Global Machine Tool Outlook

Transcription

1 216 Global Machine Tool Outlook Spring 216 Copyright 216 Oxford Economics

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3 216 Contents bmachine Tool Outlook Overview 1 Risks 7 Brazil 8 China 1 France 12 Germany 14 India 16 Italy 18 Japan 2 Mexico 22 S. Korea 24 Spain 26 Switzerland 28 Taiwan 3 Thailand 32 Turkey 34 UK 36 US 38 Smaller Markets 4 Industrial Background Aerospace 43 Basic Metals 4 Electrical Engineering 47 General Purpose Machinery 49 Metal Products 1 Motor Vehicles 3 Precision and Optical Instruments Special Purpose Machinery 7 Economic Background Overview 9 Brazil 62 China 6 Eurozone 68 France 71 Germany 74 India 77 Italy 8

4 216 Contents Economic Background (continued) Japan 83 Mexico 86 S. Korea 89 Spain 92 Switzerland 9 Taiwan 98 Thailand 11 Turkey 14 UK 17 US 11 Austria 113 Canada 114 Czech Republic 11 Hungary 116 Poland 117 Russia 118 Slovakia 119 Appendix Tables The Global Machine Tool Outlook is a project exclusively for machine tool builders associations. Current partners in the project are the AMT, CECIMO (on behalf of its member associations), AMTIL, IMTMA and TMBA. Oxford Economic ing Abbey House 121 St Aldates Oxford OX1 1HB Tel: (186) 2689 Fax: (186) 26896

5 216 Machine Tool Outlook Overview Financial woes force further downgrades In recent months, we have seen signs of global economic growth weakening into 216. Indeed, the year started with sharp declines in stock markets which were prompted by renewed concerns about China and its currency as it seeks to target a basket of currencies, not just the US dollar. Furthermore, the latest trends in the global PMI for manufacturing point to slow growth, at best, ahead and there are unwelcome signs that this is feeding through to the services sector. Despite concerns remaining about the health of the Chinese economy and extent to which investment is slowing down, many of the downgrades to economic growth have actually been in developed economies (with the noteworthy exception of Brazil). World: MT Apparent consumption Billion $ 1 9 Billion $ (LHS) (RHS) Another development which remains an important feature of our forecast has been the continued decline in global commodity prices. Despite the recent, if modest, rally in oil prices, as prices respond to freezes in output by Saudi Arabia and Russia and declines in US production, global demand has weakened somewhat suggesting that the oil price reebound is unlikely to last. Overall, our oil price forecast is considerably weaker than six months ago and we forecast averages of $36pb in 216 and $39pb in 217, down from $4pb and $9pb, respectively. Among the main emerging markets, Brazil and Russia are continuing to suffer the most. We have downgraded our economic growth forecast in Brazil considerably as the country has become engulfed in a political scandal and there is little room for counter-cyclical policies given high inflation and a gaping government budget deficit. In Russia the slide in oil prices and rouble depreciation have forced a delay in interest rate cuts, pushing the likelihood of an upturn in economic growth out to 217. In the developed world, economic growth in the US is forecast to pick up at a more modest pace than we had anticipated as a strong dollar, sluggish global growth and lower oil and gas investment dampen growth prospects. Meanwhile, economic activity in the Eurozone remains resilient amid strong consumer spending, but a lack of consumer momentum in Japan, combined with a reassessment of the impact of the impending consumption tax rise, point to GDP growth there of under 1% over the forecast period. Overall, we now expect world GDP to expand by 2.4% in 21 and 2.3% in 216, down from 2.8% and 3% respectively in our last report. World: GDP & Industrial production IP World: in machine tool purchasing industries Billion $ GDP (RHS) Billion $ (LHS) Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 1

6 216 Machine Tool Outlook Meanwhile, prospects for industrial production have also weakened. We now expect world industrial output to rise just 2.8% this year before rising by 3.7% in 217. On a regional basis, forecasts have been revised lower in 216 for Europe and the Americas but are virtually unchanged in Asia. In Europe, industrial production is forecast to edge up by.6% in 216 before a more convincing recovery takes place in the second half of this year leading to an expansion of 2% in 217. At the same time, the Americas is the only region forecast to see a second consecutive dip in output as a strong dollar impacts export-oriented sectors in the US, dire economic conditions in Brazil affect production there and the drop in oil prices hits output in Canada, where industrial production is set to shrink this year. In Asia industrial production is expected to remain steady, up by 4.3% in 216 and 4.% in 217. On a sectoral basis, transport equipment is relatively strong, as aerospace enjoys healthy backlogs and strong demand, and automotive is driven by both low petrol prices and policy incentives in some countries though the latter simply pulls forward future production. But industrial equipment remains sluggish, affected by both the decline in oilfield activity and slower investment growth in China. Reflecting slightly bleaker industrial prospects, we expect global MT-weighted output to expand by a meagre 1.% in 216, slowing from 1.8% in 21, before increasing by 2.7% in 217. At the same time, we are forecasting world investment by the key MT customer sectors to rebound by 4.1% this year, after a drop of 3.3% in 21, before increasing by 4.4% next year. As with output, the Americas will also remain the laggard in investment, with spending up by just 2.8% before recovering thereafter. Meanwhile, Asian investment is forecast to rise by 4.2% in 216 and 4.% in 217, while Europe sees growth of.3% and 4.1%, respectively, although this partially reflects a catch-up in some countries. For 216 as a whole, apparent consumption is expected to recover some ground this year with growth of 2%, in US$ terms, although we only expect growth to occur in two of the three main regions. On a regional basis, consumption in Asia is expected to rise by 2.7% this year, with the strongest MT prospects in India and weakest in Taiwan. Europe is set to see an expansion of 1.8% this year with growth supported by further monetary policy easing. Also, the exclusion of Russia from the aggregation shows that European MT consumption would be up 2.8%. Finally, MT consumption is predicted to be weakest in Americas, edging down.4% in 216 before rising thereafter. Apparent consumption Europe Asia Industrial production Americas Europe Asia Americas in machine tool purchasing industries Asia Americas Europe Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 2

7 216 Machine Tool Outlook Overview of medium-term trends The main driver for world growth in the past decade has been the emergence of China both as a producing and consuming nation and its increasing integration into world trade. Chinese real GDP growth in the ten years to 212 has averaged 1.%pa with real fixed investment spending across all sectors of the economy increasing by just under 13%pa over the same period, accounting for a much larger share of world investment than its GDP share. Over the next five years, though, both Chinese GDP and fixed investment are set to grow more slowly as the Chinese economy rebalances away from excessive investment as the main engine for growth. As a result, GDP is expected to grow at an average annual rate of 6% in the period and fixed investment at a rate of 4.4%pa. Weaker investment trends suggest more moderate Chinese MT consumption growth rates for the medium term compared to those typically seen prior to 211. At the same time, such rebalancing favours comparatively rapid consumer spending 7%pa over the period compared to GDP growth of 6% - and a switch in consumer demand towards more discretionary spending on manufactured goods and services as per capita incomes rise. Moreover, despite weaker GDP and investment growth, the process of catchup is far from complete and will ensure China remains an important engine for the world MT market for some years yet. This process of catch-up is evident in many emerging countries and is a key driver of world growth in the medium term. The eight key machine tool buying sectors will benefit from this process. For example, both motor vehicles and high-tech consumer products are expected to be increasingly in demand in emerging countries as per capita incomes rise in the coming five years. Although penetration of these discretionary products into households has increased over the past decade, there is clearly scope for further gains as the middle classes in these countries expand. This in turn is expected to drive growth in machine tool purchases in the medium term. The machine tool sector tends to be more cyclical even than overall fixed investment spending, itself one of the most cyclical parts of GDP, but these medium-term trends are expected to underpin robust growth in apparent machine tool consumption. China, already the largest consumer and producer of machine tools, is expected to maintain its lead as its domestic demand expands and its attraction as a production base for export to the rest of the world continues. This comes despite World: Machine tool consumption in 214 Italy 4% Germany 9% Canada / Mexico 4% US 11% Brazil 2% France 1% Rest of Asia 11% Japan 6% World: Nominal GDP in 214 France % Italy 4% Germany 6% Canada / Mexico % Rest of Europe 1% Germany 7% Canada / Mexico 4% US 29% Rest of Europe 11% India 2% China 17% China 39% India 3% Japan 8% Rest of Asia 4% Brazil 4% World: in machine tool-buying industries in 214 Rest of Europe % France 3% Italy 2% China 37% India 2% Japan 13% US 1% Brazil 2% Rest of Asia 1% Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 3

8 216 Machine Tool Outlook further downgrades to our macroeconomic forecasts and the ongoing erosion of China s competitiveness on the back of rising wages. World: Machine tool consumption in 219 In contrast, for Europe, GDP growth over the period is expected to be a far more modest 1.%pa, with fixed investment growth averaging 2.9% over the same period. Over this time, governments are expected to continue addressing deficits and public sector debts accumulated during the recession. China 38% India 3% Japan 7% Rest of Asia 1% Brazil 1% US 1% More fundamentally, populations are generally aging and this trend is resulting in at best very slow growth in labour supply at a time when immigration has become a political issue. Indeed, in some countries, labour forces are set to contract markedly in the coming years. Although unemployed workers can be re-employed in order to ease the restriction on growth from limited labour supply growth, such limits constrain potential output growth across the region. Greater capital intensity in production can sidestep the labour force constraints and favours increased purchases of machine tools, but another often more attractive solution is to shift further production into emerging countries where labour shortages are not prevalent and costs are lower. For the key machine tool buying sectors, fresh demand for their products (e.g. motor vehicles) is less dynamic in Europe as penetration levels are already very high. Markets here are large, so replacement demand does provide a continual stimulus to production and hence investment spending. Greater dynamism is expected to come from emerging countries. In addition, less support is expected to come from pent-up demand in the medium term, given that this has largely been met over the past two years, where European MT consumption increased by 14.% and 13% in 214 and 21, respectively. The Americas region lies between these two extremes. The region as a whole has more favourable demographic trends than Europe but revisions to long term growth projections mean that we now expect average GDP growth of around 2.2% over the forecast period while structural impediments in Brazil cap long term growth there. Overall, both GDP and fixed investment growth are expected to be faster than in Europe in the medium term, with GDP growth in the next four years expected to be just over 2%. However, unlike in Europe, MT consumption has kept pace with growth in customer sectors, thus medium term growth is likely to be relatively subdued. Rest of Europe 11% Italy 3% Germany 6% Canada / Mexico 4% France 2% World: Nominal GDP in 219 Rest of Europe 14% France 4% France 2% Italy 2% Germany 6% Canada / Mexico 3% US 16% US 32% Italy 4% China 43% China 21% Canada / Mexico % Germany 9% India 4% Japan 6% Rest of Asia 4% Brazil 2% World: in machine tool-buying industries in 219 Rest of Europe % India 2% Japan 1% Rest of Asia 1% Brazil 1% Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 4

9 216 Machine Tool Outlook Apparent consumption % of World Europe Asia Americas World industries: Metal products Electrical engineering Basic metals World industries: General purpose Special purpose World industries: Aerospace Precision & optical instruments -1-2 Motor vehicles Overview table US dollars % change GDP World Americas Asia Europe IP World Americas Asia Europe World Americas Asia Europe Apparent consumption World Americas Asia Europe Exchange rates $/ $/Yen GDP growth rates are calculated by summing the relevant countries, in dollar terms. Regions for industrial production weight relevant countries together using 21 weights. and apparent consumption are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date

10 216 Machine Tool Outlook Machine tool consumption Local currency unit unless otherwise specificied - % change Level in 214, US$bn China India Japan S. Korea Taiwan Thailand Asia Brazil Canada Mexico US Americas Austria Czech Republic France Germany Hungary Italy Poland Russia Slovakia Spain Switzerland Turkey UK Europe World ex-china World World growth rates are calculated using a weighted sum of the local currency growth rates. Each country's share of world consumption in 21, measures in dollars, is used as its weight for the world growth calculation. Regional growth rates are calculated in a similar way. Regional growth rates are a weighted sum of the local currency growth rates of the countries within the region. World ex-china is calculated a similar way to world. Note: World is defined as the aggregate of the 23 countries forecast Apparent consumption = total consumption of machine tools in the named market, For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 6

11 216 Machine Tool Outlook Risks Downside risks overpower upside We consider a scenario in which a slump in Chinese housing sales results in households delaying purchases, exacerbating the slowdown already apparent in the economy. A decline in confidence results in reduced FDI inflows and a scaling back of private investment. The Chinese authorities respond by targeting its currency, and as a result, the effective exchange rates of other currencies appreciate sharply and global trade falls sharply. Indeed, the impact of such a scenario would have a global impact upon MT consumption given China s role as the largest consumer and producer. We attach a 1% probability to such an event. Recent market jitters risks spreading further into the real economy. We consider a scenario in which further signs of weaker growth, combined with overvalued US equity markets, leads to a steep decline in equity prices. The subsequent negative wealth effects weigh on market confidence and credit conditions tighten, globally, dampening prospects for MT consumption. We believe there is a 1% chance of this occurring. The steep fall in oil prices has raised doubts about the credit worthiness of several mining firms. We consider a scenario in which a further drop in the oil price leads to increased mining sector defaults and debt downgrades in several emerging market producers. The resulting contagion leads to tighter credit conditions globally, hindering investment growth and, hence MT demand. Like the second scenario, we attach a 1% chance. % change World: Industrial output % change year on year World: in machine tool purchasing industries Autumn Current Autumn Current Rising geopolitical tensions, for which we attach a 2% probability, could derail global growth. We consider a scenario in which diplomatic tensions between Saudi Arabia and Iran escalate. As a result, oil prices rise sharply. Household purchasing power in oil-importing countries is impacted, although oil producers benefit from a boost to their terms of trade. Overall, we expect the positives to marginally offset the negatives, ultimately, capping MT consumption growth. World: Apparent consumption Billion $ Current Autumn We consider a scenario in which recent market gloom fades and confidence picks up. This spurs firms in the US and Europe to boost investment to replace and ageing capital stock. Stronger growth and low bond yields give some countries breathing room to boost public infrastructure investment having a knock-on effect on MT consumption. The likelihood of this occurring is 1% Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 7

12 216 Brazil Machine Tool Outlook Politics bad for machine tool demand The outlook for Brazil continues to struggle in light of political uncertainty. The possible impeachment of President Dilma Rousseff is merely the latest chapter in an ongoing saga of political events creating an atmosphere of business uncertainty and stagnating investment and growth. We have revised down GDP forecasts to a 4% contraction in 216 and zero growth in 217 in the face of the continued political troubles. The main MT consuming sectors are similarly feeling the unfortuanate consequences of a deeply unstable political situation. Weighted output plumbed to new lows in the latest quarter of data, falling by over 13% in 21 and expected to fall a further 12.6% in 216. All of the main MT purchasing sectors are forecast to see a decline in production this year and only a few will escape negative growth in 217. Apparent consumption Billion Real (RHS) Billion Real (LHS) Overall, the weighted consumption forecasts look set to struggle. Orders placed with foreign producers were down 2% in year-on-year terms in H2 21. Similarly import demand has fallen of a cliff in recent data, with annual growth down by 46% in year-on-year terms in January. As a result, our forecast for MT consumption in 216 is a fall of 1.1% before edging down by a further 1.9% in 217, and finally beginning to grow again thereafter. Risks to the forecast include more sustained political uncertainty most sides now view that impeachment is the fastest way to conclude political strife, but if this does not happen and uncertainty persists it could be even longer until consumption begins to grow again. Similarly if the oil price recovery takes even longer than currently anticipated (at the moment expected to begin edging upwards towards the end of 217) this could further hinder MT consumption growth. in machine tool purchasing industries Billion Real 14 (RHS) Billion Real (LHS) % Apparent consumption (Real) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ = 3.33 for Brazil % change Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 8

13 216 Machine Tool Outlook Composition of investment Motor vehicles 32% Electrical engineering 21% Precision & optical instruments 2% Apparent consumption world share % Metal products 12% Basic metals 18% Aerospace 3% General purpose % Special purpose 7% Metal products Basic metals Motor vehicles Aerospace General purpose Special purpose Electrical engineering -2 Precision & -3 optical instruments Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 9

14 216 China Machine Tool Outlook MT consumption capped at 2.8% in 216 Downward pressures on the Chinese economy have persisted since our previous report. However, we expect the government to continue to support domestic demand while further depreciation against the US$ later on this year should provide some help to exports. But with the current investment and consumption trends forecast to stay in place we expect the GDP growth to slow to 6.2% in 216 and 6% in 217. Weighted production in the key MT sectors is forecast to expand by 4.9% this year before decelerating to 3.1% in 217. Many of the key MT consuming sectors are forecast to see output growth decelerate ahead. Producers in the basic metals sector have started to respond to low steel and base metal prices and, despite some positive signs from downstream markets, we expect output growth of just 1.6% in 216 and 1.2% in 217, the worst prospects among the eight MT consuming sectors. At the same time, the boost to motor vehicles prospects in 216, largely due to government initiatives that have brought forward car purchases, is likely to be temporary unless these incentives are extended beyond this year, meaning that we expect production growth to decelerate sharply in 217. Similarly to output, we expect weighted investment growth to be lacklustre too, expanding by just 3.3% in 216 and 4.3% in 217. Despite economic policy providing some support to some of the MT consuming sectors, there is evidence that orders placed with foreign producers weakened considerably towards the end of 21, suggesting that underlying demand for machine tools is weak. Overall, we expect MT demand to expand by 2.8% and 2.9% in 216 and 217, respectively. Risks to the forecast remain skewed to the downside. A more severe slowdown in investment than currently anticipated, given overcapacity in a number of sectors could lead to a fifth consecutive year of declining MT consumption. Apparent consumption Billion Yuan (RHS) Billion Yuan (LHS) in machine tool purchasing industries Billion Yuan (RHS) Billion Yuan (LHS) % for China % change Apparent consumption (Yuan) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ = 6.28 Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 1

15 216 Machine Tool Outlook Composition of investment General purpose 16% Precision & optical instruments 2% Special purpose 16% Aerospace % Basic metals 17% Apparent consumption world share % Electrical engineering 22% Motor vehicles 1% Metal products 12% Metal products Basic metals Motor vehicles Aerospace Special purpose Electrical engineering Precision & optical instruments 1 1 General purpose Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 11

16 216 Machine Tool Outlook France Improving economy to boost MT demand We expect the French economy to expand 1.3% in 216 and 1.7% in 217. Although downgrades to the global outlook, as a result of financial market volatility, will cap export growth, a weak euro will help to partially offset this. At the same time, renewed monetary policy easing by the ECB will give a boost to investment as it loosens credit conditions. Meanwhile, low inflation and a steady labour market recovery will support private spending. After posting growth of 1.3% in 21, weighted output in the key MT sectors is forecast to pick-up to 3% in 216 and 4.8% in 217, however, some sectors are forecast to perform better than others. Two of the sub-sectors, basic metals and aerospace, are expected to decline in 216 but, beyond this, prospects for the latter are much more positive. On the other side of the spectrum, motor vehicles output is predicted to post just over 1% growth in 217, after modest growth of.9% in 216. Apparent consumption Billion Euro 1.4 Billion Euro (LHS) (RHS) Meanwhile, investment spending has picked up over past quarters and we expect growth to remain solid ahead as monetary policy becomes more supportive. Furthermore, annual orders growth picked up towards the end of 21 as order backlogs moved above long term average levels. Overall we expect machine tool consumption to expand by 7.2% in 216 and 8.7% in 217, after recording estimated double-digit growth of 17% in 21. Despite the positive outlook, risks to growth remain skewed to the downside. On the domestic side, the economy could lose momentum if the reform process continues to slowdown, potentially dampening investment spending and, as a result, MT consumption. On the external side, the most important risk is a China hard landing, which would have a considerable impact upon France via trade and financial linkages, dampening demand for machine tools. in machine tool purchasing industries Billion Euro (RHS) Billion Euro (LHS) for France % change Apparent consumption (Euro) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ =.9 Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 12

17 216 Machine Tool Outlook Composition of investment 214 Electrical engineering 18% Motor vehicles 23% Precision & optical instruments 16% General purpose 7% Special purpose 2% Apparent consumption world share % Metal products 14% Aerospace 16% Basic metals 4% Metal products 2 1 Aerospace Motor vehicles -3 Basic metals General purpose Special purpose Electrical engineering Precision & optical instruments Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 13

18 216 Machine Tool Outlook Germany Slowdown in MT demand in sight for 216 Economic growth is forecast to gain momentum as the year progresses. A strong labour market and prospected for wage growth will support consumer spending, while increasing capacity utilisation and further loosening of monetary policy should aid investment. However, we have become more cautious about the outlook for exports given weaker global trade. Overall, we forecast economic growth of 1.7% and 1.9% in 216 and 217, respectively. Many of the key MT consuming sectors, particularly the sectors, have been affected by the slowdown in China and this will continue to dampen production growth ahead, although the US has helped to somewhat offset the weakness recently. Meanwhile, the impact of the VW scandal will hinder growth in the motor vehicles sector this year and beyond as investment is postponed, having a knock-on effect on metal products output. Overall, we expect five of the eight MT consuming sectors to see output decline in 216 before recovering thereafter. Apparent consumption Billion Euro Billion Euro (LHS) (RHS) Similarly to output, weighted investment is forecast to slow this year as the recent turmoil in financial markets and VW scandal dampen investment prospects, although some respite will come from further loosening of monetary policy. Meanwhile, the outlook for foreign orders is still being weighed upon by the slowdown in China, but a welcome boost to orders from the US and Mexico in Q4 21, should feed through to consumption this year. Overall, we expect MT consumption to increase by 1.% in 216, after robust growth of.% in 21, before accelerating to 3.9% in 217. Risks to the forecasts remain skewed to the downside. Weaker Chinese investment growth than currently anticipated, especially given Germany s exposure to China, and the uncertainty caused by the possibility of an exit by the UK from the EU could hit demand for machine tools. in machine tool purchasing industries Billion Euro 16 Billion 14 Euro (LHS) (RHS) Apparent consumption (Euro) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ =.9 for Germany % change Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 14

19 216 Machine Tool Outlook Composition of investment 214 General purpose 1% Precision & optical instruments 8% Special purpose 11% Aerospace 3% Basic metals % Metal products 8% Apparent consumption world share % Electrical engineering 13% Motor vehicles 46% Metal products Basic metals Aerospace Motor vehicles General purpose Special -2 purpose Electrical engineering Precision & optical instruments Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 1

20 216 India Machine Tool Outlook Healthy prospects for MT consumption While we believe that the headline GDP overstates economic growth, we still predict growth of 7.4% in 216, after 7.3% in 21, and 7.2% in 217. Consumer spending will remain the main driver of growth but the contribution from investment is expected to rise, particularly from the private sector, as the effects of monetary easing that occurred last year feed through. However, the slowdown in global trade is dampening prospects for export growth. Of the main major emerging market countries, India generally has the most healthy growth prospects across the key MT consuming sectors. However, some sectors are expected to do better than others. On the one hand, basic metals is set to suffer a sharp deceleration this year as weak global prices lead producers to cut back output. While, on the other hand, motor vehicles production growth is forecast to remain in double-digits ahead and this will support growth in metal products output. As a whole, weighted output of the key MT consuming sectors is expected to be 7.6% this year and 8.6% next. At the same time, weighted investment is likely to pick up in a similar way to output as the conditions to facilitate investment spending improve. However, rising inflation and the possibility of rate hikes in the US mean that there is limited room for further monetary easing. Overall, we expect weighted investment to increase by.2% in 216 and 8.4% in 217, supporting MT consumption growth of 8.6% and 9.7% respectively. Notwithstanding the relatively positive outlook, the risks to the forecast are skewed to the downside. India is still vulnerable to external shocks, which could potentially lead to capital outflows that weaken the currency and push the central bank into raising interest rates, dampening investment spending and, hence, MT consumption. Apparent consumption Billion Rupee (RHS) Billion Rupee (LHS) in machine tool purchasing industries Billion Rupee 16 (RHS) Billion Rupee (LHS) % Apparent consumption (Rupee) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ = 64.1 for India % change Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 16

21 216 Machine Tool Outlook Composition of investment Aerospace Special % purpose % General purpose 8% Precision & optical instruments 2% Electrical engineering 8% Motor vehicles 17% Metal products 9% Basic metals 1% Apparent consumption world share % Metal products Basic metals Motor vehicles Aerospace 8 General purpose Special purpose Electrical engineering Precision & optical instruments Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 17

22 216 Machine Tool Outlook Italy Brief growth lull in MT consumption in 216 GDP increased by.6% in 21, the first year of growth since 211, and we forecast a slight acceleration to 1% growth this year. In the short term, however, the recent financial turmoil will hit business confidence and, hence, investment spending while weakness in external demand contains export growth. Beyond this, we expect the steady economic recovery to resume with GDP growth reaching 1.3% in 217. Following another year of contraction in 21, weighted output in the main MT-purchasing sectors is expected to edge up in 216 as economic conditions begin to steadily improve. However, a closer look at the sub-sectors shows that some sectors are performing better than others. For example, robust growth in motor vehicles and aerospace production is predicted to offset declines in basic metals. Beyond this year, we expect strong motor vehicles growth to continue into 217, pulling up demand for sectors like metal products, before decelerating thereafter. In addition to the recent financial turmoil, the slowdown in year-on-year orders growth at the end of 21 further supports our view that a convincing upturn in investment spending will be deferred until H On a positive note, however, the government has put in place a policy initiative to support MT demand. On balance, MT consumption is forecast to experience a brief lull in growth, expanding by.% in 216 before rising by 8.2% in 217. Apparent consumption Billion Euro 4. Billion Euro (LHS) (RHS) in machine tool purchasing industries Billion Euro Billion Euro (LHS) (RHS) Meanwhile, risks to the forecast are skewed to the downside. On the domestic front, subdued credit supply may limit the extent to which investment spending can recover, capping MT consumption. On the external side, the major risk to the economy is a China hard landing, which would severly dampen prospects for machine tools Apparent consumption (Euro) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ =.9 for Italy % change Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 18

23 216 Machine Tool Outlook Composition of investment Metal products 27% Basic metals 9% Motor vehicles 18% Aerospace 6% Electrical engineering 12% Precision & optical instruments 4% General purpose 11% Special purpose 13% Apparent consumption world share % Metal products Aerospace Basic metals Motor vehicles General purpose 2 1 Precision & optical instruments Special purpose Electrical engineering Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 19

24 216 Japan Machine Tool Outlook Weak orders to cap MT consumption growth The Japanese economy is forecast to expand by.% in 216 before slowing to just.3% in 217 as the expected rise in the consumption tax hits private spending. Furthermore, exports have been losing momentum as demand from China, in particular, wanes. On a slightly positive note, howeve, investment spending is expected to perform relatively well given healthy survey data and looser monetary policy. The movement away from an investment-led economy in China is clearly having an adverse effect upon the sectors given that 18% of exports are destined for China. Indeed, looking at the eight MT consuming sectors, half of these are forecast to see output decline this year including general purpose and special purpose. And although motor vehicles production is predicted to grow by 4.4% in 216, the rise in the consumption tax would likely reverse these gains with output predicted to fall by 4% in 217. Overall, weighted output is forecast to increase by 1.1% in 216 before slowing to.6% in 217. Although operating rates have been increasing across the MT consuming sectors there is still considerable spare capacity, reducing the scope for investment growth ahead. In addition, annual orders growth for both cutting and forming tools weakened towards the end of 21, dampening MT consumption growth in 216. After two years of double-digit growth, we expect the pace of MT consumption to slow sharply, expanding by 2.1% in 216 and.6% in 217. The most important risk to MT prospects remains a more pronounced decline in Chinese investment, which would negatively affect Japan s exports. Apparent consumption Billion Yen 1,2 (RHS) 1, Billion Yen (LHS) in machine tool purchasing industries Billion Yen Billion Yen (LHS) (RHS) for Japan % change Apparent consumption (Yen) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ = Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 2

25 216 Machine Tool Outlook Composition of investment Electrical engineering 2% Precision & optical instruments % General purpose 11% Apparent consumption world share % Motor vehicles 21% Metal products 9% Special purpose 13% Aerospace 1% Basic metals 1% Basic metals Metal products Motor vehicles Aerospace Special purpose General purpose Precision & optical instruments Electrical engineering Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 21

26 216 Mexico Machine Tool Outlook Slower investment to impact MT sectors The Mexican domestic economy continues to be the powerhouse behind GDP growth. Employment and wages are both growing and consumer credit is at record highs, leading to a strong consumer spending forecast for 216. In addition, robust consumer demand from the US will drive Mexican export growth and underscore the manufacturing sector which had seen a slight tail off in growth towards the end of 21. However, weighted output amongst machine tool purchasing sectors has been revised down for both 216 and 217. The basic metals sector is forecast to decline this year, while most end-use sectors have seen prospects weaken amid slower investment and falling oil prices. Likewise the machine tool investment forecast has witnessed a sharp downgrade with 216 investment forecast to grow at just 1.7%, compared to 6% in the previous report. Furthermore, investment growth in the following years has also been lowered amid slower growth in the industrial sector. However, exceptionally strong orders placed with foreign producers in H2 21 suggest that demand for machine tools is positive, although we do not expect the pace of growth seen in 21 to continue. Overall, we expect MT consumption to expand by 2.3% in 216 before picking up to.6% in 217. A key emerging risk facing the Mexican economy stems from the increasing calls for trade protectionism coming from the US presidential primaries. Populist politics has triumphed during the 216 electoral cycle that threatens the NAFTA agreement that underpins much of our assumptions regarding Mexican growth. Given the interconnectedness of US and Mexican supply chains, disruptions to NAFTA would seriously harm consumption of machine tools in Mexico. Apparent consumption Billion Peso (RHS) Billion Peso (LHS) in machine tool purchasing industries Billion Peso (RHS) Billion Peso (LHS) % Apparent consumption (Peso) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ = 1.87 for Mexico % change Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 22

27 216 Machine Tool Outlook Composition of investment Motor vehicles 36% Electrical engineering 12% Precision & optical instruments 4% General purpose 18% Apparent consumption world share % Metal products 6% Basic metals 16% Aerospace % Special purpose 3% Metal products Basic metals Aerospace Motor vehicles 22 General purpose Special purpose Precision & optical instruments Electrical engineering Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 23

28 216 Korea Machine Tool Outlook Chinese prospects weighing on MT demand Korean GDP is forecast to rise by 2.9% and 3% in 216 and 217 respectively. 216 has started on a weak note, with goods exports (in US$ terms) down steeply year-onyear and surveys showing weakening business conditions. Increasingly, concerns are growing that Korean firms could struggle in an environment of strong competitive pressures and subdued Chinese demand. Nonetheless, fiscal and monetary policies remain supportive, and favourable labour market developments should support private spending. After shrinking in 21, weighted output in the eight key MT-consuming sectors is expected to return to growth this year, albeit of just.%. The outlook is particularly weak in the metal products sector, given subdued demand from the motor vehicles and construction sectors in China. These factors are also weighing on general purpose, which is also facing increasing levels of competition from lower cost producers. A relatively subdued investment outlook in the advanced economies will provide little offset to a weaker China in 216. by the MT-consuming sectors is expected to contract for the second consecutive year in 216, reflecting the greater cyclical volatility of capex over output. The investment recovery has been pushed out further into 217, once output recovers more decisively. Consequently, MT consumption is expected to rise by 1.1% in 216, before rising in the 3-4% range in the medium-term. Risks to the MT outlook in Korea are skewed to the downside. The major downside risk comes from further slowdown in Chinese investment, with a considerable impact upon export and business confidence and, hence, MT consumption. Apparent consumption Billion Won 7, 6,, 4, 3, 2, 1, Billion Won (LHS) (RHS) in machine tool purchasing industries Billion Won (RHS) Billion Won (LHS) % change Apparent consumption (Won) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ = for Korea Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 24

29 216 Machine Tool Outlook Composition of investment Electrical engineering 37% Apparent consumption world share 7. % Motor vehicles 16% Precision & optical instruments 1% Metal products 9% Basic metals 22% Aerospace 1% General purpose 6% Special purpose 8% Basic metals Metal products Aerospace Motor vehicles General purpose Special purpose Electrical engineering Precision & -1 optical instruments Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 2

30 216 Machine Tool Outlook Spain Strong momentum set to continue GDP maintained its momentum in Q4, expanding.8% onthe-quarter, for the second quarter running. This took overall growth for 21 to 3.2%, the fastest growth rate in eight years. Though growth is now moderating from its mid- 21 peak, the outlook remains positive. Consumer spending is growing around 3%, fuelled by strong employment growth and rising consumer confidence. Weighted output in key MT consuming sectors has weakened since the last report, with growth for 216 now forecast at 3.1%. From 217 and beyond, the forecast has been nudged down to account for slightly more pessimistic views of the Spanish and European industrial climates. Meanwhile, the MT investment forecast has been downgraded in 216 albeit only marginally, dipping half a percentage point to.2%. However, we still predict healthy investment growth over the remainder of the forecast as investment catches up to pre-recession levels. And although total orders growth, in year-on-year terms, slowed toward the end of 21, the recent trend has been positive and data were adversely affected by base effects. As a result, the MT consumption is forecast to increase by 6.4% in 216 and 7% in 217. Indeed, we expect the strong momentum in consumption to continue as investment by the key MT purchasing sectors picks-up over the coming years. The major risk facing the MT consumption forecast comes from slowing Chinese investment spending. Already slowing Chinese investment led to reduced global demand for machine tools and a faster than anticipated decelaration would have considerable downward effects on MT demand. Within Spain, risks continue to stem from high public and private debt, which leave Spain more exposed to macroeconomic shocks that could reduce MT consumption. Apparent consumption Billion Euro 1. Billion Euro.9 (LHS) (RHS) in machine tool purchasing industries Billion Euro Billion Euro (LHS) (RHS) % change Apparent consumption (Euro) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ =.9 for Spain Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 26

31 216 Machine Tool Outlook Composition of investment Motor vehicles 16% Electrical engineering 12% Precision & optical instruments 4% Apparent consumption world share % General purpose 6%.8.6 Metal products 38% Special purpose 6% Aerospace 1% Basic metals 17% Basic metals Metal products Aerospace Motor vehicles General purpose Special purpose Precision & optical instruments Electrical engineering Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 27

32 216 Machine Tool Outlook Switzerland Swiss Franc holds back MT consumption Despite capital inflows depressing economic performance, reasonable quarterly growth should resume from the middle of the year. A diversified industrial base that produces high quality consumer and investment goods will underpin Switzerland s exports. However, the strong currency is expected to remain burdensome, holding back GDP growth to.8% this year before rising to 1.6% next year. Weighted output of the key MT sectors fell by 1.6% in 21 as the appreciation of the Swiss Franc hindered competitiveness in these sectors. Looking at current momentum in many of these sectors it looks likely that weighted output will continue to fall this year as the pressures of a strong currency remain. Of the main sectors, metals products, general purpose and precision goods are all forecast to fall this year. Apparent consumption Billion Swiss Franc 1.8 Billion Swiss (RHS) Franc (LHS) Turning to machine tool investment, the 216 and 217 forecasts have both been downgraded since the last report, but remains positive nonetheless. is being driven by the anticipation of rising future output. However, orders growth has weakened recently, with both domestic and foreign bookings down by 8.9% in Q4 21, dampening prospects for MT consumption. As a result, we forecast MT demand to expand by just.% in 216 before edging up to 1% growth in 217. Beyond this, we expect more convincing increases in MT consumption as the currency weakens. The major risk facing Switzerland stems from further strengthening of the Swiss Franc. A global macroeconomic shock that heightens investor risk aversion would lead to increased capital inflows driving the exchange rate up and further harming export competitiveness. Furthermore, the importance of exports to the Swiss economy means that Swiss MT purchasing sectors are particularly susceptible downward shocks in the global economy. in machine tool purchasing industries Billion Swiss Franc 2 Billion Swiss Franc (LHS) (RHS) % change Apparent consumption (Swiss Franc) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ =.96 for Switzerland Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 28

33 216 Machine Tool Outlook Composition of investment 214 Precision & optical instruments 6% Electrical engineering 4% Motor vehicles 2% General purpose 13% Special purpose 3% Aerospace 4% Basic metals 4% Metal products 13% Apparent consumption world share % Basic metals Metal products Aerospace Motor vehicles 3 2 General purpose 3 2 Precision & optical instruments Special purpose Electrical engineering Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 29

34 216 Machine Tool Outlook Taiwan China weighing on MT consumption GDP is expected to rise by 1.7% in 216, rising to 2.8% in 217, from.7% last year. Weak demand from China and growing global uncertainties have weighed heavily on export-oriented industries, and sectors like electronics and high-value are facing increasing competition from Chinese competitors. But rising wages and subdued inflation is providing some support to household purchasing power. Electrical engineering, which accounts for almost 6% of total output in the eight main MT consuming sectors, is expected to struggle this year due to weak Chinese demand and increased competition from Chinese firms. Meanwhile, the output of metal products, the largest consumer of machine tools, is forecast to shrink in 216 due to weakness in the Chinese motor vehicles and construction sectors. As a result, MT-weighted output is expected to contract by 2.% in 216, before returning to growth of 3.3% in 217. Apparent consumption Billion Taiwan $ Billion Taiwan 12 $ (LHS) (RHS) The profile for investment in MT sectors is expected to follow a similar profile to output. MT-weighted investment is expected to shrink by 2.6% in 216, before returning to growth of 3.6% in 217. Furthermore, MT orders are very negative in year-on-year terms, down 2.% in Q4 21 and order backlogs are significantly below their long-term average. MT consumption has been revised down sharply this year to a.3% decline, with 6.8% growth resuming in 217 once global demand starts to improve. Risks to the MT outlook are to the downside. More than anticipated shortfalls in Chinese investment would significantly affect the MT outlook. Moreover, January s election resulted in a victory for the Chinese-skeptic DPP. Poorly-handled political relations between China and Taiwan could greatly undermine trade and wider business confidence. in machine tool purchasing industries Billion Taiwan $ 12 Billion Taiwan $ (LHS) (RHS) % change Apparent consumption (Taiwan $) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates prior to 21 and 21 forecast exchange rates after that date 21 exchange rate per US$ = for Taiwan Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 3

35 216 Machine Tool Outlook Composition of investment Electrical engineering 8% Precision & General optical purpose instruments 1% 2% Special purpose 4% Aerospace 2% Apparent consumption world share % Motor vehicles 4% Basic metals 9% Metal products 3% Basic metals Metal products Aerospace Motor vehicles Special purpose 6 4 Precision & optical instruments 4 2 General purpose Electrical engineering Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 31

36 216 Thailand Machine Tool Outlook Political situation might contain MT demand Thailand appears to have turned the page on the political and military challenges that it confronted in 214. Then GDP grew by a meagre.8%, far below the average growth of 4% seen in the preceding 1 years. In 21 growth began to pick-up and we now forecast GDP growth 3% in 216 and 3.4% in 217, after 2.8% in 21. This positive picture spreads to the manufacturing sectors, even in spite of challenges faced by a slower China. For weighted output of key MT consuming sectors however, recovery is expected to be slightly more prolonged. Partially due to the general weak emerging market, weighted output is estimated to have grown by just.6% in 21 and, beyond this, we forecast an increase to 3.6% in 216 and 4% in 217. Growth here is mostly supported by special purpose and motor vehicles growth, which is offsetting contraction in the metal products sector. Apparent consumption Billion Baht Billion Baht (LHS) (RHS) Despite monetary policy remaining supportive throughout this year, investment spending by the main MT purchasing sectors is predicted to fall in 216, as high levels of uncertainty regarding the outlook in emerging markets as well as the political situation in Thailand contain capital expenditure. After a considerable drop, we expect MT consumption to expand by.1% and 7.6% in 216 and 217, respectively, albeit from a low base. Finally, as with much of the global economy, risks are planted firmly to the downside. On the domestic front, even higher political uncertainty could prevent investment and hence MT consumption from gaining any ground this year. On the external side, the China slowdown is not far from Thailand s shores. Should that deteriorate further, perhaps with a China hard-landing, MT consumption could face further contraction via trade linkages. in machine tool purchasing industries Billion Baht (RHS) Billion Baht (LHS) % Apparent consumption (Baht) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ = 34.2 for Thailand % change Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 32

37 216 Machine Tool Outlook Composition of investment Electrical engineering 2% Precision & optical instruments 1% General purpose % Special purpose 19% Apparent consumption world share % Motor vehicles 17% Metal products 2% Aerospace % Basic metals 4% Metal products 1 1 Motor vehicles -2-4 Basic metals Aerospace Special purpose - -6 General purpose Electrical engineering Precision & optical instruments Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 33

38 216 Turkey Machine Tool Outlook Healthy outlook but many risks Turkish GDP has been growing solidly since 29 with few wobbles. This progress is expected to continue as geopolitical and domestic issues, such as the Syria conflict and an election, have not substantively dampened economic activity. We expect Turkish GDP to grow by 3.3% in 216. However, the strong GDP masks weak domestic investment and exports of manufacturing goods. growth was just 1.2% in 21, and is not anticipated to return to more normal growth rates of over 4% until 217. Despite the challenges facing the economy, we expect weighted output to rebound strongly by 8.4% in 216, after a drop of 2.1% in 21, before decelerating to.1% in 217. A closer look shows that most of the upturn is due to a double-digit expansion in motor vehicles, which is, in turn pulling up output in related sectors like metal products. At the same time, other sectors, like basic metals and general purpose, in particular, are not expected to perform as well. Meanwhile, investment by the main MT purchasing sectors is expected to have a similar growth profile to output, with capital expenditure up by % in 216 before gradually slowing to 3.4% in 217. However, there is some evidence that underlying MT consumption may be weak as orders placed with foreign producers were down sharply toward the end of 21. Overall, we expect MT consumption to increase by 2.8% in 216 and 8.7% in 217, before slowing thereafter. Risks are broadly to the downside then, especially if Turkey s global trade partners continue to struggle. However, some positive risks are present. For instance, better than expected automotive sector performance could drive metal products demand and, hence, MT demand. Apparent consumption Billion Lira (RHS) Billion Lira (LHS) in machine tool purchasing industries Billion Lira (RHS) Billion Lira (LHS) % Apparent consumption (Lira) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ = 2.72 for Turkey % change Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 34

39 216 Machine Tool Outlook Composition of investment Motor vehicles 26% Metal products 13% Basic metals 23% Electrical engineering 21% Precision & optical instruments 3% General purpose 2% Special purpose Aerospace 1% 2% Apparent consumption world share % Metal products Motor vehicles Basic metals -2-4 Aerospace General purpose 1 1 Precision & optical instruments -2 Special purpose Electrical engineering Apparent consumption = total consumption of machine tools in the named market Total investment = spending on all assets by the eight primary machine tool purchasing industries 3

40 216 Machine Tool Outlook United Kingdom Another year of decline for MT consumption Consumer spending will benefit from improvements in purchasing power while investment spending should pickup, once the uncertainty from a potential exit of the UK from the EU fades. However, a subdued export outlook will cap growth in exports. Consequently, we forecast GDP growth of 2% and 2.3% in 216 and 217, respectively. Weighted output in the key MT-consuming sectors is expected to see zero growth this year before recovering in 217, although some industries are set to perform better than others. On the one hand, we still expect aerospace and motor vehicles output to expand at a strong pace in 216 and, although the latter is forecast to run out of steam as replacement demand fades, prospects for aerospace remain firm as producers meet order backlogs. On the other hand, basic metals production is being hit as low steel prices force plants closures. Meanwhile, investment spending by the main MT purchasing sectors is predicted to expand by 9.3% in 216 before growing by.9% in 217 supported by solid corporate finances. In addition, the likelihood of a rate hike anytime soon has diminished. However, orders growth, in year-on-year terms, slipped towards the end of 21, dampening consumption prospects in 216. Overall, we expect MT consumption to fall by 11.3% in 216, although a large portion of this is due to adverse base effects, before rebounding by 1.7% in 217, reflecting positive base effects from a weak Q1 216 as well as generally healthy investment prospects. The largest risk to the MT forecast comes from the possibility of the UK leaving the EU. The uncertainty around the UK s relationship with the EU would dent business confidence, investment and, hence, MT demand. Apparent consumption Billion Billion (LHS) (RHS) in machine tool purchasing industries Billion Billion (LHS) (RHS) % change Apparent consumption ( ) Apparent consumption (US$) GDP Industrial production All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date 21 exchange rate per US$ = 1.3 for UK Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 36

41 216 Machine Tool Outlook Composition of investment Metal products 14% Motor vehicles 32% Apparent consumption world share % Basic metals 6% 1.3 Aerospace 2% Special purpose 6% Electrical engineering 7% Precision & optical instruments 4% General purpose 6% Basic metals Metal 1 products Aerospace Motor vehicles General purpose 6 4 Electrical engineering Special purpose Precision & optical instruments Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 37

42 216 Machine Tool Outlook United States MT consumption dampened by strong dollar Moving into 216, we expect a strong dollar, sluggish global growth and reduced oil and gas investment will continue to constrain activity. Domestically, however, strong income growth should support robust spending and housing activity while the Fed will tighten policy only very gradually. We expect a 2.1% rise in GDP in 216 picking up to 2.4% in 217. Indeed, the factors constraining activity mentioned above are expected to be key features of the outlook for the main MT consuming sectors, which are typically exportorientated. Weighted growth in MT-consuming sectors is forecast at just.3% in 216 and 2.% in 217. Many of the MT sectors are forecast to see a decelaration in output growth, at best, while three of the eight are forecast to see outright declines. The basic metals sector has the worst prospects while future levels of motor vehicles output is expected to plateau, after several years of robust growth. Apparent consumption Billion $ 1 8 (RHS) 9 Billion $ (LHS) In addition to weaker prospects in the key MT consuming sectors, orders are still well below year-ago levels as the strong dollar continues to dampen prospects. However, there are some positive aspects to our forecast. For example, prospects in the aerospace sector and residential construction, which has a knock-on effect on industries like HVAC, are healthy. Furthermore, the extention of key tax incentives like the bonus depreciation up until 219 and adjustments to small business expenses should help to boost demand for machine tools. Consequently, MT consumption is forecast to expand by 1.3% in 216, after a sharp fall in 21, and 3.1% in 217. Risks to the forecasts are skewed to the downside. On the domestic side, we expect the tightening cycle to be gradual but cannot discount adverse market reactions, which may have an effect on investment and, hence, demand for machine tools. On the external front, slower global growth than anticipated and/or a stronger US$ could ultimately dampen MT consumption. in machine tool purchasing industries Billion $ Billion $ (LHS) (RHS) for US % change Apparent consumption (US$) GDP Industrial production Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 38

43 216 Machine Tool Outlook Composition of investment Electrical engineering 32% Motor vehicles 18% Metal products 7% Basic metals 7% Precision & optical instruments 16% General purpose 6% Special purpose Aerospace 6% 6% Apparent consumption world share % Basic metals -2 Metal -3 products Aerospace Motor vehicles General purpose Special purpose Precision & optical 2 instruments Electrical -1 engineering Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 39

44 216 Machine Tool Outlook Smaller markets Canada Despite GDP growing at a reasonable.2% in Q4, issues remain with the Canadian economy. We expect the allimportant extraction sector to decline this year amid ongoing difficulties with the low oil price. Meanwhile manufacturing remains fairly flat and services output is growing at a very modest pace. We expect GDP to expand by.9% this year. The low oil price environment has continued to impact MT producing sectors. This has led to a sharp downgrade in weighted investment which is now forecast to fall.4% and 1.4% in 216 and 217, respectively. The weaker investment climate will feed into apparent consumption, which is forecast decline by 4.1% this year and with only a modest recovery in 217. Canada Billion Canadian $ Apparent consumption (LHS) in machine tool purchasing industries (RHS) = Austria The Austrian economy continues to recover, albeit very slowly. GDP in Q4 was flat for a second successive quarter giving growth of just.8% for 21. The pace of growth is set to pick-up in 216 helped by continued ultralow interest rates and some pick-up in demand, but nonetheless, the rate of growth will remain modest compared to the long-run average. Output in MT consuming sectors is down slightly this year but the growth outlook remains broadly positive, and indeed the investment outlook in 216 is unchanged. Very strong apparent consumption growth at the end of 21 has led to a tail-off in our 216 growth forecast, but the relatively upbeat prospects for investment should translate into stable apparent consumption going forward. Czech Republic The Czech economy grew by 4.4% in 21, its fastest rate since 27, on the back of surging investment which we estimate to have grown by 6.8%. Looking forward, we expect growth to moderate to 2.% in 216 on slower investment growth. However consumer spending will remain robust benefitting from supportive fiscal policy and a strong labour market. Strong MT investment in 21 has led to a slight rebalancing of the investment profile, with the 216 forecast lowered to compensate. In turn, apparent consumption has been lowered slightly in 216, but brought up from 217. Austria Billion Euro Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries Czech Billion Koruna Apparent consumption (LHS) in machine tool purchasing industries (RHS) Apparent consumption (LHS) in machine tool purchasing industries (RHS) = =1 2 4

45 216 Machine Tool Outlook Hungary Hungarian GDP grew unexpectedly fast in Q4 at 1% onthe-quarter. Growth is forecast to slow to 2.1% in 216 as investment weakens on falling EU fund flows. Instead, we expect that domestic consumption will be the major driver of economic growth as low inflation and a tightening labour market drives consumer spending. MT investment in Hungary came in above forecast in 21, leading to a rebalancing of the investment forecast profile. 216 has been revised down to 1.9%, from 4.% previously, with further, albeit smaller, downgrades to 217 and 218. Consequently, apparent consumption has been lowered in 216, but the outlook for 217 remains unchanged. Poland The Polish economy remains in good shape with Q4 growth accelerating to 1.1% on-the-quarter. We expect this momentum to continue over the medium-term. The primary driver of growth will be consumption as the robust labour market and easy credit availability drive spending. Consequently, we expect GDP to grow firmly in the 3.7% range over the next five years. The MT investment profile for Poland has been rebalanced after healthy investment in 21. The 216 and 217 investment forecasts have consequently been lowered, but beyond that, the outlook remains unchanged. This has led to slightly lower apparent consumption forecasts in 216 and 217 as weaker investment points to weaker demand for machine tools. Russia The Russian economy continues to reel from low oil prices. We expect that consumers will bear the brunt of the recession this year, with private consumption falling by 4.2% in response to continuing declines in real income. Tighter fiscal policy as a consequence of reduced receipts from oil sales will also impact on aggregate demand. The ongoing difficulties in the Russian economy have driven down the MT investment forecast across the forecast period. This in turn has led to the apparent consumption forecast being downgraded across the entire forecast period. The most significant downgrade is in 216 in which apparent consumption is forecast to fall by 7.4%, but in addition, the recovery path from 217 is now far shallower than was previously anticipated. Hungary Billion Forint Apparent consumption (LHS) 2 in machine 1 tool purchasing industries (RHS) Poland Billion Zloty in machine. tool purchasing industries (RHS) Russia Apparent consumption (LHS) Billion Ruble 12 in machine tool purchasing industries 1 (RHS) Apparent consumption (LHS) = = = Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 41

46 216 Machine Tool Outlook Slovakia The Slovak economy recorded another quarter of robust growth in Q4, with real GDP growing by 1% on-the-quarter and taking year-end growth for 21 to 3.6%, the fastest rate of growth since 21. Despite falling prices in 21, we expect deflation to moderate this year, but stubbornly weak commodity prices and weak Eurozone demand will keep inflation below 2% until 218. Output amongst machine tool consuming sectors has lowered over 216 and 217 but MT investment has held up a little better, with the only downgrade occurring in 217. The apparent consumption forecast, though lowered slightly in 216 and 217, remains in double digits. Powered by strong industrial growth, the outlook for machine tools in Slovakia remains a positive one. Slovakia Billion Euro in machine tool purchasing industries (RHS). Apparent consumption (LHS) = Apparent consumption (% change unless specified) Level in 214, US$bn Canada Austria Czech Republic Hungary Poland Russia Slovakia Apparent consumption = total consumption of machine tools in the named market. For consumption levels in $, please see appendix Total investment = spending on all assets by the eight primary machine tool purchasing industries 42

47 216 Industrial Background

48 216 Industrial Background Aerospace Near-term prospects decline steeply The global aerospace sector this year is struggling to exceed last year s performance. Value-added output grew by 1.6% in 21, and is expected to ease to.7% this year. The weaker growth this year is been driven by lower jet-fuel costs reducing airlines upgrade incentives, supplychain constraints slowing the pace of deliveries, and fears about emerging economies growth prospects. However, airline profitability is improving and leasing costs remain low, and the backlog of orders should underpin production in the medium-term. This greater pessimism about near-term prospects is led by ongoing weakness in the US, which accounts for about % of global production. Boeing s 216 forecasts were discouraging; deliveries in 216 are projected at about 3% below last year s outturn, and the breakeven point for delivery of each 787 Dreamliner has been pushed into 216. The prospect for defence firms is more encouraging, driven by renewed global security concerns, but the problems in the civilian aircraft market will contain US growth to just.7% in 216. A less dramatic slowdown in 216 is envisaged in Western Europe, where production is seen expanding by 2% in 216. Airbus added to its order backlog in 21, and planned deliveries in 216 are expected to rise by around 2.%. Finally, a large order from Iran in January has further lifted Airbus order books. Sector investment is expected to perform better than output. We are forecasting a 3.2% rise in global investment in 216 with growth accelerating to.9% in 217. Beyond this, investment by aerospace firms is forecast to rise by around %pa until the end of the decade. High levels of order backlogs will require the main producers to expand capacity, particularly since current capacity constraints have prevented a strong increase in production. Furthermore, renewed concerns about global security could precipitate an increase in investment by defence firms. The risks around this rather pessimistic central forecast are broadly balanced. Enhanced airline profitability could spur further order placements, supporting activity in the medium term, but supply-chain and deferred-cost constraints on value added growth provide additional downside risks. World: by MT-buying sectors, 214 (US$bn) Other % World: Aerospace output & investment Output Aerospace % Asia: Aerospace output & investment Output Total investment = spending on all assets by the eight primary machine tool purchasing industries 43

49 216 Industrial Background Americas: Aerospace output & investment Output Europe: Aerospace output & investment Output Aerospace investment (% change unless specified) Level in 214, US$bn China India Japan S. Korea Taiwan Thailand Asia Brazil Canada Mexico US Americas Austria Czech Republic France Germany Hungary Italy Poland Russia Slovakia Spain Switzerland Turkey UK Europe World All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date Total investment = spending on all assets by the eight primary machine tool purchasing industries 44

50 216 Industrial Background Basic Metals Recovery delayed as China weakens Basic metals output growth is forecast to slow further to.% in 216, from 1.4% in 21, before edging up to 1.7% in 217. The most significant change since our previous report has been to China. Producers have finally started to react to very low steel and base metal prices and crude steel output dropped by -on-year in December and 8-on-year in January 216, after a relative stable period through 21. On a positive note, however, downstream markets for metals in China look in better shape recently. Car sales rose by 1-on-year in Q4, due to government incentives. Moreover, house prices in China have started to rise steadily heading into late 21, pointing to some stabilisation in some parts of the troubled construction market. In other emerging markets, Brazil has been the source of the other notable change to the global forecast, where our view on economic conditions has become increasingly pessimistic. Meanwhile, the US has been a significant surprise given the extended weakness there. While underlying indicators of steel consumption have been solid, crude steel production slumped by 9-on-year in January 216, reflecting strong imports and US$ strength. In Japan, this year should see stagnation though rather than contraction, as we expect a mild improvement in the industrial backdrop and automotive sector. At the same time, weak global trade and a lacklustre economy is expected to cap growth in Europe. A choppy start to this year combined with weaker global activity has naturally impacted on the global investment outlook in basic metals. Asian investment is forecast to rise by just.4% in 216, driven primarily by drawdowns in Chinese and Indian investment. Likewise, investment in the Americas and Europe is down sharply as excess global supply reduces the need to invest in new capacity. In addition, sharply reduced investment in Russia and Brazil, in particular, stemming from the severe recessionary conditions in those countries has exacerbated the current situation. Overall, global investment is forecast to increase by.4% in 216 before rising by 2.1% in 217. Risks to the forecast remain tilted to the downside with a more pronounced slowdown in China posing as the largest risk to basic metals production, globally, given that China accounts for almost half of global investment. World: by MT-buying sectors, 214 (US$bn) Other % World: Basic metal output & investment Output Basic metals % Asia: Basic metal output & investment Output Total investment = spending on all assets by the eight primary machine tool purchasing industries 4

51 216 Industrial Background Americas: Basic metal output & investment Europe: Basic metal output & investment Output -1-2 Output Basic metals investment (% change unless specified) Level in 214, US$bn China India Japan S. Korea Taiwan Thailand Asia Brazil Canada Mexico US Americas Austria Czech Republic France Germany Hungary Italy Poland Russia Slovakia Spain Switzerland Turkey UK Europe World All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date Total investment = spending on all assets by the eight primary machine tool purchasing industries 46

52 216 Industrial Background Electrical Engineering Moderate growth forecast in 216 Electrical engineering is one of the most important machine tool-consuming sectors, accounting for nearly one-quarter of the total investment of the eight key MT-buying sectors. After a decline in 21, we are expecting a moderate rebound in sector investment to 4.2% growth in 216. Lower investment growth in China has had some impact on global demand, not only domestically and in its major trade partners, likely a contributing factor behind 21 s weakness. However, Chinese household spending is holding up better, supporting demand for devices such as consumer electronics and mobile phones. spending across Asia should improve as firms increase capacity to meet this demand, rising by 6.1% this year. In contrast, investment by firms in the Americas is expected to shrink for the second consecutive year in 216, only returning to growth next year. Perhaps unsurprisingly, much of the weakness is concentrated in Brazil, which has been hit by a shock to its terms-of-trade following the steep decline in global commodity prices, exacerbating underlying structural issues and political uncertainty. Perhaps more surprisingly, US investment is forecast to grow by just.4% this year, especially given reasonable growth in the US domestic economy. The continued strength of the US dollar has weighed on profit margins, reducing firms ability to ramp up investment, and at the same time, the strong dollar has also hit the competitiveness of US produced goods. European investment is expected to be somewhat better in 216, although uncertainties surrounding the Eurozone crisis, Brexit, and weak global demand mean that regional investment is expected to rise by just 1.7%. in Eastern Europe is generally expected to outperform that in Western Europe as regional production centres shift east. strengthening in the medium-term The longer-term sector outlook is generally more favourable. A move towards the internet of things, whereby a growing number of devices are connected to the internet, will require firms to invest in the components and sensors that allow this to happen and will also require upgrades to existing electrical equipment. Sector investment is expected to increase by almost 6% in as firms upgrade their production techniques. World: by MT-buying sectors, 214 (US$bn) Other % World: Electrical engineering output & investment Output Electrical engineering % Asia: Electrical engineering output & investment Output Total investment = spending on all assets by the eight primary machine tool purchasing industries 47

53 216 Industrial Background Americas: Electrical engineering output & investment Output Europe: Electrical engineering output & investment Output Electrical engineering investment (% change unless specified) Level in 214, US$bn China India Japan S. Korea Taiwan Thailand Asia Brazil Canada Mexico US Americas Austria Czech Republic France Germany Hungary Italy Poland Russia Slovakia Spain Switzerland Turkey UK Europe World All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date Total investment = spending on all assets by the eight primary machine tool purchasing industries 48

54 216 Industrial Background General Purpose Machinery Capex struggling in the developed world This is a diverse sector incorporating the manufacture of products such as non-vehicle engines and turbines, pumps and compressors, furnaces, lifting equipment, and ventilation equipment. by the sector accounted globally for about 11% of investment spending by the eight key machine tool using industries in 214. After shrinking in 21, investment in China, which accounts for about half of global sector investment, is seen retuning to growth in 216. Nonetheless, capital spending growth over the forecast period is far below its pace recorded over the last decade. Severe excess capacity in some sectors, the result of several years of overinvestment, will weigh on demand for industrial for many years to come. In addition, the near-term outlook in the developed economies has weakened since our previous report. The strong dollar and weak global environment has weighed on US investment prospects, and, even though mining is included in special purpose, lower demand from the mining sector will also weaken sales of pumps, valves and other industrial. European investment has been slow to rebound from the global financial crisis. Capacity utilisation rates are generally high, and more investment is needed to replace an ageing capital stock. Unfortunately, uncertainties surrounding the outlook for global demand, the Eurozone crisis and possibility of Brexit are currently weighing on business confidence, and as a result, a strong rebound in investment is not expected until 217. On balance, we expect global sector investment to grow by 2.% in 216, rising towards 3% by the end of the forecast period. but China remains the key risk A more far-reaching economic slowdown in China, potentially related to the overextension of credit and both corporate and government debt, remains the biggest risk to the forecast. This would reduce investment demand far more than in the baseline, and magnify the negative effects of excess capacity and falling prices, ultimately, reducing the demand for machine tools. World: by MT-buying sectors, 214 (US$bn) Other % General purpose % World: General purpose output & investment -1 Output Asia: General purpose output & investment Output Total investment = spending on all assets by the eight primary machine tool purchasing industries 49

55 216 Industrial Background Americas: General purpose output & investment Output Europe: General purpose output & investment Output General purpose investment (% change unless specified) Level in 214, US$bn China India Japan S. Korea Taiwan Thailand Asia Brazil Canada Mexico US Americas Austria Czech Republic France Germany Hungary Italy Poland Russia Slovakia Spain Switzerland Turkey UK Europe World All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date Total investment = spending on all assets by the eight primary machine tool purchasing industries

56 216 Industrial Background Metal Products growth resuming in 216 Fabricated metal products accounted for 11% of investment by the eight key MT-consuming sectors in 214. After a decline in sector investment in 21, we forecast growth of 3% in 216. Globally, the sector is being supported by low commodity prices (particularly for base metals), which have reduced input costs, but still subdued investment growth will cap the pace of growth in 216. Surprisingly, both sector output and investment in China, which accounted for nearly 17% of global production in 21, held up reasonably well, despite the wider investment slowdown there. But looking to 216, construction, the largest end-use sector, is seen weakening and, as a result, both sector output and investment across Asia should slow in turn. Outside of China, investment by metal products firms is seen shrinking in everywhere except for Japan and India. Output in the US, about 2% of global production in 21, declined last year, and a further contraction is expected in 216. Despite relative strength in construction and domestic motor vehicle production, increased demand for metal products is being met by higher imports rather than domestic production. The strong dollar has decreased the price of imported products while at the same time making it more expensive for foreigners to purchase US-produced goods. In contrast to output, sector capex has held up reasonably well; at over 8%, sector capacity utilisation is relatively high, so firms need to invest to expand capacity. Meanwhile, production growth in Europe, which accounts for about 4% of global production, is seen improving in 216. Although the near-term business investment outlook in Europe is constrained by a number of factors, including the threat of resurgence in the Eurozone crisis and the impact of Brexit, European production is benefitting from weak currencies. As in the US, the outlook for sector investment is somewhat more favourable, driven by high capacity utilisation rates. An uptick in the global investment cycle should spur stronger sector growth from 217, both in output and investment. Moreover, by the end of the decade, base metal prices are forecast to be still some 3% below their 211 peak, providing firms with more scope to ramp up capital spending once demand picks up. World: by MT-buying sectors, 214 (US$bn) Other % World: Metal products output & investment Output Metal products % Asia: Metal products output & investment Output Total investment = spending on all assets by the eight primary machine tool purchasing industries 1

57 216 Industrial Background Americas: Metal products output & investment Europe: Metal products output & investment Output -1 Output Metal products investment (% change unless specified) Level in 214, US$bn China India Japan S. Korea Taiwan Thailand Asia Brazil Canada Mexico US Americas Austria Czech Republic France Germany Hungary Italy Poland Russia Slovakia Spain Switzerland Turkey UK Europe World All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date Total investment = spending on all assets by the eight primary machine tool purchasing industries 2

58 216 Industrial Background Motor Vehicles Uncertain demand creates caution Data for 21 suggest that motor vehicle production increased, globally, by a stronger than expected 4.2%, but sustaining that momentum this year will prove to be more challenging. In spite of the boost to the motor vehicles sector from lower energy and petrol prices, and continued low interest rates, automotive companies are becoming increasingly cautious with confidence hit by recent financial market volatility and VW scandal. In the US, company executives are warning of an imminent glut of quality, used vehicles on the market. In Europe, although the effects of the VW scandal on production have, so far, been limited, we expect the majority of the impact to be seen this year. In Asia, China s car purchase tax cut until the end of 216 will boost car sales this year, but at the expense of 217 sales, while the expected consumption tax hike in Japan could stump the forecast expansion in the motor vehicles sector, unless this is postponed beyond April 217. Indeed, if such policy measures are not extended then we could see global motor vehicles production growth drop to as low as 1% in 217. Global investment in motor vehicles fell by 2.8% in 21. Over the forecast period, the investment outlook has weakened in light of the bleaker outlook for vehicle sales over the medium term. In China, the investment downgrades are most stark. However, the investment story in Japan is more positive in the near term, with 216 investment expected to increase by 6.6% before rising by 2.9% in 217. Nonetheless, a large drop in investment in 218 is predicted to occur as the sales tax hike takes effect. In the US, investment will remain robust in the near term but we forecast a slowdown in growth ahead. as risks skewed to the downside The most significant risk to the automotive sector stems from a more aggressive Chinese economic slowdown than we currently have in our baseline forecast. Given the high importance of China to global car sales, weaker than anticipated spending would have proliferate effects. Such a scenario would see global production fall by.8% in 217 with a shallow recovery path from 218 onwards. In addition, the impact of the VW scandal poses downside risks, mainly for Germany, but some countries may benefit by capturing greater market share if the effects of the scandal remain confined to VW. World: by MT-buying sectors, 214 (US$bn) Other % Motor vehicles % World: Motor vehicle output & investment Output Asia: Motor vehicle output & investment Output Total investment = spending on all assets by the eight primary machine tool purchasing industries 3

59 216 Industrial Background Americas: Motor vehicle output & investment Europe: Motor vehicle output & investment Output Output Motor vehicle investment (% change unless specified) Level in 214, US$bn China India Japan S. Korea Taiwan Thailand Asia Brazil Canada Mexico US Americas Austria Czech Republic France Germany Hungary Italy Poland Russia Slovakia Spain Switzerland Turkey UK Europe World All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date Total investment = spending on all assets by the eight primary machine tool purchasing industries 4

60 216 Industrial Background Precision and Optical Instruments Near-term growth outlook diminished in 216 World production of precision instruments grew by.4% in 21, its strongest pace of growth since 21. Sector growth has underperformed global investment since 211, a trend that reversed in 21 (when investment grew by.4%). Looking ahead, however, global production is expected to slow, expanding by just 1.4% in 216 before picking up to 4.2% in 217. Beyond the near term, sector output should increase more in line with global investment. Output in the US, which accounts for almost half of global production, has been constrained by the persistent strength of the dollar, weak global demand and a steep decline in oil & gas investment spending. These headwinds are forecast to persist through 216, holding sector growth to just 1.2%. The flipside to the strong dollar has been a weak euro. This provided a fillip for European precision instrument output last year, but weak investor confidence in early-216 has placed a cloud over the nearterm investment outlook. We expect this to trump the impact of a weak euro in 216; Eurozone precision instrument output is expected to shrink by.3%. Chinese production grew at a robust pace of 13.6% in 21, despite its slowing investment. We expect some normalisation to growth in 216, but it should strengthen somewhat in the medium-term. China s move into higher value-added sectors will require investment in precision instruments, which should help to support local production. Despite the strong output, investment by precision instrument manufacturers was less robust in 21. Over the forecast period, sector investment is expected to run slightly ahead of sector output in the coming years as the global investment cycle rebounds in the advanced economies. Sector investment is forecast to rise 1.6% in 216, rising above % in The risks around the forecast are likely to the downside. Our forecast assumes that China continues to move up the value-chain, so production of high value goods such as precision instruments is little impacted by the impending economic slowdown there. However, we may very well be underestimating the impact of weaker Chinese investment demand on high value sectors. World: by MT-buying sectors, 21 (US$bn) Other % Precision & optical instruments % World: Precision and optical instruments output & investment Output Asia: Precision and optical instruments output & investment Output Total investment = spending on all assets by the eight primary machine tool purchasing industries

61 216 Industrial Background Americas: Precision and optical instruments output & investment Output Europe: Precision and optical instruments output & investment Output Precision and optical equipment investment (% change unless specified) Level in 214, US$bn China India Japan S. Korea Taiwan Thailand Asia Brazil Canada Mexico US Americas Austria Czech Republic France Germany Hungary Italy Poland Russia Slovakia Spain Switzerland Turkey UK Europe World All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date Total investment = spending on all assets by the eight primary machine tool purchasing industries 6

62 216 Industrial Background Special Purpose Machinery Asia key to 216 growth Special purpose covers a wide range of industries including production of mining and construction equipment, machine tools, agricultural, domestic appliances and various other types of equipment for specific applications such as food processing, packaging, etc. This sector s share of global investment by the eight key machine tool using industries has been growing gradually, reaching almost 11% in 214. After shrinking in 21, sector investment is seen rising by 4.6% in 216. Stronger capital spending by Asian firms will underpin sector investment trends in 216. Despite the broad slowdown in Chinese investment, demand for specialpurpose could hold up reasonably well due to structural shifts in Chinese manufacturing. With wages rising rapidly and poor labour force demographics, there will be an increasing need for automation in Chinese factories to counteract eroding cost competitiveness. At the same time, China is making a concerted effort to develop higher-value manufacturing. Outside of Asia, the outlook is less robust, particularly in the Americas. In the US, the strong dollar has dented sector competiveness, and a number of domestic factors are also expected to weigh on demand. Mining firms, for instance, have cut back capital spending in the wake of low commodity prices, and as a result, demand for mining has declined. Similarly, a glut of global grain has hit farming profitability, weighing on demand for agricultural. Strength in the US construction sector, by contrast, should spur demand for specialist construction. in Europe has been much slower to rebound from the global financial crisis than in other developed countries such as the US and Japan. There is thus ample scope for additional investment as firms seek to replace an ageing capital stock. However, low levels of business confidence is constraining the near-term investment outlook in Europe, with uncertainty surrounding weak global demand, a fallout from the Eurozone crisis and Brexit leading firms to delay investment plans. A convincing cyclical rebound in sector investment is now not expected until 217. World: by MT-buying sectors, 214 (US$bn) Other % Special purpose % World: Special purpose output & investment Output Asia: Special purpose output & investment Output Total investment = spending on all assets by the eight primary machine tool purchasing industries 7

63 216 Industrial Background Americas: Special purpose output & investment Europe: Special purpose output & investment Output -1-2 Output Special purpose investment (% change unless specified) Level in 214, US$bn China India Japan S. Korea Taiwan Thailand Asia Brazil Canada Mexico US Americas Austria Czech Republic France Germany Hungary Italy Poland Russia Slovakia Spain Switzerland Turkey UK Europe World All MT figures are calculated using current exchange rates to 21 and then fixed at 21 exchange rates beyond that date Total investment = spending on all assets by the eight primary machine tool purchasing industries 8

64 216 Economic Background

65 216 World Economic Prospects Overview: Markets rally but risks still to the downside Our growth forecast for 216 has been cut to 2.3% and the forecast for 217 has been cut to 2.7%. The near-term growth outlook has been supported by a decent rally in financial markets. Since mid-february; world stocks have gained around 8%, US high yield spreads have narrowed around 14 basis points and a number of key commodity prices including oil have also risen. Another supportive trend is still-healthy consumer demand in advanced economies including the US and Eurozone. Although there has been some slippage in consumer confidence, it has been modest compared to either or So overall, the global economy still looks likely to avoid recession and strengthen a touch next year. But risks to the outlook remain skewed to the downside. World: Stocks and economic surprise indices Index MSCI World stocks (LHS) 1 EM economic 14 surprise (RHS) G1 economic surprise (RHS) 14 Jan-1 Apr-1 Jul-1 Oct-1 Jan-16 Source : Oxford Economics/Haver Analytics/Citigroup Balance Despite the recent market rally, world stocks still remain below their levels at end-21 and well below last May s peak. Financial conditions more broadly also remain significantly tighter than in mid-21, and inflation expectations somewhat lower. And there are still negative signals from incoming data. The global manufacturing PMI for February showed output flat while the services PMI showed only very modest growth both were at their lowest since late 212. Economic surprise indices for both the G1 and emerging markets also remain in negative territory, and our world trade indicator suggests no improvement from the dismal recent trends. In our view, policymakers still have scope to improve the outlook. The latest ECB moves more negative rates and more QE will help a little. Widening of QE to corporate bonds also hints that more radical policy options are coming into view. But policies such as central bank equity purchases or money-financed fiscal expansions will probably require global growth to weaken further before they become likely. US and Eurozone: Consumer expectations Index Balance 12 US (Conference Board, 1 expectations, LHS) Eurozone -3 (EC, economy 12 2 months ahead, RHS) Source : Oxford Economics/Haver Analytics 9

66 216 Alternative GDP growth forecasts Oxford Baseline (3%) US Eurozone China World China hard landing (1%) US Eurozone China World Financial market contagion (1%) US Eurozone China World Global upturn (1%) US Eurozone China World W eak world commodity demand causes financial strains (1%) US Eurozone China World Geopolitical tensions (2%) US Eurozone China World W orld GDP growth at 21 prices and market exchange rates 6

67 216 Summary of International s Real GDP North America United States Canada Europe Eurozone Germany France Italy UK EU Asia Japan Emerging Asia China India World World 2 PPPs World trade Inflation (CPI) North America United States Canada Europe Eurozone Germany France Italy UK EU Asia Japan Emerging Asia China India World Exchange Rates US$ Effective $/ /$ Commodity Prices Brent Oil ($/bl)

68 216 Economic Background Brazil Brazil Highlights Highlights Brazil s economy contracted by 3.8% in 21, after GDP fell by 1.4% on the quarter in Q4. The fall during last year as a whole was the worst performance since 199. For 216, we now expect GDP to shrink by a further 4% on average, as we see no reversal in the factors that caused the contraction in 21. If our forecast materialises, in Brazil will endure its most severe two-year recession since 191. As a result, Brazil s per capita income will only return to its 213 peak by 223. The so-called lost decade is already well under way. One of the key reasons behind Brazil s poor growth performance is political uncertainty. President Rousseff is facing impeachment proceedings due to last until April. However, to oust the president, the opposition needs three-fifths of the votes in both houses of congress. The ruling coalition has only a narrow majority and is trying to gather more support from smaller parties by exchanging political favours for votes. Hence, legislators are now focused on the impeachment agenda rather than on the desperately needed reforms to the country s pension system, tax code and labour laws that have to be made if Brazil s debt is to return to a sustainable trajectory. This sense of political paralysis is causing consumer and business confidence to remain extremely depressed, thereby preventing any recovery in consumption and investment. With a U-turn in policies out of sight, S&P and Moody s downgraded Brazil s credit rating again last month, corroborating our view that Latin America s largest economy is moving further down the credit quality curve. Despite the rating downgrades, the real (BRL) held up well in February and staged a rally in early March, trading at 3.7 per USD at the time of writing. But we continue to believe macro fundamentals still point to further BRL weakness and forecast the real to close the year at 4. per USD. FX weakness and a high degree of indexation should cause inflation to remain high this year, despite the deep recession. However, the recession has brought about a major adjustment in the balance of payments. With domestic demand set to shrink by 12% since 214 and the BRL 3% down on a trade-weighted basis, the import bill in USD terms has nearly halved since 213. As a result, the current account deficit is set to shrink to just.6% of GDP by 217, from 4.3% in 214, fending off the risk of an external funding crisis. for Brazil (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Government Budget (% of GDP) Trade Balance ($bn) Current Account ($bn) Current Balance (% of GDP) Short-Term Interest Rates (%) Exchange Rate (Per US$)

69 216 Brazil The worst recession in a century Brazil is making the headlines for all the wrong reasons: the worst recession in a century, the largest fiscal deficit in the G2 (after oil-hit Saudi Arabia) and the biggest corruption scandal in its history are a few examples. Against this backdrop, what would it take for Latin America s largest economy and one of the world s largest recipients of FDI to turn things around? Brazil: GDP growth 1 1 Long-term average (4.7%) F'cst We think the answer lies in the political situation. Brazil is being dragged down by the increasingly widespread perception that politicians are either unwilling or incapable of correcting the many imbalances that have accumulated in the economy over the past six years. In such an environment, companies do not invest or hire more and consumers tend to increase precautionary savings, causing domestic demand to plunge at a time when external demand is sluggish. And the longer the authorities take to decide on a U-turn in policies and build a consensus with legislators on the need to approve reforms that limit the growth of public spending, the longer the economy will remain trapped in this bad equilibrium of shrinking output and a high risk premium. We continue to describe our baseline scenario for Brazil as muddling through, where political uncertainty only starts to recede in late 217 when agents start to hope that change towards a more market-friendly and reformoriented government could come in the October 218 elections. Our baseline also reflects the following factors: No room for counter-cyclical policies the loss of investment-grade status for the sovereign implies tighter credit conditions across the entire economy. But with inflation in excess of 1%, the BCB cannot cut interest rates to compensate. On the fiscal side, the situation is even worse, with Brazil posting the largest budget deficit in the G2 after Saudi Arabia. We see no prospect that the current administration will narrow the deficit; pensions, salaries and other benefits make up for 8% of expenditure and cutting them requires approval from a split Congress. Unless this gridlock is resolved, the risk premium and longterm rates will remain high, causing credit conditions to stay tight and public debt to increase unsustainably. Two sources of easy growth no longer available Brazil s growth between 23 and 21 was boosted by a 33% gain in the terms of trade as well as by a widespread drop in borrowing costs for EMs. However, both trends are now in reverse due to the fall in commodity prices, the increase in US interest 193: -2.1% 21: -3.8% 1931: -3.3% 216: -4.% Source: IBGE, Oxford Economics Brazil: IPCA inflation and Selic policy rate % Inflation (IPCA) Policy rate (Selic) 4. Inflation target EMs: Government balance (21) South Korea Philippines Czech Republic Turkey Hungary Thailand Chile Indonesia Malaysia South Africa Mexico Russia India China Argentina UAE Brazil Saudi Arabia Source: Haver Analytics / Oxford Economics % of GDP 63

70 216 Brazil rates and the strengthening in the US dollar. Private demand slumping faced by tighter credit conditions and a deteriorating labour market, households have no choice but to cut spending. Businesses, in turn, are even more pessimistic and have no reasons to invest in a plunging economy plagued with corruption. The silver lining of the collapse in demand is the rapid adjustment in the current account. We expect the deficit to continue shrinking fast, before stabilising at around.% of GDP from 217 onwards. This has implications for our estimates of the equilibrium FX rate in the long term, with the fair value of the real now seen at 4.8 per USD by 22 (versus a previous estimate of.3). Poor structural fundamentals are huge drag Even once the recession ends, there are no reasons to hope for a marked recovery. Brazil will remain a relatively closed economy with a large public debt to service. Although the country has a wealth of natural resources and a relatively young population, we think Brazil is in the midst of a lost decade for growth because of: Severe macroeconomic imbalances the move towards populist policies in cost Brazil the loss of its investment-grade status. Not only did those policies fail to lift investment (and growth), but they also contributed to widen Brazil s twin deficits (fiscal and external) and distorted relative prices. In order to correct these distortions Brazil has to go through an unprecedented fiscal and monetary squeeze that will amplify the downturn in growth triggered by a sharp setback to the external environment. Time is over: Brazil needs to reform, and quickly Brazil cannot lose the opportunity to reform its tax code and pensions system now that politicians are under pressure from markets and rating agencies. Without laws that constrain the increase in public expenditure the country could become insolvent. And under the current regime, tax collection will remain both insufficient and damaging to income generation. The Brazil cost as well as outdated labour laws, firms face high and complex taxes, poor infrastructure and excessive bureaucracy. These longstanding difficulties have earned the name Brazil cost and are a key reason why we think Brazil will endure a lost decade for growth, recording one of the slowest growth rates among the leading EMs in Brazil: Exchange rate v. 'equilibrium' BRL per USD = depreciation Spot exchange rate Estimated long-run 'equilibrium' rate (t+4) F'cast Brazil: Summary of macroeconomic imbalances* Q1 28 Q4 21** Public finances Fiscal balance (% GDP) Primary fiscal balance (% GDP) Interest payments (% GDP).8 8. Gross public debt (% GDP) 7 67 External accounts Current account (% GDP) FX reserves (months of imports) 1 2 External debt (% GDP) Economic activity GDP growth (2-year average) Inflation (2-year average) Public banks' balance sheet (% GDP) * 4-quarter moving average, unless otherwise stated ** Arrows denote improvement/deterioration since Brazil's upgrade to investment grade in Apr-8 Emerging markets: GDP growth (216-22) India China Indonesia Nigeria Peru Colombia Turkey Chile Mexico Argentina S. Africa Brazil Russia CAGR, % 64

71 216 Economic Background China China Highlights Highlights The Government Work Report presented by Premier Li to the National People s Congress in early March confirms that economic growth remains the government s key objective. The report stressed that the aim to double GDP and per capita income by 22, set in 21, calls for average growth of at least 6.% in The growth target for 216 was set at 6.%-7%. However, downward pressure on growth persisted at the start of 216. With export growth remaining weak, owing to sluggish global demand, growth of value added in industry slowed to.4% in January and February compared to the same period of last year (down from.9% in Q4). Retail sales volumes growth eased as well amid weaker wage growth and increased uncertainty. We estimate volumes grew by around 9.-on-year compared to 1.8% in Q4. Notwithstanding the rebound in real estate construction seen early this year, we continue to expect overall FAI (fixed asset investment) growth to remain subdued in 216. Housing sales may well continue to grow at a solid pace, given the easing of property restrictions and monetary relaxation. But two thirds of housing construction in 21 took place outside of Tier 1 and 2 cities, and in the less dynamic cities the stock of completed, but unsold, housing is so high that a sustained recovery of housing starts is unlikely at this stage. The ambitious growth target for this year will require substantial macroeconomic policy stimulus. Indeed, the Government Work report confirms that policy will be used to support growth, with a rise in the official government deficit on a cash basis, continued quasifiscal activity and generous monetary targets. However, given the challenging external and domestic environment we continue to expect GDP growth of 6.2% this year. Efforts to meet the growth target may detract from reforms. Indeed, the approach to key areas of reform highlighted in the report, including SOE reform and cutting excess capacity, appears timid. However, continued implementation of supply side reforms is vital to enable robust organic growth over the medium term and to achieve the targeted level of income. for China (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Manufacturing (value-added) Consumer Prices Current Balance (% of GDP) Government Budget (% of GDP) Current Account ($bn) Total Trade Balance ($bn) Short-Term Interest Rates (%) Exchange Rate (Per US$)

72 216 China GDP growth remains key objective The annual Government Work Report and objectives of the 13th Five Year Plan (216-2) confirm that economic growth remains the key objective. The aim of doubling GDP and per capita income by 22 set in 21 calls for average growth of at least 6.% in The target for 216 was set at 6.%-7%. However, the external environment remains challenging amid sluggish global demand and heightened volatility in financial markets, depressing export growth and value added in industry. Meanwhile, domestic demand is relatively subdued as activity in the real estate sector is affected by large inventories while private consumption is easing amid weaker wage growth and greater uncertainty. The ambitious growth target means that a more expansive macroeconomic stance will be needed. and will require steady policy easing We expect the government to continue to support domestic demand so that GDP growth does not deviate too much from the authorities target in 216. And some further depreciation against the US$ later on this year should provide some help to exports. But with the current investment and consumption trends forecast to continue into 216, we expect the economy to slow to 6.2% growth this year and 6% in 217. Growth will benefit from: Fiscal easing supporting investment government spending rose 1.9% in 21 and the cash deficit rose to 3.% of GDP. Infrastructure spending will remain a key policy lever this year, with much of it financed in the traditional quasi-fiscal way, but spending on health, education and social security should also continue to expand robustly. In addition, we also expect more consumption-oriented measures and further reductions in taxes on business. Continued easing of monetary policy in spite of the authorities stance on the RMB they want to keep it relatively stable and strong we expect two more interest rate cuts once sentiment on the currency improves. We also expect continued efforts to keep interbank rates low, including by further lowering RRRs, and encouragement of bank lending. Although policymakers are unlikely to let the CNY depreciate sharply, we forecast it will weaken to 6.8 against a China: Output PMI index China manufacturing PMI Global PMI % GDP /Markit/Caixin/JPMorgan Fiscal developments Expenditures Revenues Balance (RHS) % GDP , CEIC Data China: Monetary conditions Government excluding funds and social security funds 9 F'cast 8 3 month interbank rate 1 year 7 lending rate Inflation

73 216 China relatively strong US$ in H Consumption growth above GDP growth strong real wage growth (per capita real disposable income rose 7.9-on-year in 21) and high government spending are lifting the living standards of households, feeding through into reasonably robust spending. But we expect the momentum behind consumption to soften slightly this year on slower wage growth (wage growth seems to have moderated at the end of 21). Robust services sector with consumer spending becoming an increasingly important driver of growth as households get richer, demand for services will remain strong. Indeed, the services sector has outpaced industry since 212. Average GDP growth of.8% in Based on our favourable assessment of the scope for consumption and service sector-oriented growth and with the ongoing gradual reform process enabling further productivity gains, we forecast GDP growth in to average.8%. The Chinese government targets average GDP growth of at least 6.% in to achieve the objective set in 21 to double GDP and per capita income by 22. But these growth targets now appear very ambitious, given the various external and domestic headwinds. In addition, the authorities focus on growth may lead to trade-offs that compromise the reform programme. Indeed, the approach to key areas of reform, including SOE reform and cutting excess capacity, remains timid. But continued implementation of supply side reforms is vital to enable robust organic growth over the medium term and to achieve the hoped-for level of income: New urbanization requires fiscal overhaul the government targets an urbanisation rate of 6% by 22 (from % in 21), with around 1mn urban residency permits granted to rural migrants. However, access to public services will be needed if migrants are to spend like full urban citizens. This requires reforming the intergovernmental fiscal system. Cutting overcapacity plans to cut excess capacity in sectors such as coal mining and steel remain cautious in light of concerns about the labour market. But given the extent of structural overcapacity in these sectors, more forceful closures are needed. China: Prices and earnings Average earnings Consumer prices F'cast China: Contributions to real GDP growth %-point contribution Net exports Private consumption Public consumption Stockbuilding GDP () Source : Oxford Economics/Haver Analytics China: Real consumption and investment GDP F'cast Household consumption Fixed investment SOE reform the performance of SOEs needs to be improved and private companies should be given access to protected markets, in particular in services. 67

74 216 Economic Background Eurozone Eurozone Highlights Highlights Recent data have presented conflicting signs on the likely path of Eurozone GDP growth in the early stages of 216. We have left our forecast for GDP growth this year unchanged at 1.6%, but the downside risks surrounding the forecast appear to have risen. The GDP breakdown for Q4 confirmed that, while the domestic healing of the economy continued, the overall growth performance was once again undermined by a sharp drag from net trade despite solid consumer demand. Since then, industrial data have been a mixed bag. While the survey data suggest that the sector s troubles may have intensified in the early part of the year, robust rises in German and French industrial production in January, together with a large upward revision to the December result, provide some hope that the sector may have turned a corner Meanwhile, low inflation and the improving labour market appear to have ensured that the consumer recovery has been maintained in the early stages of this year. Admittedly, more timely measures of consumer and service sector sentiment have softened a little, but they remain at levels which on past form point to solid growth. Accordingly, at this stage we would not regard these falls as alarming. The risk of the domestic recovery failing to broaden to investment has grown, so we have downgraded our investment forecast for 217. As a result, although our GDP growth forecast for this year is unchanged, partly reflecting the latest ECB action, we have nudged down our 217 forecast to 1.8%. While the ECB remains alert to further signs of easing underlying inflationary pressures and medium-term inflation expectations, our view is that the March package of measures will be the last major easing. for Eurozone (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Government Consumption Net exports (% of GDP) GDP Industrial Production Consumer Prices Current Account (% of GDP) Government Budget (% of GDP) Short-Term Interest rate (%) Long-Term Interest Rates (%) Exchange rate (US$ per Euro) Exchange rate (YEN per Euro)

75 216 Eurozone Recovery gradually picking up pace The breakdown of Eurozone GDP in Q4 confirmed that another quarter of solid domestic demand growth was offset by a drag from net trade, resulting in a solid but unspectacular quarterly GDP rise of.3%. Although the surveys have weakened since then, a further slowdown in GDP growth is by no means inevitable. Industrial production data from Germany and France revealed strong monthly rises in January and the size of the falls in December were also reduced. The strong start to the quarter for the Eurozone overall means that we expect industry to boost GDP growth by as much as.2pp in Q1. Meanwhile, retail sales and new car registrations data bode well for household spending in Q1. While our baseline forecast is for quarterly GDP growth of.%, our GDP indicator model, based on latest available data, points to growth of.6%. Underlying domestic condition still solid We suspect that the likely strong start to the year partly reflects some temporary factors that may be reversed in Q2. Looking ahead though, we remain optimistic that the economy can record solid GDP growth in H2. The key issues for the outlook are as follows: Consumer spending prospects still bright the steady recovery in the labour market and the low inflation outlook mean that real household income may expand at its fastest pace this year since 21. Accordingly, we see the solid household spending recovery continuing this year and our forecast for growth of 1.6% could prove too cautious. to rise gradually although investment provided a bit of an upside surprise in Q4 (it expanded by a solid 1.3% on the quarter), we have become more cautious about the outlook. In the near term, the recent financial market volatility will lead to more caution. And ongoing uncertainties, most notably fears of a hard landing in China, may see some investment projects pushed back or perhaps cancelled. Even so, we expect investment growth to pick-up slightly, to 2.7% in 216 from 2.% last year, as capacity utilisation rises and ECB measures to stimulate credit take full effect. Export prospects less encouraging we have become a little more cautious about the pace of Eurozone Composite PMI & GDP Index GDP (RHS) Composite PMI (LHS) % change q/q Source : Oxford Economics/Haver Analytics/Markit Euro area GDP indicator % q/q GDP % q/q GDP Indicator /Haver Analytics Eurozone: Real household spending & income Household income Household spending Source : Oxford Economics/Haver Analytics 69

76 216 Eurozone export growth, partly reflecting the view that the recovery of global trade growth will be more gradual than assumed a few months ago. After a healthy start to 21, Eurozone exports barely rose in H2 and there is no obvious sign from latest indicators that the situation has improved in early 216. And with import growth likely to continue to grow faster than exports, we expect net trade to act as a drag on overall GDP. On balance, we expect GDP to expand by 1.6% in 216, unchanged from a month ago, but we now see growth picking up to 1.8% in 217, slightly lower than the 1.9% that we forecast in February. Inflation forecasts lowered again The recent fall in Eurozone inflation and signs that underlying inflationary pressures may be easing, given the sharp drop in core to just.7%, have led us to revise down our 216 forecast again to just.3%. And we see a slower pick-up in inflation next year to just 1.4%, implying that headline inflation is on track to remain well below target for a fifth years the last time CPI inflation was close to 2% was Q The picture is even more dismal when focusing on core inflation the last time it was 2% was in 28. With market and other measures of inflation expectations recently weakening, the threat of expectations becoming permanently de-anchored appears to have risen. ECB takes pre-emptive action in March These concerns, along with the recent weak tone to some of the economic data and a downward revision to its inflation forecasts, prompted the ECB to take further substantial action in March. The policy measures were a cut in the deposit rate by 1 basis points to -.4%, a cut in the refinancing rate to zero, an expansion of the monthly asset purchased under the QE programme from 6bn to 8bn and a new TLTRO programme with favourable terms for banks. And while we do not expect the ECB to make further substantial changes to its unconventional policy measures, we have pushed the start of the rate tightening cycle back by an additional year to Q Eurozone: Exports & foreign demand 2 Exports 2 World trade Source : Oxford Economics/Haver Analytics Eurozone: Inflation expectations and oil price Dollars per barrel Jan 14 Jul 14 Jan 1 Jul 1 Jan 16 /Bloomberg Oil price (LHS) Eurozone: ECB HICP forecasts Markets' inflation expectations (Five-year five-year forward, LHS) June 1 September 1 December 1 March Source : Oxford Economics/Haver Analytics 7

77 216 Economic Background France France Highlights Highlights The 1.3% monthly rise in industrial production recorded in January suggests a degree of resilience in the French economy to the financial market volatility seen at the start of the year. GDP growth for Q4 was also revised up to.3% q/q from.2% on higher private consumption than previously estimated. Meanwhile, the latest ECB monetary easing will further support the recovery. Revisions to the national accounts showed that the impact of the terrorist acts in Q4 was slightly smaller than previously estimated and it should continue to wear off in Q Indeed, consumer spending growth rose to its fastest pace in a year in December and January. The labour market recovery and low inflation will boost real disposable income this year, with earnings growth accelerating more significantly from 217 as unemployment drops below 1%. Recent data continues to suggest slower trade with Asia and emerging markets and slightly weaker Eurozone demand. Hence, exports should rise less strongly in 216 than 21. That said, the weak euro (expected to depreciate further this year) and lower oil prices should continue to benefit French trade. Renewed monetary policy easing in the Eurozone will give another boost to French investment as it induces a further easing in credit conditions. This comes at a time when firms have already started to boost capital spending on the back of a more positive demand outlook. Meanwhile, the construction sector should head into recovery from mid-216, adding to the investment pick-up. Given further downgrades to global growth, we have revised our French GDP forecast down for 216 to 1.3% from 1.4% last month. But from 217, growth should gather momentum, averaging 1.7% in Nevertheless, risks are skewed to the downside. French fiscal policy remains constrained by high public debt levels. Meanwhile, the economy could lose further dynamism if the reform process continues to slowdown in the face of resistance to change from both the public and policymakers. Weak global growth also remains a concern. for France (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Current Balance (% of GDP) Government Budget (% of GDP) Short-Term Interest Rates (%) Long-Term Interest Rates (%) Exchange Rate (US$ per Euro)

78 216 France Resilience in the face of market volatility The latest industrial production figure suggests that French economic activity remained resilient at the start of the year, in spite of significant financial market volatility. Meanwhile, the fall in private consumption was in Q4 was revised down to -.2% from -.3% before, suggesting that terrorist attacks of November had a less negative impact on the economy than initially thought. Consumption should thus bounce back faster to its previous level, especially with consumer confidence remaining high. However, the weaker global economic backdrop is likely to continue to weigh on the French economy. On the positive side, the government continues to engage in gradual reform efforts. The forthcoming El Khomri labour market reform should help French firms competitiveness, though the improvement will be small. with growth set for a five-year high in 216 A revival in consumer spending and investment should support economic growth throughout 216, pushing GDP growth to 1.3% (revised from 1.4% before). We then see growth strengthening to 1.7% in 217 as the contribution from net trade improves. Consumption rebounds and supports growth the household consumption backdrop continues to improve, not least due to another year of low inflation in 216 that will support household real disposable income. We now project inflation at just.1% in 216 compared to.6% last month. The unemployment rate started to decrease in Q4 21, too. While slightly helpful for employment, the forthcoming labour law will not change labour market metrics enough to bring unemployment below 1% this year. As a result, the high degree of slack in the labour market will constrain earnings growth and household consumption. Against this backdrop, household spending growth should be fairly stable overall this year at 1.2% (versus 1.4% in 21), but accelerate to 1.7% in 217. recovery continues corporate profit margins reach new heights and at the same time, the ECB s latest monetary policy easing will give another boost to corporate financing. Not only will the renewed cut in the deposit rate incentivise banks to lend more to the real economy, the new corporate bond purchase programme should give firms better access to cheap market financing. Demand France: GDP and its main components % q/q Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q Source : Oxford Economics/Haver Analytics S Net Trade France: Consumption and wages G I C GDP % y/y % 7 6 Consumption Wages and Salaries Unemployment rate (inverted, rhs) Source : Oxford Economics/Haver Analytics France: and profit %y/y 1 Gross operating surplus and mixed income Total investment

79 216 France prospects are improving as well and capacity utilisation remains high, while the renewed drop in commodity prices will support corporate profit margins further along with state measures either underway or planned (such as the Tax Credit for Competitiveness and Employment, the Responsibility Pact and the new employment plan). All this comes at a time of relatively strong business sentiment, corroborating our view that investment is in a phase of broader recovery. Admittedly, firms borrowing capacity remains constrained by high indebtedness (now 17% of GDP) and heightened uncertainty at the start of the year may somewhat weigh on investment in the beginning of 216. But we expect investment to rebound 2.3% in 216, the first rise in four years. Net trade growth to weaken the negative contribution of net trade to growth in 21 is set to widen in 216. External headwinds will see export growth soften to 3.7% from 6.1% despite the continued forecast weakening of the euro against the US dollar. Import growth will ease more modestly to 4.8% thanks to strengthening domestic demand growth. In the longer term, reform efforts to help competitiveness will likely be too little to move the French current account much into surplus territory. Heading towards above-trend growth Indeed, this weakening in net trade growth has led to a slight downgrade to our 216 GDP growth forecast to 1.3% from 1.4% previously albeit mostly due to a more upbeat forecast of the domestic economy and therefore imports. GDP growth is then forecast to average 1.7% per year between 217 and 219 above its estimated trend rate of 1.3%, but still slightly below the average for the Eurozone overall. With this broadly favourable economic backdrop and low borrowing rates, we also expect the government budget deficit to narrow over the next couple of years. As it stands, France remains on track to reduce its budget deficit below the 3% of GDP threshold by 217. However, this means that unlike the rest of the Eurozone, fiscal policy is likely to remain a drag on growth until at least 217. France: Exports by destination contrib. to % y/y growth France: Contributions to GDP growth GDP Domestic demand Net exports RoW Africa South America EU Middle East Asia North America France: Government deficit and debt % of GDP Government budget -1 (LHS) Debt position (RHS) % of GDP

80 216 Economic Background Germany Germany Highlights Highlights After a lacklustre second half of 21, there are signs that the German recovery may have regained a bit of steam in the early stages of this year. We maintain our view that GDP will expand by 1.7% this year, well above the economy s trend rate of growth. The GDP breakdown for Q4 revealed that Germany recorded robust quarterly domestic demand growth of.9%, but much of this strength was offset by a sharp drag from net trade as export volumes fell for the first time since 212 and the industrial sector slumped into recession. Although the closely-watched business surveys have weakened since then, the huge 3.3% monthly rise in industrial production in January suggests that the industrial sector has staged a rebound in early 216 and will expand at a solid pace in Q1. Meanwhile, retail sales and new car registrations data indicate that the consumer recovery shows no signs of slowing. While it is too early to draw firm conclusions about the pace of GDP growth in Q1 just yet, the available data imply that a quarterly rise of 1% is plausible. That said, the stronger the pace of growth in Q1, the more likely there will be some payback in Q2. On balance, we expect the underlying pace of growth in 216 to be stronger than last year. The government is likely to provide a modest fiscal boost this year and monetary policy will remain highly supportive. With employment still growing at a solid pace despite record low unemployment, wage pressures likely to grow and inflation set to average just.% this year, household spending should rise by almost 2%. Meanwhile, without further significant shocks, Q4 s contraction in exports is unlikely to be repeated. Overall, our baseline view remains that the economy will still accelerate this year and next, but we have cut our 217 forecast to 1.9% from 2.2% last month. for Germany (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Current Balance (% of GDP) Government Budget (% of GDP) Short-Term Interest Rates (%) Long-Term Interest Rates (%) Exchange Rate (US$ per Euro)

81 216 Germany H2 21 may have marked the low point Recent news from Germany has been something of a mixed bag. While Q4 s GDP expenditure breakdown confirmed that the economy expanded by a sluggish.3% last quarter, the breakdown revealed that domestic demand growth was a robust.9%. Q4 s weakness thus reflected a large drag from net trade. The surveys have recently softened and January s trade data suggest that the drag from the external sector may have continued in the initial stages of this year. But the other hard data point to continued solid household spending and a rebound in industrial production, which rose by 3.3% in January. Indeed, our GDP indicator suggests that growth of 1% or so is possible in Q1, although for now we have pencilled in a more modest rise. Some of the strength in Q1 may reflect temporary factors, such as a weather-related surge in construction. Accordingly, we would expect some partial reversal in Q2. Even so, we expect growth in H1 to exceed the H2 21 average of.3%. Recovery to regain steam later in the year Indeed, our baseline view is that the economic recovery will regain momentum as the year progresses. This reflects a number of factors: Exports to recover Q1 is likely to see further external weakness and we have become a bit more cautious about the pace of export growth in the quarters ahead. But we still expect an improvement in demand growth in Germany s key export markets to result in a gradual narrowing of the gap between export and import growth this year, resulting in a gradual decrease in the drag from net trade. Consumer spending to remain a bright spot household spending is likely to remain strong beyond Q1. Employment continues to rise and the prospects for wage growth remain favourable (at least from the perspective of households). Job vacancies continue to post new record highs and supply bottlenecks have prompted the IG Metall union to push for a 4.-% pay hike this year, well above the solid 3.4% deal in 21. While we still expect inflation to average.% this year, changes to our oil price forecast have contributed to a reduction in our 217 forecast from 2.1% to 1.8%, which is also favourable for household spending prospects next year. Due to financial and global uncertainties, we expect private consumption Germany: Industrial production % month Yearly change (RHS) Source : Oxford Economics/Haver Analytics Germany: GDP % quarter Outturn GDP indicator Monthly change (LHS) Source : Oxford Economics/Haver Analytics Germany: Exports and world trade Exports World trade (weighed by German trade shares) Source : Oxford Economics/Haver Analytics

82 216 Germany to grow less sharply than real incomes this year, but our forecast of 1.9% would match last year s rise to regain momentum despite the weak backdrop, investment still rose by a solid 1.% in Q4, the strongest since early-214. Nonetheless, in response to ongoing risks and the slightly weaker export growth outlook, we have scaled back the pace of investment growth over the coming quarters. Even so, underlying indicators of investment prospects such as profitability and capacity utilisation are positive. These, combined with the ECB s attempts to boost the credit channel and rising labour costs, should ensure that investment plays a fuller role in the recovery as the year progresses. Stockbuilding to provide a boost over the past couple of years or so, firms have consistently reduced their inventories and we estimate that the volume of stocks is at its lowest since the early-199s. We assume firms reduce the level of stocks throughout 216, but at a slower pace than in 21. This would boost GDP by.1% points a quarter in 216 whereas in the year to Q3 21, stock building reduced GDP by.1% points a quarter. The big picture then is that despite all these risks, we still see GDP expanding by an above-trend 1.7%. But we have become a little more cautious about the further pick-up in 217 and, largely as a result of our lower investment forecast, we have cut our growth projection from 2.2% to 1.9%. Given Germany s openness to trade, further adverse global shocks would hit the economy fairly hard relative to most of the rest of the Eurozone. But equally, if the external environment solidifies a bit more quickly, Germany s strong fundamentals could result in more robust growth over the next few quarters. Germany: Household spending and income Real household spending Real household income Source : Oxford Economics/Haver Analytics Germany: Bank lending survey % balance 8 Change in demand for 6 credit from firms Past three months Source : Oxford Economics/Haver Analytics German: GDP / annual pp contribution Inventories Net trade Government spending 4 Household spending 3 Next three months

83 216 Economic Background India India Highlights Highlights The advance GDP estimates for India paint an optimistic picture, with annual growth rising to 7.6% in 21/16 from 7.2% in the previous year. This is supported by strengthening private consumption and a pick-up in investment growth to above %. On the output side, both manufacturing and services are estimated to have registered strong growth. However, we continue to be sceptical about the pace of growth indicated by the headline GDP figures, which continue to be detached from bottom-up indicators such as industrial production. The latter grew by just 1.-on-year in Q4 21 while the national accounts data indicate a 12.6% annual increase in manufacturing GVA for the quarter. Notwithstanding such concerns, we acknowledge that India is in a gradual recovery which is likely to turn more broad-based in 216. Though consumption will remain the primary driver of growth, we expect the contributions from investment and net exports to improve, helped by concerted policy efforts to boost capital expenditure. The risks, however, remain to the downside, especially on the global front. Thus, we do not rule out the possibility of downgrading our 216 growth forecast if global demand continues to weaken and triggers more financial market turmoil. And there is now limited room for macro policy to provide further support to growth. On the fiscal side, policy credibility considerations are likely to impinge on the government s ability to delay the fiscal consolidation roadmap further. This, in turn, could weigh on public spending, especially investment. And the latter has been the main driver behind overall investment in the last year or so as private capital spending has struggled. Meanwhile, rising CPI inflation has pulled down real interest rates to just below the RBI's comfort zone of 1.-2% and real rates could fall further if the administrative steps by the government to limit food price increases fail to have the desired impact. This will limit the RBI's ability to provide extra support to growth going forward. for India * (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding & discrep (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Current Balance (% of GDP) Government Budget (% of GDP) Current Account ($bn) Trade Balance ($bn) Short-Term Interest Rate (%) Exchange Rate (Rupee per US$) * Refers to Calendar year 77

84 216 India Recovery to turn broad-based in 216 According to the advance estimates, India s GDP grew 7.6% in 21/16, up from 7.2% in the previous year. GVA growth is estimated at 7.3%, after 7.1% in 214/1. Large upward revisions to the back data helped to push up the numbers. Looking at the spending breakdown, the strong headline print is supported by strengthening private consumption (7.6% on the year after 6.2% in 214/1) and a pick-up in investment growth (to.3% from 4.9%). On the output side, industry grew by 7.3%, up from.9% in the previous year. Services growth was stable at 9.2%, but agriculture continued to languish. While we believe that the headline GDP overstates India s growth, the underlying dynamics support our view of the recovery turning more broad-based this year: Consumption will remain the primary driver of growth strengthening urban demand was one of the key drivers of India s growth last year and we expect the same in 216, with positive spillover effects on rural demand. This is underscored by the trends in automobile sales. Year-on-year growth in car sales, an indicator of urban demand, averaged 1% in Q4, up from 11% in Q3 and 7.6% in Q Two-wheeler sales were tepid in comparison, with the Q4 average boosted by a positive base effect and one-off festival impact. Nevertheless, the overall trend points towards rural demand bottoming out. Contribution from investment likely to rise investment s share in India s GDP has been on a steady decline since 28 and stood at 31.2% in H1 FY16. Though the levels are not alarmingly low yet, the aggregate investment figure masks the true state of private investment in India, which has struggled to stage a meaningful recovery since 212/13. Indeed, public investment has done most of the heavy lifting under the Modi government, which decided to give a boost to public sector investment spending in the 21/16 budget, with the hope that this would spark higher levels of private capital spending. In addition, the government has made a concerted effort to kickstart stalled projects and taken other policy measures to remove some bottlenecks that were limiting private investment. Though the response from the private sector has been quite slow, there are nascent signs of recovery, which we expect to gather pace helped by the lagged effects of last year s monetary easing. India: Contributions to GDP India: Automobile sales (3 month moving average) Two-wheeler sales -2 Passenger car sales Source : Oxford Economics/Haver Analytics India: Consumer spending and investment GDP Consumer spending Net exports Domestic demand F'cast 78

85 216 India Exports to pick up modestly in 216 weakness in petroleum products and agricultural exports (accounting for around 3% of total exports) have proved to be a significant drag on Indian exports, with nominal goods exports (in US$ terms) down 1% on the year in 21. The outlook for 216 is modestly positive, with demand from the US expected to provide a floor to exports; albeit momentum is likely to stay sluggish amid a challenging global backdrop. but risks remain on the downside The risks to the 216 growth outlook, however, remain on the downside: Still vulnerable to external shocks as our in-depth assessment of India s external vulnerability highlighted, the country is proving less resilient to external shocks than might have been hoped. Portfolio inflows to India have weakened since the beginning of 21 largely because of investors' concerns about India's dubious growth statistics and snail-paced reforms. A negative external shock would reinforce these concerns and lead to faster portfolio outflows, a slowdown in FDI and tip the balance of payments into deficit. This, in turn, would weaken the currency and dampen growth prospects. Moreover in such a scenario, policymakers would have limited scope to ease macro policy further to support growth. Fiscal policy constrained by deficit targets the Modi government has played an important role in propping up investment since 214. Going forward, however, we think fiscal deficit targets are likely to constrain its ability to support growth. With the government significantly lagging on its disinvestment programme and experiencing subdued direct tax collection, expenditure may have to bear the brunt of fiscal adjustments in 216 and 217. India: Exports & imports 7 Imports Exports month moving average Non-oil & gold imports /Haver Analytics India: Monetary conditions % % of GDP 2 CPI inflation Repo rate India: Government budget balance and debt Government debt (RHS) F'cast % of GDP 7 6 Limited room for further monetary easing rising consumer price inflation (up to.7% in January) has pulled down real interest rates to just below Governor Rajan s comfort zone of 1.-2%. Moreover there is a risk that real interest rates could fall further if the administrative steps by the government to limit food price increases fail to have the desired impact and CPI inflation moves higher. Thus, we think that there is limited room for monetary policy to support growth this year (particularly against a background of gradually rising US interest rates) Central government balance (LHS) F'cast

86 216 Economic Background Italy Italy Highlights Highlights The Italian recovery lost momentum in H2 21, with the economy expanding by just.1% in Q4, after a subdued.2% rise in Q3. Nevertheless, in 21 as a whole GDP grew by.6%, the first full year of growth after three years of deep recession. However, the breakdown of the national accounts showed that the slowdown at the end of last year was driven by inventories. De-stocking subtracted.4% from growth, while the other components made positive contributions. Consumption continued to be the main driver of growth, rising.3%, supported by steady gains in employment. But the most positive feature of the report was investment growing by.8% over the quarter, the strongest pace in five years and driven by transport and construction investments. The data so far this year have been mixed. Surveys, particular the PMIs, have weakened, with the manufacturing survey at its lowest in a year. But the strong 1.9% monthly rise in industrial production in January suggests that the industrial sector staged something of a rebound in early 216. Meanwhile, strong growth in car registrations in January and February indicate that the consumer recovery is still ongoing, and also support the idea that the latest hard data may be more resilient than the survey results in contrast to the situation during the latter part of 21. However, investment and exports will struggle to make progress in H1 216 given the financial market turmoil so far this year, where the Italian stock market index has been the hardest hit among the developed economies, and weak trade flows with sluggish emerging markets. But both should gain some momentum later in the year as external conditions and confidence gradually starts to improve. The combination of a gradually improving labour market and the recent fiscal policy initiatives on the property tax suggest that domestic demand will continue to strengthen in 216. However, this will increase the demand for imports, while subdued external demand will constrain exports. As a result, net exports will not contribute to growth in 216. Overall, we expect GDP growth to increase from.6% in 21 to 1% in 216. for Italy (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Current Balance (% of GDP) Government Budget (% of GDP) Short-Term Interest Rates (%) Long-Term Interest Rates (%) Exchange Rate (US$ per Euro)

87 216 Italy Growth forecast to edge up to 1% in 216 In Q4, GDP increased by just.1% quarter-on-quarter, the slowest growth rate among the main Eurozone countries. However, the detailed breakdown of the national accounts paints a more positive picture. While de-stocking subtracted from growth, by.4% of GDP, all the other main components of demand made positive contributions to growth. Consumer spending was the main driver of growth, rising for the tenth consecutive quarter, while investment grew by.8%, slightly above expectations. The data so far this year have been mixed. Monthly surveys, such as the PMIs and the ISTAT confidence indicators, weakened in January and February. The February manufacturing PMI was the lowest in a year, but, at 2., was still consistent with reasonable growth. However, some official hard data have been more positive, with industrial production in January increasing by almost 2% on the month (albeit some of the rise may reflect a temporary weather-related boost). Italy: Contributions to real GDP growth %-point contribution Stockbuilding -1. Net Exports Government Consumption -1. Private Consumption GDP Source : Oxford Economics/Haver Analytics F'cast Overall, we see the economy expanding by.2% over the quarter in Q1. This, combined with average quarterly growth of around.4% during the rest of the year, would result in GDP growth of 1% for the year as a whole, below the government s target of 1.6%. Lack of inflation helps consumer spending Inflation eased to -.3% in February, the lowest figure in over a year, and slightly below that of the Eurozone. We expect inflation to remain negative for the next few months, before returning to positive territory in H2 and averaging just +.1% in 216. The absence of any price pressures will continue to help households real incomes and consumption, but it will also mean that the public debt, as a percentage of GDP, will not decline to any significant extent in 216 (staying above 133% on the Maastricht definition). Slow recovery in domestic demand We expect modest growth in both private consumption and investment this year, although the latter remains particularly subject to downside risk given the fragile global background: 81

88 216 Italy Improving labour market supports consumer spending the unemployment rate was 11.% in January,.8 percentage points lower than a year earlier, while the total number of people employed was 1.3% higher, with the increase in workers on a permanent (rather than temporary) contract far outweighing falls in the number of self-employed. A continuation of solid employment creation in the coming quarters will support personal income and private consumption. The latter will also be supported by some fiscal measures (such as the elimination of the property tax) and the lack of inflation. Against this background, private consumption is set to expand by 1.2% this year, up from.9% in 21. pick-up will remain patchy investment surprised on the upside at the end of last year. grew by a robust.8% in Q4, the strongest growth rate since 21. Transport and construction both showed solid gains but investment in equipment decreased for a second consecutive quarter (albeit only slightly). However, the recent setback to confidence and the sluggishness of external demand at the start of 216 will likely mean a patchy investment performance during the first half of the year. We expect investment to grow by 1.3% in 216, after an increase of.6% in 21. Net exports to provide little impetus In contrast to Germany and France, Italian growth was boosted by net trade in Q4 21, contributing.1% to GDP. However, over the coming quarters the contribution of net exports will be negligible, as modest export growth will be offset by a slightly stronger increase in imports (reflecting the gradual recovery in domestic demand). Government is reforming but can do more Recent policies implemented by the government address some of the key issues that are hampering the Italian economy. But, as in the recent case of the bad bank, some of the moves are less effective than they might have been. For example, the agreement between the government and the EC for a guarantee scheme to offload bad loans is a step forward, but it is not a game changer. In addition, the government is trying to maintain a modestly expansionary fiscal policy; while we agree with this strategy we would have preferred a permanent reduction in the taxation of productive factors rather than the elimination of a property tax. Italy: Contributions to GDP growth Domestic demand Net exports GDP F'cast Italy: Contribution to quarterly investment growth (pp) Construction Equipment Transport Source : Oxford Economics/Haver Analytics Italy: Non-performing loans bn Past-due Restructured Substandard Bad debt Source : Bank of Italy/Haver Analytics 82

89 216 Economic Background Japan Japan Highlights Highlights The revised estimate of Q4 real GDP was nudged to a slightly less negative -.3% (from -.4%). This was due to faster business investment growth, now put at 1.% in the quarter. But the fall in consumer spending was actually increased to a.9% drop (from.8%). This was the major cause of the overall contraction in Q4 and raises concerns about growth this year as well as doubts about the proposed consumption tax increase due in April 217. We have substantially downgraded our forecasts this month for 216 through to 218. The lack of consumer momentum early in 216 has led us to cut our GDP forecast for this year to.% (from.8%). Persistent consumer weakness plus a reassessment of the likely effects of the 217 consumption tax increase, has contributed to a reduction in the 217 GDP forecast to just.3% (from 1.3%). Weaker demand for exports from China is also a factor. For 218 we have taken down the forecast to.6% (from 1.4%). Our baseline assumes that the consumption tax increase goes ahead in April 217 from 8% to 1% (except for food and non-alcoholic beverages). Since the announcement of negative interest rates in late January and their subsequent introduction in mid-february, the yield curve has shifted down significantly. The curve is now negative up to 1- years maturity and on March 1 the Ministry of Finance sold a tranche of 1-year JGBs at a negative yield for the first time ever. But there have been other implications of negative interest rates, most notably for the banking sector where share prices have fallen sharply since the announcement. Money market funds are also being closed down, unable to operate at such low interest rates. Actual inflation is likely to stay close to zero through much of 216 mainly due to the effect of lower oil prices. In January the target measure, CPI excluding fresh food, was indeed zero. Core inflation CPI excluding fresh food and energy was at 1.1% and may soon fall below 1%. We expect the BoJ to take even more decisive action in the coming months. We see the relevant deposit rate falling to -.% by yearend, with a possible extra 2trn of annual asset purchases around the middle of the year. for Japan (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Current Balance (% of GDP) Government Budget (% of GDP) Short-Term Interest Rates (%) Long-Term Interest Rates (%) Exchange Rate (Yen per US$) Exchange Rate (Yen per Euro)

90 216 Japan Consumption a big downside risk The second estimate of GDP in Q4 was revised up slightly to a contraction of -.3% from -.4%. In 21 growth was heavily skewed towards the start of the year and by Q4 the economy was.3% smaller than in Q1. The Q4 breakdown also gives cause for concern, especially the weakness of consumption (revised in the second estimate to a decline of.9% in the quarter). The level of consumer spending has barely improved since it fell in the wake of the April 214 consumption tax increase. Poor momentum into 216 The outlook is for weak growth through the first half of 216. In addition, this month, we have substantially downgraded our GDP forecasts for the next three years. For 216 we expect GDP growth of.% (.8% previously), the same as last year. For 217 we have slashed the forecast to.3% (from 1.3%) reflecting a reassessment of the likely impact of the consumption tax increase as well as weaker exports. Similarly, we now see 218 GDP growth at.6% rather than 1.4%. There is some uncertainty as to whether the April 217 consumption tax increase from 8% to 1% will go ahead but for now it remains in our baseline. Business investment holding up business investment increased by 1.% in Q4 after a.7% gain in Q3. This latest data are now more consistent with survey evidence, such as the Tankan, pointing to fairly healthy investment in the current fiscal year. In addition private core orders jumped by 1% in the month of January, the largest monthly increase since comparable records began in 2. Orders were especially strong in the steel industry. The Ministry of Finance quarterly corporate survey for Q4 showed continued healthy profits too (see chart). Consumption flagging the fall in consumption now put at.9% in Q4 last year is especially worrying. The level of consumption has barely recovered after the 214 correction following the consumption tax increase. It is likely that there will be a modest rebound in Q1 this year, although the monthly household spending data showed a further dip in January Consumer confidence also fell back in February, possibly an initial reaction to the negative interest rate announcement. More positively, annual wage growth picked up to.4% in January, and real wages should show a modest increase this year. Japan: business and consumer confidence Diffusion index Economy watchers' expectations Consumer confidence 1 Feb7 Feb1 Feb13 Feb16 Source : Oxford Economics/Haver Analytics tn % 8 Non-financial profits (LHS) Japan: Real GDP % change Y-on-Y (LHS) Q-on-Q (RHS) Non-financial corporate profits (MoF survey) as % of GDP (RHS) 1997Q4 2Q4 23Q4 26Q4 29Q4 212Q4 21Q4 Source : Oxford Economics/Japan Ministry of Finance % change Exports losing momentum real goods exports fell in both December and January, by a cumulative 3.3%. 84

91 216 Japan Unless offset by a big jump in service exports (as occurred in Q3), total goods and services exports may contract again in Q But imports are also waning so that net exports are unlikely to be a significant drag on overall GDP. Negative rates take their toll Since the announcement of negative interest rates in late January and their subsequent introduction in mid- February, the yield curve has shifted down significantly. The curve is now negative up to 1-years maturity and on March 1 the Ministry of Finance sold a tranche of 1-year JGBs at a negative yield for the first time ever. But there have been other implications of negative interest rates, most notably for the banking sector where share prices have fallen sharply since the announcement. Money market funds are also being closed down, unable to operate at such low interest rates. The overall effectiveness of the negative interest rate policy is therefore unclear. The Bank of Japan is likely to adopt a wait and see approach for the time being. We still expect interest rates to be cut further into negative territory later this year, ultimately reaching -.%. But the BoJ has emphasised the multi-dimensional nature of its policy, meaning that increased asset purchases remain very much a possibility. We have penciled in an additional 2trn around the middle of the year, which would take annual asset purchases to 1trn. Actual inflation is likely to stay close to zero through much of 216 mainly due to the effect of lower oil prices. In January the target measure, CPI excluding fresh food, was at zero. Meanwhile, core inflation CPI excluding fresh food and energy was at 1.1% and may soon fall below 1%. With its 2% inflation target proving elusive the BoJ will have to take even more decisive action in the coming months. Japan: sovereign yield curve % yield Jan Jan-16 1-Mar-16 1yr 3yr yr 7yr 1yr 1yr 2yr Source : Oxford Economics/Haver Analytics Japan CPI inflation (excluding consumption tax) 3 CPI exc fresh food CPI exc food and energy 2 BoJ's inflation target Jan Jan4 Jan8 Jan12 Jan16 Source : Statistics Japan/Haver Analytics Japan: GDP and consumption 8 6 Consumption F'cast GDP

92 216 Economic Background Mexico Mexico Highlights Highlights The central bank (Banxico) surprised everyone in mid-february by hiking its key interest rate bp to 3.7% and cancelling its daily intervention in the foreign exchange market. This sudden move is, in our view, an attempt to encourage global investors to view the peso more on Mexican economic fundamentals rather than use it as a proxy for sentiment about Emerging Markets in general (which has helped drive the MXN 29% lower since the middle of 214). However, we do not think that this hike will be swiftly followed by other moves but that Banxico will now mirror the US Fed and deliver two rate hikes in the latter part of 216, taking the policy rate to 4.2% by year-end. At the same time as interest rates were raised, the government announced cuts in public spending of about.7% of GDP. Given the tightening in both monetary and fiscal policies we have reduced our GDP growth forecasts for 216 and 217 to 2.7% and 2.9% respectively. The latest news on the economy remains fairly downbeat, particularly on the industrial side. In December, industrial production was.1% lower than a year earlier, undermined by a 3.9% fall in the oil and gas sector and a 1.7% decline in construction. However, manufacturing was up 2.4%. In 216 industry is expected to grow by an average 1.9%, modestly higher than last year s performance. The strong dollar and weak global demand are key factors behind US industrial weakness, and this has affected Mexico s commercial trade. Last year, Mexican exports fell 3.9% in value terms, with oil sales down 4.% and manufacturing exports up 1.1%. But the latter figure masked a slowdown through the year, from.8-on-year growth in Q1 to a fall of 2.7% in Q4. Inflation bounced back to 2.6% in January, but was still below the target of 3%. Lower prices for telecom services and stable housing costs have helped to offset the inflationary impact of a weaker currency. Nonetheless, the effects of the peso s sustained slide over the last 18 months will eventually show up in higher consumer prices despite the interest rate hike. Even after the surprise move by Banxico, the peso was still 6% lower than at the end of 21. We now expect that inflation will average 3.3% in 216. for Mexico (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Current Balance (% of GDP) Government Budget (% of GDP) Current Account ($bn) Trade Balance ($bn) Short-Term Interest Rates (%) Exchange Rate (Per US$)

93 216 Mexico Industry flu, domestic market the cure In 21 the performance of the industrial sector was disappointing. Moreover, despite further gradual gains in manufacturing output, the fall in construction and the crisis in the oil and gas sector will continue to set back industry in the initial stages of 216. Given the extent of excess supply in the oil market, hopes of higher oil prices and stable markets seem unrealistic; this will reduce capital spending in the Mexican oil and gas sector, dampening wider industry. In addition, public spending cuts are likely to affect construction investment. We now expect industrial output to grow by just 1.9% this year. In contrast, domestic conditions remain positive; formal employment is growing strongly, real wages are picking up and consumer credit is at record-highs. Despite the erosion of households purchasing power caused by the depreciation of the peso, consumer confidence has not yet faltered and spending remains resilient. In January, the National Association of Supermarkets and Department Stores (ANTAD) total store sales grew 11.6%, underpinning our view that the key driver of Mexican growth this year will be a strong domestic market. We estimate that private consumption will grow 3% in 216. Peso fall triggers unexpected rate hike By mid-february the Mexican peso had depreciated another 1% so far this year, caught up in the general turmoil in global financial markets and the weakness of global oil prices. With this latest fall coming on top of the 14% drop seen during 21, Banxico called an unscheduled policy meeting on February 17 and raised the key interest rate by bp to 3.7%. The move was to prevent the peso from falling even further given the danger that the higher import costs brought about by the weaker exchange rate would pass-through to increased CPI inflation and also destabilize price expectations. Indeed, inflationary pressures in the pipeline appear to be rising; producer prices ex oil increased by.9% on the month in January, the largest increase in 13 months. We expect inflation to move above the central bank s 3% target, averaging 3.3% in 216 and 3.% in 217. Provided the peso does not come under further intense pressure, we expect Banxico to move with the Fed and deliver two 2bp hikes, in September and December, taking the policy rate to 4.2% by end-216 Mexico: GDP and industrial production Mexico: Retail sales volumes 28=1 (seasonally adjusted) Source: Haver Analytics Mexico: Monetary conditions Inflation Policy rate Inflation target (mid-point) GDP Industrial production F'cast F'cast 87

94 216 Mexico but outlook still reasonable Although the recent tightening in both monetary and fiscal policy has dampened economic prospects, the overall outlook remains a reasonable one. The key factors supporting our forecast are: Real wage growth social security-registered workers the main guide to trends in formal employment grew 3.8% in January, wages increased by 1.% in real terms and the unemployment rate closed 21 at 4.4%. Steady increases in real wages and employment should provide solid domestic momentum. Mexico: Exchange rate per US$ F'cast Telecom reform pays off the new telecom reform has provided the market with new competitors and boosted investment. Moreover, thanks to the increased competition the price of cell phone services has fallen and consumers options have broadened. Public finances in reasonable shape despite low oil prices although oil revenues have been hit by the combination of plunging international oil prices and weak oil exports, government revenues are holding up well. This is due to the new tax and labor market reforms, which have increased the tax base. We forecast the budget deficit will widen to 3.8% of GDP this year, before shrinking to 3.% in 217. Encouraging domestic conditions consumer and housing credit are growing rapidly and a solid US labor market should mean a steady flow of worker remittances. And the latter will supply more pesos for Mexican families due to a stronger dollar. This should also support solid consumer spending. Energy reform problems the energy reform that broke the monopoly of Pemex in the energy sector is currently being overshadowed by the dramatic fall in oil prices and low capital spending. Pemex is now set to function as a more efficient and productive company for the government, but in the short term the crisis has forced it to slash its budget (by MXN1bn) and fire more than 13, workers. We expect that the oil and gas sector will continue to dampen overall industrial production throughout 216. Sluggish commercial trade we see Mexican commercial exports broadly following the path of US trade, which will continue to be affected by the strong dollar and subdued global demand Mexico: Industrial output 28=1 (seasonally adjusted) 12 Manufacturing 11 Oil & gas output extraction Construction Source: Haver Analytics Trade: Mexico exports & US imports Mexican goods' exports US goods' imports F'cast 88

95 216 Economic Background South Korea South Korea Highlights Highlights Monthly economic data continued to be subdued in February. The external sector was sluggish, weighed down by lackluster global demand, while domestic demand also showed signs of losing momentum. Exports receipts in US$ terms fell year-on-year for the fourteenth consecutive month, while imports have contracted for 17 straight months. Importantly, export volumes that had held up until November 21, have also trended lower in recent months. Meanwhile, consumer confidence has fallen to its lowest level since June. Given the latest data, we expect growth this year to be lower in Korea than previously estimated. Weak global demand and price pressures will weigh on Korean exports; we forecast export volumes will grow by 3.7% this year. Furthermore, in line with the slowdown in recovery in the private sector, we now expect private consumption to grow by 2.8% this year. Overall, GDP growth is now projected to average 2.9% in 216, followed by 3% in 217. Moreover, the risks to growth are skewed to the downside. A quarter of Korea s exports go to China, so economic growth could be derailed if China slows unexpectedly sharply. In addition, there is a possibility of weakness in the external sector spilling over into the domestic private sector, resulting in a more pronounced slowdown in domestic consumption. Meanwhile, volatility in the Korean won could increase later in the year when the US Fed starts to contemplate raising interest rates again, leading to a tougher environment for Korean SMEs. Last year, when some market participants were looking for the Bank of Korea (BoK) to ease, we argued that economic developments did not warrant a rate cut. However, recent information including weak domestic monthly economic indicators, the central bank s latest communiques and the disappointingly sluggish recovery in the developed economies have opened the door for further policy easing. With the BoK moving towards prioritizing domestic growth over financial stability considerations, we now expect the BoK to cut the policy interest rate by 2bp in Q for Korea (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Current Balance (% of GDP) Government Budget (% of GDP) Current Account ($bn) Trade Balance ($bn) Short-Term Interest Rates (%) Exchange Rate (Per US$)

96 216 South Korea Sluggish start to 216 The performance of the Korean economy at the start of 216 has been somewhat disappointing. The external sector has remained difficult; exports in US$ terms contracted by 12.2-on-year in February. While the overall total was supported by a rebound in shipments of computers, wireless devices and, exports of ships, petrochemical products and semiconductor chips continued to fall sharply. Meanwhile, domestic demand which had been growing at a healthy pace during much of H2 21 has shown signs of losing momentum. The consumer confidence index closely related to trends in private spending eased to its lowest level in February since June last year (during the MERS outbreak). Consumer confidence has been dragged down by a worsening assessment of the domestic economic situation. leading to further cut in growth forecast On the back of the latest data, we see less robust activity in the short term in both the external and domestic sectors. We expect private consumption to grow by 2.8% this year. And we forecast export volume growth for 216 at 3.7%. In addition to the financial market turbulence at the start of the year and the continued sluggishness of global trade, the monthly Korean manufacturing PMI showed production declining at its fastest rate in six months in February, influenced by a drop in new orders for a second consecutive month,. Meanwhile, increased tensions with North Korea, leading to the shutting down of the Kaesong industrial park, will also dampen sentiment and spending. Given the economic backdrop, we expect growth to average 2.9% in 216 and and 3% in 217. and BoK now expected to cut rates again Last year, when some market participants were looking for the BoK to ease, we argued that economic developments in South Korea did not warrant a rate cut; furthermore, monetary policy, in our view, was constrained by concerns about high leverage in the household and corporate sectors. However, we think the BoK is moving towards prioritizing domestic growth over financial stability considerations. Recent developments including weak domestic monthly indicators, the central bank s latest communiques and the disappointingly Korea: Exports in US$ and volume % y/y, 3mma Source : Oxford Economics/Haver Analytics 3 month average Volume US$ Korea: Consumer sentiment & GDP growth %y/y 8 8 For Q1 216, consumer sentiment index is an -2 average of January and Febrary 216 only Source : Oxford Economics/Haver Analytics Composite consumer sentiment index (LHS) Real GDP growth (RHS) Korea: Contributions to GDP growth GDP Net exports Domestic demand F'cast

97 216 South Korea sluggish recovery in the developed economies have opened the door for further policy easing. We now expect the BoK to cut its policy rate by 2bp in Q Slightly faster growth in 216 than in 21 We expect average GDP growth to pick up marginally in 216, to 2.9% from 2.6% last year. There are downside risks from the weak external situation lasting for longer than expected and hurting sentiment, but the domestic economy should be supported by: Expansionary fiscal policy fiscal policy has been loosened to guard against the economy stagnating, including a frontloading of expenditure into Q1 216 and an extension of the temporary consumption tax cut on passenger cars to June 216. Accommodative monetary policy the BoK is now expected to cut the key policy interest rate by another 2bp, bringing it to a record low of 1.2%, in Q Consumer spending to build momentum gradually we expect spending to recover after a weak Q1. Rising employment and very accommodative real interest rates (<1%) should also support spending. Risks balanced but downside could escalate Weak China offsetting steady US/EU demand weak sales to China and the rest of emerging Asia were a major constraint on export performance in 21 but this drag is gradually expected to ease. Overall, we expect world trade weighted by Korean export shares to grow by 2.6% in 216 and 4.1% in 217, after an estimated drop of.4% in 21. Won has been volatile in 216 so far but large current account surplus provides some protection even after a sharp rally during March, the tradeweighted won is still over 4% weaker than in April 21. Indeed, in early 216 the KRW fell to its lowest level against the US$ since 21 affected by concerns about Korea s high exposure to a possibly weakening Chinese economy, the risk of further volatility in global financial markets as the US normalizes its monetary policy and the increased tension with North Korea. However, Korea s large current account surplus and its status as a regional safe haven means that it should be better protected from global volatility than many of its neighbours. Korea: Monetary conditions % Policy interest rate Inflation % of GDP 4 Long-term interest rate Korea: Government budget balance F'cast F'cast Korea: Exchange rates 2= less competitive 6 v JPY more competitive Source: Haver Analytics / Oxford Economics v US$ v CNY 91

98 216 Economic Background Spain Spain Highlights The Spanish economy maintained its momentum in Q4 last year as GDP expanded.8% over the Highlights previous quarter (the same as in Q3). For 21 overall, the economy grew 3.2%, the fastest pace in eight years. The detailed GDP breakdown for Q4 showed a picture of broad-based growth, with household spending, investment and exports expanding at a robust pace. Although economic growth is now moderating from the peak in mid-21, the outlook remains positive. Consumer spending is growing solidly above 3% a year, fuelled by strong job creation. The renewed weakness in oil prices is also keeping inflation negative, thus boosting consumers real disposable incomes. Furthermore, exports are outperforming most of Spain s regional peers in spite of slowing global trade and sluggish growth in the Eurozone. The political situation remains uncertain following the December elections, in which the ruling conservative Popular Party obtained a victory but fell far short of winning a majority of seats. The Socialist Party, which came second, was asked to form a government but failed to obtain enough support in parliament. If a government cannot be formed by 2 May, fresh elections will be called. Given the highly fragmented parliament, we still think that this is the most likely scenario. Although our central scenario does not see any resulting radical change in policy, this situation increases the chance of policy inaction, which would slow the recovery and add risks to fiscal sustainability over the medium term. Despite increased political risk, we believe the current strong economic momentum should continue in the short term given the favourable tail winds, and we forecast GDP will expand by 2.8% this year. Going forward, we expect more moderate growth of 2.3% in 217 and then around 2.2 in , primarily as a result of slower consumer spending growth amid smaller increases in employment. for Spain (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Current Balance (% of GDP) Government Budget (% of GDP) Short-Term Interest Rates (%) Long-Term Interest Rates (%) Exchange Rate (US$ per Euro)

99 216 Spain Strongest growth since 27 GDP expanded.8% on the quarter in Q4 21, the same as in Q3. The breakdown showed robust growth across the board, with private consumption, investment and exports all expanding strongly. For 21 overall, the economy grew 3.2%, the fastest pace in eight years. and still broad-based The economy continues to benefit from strong tailwinds, namely the ultra-loose monetary policy implemented by the ECB and the continuing plunge in oil prices, the latter particularly beneficial to Spain given its dependence on imported energy. As a result, consumer spending remains the main economic engine, as households also benefit from strong job creation and a boost to their real disposable income in spite of muted wage growth. We expect consumer spending to grow by 2.9% this year and 2.4% in 217. Given ultra-low interest rates and improving economic conditions, businesses have been committing to capital spending, thus driving strong investment growth since mid-214. Although the short-term path of capital spending remains subject to downward risks owing to the increased political instability, we still expect investment to remain relatively robust, posting a rise of 4.1% in both 216 and 217. Exports continue to expand at a solid pace despite the challenging global environment, as Spain benefits from increased competitiveness and a weak euro. Although we foresee a slowdown this year, we still expect Spanish exports to continue to outperform most of its regional peers and forecast a 4.% rise in 216. On the other hand, stronger domestic demand is driving a faster rise in imports, leading to a deterioration in net trade. Outlook for 216 positive despite politics The moderation in growth in the second half of 21 is consistent with the view that we have held for some time. But Spain continues to grow well above the Eurozone average and fundamentals remain solid, with strong levels of job creation, household spending and investment fuelling robust growth in the domestic sector. That said, our 216 forecast of 2.8% may be subject to downward risks if the current political impasse persists for several months. Spain: GDP and GDP Model % quarter Spain: Inflation *Excluding fresh food/energy Source: Haver Analytics GDP GDP Indicator /Haver Analytics GDP Core* Headline Spain: Contributions to GDP growth F'cast Domestic demand Net exports 93

100 216 Spain The political situation remains uncertain following the December elections, which the ruling conservative Popular Party won but fell far short of reaching a majority of seats. The Socialist Party, which came second, was asked to form a government but failed to gather enough support in parliament. If a government cannot be formed by 2 May, new elections will be called. We continue to think this is the most likely outcome given the highly fragmented parliament and the complex alliances required. Although our central scenario does not see a radical change in policy, this situation increases the chance of policy inaction, which would slow the recovery and add risks to fiscal sustainability over the long term. Constraints on medium-term growth Further ahead, growth is forecast to slow to 2.2% a year in as structural factors weigh on activity: Private deleveraging although both consumers and businesses have gone through major deleveraging in recent years, debt remains high by historical standards. Firms will likely remain wary of borrowing, while banks continue to carry a high (albeit falling) burden of nonperforming loans. As such, credit will grow more slowly than in previous expansions. Overall, we expect investment growth of 3.% a year, in , half as fast as in the pre-crisis decade. High unemployment despite the strong pace of job creation, we do not expect unemployment to fall below 2% until H Without additional reforms, high structural unemployment could drag on consumption and the welfare bill over the medium term. So although consumer spending will grow by about 2.2% a year in , the level of spending in real terms in 219 will be little better than the peak in 27. Fiscal consolidation fiscal policy is shifting towards expansion amid an improving economy, but deficit and debt reduction remain a priority. Our forecasts see Spain exceeding its deficit targets, so further adjustment seems unavoidable. Thus only modest growth in public spending is likely during the coming years. Moreover, if tax revenues fail to grow as expected, or if interest rates and debt payments rise more quickly than expected, then deeper spending cuts will be necessary to maintain deficit reduction. Spain: Sectoral indebtedness Debt as % of GDP % Consumer Source : Oxford Economics/Haver Analytics Spain: Unemployment rate Non-financial business Domestic financial sector Spain: Government balance and debt % of GDP Government budget balance (LHS) Government debt (RHS) % of GDP 11 F'cast

101 216 Economic Background Switzerland Switzerland Highlights Highlights Swiss GDP growth slowed from 1.9% in 214 to.9% last year. But this was a better outturn than we had expected a year ago, shortly after the CHF appreciated sharply against the euro. However, growth in 21 was exaggerated by some special factors. For example, merchanting exports soared around 4%, boosting overall export volume growth by around three percentage points. In addition, Swiss GDP in nominal terms shrank by.4% last year, hit by sharp falls in prices and profit margins. More positively, real GDP increased by.4% on the quarter in Q4, while the PMI survey has been at (the growth threshold) or above in each of the last three months. At the same time, there are significant areas of concern. Consumer spending clearly lost momentum towards the end of 21 and we do not expect this situation to change quickly given the weakening labour market. We now expect household consumption to grow by only.9% in 216. The outlook for exports of services also looks quite poor. These fell sharply in Q4 and are likely to struggle during 216 given the ongoing bad conditions for financial sector exports and tourism (undermined by the uncompetitive level of the CHF). Moreover, the downside risks have been exacerbated by the disappointingly sluggish performance of the global economy at the start of 216 and the renewed pressure on the Franc to appreciate after the latest ECB policy changes. In addition, the Swiss authorities are struggling to reach agreement with the EU over access to the latter s markets in the wake of the Swiss electorate s decision in 214 to limit migration. Extensive uncertainty over the outlook will continue to dampen business investment. Against this backdrop, we have lowered our GDP growth forecasts. We now expect the economy to grow by.8% this year and 1.6% in 217, down from.9% and 1.9% last month. for Switzerland (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Current Balance (% of GDP) Government Budget (% of GDP) Short-Term Interest Rates (%) Long-Term Interest Rates (%) Exchange Rate (Per US$) Exchange Rate (Per Euro)

102 216 Switzerland Strong CHF remains heavy burden The sharp rise in the CHF in mid-january 21 undermined Swiss activity throughout last year and will remain a significant burden during 216. Overall, we now forecast that Swiss GDP will grow by just.8% in 216 as a whole after an expansion of.9% in 21. This is noticeably lower than our equivalent Eurozone growth forecast of 1.6% for this year. However, as the initial impact of the exchange rate shock fades and as global demand gathers pace, we expect growth to pick up to 1.6% in 217 and around 2% in 218. The main drivers of our short-term forecast are: Switzerland: GDP F'cast Severe overvaluation of CHF following the abandonment of the CHF/euro ceiling in January 21, Switzerland has seen a trade-weighted appreciation of close to 9% in nominal terms and around 7% in real terms, resulting in a significantly overvalued CHF. The franc is likely to remain strong in 216 and the first half 217, averaging around 1.1 CHF per euro. The poor competitiveness position is weighing on exports of goods and services, while exporters profit margins have been squeezed significantly, depressing the incentives for business investment. Gradual rise in external demand the impact of the overvalued CHF is the key driver of our export forecast, but there are some offsetting factors. World trade weighted by Swiss export shares will continue to grow, albeit modestly this year by 2.1% before picking up to growth rates of 4.3% and 4.% in 217 and 218. The latter will provide a positive background for a reasonably robust recovery as the impact of the CHF exchange rate shock gradually fades. Rising purchasing power, but falling retail sales the CHF appreciation led to a sharp rise in Swiss consumers purchasing power. And reinforcing this, the renewed weakness in oil prices means that CPI inflation is expected to average another year in negative territory in 216, around -.7%, after -1.1% in 21. But a lot of this extra stimulus is benefiting other countries as Swiss consumers shop more in France and Germany and buy imported goods. Nominal retail sales fell by around 3% in 21 the largest drop in decades while the annual growth in real consumer spending slowed to below 1% in Q4 for the first time since 211. On the plus side, many firms are Switzerland: Real trade-weighted exchange rate 21=1 12 less 12 competitive 9 trade-weighted exchange rate adjusted for relative inflation Source: Bank of International Settlements Switzerland: Export volumes and world trade Export volumes -1 World trade index F'cast 96

103 216 Switzerland benefiting from lower prices for imported intermediate goods, but this will only partly offset lower price competitiveness in export markets. Weaker labour market dampens consumer confidence the strong CHF has hit labour-intensive sectors, such as tourism (overnight stays were down in 21) and consumer services, particularly hard, while manufacturing employment is also being affected. Unemployment is forecast to rise to 3.7% by the end of 216 from 3.2% in 214. The weaker labour market has depressed consumer confidence. GDP growth of 1.8% a year seen in While the exchange rate shock will continue to undermine the performance of the economy in 216, healthy quarterly growth should resume during 217. In the medium term the economy will benefit from: Strong industrial base Switzerland exports highquality consumer and investment goods, which will be increasingly in demand from the rapidly expanding middle classes in emerging economies once their current soft patch comes to an end. The very strong CHF will also increase the pressure to innovate. Efficient monetary policy although abandoning the CHF/euro ceiling was controversial, the SNB still has the advantage of being able to adjust its policy to meet the changing needs of the domestic economy without reference to possibly conflicting requirements. This is an advantage compared with the ECB, which has to set one policy for many different economies. No need for fiscal austerity there is no need for significant austerity given years of cautious fiscal policy in the mid-2s. Population growth even after a quota system has been imposed, we expect population growth to be above that of most western European countries. We expect the working-age population to grow by around.% a year until 22. Although our central forecast is that Switzerland grows by around 1.8% pa in , there are downside risks. And these have probably increased after the gains of the right-wing parties in the latest elections and the greater likelihood of serious disagreement with the EU. Switzerland: Consumption and investment Consumption -6-9 F'cast Switzerland: Consumer confidence % balance Source: Haver Analytics Switzerland: Interest rates % 4 Long-term Short-term Source : Haver Analytics 97

104 216 Economic Background Taiwan Taiwan Highlights Highlights External pressures are still weighing on the Taiwanese economy. Merchandise exports in US$ terms contracted 11.8% in February compared to a year earlier, the 13 th consecutive monthly decline. Although this plunge stems partly from falling export prices and the strong US dollar, export volumes are also probably still trending lower. Sluggish foreign demand is especially damaging for the export-oriented manufacturing sector. Industrial output fell 3.9-on-year in January, and the strong earthquake in February is likely to have disrupted some production. The latest Nikkei Manufacturing PMI confirmed the bleak picture, indicating that operating conditions worsened again in February after two months of slight improvement. More reassuring was the 6.9% annual rise in retail sales in January (albeit some of the increase may reflect the different timing of the Chinese New Year). This suggests that consumer spending has continued to trend higher at the start of 216. Very low inflation and positive, albeit slowing, employment and wage growth are still boosting disposable incomes. Despite the current bad news on exports and industry, the outlook for the economy is likely to improve through the course of 216. Chinese import demand is expected to be stronger this year than in 21, and this should mean that Taiwan s export markets grow by around 3% on average in 216, up from just.4% last year. In addition, consumer confidence picked up in February after falling for nine consecutive months, while further monetary loosening will help to boost confidence in H1 and keep consumption growing at a respectable pace. With consumer spending trending higher and signs that import volumes may have weakened more than exports in early 216, the economy is expanding. However, given the renewed pressures on industry, we expect slightly slower growth in Q1 and Q2 than previously; this will result in GDP growth of 1.7% for 216 as a whole. Given the disappointing external background at the start of 216, and the slowdown in earnings and employment growth, we expect the central bank to cut interest rates for a third consecutive time on March 24, on this occasion by 2bp to 1.37%. for Taiwan (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Government Budget (% of GDP) Trade Balance ($bn) Current Account ($bn) Current Balance (% of GDP) Short-Term Interest Rates (%) Exchange Rate (Per US$)

105 216 Taiwan Exports and industry remain weak The Taiwanese economy continued to suffer from the persistent trade slump last month. On an annual basis, the US$ value of both exported and imported goods declined at a double-digit pace for the ninth consecutive month in February, implying that a rebound in trade volumes has been delayed yet again amid continued global trade headwinds. There remains considerable uncertainty about the strength of Chinese demand, and this has been compounded by recent concerns about the strength of the US recovery. Taiwanese industry has struggled against this background, with output down 3.9% down on a year earlier in January, while the 1.7% contraction in 21 marked the worst annual performance in the region. but outlook should start to improve soon However, there are signs that an improvement in external demand will soon emerge. We estimate that Chinese import volumes (Taiwan s main trading partner) surged.9% y/y in February after contracting 1.% y/y in January and we expect it to continue to grow at this rate throughout 216. This should ease the pressures on regional trade and help the export-oriented Taiwanese industry to regain some momentum by mid-216. Domestic fundamentals still trending up Consumer spending was the backbone of GDP growth last year, and the latest monthly data indicate that this strength has carried over into 216. Retail sales jumped 6.9% on the year in January, and consumer confidence also started to edge up again in February for the first time since April 21. Moreover, employment (+.8% y/y in January) and earnings (+.9% in December) are gradually increasing and their growth continues to outstrip core inflation (around.% in recent months). And the recent rebound in financial markets may provide another boost to confidence. The stock market has gained 14% since its January low, the strongest rise among major Asian stock markets during this period. Buoyant stock prices may be linked to the latest wave of monetary easing across major global economies, as well as fading fears over political risk that emerged after the China-critical DPP won the elections in January. Despite these positive factors, concerns over the lingering weakness in foreign demand (exports amounted to 6% of Taiwan s GDP in 21), and the risk that this spills over into the domestic economy, will likely prompt further monetary loosening (as the inflation outlook is not threatening). We expect the central bank to cut interest rates by 2bp to 1.37%. Taiwan: Exports by destination US$bn (seasonally adjusted) Taiwan: Contributions to GDP growth China & HK Rest of emerging Asia Source: Taiwan Ministry of Finance / Oxford Economics GDP F'cast -3 Net exports -6 Domestic demand US Europe Korea, Taiwan & Thailand: Industrial output 2=1 (seasonally adjusted) Korea Taiwan 8 7 Thailand Source: Haver Analytics / Oxford Economics 99

106 216 Taiwan Return to broad-based growth by end-216 The problems experienced during 21 should fade as Chinese import demand stabilises and steady growth in the US and EU spurs a recovery in world trade. Both exports and domestic demand should pick up in 216; we expect GDP to grow 1.7% this year and 2.8% in 217. External background should improve gradually after depressed 21 the slump in Chinese import volumes resulted in foreign demand weighted by Taiwanese export shares growing by just.4% in 21. However, this should pick up to 3% this year and 3.7% in 217. Rising wages and subdued inflation underpins purchasing power although the trend in employment flattened somewhat in H2 21, the labour market remains relatively tight. This, together with sizeable gains in productivity in 21-14, should ensure that wages continue to rise. Earnings grew by a strong 3% in both 214 and 21, translating into healthy real income gains as inflation is very low; we expect inflation of.4% in 216 after -.3% last year. Reasonable consumer confidence having reached a multi-year high in April 21, confidence fell steadily until February, but even after this slide it is still more positive than in 212 and 213. Spending is likely to grow at a solid pace as long as the external and financial backgrounds do not worsen significantly. Current account protection the annual external surplus will exceed US$8bn for some years, offering protection if capital flows are hit by external shocks. Turnaround in investment after falling sharply in H1 21, investment grew by 3% in H2. Provided world trade starts to improve in 216, we forecast that overall investment will rise steadily. However, as well as the possibility of external economic shocks, there is the downside risk from cooling political relations with China elections on 16 January saw the KMT lose decisively to the China-critical DPP. Poorly-handled political relations between China and Taiwan could greatly undermine trade, wider business confidence and tourism.. Taiwan: GDP, exports and world trade growth 3 2 F'cast World trade GDP -1 Total exports /Haver Analytics Taiwan: Prices and earnings Consumer prices Average earnings F'cast Taiwan: Current account % of GDP Visibles Current account Invisibles F'cast /Haver Analytics 1

107 216 Economic Background Thailand Thailand Highlights Highlights Thai GDP grew by a sub-trend 2.8% in 21. Moreover, activity has disappointed so far this year, while the downside risks are considerable, with very high levels of uncertainty about both the state of the world economy and domestic political developments. Economic activity moderated in January, with both consumer spending and manufacturing output dropping sharply on the month and private investment stagnating for the first time since June. In addition, wage growth continued to slow, while moving into February, consumer confidence dipped. And most notably, public spending decelerated in January after some expenditure was speeded up in Q4 to meet end-of-year deadlines, particularly on transport and irrigation projects. On the plus side, tourism arrivals were up 1% on the year in January. Moreover, the private sector will struggle to build much momentum this year as we expect global demand to improve only gradually. Exports in US$ terms continued to fall in January, down 8.9% on the year, and we expect them to fall by an average of 4.2% in the whole of 216. And if China were to slow more sharply than we currently expect, this would dampen Thailand s exports of both goods and services. In 21 China accounted for more than 1% of Thai goods exports and about 3% of tourists. Despite the risks, the lower oil import bill and strong tourism has sharply boosted Thailand s current account surplus, offering the baht some protection. Indeed, this may have helped the THB to appreciate during Q1 but we do not expect this trend to continue as domestic politics and more general EM worries are likely to weigh on investor confidence. Public spending should pick up after its slow start to 216 and private activity should also improve, with lower costs supporting profits and incomes. However, political tensions may escalate at any time given the unresolved divisions within Thai society. Moreover, a number of events could trigger such a development. The government has announced that there will be a referendum on the draft constitution in August, followed by elections next year. Meanwhile, the 88-year old king is very frail and his death could spark a dispute over the royal succession. And it is uncertain what will happen if the constitution is rejected, while any fair election will be fiercely contested. for Thailand (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Government Budget (% of GDP) Trade Balance ($bn) Current Account ($bn) Current Balance (% of GDP) Short-Term Interest Rate (%) Exchange Rate (Baht per US$)

108 216 Thailand Modest economic performance Public spending decelerated in January, having accelerated during Q4 21 to meet end-of-year deadlines (which in turn ensured solid quarterly GDP growth in that quarter). Meanwhile, goods exports continued to fall and private spending and investment also stuttered in January (having edged up modestly in H2 21). Tourism remained strong though and, notwithstanding its recent volatility, public spending should maintain a strong upward trend this year. and vulnerable to political developments Moreover, political risks remain high. In January a second draft of the new constitution was released after the first draft was rejected last September. A referendum is to be held on it in August prior to elections in 217 but it is far from guaranteed that it will be passed. The spokesman of the Constitution Drafting Committee has admitted there are no guidelines to determine what will happen if it is rejected; however, the Prime Minister has said elections will be held next year regardless. But even if a constitution can be agreed on and the elections can be held, there is no evidence that the underlying polarisation in Thai politics and society has been diminished. As a result, the election could re-ignite severe political tensions, as could a disputed royal succession. The King is 88 and in frail health, while his eldest son, the Crown Prince, is not nearly as popular. Political uncertainty will continue to weigh on domestic activity, constraining the strength of the recovery. Although public spending will provide a significant impetus and private activity is likely to pick up this year, the risks to growth are skewed to the downside notably the risk of a sharper slowdown in China, disruptive global financial markets and a possible deterioration in the political situation. Last month we downgraded our forecast for world GDP growth in 216 from 2.6% to 2.3%. However, a gradual improvement in import demand from China and the rest of Asia should nonetheless underpin slightly stronger regional trade this year than in 21. GDP growth of 3-3.% expected in While we forecast growth to pick up to 3.% in 216 and 3.4% in 217, this is well below the 3.8% pace seen in We see consumer spending growing steadily, albeit constrained by still low levels of confidence and a Thailand: Exports and imports Thailand: Quarterly contributions to GDP % quarterly contribution month moving average (US$) Exports Fixed investment Net exports Stockbuilding Q1 Q2 Q3 Q4 21 Source : Oxford Economics / Haver Analytics Thailand: GDP and consumer spending Consumer spending -3 Imports Source: Thailand Customs Department Private consumption Government consumption GDP GDP -1 F'cast

109 216 Thailand slowdown in nominal wage growth. In addition, goods exports should start to strengthen slightly as world trade improves, while tourism will continue to boost activity. Tourism boom to continue, but narrowly based arrivals rose by more than 2% last year and the government is targeting a record 32 million visitors this year, up 7.1% on 21. However, with almost a third of tourists now coming from China or Hong Kong, a sharper Chinese slowdown than we currently expect would hit the Thai tourism sector significantly. Planned rise in government spending the budget for the 21/16 fiscal year plans a 2% increase in public investment. A number of large projects are due to be started this year, but some planned by the previous government are still on hold. Private investment picking up but risks high private investment has trended upwards over the last twelve months. But, as has been the case for some time, the investment recovery will depend on the political situation staying calm; and this may not be enough to attract higher FDI inflows. Moreover, high levels of uncertainty about the state of the world economy may also deter investment. Monetary policy to remain supportive record-low interest rates are helping to promote recovery. With activity picking up and the BOT not wanting to spur even higher levels of household debt, we do not expect any more rate cuts. Nonetheless subdued domestic activity, fragile external demand and the need to maintain financial stability means that we do not expect the BOT to hike rates until Q Low oil price boosts consumers but wage growth modest deflation has boosted households purchasing power but wage growth has slowed and lower food prices have reduced rural incomes. Trade to recover, but only gradually after two years of stagnation, export volumes are expected to rise this year, albeit only by 2%. The risks are still on the downside Sharper Chinese slowdown a risk there is a small risk that China might slow sharply. Thailand would be very exposed through both services and goods trade. Political outlook could deteriorate rapidly with the referendum on the constitution in August, and elections scheduled for 217, unresolved political tensions are likely to become much more obvious. % Thailand: Government budget balance and debt % of GDP Government debt (RHS) % of GDP 4-4 Government balance (LHS) -6 F'cast Thailand: Monetary conditions Short-term interest rate Inflation Thailand: Stockmarket SET index F'cast Source: Stock Exchange of Thailand

110 216 Economic Background Turkey Turkey Highlights Highlights In 216, Turkey may yet again miss an opportunity to take advantage of favourable external conditions to rebalance its economy. The lower oil price environment is expected to last throughout the year, which will help sustain consumption as the main driver of growth. But rising domestic violence and an increasingly polarised political environment will also dampen confidence and investment, while regional and security risks will take a toll on tourism. We estimate that GDP grew by a relatively robust 3.7% in 21. Private consumption remained resilient despite an increase in domestic political turmoil, while strong government spending during the election cycle also helped to underpin growth. Lower oil prices and a large increase in the minimum wage will facilitate higher consumption in 216, which will continue to drive growth. But the economy will face significant headwinds this year and growth is likely to disappoint, moderating to 3.3%. Private investment will continue to falter, while the boost to the external accounts from lower oil prices will be offset by weaker tourism receipts. A rally in emerging market assets on the back of rising commodity prices and more accommodative monetary policy globally has helped the Turkish lira (TRY) strengthen to below 2.9 per US$. But we retain our cautious outlook on the TRY and expect it to weaken in the coming quarters. The easing of pressure on the lira has allowed the central bank (CBRT) to take some steps towards simplifying its monetary policy framework. At the final MPC meeting of his term in office, CBRT governor Basci unexpectedly cut the overnight lending rate by 2bp to 1.% but kept the main one-week repo rate steady at 7.%. We now think that the latter will be held throughout this year (previously we expected it to increase by 1bp during 216), notwithstanding the fact that inflation remains stubbornly high. The political and security outlook has deteriorated, with an intensifying domestic conflict with the Kurds and further attacks by IS. The AKP s victory in the November election has not led to a normalisation of political risk and, while still remote, the likelihood of early elections in the next months is slowly rising. This would undermine investor confidence. for Turkey (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Government Budget (% of GDP) Trade Balance ($bn) Current Account ($bn) Current Balance (% of GDP) Short-Term Interest Rates (%) Exchange Rate (Per US$)

111 216 Turkey Growth set to slow in 216 Despite the turbulent developments throughout 21, the economy managed to grow by an estimated 3.7% on the back of resilient private consumption and a surge in public spending during a year which saw two elections. But while consumption is likely to remain the main driver of growth, we expect strong headwinds to slow growth to 3.3% in 216. The 3% increase in the minimum wage that came in effect in January and lower oil prices will boost consumption and growth. But this will be offset by other factors. Domestically, the fact that the government continues to prioritise strengthening the presidency s executive powers means that a certain degree of uncertainty will continue to hang over economic policy. In addition, an increase in violence since the resumption of hostilities with the Kurds, combined with a number of attacks by IS, may start to sap confidence and dampen both private investment and tourism. A rally in commodity prices and more accommodative monetary policy by major central banks has helped boost risk appetite for EM assets, including the Turkish lira. This has given the CBRT some leeway to begin simplifying its monetary policy framework, cutting the overnight lending rate by 2bp. In signalling its easing bias, the CBRT seems to be expecting that the lira will remain relatively stable. But we think lira weakness will resume, contributing to inflationary pressures staying high. That being said, we now expect the main one-week repo rate to stay at 7.% this year, down from our previous call of it increasing by1bp in H despite robust consumption Our forecasts are influenced by the following factors: Consumption will be driver of growth despite months of political uncertainty and eroding purchasing power, consumption has held up surprisingly well. A 3% increase in the minimum wage came into effect at the start of this year; this will help boost consumption growth to 4.2% in 216, but will probably also raise inflation and lower productivity. Meanwhile, against a poor external background and more difficult financial conditions, investment and exports are likely to be sluggish, constraining overall growth in 216. Inflation will remain high this year inflation fell to 8.8% in February from its twenty-month high of 9.6% in January on the back of slowing food price growth. Core inflation, however, continued to rise, reaching Turkey: Contributions to GDP 1 GDP F'cast 1 - Net exports -1 Domestic demand Turkey: CBRT monetary policy framework % One-week repo (policy rate) Overnight borrowing rate 4 Overnight lending rate Overnight interbank rate (TRLIBOR) Weighted average cost of CBRT funding Source : Oxford Economics/Haver Analytics Turkey: Nonresidents' holding of assets $ billion TRY:USD Bonds Equity Average exchange rate (RHS) 3 Jan 14 Apr 14 Aug 14 Nov 14 Feb 1 Jun 1 Sep 1 Jan 16 Source : Oxford Economics/Haver Analytics, CBRT

112 216 Turkey 9.7%. We expect price pressures to persist during 216, driven by the minimum wage hike and the fulfilment of other election pledges to boost consumer spending, while lower oil prices will play a smaller mitigating role this year than in 21. Finally, our expectation of further lira weakness will keep up the pressure on inflation this year. Overall, we expect inflation to average 8.8% in 216, up from 7.7% in 21. Lira weakness to resume the Turkish lira (TRY) has recently strengthened to below 2.9 per US$, helped by a rally in emerging market assets on the back of rising commodity prices and accommodative monetary policy globally. The currency has also benefited from domestic factors, with Moody s affirmation of its credit rating and the prospect of closer cooperation with the EU (resulting from the migration crisis). However, we expect that the lira will weaken during the rest of 216, given the ongoing political and security risks, and the uncertainty around the monetary policy outlook after the current CBRT governor s term expires in April. But central bank signals shift towards easing the CBRT has taken advantage of the increased risk appetite for the lira in recent weeks to (unexpectedly) cut the overnight lending rate by 2bp at its March meeting, reducing it to 1.%. But it kept its main oneweek repo rate steady at 7.%, signalling that it sees TRY stability as an opportunity for simplifying monetary policy. In our opinion, it now seems quite likely that the CBRT will keep the repo rate at 7.% throughout this year, whereas we had previously expected some tightening in H2. Such a stance would do little to restore the CBRT s credibility, as inflation is likely to remain high this year, far above the % target. Lower tourism revenues to block further current account improvement the current account deficit narrowed to 4.% of GDP in 21 from.4% in 214, driven by a US$1bn reduction in Turkey s net oil imports. Lower oil prices will keep the current account deficit below % of GDP in 216, but improvements in the non-oil component will be limited. We expect tourism receipts, which are an important contributor to the current account, to decline, while stronger consumption will cause import growth to outpace exports. Turkey: Inflation to remain high % change, y/y Headline Core Source : Oxford Economics/Haver Analytics Turkey: Central bank policy rate and inflation % 12 One-week repo rate Inflation Source : Oxford Economics/Haver Analytics Turkey: Current account balance $ billion, 3mma, sa Current account bal. net Energy Source : Oxford Economics/Haver Analytics 16

113 216 Economic Background United Kingdom United Kingdom Highlights The second estimate for quarterly GDP growth in Q4 21 was unrevised at.%. This came as a pleasant surprise since the weaker monthly production and construction data had flagged the possibility of a downgrade. That said, the Q4 outturn completed a year of sub-par growth which was particularly disappointing given the extent of the support from low inflation. Looking at the components of demand, it is clear that the weak link has been the external sector, with net trade having exerted a drag of.ppt on GDP growth in 21. The Prime Minister has announced that the referendum on the UK s membership of the EU will be held on 23 June. The announcement was preceded by Mr Cameron s renegotiation of the terms of the UK s membership. Though he claimed this gave the UK a special status within the EU, in our view the reforms were pretty small scale and we do not expect them to have a material impact on the UK s relationship with the EU. Our baseline forecast assumes that the UK remains a member of the EU. Though the referendum date had been strongly rumoured for several weeks, and therefore should have been largely priced in, markets reacted nervously with the pound sinking to a seven-year low against the dollar in the week after the referendum date was announced. However, sterling has since regained virtually all of its post-announcement losses and, provided that the remain camp maintain their lead in the opinion polls, sterling should remain resilient to Brexit uncertainty. We have modelled an alternative scenario which sees the UK vote to leave the EU. Market pricing suggests that this scenario could trigger a depreciation of sterling in the region of 1%, which would temporarily push up inflation and squeeze household spending power. The uncertainty around the UK s future relationship with the EU would also dent corporate confidence. Our modelling suggests that the level of GDP could be around 1.3pp lower by Q2 218 the likely end date for the UK s exit negotiations compared with our baseline forecast. for UK (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production CPI Current Balance (% of GDP) Government Budget (% of GDP) Short-Term Interest Rates (%) Long-Term Interest Rates (%) Exchange Rate (US$ per ) Exchange Rate (Euro per )

114 216 United Kingdom for GDP growth nudged down We have revised down our forecasts of GDP growth for this year and next to 2.% and 2.3% respectively. The downgrades reflect the heightened uncertainty caused by the recent financial market turbulence and the upcoming referendum on the UK s membership of the EU, as well as evidence of softer global growth. We expect the first interest rate hike to come in Q2 217, with the risks skewed towards a later move. on increased uncertainty at home & abroad The second estimate of quarterly GDP growth for Q4 21 was unrevised at.%, with early survey evidence for Q1 216 pointing to that sub-par pace of growth being maintained into the New Year. We expect domestic demand to remain the dominant driver of UK growth this year, though the drag from net trade should lessen as the impact of the recent depreciation of the pound filters through. The key drivers of our forecast are: Further improvements in household spending power in the short-term CPI inflation remained close to zero throughout 21. While it should steadily rise through 216, as the base effects associated with the collapse in the oil price last year kick in, the scale of the pickup will be muted by the renewed fall in oil prices over the past couple of months, the recent price cuts announced by domestic gas suppliers and by the weakness of core inflationary pressures. As such, we expect CPI inflation to average just.% in 216. When combined with stronger wage growth, as a result of a tightening labour market, consumers should continue to enjoy improvements in their spending power through this year, albeit at a slightly more measured pace than in 21. But the government s plans to reduce welfare spending by around 12bn by will increasingly weigh on household incomes, more than offsetting the boost from the introduction of the national living wage. As a result, consumer spending growth is forecast to slow from 3% in 21 to average just 2% a year from Robust investment, once uncertainty has cleared business investment has grown much faster than the wider economy over the past couple of years, despite firms continuing to run sizeable financial surpluses. The financial position of firms remains UK: Real GDP %q/q q/q (LHS) y/y (RHS) Source : Haver Analytics UK: Consumer spending and income Consumer spending UK: Business investment and GDP - Real disposable income GDP Business investment %y/y

115 216 United Kingdom very healthy and should promote strong business investment growth. However, we expect heightened uncertainty, both at home and abroad, to result in a softer patch in H As a result, business investment growth is set to slow from 4.8% in 21 to 3.2% this year, before accelerating again to 6.% in 217. Subdued export outlook there are major question marks over the quality of the official trade data; it has shown substantial volatility and reported movements in the real and price data which are hard to reconcile. The business surveys suggest that exporters are continuing to struggle, with sterling s appreciation against the euro during 21 often cited as a constraint. UK: Exchange rates 2.2 US$/ Euro/ 1.2 The outlook is mixed. On one hand, we expect the pound to fall by more than 6% on a trade-weighted basis in 216, which will offer a much needed boost to competitiveness. But the support from this source will be offset by the impact of disappointing global growth. And with firm consumer demand underpinning sustained growth in imports, we expect net trade to remain a drag on GDP growth in 216. Further austerity on top of the cuts to welfare spending mentioned above, tax rises and cuts to departmental spending will see fiscal policy continue to drag on growth prospects over the next few years. The Office for Budget Responsibility estimates that fiscal tightening will exert an average drag of.9% a year on GDP growth until In our view, there are significant question marks over whether the planned budget surplus will actually be achieved. First rise in Bank Rate to come in Q2 217 Financial market pricing currently suggests that interest rates will not rise for another four years, a major shift compared with the expectation at the start of this year of a rate hike in summer 216. This appears to be a reflection of the markets perception about the balance of risks, given that it is difficult to find any hard evidence on the real economy which would warrant such an extreme shift. The MPC s forecasts in the February Inflation Report were consistent with a first move before H2 217 and we see Q2 217 as being the most likely timing for the first hike. A number of the downside risks would need to play out for the first move to come as late as markets currently anticipate UK: Contributions to GDP growth %pts UK: Interest rates % Source : Oxford Economics Source : Oxford Economics Consumer spending Govt. consumption Net trade year gilt yield Bank Rate Inventories 19

116 216 Economic Background United States United States Highlights Real GDP grew 1.% (saar) in Q4 21 with final sales up 1.2% and inventories subtracting.1pp from growth. Net trade and weak business investment were major drags on economic activity while consumer spending advanced moderately. Payroll growth rebounded in February with the economy adding 242, jobs, the unemployment rate remaining at a low 4.9% and the participation rate rising to 62.9%. Unfortunately, wage growth slipped back to a modest 2.2% y/y pace. We continue to expect, however, that reduced labour market slack will support stronger wage growth. Real disposable income growth remains solid, up 2.8% y/y in January, and supportive of solid consumer spending, up 2.9% y/y. We see these trends remaining in place through most of 216 with average consumer spending growth just shy of 3%. Housing activity should also maintain a steady pace supported by strong income growth and generally affordable conditions. Housing supply is a constraint, but increased construction should alleviate some of the lack of inventory. Residential investment is expected to add.3pp to GDP in 216. Core durable goods shipments remain depressed, and point to ongoing weakness in business investment, expected to grow around 2% this year. The strong dollar and weak global demand environment will continue to weigh on business spending and net trade which will subtract.1pp from GDP growth in 216. Inflation is rebounding on a combination of base effects and resilient domestic activity. We expect it will abate in mid-year before rebounding later in the year. We see annual headline and core PCE inflation at 1.3% and 1.7% this year. Reflecting more modest import momentum, we revise our 216 GDP growth forecast up.1pp to 2.1%. Growth in 217 is revised down a tick to 2.4% on weaker net exports and investment. We believe the Fed will wait until September to raise rates 2 basis points and we see at most two rate hikes in 216 and three in 217. for US (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Stockbuilding (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Current Balance (% of GDP) Government Budget (% of GDP) Short-Term Interest Rates (%) Long-Term Interest Rates (%) Exchange Rate (US$ per Euro) Exchange Rate (Yen per US$)

117 216 United States Modest momentum into 216 Real GDP growth was revised up to 1.% in Q4 21 with final sales rising 1.2% and inventories shaving.1pp from growth. Consumer spending advanced modestly, up 2.%, while residential investment capped off a strong year with a 7.9% advance. The major drags on growth came from net trade and business investment. We revised our 216 GDP up a tick to 2.1% while 217 growth was shaved to 2.4% on weaker net exports and business investment. The picture remains one of solid domestic fundamentals constrained by global headwinds. as global headwinds deter activity A strong dollar, sluggish global growth and reduced oil and gas investment will continue to constrain activity. Domestically, however, strong income growth should support robust spending and housing activity while the Fed will tighten policy only very gradually. Key forecast drivers include: Solid labor market gains nonfarm payrolls rose 242, in February, while the unemployment rate fell to 4.9%, the participation rate rose to 62.9% and wage growth slipped to 2.2% y/y. Stronger consumer spending boosted by buoyant private sector confidence, steady increases in employment and faster wage growth, consumer spending growth should average 2.6% in Financial conditions financial market strains will weigh on confidence and marginally affect the momentum in private sector outlays. Business investment constrained business investment will remain constrained by the strong US dollar, weak global growth and depressed oil prices. Accelerating housing activity the confluence of low mortgage rates, reduced home price inflation and stronger wage growth should support housing activity. We see residential investment contributing.3pp to overall growth in 216. Low inflation for now the Fed s favored inflation gauge remains well below the 2% inflation target. However, strengthening activity and base effects should push inflation closer to 2% during 216. Sluggish global trade we see US exports picking up modestly in 216, albeit they will continue to be hindered by the strong dollar and weak global growth. 111