EFTA01475956.pdf

Deutsche Bank Research Global Cross-Discipline Date 8 December 2015 World Outlook 2016 Managing with less liquidity David Folkerts-Landau 'tors Peter Hooper Chief Economist Matthew Luzzetti Chief Economist Mark Wall Chief Economist Torsten Slok hi f E n mi t Deutsche Bank AG/London DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 124/04/2015. EFTA01475956 8 December 2015 World Outlook 2016: Managing with less liquidity Table of Contents Global Overview Managing with less liquidity US Dollar drag Europe Not a global engine Japan Return to steady recovery trend China Rising challenges to trigger further policy easing Asia (ex Japan) Triple troubles Latin America Still adjusting to low commodity prices Bond Market Strategy Peak policy divergence US Credit US credit feels the pressure of high commodity exposure European Credit Strategy To follow the US or march to its own beat? US Equity Strategy Still low Treasury yields despite Fed hikes to boost S&P PE — Heavy tilts to Health Care & Tech European Equity Strategy 7% upside in 2016 but beware of the risk of a near-term correction FX Strategy Plenty of run left in the USD upswing Commodities Supply adjustment is well underway for oil, not so for the metals Global Asset Allocation The case for normalization Geopolitics The EU's geopolitical crisis eclipses its economic crisis Forecast table Key Economic Forecasts Key Financial Forecasts Long-term Forecasts Contacts 3 18 23 32 34 37 40 42 49 51 EFTA01475957 53 57 59 61 67 71 74 76 77 78 Page 2 Deutsche Bank AG/London EFTA01475958 8 December 2015 World Outlook 2016: Managing with less liquidity Global Overview: Managing with less liquidity IIThe long-awaited turn toward the normalization of US monetary policy should finally get under way next week, with the Fed set to raise rates for the first time since 2006. In the year ahead, we could also see signals that the monetary spigots in Europe will begin to close as well. While such indications are probably more than a year away in Japan, we do not expect the BoJ to add to its asset purchases. In a world that has been awash with central bank liquidity for most of the past decade, the central question for the year ahead is how the global economy and financial markets will react as the tap on that liquidity begins to tighten. IIWhile the pivot away from this great monetary experiment is unprecedented and will not be without risks, we expect the world economy and financial markets to weather this turn in policy reasonably well. Supporting this adjustment is the expectation that major central banks -- and the Fed in particular -- will be moving far more cautiously than they have in the past as they withdraw accommodation. IIThe economic backdrop should allow for this gradual pace of policy normalization, at least initially. Global growth is expected to rebound gradually from the weakest growth rate since the financial crisis in 2015. Growth in advanced economies is projected to hold steady just shy of 2% over the next three years, with growth in the US slowing to near 2%, Europe's steady recovery continuing and Japan rebounding from disappointing growth this year. IIThe coming year should see growth in emerging market economies rebound, as the severe contractions in Russia and Brazil moderate and recent declines in export growth are expected to reverse, albeit weakly. Nonetheless, 2016 will be challenging for the emerging markets as falling commodity prices and still-weak global trade growth extend the recent experience with budgetary and balance of payments pressures. China is expected to continue its gradual deceleration, offering little respite to commodity producers. IIMarket interest rates should rise next year — we see the 10-year Treasury yield ending the year at 2.5% with risks skewed to the upside -- as the market prices a tightening Fed. US credit spreads are likely to widen further as defaults rise moderately, but we do not see Fed hikes proving problematic for credit next year. The US dollar upswing should continue, though at a more modest pace. And we see equities remaining resilient and presenting some upside, as long as the rise in rates is limited and orderly. IIThe risks around our baseline view seem more numerous than in the past due to the unprecedented shift in monetary policy. The main downside is that the market adjustment to a tightening Fed is more adverse than we anticipate. A spike in yields could set off a significant re-pricing of EFTA01475959 global risk assets. This reaction would intensify if the Fed finds itself behind the curve as inflation rises from a tight labor market. Beyond the Fed, a sharper-than-expected slowdown in China next year would have obvious knock-on effects on commodities, global trade and emerging markets. Meanwhile, intensified European political risk is also possible if differences of opinion between countries on divisive themes like the refugee crisis spill over into other policy areas IIOn the positive side, a surprising recovery in productivity growth in advanced economies, especially the US, would allow normalization to proceed very slowly and support a stronger recovery on the demand side of the economy. Risks are also skewed to the upside of our US economic outlook. The rebound in business fixed investment from a low base could be stronger than expected, especially with the peak impact from the drop in oil likely behind us, and the drag from a stronger dollar should begin to wane after mid-year. Deutsche Bank AG/London Page 3 EFTA01475960 8 December 2015 World Outlook 2016: Managing with less liquidity Introduction and Summary Barring a significant negative economic or financial shock in the week ahead, the long-awaited turn toward the normalization of US monetary policy should finally get under way before the end of this year. The 25-basis-point fed funds rate hike now widely anticipated at the Fed's December meeting would be the first such move since June 2006. In the year ahead, we could also see signals that the monetary spigots in Europe will begin to close as well. While such signals are probably more than a year away in Japan, we don't expect the BoJ to add to its asset purchases, implying a gradual easing of stimulus there. In a world that has been awash with central bank liquidity for most of the past decade, there is both great curiosity and great concern about how the global economy and financial markets will react as the tap is finally shut on that liquidity. This question is a central focus of our World Outlook for 2016. The pivot away from this great monetary experiment is unprecedented and will not be without risks. However, we expect both the world economy and global financial markets to weather this turn in policy reasonably well, partly because major central banks -- and the Fed in particular -- have made it abundantly clear that they will be moving far more cautiously than they have in the past as they withdraw accommodation. Markets appear so far to have settled comfortably into the expectation that the Fed will be moving very slowly, expecting only about half the pace of hikes as the median Fed expectation, which is, in turn, about half the pace of historical Fed hiking cycles. The economic backdrop should allow for this gradual pace of policy normalization, at least initially. Global growth has been slowed by significant headwinds on both the demand side and the supply side of major economies. While moderate consumer spending growth has increasingly been the principal driver of a sluggish recovery, capital spending has been very slow to advance. A result of weak business investment has been that labor productivity growth has slowed to historically low rates in advanced economies. The inevitable slowing of China's economy to a more sustainable pace has also been a significant headwind to growth with dramatic implications for the world economy. China's slowdown has been a major factor underlying the weakening of commodity markets, trade flows, business investment, and manufacturing activity globally. But the slow growth of supply—or decline in potential growth—has also meant that sluggish recoveries in demand have been able to achieve considerable progress in removing economic slack. The US and Japanese economies are already nearing full employment, and even Europe's labor market has shown gains. The progress to date in reducing unemployment will help, along with the stabilization of energy and other commodity prices, to push inflation higher in the year ahead from recent extreme lows. The prospective pickup in wage and price inflation, as well as the continuing improvement in the labor EFTA01475961 market, is what is inducing the Fed to commence policy normalization. Spillovers from the Fed's move will help the ECB and the BoJ to achieve their inflation targets, as prospective rate increases in the US further strengthen the dollar against the euro and the yen. This raises the question of how far this policy divergence can go. Economic slack is declining enough to push Europe's core inflation close to its historical average by end-2016. Stable and eventually rising commodity prices, supportive currency developments, and rising inflation expectations could lead the ECB to start talking before year end about tapering in 2017. In this light, the recent extension of its QE program, while disappointing to the markets, could prove to have been unnecessary. For the Bo], any change in policy stance seems unlikely until well after the April 2017 consumption tax increase. Page 4 Deutsche Bank AG/London EFTA01475962 8 December 2015 World Outlook 2016: Managing with less liquidity But the changing market expectations for ECB and Bo] policy have the potential to induce another bout of market turbulence akin to the taper tantrum of mid-2013, though likely with more limited implications for the global economy and financial markets. While our baseline scenario sees a global economy that continues to grow at a moderate pace over the next two years, there are substantial risks on either side. On the down side, global financial markets could respond much more negatively to Fed normalization than we expect, with adverse repercussions for household and business spending around the globe. The gap between the market's and the Fed's forecasts for interest rates suggests that this negative response could result from an upward adjustment in market expectations towards the Fed, even without more aggressive tightening than the Fed currently envisions. A signal that the Fed will begin to wind down its reinvestment of securities could add to this turbulence. This downside risk would be exacerbated if there were a surprising resurgence of inflation pressures in the US as the unemployment rate moves below full employment. Such a development would likely prompt the Fed to adopt a significantly more rapid pace of normalization. A more aggressive Fed would, in turn, be negative for risk assets with potentially strong depressing effects on aggregate demand. A sharper-than-expected slowdown in China next year would have obvious knock-on effects on commodities, global trade and emerging markets. But on the positive side, it is possible that the recent poor performance of productivity growth globally (especially in the US) has been an aberration, and that recent technological advances could spur a surprising recovery. Faster supply-side growth would allow normalization to proceed very slowly and support a stronger recovery on the demand side of the economy. In addition, the risks to our US outlook are skewed to the upside: the peak drag on business investment from the sharp drop in oil prices is likely behind us, and the drag from net exports from the dollar surge is likely to dissipate beyond mid- year. In what follows, we begin by presenting our baseline forecast for the global economy and financial markets, with an emphasis on 2016, but also a peek into 2017. We then provide a more detailed description of the outlook for the globe's major economic blocks. Next, we summarize our asset class views for the year ahead. We conclude by fleshing out the upside and downside risks to our baseline outlook in more detail. Deutsche Bank AG/London Page 5 EFTA01475963 8 December 2015 World Outlook 2016: Managing with less liquidity Global outlook Disappointing global growth to pick up slightly next year Growth in global economic activity is now projected to bottom this year and rise gradually toward trend by 2017, led primarily by an acceleration in emerging market economies. We expect global growth will have dipped to 3.1% in 2015, its slowest pace since the global financial crisis in 2009. This slowdown has been driven primarily by a deceleration in emerging market economies, where growth is expected to have fallen by more than one-half of a percentage point from 2014. The sharp contractions in Russia and Brazil are the main reason for this deceleration. Conversely, faster growth in the euro area and Japan implies a modest pickup in growth in advanced economies this year. Over the next two years changes in the global growth outlook are likely to be driven entirely by fluctuations in emerging market growth. Next year growth is projected to rise gradually, as the severe contractions in Russia and Brazil moderate. This should help boost emerging market growth by almost one-half of a percentage point, even with growth slowing further in China. But the emerging markets growth story is not simply a technical one: recent declines in export growth should reverse, albeit weakly, providing a more positive basis for recovery than the 'less bad' Brazil and Russia outlooks. Growth in advanced economies should remain stable at just below 2% in 2016, as a more- thandoubling in growth in Japan and a slight pickup in the euro area offset deceleration in the US. Further acceleration in global economic activity in 2017 is likely to be due to additional improvement in Russia and Brazil, while a pickup in India and stability in China would imply a modest acceleration in emerging Asia. Advanced economy growth is once again expected to remain just shy of 2% in 2017, despite a halving of growth in Japan. Figure 2: Fluctuations in growth in emerging market economies driving global growth dynamics over next two years GDP growth, % G7 US Japan Euro area Asia (ex-Japan) China India EEMEA Russia Latin America Brazil EM economies Global EFTA01475964 2014 2015F 2016F 2017F 1.8 1.7 2.4 -0.1 0.9 6.4 7.3 7.1 2.4 0.6 0.8 0.1 Advanced economies 1.7 4.6 3.4 Source: Deutsche Bank Research 1.9 2.4 0.7 1.5 6.1 7.0 7.3 1.0 -3.7 -0.8 -3.7 1.9 4.0 3.1 1.9 2.1 1.5 1.6 6.1 6.7 7.5 1.9 -0.7 -0.1 -2.4 1.9 4.4 3.3 2.1 0.8 1.5 6.3 6.7 7.8 EFTA01475965 2.5 0.5 2.2 1.0 1.8 4.9 3.6 1.5 1.6 2.8 0.4 3.4 2.0 6.7 6.0 7.8 CPI inflation, % 2014 2015F 2016F 2017F 0.3 0.2 0.8 0.1 2.4 1.4 4.9 8.7 15.6 9.0 0.3 5.6 3.4 1.5 1.9 0.7 0.9 2.9 1.8 5.4 6.7 9.2 8.5 1.4 5.9 4.0 2.1 2.3 2.1 1.6 2.9 1.8 5.0 EFTA01475966 5.9 7.1 12.5 15.2 18.8 19.4 6.3 6.2 1.3 5.3 3.6 2.0 5.7 4.2 Figure 1: Global growth to rise toward trend from its slowest pace since 2009 10 % yoy -6 -4 -2 0 2 4 6 8 Real GDP growth Forecasts World Advanced economies Emerging economies Note: Trend period: 1995:2017 Source: IMF, Haver Analytics LP, Deutsche Bank Research Page 6 Deutsche Bank AG/London 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 EFTA01475967 2013 2014 2015 2016 2017 EFTA01475968 8 December 2015 World Outlook 2016: Managing with less liquidity Growth marked down broadly this year and next Compared to our previous global update in June, growth has once again been marked down broadly for 2015 and 2016. Sharper-than-expected contractions in emerging market economies were the main downside surprise to our growth forecast for 2015. Projectedd growth in Russia has been marked down by 0.5 percentage points — after downward revisions earlier this year, while the forecast for Brazil has been reduced 2.3 percentage points since June. On the other hand, growth expectations for advanced economies were upgraded modestly, as upside surprises to growth in the US and the euro area more than offset disappointing growth in Japan. Figure 3: Global growth projections revised down for 2015 and 2016 GDP forecast & revision (% yoy) Forecast level Current G7 US Japan Euro area Asia (ex-Japan) China India EEMEA Russia Latin America Brazil Advanced economies EM economies Global 1.9 2.4 0.7 1.5 6.1 7.0 7.3 1.0 -3.7 -0.8 -3.7 1.9 4.0 3.1 1.9 2.1 1.5 1.6 6.1 6.7 7.5 EFTA01475969 1.9 -0.7 -0.1 -2.4 1.9 4.4 3.3 2.1 0.8 1.5 6.3 6.7 7.8 2.5 0.5 2.2 1.0 1.8 4.9 3.6 Forecast change since June 15 WO Update 2015F 2016F 2017F 2015F 2016F 2017F 1.8 0.1 0.3 -0.4 0.1 -0.2 0.0 -0.2 -0.2 -0.5 -1.0 -2.3 0.1 -0.3 -0.2 -0.5 -0.9 -0.3 0.0 -0.2 0.0 0.0 -0.3 -0.3 -2.0 -3.0 -0.4 -0.5 EFTA01475970 -0.4 Note: June 15 World Outlook update forecasts have been recalculated using IMF WEO October -15 PPP weights Source: Deutsche Bank Research The downward revision to expected global growth is more significant and broad-based for 2016. This growth is now expected to be 0.4 percentage points slower next year compared to our June forecasts, as advanced and emerging market economies were downgraded by similar amounts. Within advanced economies, the downward revision to US growth (-0.9 percentage points) is most severe. This downgrade is due mostly to the increased drag on net exports from greater-than-expected dollar appreciation, while reduced estimates of potential growth have also contributed. Expected growth in Japan was also revised down, though by a more modest 0.3 percentage points, while the growth outlook in the euro area is unchanged. Once again, Russia and Brazil represent the main downgrades to growth within emerging markets, while our outlook for a slight slowdown in China and pickup in India is unchanged. DB's top-line global growth forecast roughly consistent with alternative projections Our downgraded global growth forecast is about in line with outside alternatives from the IMF and Bloomberg through 2017. However, this consistency masks significant regional differences. In particular, while our US growth forecasts are nearly one-half of a percentage point below alternative Deutsche Bank AG/London Page 7 n.a -0.7 -0.2 -0.1 n.a 0.0 -0.2 n.a -0.8 n.a -1.1 n.a n.a n.a EFTA01475971 8 December 2015 World Outlook 2016: Managing with less liquidity forecasts for 2016 and 2017, our China growth forecasts are a few tenths above alternatives over this same timeframe. The Chinese government may clarify in the coming weeks its growth target for 2016, and forecasts for growth below 6.5% may be revised higher if, as seems likely, the government's target is at least that high. Meanwhile, our outlook for growth to remain near 1.5% in the euro area is close to alternative forecasts from the IMF, Bloomberg and Consensus Economics. Figure 4: In-line global growth forecasts mask regional differences Consensus Forecast table, GDP growth, % Global DB (Jun'15 WO) DB (Current) Bloomberg (Nov Survey) Bloomberg (DB aggregation) IMF (Oct'15) IMF (DB aggregation) US DB (Jun'15 WO) DB (Current) Bloomberg (Nov Survey) IMF (Oct'15) Consensus Economics (Oct Survey) Euro area DB (Jun'15 WO) DB (Current) Bloomberg (Nov Survey) IMF (Oct'15) Consensus Economics (Oct Survey) China DB (Jun'15 WO) DB (Current) Bloomberg (Nov Survey) IMF (Oct'15) Consensus Economics (Oct Survey) 2015F 3.3 3.1 3.0 3.0 3.1 3.0 2.2 2.4 2.5 2.6 2.5 1.4 1.5 EFTA01475972 1.5 1.5 1.5 7.0 7.0 6.9 6.8 n.a 2016F 3.8 3.3 3.4 3.4 3.6 3.4 3.0 2.1 2.5 2.8 2.6 1.6 1.6 1.7 1.6 1.7 6.7 6.7 6.5 6.3 n.a Note: June 15 World Outlook update forecasts have been recalculated using IMF WEO October -15 PPP weights Source: Deutsche Bank Research, cited sources 2017F n.a 3.6 3.4 3.7 3.8 3.6 2.8 2.1 2.5 2.8 2.5 1.6 1.5 1.8 1.7 1.6 6.7 EFTA01475973 6.7 6.3 6.0 n.a Global inflation to accelerate after bottoming in 2015 Global inflation is projected to rebound strongly over the next two years after falling to its lowest level since the financial crisis. Both the decline and the anticipated rebound are driven primarily by the sharp decline in global commodity prices over the past 18 months and our expectation that prices will be roughly stable in the coming year. But inflation dynamics are varied across regions. In advanced economies, headline inflation fell about 1 percentage point this year, leaving price increases only a few tenths above deflationary territory. The sharp drop in headline inflation was driven by the 60% decline in oil prices since mid-2014. Meanwhile, inflation in Latin America and EMEA economies rose this year, due mostly to sharp currency depreciations. Weak currencies don't seem to have had the same effect in emerging Asia, though. Figure 5: Global inflation to rebound strongly 10 % yoy Inflation Forecasts 8 6 4 2 0 -2 -4 World Advanced economies Emerging economies Note: Trend period: 2000-:2017 Source: IMF, Haver Analytics LP, Deutsche Bank Research Page 8 Deutsche Bank AG/London 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 EFTA01475974 2012 2013 2014 2015 2016 2017 EFTA01475975 8 December 2015 World Outlook 2016: Managing with less liquidity Inflation is expected to rebound sharply in 2016 and rise modestly further in 2017. The initial acceleration is driven primarily by the stabilization of energy price, removing what has been a considerable downward force on broad price indexes. Hence, the gap between headline and core inflation will close in the coming year. In addition, core inflation rates in the G3 economies have already begun to rise gently, and our expectation is that even after the commodity price effect lifts headline inflation, the underlying rising trend in core inflation will continue to push inflation higher. Advanced economy inflation is projected to rise by 1 percentage point next year and 0.6 percentage points in 2017. On the other hand, inflation in emerging market economies — less influenced in most cases by energy prices -- is expected to rise modestly next year and remain stable in 2017. Upside risks to inflation from food prices are a concern-this year has seen the most pronounced El Nino cycle on record and weather patterns may be equally disruptive next year. As yet, however, food prices globally are not showing any upward momentum. Figure 7: Global inflation revised up led by emerging market economies Inflation forecast & revision % yoy G7 US Japan Euro area Asia (ex-Japan) China India EEMEA Russia Latin America Brazil Advanced economies EM economies Global Forecast level Current 1.5 1.9 0.7 0.9 2.9 1.8 5.4 8.7 15.6 15.2 EFTA01475976 9.0 0.3 5.6 3.4 6.7 9.2 18.8 8.5 1.4 5.9 4.0 2.1 2.3 2.1 1.6 2.9 1.8 5.0 5.9 7.1 19.4 6.2 2.0 5.7 4.2 Forecast change since June 15 WO Update 2015F 2016F 2017F 2015F 2016F 2017F 0.3 0.2 0.8 0.1 -0.1 0.0 -0.1 -0.2 2.4 1.4 4.9 -0.2 -0.2 -0.2 0.2 0.4 2.2 0.5 -0.1 0.2 0.1 -0.5 -0.6 EFTA01475977 -0.3 -0.5 -0.6 -0.9 -0.3 1.0 2.2 6.2 2.6 -0.5 0.7 0.2 Note: June 15 World Outlook update forecasts have been recalculated using IMF WEO October -15 PPP weights Source: Deutsche Bank Research Our inflation forecasts have undergone significant revisions since the June update. Global inflation expectations have been revised up by 0.1 and 0.2 percentage points for 2015 and 2016. The impetus for this revision is higher inflation in emerging market economies resulting from greater-than-expected currency depreciation. This is most pronounced in Latin America, where forecast inflation has been revised up by 2.2 and 6.2 percentage points for 2015 and 2016, respectively. Inflation has been marked down broadly across advanced economies and emerging Asia, with forecasts falling by a few tenths for 2015 and by about one-half of a percentage point for next year. n.a -0.3 0.2 -0.1 n.a -1.2 -0.5 n.a 0.3 n.a 1.2 n.a n.a n.a Figure 6: G3 core inflation %yoy US (PCE) -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 EFTA01475978 3.0 2008 2009 2010 2011 2012 2013 2014 2015 Note: Japan "core core" inflation, net of the consumption tax increase. Source: CEIC, Deutsche Bank Research Euro area Japan Deutsche Bank AG/London Page 9 EFTA01475979 8 December 2015 World Outlook 2016: Managing with less liquidity Regional detail US outlook US GDP growth is projected to have slowed to less than 2% in the second half of 2015, and we see it picking up slightly to just over 2% during 2016 and 2017. The economy should be driven predominantly by a healthy expansion of consumer spending, plus some outsized gains in residential investment as the housing market continues to tighten. Business investment growth should remain relatively subdued, held back by, among other factors, a strengthening dollar, election-year uncertainties, subdued corporate earnings growth, and in the longer term, tightening financial conditions. Output growth should be restrained substantially in the year ahead by the lagged depressing effects on net exports of past substantial appreciation of the dollar and some further increases to come. That restraint should ease over time, but domestic demand growth should slow as the Fed's normalization of monetary policy progresses. And that slowing should help keep the labor market from overshooting too much The modest pace of GDP growth that we are projecting should be more than enough to effect ongoing tightening of the US labor market. With labor productivity growth and labor force growth both running at historically depressed rates, we estimate that potential GDP growth has slowed to around 1% currently, and is likely to rise only gradually as productivity and labor force growth pick up over the period ahead. We see the unemployment rate falling into the mid-4% area over the next couple years, putting it noticeably below NAIRU, but not by enough to effect more than a gradual pickup in wage and price inflation. We see core PCE inflation returning to near 2% two years hence, roughly in line with FOMC projections. However, our forecast for growth is a bit below consensus and the FOMC median projection, and we see the dollar rising more than the Fed is likely to have assumed. On a trade-weighted basis, we expect the dollar to rise nearly 5% next year. While significant, this appreciation is a notable deceleration from the 20% rise in the trade- weighted dollar since mid-2014. Accordingly, we expect the Fed to raise rates slightly less rapidly than anticipated in the most recent (September) FOMC median projection (a projection that could be revised down somewhat for the December FOMC meeting). At the same time, our projection for 100 bps of Fed rate hikes by the end of 2016 (including a 25 bp liftoff this month) and another 100 bps during 2017 is noticeably more than the market has been pricing. We also expect the Fed to taper the reinvestment of its maturing asset holdings and allow its balance sheet to begin to run off naturally after mid-2016. Outlook for Europe We expect euro area GDP growth to be broadly unchanged at 1.6% in 2016 and to slow in 2017. This reflects the shifting intensity of countervailing EFTA01475980 headwinds and tailwinds. Global growth should rise, but less than we previously thought. Lower oil prices were a source of strong stimulus in 2015 and allowed private consumption to compensate for weaker net trade. However, we expect oil prices to be flat in 2016 and to rise about 10% in 2017 as supply constraints bite. Dual monetary and fiscal easing should help protect euro area economic growth from the fading oil stimulus in 2016. With both monetary and fiscal policy likely to tighten modestly in 2017, economic growth will be more exposed to the squeeze from higher oil prices. The net result is that we expect the average annualised rate of GDP growth to slow from 1.7% in 2016 to 1.4% in 2017. The euro exchange rate is expected to fall about 5% in trade weighted terms in 2016, with EURUSD breaching parity. A partial normalisation of euro area rate markets is likely to cause some tightening of financial conditions later in the Page 10 Deutsche Bank AG/London EFTA01475981 8 December 2015 World Outlook 2016: Managing with less liquidity year. With productivity and potential growth running low, the output gap should gradually narrow even with these modest rates of GDP growth, and past euro depreciation starting to become more visible in inflation. Core inflation should be close to historical norms in H2 2016. By end 2016, the ECB's medium-term headline inflation projections should be at levels consistent with tapering starting to be discussed at the ECB and implemented in 2017; we see the first ECB policy rate hike only at the end of 2018. The risk is that oil prices continue to decline in the near term and weigh on headline inflation. If this weakens medium-term inflation expectations, the late-2016 tapering risk should dissipate and the pressure for further ECB easing will grow. The refugee crisis will remain a theme in Europe and fear of a repeat of the Paris terror attacks will linger. While refugee and security-related public spending is likely to lead to some relaxation in the fiscal stance in the year ahead, we expect compliance with Europe's fiscal rules to improve into 2017. We expect euro area political uncertainty to rise as 2017 approaches. The refugee crisis has created frictions within and between countries, but the common threat to security highlighted by the attacks in Paris may unify Europe and reduce the risk of local political events — including Greek debt relief negotiations, Portugal's minority government, Catalonia's independence bid and the UK's EU negotiations — from undermining area-wide stability in 2016. In our view, the unity won't last into 2017. The closer we get to the Dutch, French and German elections in 2017 — Italy may bring forward its election into 2017 too — the more political tensions are likely to build and impose a risk premium on the recovery. There is little basis to expect a strong non-cyclical euro area recovery either. France may make some further modest progress on structural reforms in early 2016, but reform progress across the zone over the next couple of years is likely to remain slow. UK economic growth appears set to slow over the next couple of years — but despite fiscal austerity, sterling currency strength and maybe some EU referendum-related uncertainty, GDP growth should be no worse than trend. We expect the robust labour market to keep private consumption growth well supported. Inflation base effects should push inflation up to close to the lower bound of the Bank of England's inflation target range before mid-year. We continue to expect the Bank of England to raise policy rates for the first time in this cycle in May. The EU referendum could be held as soon as late next year. According to opinion polls, the outcome looks closer than the last referendum in 1975 when 66% voted to remain in the EU. Outlook for Japan After what we view as a soft patch over the summer, due in part to unseasonable weather but also to a temporary pullback in capital investment, EFTA01475982 we see the economy bouncing back strongly in Q4 and then returning to its underlying 1-1.5% trend during 2016. For an economy that has been repeatedly buffeted by shocks — some self-inflicted, most genuinely exogenous — we are conscious of the difficulty of making firm forecasts. But we do see Japan's economy as following an underlying growth rate well above its longrun potential and are therefore likely to continue to see the labour market tightening from what is already the lowest unemployment rate in 20 years. Household income growth, reflecting the combination of rising wage growth and employment, should remain at about 2-2.5%, providing the main driver of growth for the economy. While headline inflation should rise through 2016 as the base effect on past oil price declines drops out of the year-on-year comparison, we don't see it rising beyond 1% until 2017. "Core core" inflation, excluding food and energy prices, Deutsche Bank AG/London Page 11 EFTA01475983 8 December 2015 World Outlook 2016: Managing with less liquidity has risen sharply in recent months and we expect this to continue for a few more months, rising to above 1% in the first half of 2016. But with the lagged effects of yen depreciation wearing off, we expect inflation to stabilize at about 1% rather than moving higher. This may induce the BoJ eventually to add to its asset purchases, but our base case is that it would choose to continue the current level of investments for longer rather than increase the scale of purchases. In any event, the risks likely remain tilted in the direction of any negative shock to growth or inflation expectations leading to an augmentation of QE. China and other emerging markets The coming year will likely remain challenging for emerging markets as falling commodity prices and weak global trade growth are likely to extend the recent experience with budgetary and balance-of-payments pressures and slow growth in many EM economies. We expect growth in China to slow further in the coming year to 6.7% from 7.0% in 2015 and 7.4% in 2014, offering little respite for commodity producers. This will probably force continued output cuts to close the supply-demand gap for resources. We think that by the end of 2016, this will have been achieved in the oil market, thanks to production cuts, especially in the US; but in most other commodity markets, balance should be restored only in 2017. But the China forecast offers some hope in that the source of demand growth could shift at the margin back towards more commodity-intensive infrastructure and property investment. The 2017 forecast offers more encouragement for commodity exporters in the form of an end to the China slowdown — growth is expected to be maintained at 6.7% — perhaps allowing for the return to a positive cycle in commodity prices once supply cuts have been effected in 2016. In the near term, we think maintaining the gentle downward glide path to growth in China will require more fiscal and monetary stimulus — we expect two more rate cuts, for example — but the recovery in the property market could remove some of the downward pressure on Chinese growth. The rate at which property prices are rising — and the stabilization of prices in more and more smaller cities — combined with the rise in land sales revenues could be taken as indicators that property investment could be heading for a familiar boom following the 2014 'bust'. Our forecast is for a more restrained rebound, however, as a large stock of unsold properties and slowing of rural-to-urban migration serve to limit developers' enthusiasm to reinvest. In India, we expect only a very modest pickup in activity and only late in our forecast horizon. Banks and corporates will have to resolve a growing stock of problem assets and stalled projects, a task that we don't expect will be EFTA01475984 completed quickly. The growth outlook, therefore, has a very gradual rise over the next two years. We are optimistic that the government's reform plans can, in the medium term, put India on a path towards much higher growth rates, but much hard work remains to be done in the meantime, including the implementation of tax, labour, land acquisition and investment reforms. For 2016, growth forecasts for Brazil and Russia offer only the prospect of a slowing pace of decline and eventual stabilization in activity, with growth expected to return in 2017. Given the size of these economies, this should be enough to boost regional growth forecasts. But a slower pace of recession is hardly cause for celebration. More encouragement comes in Argentina's likely adoption of more positive economic policies. The path to restoring investor confidence and market access will not be easy — likely involving a devaluation of the official exchange rate and a significant decline in government spending — but we have a fundamentally positive outlook for the Argentine economy at last, albeit again one that offers more growth potential in 2017 than in 2016. Page 12 Deutsche Bank AG/London EFTA01475985 8 December 2015 World Outlook 2016: Managing with less liquidity For most other emerging markets, a positive outlook requires an end to commodity price declines and also an end to the puzzling weakness in exports. In Figure 8, we plot the growth in real exports of goods and services in the major EM economies by region against US and EU combined GDP growth. Aside from weighting EM countries by the size of their exports rather than GDP, we have made one other notable change, adjusting Chinese exports for alleged over-invoicing in early 2013. This latter modification serves to highlight that the decoupling of Asian exports from US and EU GDP growth is really a very recent phenomenon, emerging only in the last year. Growth in Emerging Europe exports has similarly decoupled from EU growth over the past year. Export growth in Latin America has been weak but reasonably closely aligned with US growth. Many hypotheses have been proposed to explain the loss of export vitality, some of which we find unconvincing. "Onshoring" of manufacturing back to the US seems inconsistent with the weakness in US manufacturing output — particularly in information and communications technology, which is the mainstay of Asian exports to the US. Manufacturing output growth in the EU has followed a similar pattern to imports, implying again that domestic production doesn't seem to be rising at the expense of imports. Indeed, import penetration into the US and European Union is not falling. While China has seen a loss of competitiveness in labour-intensive manufacturing, that has more than been offset by increasingly competitive higher-value industries. China now exports automobiles, high-speed trains and, soon, passenger jets; its share of global manufactured goods exports is rising today at about the same pace it was in the pre-crisis years. With only about a year's data, it is hard to arrive at a convincing explanation, but we think the following factors are important. First, slower growth in Chinese demand for commodity imports may have depressed overall export volumes among the commodity exporters. Second, those sectors that saw the greatest outward migration in production from advanced to emerging economies are now much more mature. Of particular importance, consumer electronics devices — mobile phones, laptops and tablets — are now ubiquitous in advanced economies and most emerging markets too. There simply doesn't need to be the growth in sales of such products since for most consumers the need simply is to replace worn-out devices. Third, as China moves up the value chain, production networks may be shrinking. As Chinese suppliers become more proficient, it may require fewer imports of intermediate goods to produce exports. And as multinationals in China focus more on serving the domestic market — now growing in USD terms as fast as the US market — they may be replacing more expensive imported components with locally sourced 'good enough' parts. Finally, the sharp depreciation of the euro in 2014 must surely have played a role, as the weak euro has depressed the growth of imports EFTA01475986 while stimulating exports in Europe. Some of these influences depressing EM exports may become less of a constraint in the year ahead. The much slower pace of growth in the IT sector noted above likely reflects a temporary inventory depletion phase, which we think could end in the coming months with both production and imports rebounding. Even a mature sector like IT is likely still to see some growth as long as the broader economy is growing. The euro is expected to depreciate, but less than it did in 2014. As the competitive advantage of China shifts to higher-value goods, carrying the rest of Asia with it even if to a lesser degree than ten years ago, it is reasonable to expect export volume growth to recover. This matters for the large number of small open economies in the EM universe, for which export growth has a highly significant influence on economic activity. Even the modest recovery in export growth that we forecast for 2016 and 2017 will be enough, we think, to take GDP growth somewhat higher in most emerging economies. Deutsche Bank AG/London Page 13 Figure 8: EM exports of goods and services vs. G2 GDP Asia (lhs) EMEA (lhs) 10 15 20 25 30 -20 -15 -10 -5 0 5 2005 2007 2009 2011 2013 2015 Note: Regional data weighted by 2014 nominal USD goods and services exports. Source: Haver Analytics LP, Deutsche Bank Research %yoy Latam (lhs) US&EU GDP (rhs) %yoy -6 -4 EFTA01475987 -2 0 2 4 6 8 EFTA01475988 8 December 2015 World Outlook 2016: Managing with less liquidity Given the challenges facing many EM economies, the coming year will likely see a marked divergence in monetary policy across the regions. In Latin America, despite a reasonably subdued growth backdrop, we expect central banks to raise interest rates in most countries and by almost as much as the Fed. In EMEA, we see rates going up in South Africa and Turkey and later in the year in Israel, but continuing to come down in Russia. In Asia, in sharp contrast to past Fed cycles, we expect only the Philippines will see rate hikes in 2016. Instead, we expect central banks in China, India, Indonesia and Taiwan to cut rates. By implication, interest rate differentials in Asia should move in favour of the US dollar, implying a risk of continued weakness in Asian currencies against the dollar. We expect most emerging market currencies to outperform the euro, though. Of particular note, we expect only about a 4.5% depreciation of the RMB against the USD, mostly late in the year as the PBOC cuts rates. The possibility that policymakers in China decide to move the exchange rate in a larger, discrete, devaluation is probably the greatest risk to the emerging markets currency outlook as that would likely trigger similar moves in other EM currencies. Partly for that reason — that it wouldn't get much of a competitive advantage from a devaluation — we don't expect China to devalue the RMB. Summary of strategy views on the markets Rates: Peak policy divergence As the divergence between US and European monetary policy may have peaked, we believe that 2016 should see a partial convergence of US and European bond yields. Our end-year forecasts see the 10-year Bund around 1.1% and 10-year US Treasury at 2.5% (although our macro forecast—with the Fed on a slow but steady uptrend — may be consistent with a somewhat higher yield by end 2016). In Europe, absent an external shock, the market is likely to focus in the second half of the year on the prospects of the ECB discussing (but not implementing) a tapering-off of asset purchases, while the front end should remain anchored. This should lead to steeper curves. In the US, the terminal rate priced by the market is arguably too low, and we see scope for the market to re-price this on the back of some improvement in historically low productivity and a reduction in growth headwinds that have been suppressing the neutral rate. However, the pace of hikes next year looks closer to fair given the lagged impact of the US dollar on core PCE inflation, which should limit the scope of hikes in 2016. Credit: US credit feels the pressure of high commodity exposure US credit markets made a U-turn midway through 2015, as doubts began to surface with respect to issuer fundamentals and exposure to commodities and EM. Though current spread levels are more attractive than those prevailing just a few months ago — both HY and IG are at 3- to 4-year wides — we expect the EFTA01475989 push-and-pull to continue between those seeking more yield and those seeing signs of a cycle turn. However, we expect only a moderate rise in ex-energy defaults and continued pressure on HY spreads. Higher vulnerability of HY therefore makes IG credit a more attractive alternative, especially in light of current levels. We recommend avoiding sectors exposed to the energy sector's capital expenditure declines, such as capital goods. Two to three hikes by the Fed should not be problematic for credit. Fundamentals are better for European credit: debt accumulation has been nowhere near as aggressive as in the US market, and European credit has far less exposure to the energy and materials sectors. Overall, Europe is some way behind the US in terms of a deteriorating credit cycle, so we believe European credit can continue to outperform even if US credit widens further. Page 14 Deutsche Bank AG/London EFTA01475990 8 December 2015 World Outlook 2016: Managing with less liquidity US equity strategy: Still-low Treasury yields despite Fed hikes to boost S&P PE Our S&P 500 targets are 2100 for 2015 end and 2250 for 2016 end, representing 5-10% upside. Health Care and Tech — which represent more than one-third of the S&P 500 — are why we are reasonably bullish for 2016, while Energy and Industrials remain a significant concern. Most of the rest of the market, both the S&P and the Russell 2000, seems fully valued except a few big Banks, Utilities, Airlines, and some of our specific stock picks. We do not believe that a recession looms or that S&P profits will fall again in 2016. We also do not expect the S&P will suffer a bear market or a sharp correction. But there are a number of key risks for equities: any further dollar gains must be slow, wage gains must be accompanied by better productivity, and the rise in yields as the Fed hikes must be gradual and contained. European equity strategy: 7% upside in 2016E but beware of the risk of a nearterm correction We see around 7% upside for the European equity market by end 2016, with a target of 410 for the Stoxx 600. European equities should benefit from stronger EPS growth, low real bond yields, FX support from a further decline in the euro and relatively attractive valuations. Among sectors, we like European banks, where investor pessimism persists despite relative return on equity rising to a seven-year high, and cyclicals, especially tech and auto. We are more cautious on the outlook for the resource sectors and consumer staples, which are exposed to a further decline in commodity prices and an additional drop in emerging market exchange rates and rise in US bond yields. There is a risk of a 5-10% correction in the near term if an adverse reaction to Fed hikes leads to a substantial tightening in global financial conditions. FX: Plenty of run left in the USD upswing Following the historical 20% surge in the US dollar over the past year and a half (on a trade-weighted basis), we see the dollar upswing extending for at least another two years, though at a more modest pace. There are several unique circumstances with the current dollar upcycle, including that G10 central banks are not expected to follow the Fed's tightening impulse this time around. How 2016 shapes up will be heavily influenced by whether the main macro driver is the Fed or China. If it is the Fed, US dollar gains are likely to be slow and broad-based. Conversely, if the RMB again becomes a source of instability, US dollar gains should be heavily concentrated in commodity and EFTA01475991 EM currencies. Our end-2016 forecasts are largely unchanged: EUR/USD at 0.90, USD/JPY at 128, and GBP/USD at 1.27. Commodities: Supply adjustment is well underway for oil, not so for the metals We expect OPEC will have engineered one of the sharpest historical declines in US production by next year. While we expect that the first half