and 19. For 19, we expect GDP growth to moderate further to 1.8% but stay above potential growth, which the European Commission (EC) estimates at 1.%. Hence, the output gap should turn positive with the expected growth path, supporting our view of a continued fall in the unemployment rate from its current level of 9.% to 7.8% at end-19. However, the EC has again lowered its NAIRU estimate from 8.8% to 8.4% in 18, indicating that there is still a fair amount of slack in the labour market when looking at broader measures of unemployment, which include, for example, involuntary part-timers, especially in the periphery. We expect the unemployment rate to fall below the NAIRU not before 19, meaning that wage growth will stay muted despite the recent modest acceleration, also due to low inflation expectations affecting negotiated wages adversely. Apart from the lingering Catalonia crisis, a stalling government formation process in Germany and the possible collapse of Brexit negotiations, downside risks to the growth outlook still stem primarily from the Italian parliamentary elections in early 18. Italy remains the most fragile among the big eurozone countries due to a combination of banking sector weaknesses, a high public debt burden combined with a weak growth outlook and political risks (see also Significant Challenges for Italy: All you need to know about key issues, 14 August). A government led by the euro-sceptic Five Star Movement (although not our base case) could quickly derail the current market complacency and bring concerns about Italian debt sustainability and a possible euro exit back to the forefront of investors minds, endangering the economic expansion through financial spill-overs. Investments have been depressed, pointing to pent-up demand % of GDP % of GDP Euro area investment Source: Eurostat, Macrobond Financial, Danske Bank Average before financial crisis Private consumption growth set to accelerate in 18 Balance Retail sales (3m MA) (rhs) Private consumption (rhs) Consumer confidence (lhs) Source: Eurostat, EC, Macrobond Financial, Danske Bank Five Star Movement Centre left coalition (PD, Popular Alternative & MDP) Centre right coalition (Forza Italia, Lega Nord & Brothers of Italy) Centre right-left coalition (Forza Italia & PD) High uncertainty about future Italian government composition, as no clear majority in sight % Italy opinion polls % Mar May Jul 17 Sep Nov Source: Macrobond Financial, Danske Bank

14 14 Danske Bank / The Big Picture ECB exit strategy back in focus in 18 At the October meeting, the ECB announced an extension to its QE programme in 18 for another nine months. However, it cut its monthly purchases by half to EUR3bn, citing growing confidence in the inflation outlook due to the strong growth momentum in the eurozone and rising underlying inflation pressures. At the same time, the ECB was not yet confident that the recent uptick in inflation was self-sustaining enough to announce a definite end date for its QE programme, leaving it open-ended instead (see also ECB Review: ECB opts for lowerfor-longer QE extension, 6 October). We still think the ECB is too optimistic on its outlook for core inflation, which we expect to average only 1.1% in 18. Headline inflation has fallen back in recent months to 1.% in November and, in particular, the drop in core inflation to.9% is unwelcome news for the ECB following its QE scale-down decision. We project headline inflation will approach 1.% in early 18 due primarily to energy price base effects. Although we expect recent higher oil prices to lift headline inflation in mid- 18, energy price inflation will continue to be a drag from late 18 onwards according to our projection. The linchpin for a sustained rise in the underlying inflation pressure remains a pickup in wage growth but due to the above-mentioned factors, we expect this to materialise only gradually in 19. Despite an expected pickup in core inflation in 19, we expect inflation to continue undershooting the ECB s target as even higher energy price inflation is required to lift HICP inflation back to the % target. We think the ECB will end its QE programme in 18, with demands to put a specific end date on the QE purchases growing in the Governing Council. However, Mario Draghi has stressed that QE will not end abruptly, which leads us to expect a gradual tapering of purchases to zero in Q4 18. Headline inflation will not have returned to the target by then according to our inflation forecast, as this would require further rises in energy prices, which we do not project. However, we do look for core inflation to remain above 1.% in 18, which should be an important argument in the ECB s QE exit decision. We think the binding technical restrictions should also contribute to the ECB s eventual tapering decision and additional support for a further reduction of monetary stimulus will come in the form of the reinvestments on maturing bonds, which will grow in size and importance over 18. Following the end of the QE programme in 18, we expect the ECB to embark on a gradual hiking cycle, delivering the first bp deposit rate hike around six months later in Q 19. The MRO rate will be moved in similar steps, in our view, thereby keeping the corridor tight, seen from a historical perspective. The ECB s preference for an orderly policy normalisation process that prevents market overreactions and a cautious hiking pace to avoid stifling the recovery speak in favour of an initial hike of bp instead of bp, in our view. The beginning of the hiking cycle should again reflect that the inflation outlook has improved. With wage growth and core inflation expected to move gradually higher, the second bp deposit rate hike is likely to come another six months later in Q4 19. Wage growth set to stay muted despite continuing employment gains % Unemployment rate EC NAIRU estimate Wage growth Source: Eurostat, EC, ECB, Macrobond Financial, Danske Bank Average since Inflation set to pick up in 19 but stay below target without lift from energy prices % HICP inflation (Danske Forecast) Core - contribution to inflation 17 Source: ECB, Eurostat, Macrobond Financial, Danske Bank Energy - contribution to inflation Food - contribution to inflation We expect ECB to taper QE purchases to zero in Q4 18 and start gradual hiking cycle in mid-19 EUR bn % Monthly asset purchases QE programme ECB interest rates Q1 Q Q3 Q4 Q1 Q Q3 Q4 Q1 Q Q3 Q4 Q1 Q Q3 Q4 Q1 Q Q3 Q MRO rate Deposit rate EUR bn % Source: ECB, Macrobond Financial, Danske Bank

15 Danske Bank / The Big Picture Expectations for key figures and central banks over coming quarters % Change q/q Calendar year average Annualised rate Q1 Q Q3 Q4 Q1 Q Q3 Q GDP Private Consumption Private Fixed Investments Public Consumption Exports Imports Net exports Unemployment rate (%) CPI (y/y) Core CPI (y/y) Public Budget Public Gross Debt Current Account ECB depo rate Contribution to GDP growth. Pct. of GDP 3. End of period Source: Eurostat, European Commission, Danske Bank

16 Danske Bank / The Big Picture UK Brexit uncertainties dominating theme Growth is set to stay weak in coming years due to a combination of negative real wage growth and Brexit uncertainties. Brexit has lowered potential GDP growth to around 1.%, according to Bank of England estimates. Brexit uncertainty remains high but eventually we expect the UK and the EU to agree on a transition period (two to three years) and a final deal to look something like the EU-Canada CETA deal. The Bank of England is flexible on further rate hikes next year but our base case is that it remains on hold.

17 Danske Bank / The Big Picture 17 Growth set to remain weak As expected, economic growth in the UK has slowed this year and the country is now among the slowest growing economies in the EU8. The reason is a combination of negative real wage growth, which has slowed private consumption growth (the main growth driver), and political uncertainty, which weighs on business investments. Growth picked up slightly in the second half of 17 from the first half of the year, likely on the back of strong growth in the rest of Europe. Still, it is noticeable that while growth has accelerated in the rest of the advanced economies, UK growth has slowed. UK growth has slowed despite increasing growth in rest of Europe and the US Real GDP growth We are having a hard time seeing this changing any time soon. Inflation remains high and wage growth is in our view unlikely to pick up significantly, meaning real wage growth will remain under pressure, limiting how much private consumption can grow. Brexit uncertainties remain high, as the UK and the EU have not even agreed on a transition period right now, which are likely to weigh on business investments. Exports growth has risen but that is mainly due to increasing growth in the rest of Europe and not to a boost from the weaker GBP. The government is unable to stimulate the economy through expansionary fiscal policy, as government deficits and debt are already high. We forecast growth of 1.3% in 18 and 1.% in 19 but stress that uncertainty surrounding our forecast is higher than usual due to Brexit. Note the Bank of England has estimated that potential GDP growth has declined to 1.% (so approximately.3% on a quarterly basis) on the back of Brexit, which corresponds to a negative supply shock, as the UK, for example, loses the gains from trading in the EU internal market. Inflation is set to ease slowly Both headline and core CPI inflation have risen significantly, pushed up by higher commodity prices and the weaker GBP. Headline inflation was 3% in October,.1pp higher than in October, as the significant GBP depreciation has increased import prices, which have passed through to consumer prices. Prices of non-energy industrial goods, which have a high import intensity, were.6% higher in October 17 than in October. However, we think there are signs that the effect of the weaker GBP will soon start to fade, as, for example, import price inflation has peaked. The same is true of food inflation, as food prices measured in GBP have peaked. We forecast CPI core inflation will fall slowly over the forecast horizon, from.7% currently to.% at the end of 19. We expect headline inflation to run below core inflation, as the positive contributions from energy and food diminish. Although we expect inflation to remain elevated, we do not think the underlying inflation pressure is high, as nominal wage growth remains subdued. Inflation expectations are also well-anchored and not out of control, despite higher actual inflation. Labour market has been quite resilient The labour market has proven to be quite resilient to slower growth and Brexit uncertainties and the unemployment rate has fallen to 4.3%, the lowest since the 197s. However, this is not the same as saying Brexit has not had an impact, as the higher inflation, driven by the weaker GBP, corresponds to a de United Kingdom Euro Area United States Source: ONS, BEA, Eurostat, Macrobond Financial, Danske Bank Negative real wage growth has slowed private consumption growth CPI inflation Regular pay, 3m MA Real wage growth Source: ONS, Macrobond Financial, Danske Bank Import price inflation has peaked, so overall CPI inflation should start to fall again soon %y/y Trade weighted GBP (rhs) Import prices ex oil (lhs) Source: ONS, Bank of England, Macrobond Financial, Danske Bank %y/y (reversed)

18 18 Danske Bank / The Big Picture facto wage cut, as real wage growth has turned negative again. So instead of firms letting people go, wages have taken the adjustment instead. In our view, it is difficult to see a pickup in nominal wage growth right now. While we expect the unemployment rate to fall further over the forecast horizon, we expect it to do so at a much slower pace. We forecast the unemployment rate will decline to 4.% by the end of 19. Also very interestingly, the UK has begun to experience more labour shortages, as immigration to the UK has fallen after the Brexit vote, which has made it more difficult find labour in some sectors. This highlights that Brexit is more a supply side story than a demand side story. Brexit uncertainties remain high The formal date of exit by the end of March 19 is getting closer and negotiations on phase 1 (divorce bill, Irish border and citizens rights) have not been concluded yet, leaving only limited time to negotiate the future relationship. The negotiations are complicated further because Theresa May s minority government is weak and is under pressure from both hardcore Brexiteers and pro-eu Conservative members of parliament. That said, it seems that the negotiations are moving forward, after PM Theresa May (and her team) has taken over from Brexit secretary David Davis, and at the moment the Irish border issue seems to be the biggest obstacle, as the UK has apparently accepted the outline of a divorce bill. The next question is, whether the EU leaders will say there has been sufficient progress at the EU summit meeting in December 17 to move to the negotiations phase (future relationship). If not, the UK may have to wait until March 18, when the next EU summit takes place. While it is positive for GBP that the negotiations are moving forward, it is still too early for the markets to price out the Brexit risk premium, as there are still many unresolved issues about what Brexit really means, even when phase 1 is concluded. We still see EUR/GBP within the range nearterm with a move lower in the longer-term when we get more clarification on Brexit. Too early for markets to price out Brexit premium just yet EUR/GBP EUR/GBP Brexit vote Source: Bank of England, Macrobond Financial Unemployment rate has declined to the lowest level since the 197s despite slower growth 17 EUR/GBP % % BoE s NAIRU estimate Unemployment rate Source: ONS, Macrobond Financial, Danske Bank Our base case for Brexit remains that the UK and the EU will reach a deal on a transition period (two to three years) eventually but that it is unlikely that a full deal will be reached before March 19. We expect the final deal to look something like the EU-Canada CETA deal, which reduces/removes trade barriers for goods but is weak on services. The longer it takes to conclude the negotiations (and agree on a transition period), the greater the risk that the uncertainty will hit the economy. BoE flexible on further rate hikes Despite slower growth, the Bank of England raised the Bank Rate to.% from.% at its meeting in November, as it has become more concerned about the combination of high inflation and low unemployment. Overall, the Bank of England kept its flexibility on further rate hikes in 18 and said it will monitor closely incoming data. We still believe the rate hike was about taking back the emergency cut from August just after the Brexit referendum and not necessarily the beginning of a new hiking cycle. We think the Bank of England is too optimistic on wage growth (and hence underlying inflation) and that it does not want to tighten monetary policy too much relative to the ECB, so our base case right now is no further rate hikes in 18.

19 Danske Bank / The Big Picture 19 Macro forecasts - UK % change q/q Calendar year average Q1 Q Q3 Q4 Q1 Q Q3 Q GDP Private consumption Government consumption Fixed investments Exports Imports Net exports Unemployment rate (%) CPI () Core CPI () Public budget Public debt Current account BoE Bank Rate (%) Contribution to GDP growth. % of GDP, OBR forecasts 3. %, end of period Source: OBR, Danske Bank

20 Danske Bank / The Big Picture Japan Strong but very globally dependent economic upturn We expect GDP growth to end up at 1.6% in 17. Going forward, we expect to see growth closer to trend as fiscal stimulus wanes. We forecast 1.3% in 18 and.8 % in 19. Reflating the economy is a lengthy process. For the time being, we believe PM Shinzo Abe and the Bank of Japan can only hope the global economic upswing lasts long enough for it to happen. We see the main risks to the current economic recovery as a Chinese slowdown and the planned October 19 consumption tax hike. We expect the Bank of Japan to stay on hold for the coming year and then increase the -year target rate to. % in H1 19 in the wake of a global steepening of the yield curve.

21 Danske Bank / The Big Picture 1 Strong growth on back of global economic recovery Growth momentum in Japan has been strong recently and the economy has now expanded for seven consecutive quarters the longest economic upturn since the beginning of the s. Growth is being driven primarily by the global economic recovery, which on the back of the relatively weak Japanese yen is pushing exports to their strongest streak since the big rebound in the global economy in. Foreign demand has helped the labour market reach a tightness of historic proportions. Unemployment stands at.8%, the lowest since 1994 and for every applicants there are currently job openings. Businesses, especially the smaller ones, are reporting an increasing shortage of labour. Even so, Japan is still struggling to reflate the economy. Growth in labour earnings is still modest. Rising energy prices have pushed inflation up recently, which means yearly real cash earnings growth is currently close to zero. That makes it hard to kick-start private consumption, which is needed to drive up core inflation and make the economy less dependent on foreign demand and more self-driven. After a promising H1 17, private consumption also decreased again in Q3. We are moderately upbeat on private consumption going forward. On the one hand, wage increases remain stubbornly low. On the other hand, employment continues upwards, which increases household incomes and consumer confidence currently stands at its highest in four years. Exports the key growth driver %-point Q1 Private consumption Net exports Goverment consumption Contributions to annualised GDP growth Q Q3 Q4 Q1 Q Q3 17 Source: Japanese Cabinet Office, Macrobond Financial Investment, total GDP Labour market tightness of historic proportions % %-point Ratio.3..7 We expect PM Abe s fiscal spending to boost the economy through the current fiscal year (April 17-March 18) contributing to a strong 17, where we see GDP growth of 1.6%. As stimulus starts to wear off and growth in Japan s most important export markets becomes slightly more subdued, we expect growth to decrease to something closer to trend. We forecast 1.3% in 18 and.8 % in 19. Increasing business investment will help reflation along by increasing labour productivity, which should eventually cause labour earnings to rise. Investments have begun to pick up recently and as the output gap increases, we expect to see more of this. Businesses are also reporting an increasing insufficiency of capital. Japan is struggling with a rigid labour market, though and for some businesses the incentive to invest can be limited because capital cannot easily replace labour, as labour is typically very difficult to get rid of. Reflating the economy could still be a long process and currently Japanese policymakers can only hope the global economic recovery remains on track for long enough for it to happen. We expect inflation to increase slightly as the labour market tightens further but % still looks a long way off. A key risk to a continuation of the current upswing in Japan is a slowdown in the Chinese economy. China is Japan s second biggest export market, only slightly behind the US, buying nearly a fifth of Japanese exports. More than half of these exports alone are machinery and transport equipment. Thus, Japan is a big contributor to the Chinese capex-driven economy and remains vulnerable to a possible Chinese slowdown Unemployment rate (lhs) Job-to-applicant (rhs) Source: Japan Statistics Bureau, Japanese Ministry of Labour, Macrobond Financial...has businesses screaming for labour %-points Small enterprises Large enterprises Employment Conditions, TANKAN survey %-points Note: Shows percentage of enterprises reporting excessive employment minus those reporting insufficient employment. Source: Bank of Japan, Macrobond Financial

22 Danske Bank / The Big Picture Pacifist constitution could steal focus from structural reform In October, Abe won a landslide victory in the election to the Japanese lower house. His Liberal Democratic Party kept its single party majority. However, the outcome of the election reflects a divided and chaotic opposition more than anything. Abe s approval rate has not recovered from the political scandals he was involved in this summer and he needs to choose his battles; political capital is no longer in abundance. Five years into Abe s reign, the reform pillar of Abenomics still leaves much to the imagination and currently it looks as though a change to the pacifist constitution from 1947 is higher on the agenda than economic reform. Instead, Abe hopes to help reflation along by influencing the spring 18 wage negotiations. At least, tax exemptions for companies that raise wages by 3% have been on the table. The reality is that companies are cautious about raising wages for regular workers because it increases expenses permanently in a competitive environment; something Japanese companies have not been used to for decades. Many companies are raising wages for non-regular workers, though, in order to ensure sufficient labour supply. thus expansionary measures remain the doctor s prescription Wage negotiations are crucial for Abe and the Bank of Japan (BoJ) in order to get inflation on the path to % and time is of the essence. The planned consumption tax increase from 8% to % in October 19 is looming ahead. When the consumption tax was last hiked back in 14, the economy fell straight into recession. We think there is a considerable risk that the tax hike will derail the economy and postpone the reflationary process even further. On Abe s schedule is also the appointment of a BoJ governor, as current governor Haruhiko Kuroda s term expires in April 18. A reappointment looks like the most plausible scenario. Kuroda has been a key figure in Abenomics and Abe continues to express his confidence in the BoJ. With the current composition of the board, we doubt it is going to be a big game changer, if Abe should end up replacing Kuroda, though. The current board has voted almost unanimously for policy measures in the recent meetings and the hawks effectively disappeared from the BoJ board in July. The current policy measures are credible as the pace at which the BoJ picks up government bonds in its QQE programme with yield curve control is not higher than one which can be upheld for a longer time horizon. That said, the BoJ is for sure speculating how to best ease out of the current extremely dovish stance. In our main scenario, we expect long global yields to increase and this should make room for the BoJ to increase the target rate on -year government bonds. As long as we are not seeing any pickup in core inflation and long global yields remain low, we believe it is too soon, though. A policy tightening would strengthen the yen, potentially hurting the export-driven economic upturn. However, you cannot get too close to the tax hike at end-19, as this already imposes a risk for growth momentum. We expect, the BoJ to increase the -year target rate from the current.% to.% sometime during H1 19. Earnings growth eaten up by higher (but still low) inflation Total earnings Consumer price index excl. fresh food Source: Japan Statistics Bureau, Japanese Ministry of Labour, Macrobond Financial Slowly increasing output gap should induce higher business, investments 17 4 % % of potential output Business investments/gdp (lhs) Output gap (rhs) Source: Japanese Cabinet Office, Bank of Japan, Macrobond Financial and Danske Bank Real wages increase for non-regular workers Total Part time Temporary position Source: JBRC, Macrobond Financial

23 Danske Bank / The Big Picture 3 Macro forecasts - Japan GDP Private Consumption Private Fixed Investments Residential investment Non-residential Public Investments Public Consumption Exports Imports Unemployment rate (%) CPI. excl. fresh food (y/y) Excluding consumption tax hike BoJ rate on deposit facility year government bond rate Source: Danske Bank and Macrobond

24 4 Danske Bank / The Big Picture China Slowing down We expect a moderate slowdown of Chinese growth over the next couple of years as the housing market is set to cool. We look for 6.8% in 17 to be followed by 6.3% and 6.% in 18 and 19, respectively. We expect a renewed reform push and further measures to deleverage to weigh on activity, but we see it as a positive sign that China is increasingly willing to take some short-term pain for longer-term gain. Focus on education, innovation and investment in high-technology sectors leaves a positive medium- and long-term picture of continued catching up. The main challenges remain rebalancing away from investment-driven growth and dealing with the high debt increase.

25 Danske Bank / The Big Picture Robust growth set to ease over the coming year Chinese growth has been robust since a recovery started in early. The engines behind the strong performance have been (1) a pickup in housing, () robust export growth driven by the global recovery and (3) the continued high pace of infrastructure investments. Private consumption is also growing briskly, albeit at a lower percentage growth rate than earlier. However, percentage growth rates can be misleading as the size of the Chinese economy is much bigger today than years ago. Being a USD1trn economy today a 6.8% growth rate in 17 would add more than USD7bn to GDP. Ten years ago a % growth rate would have added USD7bn to the economy. One of the three engines mentioned above is set to lose pace during 18. The housing market is heading for a soft landing engineered by a series of tightening measures over the past year (see Research China: The housing party is over, 14 November 17). This is set to drive a moderate slowdown of the Chinese economy in the coming years. GDP growth set to go lower China GDP growth Expected 6.% target for avg. growth - Source: Macrobond Financial, Danske Bank We also expect the export engine to run a bit slower and the deleveraging measures in the State Owned Enterprises (SOEs) to weigh on investment growth. When it comes to private consumption, we look for growth to stay robust around 8. Household incomes are growing briskly and the very high savings rate leaves room for more spending as wealth increases have been strong following gains in both the housing market as well as the equity market over the past year. Global recovery creates window of opportunity for reform China s President Xi Jinping has received a lot of criticism for not delivering on his reform promises. After presenting an ambitious reform agenda following the third Plenum of the Central Committee of the Communist Party in 13, hopes were high for a reform push. However, on several fronts implementation has lagged. Overcapacity in many sectors is still significant and the SOEs have become even more indebted and are still supported by subsidies and favourable lending terms relative to private companies. We are optimistic, though, that Xi Jinping will put more effort into economic reforms now that he has secured his power base after the 19th National Congress of the Communist Party. At a party workshop held in July 17, Xi stressed that China will keep deepening supply-side reform to push forward. It includes the major tasks of deleveraging, destocking, cutting excess capacity, reducing costs and shoring up weak areas. An increased pace of reform would also entail further efforts to rein in financial risks by forcing through deleveraging in the SOE sector and cracking down further on shadow finance. China s central bank governor for years (expected to retire soon) has used strong words lately in warning against financial risks. Bond yields and money-market rates have also resumed increasing after the Party Congress ended. This is a sign of a continued drive to reduce leverage in the financial system. The strengthening reform push and fight on financial risks is a positive development but it raises the downside risks to growth in the short term. China has a good window of opportunity cur- Chinese housing set to slow down 3ma China credit growth, 3m lead (lhs) China home sales (rhs) Source: Macrobond Financial, Danske Bank 14 Chinese consumption growth to stay robust China, real household income (lhs) China, real retail sales (rhs) Source: Macrobond Financial, Danske Bank

26 6 Danske Bank / The Big Picture rently to take short-term pain for a longer term gain, because the global environment is the most favourable it has been in many years. During the financial crisis, the euro debt crisis and the Chinese financial turmoil in late /early, it was hard to implement reform measures that would be painful. However, the current favourable global developments are a golden opportunity to take another step forward on reforms. While SOE reforms have been lacking, we believe China has progressed in many other areas. A strong focus on innovation and industrial upgrade is the cornerstone of the Made in China strategy that China launched in. Research and Development is rising fast and China is investing heavily in new technology. The fight against corruption and improving conditions for small businesses should also help make the Chinese economy more efficient and encourage more entrepreneurship. When it comes to rebalancing the Chinese economy, China is still facing challenges. Although consumption is taking up a rising part of GDP, investments still dominate, with a share of more than 4%. It is not a big problem in the short run, as China can still justify adding more infrastructure and housing but the pace at which new houses are built and new roads and railways are constructed is very high. It means that (a) a very large amount of resources and companies is exposed to these sectors, (b) it will not be that long before China needs to reduce the pace at which it is adding more infrastructure and housing and (c) the marginal return of building more infrastructure is falling. When the need for new housing and infrastructure comes down a lot of companies will probably not survive. Many of them are highly indebted and a significant amount of debt losses could be the result. This is the main reason why we believe it will be hard for China to avoid some kind of growth crisis down the road. The renewed focus on deleveraging and rebalancing may reduce the problems in the future but then it will be at the expense of weaker growth in the next few years - as recommended by the IMF in its annual Article IV Consultation Report, August 17. Monetary policy set to be on hold for some time Official monetary policy rates have been unchanged for two years now. However, in reality, policy has been tightened as China has used other liquidity tools to manage a gradual increase in money market rates. The goal has been to engineer a decline in financial leverage - that has increased in recent years - and in combination with other measures to take the froth out of the housing market. China accumulating capital at a very high pace Investment % of GDP Investment % of GDP South Korea Taiwan China 7 8 Source: Macrobond Financial, Danske Bank: Benchmark rates stable, but monetary policy tightening via money markets % Lending rate (1y or less) 1 m Shibor rate Deposit rate (1y) Source: Macrobond Financial, Danske Bank % The tightening has not been aimed at fighting inflation. CPI inflation is still only 1.9 in safe distance from the 3% target. With clear signs of a cooling in the housing market, we expect money-market rates to be broadly flat over coming quarters. We expect USD/CNY to be broadly flat over the coming 1 months as relative rates versus the USD will work in favour of a weaker CNY, whereas our expectation of a weakening of the USD against the EUR would work in favour of a stronger CNY versus USD.

27 Danske Bank / The Big Picture 7 Macro forecasts - China GDP Private consumption Investment Net exports Total investment share Total savings rate Current account balance CPI Household income (real) Household savings rate, % of disp income Wage growth (nominal, urban) Government budget balance Augmented fiscal balance (IMF) 3, USD/CNY EUR/CNY PBoC 1-year lending rate, % , : contribution % to GDP 3. % of GDP 4. Includes local government and off-budget activity plus excludes land sale proceeds. End of year Source: Danske Bank and Macrobond

28 8 Danske Bank / The Big Picture Emerging markets Solid growth outlook Emerging markets set to grow at a decent pace in 18, benefiting from pickup in global trade. Inflation has fallen to the lowest level ever, which is likely to allow looser monetary policies in many countries. Asian economies will lead the economic expansion, but Eastern European countries should also grow at a fast pace. A slowdown in China and more aggressive Fed tightening are key risks.