Swiss economy. Global risks to weigh on Swiss growth

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1 Global risks to weigh on Swiss growth Chief Investment Office WM 8 November 8 7: am GMT+: Translation: November 8 Alessandro Bee, Economist, alessandro.bee@ubs.com The Swiss economy is likely to grow by.6% next year. This corresponds to long-term trend growth but is significantly lower than our GDP growth forecast of.9% for this year. Export and investment growth is likely to slow next year on the back of a weaker global outlook. In contrast, consumer demand may benefit from a stronger labor market. An improving capacity utilization and high oil prices are likely to support inflation. Various economic and geopolitical uncertainties weigh on next year s outlook. The biggest risks for the Swiss economy stem from Italy s fiscal policy, a significant cooling of the European economy and the possibility of a global trade war. Swiss economic growth has accelerated significantly since mid-7. In the last five quarters, GDP expanded by.8% on average, considerably above its long-term quarterly growth rate of.45%. The current solid momentum of Swiss growth is matched only by the rebound after the Great Recession (Figure ). Swiss franc, global economy and World Cup bolstered Swiss growth Economic growth has been boosted by a rebound in the export industry (Figure ), which in turn stimulated manufacturing. While in 5 and 6 most export sectors were ailing and only the pharmaceutical industry was thriving, export growth broadened markedly in the last quarters (Figure ). Manufacturing activity benefited from robust growth in the global economy in the previous quarters and from the weaker Swiss franc in H8. While EURCHF oscillated around.7 in H7, it nearly hit the. mark this April. 8 s major sporting events, the Olympic Winter Games and the FIFA World Cup, further supported Swiss growth. Switzerland is home to many sports associations headquarters. Whenever major sporting events take place, revenues stemming from TV and merchandising fees flow into Switzerland and bolster Swiss activity. This year s two major sporting events may have added up to. ppt to GDP growth. Stronger economy supports jobs Swiss economic growth is heavily influenced a by a few sectors which are important in terms of value added but which employ relatively few workers, namely the pharmaceutical industry and commodity trading. This raises the question whether the current strong GDP growth only exists in national accounting terms or whether it also affects the real word, i.e. employment. Fig. : Swiss GDP growth accelerates strongly GDP growth quarter-on-quarter and year-on-year, in % GDP growth yoy, left hand scale GDP growth qoq, right hand scale Sources: Macrobond, SECO, UBS Fig. : Swiss economy gaining from a rebound in manufacturing Contribution to GDP growth from manufacturing and services, in percentage points.5%.%.5%.%.5%.%.5%.% -.5% -.% Contribution manufacturing Contribution services Rest Sources: Macrobond, SECO, UBS GDP growth This report has been prepared by UBS Switzerland AG. Please see important disclaimers and disclosures at the end of the document.

2 Indeed, the Swiss economy has recorded not only a strong pickup in activity but also a healthy rebound in employment (Figure 4). The shift from pharmaceutical-driven to more broad-based export growth has boosted job creation in manufacturing, which in Q8 recorded the strongest employment gains in years. Switzerland s growth surge in H8 will help the economy to expand by.9% this year (Figure 5), which is the strongest growth rate since. GDP growth that is considerably above potential has also improved capacity utilization. After the Swiss National Bank (SNB) abolished the EURCHF currency floor in January 5, capacity utilization fell strongly and the output gap (the difference between realized GDP growth and long-term trend growth) widened. The recent acceleration in activity has helped to close the output gap. We estimate that the Swiss economy is currently running.8 ppt above long-term capacity constraints (Figure 6). Swiss outlook clouds over While Swiss economic growth in H8 was buoyant, the outlook for 9 is clouding over. Global economic growth is likely to slow in the coming quarters, in our view. In the US and China, negative side effects of the trade tensions may hamper growth. Eurozone growth is also set to slow, as the current above-par growth rates are not likely to continue indefinitely and leading indicators already point to weaker growth. While we expect global growth near 4% this year, we anticipate it to slow to about.5% next year. Various global risks including a global trade war, a hard landing in China, a hard Brexit, and a resurrection of the euro crisis are fueling uncertainty for Swiss companies. Meanwhile, the fragile geopolitical situation in the Middle East points to upside risks in the price of oil. Export-oriented Swiss companies may hesitate to invest in this environment, which, in turn, could weigh on growth. The Swiss franc has regained strength in the last months. While we do not foresee a longer-term appreciation of the Swiss franc, this bout of strength in combination with a slowing global economy is likely to weigh on Swiss growth. Swiss economic growth may slip to.6% in 9 (Figure 5). While such a drop seems like a sharp deterioration compared with 8, next year s expected growth corresponds to Swiss trend growth and so is a far cry from a major growth slump. Global political risks may burden Swiss companies willingness to invest but are unlikely to cause further damage, as we do not expect the aforementioned risk scenarios to materialize. That said, should one of the risks come to pass, Swiss growth may take a significantly stronger hit. We worry most about a full-blown trade war, which, according to our simulations, could reduce global growth to just % and would point to Swiss growth clearly below trend growth. Fig. : Export growth broadens in H8 Export growth of the pharmaceutical industry and of the Top 6 sectors ex pharmaceuticals (chemistry, machines & electronics, metals, precision instruments, watches) in %, -months-average Total exports Pharmaceutical exports Top 6 ex pharmaceuticals Sources: Macrobond, FCA, UBS Fig. 4: Robust employment growth in Q8 Employment growth year-on-year in manufacturing and services, in % Sources: Macrobond, BfS, UBS Total Manufacturing Services Fig. 5: Slower growth in 9 inflation to remain stable Swiss GDP growth and inflation with UBS forecasts for 8 and 9, in % E 9E E 9E GDP growth Inflation Sources: Macrobond, UBS UBS CIO WM 8 November 8

3 Slower export and investment growth This year s robust global conditions favor cycle-sensitive exporters like electronics, machines and metals. But these sectors may suffer most from a global slowing going forward. A stronger Swiss franc is likely to hurt Swiss tourism, the most currency-sensitive export sector. Pharmaceutical exports, on the other hand, generally remain almost untouched by changes in economic growth or the currency situation. The biggest threat to the pharmaceutical industry is posed by a major revamp of the US health care system, if such a revamp is associated with major cost-cutting measures. Investments in equipment are hurt twofold by a slowing global economy. First, a deceleration in export growth, and so in manufacturing growth, will also reduce the need for capacity expansion and the need to invest in equipment. Second, heightened global uncertainty may force companies to defer investment plans. Rising vacancies should slow construction investment Swiss domestic risks are less pronounced than global ones but do exist, particularly in the real estate market. Vacancy rates are rising markedly and may hit new all-time highs next year, which in turn could cloud the outlook for the construction sector. The recent drop in building applications also points to a cooling in construction (Figure 7). But whether construction activity really falls given fading demand is uncertain, as it has proven resilient to rising vacancies in recent years. In the current environment, institutional investors are prepared to accept some vacancies in their real estate portfolios rather than turn to negative interest rates on cash holdings. Construction activity is likely to only slow in the course of 9 what could amplify imbalances in the Swiss real estate market in the short term. On the household side, there is significant room for improvement. Private consumption has shown sub-par growth in the last two years, and we anticipate consumer demand will advance by only.% this year. Robust employment gains and a turnaround in the pace of net immigration should bolster consumer demand in the medium term. But higher inflation rates may hold back households' willingness to consume in the short term. Inflation rates around % could turn nominal wage gains of.8% into real wage losses. Nominal wage growth fluctuated between.5 and % in recent years (Figure 8). An improving labor market could push wage growth to the upper end of this band and, longer term, above the % mark. That said, we expect nominal wages and the inflation rate to grow both by % next year what implies a stagnation in real wages. Consumer-oriented sectors to improve only medium term (Author: Sibille Duss) Swiss exports were able to distinguish themselves from the pharmaceutical industry in recent quarters. The metal and watch industries reported strong gains of % and %, respectively, from January to August compared to the same period of last year. Fig. 6: Output gap of Swiss economy closed Output gap (materialized GDP growth less GDP trend growth), in % of GDP Sources: Macrobond, UBS Fig. 7: Significant drop in building applications Building applications per quarter and 5-year average 6' 4' ' ' 5 year average 8' Sources: Docu Media, UBS Fig. 8: Nominal wages to rise slightly Wage growth in nominal terms, in %, with UBS forecasts for 8 and Sources: BfS, UBS UBS CIO WM 8 November 8

4 Sectors with a high export share like the MEM-industry (with an export share of almost 8%) would suffer most from the consequences of the trade dispute. Through second-round effects, more protectionism could also hurt suppliers, e.g. the Swiss suppliers for the German car industry. These sectors do not heavily export to the US or China but are supplying exporters that have exposure to these markets. Besides a trade war, an appreciation of the Swiss franc serves as one of the major risks for many sectors. A stronger Swiss franc will weigh not only on the industry sector, but also on tourism and retail trade. A study by the KOF Swiss Economic Institute suggests that a % increase in prices leads to an 8% decrease in overnight stays from German tourists, the most price-sensitive guests. The retail and wholesale sector and logistics are likely to feel the still sub-par growth rate of consumer demand. We expect consumer demand to improve in the medium term, which may also sustain these sectors, but structural challenges will persist, especially for retail. Stable inflation capacity utilization as a future driver Inflation gained momentum in H8 and in the summer reached levels not seen since. The latest rise in inflation was driven by rising oil prices. The softer franc in H8 also boosted import prices (Figure 9). Finally, improving capacity utilization led to some domestic price pressures, which are reflected in a modest rise in core inflation. We expect consumer prices to rise by % in 8. Oil prices are set to rise further in the coming months and should underpin inflation rates in the short term. The Swiss franc is likely to weaken in the course of 9 and should drive inflation in the second half of next year. So we expect Swiss inflation to remain at % in 9, as well. While we regard oil prices and the Swiss franc as the main inflation drivers for this and next year, capacity utilization could become the prime driver in. An improving economy will return some bargaining power from buyers to sellers and from companies to their employees. The resulting wage gains should support core inflation and keep inflation around % in, even as the impact from oil prices and the currencies fades. Labor market on the mend despite all the noise Labor market indicators paint a rosy, but sometimes conflicting, picture of the Swiss job market. Full-time equivalent employment growth accelerated significantly in Q8. More than 75, new jobs were created from mid-7 to mid-8. The service industry added more than 6, new jobs,, jobs were created in manufacturing, construction also added jobs. Job growth in manufacturing benefited from the watch industry, where 5, new jobs were created. Unemployment rates have evolved inconsistently. The unemployment rate published by the SECO, which is based on unemployed persons registered at the regional job service centers, dropped sharply (Figure ). Fig. 9: Inflation driven by oil and import goods Contribution to total inflation by oil prices, import goods ex petroleum and domestic goods, in percentage points Jun 6 Dez 6 Jun 7 Dez 7 Jun 8 Domestic goods Import goods ex petroleum Sources: Macrobond, BfS, UBS Petroleum goods Total Fig. : ILO and SECO unemployment rates diverging Unemployment rates defined by ILO and unemployment rates published by the SECO, in % Unemployment SECO, seasonal adjusted Unemployment ILO, seasonal adjusted Sources: Marcobond, BfS, SECO, UBS UBS CIO WM 8 November 8 4

5 But only half of the drop is economically relevant, as the other half is due to a technical change in regional job service centers and does not reflect stronger labor market conditions. Even so, the fall in the SECO unemployment rate points to a noticeable improvement in the Swiss labor market in H8, even after taking into account the methodological changes. By contrast, the unemployment rate generated by following the definition of the International Labor Organization (ILO) has not shown any improvement yet. It remained near 5% in Q8. The different behavior of the two unemployment rates is surprising since in the past they have moved in sync. One explanation for this difference may be that, at the beginning of a labor market recovery, people who are out of the job market for a long time usually find it harder to reenter the labor market than short-term unemployed people. The ILO unemployment rate differs from the SECO rate in that it includes more long-term job seekers. Leading indicators for the Swiss labor market point to a continuation of the labor market's recovery. Indicators from Adecco, KOF and the PMIs show similar conditions today as were seen in or 4, when the Swiss labor market recovered markedly (Figure ). In 9, employment growth is likely to slow due to softer growth. While GDP growth at.9% in 8 implies annual employment growth at nearly %, our 9 GDP growth forecast of.6% points to employment advancing by about %. As SECO unemployment rates are already at very low levels, we only foresee a slight drop next year, but we hope to see significant improvement in the ILO rate to 4.4% in 9, as a more advanced labor market recovery also gives long-term unemployed job seekers more opportunities to reenter the market. Net immigration (immigration minus emigration) remained near the levels of last year and should end the year slightly above the 5, mark (Figure ). Given the strong rebound in employment and the tighter labor market in Switzerland (at least according to SECO readings), this is a clear indication that improvements in labor market conditions in the Eurozone reduce the push factor for foreign workers to move to Switzerland. A further improvement in the labor market is likely to accelerate net immigration next year, albeit not to levels seen five years ago when labor markets in the Eurozone were in significantly worse shape than today. All eyes on a possible corporate tax OASI deal vote Domestic risks for the Swiss economy are emerging not only from the real estate market, but also from economic policy. In May 9 important domestic issues will arrive at the ballot box when Swiss voters may (it s still not clear yet whether a referendum will come about) cast their votes on a combined proposal reforming the old age and survivor insurance (OASI) and corporate taxation. The intensification of the global tax competition has increased the urgency of a reform in corporate taxation. Tax cuts initiated under US President Donald Trump may trigger a downward spiral in international corporate taxation. Switzerland, a long-time leader in this area, faces the risk of falling behind. Should the proposal fail, uncertainty stemming from global risks may be amplified and investments could be hurt. Fig. : Labor market indicators point to further improvement Labor market indicators, normalized deviations from the mean Adecco PMI manuf. PMI non-manuf. KOF Sources: Macrobond, UBS Fig. : Net immigration on last year s level Evolution of net immigration (permanent and non-permanent population) in the course of the year (-) 6' 5' 4' ' ' ' Sources: SEM, UBS Table : UBS economic forecasts Switzerland % change yoy in real terms, adjusted for seasonal and calendar effects Forecasts UBS Level* F 9F Gross domestic product Private consumption Government spending Capital spending Construction Equipment Exports** Imports** Inflation Unemployment rate*** *Year 7 (in CHF billion at current prices) **Without valuables and non-monetary gold ***Annual average P: UBS forecast Sources: UBS UBS CIO WM 8 November 8 5

6 The relationship between Switzerland and the European Union is also a major topic. The self-determination initiative (Selbstbestimmungsinitiative) will be put to the vote on 5 November. If approved, negotiating a new framework for the bilateral agreement with the EU (Rahmenabkommen) will become more difficult. The initiative for limiting immigration (Beschränkungsinitiative) aims to repeal the free movement of people between Switzerland and the EU and could if approved end the bilateral agreements. However, this initiative will not come to a vote before. Even if these initiatives are rejected at the ballot box the prospect of a further deepening of relationships with the EU is modest at best. As long as the EU is engaged in negotiating the terms of the UK departure from the EU and possibly a new trade deal, there is little hope for a substantial step forward. Only after the Brexit deal is settled will Swiss politicians know whether and where there is leeway to negotiate. Looking further ahead, Swiss general elections will take place in October 9 but are unlikely to have a significant impact on Swiss economic policies. There are no clear-cut coalitions in Swiss politics with alliances changing across topics and issues. The impact of the parliament is also limited because of public voting. Today the National Council is dominated by a thin margin by the FDP and the Swiss People s Party (Figure ), while Christian Democrats and Socialdemocrats have a majority in the Council of States (Figure 4). Next year s elections could bring the majority back to the centerleft in both chambers. But this potential shift would only be a minor change in the Swiss political landscape as, in a majority of economic issues, the separation line runs between the center-right parties and the left. Fig. : Swiss People s Party and FDP have a slight majority in the National Council Current distribution of the seats in the National Council Socialdemocrats 4 Green Liberals 7 BDP 7 Christian Democrats Sources: UBS Greens FDP Swiss People's Party 68 Fig. 4: Center-right parties dominating the Council of States Current distribution of the 46 seats in the Council of States Socialdemocrats Green Party Swiss People's Party 6 BDP FDP Sources: UBS Christian Democrats UBS CIO WM 8 November 8 6

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