1h 2017: global macro outlook - market securities 2017... · according to factset, after dropping...

1H 2017: Global Macro Outlook

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1. U.S. GDP Should Be Above Potential This Year

We see the U.S. growth rate rising to a 2.5%-3.0% range in 2017 following the slowdown experienced in 2016 (1.6%e vs 2.6% in 2015). Helped by the strong markets’ reaction to the Presidential election, the improvement should be sustained by:

1. The normalisation effects (oil prices rebound, exit from earnings recession, end of inventory correction and global growth acceleration).

2. The positive momentum in 2H 2016 (recovery in business investment and resilient consumer spending amid higher loan growth).

3. The potential stimulus from a Trump White House and a Republican-led Congress (repatriation of overseas cash, deregulation, tax reductions, defence and infrastructure spending).

At the opposite, trade balance is likely to be a drag as the dollar index has gained more than 6% since early September while a Trump protectionist policy (at least for several sectors) could lead to retaliations.

2016 was marked by political uncertainties around the Brexit and above all the U.S. Presidential election, which, in a context of declining profits (S&P Earnings growth rate was negative YoY from 2Q 2015 to 2Q 2016) and global slowdown (3.1%e in 2016 vs 3.2% in 2015), hurt business investment and inventories. In addition, oil exploration and production contracted sharply in 1H 2016 due to the drop in oil prices while public spending remained contained.

These factors explain why 2016 GDP growth is expected to be the weakest since 2011. Fortunately, most of these factors are transitory, some will disappear and other will reverse, supporting an above average trend* in 2017.

Global Growth Is Likely To Rebound In 2017…

*On average, U.S. GDP reached 2.2% from 2010 to 2015.

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The election result has been perceived positively by companies as suggested by recent surveys such as the Business Roundtable CEO Economic Outlook Index (highest since 2Q 2015) or the Duke CFO Optimism Index (highest level in nearly a decade). Moreover, in December 2016, the NFIB Small Business Optimism Index reached its highest level since December 2004. According to NFIB, the November index was basically unchanged from October up to the day of the election and then rose dramatically after the election results were known. As a consequence, private domestic investment should accelerate next year (especially from 2Q 2017 after more clarity on tax reform).

This scenario is also supported by the recent rebound in oil prices. The latter has already induced the oil rig count to increase by more than 70% since May 27th, which will stimulate Fixed Investment in Structures Mining.

Sources: Bloomberg, Market Securities


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Meanwhile, the recent exit from an earnings recession will also be a positive factor for Private Domestic Investment. According to Factset, after dropping from 2Q 2015 to 2Q 2016, S&P earnings are likely to rise YoY in both 3Q 2016 (+3.3%) and 4Q 2016 (+3.4%e). Over the year, they are expected to remain almost unchanged (+0.2%e) but they should rebound significantly in 2017 (+11.4%e). In the meantime, BEA data already showed that, on a YoY basis, in 3Q 2016, total Corporate Profits After Tax (without IVA and CCAdj) rebounded for the first time in six quarters.

The exit from the earnings recession is likely to correspond to the end of the inventory correction, which weighed heavily on GDP between 2Q 2015 and 2Q 2016.

Sources: Factset, BEA, Bloomberg, Market Securities


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Also on the positive side, according to the latest FDIC report, banks kept posting strong growth in lending, led by commercial real estate and residential mortgages. In 3Q 2016, total loans and leases rose 6.8% YoY, which was close to a 8-year high.

Separately, Donald Trump also unleashed consumer animal spirits. In December 2016, the Conference Board Consumer Confidence Index reached its highest level since August 2001 while the University of Michigan said its monthly index of consumer sentiment rose to the highest level since January 2004.

Sources: FDIC, Bloomberg, Market Securities


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Households will remain the key driver of growth amid a further drop in the unemployment rate and rising wages. According to our forecasts, average hourly earnings of Production and Non-Supervisory Employees (Private) should converge towards 3% by the end of 2017 (vs 2.4% by the end of 2016).

Finally, Trump’s economic policies could support growth through different means such as the repatriation of overseas cash, deregulation, tax reductions for companies and households (likely in 1H 2017 with potential retroactive effects), defence (1H 2017) and infrastructure spending (2H 2017 at the earliest but 1H 2018 seems more likely).



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2. Eurozone Growth Should Be Resilient Despite National Elections

The Eurozone’s recovery is gaining traction helped by a strong industry sector. Industrial production in November 2016 surprised positively and this trend is common across top European economies as the latest data from France, Italy and Spain were particularly upbeat. The manufacturing activity is likely to be well oriented in 2017 according to the latest purchasing managers surveys. Eurozone Markit Manufacturing PMI ended 2016 with positive momentum, standing at 54.9, its best reading since April 2011. Faster growth of production and new orders were observed in six out of the seven nations covered by the survey.

Services are also on a good path and companies linked higher levels of business activity to a combination of solid inflows of new orders and rising backlogs of work (seven successive months). All in all, optimism is broad-based from business to households as measured by the Eurozone Economic sentiment which reached its highest level in more than four years.

Sources: Bloomberg, Markit, Market Securities,


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The credit dynamic will also support growth. The recovery of loan growth ticked up in 4Q 2016 and is likely to regain momentum early this year. Credit to non-financial corporations are especially well oriented and this should help companies to develop their businesses. As a matter of fact, according to the latest SAFE survey, small and medium enterprises reported an overall improvement in their financial situation and in the availability of external sources of finance. Indeed, “Access to finance” was considered the least important concern for euro area SMEs.

ECB’s accommodative monetary policy is continuing to pass through to borrowing conditions for households and companies. According to the latest ECB banking survey, overall credit conditions will remain very supportive in 1Q 2017.

Sources: Bloomberg, Market Securities, Markit


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On the other hand, national elections will bring uncertainties in the Eurozone. Elections are scheduled in the Netherlands, France, and Germany. Following the “no vote” to Matteo Renzi’s referendum, an Italian general election is also possible as soon as this spring. Moreover, the U.K is expected to trigger Article 50 by the end of March which could lead to turbulences within the European Union. Negotiations will be long and market reactions could be more significant once the exit process has started.

However, there is no risk per se in the short term, but this will induce political uncertainty which is never welcomed by financial markets. In this context, the euro is likely to weaken especially against the dollar as suggested by the interest rate differential of the U.S. Treasury relative to the German Bund. This should improve further Eurozone countries’ trade balances.


European Political Calendar 2017

15 March Dutch general election

31 March UK government intended date to trigger Article 50

23 April & 7 May French presidential election (1st and 2nd round)

7 May German state election in Schleswig-Holstein

14 May German state election in North Rhine-Westphalia

11 & 18 June French parliamentary election

24 September German Federal election


10 Sources: Bloomberg, CPB, Market Securities

3. Global Trade Will No Longer Be A Drag

According to our estimates, global trade in value (USD) is likely to decrease by 4% in 2016 (vs -11.7% in 2015). It will be the first time on record (1991) that global trade falls for two consecutive years. The phenomenom can be explained by the significant drop in oil prices, the rebound in the USD, the slowdown in global growth and to a lesser extent, the implementation of protectionist measures. As a matter of fact, G20 members introduced more than 1,200 trade control measures over the last five years.

Global Growth Is Likely to Rebound in 2017…

Acceleration

Contraction

Longest losing streak

11 Sources: Bloomberg, CPB, Market Securities

However, global trade in value (USD) should rebound this year amid a sharp rebound in oil prices and a global growth rebound. The rebound in oil prices will help some emerging economies such as Brazil or Russia to normalize. Coupled with the acceleration in the U.S. and the resilience in the Eurozone, global growth should reach 3.4% (first increase since 2014 and up from 3.1%e in 2016).

Even if global monetary policy is likely to be less accommodative (U.S., Eurozone, China, etc.), fiscal policy should contribute positively to global growth for the first time since 2010. Excluding the potential stimulus from the U.S., Japan has already announced a fiscal stimulus package amounting to around 1.5% of GDP (spent over the current and the next fiscal year.) China reiterated its willingness to increase spending in order to stabilize growth while the European Commission has recommended a positive fiscal stance to support the recovery.


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1. China Will Face Another Slowdown In 2017

After being one of the major support in 2016, the real estate sector will become a drag in 2017 as officials try curb credit growth and housing bubble.

• For several quarters, the accommodative monetary policy has fueled growth in the real estate sector. Investors, shaken by the summer crash of the stock markets in 2015, have chosen to pile more money into housing, especially in a context where savings are remunerated at only 1.5% (down from 3.5% in May 2012). As a consequence, growth in real estate has sharply accelerated and has outpaced total growth since 1Q 2016. For the last ten years, this phenomenon never exceeded four consecutive quarters.


...But Several Headwinds Will Persist

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• This move has contributed to a sharp rise in credit growth. According to Fitch, new mortgages of CNY2.2Trn accounted for 45% of the increase in total loans at 14 rated Chinese banks in 2015 (vs 25% in 2014). According to Reuters, at the end of 2015, China's top five banks’ exposure to the housing sector exceeded 40% on their books, up from about 26% seven years ago.

• PBoC data shows this trend gained traction in 2016 as the percentage of new long term loans to households (used as a proxy for new mortgage loans) surpassed 50% in 2016. Therefore, new home prices rose more than 30% YoY among some tier-1 cities. In reaction, in 1Q 2016, top-cities (Shanghai, Shenzhen, Beijing, etc.) started to take restrictive measures to rein in increasing house prices but they appear to have encouraged a rush to buy in neighboring cities (tier-2, tier-3 cities).



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New Yuan Loans: % of Long Term Loans to Households (Proxy for Housing)12-month moving average

14 Sources: Bloomberg, National Bureau of Statistics of China , Market Securities

• In a context where housing frenzy has spread to smaller towns, at least 22 cities (including all tier-one cities) have come up with new property curbs in 4Q 2016.


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• Housing market cooling measures differ from one city to another but most of them include purchase restrictions on the number of properties and raising mortgage down-payments,

• In the meantime, property developers and intermediaries are also under scrutiny. According to the ministry, 45 real estate developers and intermediaries were investigated and punished for encouraging housing price speculation through false advertisements and breaking pre-sale rules.

• Separately, several bank executives told Caixin that managers from 17 banks, including the state-owned, attended a meeting in 4Q where the PBoC demanded that banks rein in granting home loans. In Shanghai, authorities reportedly asked some banks to limit loans to property developers for land purchases, the Shanghai Daily reported.

Key Measures taken during the Golden Week

Home-Purchase Bans Down-Payment Requirement

+13 new municipalities imposed home-purchase bans +4 municipalities increased restrictions

+18 cities tightened down-payment requirements

3rd home purchase is not allowed in most cities Mortgage banned for 3rd home purchase in most cities

1st home purchase: non-resident have to provide from 1 to 5 year social security

2nd home purchase: banned for non-resident in many cities

1st home purchase: most cities imposed 30% (50% in Shenzhen the highest in the country)

2nd home purchase: from 30% to 80% (most cities imposed

40%-50%)


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• As a consequence, PBoC data highlights that new home mortgage loans in Shanghai reached CNY15.5BK in December (down 25% YoY and lowest level in 14 months).

• Meanwhile, the floor of space of residential buildings sold (YTD) rose only 22.4% YoY in December (12-month low), down from 24.5% in November. NBS data shows that the serie reached a top in April 2016. Based on historical relationship, it should be followed by a slowdown in prices increase no later than March 2017 (see table below).

Sources: Bloomberg, National Bureau of Statistics of China, Market Securities

Floor of Space (High) Prices Increase (High) Lag in months

Sep. 2007 Feb. 2008 5

Nov. 2009 Apr. 2010 5

Feb. 2013 Dec. 2013 10

Apr. 2016 [Dec. 2016* - Feb. 2017]e [8 - 10]e

*Data shows prices increase accelerated in Oct., Nov. and stabilized in Dec.


5 10

? 5

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The problem of overcapacity is not resolved yet. In line with Xi Jinping strategy, Chinese officials decided to support a more qualitative growth model based on domestic consumption and services instead of relying on massive investments and manufacturing sector. This change, which implies a lower growth target, has occurred sooner than expected to the extent that manufacturing demand has faced significant headwinds. In the meantime, air pollution has become a major issue and China has no choice but to cut overcapacity while exporting a part of its commodity production.

• The global economic environment has made manufacturers’ life more complicated as world growth slowed from 5.4% in 2010 to just 3.1%e in 2016. Those in China have arguably been the most severely affected given the country’s status as the workshop of the world.

• Wages in the manufacturing sector rose sharply (they were multiplied by 10 in the last 20 years). This has resulted in a lack of competitiveness compared to other Asian countries and significant capital outflows. Most multinationals that produce labour-intensive goods, such as textiles and apparels, are actively seeking to diversify beyond China to reduce costs but also to mitigate political and supply-chain risks.

• According to McKinsey research, “by 2020, the income of more than half of China’s urban households will catapult them into the upper middle class, a category that barely existed in China in 2000. The members of this group already demand innovative products that require engineering and manufacturing capabilities that many local producers do not yet adequately possess”.

• As previously discussed, growth in the real estate sector is likely to slow in 2017, weighing negatively on basic materials.


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• All in all, the centrally-planned model was built for demand growth that hasn’t come through. This bad resource-allocation decision has led to excess capacity and even “saturation” in several sectors. Facing significant losses, private companies slowed their Capex (from more than 20% YoY in 2014 to just 3% recently).

• At the opposite, despite losing money, state-owned companies kept on investing to avoid a jump in the unemployment rate and social tensions. However, this situation is not sustainable and should normalize with a slowdown in public investment.



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A composite of 365 images taken by photographer Zou Yi for CNN from his home in Beijing in 2015


• In the meantime, air pollution has become a major issue as coal was still responsible for more than 60% of China's total energy consumption. The Berkeley Earth researchers said that “air pollution kills about 4,000 people every day, about 17% of all deaths in China”, but added that connecting mortality to pollution was "complicated".

• According to analysts, China's coal overcapacity may be trimmed but remain a problem by the end of 2020. While the NDRC aims to cut 800 million tons of outdated production capacity in 2016-20, with another 500 million tons to be upgraded. Though that will lift efficiency, the reduction in possible output cut isn't enough to remove the existing glut of about 2 billion tons of coal and solve the problem of air pollution.

Sources: Bloomberg, China Coal Ressources, CNN, Market Securities

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Tightening monetary policy and regulation should cool traditional financing and shadow banking. Five elements suggest that credit growth will slow in 2017:

1. Officials made it harder for real estate developers to sell bonds.

2. Officials drafted rules to limit P2P lending and clean the online financial sector.

3. Banks face more curbs on selling wealth management products.

4. PBoC has tightened monetary conditions, pushing short term rates higher.

5. Adverse financial conditions have spurred widespread cancellation of corporate bonds issues.

• With inflation pressure set to rise, leaders are less open to an accommodative monetary policy as they seek to reduce risks. In December, Xi and his top economic policy lieutenants pledged to make preventing and controlling financial risk to avoid asset bubbles a top priority for 2017. They also said they plan prudent and neutral monetary policy.

• In 2Q 2016, a front-page article in the People’s Daily – the official paper of China’s Communist Party – already highlighted the dangers of supporting short term growth with ever-increasing leverage.

• In 4Q 2016, the PBOC cut language from its quarterly statement saying it would reduce lending costs. That means the interest rate easing cycle that began in November 2014 and saw six cuts by October 2015 is probably over.


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• The main problem of China is that according to the BIS, the country’s core debt (total credit to the non-financial sector) has ballooned to more than 250% of GDP. The move was due to Beijing’s repeated use of cheap credit to stimulate slowing growth, unleashing a massive, debt-fuelled spending binge. More concerning is that since several quarters, the pace of increase has accelerated to 20% a year.

• In the meantime, total debt for Chinese developers (data compiled on 196 listed companies) has risen very fast, tripling in only four years. As a consequence, in 4Q 2016, the regulator introduced rules to tighten property bond sales. Shanghai Stock Exchange suspended bond raising applications from developers that would be disqualified from issuing corporate debt under new guidelines. Under the rules being considered, the exchange would only accept note-offering applications from developers rated AA or higher. Firms would also need to meet at least one of the following requirements: be listed either onshore or offshore; be owned by a province, a provincial capital, some major city or the central government; or be among the top 100 builders ranked by the China Real Estate Association.


Sources: BIS, Bloomberg (data compiled on 196 –listed companies), Market Securities

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• New regulations aimed at shadow banking activity were set to weigh on credit creation. In 2Q 2016, the Chinese government implemented rules to limit P2P lending and clean the online financial sector.

• Starting this quarter (1Q 2017), the PBOC is including wealth management products held off bank balance sheets in its framework for assessing risks and credit expansion for lenders. This will limit WMP expansion and worsen lenders’ liability shortage. According to the China Central Depository & Clearing Co. Ltd, the outstanding balance of WMPs reached CNY26.3Trn ($3.8Trn) at the end of the first half of 2016.

• Since 4Q 2016, the PBOC has been allowing a steady increase in money-market rates (selective tightening) to squeeze leverage in the bond market. In December 2016, as borrowing costs soar, firms canceled or postponed bond selling, dragging total issuance sharply lower. Over this period, according to the PBoC, the net financing of corporate bonds turned negative, reaching the lowest level on record.



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More default incidents and a rise of bad loans should happen (especially in the housing sector), likely leading to financial turbulences.

• According to Bloomberg, about 29 notes defaulted last year, up from seven in 2015. For homebuilders, 2017 could be the year that the borrowing binge finally catches up with them. The median total debt for Chinese developers (data compiled on 196 listed companies) jumped to 8 times earnings before interest, taxes, depreciation and amortization (EBITDA) from 4.9 in 2010. More worrying, the average Total Debt/EBITDA soared to 45.4, quadrupling in only two years. This means that half of the companies are very far from the median Debt/EBITDA ratio, implying that a batch of them are deeply indebted.

• According to Bloomberg, the curbs (tougher regulation and a rise in borrowing rates) couldn’t have come at a worse time, with a record $18.4 billion of developer bonds due in 2017, $30.5 billion in 2018 and $57.3 billion in 2020.

Sources: Bloomberg (data compiled on 196 –listed companies), Market Securities


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• The amount of NPLs has already ballooned in the past several years, rising to CNY1.4Trn in 2016 from about CNY400Bn in 2011. The NPL ratio reached 1.76% in Q3 but the situation could be even worse as Chinese banks’ definition of NPL is more flexible than their peers in Western countries (see table below).

• In addition, according to Bloomberg, debt of listed companies with insufficient earnings to cover their interest payments accounted for as much as 14% of the total debt of all listed companies in 2015. That points to more write-offs in the pipeline.

Sources: Bloomberg, Pwc (citing CBRC provisioning rules), Market Securities

Western banking « norm »

China

NPL when:

• Loans are more than 90 days past due

• Loans are less than 90

days past due but there are other warning signs

• Loss given default is

not a factor in assessment

• The borrower cannot repay the loan and (even after considering the collateral value) there may be a loss

• Loans more than 3

months past due are « usually » an NPL only when a bank expect a loss


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In order to counterbalance downside pressures on FX reserves and economic growth, Chinese officials should implement measures to attract foreign investment, limit outflows and increase public spending. Nevertheless, public support could be lower than several economists expect as public spending already increased significantly in 2016 and capital flight is burning FX reserves. Therefore, after rising every year since 2012, public deficit target could be unchanged compared to 2016.

• Latest figures show China's foreign exchange reserves fell for a sixth straight month in December 2016 to the lowest since February 2011 as authorities stepped in to support the yuan despite massive capital outflows. While several investors just want to invest overseas in order to diversify their portfolio, others expect the Yuan to devalue as Chinese growth is subjected to significant downside risks and China-US policy differential has diminished.

Sources: Bloomberg , Market Securities


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• In this context, in late 2016, officials implemented restrictions on buying insurance products in Hong Kong, limiting overseas acquisitions and investments, and demanding more details from citizens when converting their annual quota into foreign exchange.

• In January 2017, China released plans to relax restrictions on foreign investment for different sectors (finance, oil, gas, etc.) and make it easier for overseas companies to list on domestic markets. In the meantime, China has halted leveraged trading in bitcoins after the PBOC found that the platform BTCC in Shanghai provided shadow financing to investors.

• Given the risk of financial turbulences and ongoing expectations of a strong USDCNH, these measures do not seem sufficient. In 2017, we believe that authorities will try to avoid another one-off devaluation coupled with the launch of a floating exchange rate. As a consequence, we would not be surprised if authorities add new restrictions:

1. Policy makers are likely to require more reporting from bitcoin exchanges and incorporate their flows into the monitoring of citizens’ annual $50,000 quota to buy foreign exchange.

2. China’s cash exodus has been partly driven by an increase in financial institutions’ overseas assets. Policy makers can probably discourage state banks from building up foreign assets and encourage lenders to issue more dollar-dominated debt offshore. Then, banks could convert such funds raised overseas into yuan with the PBoC, helping to boost the central bank’s foreign-currency reserves.

3. Policy makers are likely to require more reporting from bitcoin exchanges and incorporate their flows into the monitoring of citizens’ annual $50,000 quota to buy foreign exchange.

4. The biggest move authorities can make would be to force exporters to sell their foreign-exchange proceeds.

5. The currency regulator said in March last year that China was considering imposing a tax on foreign-exchange trading to limit capital outflows. The PBoC has already drafted rules for such a measure, people familiar with the matter told Bloomberg News that same month. However, . A so-called Tobin tax would complicate plans by China to boost the yuan’s global role and could undermine the leadership’s pledge to increase the role of market forces in the world’s second-largest economy.



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• Separately, like in 2016, Chinese government is likely to support activity through public spending, especially the year where the 19th National Congress of the Communist Party of China (CPC) will be held (autumn 2017). The party delegates at the congress will elect the new leadership of the CPC, including the Central Committee and alternate members of the Central Commission for Discipline Inspection. During the meeting of new Central Committee, the elections of General Secretary, Politburo, Politburo Standing Committee (top decision-making body) and Central Military Commission will be held.

• However, the pace of increase is unlikely to accelerate compared to 2016 where infrastructures’ spending kept rising (+9.5%), exceeding $1.7Trn. As a comparison, President-elect Donald Trump has proposed spending up to $1Trn over a decade to make America's infrastructure "second to none."



Autumn 2017 March 2017

The National

People’s Congress

GDP, Deficit, M2 Targets

7th Plenum of the 18th Party’s Congress

19th Party ’s Congress

Election of the new Leadership of the CPC

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2. Oil Prices Should Remain Contained

In November 2016, OPEC has agreed its first oil output cuts since 2008 in order to lower massive inventories. Members of the cartel agreed in Algeria to reduce output by around 1.2M bpd to ~32.5M bpd from January 2017. Libya is exempt from the OPEC agreement, Indonesia is temporary suspended from OPEC and Iran is the only state allowed to increase production.

Non-OPEC producers are also expected to cut output by about 558K bpd. As of the beginning of 2017, OPEC members reportedly complied with production cuts as promised and Russia has already cut production by 100K in January according to two sources cited by Reuters. A Control committee headed by Kuwait has been set up for monitoring the agreement. The committee also includes four other energy ministers which are Venezuela and Algeria from OPEC and Russia and Oman from the non-OPEC side.

Sources: Bloomberg, Reuters, MNI, Market Securities

…But Several Headwinds Will Persist

OPEC Production Target Cut in Thousands bpd Non-Production Target Cut in Thousands bpd

Saudi Arabia 486 Russia 300

Iraq 210 Mexico 100

UAE 139 Azerbaijan 40

Kuwait 131 Oman 35

Venezuela 95 Kazakhstan 20

Angola 78 Malaysia 20

Algeria 50 Bahrain 12

Qatar 30 Guinea 12

Ecuador 26 South Sudan 8

Gabon 9

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However, positive impacts from oil OPEC deal could be capped by U.S. shale production. The recent rebound in U.S. rig count (>65.0% since May 2016) suggests that U.S. oil producers increased investments and restarted production. Profits of U.S. shale gas companies have climbed with WTI price above 50$. As an example, according to consultancy Rystad Energy, the breakeven cost per barrel, on average, to produce Bakken shale at the wellhead has fallen to $29.44 in 2016 from $59.03 in 2014.

Moreover, according to Reuters, banks extended credit line to U.S. shale drillers for the first time in two years. This should result in more spending on exploration and production as shale producers are looking to increase market shares amid oil price recovery. In its latest STEO reports of January, EIA forecasts U.S crude oil production to rise to 9.0 million bpd in 2017 as production should rise from increasing drilling activity, rig efficiency and and well-level productivity.



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Many analysts are sceptical about the complete compliance to the OPEC deal and there are also doubts whether the overall cuts will be enough to rebalance the market. As an example, Saudi Arabia is facing a “twin deficit” (fiscal and current account deficits) which adds pressure on its foreign assets (down 28% since August 2014). In the meantime, the Kingdom is losing market shares in China while its GDP growth eased. Therefore, the Kingdom could be tempted to not fully implement the deal especially if others do not deliver.

Separately, Iraq will probably be facing problems in implementing the deal since the country is not completely in control of its own production. It has contractual commitments it has made with international oil companies that require the government to compensate drillers when production is cut by the government. Moreover, the cash-strapped country lost control over the north of the country which is in the Kurdish’s hands who are not willing to cooperate.

Elsewhere, countries that are financed in dollar could be forced to produce more even though they agreed to curb output. The strengthening of the greenback is a headwind for oil, but it also means that some emerging countries will be more indebted.



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* *Data from January to November 2016

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Oil demand is also likely to be under pressure in the short term as India’s banknote demonetization is having side effects on the economy. In November 2016, the government withdrew high-value currency and the consequence was immediate as the Composite PMI shrunk to 47.6 in December (3-year low). Moreover, sales of cars, scooters and motorcycles, one of the key drivers for gasoline demand, have already taken a hit.

A slowdown in the first quarter of 2017 could have a substantial impact on consumption and on demand as India is the 3rd biggest importer of oil. According to Ivy Global Energy Pte., FGE and Centrum Broking Ltd, diesel and gasoline use, which account for more than half of India’s oil demand, will probably slow or contract early this year. Besides, Chinese deceleration could threaten oil rebound in a context where aggregate demand from China (1st importer of oil) and India is already fading.



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3. Protectionism And Geopolitical Tensions (Mainly Between the U.S. And China) Will Remain A Focus

A lot of uncertainties remain about Trump’s trade policy. Even if his cabinet office seems pro-business, we can’t exclude a protectionist policy (at least in several sectors such as steel, coal, etc.) which is likely to lead to retaliations. There is no reason for Trump to go against the actual trend given that Obama’s administration was already very protectionist (especially with China):

1. In December 2015, the U.S. Department of Commerce said that corrosion-resistant steel imports from China were sold at unfairly low prices and would be taxed at 256%.

2. In May 2016, Washington imposed similar duties of up to 522% in a separate action targeting Chinese-made cold-rolled steel.

3. In December 2016, the U.S. didn’t recognize China’s Market Economy Status.

4. In January 2017, the Obama administration launched a new complaint against Chinese aluminium subsidies at the World Trade Organization, accusing Beijing of artificially expanding its global market share with cheap state-directed loans and subsidized energy.

5. The Obama administration completed a study that could lead to restrictions on Chinese investment in the U.S. semiconductor sector.

On the geopolitical side, Donald Trump has enraged China after upending decades of diplomatic protocol last month by taking a congratulatory telephone call from Taiwan President Tsai Ing-wen, adding that "One China" policy was up for negotiation. At the opposite, China's foreign ministry said "One China" was the foundation of China-US ties and was non-negotiable.


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• Elsewhere, in addition to the conflicts in the South China Sea, Ukraine, Syria, Yemen, we would not be surprised to see more tensions emerging from oil-sensitive countries such as Venezuela, whose foreign reserves have plunged. Among the big players, Brazil will also be a source of concern with large debt burdens in foreign currencies, political uncertainty and an economy that is highly reliant on commodities (biggest trade partner being China).

• In Africa, Algeria should struggle as 60% of its budget relies on oil. The nation plays a key political and economic role in the region, but seems vulnerable especially since President Bouteflika’s health worsened. The main risk in Africa is to see several countries collapsing (following the example of Somalia and Sudan) adding more uncertainty in the region. Nigeria, devastated by decades of oil pollution, could be one of the first to suffer.

• Elsewhere, Turkish leaders are likely to be under pressure this year with another drop in Lira. Current account deficit could exceed 5% in a context where Russian sanctions have weighted on tourism and a rise in U.S. rates has led to capital outflows.


Sources: IMF, ING ,Bloomberg, Market Securities

34

1. China’s PPI Rebound Could Be A Game Changer For Central Banks

Chinese PPI surprised by rising 0.1% YoY in September (the first increase since January 2012) and even accelerated to +3.3% YoY in November. According to several officials from NBS and PBoC, the trend should also remain positive in 2017. These figures suggest that consolidation has been partly done in several sectors such as coal and copper where officials implemented measures to reduce overcapacity.

The rebound in Chinese PPI is a game changer for central banks given that Chinese export prices are rebounding, ending one of the disinflationary pressures that have hurt developed countries over the past five years (even though the move will be partly offset by Yuan weakness).

In line with this new trend, Citi Global Inflation Surprise index rose sharply lately reflecting unexpected inflation pressures.


Policy Divergence Will Gain Traction As Inflation Will Rebound At Different Pace

-30

-25

-20

-15

-10

-5

0

5

10

15

20

Feb

-11

Jul-

11

De

c-1

1

May

-12

Oct

-12

Mar

-13

Au

g-1

3

Jan

-14

Jun

-14

No

v-1

4

Ap

r-1

5

Sep

-15

Feb

-16

Jul-

16

De

c-1

6

Citi Global Inflation Surprise Index

35

2. The ECB Will Not Change Its Policy Until Q3 2017 Despite A Rebound In Inflation

The ECB will have to deal with upward pressures coming from imported inflation (rebound in Chinese export prices, gasoline prices, weakness in euro).

• In November 2016, Germany, which is the main importer of Chinese goods in the euro area saw its import price index rebounding for the first time since November 2012. Similarly, the producer price index turned positive for the first time since June 2013. As a consequence, the German CPI is accelerating faster than other countries and this may create tensions within ECB members.

• The rebound in the energy sector will also be scrutinized. The impact of higher oil prices is already passing through the pumps and this should push the euro area consumer price index around 1.5% YoY by Q1 2017. Based on actual prices, Brent (converted into euros) is likely to grow by at least 50% on an annual basis in Q1 2017.


-8%

-6%

-4%

-2%

0%

2%

4%

6%

German PPI YoY German Import Prices YoY


36

The ECB will assess the persistence of these external factors and will probably adopt a more balanced stance (less dovish). However, it should remain accommodative and temper some governing council members wishing to exit quickly from QE since core inflation is not picking up and uncertainties remain.

• Core inflation remains weak mainly because of poor wage growth. As a matter of fact, core HICP inflation only rose 0.9% YoY in December 2016 while negotiated wages only increased by 1.4% YoY in 3Q 2016 (slowest pace since 4Q 1991).

• Moreover, the Italian banking crisis is not resolved yet even though the government is ready to pump in 20 billion euros into banks in difficulty. The problem is that under EU rules, government funds can’t be used if bond holders haven’t first taken a hit .The main focus for now is around Banca Monte dei Paschi di Siena (MPS) which has the highest proportion of NPLs of any Italian bank. According to the European Banking authority, Italy is the third most exposed country to NPL in the EU. Should MPS or other large banks fail to find a deal, Italy would sink into an economic crisis that would have effects on other EU members.

Sources: Bloomberg, Market Securities,EBA

EU Average


37

3. The Next BOE Move Could Be Either Up Or Down Depending On The Pace Of Inflation Acceleration

Inflation jumped 1.6% YoY in December 2016 (highest since July 2014) as the pound’s sharp drop push up costs. The relative resilience of the U.K is likely to show signs of weakness soon as inflation is increasing much faster than wages. This may weigh on real consumer spending as soon as 1H 2017 while mounting political and economic uncertainty are likely to have a negative impact on investment. Fears of a “hard Brexit” are materializing. On January 17th, May’s speech confirmed Britain plans to leave the single market, adding that Britain do not want to continue as a member of the Customs Union but would look to negotiate a "customs agreement" with the EU. May intends to trigger Article 50 in March 2017 and European diplomats will probably take a hard stance since she clearly claimed that the U.K will not contribute to the EU budget anymore.

In this context, It will be challenging for the BOE to manage rising inflation while keeping an accommodative stance. Even though the BOE can overshoot inflation, there are limits to which above-target inflation can be tolerated. As a result, the next interest rate move could be either up or down as BOE governor Carney said.


-20%

-15%

-10%

-5%

0%

5%

10%

15%

1Q

20

07

3Q

20

07

1Q

20

08

3Q

20

08

1Q

20

09

3Q

20

09

1Q

20

10

3Q

20

10

1Q

20

11

3Q

20

11

1Q

20

12

3Q

20

12

1Q

20

13

3Q

20

13

1Q

20

14

3Q

20

14

1Q

20

15

3Q

20

15

1Q

20

16

3Q

20

16

UK Business Investment YoY


38

4. The Pace of Normalisation In The U.S. Could Be Quicker Than Investors Expect

We believe that the Fed will raise rates at least two times in 2017 and will cease reinvestments of maturing securities on its balance sheet. The Fed is now close to meeting its dual mandate as employment situation is very close to equilibrium while inflation is likely to overshoot target in the short term.

Sources: Bloomberg, Congressional Budget Office, Market Securities


-4%

-2%

0%

2%

4%

6%

8%

10%

2Q

19

61

4Q

19

62

2Q

19

64

4Q

19

65

2Q

19

67

4Q

19

68

2Q

19

70

4Q

19

71

2Q

19

73

4Q

19

74

2Q

19

76

4Q

19

77

2Q

19

79

4Q

19

80

2Q

19

82

4Q

19

83

2Q

19

85

4Q

19

86

2Q

19

88

4Q

19

89

2Q

19

91

4Q

19

92

2Q

19

94

4Q

19

95

2Q

19

97

4Q

19

98

2Q

20

00

4Q

20

01

2Q

20

03

4Q

20

04

2Q

20

06

4Q

20

07

2Q

20

09

4Q

20

10

2Q

20

12

4Q

20

13

2Q

20

15

4Q

20

16

Recession Inflation Gap (Core PCE YoY Relative to 2% Target) Unemployment Gap (UR Relative to CBO Natural Rate of Unemployment)

39

As underlined by the Fed, “inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports”. However, oil prices have rebounded since August supported by the OPEC/Non-OPEC deal and will keep pushing gasoline prices higher. In the meantime, the U.S. Import Price Index from China started to stabilise and could turn positive in the coming months with the resurgence in Chinese PPI.

In a context where private wages rose 2.9% YoY (in December 2016) and rents (fastest pace since June 2007) are likely to remain sustained due to a shortage of housing inventory, we would not be surprised to see inflation exceeding central banks’ target of 2% in the coming months.


Imported Inflation

Imported Deflation


U.S. Macroeconomic Forecasts

Growth Unemployment rate CPI Public Deficit

2015 2.6% 5.3% 0.1% 2.6%

2016 1.6% 4.8% 1.3% 3.2%

2017 2.7% 4.6% 2.4% 3.4%

Risk Factors to the Economy Positive Factors for the Economy Uncertainties around Trump’s program (international

relations, immigration and public finances)

Trump’s program will stimulate growth by reducing

individual tax rates, corporate income taxes and rising spending on infrastructures and defence

Protectionist policies (at least for several sectors) could

lead to retaliations.

Repatriation of overseas cash, deregulation

Dollar strengthening and decline in exports

Exit from earnings recession (positive for non-residential

investment)

Fed’s credibility and tightening monetary policy.

Recovery in Structures Mining Investment with oil prices >

50$

Lack of offer in the housing sector (increase in home sales, prices and construction spending)

40

Growth Unemployment rate CPI Public Deficit

2015 2.0% 10.9% 0.0% 2.1%

2016 1.7% 10.1% 0.2% 1.9%

2017 1.7% 9.6% 1.4% 1.8%

Risk Factors to the Economy Positive Factors for the Economy Political uncertainty (Italy, Netherlands, France, Germany,

etc.) and rise of populist parties U.K. exit from the European Union (Hard Brexit)

Downgrade of Portugal rating at DBRS (Ineligibility to ECB

QE)

Greece: non implementation of the bailout terms An unexpected slowdown in ECB purchase program

Increase in credit (households and companies)

Juncker plan and an increase in public spending

Greece: potential eligibility to ECB QE (post sustainability analysis)

Easing sanctions against Russia

Weak energy prices

Eurozone Macroeconomic Forecasts

41

42

GDP Forecasts Summary

Countries 2015 2016 2017

U.S. 2.6% 1.6% 2.7%

Eurozone 2.0% 1.7% 1.7%

China 6.9% 6.7% 6.3%

Japan 0.6% 0.9% 0.8%

Latin America 0.0% -0.7% 1.2%

World 3.2% 3.1% 3.4%

43

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Christophe BARRAUD, Ph.D Chief Economist Strategist

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25 rue Balzac, 75008 PARIS T: +33 1 70 99 52 29

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