2018 global economic and market outlook -...

Please refer to page 98 for important disclosures and analyst certification, or on our website

www.macquarie.com/research/disclosures.

As 2017 draws to a close, the combination of good global growth and low inflation

has seen risk assets move substantially higher. However, despite the strong

gains, the rally has been among the most unloved in history, as many investors

have remained on the sidelines, worried about valuation and the risk of further

shocks.

Over the following 96 pages we provide detailed forecasts for the global

economy and major markets.

While the consensus remains nervous, we feel that the global economy has

finally moved onto a stronger footing, with above average growth likely to persist

over 2018, notwithstanding a slowdown in China. This, combined with still low

interest rates should see current ‘goldilocks’ conditions continue well into 2018.

We note, however, that investors should make hay while the sun shines, as 2019

is likely to be more dangerous as stronger wages and inflation in the US along

with the first rate hike in Europe, collide with further China weakness.

Macquarie Securities (Australia) Limited Ric Deverell +61 2 8232 4307 [email protected]

November 2017

2018 Global Economic and Market Outlook

Make hay while the sun shines…

Macquarie Research 2018 global economic and market outlook

27 November 2017 2

Analysts

Macquarie Securities (Australia) Limited Ric Deverell +61 2 8232 4307 [email protected] Justin Fabo +612 8232 0696 [email protected] Jason Todd, CFA +61 2 8237 3134 [email protected] Macquarie Capital Markets Canada Ltd. David Doyle, CFA +1 416 848 3663 [email protected] Neil Shankar +1 416 607 5055 [email protected] Macquarie Capital Limited Larry Hu, PhD +852 3922 3778 [email protected] Viktor Shvets +852 3922 3883 [email protected] Lynn Zhao +86 21 2412 9035 [email protected] Macquarie Capital (Europe) Limited Matthew Turner +44 20 3037 4340 [email protected] Vivienne Lloyd +44 20 3037 4530 [email protected] Serafino Capoferri +44 203 037 2517 [email protected] Jim Lennon, Senior Commodities Consultant +44 20 3037 4271 [email protected] Macquarie Capital Securities (Japan) Limited Peter Eadon-Clarke +81 3 3512 7850 [email protected] Macquarie Capital Securities (India) Pvt. Ltd. Upasana Chachra +91 22 6720 4355 [email protected] Macquarie Equities South Africa (Pty) Ltd Elna Moolman +27 11 583 2570 [email protected] Macquarie Capital (USA) Inc. Vikas Dwivedi +1 713 275 6352 [email protected] Julia Surgeon, CFA +1 713 275 6461 [email protected] Abigail Lang +1 713 275 6145 [email protected] Walt Chancellor +1 713 275 6230 [email protected] Xiaolong Liang, CFA +1 713 275 8998 [email protected]

Contents Executive summary ....................................................................................... 3

Global economic outlook ............................................................................... 5

Topical Essays .............................................................................................. 7

Give me higher wages, inflation and yields O Lord, but not just yet…. ......... 8

The outlook for US productivity ................................................................... 14

China: Embracing a new political cycle ....................................................... 17

The outlook for US tax reform ..................................................................... 21

Developments in Emerging Markets ........................................................... 24

The outlook for the BOJ .............................................................................. 26

Political risk in Europe ................................................................................. 28

Individual country economic outlook ........................................................... 30

United States: Age shall not weary us… ..................................................... 31

China: Structural slowdown to resume........................................................ 34

Europe: Recovery, recovery at Last… ........................................................ 39

UK: growth slow… disaster? No… .............................................................. 41

Japan: Steady as she goes ......................................................................... 42

Australia: Waiting for wages........................................................................ 44

India: Growth Normalisation ........................................................................ 48

Canada: Housing headwinds are here ........................................................ 50

South Africa................................................................................................. 52

Global Markets Outlook............................................................................... 56

Interest rate outlook: Conundrum all over again…...................................... 57

FX Outlook: A year of two halves ................................................................ 62

Commodities outlook: oil ............................................................................. 66

US natural gas outlook ................................................................................ 71

Commodities outlook .................................................................................. 73

Global equity outlook – Year of choices & consequences .......................... 76

Australian equity outlook – Beauty and the beast ....................................... 92


27 November 2017 3

Executive summary For much of the post-crisis period the global economy has struggled to gain traction, with

GDP growth consistently below longer-run averages, as structural headwinds and regular

shocks held back growth. However, while challenges remain, to us 2017 has been a

watershed year, with the global economy finally beginning to shake off the shackles of the

financial crisis – nearly 10 years after Lehman Brothers fell.

This turnaround is well illustrated by the fact that following a period of continual

downgrades from 2011 to 2016, forecasters have for the first time since 2010 begun to

upgrade their growth outlook in recent months (Fig 1).

Fig 1 IMF has for the first time this cycle revised its current year forecast up…

Source: IMF, Macquarie Research, November 2017

This raises the tantalising question: is the global economy finally beginning to

‘normalise’ following what was a most bruising crisis?

While risks remain, we think that the healing process is well under way, and that growth

will remain solid over the coming year. Our sunny view is underpinned by the fact that

domestic demand is now growing in all the major regions, with the rising tide likely to continue

to lift all boats, despite the slowdown underway in China. Indeed the recovery in domestic

demand in the major economies, and in particular the improvement in business investment,

has already seen global exports rebound, with good growth likely to persist through 2018.

This view is consistent with the deep academic literature on the impact and aftermath of crisis

(for example Reinhardt and Rogoff 2009).

While it is clear that financial shocks are often followed by a slow, unfulfilling recovery,

history suggests that the crisis does in fact eventually pass.

For example, in Give Me Higher Wages… we highlight the slow recovery from the

depression of the 1890s when, while slow, reflation did eventually occur.

Notably, while growth has been good in 2017, it has not been “too strong” with real

economy outcomes generally softer than suggested by the surveys. This is important as

the lack of a boom (at least to date), reduces the chances of a bust in 2018.

Finally, over the past few years every time growth began to recover it was derailed by a

substantial shock (Europe 2011/12 and Oil in 2015).

While one should never say never, to us the probability of another idiosyncratic shock

large enough to derail global growth is relatively small in 2018.

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2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

IMF Fall forecast change to current year

Ric Deverell +61 2 8232 4307 [email protected]


27 November 2017 4

The fact that growth has not been too strong, accompanied by the fact that there is still

excess capacity in many regions and very low inflation, suggests that it will remain

supported by very accommodative central banks (outside the US), with the ECB leaving

its policy rate negative throughout the year, and the BoJ continuing to lock its 10-year yield

near zero. This is likely to see long yields everywhere remain low for much of the year,

despite ECB tapering and Fed sales, which in turn should continue to support risk assets.

For 2018 we expect:

Global GDP growth of 3% YoY, with Europe, the US and Japan to remain robust, while

China slows a little as the property slowdown and weaker public Fixed Asset Investment

(FAI) weigh.

The Fed to continue to gradually reduce the pace of re-investment, and to increase the

Fed funds rate by a further 100 basis points to 225 basis points. (See p 25)

The ECB to continue to taper, but importantly to keep policy rates negative until 2019.

(See p 38)

The BoJ to continue to target a zero per cent 10-year yield. (See p 41)

The RBA to keep rates on hold until at least August, with a risk that policy is

unchanged in 2018. (See p 43)

The US to introduce tax stimulus, which should add between ¼ ppt and ½ ppt to

growth, and importantly result in a substantial repatriation of company profits over 1H.

(See p 21)

Long rates to drift modestly higher over the course of the year, but to remain in recent

ranges in most economies over 2018, as continued financial repression in Japan and

Europe, coupled with a slow rebound in US wages growth continue to weigh. (See p 56)

The US dollar to find some support in 1H as tax reform incentivises corporates to

repatriate profits. But to resume its decline in 2H. (See p 61)

Risk assets to continue to rally, with equity markets in Australia, Europe and Japan

continuing to play catch-up with the US. (See p 55)

Industrial commodities to be mixed as the China slowdown interacts with still good

Western growth and supply developments in China, the US and OPEC. (See p 65)

Risks

On the downside, the main risk we see emanates from China. In our central scenario,

Chinese growth slows from the current 6.8% yoy to 6¼% by 4Q next year, as FAI and

housing slow. However the risk is that the newly formed government loses patience with

the current slow pace of reform, and pushes through a more aggressive agenda that

could see substantial weaker growth (see chapter 16 on China reform)

The other significant risk we see is an earlier-than-expected move higher in the global

cost of capital. While we think this period of strong growth, low yields and appreciating asset

prices will persist for much of 2018 (make hay while the sun shines), investors should be

aware that the laws of supply and demand do still work, with the risk that market storm clouds

begin to appear as 2018 comes to an end, with stronger US wage growth coupling with

signs that the ECB will finally move away from negative rates portending a much more

volatile 2019 for risk assets.

Of course, it is possible that markets anticipate this pivot, and begin to price overheating

well ahead of actual evidence.

Related to this, while many will continue to focus on downside risks, we see an equally

likely situation where the self-reinforcing forces that appear to have been unleashed in

2017 strengthen in 2018, pushing GDP growth well above average, acting to hasten

overheating fears.

The essays that follow explore some of the key themes that underpin this outlook, and are

followed by a summary of the economic outlook for each of the major economies, as well as

an overview of our outlook for the various markets we cover.

We thank you, our readers and clients, for the business relationships we share and wish you

great success in finishing 2017 and mapping your strategies for 2018.


27 November 2017 5

Global economic outlook After a relatively weak 2014 and 2015, global growth bottomed in early 2016, and has now

been recovering steadily for nearly two years.

Our preferred cyclical indicator (trend monthly industrial production growth), has

rebounded from near zero in early 2016, to around 5% – well above the 3% long-run

average.

Similarly, global GDP growth, has been steadily recovering, and has now been at or above

the long-run average for the past 6 quarters, with the 6 months spanning 2Q and 3Q the

best growth seen since the initial sharp bounce from the crisis in 2010.

Fig 2 Global GDP growth is now above average

Fig 3 Global industrial production growth will peak soon, but remain above average in 2018

Source: Macquarie Research, Bloomberg, Log Level, November 2017 Source: Macquarie Research, Bloomberg, Log Level, November 2017

Significantly, global growth is now broadly based, with almost all economies currently

expanding, suggesting that the “rising tide lifts all boats” effect could continue to support

growth for some time.

Note that while we saw synchronised expansions in 2010 and again briefly in 2014, in

those instances, the rebound was short-lived, as idiosyncratic shocks (Europe in 2011,

and oil in 2014) weighed on growth.

While this volatility shows that we should not take the recovery for granted, we feel that

growth is now on a firmer footing, with 2018 more likely to follow the pattern of the 2000s,

than that seen in the current recovery.

Global trade growth has also finally rebounded, with growth likely to persist over 2018 as

the recovery in domestic demand almost everywhere, and in particular the bounce in

business sentiment and investment continues to lend support.

46.0

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11 12 13 14 15 16 17 18 19

IndexPer cent

Global Industrial Production GrowthMonthly, trend

Industrial productiongrowth(LHS)

Global manufacturing PMI(RHS)

Ric Deverell +61 2 8232 4307 [email protected]


27 November 2017 6

Fig 4 The recovery is also highly synchronised, with almost all countries currently growing…

Source: Macquarie Research, BP, Bloomberg, November 2017

Given this, while the most recent global PMI data suggests that the pace of growth is

probably in the process of peaking (in large part because it always has in the past when it

has been this strong), we expect growth to remain above average well into 2018.

We expect the quarterly pace of GDP growth to slow from the solid 3¼% saar seen in 3Q,

to around trend at 2¾% saar by the end of next year.

Trend monthly IP growth should similarly remain above average for much of next year,

only dipping back toward trend in 4Q.

For a detailed discussion of the major economies see:

United States – page 31

China – page 34

Europe – page 39

UK – page 41

Japan – page 42

Australia – page 44

India – page 48

Canada – page 50

South Africa – page 52.

0

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99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

Per cent

Share of Country PMIs Above 50


27 November 2017 7

Topical Essays

Give me higher wages, inflation and yields O Lord, but not just yet…. ................................................. 8

The outlook for US productivity ........................................................................................................... 14

China: Embracing a new political cycle ............................................................................................... 17

The outlook for US tax reform ............................................................................................................. 21

Developments in Emerging Markets ................................................................................................... 24

The outlook for the BOJ ...................................................................................................................... 26

Political risk in Europe ......................................................................................................................... 28


27 November 2017 8

Give me higher wages, inflation and yields O Lord, but not just yet…. Summary

As 2017 comes to an end, a key question for policymakers and investors alike is whether and

when wages and inflation will begin to recover? Or in more technical terms, whether the

Phillips curve has indeed been cast aside?

In this essay, we analyse the situation in both the US and Australia, drawing on the long

sweep of history, as well as theory, to assess the likely path for 2017.

We conclude that both wages and inflation will respond as the labour market gets yet

tighter – indeed in the US the wages recovery has been occurring since 2012.

We note however, that both in the US (and with a lag Australia) a return to more “normal”

wages growth and inflation will take some time, with the much-anticipated shock to

markets from higher inflation and yields a story for 2019, rather than next year.

Fig 5 Wages growth has been increasingly very slowly since 2012… but remains well below a ‘healthy’ pace….

Source: Macquarie Research, Bloomberg, November 2017

An important conclusion of this analysis is that once inflation and wages do return, and the

extreme financial repression on long yields by non-US central banks begins to moderate

(we see the likely end of negative interest rates in Europe in 2019 as a key trigger), long

yields could move higher than many people currently think possible.

In the bond outlook section we note that over time, 10-year yields tend to move with

nominal GDP growth, which we expect to track around 4¼ % or a little higher over coming

years, and 4½% in Australia.

We note, however, that history suggests that even once inflation (and hence nominal GDP

growth) changes course, long bonds take some time to buy into the new paradigm – see

the bond outlook, page 57)

Ric Deverell +61 2 8232 4307 [email protected] David Doyle, CFA +1 416 848 3663 [email protected] Justin Fabo +612 8232 0696 [email protected]


27 November 2017 9

The US experience

While much of the discussion over recent months has been on the so called “paradox” of

continued low inflation and wages growth in the US, despite low unemployment, we see little

to support the current hand wringing about the so called “death of the Philips curve”. Indeed,

as outlined in Synchronised growth, but a momentum peak is near, to us history suggests that

the NAIRU moves substantially between cycles, with the long-tail of the crisis along with

demographic and technological disruption likely to require a lower unemployment rate than

seen recently before wages begin to improve.

Indeed, while wages growth remains weak, we note that it is clear that they have already

bottomed, with a gradual upward trend having been in place since 2012.

To try to get a sense of how long the reflationary period could take, we draw on the long run

of data to see if there are periods from which we can draw lessons.

To us, two stand out:

The recovery from the depression of the 1890s; and

The return of inflation in the mid-1960s – well ahead of the oil shock.

Lessons from 1880 to 1914: Reflation can take a long time

While we don’t have wage growth data from this time period, it is clear that it took several

years for both inflation and yields to move back to levels seen before the economic collapse.

This could suggest that while reflation is possible following sharp economic downturns, it can

take a long time.

Noticeably, while one should not put too much weight on the unemployment rate as a

measure of labour market slack over such a long period, inflation did not really begin to pick

up until the unemployment rate began to fall rapidly in the 1898 to 1901 period, falling from

8.0% to 2.4% over this three-year period.

With 10-year yields, it is notable that while they did recover, it took nearly a decade after the

crisis for yields to return to their previous level.

Note however that once reflation arrived, yield moved above those seen pre-crisis.

Fig 6 A shift from a deflation regime to a low inflation regime occurred around 1900…

Fig 7 ... this was around the same time as the unemployment rate moved to ~2%

Source: Robert Shiller, Macquarie Research, November 2017 Source: Robert Shiller, Macquarie Research, November 2017

-8%

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1880 1885 1890 1895 1900 1905 1910

US CPI - YoY % change (three year average)

1880-96 avg = -1.6%

1897-1914 avg = +2.3%

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27 November 2017 10

Fig 8 Yields moved gradually higher over a decade from 1900 to 1910

Source: Robert Shiller, Macquarie Research, November 2017

Lessons from the 1960s: After being dormant for an extended period, tight labour markets and fiscal stimulus can drive an inflation rebound…

The second period that we think is relevant is the 1960s. Contrary to the popular narrative,

inflation began to increase in 1965, well before the oil price shocks of the 1970s. Indeed, the

inflection point for inflation occurred in 1965 as the unemployment rate fell from an average of

~5.0% in 1Q to 4.1% in 4Q, and fiscal spending surged (both the new society programs and

the Vietnam War).

Notably, during this time period, average hourly earnings growth lagged inflation, only

picking up in 1967, two years after inflation began to move.

It is interesting that while yields began to move higher with inflation in 1965, they did not

move materially higher until wages kicked in in 1967.

Fig 9 In the 1960s, inflation began moving higher well in advance of the oil shocks …

Fig 10 ... unemployment was sub 4% for 18-24 months before wage growth moved up

Source: EIA, BLS, Macquarie Research, November 2017 Source: BLS, Macquarie Research, November 2017

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average hourly earnings YoY

unemployment rate


27 November 2017 11

Fig 11 Stronger wage growth accompanied the back-up in the 10-year Treasury yield in the late 1960s

Source: BLS, Federal Reserve, Macquarie Research, November 2017

The implications from these history lessons for 2018 and beyond

As we have highlighted previously, we suspect that it will take some time for wages to pick up

materially. Average hourly earnings are starting from a very low rate and continue to be

depressed by Baby Boomer retirements, the long tail of the crisis, technological disruption

etc. What’s more, given intense retail pricing pressures, and the historically low labour share

of GDP, business is likely to be forced to absorb the initial increase in wages, with inflation

only following with a lag.

This, in conjunction with our view that the long end of the US curve is more influenced by

global factors (savings glut, Japan pegging 10s at zero, negative rates in Japan, ongoing

QE in the Euro area, albeit at a slower pace than recent years) suggests that it will take some

time for yields to break out of the range seen in the past year few years (where the peak

was 3%).

However, as unemployment falls into the 3s over the course of 2018, it is likely that

inflationary pressures will continue to build, and that wage growth will begin to move to new

expansion highs and make progress towards reaching its pre-recession growth rates. This

suggests to us that global investors should enjoy the current risk rally while they can, because

2019 could prove more risky as the ECB starts to normalize rates, US wage growth begins to

accelerate, inflation normalizes, and the BoJ debates stepping back from its 10-year target.

The long path back for Australian wages growth

Australian households are experiencing the weakest sustained period of average real wages

growth – zero – since the 1980s (Fig 12).

The single-biggest driver of this has been the fall in commodity prices and Australia’s

terms of trade over the past six years. This has resulted in a necessary downward

adjustment in Australia’s labour cost base (Fig 13).

This adjustment is largely following the script. Absent an abrupt economic shock, a textbook

realignment in an economy’s cost structure typically plays out in ‘real’ terms over long

periods rather than as short, sharp nominal adjustments – this is what is happening. The

good news is that lower relative labour costs are supporting stronger employment growth

than would otherwise be the case.

The changing composition of employment, particularly within sectors, has also been

weighing on growth in average earnings (Fig 14). In addition, demographics have also

played a role as the share of ‘prime’ working age employees – who have the highest

average earnings and earnings growth – in the workforce has fallen (Fig 15). This structural

adjustment, however, has been playing out over a much longer period (more than 15 years)

and appears to be drawing to an end.

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27 November 2017 12

Fig 12 Weakest sustained period of real wages growth since the 1980s

Fig 13 Australia’s relative labour costs are being slowly dragged lower alongside commodity prices

Source: ABS, Macquarie Research, November 2017 Source: ABS, OECD, Macquarie Research, November 2017

Fig 14 Average earnings have recently been flat, in part due to the changing composition of employment

Fig 15 Demographics have been weighing on wages growth but this is abating

Source: ABS, Macquarie Research, November 2017 Source: ABS, Macquarie Research, November 2017

Outlook and implications

Australia’s terms of trade and productivity performance will largely dictate the path for wages

growth in 2018 and 2019. Our view is that consumers’ real hourly wage rates will continue

to track broadly sideways for at least another 12-18 months as the adjustment associated

with the lower terms of trade continues (Figure 13).

We expect the recent improvement in commodity prices and Australia’s terms of trade to

be mostly temporary. The outlook for China is key here: if our commodities view is too

bearish and the terms of trade performs better than expected, then the outlook for wages

growth would be for a quicker recovery.

Any faltering of productivity growth from current solid rates will prolong the adjustment

in wages.

The overseas experience suggests that even after Australia’s relative wages eventually

realign lower, any improvement may still be slow. The pick-up in wages growth in many

developed economies has so far been relatively modest despite unemployment rates falling to,

or beyond, levels consistent with estimates of ‘full employment’.

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* Deflated by household consumption deflator 70

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IndexIndex

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Terms of trade (RHS)

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(LHS)

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casts

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(LHS)

Annual real wages growth(smoothed, RHS)*

* 21-quarter centred moving average of real non-farm earnings per employee

Commodity price boom temporarilyinflated real wages growth


27 November 2017 13

While the causal factors are open to debate, it seems likely that Australian wages are not

immune to the global experience. The upshot is that even as the unemployment rate

approaches the 5% estimate associated with ‘full employment’, any improvement in wages

growth is likely to be slow.

Weak wages growth means that household spending growth is unlikely to improve

beyond its current 2.5% annual rate until at least 2019 (Figure 17). The risks are skewed to

weaker outcomes, particularly if slower housing price growth and high leverage give

households less confidence to reduce their saving rate as quickly as has occurred in

recent years.

This is obviously important for the outlook for interest rates. It is more difficult to identify

upside risks to the wages, spending and inflation outlook over the next year or two. Our

central case is that the RBA will slowly begin to wind back its policy support to the economy

from August 2018 to reduce the medium-term distortionary risks from very low interest rates.

The risk is that this course of action will begin later.

Fig 16 Real hourly wages will stay broadly flat until productivity ‘catches up’ further

Fig 17 Risks to the consumer spending outlook are skewed to the downside


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IndexReal Wages & Productivity

Real wages per hour received by consumers

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Terms of trade boom

Terms of trade falling

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Per cent

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Consumption

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27 November 2017 14

The outlook for US productivity Productivity growth has likely bottomed and a new regime is emerging

With labour supply constraints increasingly becoming restraints on output and available

labour slack diminishing, supply side growth is likely to become increasingly dependent on

productivity growth. While this has been one of the disappointing aspects of the current

expansion so far, there has been some improvement in recent years and there is reason to

believe that productivity growth has bottomed.

After averaging ~0.4% from 2011 to 2013, productivity growth appears to have shifted higher.

2017 is on track to be the third year in four where productivity growth will be 1% or more in

the United States and we are confident that it has likely moved to a structurally higher regime

compared to the earlier years in the expansion.

An analysis based solely on the potential mean reversion would suggest the long-run trend in

productivity growth should return to 1.5 or even 2% (Fig 18). This remains possible in the

long-term in our assessment. We see scope for further improvement in productivity growth

from some of the technological solutions in development (driverless cars, machine learning,

automation, etc.).

Fig 18 Productivity growth has been trending well below its average

Source: Bureau of Labor Statistics, Macquarie Research, November 2017

Retirements present a headwind for productivity growth out the next 10 years

It may take some time, however, for businesses to realize the potential productivity gains that

may flow from these sources. One factor that remains a headwind is retirements. These have

soared in recent years with the consequence that highly productive baby boomers have been

exiting the workforce and are being replaced with less productive and less experienced

younger workers. Given the relative size of the baby boom generation, this is occurring on an

unprecedented scale relative to history

This has meant that the growth rate in the average years’ experience per worker in the

economy has been pulled much lower than in previous decades. The long tail to the baby

boom generation means elevated retirements are likely to persist through 2026-7 putting

persistent downward pressure on the growth rate in average years’ experience per worker

(Fig 19). One of the reasons we are confident that the trend in productivity growth has

bottomed is that this measure should begin to show some slight improvement in the years

ahead after decelerating for nearly a decade.

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1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013

US labour productivity growth (3 year average)

1951-2017 avg

David Doyle, CFA +1 416 848 3663 [email protected] Ric Deverell +61 2 8232 4307 [email protected]


27 November 2017 15

Fig 19 The pace of growth in average years’ experience has bottomed


Capital deepening may be improving and could explain the shift higher

While retirements are likely to continue as drags over the next several years, there are two

other drivers of productivity that may relent, supporting the notion that productivity growth has

entered a new, higher growth regime relative to the 2011-14 period.

The first (and most compelling driver) is capital deepening. This is the contribution that an

increase in the amount of capital being deployed per worker has to productivity growth. This

has been much lower in the US and in other major economies during the current expansion

relative to previous decades (Fig 20). With employment growth likely to continue to slow in

the years ahead, capital deepening may pick up. Labour scarcity could help motivate firms

to increase the growth rate in capital investment as a means to meet demand growth.

A second potential driver could come from a pick-up in creative destruction. There has been a

sharp slowdown in terms of job creation/destruction and firm entry/exit (Fig 21). This suggests

there is a less dynamic labour market and potentially less entrepreneurship than in prior

decades. We believe that the aging population may be partly behind this (entrepreneurs and

risk takers tend to be younger), but there is reason to hope for some improvement in the

years ahead. Disruptive technologies together with the potential for tax reform measures and

deregulation could lead to some improvement on this front.

Fig 20 Capital deepening may improve … Fig 21 … as could firm entry & exit

Source: OECD, Macquarie Research, November 2017 Source: Census Bureau, Macquarie Research, November 2017

0.0%

0.2%

0.4%

0.6%

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1989 1993 1997 2001 2005 2009 2013 2017 2021

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27 November 2017 16

Our productivity growth forecasts through 2021

As part of this note we have lifted our estimate for US productivity growth in the long-run

(2021 and beyond) by a further 10 bps. This comes in addition to the 20 bps increase we

made in October in US growth upgrade.

The total 30 bp increase over the past two months reflects our growing confidence that

productivity growth has moved structurally higher compared to the early years of the

economic expansion (Fig 22).

Even with our upgrade, however, we still are calling for a modest pullback in productivity

growth in 2018 relative to the strong performance in 2017. Outsized gains from the energy

sector have been partially responsible for the strong productivity gains in 2017. These gains

are unlikely to persist at the same pace in the years ahead meaning the positive impulse from

the energy sector on productivity growth should lessen.

Fig 22 Productivity growth in the expansion (blue) and our forecast (red)


0.1%

0.9%

0.3%

1.0%

1.2%

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2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

US productivity growth (annual average)


27 November 2017 17

China: Embracing a new political cycle The widely watched 19th Party Congress wrapped up and China has entered a new political

cycle, which will lead to the 20th Party Congress at 2022. As was the case in the past, the

Party Congress was mainly about personnel changes at the top level – it was not a place to

introduce new reform plans.

Looking forward however, with 15 new members joining the 25-member Politburo, the

political power at the top level is now far more consolidated. This suggests that if the

President so chooses, he will have the power to significantly change policy direction in

coming months.

In this note we discuss our thoughts on this critical issue.

We will also discuss the limitation of financial deregulation without reforming SOEs and

local governments.

What happened in the past five years?

Within 12 months of the 18th Party Congress in 2012, three major themes emerged:

anti-corruption, mini-stimulus and financial deregulation.

In their first five-year tenure, China’s top leaders decided to use the time to consolidate power

and anti-corruption is one way to do that. For this purpose, they need a stable economic

backdrop and thereby mini-stimulus has been adopted to smooth volatility. As a result,

China’s economy in the past five years has been much more stable compared with the past

(Fig 23). At the same time, compared with SOE and land reforms, it’s easier to push forward

financial deregulation, which hopefully could increase the efficiency of capital allocation.

Now, compared with five years ago, the power structure is much more consolidated thanks to

anti-corruption but the room for further mini-stimulus through property and infrastructure has

also been limited. Meanwhile, financial deregulation without overhauling the SOEs and local

governments has led to huge moral hazard and thereby heightened financial risks. While in

the past five years, the market might be over-pessimistic towards China on concerns on debt,

property, RMB and capital flows, the deep structural issues in China’s economy such as huge

misallocations of capital and land remain unsolved. Policymakers will have to address these

issues in the next five years.

What policymakers will do in the next five years

With political power being much more consolidated than five years ago, now the key

challenge for top leaders is to justify the new power structure by continuing to deliver on their

key mandate: the Chinese Dream (i.e., to make China great again). To do that, they need to

overcome two potential traps: the middle-income trap and the Thucydides trap (i.e., managing

a peaceful rise as a great power).

Fig 23 Mini-stimulus smoothed out growth volatility in the past few years

Source: CEIC, Macquarie Research, November 2017

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Larry Hu, PhD +852 3922 3778 [email protected]


27 November 2017 18

It will take more time for the market to have a better understanding of what is in the minds of

top leaders for the new political cycle. But below are our main takeaways from President Xi’s

speech during the Party Congress.

Growth: China’s policymakers spent lots of time in the past five years stimulating the

economy. The end of the power reshuffle should make them more tolerant about growth

volatility. In his opening speech, President Xi did not mention any growth target. As a result,

China’s economic growth could have another leg down in the next few years, in our view.

Property: Property is an important issue that matters for both economic growth and wealth

distribution. Over the past five years, home prices in many cities more than doubled.

Policymakers are under rising pressure to solve the problem, either through land reform or

property tax – neither of which will be easy. Indeed, both are highly risky to the current growth

model.

Industrial policy: Economic growth is still the biggest source of legitimacy for the ruling

party. As both infrastructure and property investment are set to slow, we believe policymakers

will continue to be supportive of the new economy as well as a dozen key industrial sectors

such as semiconductors, airplanes, new energy cars and so on.

Xi’s agenda: As political power has become more centralized, President Xi’s agenda will be

pivotal for the whole Party. Environmental protection and poverty reduction are important.

One-belt-one-road (OBOR) will be pushed forward, too. RMB internationalization, a key input

of OBOR, will regain momentum.

SOE reform: SOE reform, which is the hardest and likely the last among all reforms, is

currently still far from certain. Historical experience suggests that an adverse growth “shock”

may be needed to get things really moving. We are not there yet. For the same reason, it is

also too early to call land reform.

Importance for SOE and land reforms

While politically difficult, the SOE and land reforms remain the most important things for

China’s economy in the long term. The political economy plays a more important role than

pure economic considerations in the process.

These reforms are hard because the two most powerful vested interest groups are SOEs and

local governments. After all, SOE reform is largely about downsizing SOEs, while local

governments rely heavily on land as a source of revenue. Amid the power consolidation

between 2012 and 2017, it’s hard to push them forward. Therefore, policymakers chose to

start from easier tasks such as financial deregulation. However, financial deregulation has led

to rising risks due to a lack of reforms for SOEs and local governments. This has been

highlighted by the four boom-and-bust cycles over the past five years in the financial sector.

Four boom-and-bust cycles amid financial deregulation

In the past five years, China experienced the largest financial liberalization in history. From

2012, the market cap of A-shares rose from Rmb22tn to Rmb55tn, while that of the onshore

bond market rose from Rmb22tn to Rmb46tn. However, this period also saw four boom-and-

bust cycles in the financial sector, showing the intrinsic problem in this wave of financial

liberalization. Below we briefly discuss why they happened.

The first boom-and-bust cycle happened in 2012-13. In essence, it was an interest rate

liberalization in the real economy. In the process, banks were allowed to bypass the interest

rate cap by raising money through Wealth Management Products (WMP), then lend it to trust

companies, who then lent to borrowers in the real economy at higher rates than formal bank

loans. This was interest rate liberalization because WMPs liberalized deposit rates and trust

companies liberalized lending rates. As a result, both borrowers and depositors in the real

economy got higher interest rates than before. While trust companies were called shadow

banks back then, they are more like banks’ shadows in the sense that they act as a channel

for banks to bypass interest rate regulations.

The original thoughts of policymakers were that private enterprises were more efficient than

SOEs, so they could afford higher borrowing costs than SOEs. However, private enterprises

were crowded out by Local Government Financing Vehicles (LGFV), which were backed by

local governments and could offer even higher interest rates. In mid-2013, the PBoC decided

to clamp down on such activities and the effort led to a credit crunch in June 2013.


27 November 2017 19

The second boom-and-bust cycle was the A-share market in 2014 and 2015. This is familiar

to our readers so we will not elaborate here.

The third was the RMB internationalization, which took off between 2012 and 2015, then

collapsed due to depreciation and capital outflows pressure.

The last one happened between 2014 and 2016, essentially an interest rate liberalization in

the interbank market. Big banks borrowed money from the PBoC, then lent to smaller banks

through Negotiable Certificates of Deposit. Smaller banks then lent the money to nonbank

financials such as brokers or investment funds, who mainly invested in the bond market, but

sometimes channelled the money to the real economy.

The original thoughts by policymakers were that the process could facilitate the transmission

of policy rates from the central bank to the interbank market, then to the bond market, and

finally to the real economy. However, small banks and non-bank financials seized the

opportunities to leverage up to profit from the duration and credit mismatch in the belief that

the PBoC would bail them out if the worst happened. The bond bull market lasted 2.5 years

until July 2017, when policymakers thought it too risky and decided to tighten again.

Moral hazard – no matter whether embedded in LGFVs or state-owned bank – was

behind the four boom-and-bust cycles. Meanwhile, another major source of moral hazard

in the economy is SOEs, which are also backed by the government. As we discussed in

China’s debt, Myths and Realities, two-thirds of China’s corporate debt is SOE debt. In short,

the moral hazard problem embedded in China’s economic system could pose huge risks for

the future. Indeed, we could see the problem from another angle: China’s debt problem.

The road to deleveraging ahead

To be sure, we don’t think that China is facing an imminent debt crisis. The majority of

China’s debt occurs within the public system, so policymakers can easily shuffle the existing

debt within the system, say, from local governments to the central government

(local government debt swap), or from SOEs to banks (debt to equity swap).

On the other hand, we see that rising debt is a severe issue as it reflects large-scale capital

misallocation between the private and the public sectors, which would lower productivity and

cause China to fall into a middle-income trap. In sum, China’s debt problem is largely a

reflection of the deep structural issues embedded in the system. Even if the gap between

credit and nominal GDP growth has narrowed recently thanks to improved economic

performance (Fig 24), the leverage problem will come back again when growth slows down.

Fig 24 The gap between credit and nominal GDP growth has narrowed

Source: CEIC, Macquarie Research, November 2017

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27 November 2017 20

Recent speeches by China’s policymakers show that they have come to understand the

nature of China’s debt problem and financial risks. While the Financial Work Conference in

2012 emphasized the role played by finance in enhancing productivity, this latest one held

this June had a more sophisticated view on the limitations of financial reform and the

importance of disciplining SOEs and local governments. For SOEs, the conference said that

“the most important thing (in containing financial risks) is to deleverage SOEs”. For the local

government, the Conference said that “local officials should be permanently held accountable

for the debt they raise.”

The bottom line is, China still needs to carry out ownership reforms for SOEs and local

government reforms, although these reforms are politically difficult. Past experience shows

that financial liberalization doesn’t work by itself without ownership reform. Over the past five

years, the A-share and the onshore bond markets have largely been driven by the rise and

fall of financial liberalization, while the H-share and commodity markets have been influenced

by the desire of policymakers to maintain a stable economic backdrop for political power

consolidation. This scenario is unlikely to persist for another five years, because financial

reform has caused many troubles while the room for further stimulus is much smaller

compared with five years ago. The key driver for Chinese financial markets in the coming

years is set to be the ownership reform, or the lack of it.


27 November 2017 21

The outlook for US tax reform Tax reform has gained momentum

In recent weeks momentum has built behind US tax reform legislation. While there remains

much work (and likely horse trading) to be done to ensure passage of the same bill in both

the Senate and the House, we now anticipate that something will be pushed through in 1Q18.

We estimate the eventual bill will have a positive economic impulse of a total of ~0.5

percentage points flowing through in 2018 (0.4 ppts) and 2019 (0.1 ppts). This is a more

substantial figure than we had previously incorporated in US growth upgrade and so has

positive implications (for our US real GDP forecasts in 2018 (+20 bps) and 2019 (+10 bps).

Near-term economic impulse felt through consumer spending

The near-term impact of tax reform will be felt through the consumer spending channel as

lower taxes increases disposable income. Our analysis (Fig 25) utilizes updated estimates

from the Tax Policy Center to reflect the Tax Cuts and Jobs Acts bill passed by the House of

Representatives. The estimates of the income gains for each age group suggests a potential

stimulus through the consumer spending channel of ~0.5 percentage points. Our analysis

suggests the bill under consideration in the Senate yields a similar estimate.

While part of this is likely to leak out through higher imports and spending abroad, we believe

this should be offset by a modest uptick in capital expenditures associated with the corporate

tax reduction.

Fig 25 The impact would likely prove positive for consumer spending, potentially boosting GDP growth by $103 billion

Source: Tax Policy Center, Macquarie Research, November 2017

Longer-term economic impulse felt through capital deepening

Beyond 2018 and 2019, there may be some modest boost through a firmer pace of capital

expenditures growth. This could result in a slightly firmer pace of capital deepening and

informs why we have raised our estimate on long-run productivity growth to 1.3%. Given

growing evidence of firming productivity (following a strong 3Q real GDP and what looks to be

a firm 4Q), we are lifting our estimates for productivity growth in 2018 (to 1.1%) and 2019

(to 1.2%). More on this can be found in the accompanying essay on US productivity growth.

Average federal tax

reduction

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filers (millions)

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Lowest quintile $60 28 $1.7 100% $2

Second quintile $310 28 $8.7 100% $9

Middle quintile $830 28 $23.2 75% $17

Fourth quintile $1,610 28 $45.1 50% $23

80-90 $2,350 14 $32.9 50% $16

90-95 $2,590 7 $18.1 40% $7

95-99 $6,640 5.6 $37.2 30% $11

0.1 to 1st percentile $37,100 1.4 $51.9 25% $13

top 0.1% $174,620 0.14 $24.4 20% $5

Total 140 $243 $103

2018 calendar year impact by income group

David Doyle, CFA +1 416 848 3663 [email protected]


27 November 2017 22

State of Play for the Tax Proposal

The House of Representatives and Senate have each released draft versions of a tax reform

bill. A summary of the key elements of the bills current as of this writing is provided below

(Fig 26). While there is substantial overlap on many of the key elements, significant

differences remain, meaning that the negotiation of tax reform could drag out into 1Q18.

The House bill has been passed meaning the Senate is the constraint. As of the writing of

this paper, the Senate version had made its way through committee, but was still awaiting a

vote in the broader chamber. Indications are that this will take place in late November or

early December.

Should the Senate’s version of the bill pass, a further negotiation will take place between

House and Senate leadership to reconcile the two different bills into one. This final bill must

then be passed by both Chambers and then signed into law by the President.

Fig 26 How the Senate and House Tax Bills stacked up as of 23 November

Source: Tax Policy Center, Macquarie Research, November 2017

Constraints on the magnitude of tax reform

Tax reform is following the reconciliation process in Congress. This will allow the passage of

the legislation with a simple majority in the Senate (typically 51 votes) rather than usual

60 votes that are required. Following this process means the Republican Party can pass

tax reform with conceivably no support from Democrats. There are two important constraints

that flow from following reconciliation.

First is Congress’ 2018 budget resolution. This caps the proposed tax reform’s impact on the

federal government’s deficit over a ten-year period at $1.5 trillion.

Second is the Byrd rule. This would allow the Democrats to block the proposed legislation in

the Senate if it adds to the deficit beyond a ten year period. To avoid breaking this constraint,

at the writing of this paper, the Senate bill has most of the individual income taxes expiring

after 2025, while the corporate income tax will be permanent.

Key elements House bill Senate bill

State and local tax deduction Mostly repeal, $10k cap property tax Repeal entire deduction

Medical expense deduction Repeal Maintain

Individual mandate tax Maintain Repeal, expiry in 2025

Child/Family tax credit $1600/child (permanent) $300/tax filer (2023 expiry) $2000/child, expiry in 2025

Non-child dependent credit $300/non-child dependent, expiry in 2023 $500/non-child dependent, expiry in 2025

Corporate tax rate Cut to 20% in 2018 Cut to 20% delayed until 2019

Immediate expensing of assets with life < 20 years for the next 5 years for the next 5 years

Expiry of corporate income tax measures Permanent Permanent

One-time repatriation tax From 35% to 14% on cash and 7% on non-cash From 35% to 10% on cash and 5% on non-cash

Mortage interest deduction Cap at $500k, limit to one home Maintain at $1 million cap

Estate tax Double exclusion, repeal in 2024 Double exclusion

Income tax brackets Consolidate to 4 brackets Consolidate to 7 brackets

Expiry of individual income tax measures After 2022 After 2025

Top income tax rate 39.6% 38.5%

Standard deduction $12k individuals, $24k couples $12k individuals, $24k couples

House and Senate tax reform bills: Key elements


27 November 2017 23

There are challenges ahead for tax reform to become law

While we believe a bill will be passed in 1Q18, there are still challenges in the road ahead.

This is especially so given the thin majority (52 out of 100 seats) that the Republicans

possess in the Senate.

At the time of writing of this paper, four Republican senators have warned that they may

oppose the latest versions of the bill for three different reasons, illustrating the complexity

of the challenge ahead.

Ron Johnson (Wisconsin) has indicated concern over the pass through tax rate for sole

proprietorships and partnerships. Susan Collins (Maine) has commented on concerns over

the repeal of the Obamacare individual mandate. Finally, Jeff Flake (Arizona) and Bob

Corker (Tennessee) have expressed concern over the impact on the debt and deficit

respectively. It is also possible the repeal of the entire state & local tax deduction will impact

some states more than others. This could lead to further opposition.

Given the challenges that were experienced with reforming health care, the incorporation of

the repeal of the Obamacare individual mandate may complicate matters and could lead to

further opposition as the Congressional Budget Office estimates this would result in

4 million fewer Americans with health insurance in 2019 and 13 million fewer in 2027.

This component creates over $300 billion in budget savings over the ten year period and so

is an important part of the Senate’s proposed bill in allowing the bill’s impact to come in under

the $1.5 trillion cap.

The impact on the deficit from the proposals is also significant. The Congressional Budget

office’s analysis of the House bill including the debt service impacts illustrates this would be

0.7 percentage points of GDP on average over the 2018-27 period (Fig 27). This could limit

the willingness of additional members of the Senate to back the plan.

Fig 27 Tax reform is likely to lead to a larger Federal deficit

Source: CBO, Macquarie Research, November 2017

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27 November 2017 24

Developments in Emerging Markets 2017 marks acceleration in EM growth after 6 years of deceleration

Global growth outcome in 2017 has been better than expected with most regions and

economies seeing upward revision in growth expectations. Indeed, 2017 is also the first year

of a synchronous expansion in growth in both developed and emerging market economies.

A better growth environment has helped to improve the growth outlook for EMs which have

been battling both global and domestic shocks since the credit crisis. Indeed, 2017 marks the

first year of acceleration in EM growth after six consecutive years of growth deceleration.

PMI data for EM economies indicates a continued expansion: The improvement in activity

levels is corroborated with the emerging market PMI (manufacturing index) remaining above

the 50 level for the past 16 months (after remaining in contractionary territory in the previous

15 months). This also marks the longest continuous expansionary cycle in EM manufacturing

PMI since 2011. Indeed, recovery in EM PMI’s is broad based with 12 of the 15 EM

economies (for which we have data) seeing an expansion in the manufacturing PMI levels.

Fig 28 EM PMI in expansionary zone for last 16 months

Source: Markit, Macquarie Research, November 2017

Where are EMs in the macro cycle?

In our view, economies move through a macro cycle of:

High productive growth: High productive growth is characterised with strong domestic

fundamental accompanied with government policy such as high investments which creates a

productive growth environment.

Excesses created due to policy missteps: Missteps by policymakers such as continued

loose fiscal or monetary policy in the face of aggregate demand pressures often lead to

macro imbalances of higher inflation and or current account deficit.

Period of macro adjustment: Usually a macro shock in the form of decline in commodity

prices and or exchange rate movements leads to a period of macro adjustment which is

characterised by a period of prudent fiscal / monetary policies which will helps to regain

macro stability.

Slow growth recovery: Following a period of painful macro adjustment, the economy heals

and a slow demand recovery is accompanied, however this period is characterised by a slow

and narrow growth recovery.

Back to high productive growth: Starting with a slow growth recovery, if government policy

actions sustain on the right track, it creates the foundation for high productive growth.

In our view, the majority of EMs are now in the phase of growth recovery having gone through

a period of painful macro adjustment.

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Upasana Chachra +91 22 6720 4355 [email protected]


27 November 2017 25

What has aided improvement in EM growth?

A combination of a supportive global environment and better domestic fundamentals have

helped to improve the growth outlook in 2017. To enumerate:

Better global growth, helping the EMs which rely on global growth and exports for

development: As per the IMF estimate, global growth is expected to end the year at 3.6%

in 2017 – the highest in six years. The forecasts for 2018 also bode well for EM outlook.

Reflation in global commodity prices, helped the EM commodity exporter groups:

Between 2014 and 2016 the sharp decline in commodity prices meant that commodity

export economies faced a severe shock in terms of decline in export income. Indeed, the

growth in Brazil and Russia slipped into the contractionary zone in 2015/16 while growth

in Indonesia, Malaysia, and Thailand decelerated.

Improvement in domestic fundamentals of EMs: The domestic fundamentals in EMs

has also improved as witnessed through lower macro imbalances (such as lower inflation

and current account deficit in India, Brazil, Indonesia; lower inflation in Russia). This

coupled with an improving global growth outlook has aided EM growth.

Fig 29 Synchronous recovery in growth Fig 30 Inflation trending lower in EMs

Source: IMF (including estimates), Macquarie Research, November 2017 Source: IMF (including estimates), Macquarie Research, November 2017

What are the risks to the EM outlook?

While the current macro outlook for EMs seems sanguine, we need to be cognizant of the

risks to the outlook. The risks to the macro outlook could emerge from:

Slowdown in global growth with risks emanating from slower expansion in the US, or a

faster than expected slowdown in China and or threat from rising protectionist policies.

Risks from volatility in capital flows, as DM central banks embark on monetary policy

normalisation through rates hikes and reduction in balance sheet expansion (mainly the

US Fed).

Geo-political risks emanating from rising tensions with North Korea.

Domestic political events to watch out for – such as the outcome of African national

conference due in Dec-17 in South Africa, important state elections in India in the run-up

to general election in 2019, general elections in Mexico in July 2018, presidential elections

in Brazil in Oct-18, and presidential elections due in Russia in Mar-18.

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27 November 2017 26

The outlook for the BOJ We expect the BOJ to remain the global outlier, with no change to its targeting of 10-year

government bond yields at around zero. PM Abe has just won a Lower House election with

an election manifesto which included fiscal consolidation, i.e. implementing the legislated

increase in the consumption tax rate to 10% from 8% in October 2019. Japan’s fiscal deficit is

still around 4% of GDP, chart below. With the fiscal tightening two years away, monetary

policy must remain very accommodative.

Fig 31 Japanese public expenditure and revenue as a % of GDP, 1990-2015

Source: OECD, Macquarie Research, November 2017

In addition, the BOJ remains far from achieving its 2% headline CPI target. The BOJ’s

preferred measure of underlying inflation is the CPI excluding fresh food and energy shown

below. We attribute the move to around 1% over 2014-15 to the pricing flexibility provided by

the sharp weakening of the Yen over 2013-14. With the Yen having been broadly stable since

then, underlying inflation has fallen back to just above zero.

Fig 32 Japan’s economy (underlying CPI, real GDP growth) and BOJ monetary policy

Note: The CPI figures are adjusted for changes in the consumption tax rate

Source: BOJ, Ministry of Internal Affairs and Communications, Cabinet Office, Macquarie Research, November 2017

25

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Per cent of GDP

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Peter Eadon-Clarke +81 3 3512 7850 [email protected]


27 November 2017 27

There is still no inflationary dynamic coming from Japan’s labour markets with nominal wage

growth per head, at around 0.5% pa, remaining beneath Japan’s trend labour productivity of

1.0% p.a. We believe there remains a reservoir of under-utilized regular workers inside

Japan’s older companies, and that, therefore, the labour market is not as tight as the

conventional indicators suggest.

The table below comes from a speech given by Deputy Governor Nakaso, a potential

successor to Governor Kuroda whose term completes in April 2018. We believe the BOJ is

effectively ‘all in’ with a full breadth of policies shown below.

Through 2018 we forecast that the BOJ will remain committed to its current policies, with one

small exception. We expect the BOJ to undershoot its ¥6tr annual equity ETF purchase

target, but only because Japanese equities have been strongly appreciating.

We believe the appointment of Deputy Governor Nakaso as the next BOJ Governor would be

a signal for policy continuity.

Fig 33 The evolution of the BOJ’s monetary policy

Note: from the speech at the Central Banking Seminar hosted by the FRB of NY, 18 October 2017 Evolving Monetary Policy: The Bank of Japan’s experience by Hiroshi Nakaso

Source: BOJ, Macquarie Research, November 2017


27 November 2017 28

Political risk in Europe How can you relax about a currency bloc that contains 19 separate democracies? That is a

perennial question for investors contemplating whether the electoral politics of Eurozone

countries in the year ahead could derail the bloc’s economic recovery.

Elections can be positive economic events, bringing in much-needed reforms or just a new

sense of purpose. Some are dull, even if they see a change of government. Even ones that

surprise investors don’t seem to be the economic calamity many feared (look at the UK or US

economies post the Brexit referendum or election of President Trump.

Nevertheless there’s something a little different about elections in the Eurozone, which boils

down to the fact that it is a monetary union but not a political union1.

The first consequence of this is there are a lot of elections. Nineteen countries with a four- or

five-year political cycle means on average there will be 4-5 elections a year, and that is a

minimum – since the euro was launched there have in fact been just under 6 a year (Fig 34).

The same is true of US state elections. But US states are not nations, and that leads to the

second issue, which is Eurozone states are far more powerful than other monetary union

regions. They retain the trappings of statehood and their governments a large capacity for

independent action, including over many areas of financial and economic policy which

continue to operate mainly at the national level, such as taxation and banking. In contrast the

institutions of Eurozone central government are weak. So national elections matter.

Furthermore Eurozone elections can be unpredictable or misaligned. It is widely known that

there is only a limited pan-European demos, i.e. a political connection between voters in

different Eurozone states. This reduces the potential for inter-state co-operation and prevents

the emergence of stronger central institutions.

Taken together what this means is that the Eurozone throws up many opportunities each year

for politics to cause asymmetric shocks that the Eurozone’s institutional framework – both

public and private – is notoriously bad at dealing with.

Nevertheless the Eurozone was around for 10 years before elections became a focal point of

investors an aggregate level.

Until then there was little discussion of the only short-term consideration that really worries

investors – the risk of the Eurozone breaking up. Market panic saw this climb the agenda

during Eurozone crisis of 2011/2012, and the ongoing Greece debt crisis through 2014/2015

(Fig 36).

1 There are European Parliament elections at the EU level, but it is a weak body.

Fig 34 A lot of elections every year (parliamentary – red shows big four of Germany, France, Italy & Spain)…

Fig 35 …and in 2017 a lot of people voting. Fewer, probably, in 2018.

Source: IDEA, Macquarie Research, November 2017 Source: Various sources, Macquarie Research, November 2017

0

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Matthew Turner +44 20 3037 4340 [email protected]

Nineteen

democracies means

a lot of elections


27 November 2017 29

By this time last year break-up was still on investors’ minds but in a different way. The

prospect of a country being forced out had dwindled, with even Greece’s position more

secure (and arguably mechanisms had been put in place to make its exit, if needed, less of

an event). But a voluntary exit was now a possibility, as years of high unemployment and

slow growth were boosting anti-euro populist parties in elections and the polls. Fears they

would soon get power were boosted by the shock Brexit referendum and Trump Presidential

election victory and 2017 had unusually important elections in the Eurozone, with nearly half

of the population going to the polls (Fig 35).

Of course it didn’t happen. The tone was set on early on with the populist parties doing worse

than expected in the Netherlands and France, and their anti-euro stance was seen as one of

the reasons for that. The perceived risk among investors of Eurozone break-up, which had

increased at the start of the year, fell back quite sharply (Fig 36). Economic growth

accelerated, and the mood shifted sufficiently that even when populist parties did a bit better

than expected in Germany, market reaction was limited.

Looking ahead to 2018 the scheduled electoral calendar is decidedly thinner, with fewer than

20% of the Eurozone population going to the polls. But one of those countries is Italy, long

seen as a one of the weakest links in the currency bloc due to its slow growth and high debts.

And the breakdown in German coalition talks in November has brought the possibility of an

unscheduled election in the Eurozone’s most important and hitherto politically stable country.

Starting with Italy, support for the euro is the lowest (though still net positive) among any of

the member states except Cyprus (see Fig 37) and the populist Five-Star movement, which

has long campaigned for a referendum on euro membership, has a growing lead in the

opinion polls. But the economy is finally growing again, with 2017 set to be the best year in

seven, and support for the euro has picked up. In response Five-Star have toned down their

anti-euro rhetoric, and the election is unlikely to cause a decisive break.

Turning to Germany, the risks are very different. Germany is not going to leave the Eurozone,

but any signs of political paralysis will have repercussions across the region, and European

politics post Chancellor Merkel, in charge for the last 11 years, now has to be contemplated.

Put this together, we think political risks will always be evident in the Eurozone for as long as

it is a collection of national states with different interests. But the immediate risks of breakup

still seem small – either forced or chosen. Where we are less optimistic is the longer-term,

with few of the institutional challenges yet resolved (such as fiscal or banking union), and as

such likely to dampen pan-European investment, a major headwind to the Eurozone being

able to growth more than the ~2.5% it has now reached.

Fig 36 Break-up risk seen as low (Sentix, %) Fig 37 Net support for the euro – weak in Italy (%)

(2017 v 2016)

Source: Sentix, Macquarie Research, November 2017 Source: Eurobarometer, Macquarie Research, November 2017

Just when you

thought it was safe

… Italy and possibly

Germany in 2018


27 November 2017 30

Individual country economic outlook

United States: Age Shall Not Weary Us… ......................................................................................... 31

China: Structural slowdown to resume ................................................................................................ 34

Europe: Recovery, Recovery at Last… ............................................................................................... 39

UK: growth slow… disaster? No… ...................................................................................................... 41

Japan: Steady as she goes ................................................................................................................. 42

Australia: Waiting for wages ................................................................................................................ 44

India: Growth Normalisation ................................................................................................................ 48

Canada: Housing headwinds are here ................................................................................................ 50

South Africa ......................................................................................................................................... 52


27 November 2017 31

United States: Age shall not weary us… The US expansion continues to remain on firm footing. Recent data strength led us to

upgrade our outlook for real GDP growth in US growth upgrade: More optimistic about 2018

and beyond.

Demand drivers: Consumer spending and residential investment

Since this publication we have become more optimistic on both the demand side and the

supply side. On the demand side, our updated assessment suggests a more significant boost

to consumer spending will come through from tax reform (see page 20) and leads us to

update our call on real GDP growth by 20 bps in 2018 to 2.3% and by 10 bps in 2019 to 2.0%

(4Q on 4Q basis).

Consumer spending should continue to underpin growth. Fundamentals are robust with

positive real wage growth, persistent downward pressure on unemployment and minimal

signs of froth. Strong labour demand bodes well for employment and wage growth, while

the steady stream of baby boomer retirements (and associated pension withdrawals)

provides a kicker to funds available for spending. These are themes we discuss in detail in

King Consumer: Stronger for longer – the aging gorilla.

Residential investment is a second area we foresee making a disproportionate contribution to

real GDP growth in 2018. It remains well below its long-term average as a share of GDP

(Fig 38). While there is further room for improvement from here, we emphasize that its peak

level will likely prove to be well below that of prior cycles given shifts in the demographic profile.

Fig 38 Residential investment has further room still to improve

Source: Bloomberg, Federal Reserve, Macquarie Research, November 2017

Supply side: Firmer productivity amidst decelerating jobs growth

On the supply side, our updated assessment reflects greater confidence that productivity

growth has moved to a new regime of over 1% given its recent performance. While we

expect some pullback in 2018 (due to less growth in the energy sector), following this we

anticipate gradual improvement through 2021.

While the underlying trend in payrolls growth is now ~165K per month (Fig 39) and has been

decelerating at a pace of ~30K over the past two years, this is due to labor supply constraints

rather than slowing labour demand. Despite this continued deceleration, downward pressure

on the unemployment rate has persisted. Going forward, we estimate that just 70-75K jobs

per month will be needed to do this in 2018 (assuming flat age group participation rates).

2%

3%

4%

5%

6%

7%

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

US residential investment share of GDP

+1 STDEV

Average

-1 STDEV

2005-6

1987

19731978

1999

1980



27 November 2017 32

Fig 39 Despite decelerating jobs growth downward pressure on unemployment should persist

Source: BLS, Macquarie Research, November 2017

What it means for the FOMC and the yield curve

An economy running above a potential output pace and continued downward pressure on

slack should lead the FOMC to continue on its path to tighter policy. Given our growth

upgrade and assessment that tax reform should pass we are increasing our assessment for

the number of hikes in 2018 to “3” from “2-3” and in 1H19 to “2” from “1-2”. As long as

downward pressure on the unemployment rate persists the FOMC is likely to continue hiking.

We anticipate this to continue through 1H19, at which point it will become apparent that the

trend in the pace of payrolls gains is slowing towards the ~70K that is needed to keep the

unemployment rate stable.

This dynamic suggests a terminal Fed Funds rate in the 2.5 to 2.75% range. A perceived

undershooting in the unemployment rate will push the FOMC to hike through model estimates

of the nominal natural rate of interest (1.75% – 2.0%), a similar dynamic as what occurred in

1999-2000 and 2005-7. As the FOMC continues to hike, the yield curve should continue to

flatten in 2018 as has been the case for much of the past thirty years during hiking cycles

(Fig 40).

Fig 40 The FOMC continuing to hike rates should lead to a flatter yield curve

Source: Bloomberg, Federal Reserve, Macquarie Research, November 2017

50

100

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Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Jan-19 Jan-20

Monthly nonfarm payrolls change - 12 month average (thousands)

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projection = decline of 30K per year

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Dec-13 (taper commences)

QE3

QE2

Mar-15 FOMC

Feb-95(end of rate hike cycle)

Jun-06 (end of rate hike cycle)2001 rate cuts

commence


27 November 2017 33

Fig 41 US economic forecasts (end-quarter, forecasts shaded)

US

Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19 5y

average 30y

average

GDP q/q ar 1.2 3.1 3.0 2.5 2.3 2.4 2.3 2.3 2.1 2.1 1.9 1.9 y/y 2.0 2.2 2.3 2.4 2.7 2.6 2.4 2.3 2.3 2.2 2.1 2.0 2.4 2.5 CPI q/q ar 3.1 (0.3) 2.0 3.1 2.0 2.1 2.2 2.3 2.3 2.3 2.3 2.3 y/y 2.6 1.9 2.0 2.0 1.7 2.3 2.4 2.2 2.2 2.3 2.3 2.3 1.3 Core CPI q/q ar 2.5 0.6 2.1 1.8 2.0 2.1 2.2 2.3 2.3 2.3 2.3 2.3 y/y 2.2 1.8 1.8 1.7 1.6 2.0 2.0 2.2 2.2 2.3 2.3 2.3 1.9 EURUSD 1.07 1.14 1.18 1.17 1.15 1.18 1.22 1.25 1.27 1.29 1.32 1.35 Fed Funds rate % 0.88 1.13 1.13 1.38 1.63 1.88 2.13 2.13 2.38 2.63 2.63 2.63 0.3 2yr yield % 1.3 1.4 1.5 1.80 2.00 2.25 2.50 2.65 2.65 2.65 2.65 2.65 0.7 10yr yield % 2.4 2.3 2.3 2.40 2.60 2.65 2.70 2.75 2.75 2.75 2.75 2.75 2.2

Source: National sources, Macquarie Research, November 2017


27 November 2017 34

China: Structural slowdown to resume Over the past two years China has once again defied the naysayers, with growth stabilising

at a still-strong range of 6.5–7.0%, as the government prepared for the leadership transition.

Notably, as growth fears dissipated, the Middle Kingdom all but disappeared from the list of

immediate “worries” confronting many investors.

While we have always felt that the more passionate China pessimists have consistently

overplayed their cards, to us the pattern of the post Great Recession period suggests that just

as everyone has once again become comfortable with the Chinese outlook (as occurred

during the previous ‘mini-cycles” in 09 and 13), the resumption of the structural slowdown will

again bring China front and centre for many investors.

The outlook for 2018

Despite showing resilience in 2017, we expect the structural slowdown in Chinese growth to

resume over 2018 and 2019, as the impact of the 2016 stimulus fades, with y/y growth falling

from the current 6.8% to 6.1% by 4Q18, and dipping below 6.0% in 2019. We note, however

that while growth will moderate, it will do so in a relatively controlled fashion, with

consumption, infrastructure spending and exports remaining key supports.

While there are many risks around this outlook, we feel that the Government can still exert

considerable influence on near-term growth, and as such the outlook for China will once

again be in large part driven by the government’s policy agenda, with decisions made in

coming months as the new leaders settle in (see China, embracing a new political cycle).

Fig 42 Chinese GDP growth is likely to slow further in coming years…

Fig 43 But while IP growth will also slow, it should remain supported by solid exports given the recovery in G-10 domestic demand

Source: CEIC, Macquarie Research, November 2017 Source: CEIC, BIS, Macquarie Research, November 2017

As has been the case in the post Great Recession period, over the past year Chinese macro

management has seen its main influence through two sectors: housing and public fixed asset

investment. And while underlying growth continues to slow, these sectors are likely to

continue to drive near-term momentum.

As seen in previous mini cycles, these sectors surged when the authorities decided to

stimulate, and are currently in the process of slowing as the impact of the stimulus fades.

In many ways, the outlook over the coming year depends on to what extent the government

allows the necessary structural adjustment (which would necessitate weak growth for a time).

Or to put it another way, headline growth will be to a large degree dictated by the trade-off

between longer-term structural needs and the appetite for short-term pain.

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Larry Hu, PhD +852 3922 3778 [email protected]


27 November 2017 35

The outlook for property: Entering a down-cycle

The property sector could be the main drag in 2018. On one hand, the strong performance

this year means a high base and substantial sales frontloading. YoY housing sales growth

has stayed positive for 29 months until Sep 2017, which is almost twice the length vs. the

previous up-cycles. Housing sales grew 23% in 2016 and 10% in the first nine months of

2017. They could hit a historical high of 1.7bn sqm for the whole year, more than 40% higher

than that seen in 2014. As such, it’s quite likely that property sales could drop to negative

growth in 2018. This would imply that key indicators such as starts and investment would

slow down as well.

On the other hand, policy is turning more restrictive as more cities are tightening their

property measures. Given President Xi’s comment yesterday that “houses are for living in,

not for speculation,” we see almost no chance that property measures will be loosened in the

next twelve months. Finally, mortgage rates, which have correlated with sales pretty closely in

the past, have been rising in 2017 due to tighter liquidity.

Fig 44 Property sales growth turned negative again, with the main question being will the dip be as severe as seen in 2014/15?

Fig 45 Prices in most cities continue to expand, although the experience in 2014 suggests that this can change quite quickly…


The outlook for FAI: Headwinds in 2018-2019

After stabilising for much of 2016, growth in fixed asset investment (FAI) has begun to slow

again in the past few months, as the stimulus fades, with the pace of expansion hitting a new

low of 3.2% YoY in October, the lowest for such reading in many years.

The weakest sector remains manufacturing, with real estate also slowing, as noted above.

On current trends both of these sectors could turn negative over the course of 2018,

placing a significant drag on growth.

In contrast, while it has slowed in recent months, infrastructure related investment was still

up 16% in the year to October. And while it is likely to moderate a little further in coming

months, it is notable that new projects have rebounded in recent months suggesting to us

that the government will continue to use this important sector as a key growth driver.


27 November 2017 36

Fig 46 China FAI growth showed a clear slowdown in 2H this year…

Fig 47 …but growth of planned investment from projects under-construction stays strong

Source: NBS, CEIC, Macquarie Research, November 2017 Source: NBS, CEIC, Macquarie Research, November 2017

Growth to be supported by global demand and consumption (positive)

While property and FAI will probably be a drag on growth in the coming year, we feel the

impact on overall growth will continue to be moderated by growth in consumption and

exports.

Exports have recovered this year, and, in our view, should remain positive as solid domestic

demand in the West continues to lend support. With Europe still China’s biggest export

market, the robust recovery in European demand should be a particularly welcome support.

Similarly, while consumption growth is not immune to weakness elsewhere, continued strong

wage growth is likely to see consumption remain a key growth engine.

Fig 48 Exports have supported growth this year, and are likely to remain supportive in 2018

Fig 49 Consumption growth has also stabilised, and will remain a key support in 2018


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27 November 2017 37

The Outlook for IP: Slower on softer domestic demand and the supply-side reform

Industrial production (IP) is the best monthly proxy for GDP numbers, which are released on a

quarterly basis. Given our view of gradual slowdown for GDP growth in the coming quarters,

we expect IP growth to trend down as well.

The main headwind is from domestic demand, especially the slowdown in the property sector.

The weaker demand could certainly weigh on production activity. Meanwhile, supply-side

reforms in the name of environmental inspection and capacity cuts, could put pressure on IP

as well. Meanwhile, external demand could lend support to IP growth.

Overall, we expect IP growth to slow to around 6% in 2018 from 6.7% this year. In the long

run, IP growth could continue to trend down and grow at a slower pace than the overall

economy, as China is rebalancing from an investment and manufacturing-driven economy to

a consumption- and service-driven one.

Liquidity overhang to ease on lower inflation and slower growth

The onshore bond market has been under pressure recently, after the PBoC Governor Zhou

said China would grow 7% in 2H17. Meanwhile investors are also concerned that the new

leadership could become more hawkish than before. However, since growth could gradually

slow in 2018, we see lower bond yields in the next 6-12 months, while both CPI and PPI

inflation are likely to be between 2–3% next year, vs. 1.6% and 6.0% this year. Mild inflation

is not very likely to concern policymakers in the year ahead.

Financial regulation is an overhang for sure. The exit of QE in developed countries poses

another uncertainty. However, we believe they could be more than offset by lower financing

demand in the real economy, which could cause more liquidity to stay in the financial system.

As the economy starts losing momentum, it’s also hard for policymakers to further ramp up

tightening measures. Finally, as currency depreciation expectations are easing, capital

inflows could also improve liquidity conditions.

RMB to be range-bound in the year ahead

We expect the USD/CNY to be range-bound between 6.4 and 7.0 in the coming year. It will

be heavily impacted by movements in the US$. However, the newly introduced counter-

cyclical factor has made it much easier for the PBoC to manage the currency. Unsurprisingly,

with the easing of currency depreciation and capital outflow pressures, the PBoC has quietly

loosened capital control measures introduced in late 2016.

While the key battle for the PBoC in 2016 was to fight capital outflows and that in 2017 was

against depreciation expectations, the battle in 2018 is to relaunch financial openness, which

gained strong momentum from 2010 to 2014, but was interrupted by capital outflows and then

RMB weakness in 2014–16.

From a long-term perspective, we remain positive toward the RMB. Since 2015, China has

had a surplus of US$1.3tn under goods traded, but less than a quarter of the money has been

converted into RMB. During the years of strong appreciation expectations, close to 100% was

converted into the RMB. With such pent-up demand for the RMB and the existing capital

controls, the RMB could face renewed appreciation pressures as depreciation expectations

turn around.

In coming years, the PBoC is set to allow more volatility for the RMB, so that the currency can

be more driven by market forces. It will not only give the PBoC more freedom in terms of

monetary policy, but it’s also a prerequisite for China to open its capital account. Any student

of financial history knows that a combination of fixed exchange rate and an open capital

account is very dangerous. Therefore, China’s policymakers are keen to increase RMB

volatility in the years ahead.


27 November 2017 38

Risks to our baseline scenario

We see the risks to our baseline scenario are largely balanced. One upside risk comes from

the stronger-than-expected global recovery. The other upside risk comes from the property

side, which surprised on the upside in 2017. Property is always very hard to forecast as it is

influenced by so many forces: central government, local government, developers, financial

institutions and consumers. To be sure, property could also pose downside risks to our base

case scenario.

The other downside risk comes from the possibility that the government might reduce

infrastructure investment growth for next year and beyond. To be sure, if the government

really wants to maintain the same infrastructure FAI growth next year, it can do it through the

formal fiscal and shadow fiscal systems such as lending from the China Development Bank

to local governments. But it might not want to do that again as the power reshuffle is done.

One thing to watch is the Central Economic Work Conference to be held in mid-Dec,

on whether the GDP growth target for next year will be lowered from 6.5% to, say, 6.0–6.5%

or even 6.0%. Meanwhile, while we don’t see any property tax being rolled out in 2018, it is

an important factor to watch going forward.

Fig 50 China economic forecasts (end-quarter, forecasts shaded)

Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19 5y average 30y average

GDP q/q saar 5.7 7.4 7.0 6.6 6.3 6.1 6.1 5.9 5.7 5.7 5.5 5.5 y/y 6.9 6.9 6.8 6.7 6.8 6.5 6.3 6.1 6.0 5.9 5.7 5.6 7.1 9.5 CPI y/y 1.4 1.4 1.6 1.9 2.6 2.4 2.4 2.3 2.2 2.2 2.2 2.2 1.8 4.2 Core CPI y/y 2.0 2.1 2.2 2.5 3.0 2.8 2.8 2.6 2.5 2.5 2.5 2.5 1.6 USD/CNY 6.9 6.8 6.6 6.7 6.6 6.6 6.5 6.4 6.3 6.2 6.0 6.0 1-yr deposit rate % 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 2-yr yield % 3.0 3.5 3.5 3.5 3.6 3.4 3.3 3.2 3.2 3.1 3.0 2.9 10-yr yield % 3.3 3.5 3.6 3.6 3.8 3.7 3.6 3.5 3.5 3.4 3.3 3.2



27 November 2017 39

Europe: Recovery, recovery at last… Despite an impressive 2017 it is still all too easy to be pessimistic about the Eurozone’s

prospects. But while acknowledging a number of downside risks, we see upside risks too,

and believe the increasingly fast, broad and domestically focused recovery in the Eurozone

will continue in 2018.

There’s no doubt 2017 has been a good year for the Eurozone. In 9M 2017 it enjoyed its

fastest rate of growth for seven years, with GDP expanding by a quarterly average of 0.6%,

taking the YoY expansion to 2.5%.

Perhaps as important, given the rickety institutional setup of the Eurozone, it has also enjoyed

its broadest expansion for many years. This is true whether you look by country (Fig 51), with

only Ireland this year seeing a QoQ contraction (and Ireland is a special case) or by sector

(Fig 52), where in 1Q 75% of the Eurozone’s 180 GDP sectors grew, the most since 2007,

and a similar 73% in 2Q (with the prospect of an upwards revision). The recovery has also

been domestically focused, with even the severely depressed construction and investment

sectors accelerating.

Fig 51 Eurozone best run of growth in 7 years (% QoQ) Fig 52 …and the broadest by sector since 2007

Source: Macrobond, Macquarie Research, November 2017 Source: Eurostat, Macquarie Research, November 2017

All indications are that we are set for a similar performance in 2018. High-frequency indicators

such as the PMI and sentiment surveys point to a strong 4Q 2017, which will ensure strong

momentum going into 2018 (“carry-over” of growth will be 1.7%). Moreover we expect the

quarterly profile of growth to remain robust, with only a slight moderation compared to 2017.

Fig 53 Surveys point to strong end to 2017 Fig 54 With more catch-up potential (GDP 2007 = 100)

Source: Macrobond, Macquarie Research, November 2017 Source: Eurostat, Macquarie Research, November 2017

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1999 2002 2005 2008 2011 2014 2017

Fast, broad and

domestically

focused recovery

ticks all the boxes



27 November 2017 40

What could go wrong? One possibility would be if the economy hit supply-side constraints,

prompting higher inflation and further EBC tightening. But this seems a distant prospect.

For a start there is surely still “catch-up” potential. The double dip recession means the

Eurozone economy is only 5% larger than its pre-GFC 2007 level, lower than the US’s 15%

and the UK’s 10% (Fig 54). About half of this can be explained by the bloc’s lower population

growth, but unemployment is still far higher in the Eurozone than those two countries, despite

coming down significantly, and it importantly is still above its pre-crisis lows (Fig 55).

Of course certain countries have much tighter labour markets than others, notably Germany,

and it is possible those where unemployment is still high, such as Spain and Italy, have lost

productive capacity since the previous bull market. But the aggregate measures reinforce the

view of plentiful spare capacity across the bloc, with subdued core inflation, just 0.9% in the

year to October, and surveys showing tepid wage growth, around the 1.5% YoY level

(Fig 56).

Fig 55 Employment up, unemployment down (%) Fig 56 Eurozone core inflation & wages, % YoY

Source: Eurostat, Macquarie Research, November 2017 Source: Eurostat, Macquarie Research, November 2017

The risks of policy error also seem minimal. True the ECB is tightening partly because of

institutional constraints on its QE programme, but policy remains accommodative. Fiscal

policy is constrained due to high debt levels but in 2018 this will offer a slight tailwind.

External demand will provide some challenges. It has not been a feature of the recent

recovery, but could be a drag given the strength of the euro and the worse performance by

the UK, the EU’s largest trading partner. But the global upswing will cushion the blow.

That leaves domestic politics. We look at political risk in the Eurozone on p.27. It offers both

upside and downside. This year’s upside came in 1H with the Dutch and French elections;

things have soured somewhat in 2H with the German election. Italy’s 2018 vote is the next

challenge. We don’t see this as a major risk to the recovery – but we do think a lack of focus

on Eurozone reform will prevent another leg higher.

Fig 57 Eurozone economic forecasts (end-quarter, forecasts shaded)

1Q 17 2Q 17 3Q 17 4Q 17 1Q 18 2Q 18 3Q 18 4Q 18 1Q 19 2Q 19 3Q 19 4Q 19

GDP q/q ar 2.2 2.6 2.5 2.0 2.4 2.0 2.4 2.0 2.0 1.6 2.0 1.6 y/y 2.0 2.3 2.5 2.3 2.4 2.2 2.2 2.2 2.1 2.0 1.9 1.8 CPI q/q ar 0.0 4.0 (0.8) 2.2 0.0 4.5 (0.8) 2.4 0.0 4.1 (0.4) 2.8 y/y 1.8 1.5 1.5 1.3 1.3 1.5 1.5 1.5 1.5 1.4 1.5 1.6 Core CPI q/q ar (3.2) 6.5 (0.7) 2.4 (3.0) 6.7 (0.5) 2.6 (2.8) 6.9 (0.3) 2.8 y/y 0.8 1.1 1.2 1.2 1.3 1.3 1.4 1.4 1.5 1.5 1.6 1.6 EUR/USD 1.07 1.14 1.18 1.17 1.15 1.18 1.22 1.25 1.27 1.29 1.32 1.35 Eurozone (Deposit rate) % (0.4) (0.4) (0.4) (0.4) (0.4) (0.4) (0.4) (0.4) (0.2) 0.0 0.3 0.3 Eurozone 2yr yield % (0.3) (0.3) (0.4) (0.3) (0.1) 0.1 0.2 0.3 0.5 0.5 0.7 0.7 Eurozone 10yr yield % 1.2 1.2 1.2 1.0 1.4 1.3 1.5 1.7 1.9 1.9 1.9 2.0


No sign of supply-

side constraints on

continuing growth


27 November 2017 41

UK: growth slow… disaster? No… After a weaker 2017 the UK economy faces further supply- and demand-side challenges in

2018. Slow growth seems assured, if only because spare capacity is so limited. How slow will

depend on how the demand side holds up as the UK’s exit from the EU approaches. As we

expect what in practice will be an extension to the UK’s membership, the answer is probably

less than one thinks and we find ourselves on the bullish side of consensus.

The UK economy has suffered in 2017 because the devaluation of sterling post the June

2016 Brexit referendum has made the British poorer and in 1H (Fig 58) they responded by

spending less. Much of the impact has now occurred and inflation will start to fall.

Growth will not return to its 2012-2016 average of 2%, however, because the economy is

running out of spare capacity, shown by the easing of employment growth. From 2.6% YoY

in 2Q 2014 to less than 1% as of August (Fig 59), we see it falling to 0.5% over the next year.

Where will the workers come from? Unemployment is at a 42-year low, the participation rate

is near an all-time high, and immigration is on its way down.

Fig 58 UK GDP (proxied by monthly value add) – a slower 2017 but most of damage in 1H (2007 = 100)

Fig 59 Falling employment growth means consumer squeeze to continue though wages to improve (% YoY)

Source: ONS, Macquarie Research, November 2017 Source: Eurostat, Macquarie Research, November 2017

But while this will mean a continued squeeze on consumption, it won’t be as bad as in 2017

as real wages will pick up as inflation falls. We even see some potential for higher nominal

wage growth, though gains will be limited by moribund productivity.

All of this is dependent on there not being a disaster in the Brexit negotiations. We continue to

hold the view that the UK’s options are in the short-term rather limited, and point to a near

status-quo transition period being agreed. As this becomes clearer, we think the resulting

uptick in confidence will see the Bank of England raise rates again.

Fig 60 UK economic forecasts (end-quarter, forecasts shaded)

1Q 17 2Q 17 3Q 17 4Q 17 1Q 18 2Q 18 3Q 18 4Q 18 1Q 19 2Q 19 3Q 19 4Q 19

GDP q/q ar 1.0 1.2 1.6 1.8 1.2 1.2 1.6 1.4 1.6 1.6 1.6 1.2 y/y 1.8 1.5 1.5 1.4 1.4 1.5 1.5 1.4 1.5 1.6 1.6 1.5 CPI q/q ar 2.0 4.7 2.1 3.4 0.8 3.4 0.4 2.1 0.4 4.1 1.2 1.8 y/y 2.2 2.8 2.8 3.0 2.7 2.4 2.0 1.7 1.6 1.7 1.9 1.9 Core CPI q/q ar 0.3 5.5 2.2 2.7 (0.5) 4.3 1.0 2.3 (0.5) 4.4 1.0 2.3 y/y 1.8 2.5 2.6 2.6 2.4 2.2 1.9 1.8 1.8 1.8 1.8 1.8 GBP USD 1.25 1.30 1.34 1.30 1.28 1.32 1.36 1.38 1.40 1.42 1.45 1.45 GBP EUR % 1.17 1.14 1.13 1.11 1.11 1.12 1.11 1.10 1.10 1.10 1.10 1.07 Base rate % 0.25 0.25 0.25 0.50 0.50 0.75 0.75 1.00 1.00 1.25 1.25 1.25 2-yr yield % 0.11 0.34 0.45 0.50 0.65 0.80 1.00 1.25 1.40 1.60 1.60 1.75 10-yr yield % 1.12 1.28 1.38 1.50 1.60 1.70 1.70 1.80 1.80 1.90 1.90 2.00




27 November 2017 42

Japan: Steady as she goes We are expecting the global industrial recovery and moderate export growth to support

growth over 2018, but strong domestic growth remains elusive. The impact of financial

repression on savings is leading households to be subdued consumers. For more on

the latter, please see the 5 January 2017 Japan’s debt-deleveraging marathon and the

7 June 2017 Myth-busting: Japanese wages.

Looking at recent developments, real export growth appears to have slowed somewhat after

a very strong 2016 4Q and 2017 1Q six-month period, below. Real consumption also appears

to have faded after a strong 2017 1Q–2Q six-month period.

Fig 61 Key drivers of Japanese real GDP growth

YoY % change Seasonally adjusted QoQ % change

2015 2016 2016 2017

CY CY 3Q 4Q 1Q 2Q 3Q

Real exports 2.7 2.5 0.9 2.5 2.8 -0.5 1.9

Real Consumption -0.3 0.1 0.5 0.0 0.8 0.9 -0.6

Note. Real consumption is the BOJ real consumption activity index which includes inbound tourism consumption and excludes outbound tourism consumption

Source: BOJ, Macquarie Research, November 2017

A slowing in industrial production momentum is occurring, below left, though there is

considerable noise in the data over short periods, below right.

Fig 62 Manufacturing PMI (red lines) and 3-months on 3-months % change in industrial production (blue)

Source: METI, Markit, Macquarie Research, November 2017

Whilst the above leads us to forecast a deceleration over the coming year, 2018’s real GDP

growth of 1.0% YoY is still expected to be a second year of growth above Japan’s 0.8% p.a.

estimated potential growth rate.

Fig 63 Japan: key macroeconomic forecasts

CY11 CY12 CY13 CY14 CY15 CY16 CY17E CY18E CY19E

GDP (YoY, %) -0.5 1.7 1.4 0.0 0.6 0.8 1.4 1.0 0.6 CPI (YoY, %) -0.4 -0.5 0.1 2.2 0.6 -0.3 0.3 0.2 0.2 (**) Overnight call rate (*) 0.1 0.1 0.1 0.1 0.0 -0.1 0.0 0.0 0.0 10-year JGB (*) 1.0 0.8 0.7 0.3 0.3 0.0 0.0 0.0 0.0 ¥/$ (*) 76.9 86.8 105.4 119.8 120.4 117.1 112.0 110.0 100.0

Note: CPI is the headline CPI ex fresh foods. (*): per period end, Macquarie forecasts. (**) The consumption tax rate increase to 10% from 8% is now scheduled for October 2019.

Source: Bloomberg, Macquarie Research, November 2017

Peter Eadon-Clarke +81 3 3512 7850 [email protected]


27 November 2017 43

Our house view for the US dollar to unwind much of its gain seen in 2014 and 2015 from the

2H of 2018, means that the weak Yen period of the last five years is coming to an end.

Initially, the consequences could be growth positive as real household incomes improve with

lower import prices. By the 2H of 2019, however, the negative impact on net exports is

expected to begin to arrive.

We regard the end of the weak yen period as a necessary adjustment that must be endured.

Only reform would jolt the economy onto a higher growth trajectory, in our opinion.

Based on the OECD statistics, there has been minimal labour productivity growth outside the

manufacturing sector since 1990, chart below.

Fig 64 The productivity gap between manufacturing and non-manufacturing

Source: OECD, Macquarie Research, November 2017

The needed reform is more flexible labour markets. We believe Japan has a reservoir of

underemployed regular workers now aged 47–59 years old, who were hired over 1980–92

when growth was expected to continue at 4% pa. We estimate this is equivalent to 14% of the

workforce. Companies are unable to fire these employees, even if they wanted to, under

Japanese employment law. With an effective excess of workers, companies have no

incentive to invest in them; hence Japan’s weak service sector productivity, and absence of

significant wage increases.

The strong showing by the LDP in October’s Lower House election, below, implies that

Shinzo Abe will lead the LDP through September 2021. He is now a strong favourite to

secure the LDP presidency in September 2018, for a third three-year term. The LDP

president is the PM if the LDP is the government. The PM calls a Lower House election within

a 5-year term, i.e. by October 2022 now.

Unfortunately, we do not believe labour market reforms are a priority of PM Abe, below.

Fig 65 Our expectations for policy

Ranked by our perception of priority Our conviction

1) Corporate revitalisation (loose monetary policy, corporate tax cuts) High 2) Fiscal reconstruction (financial repression, consumption tax increase) High Note: October 2019 consumption tax rate increase to 10% from 8% High 3) Unwavering geopolitical support for the US High 4) Mild constitutional reform (enacted after a referendum) Moderate 5) Nuclear power plants reactivated by a court-driven approval process High

Note: Please see the Big business and policy priorities for more

Source: Macquarie Research, November 2017

90

130

170

210

250

290 (index 1970=100)

Manufacturing

Non-manufacturing


27 November 2017 44

Australia: Waiting for wages Growth in the Australian economy is expected to improve moderately in 2018. Better global

growth is supporting this outlook as are supportive domestic monetary and fiscal policies.

The major downside risk to the 2018 outlook is a faster slowing in China’s economy than

we expect.

Changing drivers of growth

Household spending is expected to remain relatively soft through 2018. Consumption growth

is forecast to remain subdued amid ongoing weak income growth and a reduced tailwind from

strong housing market activity on the eastern seaboard. Dwelling investment has passed the

peak, and while remaining at a high level, is expected to be a mild drag on overall growth.

In contrast, the investment outlook is relatively bright amid a sharp pick-up in infrastructure

spending. The significant drag on overall growth in recent years from falling mining

investment is also diminishing and will cease later next year. Both of these factors are also

helping to support improving non-mining business investment.

Resource exports, particularly LNG, are also expected to continue contributing heavily to

GDP growth but this source of growth is associated with relatively few additional jobs.

Labour market conditions are expected to tighten modestly further over 2018. Employment

growth and inroads into the unemployment rate are expected to slow, possibly sharply, in the

first half of 2018 – jobs growth has reached 3% over the past year and a pullback is due.

Outside of the already tight Sydney labour market, ample labour market spare capacity is

expected to persist heading into 2019. The jobless rate is expected to decline a further ¼ppt

over 2018 from 5.4% currently.

Interestingly, while Australia’s potential GDP growth is commonly thought to be around

2½-2¾%, the unemployment rate has fallen 0.8ppts over the past two years despite average

annual GDP growth of a little less than 2½% over that period.

Consumer price inflation is forecast to remain at 1¾–2% in underlying terms over 2018

(headline inflation will be a little higher). The weak labour cost backdrop (see Long Path Back

for Australian Wages Growth) will keep overall inflation contained despite modestly higher

tradables inflation associated with some expected A$ depreciation.

By the second half of 2018, we suspect that it will become clearer that inflation is on a gradual

trajectory to move back into the RBA’s 2–3% target band. There is a reasonable risk,

however, that it will take longer for the RBA to become confident that a higher cash rate is

warranted than our current view of 100bps of tightening over the year from 3Q 2018.

Fig 66 Australia economic forecasts (end-quarter, forecasts shaded)


GDP q/q ar 1.3 3.3 2.0 2.6 3.4 2.6 2.1 2.7 2.0 2.7 2.5 2.1 y/y 1.8 1.8 2.8 2.3 2.8 2.7 2.7 2.7 2.4 2.4 2.5 2.3 2.4 3.1 CPI q/q ar 1.8 0.7 2.5 2.0 2.2 1.1 2.8 2.2 2.6 1.5 2.4 1.8 y/y 2.1 1.9 1.8 1.8 1.9 2.0 2.1 2.1 2.2 2.3 2.2 2.1 1.8 q/q ar 1.9 2.3 1.4 1.7 1.8 1.8 1.9 2.0 2.0 2.0 2.0 2.0 y/y 1.7 1.9 1.9 1.8 1.8 1.7 1.8 1.9 1.9 2.0 2.0 2.0 2.1 AUD/USD 0.76 0.77 0.78 0.76 0.74 0.74 0.76 0.76 0.77 0.77 0.77 0.77 0.83 RBA cash rate % 1.50 1.50 1.50 1.50 1.50 1.50 1.75 2.00 2.25 2.50 2.50 2.50 2.16 3-yr yield % 1.91 1.91 2.15 1.90 2.00 2.40 2.70 3.10 2.80 2.75 2.75 2.75 2.25 10-yr yield % 2.70 2.60 2.84 2.55 2.70 2.75 2.90 3.20 3.30 3.20 3.20 3.20 3.03

Notes: Core CPI is the average of trimmed mean and weighted median measures. Source: National sources, Macquarie Research, November 2017

Justin Fabo +612 8232 0696 [email protected]


27 November 2017 45

Fig 67 Growth is forecast to improve modestly in 2018 as stronger investment offsets softer household spending

Fig 68 Resource exports continue to provide significant support to overall growth


Fig 69 The decline in the unemployment rate is forecast to pause in 1H 2018 before continuing further out

Fig 70 It won’t be until at least 2H 2018 that an upward trend in inflation will be evident


Hamstrung households

Growth in overall consumption by Australian households has been soft over the past couple

of years amid weak wages growth and despite significant support from a falling propensity to

save. (Note that the annual national accounts revealed sizeable downward revisions to

consumption growth which is now just 2.1% for 2016-17).

The weak outlook for wages growth, coupled with some expected slowing in employment

growth in 2018, implies that households’ saving ratio must continue to decline to support even

moderate rates of consumption growth. While this is what we forecast, albeit at a slower rate,

there is a risk that slower wealth gains alongside weaker housing price growth results in

slower declines in the saving ratio.

New housing construction and broader housing-related activity have provided an important

source of growth over the past five years as the economy has adjusted to lower commodity

prices and mining investment. Dwelling investment has peaked, however, and it will not

contribute to growth in 2018. While we expect housing construction to remain at a high level

amid low interest rates, there is some risk around apartment building activity given slower

foreign demand.

-4

-3

-2

-1

0

1

2

3

4

5

6

7

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19

pptsGDP GrowthYear-average

Household consumption Public demand*Dwelling investment Business investment*Exports ImportsStocks GDP growth

* Net of asset transfers

-0.3

0.0

0.3

0.6

0.9

1.2

05 06 07 08 09 10 11 12 13 14 15 16 17 18 19

ppts

Resource ExportsYear-average contribution to GDP growth

-1

0

1

2

3

4

5

6

7

8

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19

Per centEmployment & Unemployment Rate

Unemployment rate

Year-ended employment growth

Quarterly employment growth1.0

1.5

2.0

2.5

3.0

3.5

1.0

1.5

2.0

2.5

3.0

3.5

10 11 12 13 14 15 16 17 18 19

Per centPer centUnderlying CPI Inflation

Year-ended

RBA Nov 2017

(Trimmed mean)

Macquarie

Forecasts


27 November 2017 46

Fig 71 A risk to the outlook is that households’ propensity to save does not decline as we forecast

Fig 72 Dwelling investment expected to stay high in 2018 but start to weigh on growth from 2019


What fiscal restraint?

Government spending (23% of GDP) has grown by a strong 4¾% per annum in real terms in

Australia in the past two years, accounting for more than two-fifths of GDP growth. We expect

this strong growth to continue at around the same rate in 2018.

Government consumption has risen to a high share of GDP and will be supported over the

next few years by a doubling of spending on disability services under the NDIS (from ~$10b

to ~$22b per annum).

The big kick will come from infrastructure spending (see: Time to put the hard hat back on).

The existing stock of public sector engineering work yet to be done is very large and points to

a sharp pick-up in this part of government investment in 2018.

Fig 73 Government spending will continue to contribute significantly to overall growth

Fig 74 Infrastructure spending will provide a significant boost to overall growth


-4

-2

0

2

4

6

8

10

12

-4

-2

0

2

4

6

8

10

12

02 04 06 08 10 12 14 16 18 02 04 06 08 10 12 14 16 18

Per centPer centHousehold Consumption & Income

Real household income & consumption

Disposableincome

Consumption

Net household saving ratio

4

6

8

10

12

14

16

18

92 94 96 98 00 02 04 06 08 10 12 14 16 18

$bReal Dwelling Investment

Alterations &additions

New & usedconstruction

16.0

16.5

17.0

17.5

18.0

18.5

19.0

19.5

20.0

3.5

4.5

5.5

6.5

7.5

8.5

92 94 96 98 00 02 04 06 08 10 12 14 16 18

Per centPer centGovernment Demand

Per cent of GDP

Governmentinvestment*

(LHS)

Government consumption(RHS)

* Net of second-hand asset transfers

1

2

3

4

5

6

7

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

98 00 02 04 06 08 10 12 14 16 18

Per centPer centGovernment Investment

Per cent of GDP

Government investment*

(LHS)

Engineering workyet to be done

for the public sector(RHS)

* Net of second-hand asset transfers


27 November 2017 47

Tentative signs of ‘animal spirits’

The outlook for business investment in Australia has turned positive for the first time in

several years. Admittedly, emerging signs of ‘animal spirits’ in Australia’s business sector

might be more of the pussycat variety, but it does appear to be slowly happening. Some

evidence of this might be found in the sharp increase in art sales in Australia this year.

The very large declines in mining investment are in the past and will cease being a drag on

growth in 2H 2018. Mining investment is expected to settle around 2–2.5% of GDP as firms

spend on operational and small-scale new investments but no new large greenfield projects.

Non-mining business investment has been improving in fits and starts since mid-2013. The

outlook appears to be improving as evidenced in the business surveys and because there is

now little drag on non-mining investment from falling mining investment. The outlook for non-

residential building activity appears strong given the sharp improvement in building approvals.

Fig 75 The decline in mining investment is drawing to a close and non-mining investment is strengthening

Fig 76 Improving ‘animal spirits’ also points to greater confidence among businesses to invest

Source: ABS, Macquarie Research, November 2017

Source: ABS, Australian Art Sales Digest, Macquarie Research, November 2017

Fig 77 Non-mining business investment is improving and should be supported in 2018 by solid demand growth

Fig 78 Non-residential building is set to pick up given the strength in building approvals


0

2

4

6

8

10

12

14

92 94 96 98 00 02 04 06 08 10 12 14 16 18 20

Per centBusiness Investment

Per cent of GDP

Non-mining

Mining

25

71

117

163

209

255

0

40

80

120

160

200

89 91 93 95 97 99 01 03 05 07 09 11 13 15 17 19

$bn$mNon-mining Business Investment & Art Sales

Nominal, annual

Art sales in Australia,

advanced 1 year (LHS)

Non-mining business

investment(RHS)

-4

-2

0

2

4

6

8

-20

-15

-10

-5

0

5

10

15

20

25

87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 17 19

Per centPer cent

Non-mining Business Investment & DemandYear-average growth

Non-mining business investment

(LHS)

Gross national expenditure ex business investment

(RHS)

1.5

2.0

2.5

3.0

3.5

4.0

0.5

1.0

1.5

2.0

2.5

3.0

92 94 96 98 00 02 04 06 08 10 12 14 16 18

Per centPer cent

Private Non-residential BuildingPer cent of nominal GDP

Building approvals, trend(advanced 9 months, LHS)

Building(RHS)


27 November 2017 48

India: Growth normalisation Growth rate to normalise in 2018 after a weaker 2017, however, recovery still remains

narrow: We expect GDP growth to improve to 7.2%YoY in CY 2018 from an estimated 6.3%

in 2017 as the economy normalises from the transitory weakness caused by demonetisation

and the implementation of the goods and service tax. While growth is expected to accelerate

in 2018, it remains below the 2016 average of 7.9% and we continue to expect a narrow

recovery. The drivers of growth continue to be consumption, public infrastructure spending

and support from export growth on the back of better global growth environment. Sharp

recovery in private capex is likely to be elusive and we expect a tepid recovery in 2H 2018.

We expect growth to accelerate to 7.7% in 2019 as the economy gets added support from

private capex spending.

Recapitalization of PSU banks improves the outlook for capex and we highlight upside

risks to growth outlook: From a growth perspective the recap of PSU banks improves

private capex outlook, but with challenges on the demand side, we retain our 2018 growth

estimates at 7.2%YoY. We highlight upside risks to growth outlook on the possibility of a

quicker turnaround in private capex and or accelerated execution of planned infrastructure

spending.

Where are we in the growth cycle?

Growth has been weak not just because of transitory factors: GDP growth has witnessed

a slowdown over the last five quarters, while a part of this slowdown can be attributed to the

disruptions caused by the demonetization and implementation of GST, in our view, the

slowdown reflects the uneven growth driven only by consumption as other drivers failed to

take off in the interim. Indeed, consumption has been the mainstay of growth which has been

supported by generous government spending.

What are the drivers for growth recovery in 2019?

Consumption – support to come from recovery in rural demand even as urban

consumption may not see more legs of growth: Private consumption accounts for nearly

60% of GDP and is usually seen as a strong driver of the domestic demand story. Indeed,

total consumption has grown at a faster pace of 10.1% vs. overall GDP growth of 6.9% in the

last 15 months. The driving force has been urban consumption which has been supported by

lower inflation, borrowing costs and support from wage hikes for government employees.

Rural consumption, on the other hand has been weak for the last 2–3 years, initially impacted

by sub-par monsoons and more recently by the decline in food prices and lower rural wages.

In our view, going forward, rural consumption will recover from here as indicated by an

improvement in real rural wages, slight uptick in MSP prices and improvement in terms of

trade for the farmers. We expect urban consumption to grow at a steady state level as the

support from wage hike related fiscal spending and trailing benefits of lower inflation /

borrowing costs taper off.

Exports – expect recovery to continue on the back of better global growth forecasts:

With exports of goods and services accounting for nearly 20% of GDP, health of the global

economy does have an important bearing on India’s overall growth trajectory. Export growth

has been in positive territory over the last 14 months, averaging 10.3% after declining in the

preceding 22 months. Indeed, the trend in exports influences industrial production, capital

formation and capacity utilisation. The trend of the last 12 months has indicated that while

commodity price reflation has contributed positively, non-commodity exports, too, have been

edging up, indicating some improvement in global demand conditions. In this context, the

continued robust global growth outlook for 2018 (IMF expects global growth at 3.5% and

3.6% in 2017 and 2018 respectively) bodes well for growth outlook.

Private capex has been has been on a weak trend…: The key concern for the growth

outlook has been that private capex recovery has remained elusive for the last four years.

To be sure, there are various constraints for a full-fledged capex recovery to follow through

immediately, i.e. low capacity utilisation, stress in banks’ balance sheets and high corporate

leverage. Policymakers have been taking steps in the right direction to address these issues.

We believe this will lead to a tepid recovery in 2H2018.

Upasana Chachra +91 22 6720 4355 [email protected]


27 November 2017 49

… Recap of PSU banks provides a much needed support, however challenges remain

on the demand side / low capacity utilization: Given that stressed assets at PSU banks

(which account for ~70% of the system) has been an important factor constraining PSU

banks credit growth, the government’s PSU bank recap plan addresses an important supply

side issue and improves the outlook for private capex recovery. A synchronous recovery in

domestic and external demand can help improve the capacity utilization level which is

currently tracking near post credit crisis lows.

Acceleration in infrastructure spending can fill the lacuna due to weak or delayed

private investment spending: Public investment has been holding up in the past few years,

helped by a combination of higher central government capital spending, accelerated efforts by

public sector enterprises to increase capital outlay and increase in states’ capital expenditure.

The government also recently unveiled an ambitious infrastructure spending program with a

specific focus on the roads sector with a plan to spend US$105bn over next 5 years. If the

government focuses on proper execution of infrastructure spending, that could provide a

meaningful boost to the capex and growth outlook.

Inflation to meander around 4.5–5%, RBI to be on pause in 2018

We expect inflation to remain moderate and meander around 4.5% levels in the next

12 months. Indeed, excess capacity in the system, benign global commodity prices, proactive

food supply management and prudent fiscal management will keep price pressures subdued.

With inflation tracking near to above the RBI’s 4% medium term target and weak growth

recovery, we expect the central bank to remain on hold in 2018.

What are the risks to the growth outlook?

The risks to the growth outlook would stem from: (1) external demand environment – weaker

than expected global growth could dampen India’s recovery, (2) spike in global commodity

prices – increase in global commodity prices exposes India to macro-stability risks of higher

inflation and wider current account deficit, (3) capital market risk aversion due to spill overs

from the normalization of monetary policy in advanced economies, and (4) changes in

government policy stance such that it meddles negatively with the productivity dynamic.

Fig 79 Slow growth recovery expected Fig 80 Consumption has been the driver of growth

Source: CEIC, Macquarie Research, November 2017 Source: CEIC, Macquarie Research, November 2017

Fig 81 India economic forecasts (end-quarter, forecasts shaded)


GDP q/q ar 5.4 5.6 8.7 8.1 7.4 4.5 8.6 7.9 8.1 6.9 8.8 7.7 6.9 6.6 y/y 6.1 5.7 6.4 6.9 7.5 7.2 7.1 7.1 7.3 7.9 7.9 7.9 CPI y/y 3.6 2.2 3.0 4.2 4.8 5.6 4.3 3.2 3.2 3.9 4.6 4.9 8.0 7.7 Core CPI y/y 4.6 4.8 5.5 5.1 4.5 4.4 4.4 4.7 5.1 USD/INR 64.8 64.6 65.3 64.8 65.5 66.0 66.3 66.5 66.8 67.0 67.3 67.5 1-yr deposit rate % 6.25 6.25 6.00 6.0 6.0 6.0 6.0 6.0 6.0 6.0 6.3 6.3 10-yr yield % 6.26 6.30 6.23 6.9 6.9 7.0 7.0 7.1 7.1 7.1 7.3 7.3


6.1%

7.0%

7.5%7.9%

6.3%

7.2%7.7%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

2013 2014 2015 2016 2017e 2018e 2019e

0%

2%

4%

6%

8%

10%

12%

14%

Ju

n-1

2

De

c-1

2

Ju

n-1

3

De

c-1

3

Ju

n-1

4

De

c-1

4

Ju

n-1

5

De

c-1

5

Ju

n-1

6

De

c-1

6

Ju

n-1

7

Real GDP, YoY% Consumption Growth, YoY%

Since Jun-16consumption growing faster than real GDP


27 November 2017 50

Canada: Housing headwinds are here After a very strong 1H17, Canada’s growth has slowed sharply in 2H. Export growth has

suffered, in part, due to mid-year currency strength. A back-up in interest rates has created

headwinds for both housing investment and consumer spending. We anticipate that this will

continue through 2018 and are forecasting a pace of real GDP growth of 1.4%.

Demand drivers: Housing and consumer spending are becoming headwinds

For much of the economic expansion, unsustainable sources of growth (leveraged driven

consumption and housing investment) have underpinned Canada’s real GDP growth.

As consumer leverage has moved higher in Canada for the past 10-15 years, residential

investment has soared relative to GDP, reaching an all-time high in 1Q17 (Fig 82).

Residential investment has now begun to roll over and faces further challenges in 2018.

The BoC’s recent 50bps in hikes will continue to have a slowing impact. Notably, the back-up

in the yield that matters most for Canada’s housing market (the Government of Canada five-

year bond) has been even more substantial at ~75bps. Further adding to housing’s headwinds

is that the bank regulator, OSFI, has formally introduced tighter regulations (B-20) on uninsured

mortgages that are set to take effect in January. Our analysis suggests this will decrease the

maximum price purchasing power of borrowers with uninsured mortgages by ~17%.

Much of the strength in consumer spending over the past year has resulted from housing and

autos related categories, both of which are likely to be negatively impacted by higher rates.

In 2H, housing-related spending has begun to weaken, with much more potential downside

remaining. Moreover, spending on autos remains extremely stretched and has yet to turn

down. Both will be headwinds in 2018.

Several other factors are likely to add to Canada’s struggles. Given ongoing challenges with

competitiveness, non-energy exports are likely to remain disappointing. Even within the

context of a firm US economy these declined over 3% YoY in 3Q. Uncertainty over how the

NAFTA renegotiation will resolve may act as a further restraint, both on export activity and

business investment. Adding fuel to the fire is a substantial minimum wage hike set to take

place in Ontario in January. This could be a drag as firms, particularly small business,

struggles to cope with higher input costs.

Fig 82 Housing investment is stretched and has begun to rollover

Source: Statistics Canada, Macquarie Research, November 2017

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

7.5%

8.0%

8.5%

1947 1955 1963 1971 1979 1987 1995 2003 2011

Canada nominal residential investment share of nominal GDP

+1 STDEV

Average

-1 STDEV

+2 STDEV



27 November 2017 51

Supply side: Despite weak growth, labour slack will be reduced

Despite our subdued outlook for real GDP growth, we believe Canada can continue to make

gradual progress towards reducing what remains of its labour slack (Fig 83). Baby boomer

retirements mean that even after accounting for the federal government’s increase to its

immigration target, just ~7K jobs per month will be needed to ensure a stable unemployment

rate. This level is likely to be exceeded even as jobs growth continues to slow sharply.

Unlike in the US, where we believe a new regime of productivity growth in the 1 to 1.3%

range has been established, we expect productivity growth in Canada to remain subdued.

This continues a multi-decade trend of relative underperformance. This is underpinned by

weak investment in equipment, information, communications & technology, and research &

development. It also reflects a higher share of the workforce in the public sector, a higher

unionization rate, and a less entrepreneurial culture.

For the past two decades this productivity differential has been offset by more favourable

labour force participation rates in Canada. This is a factor we believe is unlikely to increase

further, meaning Canada’s growth for the foreseeable future will come in well below that of

the US.

Fig 83 Progress towards reducing labour slack should moderate in 2018

Source: Statistics Canada, Macquarie Research, November 2017

Policy outlook: The implications for the BoC

Sharply slowing data in 2H17 and early 2018 is likely to put the BoC on a prolonged pause to

start the year. In 2H18, we anticipate the growth slowdown should stabilize and as further

progress is made on reducing labour slack, the BoC will hike twice more over the coming

18 months (once in 2H18 and once in 1H19). This is a pronounced policy divergence relative

to our view in the US, where we believe the FOMC will hike rates six times by June-2019.

Fig 84 Canada economic forecasts (end-quarter, forecasts shaded)


GDP q/q saar 3.7 4.6 (1.1) 2.0 1.5 1.4 1.4 1.3 1.3 1.3 1.3 1.3 y/y 2.3 3.7 2.4 2.3 1.7 1.0 1.6 1.4 1.3 1.3 1.3 1.3 1.9 2.4 CPI q/q ar 2.6 0.1 1.2 1.5 1.5 1.7 1.8 1.9 2.0 2.0 2.0 2.0 y/y 1.9 1.4 1.4 1.4 1.1 1.5 1.6 1.7 1.8 1.9 2.0 2.0 1.4 Core CPI q/q ar 2.5 2.2 0.7 2.1 1.5 1.7 1.8 1.9 2.0 2.0 2.0 2.0 y/y 2.0 1.4 1.4 1.9 1.6 1.5 1.8 1.7 1.8 1.9 2.0 2.0 1.5 USD/CAD 1.33 1.30 1.25 1.30 1.36 1.38 1.36 1.36 1.36 1.36 1.36 1.36 1.19 Overnight rate % 0.50 0.50 1.00 1.00 1.00 1.00 1.00 1.25 1.50 1.50 1.50 1.50 0.8 2-yr yield % 0.75 1.10 1.58 1.40 1.30 1.35 1.65 1.70 1.70 1.70 1.70 1.70 0.9 10-yr yield % 1.60 1.76 2.10 1.90 1.90 1.90 2.00 2.00 2.00 2.00 2.00 2.00 1.8

Source: Bloomberg, Bank of Canada, Macquarie Research, November 2017

0

100

200

300

400

500

600

Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Jan-19 Jan-20

forecast

Canada - labour slack assuming 5.6% trough unemployment rate (thousands of workers)


27 November 2017 52

South Africa The ANC’s five-yearly National Conference scheduled for 16–20 December (there is a

modest risk of a delay) will elect new leaders and will also adopt policy resolutions that set

the ruling party’s (and, by extension, essentially government’s) policy agenda for the next five

years. It will likely be a watershed for the South African economy, either turning the corner

and beginning to restore the fiscal situation and growth prospects, or continuing on an

unsustainable low-growth trajectory in which fiscal and poverty challenges continue to

escalate. The conference is expected to be such a binary event, that our economic outlook

discussion below sets out two extreme scenarios, in which both the leadership and policy

decisions are assumed to be either market-friendly or have a populist bias. It is possible that

the policies might have a more populist bias with a market-friendly leader or vice versa, and

likewise probable that the policies and/or leader have a particular bias but elements of both,

in which case the economic impact will be on the spectrum of possibilities between the two

scenarios presented here. At this stage, our base case outlook is slightly biased towards the

more positive side, assuming that either leader will at least bring more policy certainty and

hopefully slightly more government efficiency. It is thus somewhat of a muddling along base

case trajectory, assuming that there is no further deterioration but also assuming that no

decisive corrective steps are taken.

Market outcome scenario

In essence, our “market outcome” scenario assumes a leader is elected who will decisively

address key economic growth impediments such as corruption and policy uncertainty;

reform the state-owned companies (which have become a significant contingent liability for

government and drain on the fiscus); and generally balances economic growth considerations

with the need to address (racial and income) inequality. Policy choices in this scenario also

balance these considerations, are generally market-friendly and specifically do not support

the proposed policy of expropriation without compensation or other populist policies, while

there is expected to be a renewed commitment to fiscal consolidation.

While policy and political uncertainty should then be substantially lower than now, there would

still be challenges curtailing any upside to economic growth. Fig 86 unpacks the Treasury’s

potential economic growth estimate, with which we generally agree except that policy

certainty should, in our view, be part of the requirements to get economic growth to even

2% (not 3% as in this chart). In this scenario, we would assume that the impediments to reach

2–3% growth can be alleviated significantly within the 12–24 month focus of our analysis but

we strongly doubt that further improvements (required to reach higher growth rates) will be

affected within this timeframe. Also, despite our characterisation of the leadership choice in

this scenario as having a generally pro-growth approach to policy decisions, the extreme

levels of poverty and inequality mean that policies cannot solely focus on economic growth

and there will be some trade-offs between promoting economic growth and reducing

inequality and poverty.

In this scenario, we assume a renewed commitment to fiscal consolidation, with a reversal of

the expenditure ceiling breach and fiscal slippage announced in the October 2017 Medium-

Term Budget Policy Statement (MTBPS). This will likely entail a combination of non-core

asset sales, decisive efforts to reduce fiscal leakage, increasing the efficiency of government

spending (including better quality services such as education), and efforts to lift economic

growth. We would expect significant capital inflows into SA, which should drive the rand

stronger. It may very well temporarily overshoot relative to our forecast for this scenario.

However, in our view, a rand stronger than ~R13–R13.50/$ in real terms would be

unsustainable (a repeat of the unsustainable 2005 and 2010 overvaluations). Still, relative to

our current base case forecasts, the rand would be stronger and inflation lower, which would

create some space for the SARB to provide marginally more support to the economy via

interest rate cuts.

This scenario includes a boost to economic growth from a combination of a moderate tailwind

to consumers from lower inflation (on the back of rand strength) and possible further

monetary easing. The higher growth combined with focussed efforts to improve the efficiency

of government spending and reduce fiscal leakage should in turn support the fiscal metrics,

so that the increase in the tax burden will be shallower than under the less growth-focussed

scenario (and a fiscal debt trap will be avoided).

Elna Moolman +27 11 583 2570 [email protected]


27 November 2017 53

But the biggest lift to growth is expected to come in this scenario from a recovery in private

sector fixed investment. This is likely to be somewhat delayed, as businesses first have to be

convinced that there has indeed been a step-change with respect to policy implementation,

certainty and focus. Not only do businesses signal that political uncertainty is the single most

important constraint to economic growth at this stage, but the weakness in fixed investment in

2016 and 2017 (relative to demand) also suggests that a reasonably strong rebound in

private sector fixed investment is possible. We further expect that there might be more room

for private sector involvement in the construction (and possibly operation) of public

infrastructure in this scenario, perhaps replicating the model of the renewable energy

independent power producer programme to other types of infrastructure.

Populist outcome scenario

In contrast, the “populist outcome” scenario assumes a leader that does not alleviate key

economic growth constraints, with corruption, policy uncertainty and weak state capacity/poor

government service delivery persisting. Ultimately, ongoing fiscal leakage and inefficiency,

combined with weak(er) economic growth and possibly more populist policies, points to a

likely fiscal debt trap. In this scenario, the ANC supports expropriation without compensation2

as part of the accelerated land reform drive (even though protracted legal processes and

obtaining sufficient support within the party and if needed from other political parties will likely

delay implementation thereof). (The scenario does not incorporate an actual threat to general

property rights but the perceived risk should increase, and the lingering uncertainty should

further weigh on private sector fixed investment). Policies such as a return to prescribed

assets and tighter exchange controls are a significantly higher risk in this scenario than in the

alternative scenario.

In this scenario, private sector fixed investment continues to contract as firms halt any

expansion investment and potentially start to trim maintenance investment as well in the face

of ongoing policy risks and concerns about a weak economic growth trajectory in the longer

term. This could entail modest net job losses, while consumers would then also face

increased headwinds from higher inflation on the back of expected rand weakness, with

possible modest monetary policy tightening.

Base-case forecasts

Our base case is at this stage a mid-way between the two extreme scenarios, reflecting the

prospect that it will not be easy for any new leader to make swift and decisive changes and

also the relatively evenly balanced support between the two (market-friendly and populist,

respectively) factions. Our rand exchange rate forecasts are slightly weaker in the near term,

reflecting the prospect of credit rating downgrades (and large outflows when SA then falls out

of the WGBI). However, we argue that the rand is already competitively valued, and in the

context of our expectation that the current account deficit will remain small, amid still relatively

strong capital flows into emerging markets, we do not expect real depreciation (in the

absence of a negative shock). This should then help to contain inflation. In the absence of an

inflationary exchange rate shock – of which the cause will most likely be a policy or political

shock – there could still ultimately be scope for the SARB to ease monetary policy marginally

once the immediate and clear political and credit rating risks have been resolved. However,

our interpretation of the SARB’s actions from the first rate hike in the latest cycle, as well as

its rhetoric and analyses around real rates, suggest to us that the room for cuts is limited.

At this stage our base-case forecasts do not factor in any interest rate changes in 2018.

The mediocre growth forecast for 2018 (at around 1.2%), virtually all stems from some

consumer spending growth, which is, in turn, driven by real wage growth. After two years of

marked contractions in private sector fixed investment, we expect it to essentially trend

sideways in 2018 as firms have already cut back on expansion investment post the

reshuffling of Finance Ministers in December 2016 and are essentially just continuing

maintenance investment. We do not expect any contribution from net exports.

2 In our view, this threat is more than just campaign rhetoric and there is genuine support within factions of the party for this policy proposal, and the market is in our view overly complacent about this risk. However, our base-case view remains that it will not become the party’s official policy at this juncture. Instead, there is a relatively strong likelihood that expropriation within the existing legal framework will be pursued more aggressively for now, although we increasingly suspect this particular decision might be delayed further (beyond the December conference).


27 November 2017 54

Fig 85 Economic scenario detail

Market outcome Populist outcome

Growth 2-2.5% 2018; 2.5-3.5% 2019 -2.5% 2018, 2019 similar or worse

Confidence: A rebound in economic growth from pent-up demand, lower interest rates (see below), stronger confidence, reduced policy uncertainty and better policy coordination and implementation. This includes long-term certainty on the once empowered, always empowered principle, and for example speedy resolution of the mining charter and MPRDA after consultation with all relevant stakeholders.

Downward pressure on economic growth from weak business and consumer confidence (hence delayed capital investment). Downside somewhat limited by weakness already (i.e. base effect) in confidence and fixed investment post the December 2015 finance minister reshuffle.

Land reform: Accelerated land reform, including by (farm land) expropriation (with just and equitable compensation) and scaling up of successful market-friendly reform models. Market-friendly traction with land reform could boost confidence and investment in the agricultural sector, positively impacting food security and net exports.

Expropriation without compensation is adopted as ANC policy in this scenario. It will be subject to a protracted legal process, with a possibility that the ANC does not have the necessary support in parliament to change the constitution, which contains the short-term economic impact. Although the initial context of the policy shift will be agricultural land reform, there will be a perceived risk that this may, in the longer term, become a more general threat to property rights. The reduced policy certainty and confidence weighs on private sector expansion (capex and employment) in this scenario. It weighs on the agricultural and banking sectors.

Policy framework: Policy would generally still have to balance growth and inequality/redistribution considerations. In other words, growth still cannot be the sole policy focus, and policy changes would necessarily entail compromises, which may limit the short-term upside to economic growth.

Insufficient priority given to economic growth. Policy uncertainty and implementation weakness persist, with resolution of policies such as the MPRDA and mining charter delayed and/or market-unfriendly.

Infrastructure spending:

Privatisation still unlikely but the renewable energy independent power producer (REIPP) model may be extended to other types of infrastructure, which may create opportunities for construction companies, ensure greater efficiency of infrastructure spending, and ultimately lift trend economic growth.

Infrastructure spending crowded out by inefficient and consumption-biased government spending.

Structural impediments:

Despite the rebound, growth upside is limited by structural growth impediments and significant deterioration in trust between government and business (which may improve but won’t be resolved quickly).

No political will to improve government capacity and efficiency. Sustained (or additional) corruption and government inefficiency negatively impacts competitiveness and fiscal metrics.

Monetary policy: Positive growth impact from lower interest rates (see below). While this provides only marginal relief, consumer spending is boosted by the combination of lower inflation, tax and interest rates combined with some job creation, while private sector capex is supported by the net impact from lower rates and improved confidence, demand and policy certainty.

Negative growth impact from higher interest rates (see below). While this provides only marginal additional pressure, consumer spending is constrained by the combination of higher inflation, tax and interest rates combined with some job losses, while private sector capex is constrained by the net impact from higher rates and weaker confidence, demand and policy certainty.

Fiscal policy: Positive growth impact from less tax hikes (see below). Negative growth impact from higher tax burden on consumers and crowding out of infrastructure spending (see below).

Exchange rate Temporarily ± R12/$-RR12.50/$ (ultimately ±R13-R13.50/$ real)

Temporarily ±R16.50/$ Should partially recover.

Current account: The rand could overshoot but excessive strength will be unsustainable (a repeat of overvaluation episodes in 2005 and 2010). There is still some risk of further credit rating downgrades, although it is significantly lower than in the worst case scenario; this should then also weigh on the Rand.

Rand may overshoot but real trade-weighted starting point is already competitive (it is also weaker than PPP against the USD). Some of the rand adjustment may have taken place already given heightened political risk and policy uncertainty for at least two years. Strong terms of trade, a relatively supportive global backdrop, and a relatively small CAD limits the downside.

CPI 3.3% avg 2018; 4.5-5% 2019 6.8% avg 2018; 6.3% avg 2019

Exchange rate pressure:

Disinflationary rand. Higher inflation from rand depreciation (despite wider output gap). The inflation shock will occur relative to a benign starting point and subdued global inflation, which helps to contain the inflation peak.

Food inflation: No impact on food supply/prices from sensible land reform approach.

Unsuccessful land reform may negatively impact food production (boosting food inflation while hurting the trade balance).


27 November 2017 55

Fig 85 cont. Economic scenario detail

Repo rate 6% 7%

Inflation: SARB will use the room provided by low inflation to give relief to the economy but the trough in interest rates will also be influenced by the SARB's view of structural inflation relative to which the bank will likely keep a positive real rate of ~1%.

Despite higher inflation, the SARB's reaction is likely to be muted given the weaker economic growth.

Tax & fiscal policy

Corruption, government inefficiency:

Political will to reduce corruption (the Office of the Chief Procurement Officer expects the programmes underway will save R25bn p.a. – this is only a moderate part of the leakage); this supports fiscal consolidation without tax hikes and/or supports provision of more government services.

Persistent (or escalating) corruption and government inefficiency negatively impact fiscal metrics, sustainability and sovereign credit ratings. Taxes are higher than necessary which, alongside aforementioned factors, further constrain economic growth.

Redistribution: Higher income individuals will still likely be taxed more to support redistribution but tax hikes will be smaller than in the populist scenario and income inequality will also be addressed by other (non-fiscal) policies such as improved government service delivery (particularly education).

Tax hikes will likely be biased towards individuals, particularly higher income groups. There may not be space for additional pro-poor spending but the existing pro-poor spending plans should be sustained.

SOE reform: Political will to reform SOEs, which will positively impact the fiscal prognosis. The reduced corruption and increased efficiency of reformed SOEs will be growth-positive as it significantly reduces the cost of doing business (in monetary and efficiency terms).

Lack of political will to reform the SOEs means that their inefficiency and leakage continues, which not only negatively affect the fiscal prognosis but also the credit ratings outlook. This is despite the ANC’s current commitment to fiscal consolidation.

Prescribed assets: There is still a risk (albeit lower than in the populist scenario) that prescribed assets may be introduced but this does not replace SOE reform in this scenario.

Insufficient political will to reform the SOEs means that funding pressures persist, and increases the risk that prescribed assets are reinstated to reduce the cost of funding and increase the availability of accessible funds.

10-year bond yield <8% ±10%


Fig 86 Potential growth

Fig 87 Firms’ perceptions of growth constraints

Source: Treasury, November 2017 Source: BER, November 2017

Fig 88 South Africa economic forecasts (end-quarter, forecasts shaded)

Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

GDP q/q ar -0.6 2.5 1.9 1.0 0.9 1.0 1.0 1.1 2.1 3.0 2.6 2.3 y/y 1.0 1.1 0.7 0.8 1.6 1.2 1.0 1.0 1.3 1.8 2.2 2.5 CPI q/q ar 7.8 4.5 3.0 3.2 6.1 6.3 5.3 3.2 6.1 6.3 5.3 3.2 y/y 6.3 5.3 6.0 4.6 4.2 4.5 5.2 5.2 5.2 5.2 5.2 5.2 USD/ZAR 13.42 13.10 13.50 14.60 14.60 14.30 14.15 14.00 14.11 14.21 14.32 14.42 Repo rate % 7.00 7.00 6.75 6.75 6.75 6.75 6.75 6.75 6.75 6.75 6.75 6.75 10-yr yield % 8.81 8.76 8.57 9.50 9.40 9.30 9.20 9.20 9.20 9.20 9.20 9.20


0

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Mar-88 Mar-94 Mar-00 Mar-06 Mar-12

Index

Interest rates Insufficient demand Political climate


27 November 2017 56

Global markets outlook

Interest rate outlook: Conundrum All Over Again… ............................................................................ 57

FX Outlook: A Year of Two Halves ..................................................................................................... 62

Commodities outlook: oil ..................................................................................................................... 66

US Natural Gas Outlook ...................................................................................................................... 71

Commodities outlook .......................................................................................................................... 73

Global equity outlook – Year of choices & consequences .................................................................. 76

Australian equity outlook – Beauty and the Beast ............................................................................... 92


27 November 2017 57

Interest rate outlook: Conundrum all over again… As we have discussed in previous chapters, 2018 will be a most interesting year for global

interest rate markets.

At the short end, we expect:

The Fed to continue on its gradual hiking path, with the Fed funds rate likely to be around

2.25% by the end of 2018, and the US two-year bill yield increasing to 2.75%.

In contrast, we expect the other G3 central banks to keep their policy rates unchanged

below zero.

While the ECB will continue its current gradual taper, the BoJ will continue to target a

zero 10-year yield (arguably the easiest monetary policy in recorded history).

While several other central banks will have aspirations of tightening, it is still far from clear

how far they will get given still weak wages growth almost everywhere.

We expect the RBA to begin to hike rates in August. But if wages and inflation

continue to disappoint, or if the slowdown in house prices current underway proves

persistent, a rate hike might have to wait until 2019.

While the Bank of Canada surprised the market and snuck in two hikes earlier this

year, we expect them to be on hold for much of 2018, with the next hike not until Q4.

The Bank of England has hiked once this year. At this stage we expect two more hikes

in 2018. But if the economy continues to slide it will become increasingly unlikely they

will have the opportunity for an encore performance in 2018.

At the long end, despite the Fed, we expect rates to remain relatively contained everywhere,

as ongoing excess capacity at a global level, demographic factors, political dysfunction and

financial repression by the ECB and BoJ keep rates contained.

In the US, we expect the curve to be flat between 2s and 10s by Q4, as the 10-year bill

yield increases to only 2.75%.

In Japan, the 10-year will still be near zero at the end of 2018; and

In the Euro Zone, the 10-year will be only 1.75%.

While the idea of a flat US curve may sound counter intuitive to many, we have for some time

felt that the long end of the US curve has been more a reflection of global and demographic

factors rather than being driven by domestic cyclical US considerations.

In essence we are forecasting a repeat of the last cycle, where the Fed increased the

Fed funds rate by 25 basis points for 17 meetings in a row (from 1% to 5.25% and

the 30-year yield continued to trend lower.

Ric Deverell +61 2 8232 4307 [email protected] Justin Fabo +612 8232 0696 [email protected] David Doyle, CFA +1 416 848 3663 [email protected]

Larry Hu, PhD

+852 3922 3778 [email protected]

Matthew Turner

+44 20 3037 4340 [email protected]

Upasana Chachra



27 November 2017 58

Fig 89 The 30-year yield in the US has been impervious to the near-term business cycle over the past 30 years

Fig 90 We expect the 2-10 year spread to narrow further in 2018

Source: ABS, Bloomberg, Macquarie Research, November 2017 Source: ABS, Bloomberg, Macquarie Research, November 2017

What is the equilibrium long run US 10-year yield?

While we do not expect long yields to move much higher in the coming year, we take issue

with much of the commentary suggesting that yields will be permanently stuck in the current

low range. And while there are lots of moving parts in assessing the likely path of long yields,

theoretically at least, over longer periods, we feel that rates should loosely move with the rate

of nominal GDP growth.

It is also notable that while they move together over time, the bond market has in the past

taken some time to become convinced of regime change when it comes to inflation and

consequently nominal GDP growth. We see four interesting periods in the period under review.

Fig 91 The 10-year Treasury yield has tended to follow nominal GDP growth

Source: BEA, Robert Shiller, Bloomberg, November 2017

0%

2%

4%

6%

8%

10%

12%

14%

1950 1960 1970 1980 1990 2000 2010

10 year yield (3 yr avg)

nominal GDP growth (3 yr avg)


27 November 2017 59

1) The 1960s. Yields lagged nominal GDP growth moving higher. During this decade there

was first a pick-up in real GDP from 1962-1966 over the prior five years. While in the

latter part of the decade real GDP growth moderated, inflation picked up. After averaging

just 1.4% from 1960-65, the GDP price index averaged 3.7% from 1966 to 1969.

2) 1980–2000. Yields lagged nominal GDP growth moving lower. It took time for the bond

market to appreciate the duration and magnitude of the disinflationary trend set in motion

by FOMC policy under Volcker as the five-year average in the GDP price index fell from

8% in 1981 to 1.6% in 1999.

3) 2000–2012. With the disinflationary trend of the 1980s and 1990s having abated,

treasury yields caught up with the trend in nominal GDP growth. While for much of this

time period, nominal GDP growth and yields moved together, there were two temporary

dislocations. First, during 2006-08, nominal GDP growth moved higher driven by oil led

inflation, but Treasury yields did not follow as inflation expectations remained contained.

Second, during 2009-11, trend nominal GDP growth moved much lower than Treasury

yields as a consequence of the collapse in real growth during the recession.

4) 2012 onwards. The trend in nominal GDP growth has held steady, averaging 3.7% over

this time period. Yet rather than move upwards, Treasury yields have been trending

lower suggesting a dislocation. In our view, this suggests there is likely a reversal

forthcoming, whereby Treasury yields will rise once again to move back in line with the

underlying trend in nominal GDP growth, a pace we estimate at ~4%.

While yields tend to lag changes in nominal GDP growth, it is notable to us that nominal GDP

growth over the past eight years has been relatively stable at roughly 4% per annum. While a

step down from the 6% seen before the crisis, we feel that once inflation and wages grow

return to more normal levels, and in particular financial repression in Europe comes to an end

(probably beginning in early 2019), yields could move back toward 4%.

This view is supported by a recent BIS working paper, where Charles Goodhardt and Manoj

Pradhan (August 2017) argue that the demographic factors that have been pushing yields

lower may soon reverse.

Australian rates

The Australian yield curve has been anchored by market expectations of very little increase in

the RBA cash rate until well into 2019 amid few signs of higher wage and price inflation in

Australia (Figure 92). Currently, the spread between Australian and US two-year yields is the

narrowest since 2000 at just 10bps. We see a strong chance that this spread turns negative.

At the longer end of the curve, the outlook for US yields have a strong influence on Australian

yields. Here, we forecast Australian 10-year yields to rise by only a little more than US 10-year

yields by end 2018. In part this is driven by the fact that the Australian economy has more

scope to see a lift in growth from current sluggish rates. Historically, the Australian-US

10-year yield spread has moved relatively closely with changes in the relative performance

of the two economies (Figure 93).

Moreover, the low point in Australia’s nominal growth is now in the past and should be placing

little downward pressure on long-term yields. History suggests, however, that it can be some

time before higher nominal growth is reflected in bond yields.


27 November 2017 60

Fig 92 Markets are pricing less than one 25bp RBA rate hike in 2018

Fig 93 The narrowing in long-term Australia-US spreads has followed macro fundamentals

Source: RBA, Macquarie Research, November 2017 Source: ABS, Bloomberg, Macquarie Research, November 2017

Fig 94 Stronger nominal growth will eventually lift long-term yields

Source: ABS, RBA, Macquarie Research, November 2017

Indian rates

We expect the central bank to be hold in 2018 as inflation edges up from the low of 2017.

However, a weak growth recovery and inflation ~4.5–5% may keep RBI on hold for a while.

In this context, we expect the 10Y bond yield to edge up slightly with the likely range for the

10Y to be 6.85–7.1% in 2018. The triggers are more to the upside with inflation edging up,

US policy rates hikes continuing in 2018, risks of elevated crude oil prices creating inflation

and fiscal uncertainty and modalities of the bond issues under the PSU bank recapitalisation

plan could also weigh on the sentiment. We would be closely tracking the budget for FY2019

to be announced on 1 February 2018 (tentative) to assess government’s plan on fiscal

consolidation and the implications for market borrowing.

1.00

1.50

2.00

2.50

3.00

1.00

1.50

2.00

2.50

3.00

14 15 16 17 18 19

24-Nov-17

31-Oct-17

30-Sep-17

30-Jun-17

Macquarie forecast

Australia: RBA Cash Rate ExpectationsPer cent Per cent

RBA cash rate

-6

-4

-2

0

2

4-75

0

75

150

225

300

98 00 02 04 06 08 10 12 14 16 18

pptsBps AU-US 10yr & Unemployment Rate Spreads

Aust lessUS 10-yr yield

(LHS)

Aust less US unemployment rate

(RHS, inverted)

Macquarie

fore

casts

0

2

4

6

8

10

12

14

16

18

20

60 65 70 75 80 85 90 95 00 05 10 15 20

Per centAustralia: 10-year Yield & Nominal GDP

10-year governmentbond yield

Nominal GDP growth*

* 11-quarter centred moving average


27 November 2017 61

Canadian rates

In Canada, we forecast a single rate hike in 2018 (in 4Q) as we believe housing, consumer

spending, and exports will continue to act as headwinds to growth through 1H18, keeping the

BoC cautious and tepid. As this is less than current market expectations we believe there

will be downward pressure on the two year government yield in 1H, while the 10-year yield

should remain range bound. In 2H, as the growth deceleration moderates and evidence

grows that the economy is stabilizing (albeit at a low level of growth), we anticipate yields to

back-up modestly.

South African rates

At this stage we forecast a steady policy interest rate through 2018, as real rates are in our

view relatively high for the current economic context, but the SARB will be too uneasy to cut

rates amid very elevated political and credit rating risks. We expect 10-year yields to remain

elevated in the near-term given high political, credit rating and fiscal risks, but even though it

should fade slightly once these risks are resolved, steep increases forecast in funding

requirements in the medium-term while likely continue to support yields.

Fig 95 Interest rate forecasts (end-quarter, forecasts shaded)

Policy Rate Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

US (Fed Funds rate) 0.88 1.13 1.13 1.38 1.63 1.88 2.13 2.13 2.38 2.63 2.63 2.63 China 1-yr deposit rate 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 Eurozone deposit rate (0.4) (0.4) (0.4) (0.4) (0.4) (0.4) (0.4) (0.4) (0.2) 0.0 0.3 0.3 Japan deposit rate (0.1) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 India RBI repo rate 6.3 6.3 6.0 6.0 6.0 6.0 6.0 6.0 6.0 6.0 6.3 6.3 UK base rate 0.3 0.3 0.3 0.5 0.5 0.8 0.8 1.0 1.0 1.3 1.3 1.3 Canada overnight rate 0.5 0.5 1.0 1.0 1.0 1.0 1.0 1.3 1.5 1.5 1.5 1.5 Australia RBA cash rate 1.5 1.5 1.5 1.5 1.5 1.5 1.8 2.0 2.3 2.5 2.5 2.5 South Africa repo rate 7.0 7.0 6.8 6.8 6.8 6.8 6.8 6.8 6.8 6.8 6.8 6.8

Short-term yield Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

US 2yr yield 1.3 1.4 1.5 1.8 2.0 2.3 2.5 2.7 2.7 2.7 2.7 2.7 China 2-yr yield 3.0 3.5 3.5 3.5 3.6 3.4 3.3 3.2 3.2 3.1 3.0 2.9 Eurozone 2-yr yield (0.3) (0.3) (0.4) (0.3) (0.1) 0.1 0.2 0.3 0.5 0.5 0.7 0.7 Japan 2-yr yield (0.2) (0.1) (0.1) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2) UK 2-yr yield 0.1 0.3 0.5 0.5 0.7 0.8 1.0 1.3 1.4 1.6 1.6 1.8 Canada 2-yr yield 0.8 1.1 1.6 1.4 1.3 1.4 1.7 1.7 1.7 1.7 1.7 1.7 Australia 3-yr yield 1.9 1.9 2.1 1.9 2.0 2.4 2.7 3.1 2.8 2.8 2.8 2.8

Long-term yield Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

US 10-yr yield 2.4 2.3 2.3 2.4 2.6 2.7 2.7 2.8 2.8 2.8 2.8 2.8 China 10-yr yield 3.3 3.5 3.6 3.6 3.8 3.7 3.6 3.5 3.5 3.4 3.3 3.2 Eurozone 10-yr yield 1.2 1.2 1.2 1.0 1.4 1.3 1.5 1.7 1.9 1.9 1.9 2.0 Japan 10-yr yield 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 India 10-yr yield 6.3 6.3 6.2 6.9 6.9 7.0 7.0 7.1 7.1 7.1 7.3 7.3 UK 10-yr yield 1.1 1.3 1.4 1.5 1.6 1.7 1.7 1.8 1.8 1.9 1.9 2.0 Canada 10-yr year yield 1.6 1.8 2.1 1.9 1.9 1.9 2.0 2.0 2.0 2.0 2.0 2.0 Australia 10-yr yield 2.7 2.6 2.8 2.6 2.7 2.8 2.9 3.2 3.3 3.2 3.2 3.2 South Africa 10-yr yield 8.8 8.8 8.6 9.5 9.4 9.3 9.2 9.2 9.2 9.2 9.2 9.2

Source: Macrobond, Macquarie Research, November 2017


27 November 2017 62

FX outlook: A year of two halves As always, one of the key prices to watch in 2018 will be that of the US dollar. And as always,

the Greenback will be one of the most challenging prices to forecast, with the output of most

econometric models showing little relationship to past outcomes in the near term.

Notwithstanding this, we see two competing forces in 2018.

The first is the likelihood that the US government will enact some form of tax reform some

time in 1Q (tax reform chapter).

The second is our expectation that with the US economy no longer outperforming the rest

of the world, the dollar Bull Run over recent years has probably come to an end.

This suggests to us that 2018 will be a year of two halves, with the dollar stabilising and

probably rallying a little in 1H, before sliding further in 2H.

We note, however, that if tax reform fails to materialise, the dollar would be likely to

fall substantially.

Tax reform

As outlined in the chapter on tax reform, we expect a modest package to be passed in 1Q.

And while the final details are anyone’s guess, one of the least controversial parts of both the

senate and house packages is the proposal to give US companies a tax holiday to allow them

to repatriate off-shore profits.

While the concessional tax rate is looking like being something like 12%, a little higher than

the 5.5% permitted back in 2005 – when President Bush enacted a similar policy – the

experience from that time suggests that the flow of funds back to the US will see the dollar

move modestly higher for a time, before resuming its previous trend – which then as now was

downwards.

Fig 96 The 2005 tax holiday saw significant flows back to the US…

Fig 97 And propelled the dollar higher for a time…

Source: CEIC, Macquarie Research, November 2017 Source: CEIC, Macquarie Research, November 2017

0

50

100

150

200

250

300

350

1999 2001 2003 2005 2007 2009 2011 2013

Total repatriations of US multinational companies ($ billions)

65

75

85

95

105

115

125

2001 2003 2005 2007 2009 2011 2013 2015 2017

Counter-trend rally in USD

US dollar index spot rate (DXY)

Ric Deverell +61 2 8232 4307 [email protected] Justin Fabo +612 8232 0696 [email protected] David Doyle, CFA +1 416 848 3663 [email protected]

Larry Hu, PhD

+852 3922 3778 [email protected]

Matthew Turner


Upasana Chachra



27 November 2017 63

Once the impact of repatriation washes through, however, we feel that the slide seen in the

dollar for the majority of 2017 will continue – note that the dollar has fallen against most

currencies so far this year. In terms of the majors we expect:

EURUSD to trade sideways in the first half of the year as continued economic strength is

tapered by political uncertainties, and by the strength in the dollar. But to strengthen further

in 2H as the market begins to focus on the likelihood that the ECB will begin to hike rates

in early 2019, and the dollar slides. Specifically we expect 118 in 2Q18, and 125 in 4Q18.

For USDJPY, we expect a similar pattern in 1H, as the market first looks toward and then

benefits from repatriation flows, we expect dollar yen to move modestly higher, to

something like 116 in 2Q18. However, the yen is unlikely to benefit as much as the euro

in 2H from expectations that interest rates will are likely to finally move away from their

post-crisis lows. And while the yen may strengthen as the dollar comes under broad

based pressure, the likelihood that the BoJ will by then be an increasing outlier – as it

continues to target a zero 10-year yield – may limit the ability of dollar yen to fall.

We expect 110 in 4Q18.

Fig 98 The US dollar looks to be in the process of peaking…

Source: BEA, Robert Shiller, Bloomberg, November 2017

Australian dollar

The Australian dollar has depreciated from a peak of US$0.81 in September to settle back in

the US$0.70-0.80 range it has largely traded in since early 2015. The recent weakness has

occurred alongside weaker prices for some of Australia’s key commodity exports. Spreads

between Australian and US yields have also narrowed, particularly at the short end, reflecting

divergent monetary policy outlooks for the RBA and the Fed (Figures 99 and 100).

In our view, an extension of these trends will put downward pressure on the A$ in coming

months. The normal volatility of the A$ – typically a 4-6 US cent range over a three-month

period – could see dips into the low US$0.70s.

We see some A$ appreciation in the second half of 2018 as monetary policy tightening in

Australia comes closer into view. A$ weakness could prove more pervasive, however,

if slower growth in China’s economy results in lower commodity prices than we forecast.


27 November 2017 64

Fig 99 Narrowing Australia-US short-end spreads are weighing on the A$...

Fig 100 …as will lower commodity prices in 2018

Source: ABS, Bloomberg, Macquarie Research, November 2017 Source: ABS, Bloomberg, Macquarie Research, November 2017

RMB

We expect the USDCNY to be range-bound between 6.4 and 7.0 in the coming year. It will be

heavily impacted by the movement of the US$. However, a newly introduced counter-cyclical

factor has made it much easier for the PBoC to manage the currency. Unsurprisingly, with the

eased pressure of depreciation and capital outflows, the PBoC has silently loosened capital

control measures introduced in late-2016.

While the key battle for the PBoC in 2016 was to fight capital outflows and in 2017 was

against depreciation expectations, the battle in 2018 is to relaunch financial openness, which

gained strong momentum from 2010 to 2014, but was interrupted by capital outflows and then

RMB weakness in 2014-16.

From a long-term perspective, we remain positive toward the RMB. Since 2015, China has

had a surplus of US$1.3tn under goods traded, but only less than a quarter of the money has

been converted into RMB. During the years with strong appreciation expectations, close to

100% was converted into RMB. With such pent-up demand for RMB and the existing capital

controls, RMB could face renewed appreciation pressure as the depreciation expectations

turns around.

In the coming years, the PBoC is set to allow for more volatility for the RMB, so that the

currency could be more driven by market forces. It will not only give the PBoC more freedom

in terms of monetary policy, but it’s also the prerequisite for China to open its capital account.

Any student of financial history knows that a combination of fixed exchange rate and open

capital account is very dangerous. Therefore, China’s policymakers are keen to increase to

increase the volatility of the RMB in the years ahead.

Indian rupee

The rupee has gained 4% in 2017, led by an improvement in macro stability and weakness in

the dollar index. In 2018, we expect the rupee to weaken mildly, driven by fundamentals of

higher inflation differentials with the trading partners, compressed real rate differentials and

more policy action from the Fed and US government tax incentives supporting the dollar index

(in 1H18 as per our global FX view). We thus expect the INR to weaken to 66.5 by Dec-18.

The volatility in rupee movement could stem from domestic macro stability indicators and

movements in capital flows, which could trigger movement on either side. From a fundamental

perspective, we believe a mild depreciation path for the rupee will be beneficial to maintain

export competitiveness especially in context of robust global growth environment.

0.50

0.60

0.70

0.80

0.90

1.00

1.10

1.20

-100

0

100

200

300

400

500

600

07 08 09 10 11 12 13 14 15 16 17

A$/US$bpsA$/US$ & 2-year Yield Spread

AU-US 2yr yield spread (LHS) A$/US$ (RHS)

0.50

0.60

0.70

0.80

0.90

1.00

1.10

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

02 04 06 08 10 12 14 16 18

A$/US$IndexTerms of Trade & Australian Dollar

A$/US$(RHS)

Terms of trade(LHS)


27 November 2017 65

Canadian dollar

2017 has been a volatile year for USDCAD. After weakening in 1H to $1.37, predominantly

on reduced expectations for policy-tightening from the BoC, a policy pivot in June led to an

~11% rally with the pair reaching a peak of $1.21 in early September, in the aftermath of the

BoC’s second rate hike. Since this time, it has moved back to the $1.27–$1.28 range as the

BoC has moderated its outlook on the future of policy hikes.

Current market expectations for the next 12 months have the BoC hiking at a similar pace as

the FOMC. We think this is very unlikely. Whereas we believe the FOMC will hike by

100bps over the next 12 months, we see the BoC as disappointing relative to market

expectations and hiking by just 25bps.

This policy divergence is likely to become reflected in two-year sovereign yield spreads in

coming quarters as Fed hikes persist and the BoC moves further in a dovish direction.

We anticipate this to be priced into the exchange rate over the next six to nine months and

forecast a level in 2Q of $1.37 in 2Q (quarter average basis) and $1.39 (end of quarter basis),

before broad USD weakness sets in, leading to modest improvement by the end of the year.

South African Rand

We expect the South African rand to be on the back foot in the near term, given the

uncertainty and risks around the ANC leadership election at the end of the year and the

upcoming credit rating reviews during which SA could be stripped of its investment grade

status. But we do not expect real depreciation beyond the near term, given that we regard the

rand as already competitively valued and we expect the current account deficit to remain

small while capital flows into emerging markets should remain resilient.

Fig 101 FX forecasts (end-quarter, forecasts shaded)

FX Rates Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

EUR USD 1.07 1.14 1.18 1.17 1.15 1.18 1.22 1.25 1.27 1.29 1.32 1.35 USD JPY 111.8 110.0 110.0 112.0 116.0 116.0 113.0 110.0 110.0 110.0 105.0 100.0 USD CNY 6.88 6.78 6.65 6.70 6.60 6.60 6.50 6.40 6.30 6.20 6.00 6.00 GBP USD 1.25 1.30 1.34 1.30 1.28 1.32 1.36 1.38 1.40 1.42 1.45 1.45 USD INR 64.82 64.63 65.34 64.75 65.50 66.00 66.25 66.50 66.75 67.00 67.25 67.50 USD CAD 1.33 1.30 1.25 1.30 1.36 1.38 1.36 1.36 1.36 1.36 1.36 1.36 AUD USD 0.76 0.77 0.78 0.76 0.74 0.74 0.76 0.76 0.77 0.77 0.77 0.77 USD ZAR 13.42 13.10 13.50 14.60 14.60 14.30 14.15 14.00 14.11 14.21 14.32 14.42

Source: National Sources, Macquarie Research, November 2017


27 November 2017 66

Commodities outlook: oil We expect a balanced market – good enough for price stability but not a rally

We expect the 2018 oil market to be relatively balanced but not strong enough to continue

the current rally. Our 2018 S-D balances are bearishly skewed versus consensus expectations,

and as a result, so is our 2018 oil price outlook. 2H17 fundamentals have benefitted from (1)

coordinated production cuts of 1.8 MM BPD, (2) extremely strong demand growth of 1.8 MM

BPD, and (3) backend-loaded US production growth, with sharp acceleration expected in 4Q17.

Of the three drivers listed above, the production cut extension appears to be the only one that

is fairly certain. We expect OPEC to extend cuts through 3Q18, but would not be surprised if

the extension ran through YE18. We forecast 1.6 MM BPD demand growth in 2018.

Despite a favourable global macro outlook, we don’t believe demand growth can get any

better than the 1.8 MM BPD run rate achieved in 2H17. Demand growth was 1.8 MM BPD in

2015, a year when oil price fell to $26, averaged $54, and global GDP realized at 2.7%. In our

assessment, the market is not organically balanced until production cuts are reversed and

absorbed by demand; a process that could take until 2020.

Likewise, the late-2017 ramp in US shale creates a fast start for 2018 production. The recent

price rally and follow-on hedging has created an upward skew to production growth versus

very recent base case estimates. Although the “shale disappointment” narrative seems to

have reached a peak in recent weeks, we continue to expect US onshore growth to surprise

to the upside relative to consensus. E&P production results were solid in 3Q earnings and

guidance, which has always pointed to a 2H ramp, largely held.

2018 global price summary: $49 Brent, $46 WTI

Our 2018 forecasts of $49 Brent and $46 WTI reflect productivity gains in U.S. tight oil and

good but not great demand growth. Under our base case, which presumes an OPEC

extension through 3Q18, our modelling indicates that 2018 surpluses will average a modest

deficit of 29 K BPD, followed by a modest surplus of 81 K BPD in 2019.

Fig 102 Oil price forecasts

1Q18 2Q18 3Q18 4Q18 2018

Brent $52.80 $47.60 $47.10 $49.80 $49.33 WTI $49.80 $44.60 $43.60 $46.30 $46.08


Demand – Strong macro, uncertain micro

We expect strong 2017 economic-driven oil demand growth to follow through in 2018 with an

estimate of 1.6 MM BPD. Global IP stands at 4.13% relative to the 10-year average of 2.1%

demonstrating increasing economic momentum and is supported by an improving global GDP

estimate of 3.5% in 2018 versus 3.4% in 2017. Physical product demand confirms broader

economic momentum with TTM product growth of 1.65% led by improved diesel, LPG, and

Jet fuel. Lastly, renewed OECD demand of nearly 400K BPD combined with a weak dollar

have lowered the burden on emerging markets that continue to be the core growth driver.

Key Drivers:

Synchronized global growth

US hurricanes improved global product balances, driving increased crude runs and

refinery utilization

India taking the demand torch from China

Risks:

Sustainability of economic momentum – Potential for accelerating US interest rates

reversing weak dollar benefits

OECD strength repeatability – US Rig count growth and European diesel growth unlikely

to repeat

Delayed price sensitivity – Global pump prices near $100 oil levels, US fleet efficiency

trends flat for three years

Vikas Dwivedi +1 713 275 6352 [email protected]


27 November 2017 67

Fig 103 Global product demand growth [K BPD] Fig 104 End-consumer gasoline retail prices

(local currency/litre, % of 2011 prices)

Source: FGE, JODI, Macquarie Capital (USA), November 2017 Source: IHS, Macquarie Capital (USA), November 2017

Supply – Deal or no deal

On November 30, OPEC convenes to discuss continuing the production cut beyond 1Q18.

We believe the market is pricing a six-month extension announcement by OPEC; nine

months would be viewed as bullish, worth $1 to $2, but less than six months would be seen

as bearish, worth ($3) to ($5).

In the event that production cuts are not extended, we expect the return of OPEC production

would overwhelm global balances, resulting in an average surplus of 1,023 K BPD in 2018,

weighted to the second half of the year.

We believe the more likely scenario is that some form of extension is announced. In our base

case, OPEC agrees to extend production cuts through 3Q18. At a $50 crude price, the return

of OPEC in 4Q18 would delay sizeable builds to 2019, which would see average builds of

567 K BPD. However, at our current price deck (Brent – $49/bbl, WTI – $46/bbl), a 4Q18

OPEC return would be met by more subdued NOPEC production, and global balances would

average a small deficit in 2018 (29 K BPD), followed by more manageable builds in 2019 of

81 K BPD.

Fig 105 No Deal: no extension to OPEC cuts

Fig 106 Deal: OPEC extension through 3Q with

$50 crude

Source: IEA, Macquarie Capital (USA), November 2017 Source: IEA, Macquarie Capital (USA), November 2017

1,443

-896

1,821

885

-617

1Q

12

3Q

12

1Q

13

3Q

13

1Q

14

3Q

14

1Q

15

3Q

15

1Q

16

3Q

16

1Q

17

3Q

17

1Q

18

3Q

18

1Q

19

3Q

19

Global S/D Balances [K BPD]

Updated

1,443

-896 -913

575 709

1Q

12

3Q

12

1Q

13

3Q

13

1Q

14

3Q

14

1Q

15

3Q

15

1Q

16

3Q

16

1Q

17

3Q

17

1Q

18

3Q

18

1Q

19

3Q

19


Updated


27 November 2017 68

Fig 107 Deal: extension through 3Q at Macquarie deck

Fig 108 Deal: extension to OPEC cuts through FY18

Source: IEA, Macquarie Capital (USA), November 2017 Source: IEA, Macquarie Capital (USA), November 2017

NOPEC: Conventional declines moderating in key regions in response to price

With the 2018 outlook heavily dependent on an upcoming binary event, the sensitivity (or lack

thereof) of NOPEC barrels to price will be key in the development of oil market dynamics.

To this end, declines in high cost, onshore conventional non-OPEC production, which acted

as a shock absorber for oversupplied oil markets in 2015-16, have begun to moderate as oil

prices have improved, particularly among the leading producers in our reviewed sample

(China, Colombia, Conventional US and Canada). Under our base-case assumption of an

OPEC cut extension through 3Q18, we would expect to see a continuation of moderating

declines from these regions, buoyed by prices supported by suppressed OPEC supply.

Fig 109 Conventional declines moderating in key regions in response to price

Source: Source: Bloomberg, IHS, NEB, Colombia Ministry of Mines and Energy, JODI, Pemex, Argentina Secretaria de Energia, India Ministry of Petroleum, ANP, Macquarie Capital (USA), November 2017

1,443

-896 -981 -786

1Q

12

3Q

12

1Q

13

3Q

13

1Q

14

3Q

14

1Q

15

3Q

15

1Q

16

3Q

16

1Q

17

3Q

17

1Q

18

3Q

18

1Q

19

3Q

19


Updated

1,443

-896-588

-784

1,019

1Q

12

3Q

12

1Q

13

3Q

13

1Q

14

3Q

14

1Q

15

3Q

15

1Q

16

3Q

16

1Q

17

3Q

17

1Q

18

3Q

18

1Q

19

3Q

19


Updated


27 November 2017 69

NOPEC Offshore production remains strong, although Mexico still in decline

While offshore oil production remains vulnerable longer term, with limited project sanctions

since late 2014, across the bulk of non-OPEC offshore, production remains reasonably

resilient. This is consistent with the long lead times associated with these projects. In total,

Brazil, US GOM, North Sea, and Mexico GOM are up ~150 K BPD since Nov. 2014.

Looking at the global project schedule for offshore, we do not expect material relief in 2018,

as project start-ups look strong again next year. With these projects continuing to ramp

through 2019, ultimately, offshore may not function as a source of supply rationalization until

2H19 or 2020.

Fig 110 Offshore production remains strong in NOPEC, although Mexico still in decline

Source: ANP, JODI, Pemex, EIA, Macquarie Capital (USA), November 2017

US production: Tight oil growth expected to accelerate in 4Q17, re-shaping 2018 landscape

Although the “shale disappointment” narrative seems to have reached a peak in recent

weeks, we continue to expect US onshore growth to surprise to the upside relative to

consensus for 2017, setting the stage for a continued response in 2018. We believe 4Q17

should re-frame the narrative around shale, with guidance from the far-flung US E&P sector

indicating rapidly accelerating growth. Specifically, we have an onshore guidance sample of

73 companies accounting for 2.9 MM BPD net that after adjusting the 3Q baseline for

Hurricane Harvey impacts, appear to be guiding to ~8.4% oil growth q/q (251 K BPD). On an

unadjusted basis, guidance implies 10.2% oil growth q/q (301 K BPD) for this group, and we

note significant growth potential from public and private tight oil producers outside of this

sample as well. All told, on the strength of heavy 4Q acceleration, we expect L-48 onshore

to deliver 1.3 MM BPD of exit/exit growth in 2017.


27 November 2017 70

Fig 111 Sharp acceleration expected in 4Q based off sample of 73 cos w/ 2.9 MBD

Source: Company data, Macquarie Capital (USA), November 2017

While our base case anticipates this steep rate of growth being stymied by lower oil prices

and a falling rig count in 2H18, at the current rig count, the US is capable of delivering steady

annualized growth of 1.2 – 1.3 MM BPD through 2019, even without the benefit of DUCs.

While oil markets may be able to accommodate this growth at present, we view these US

activity levels as ultimately unsustainable. At the current rig count, including NGLs, US

liquids growth would roughly match annual demand growth of 1.6 MM BPD, likely leaving

no room for re-absorption of OPEC+Russia barrels.

Fig 112 Forecasted L-48 production (ex-federal offshore) at current rig count

Source: EIA, IHS, Baker Hughes, Macquarie Capital (USA), November 2017 Note: Assumes now reduced pace of DUC drawdown


27 November 2017 71

US natural gas outlook Production growth remains the dominant factor for the US gas S-D picture, in our view. For

Summer ’18, we expect YOY growth of ~5.3 BCFD with incremental pipeline capacity out of

the N.E roughly double that figure. While a dynamic and healthy demand profile can provide

support for gas prices, the completion of several key projects including LNG trains and

Mexican pipelines are now heavily skewed toward YE18, given delays and long lead times.

While weather can still drive short-term bounces, the already historically high dry production

levels achieved in November ‘17 leaves very limited room for the market to achieve a

sustained rally in 2018.

Fig 113 2018 natural gas price forecast [$/MMBTU]

Source: Company Data, Macquarie Capital (USA), November 2017

Shale gas growth machine delivering again and again

Although dry production just hit a record high this month at 76 BCFD, we do not expect

production to stall at this level with Rover P2 and Leach Xpress adding 3+ BCFD of capacity

in 1Q18. Betting against US shale growth has historically proven to be a poor risk/reward

choice and is an even more challenging proposition considering the return of associated

production growth from strong tight oil activity. Even as the market focuses on producers

optimizing between growth and returns, massive capacity expansions in 2018 lay a solid

foundation for another record year.

Fig 114 Northeast pipeline expansion projects [BCFD]


LNG – Can the hero of US demand save the day?

LNG remains the most constructive demand-side driver in the gas balance, and while we

expect US exports to grow by 7.4 BCFD to 10.2 BCFD by YE ’20, we forecast only ~1.4 BCFD

of YOY growth in 2018. While Chinese demand is a strong feature of the current global LNG

market, for ’18 balances in the US, hurricane related project delays for LNG construction is

the more meaningful driver. Looking out longer term, early completion of any USGC projects

could help relieve supply-side pressure, but risks of economic LNG shut-ins could also

surface during low-consumption, late injection seasons. All told, we see a healthy demand

profile for gas in ’18 and through ‘20, but do not expect this to overwhelm the US’ robust,

low-cost resource base.

0

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Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18

ETP RoverTCO Leach XpressTGP SW Louisiana SupplyTGP OrionTGP Broad Run EXPNTransco Atlantic SunriseTCO WB XpressPennEastNexusTCO Mountaineer XpressMillennium CPV Valley Lat.

Vikas Dwivedi +1 713 275 6352 [email protected]


27 November 2017 72

Fig 115 Forecast LNG exports by terminal [BCFD]


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27 November 2017 73

Commodities outlook Metals and bulks

The more benign global economic outlook forecast in 2018 is good news for metals demand

and prices. But it will not be so positive as to guarantee a boom in pricing – instead we expect

it to drive greater divergence of fortunes as no one factor is strong enough to dominate. This

will continue a trend in place of 2012 of falling cross-metal correlations (see the figure below),

reversing the greater synchronicity that occurred in the 1990s/2000s as the rise of China, the

financialisation of commodities and a succession of severe macro shocks saw prices rise and

fall together.

This does not mean, of course, that macro factors are not going to play any role in 2018. After

all the various metals react differently to macro-factors. In particular China plays a far more

important role for many than it does in the world economy at large, and drilling down further,

the Chinese property market – which we expect to slow markedly – has an even more

outsized impact on a number of commodities such as steel.

Fig 116 Metal prices diverging again… Fig 117 Forecasts of demand from batteries, %

Source: IMF (including estimates), Macquarie Research, November 2017 Source: Macquarie Research, November 2017

But the focus will be elsewhere. In addition to the usual array of specific supply and demand

issues for individual commodities, there are two broader developments which have a clear

potential to see prices head in different directions in 2018.

First, commodity supply-side reform in China. Widespread scepticism about the Chinese

government’s willingness to change things has given way to an impressed acceptance as

various measures have transformed global steel markets, rescued aluminium, and installed

the “Beijing put” for coal. In 2018 with a new government in place we expect reform to be front

and centre.

Second, the revolution in motor vehicles technology. For over one hundred years many

commodities’ fortunes have been closely tied to cars, for example steel, and in particular the

internal-combustion engine (ICE), the dominant consumer of oil and platinum-group metals

(PGMs). Battery-powered electric vehicles (EV) threaten to up-end these relationships and

after many false starts, this time it looks like it is really happening. We recently upgraded our

forecasts for EV market share out to 2022 on the back of booming sales and government

targets – 2018 is meant to be the year Tesla’s Model 3 hits the mainstream.

But there are many uncertainties as to the impact on these events on commodities. Chinese

supply side reform will push many commodity prices higher as excess capacity is shut. But for

some such as coal, lower output downstream will directly mean weaker demand, and there is

a wider risk that an overly zealous Chinese government could take reform too far, hurting the

wider economy. EVs will obviously benefit cobalt and lithium, as well as nickel. But how

soon? Even with an estimated 40% growth in sales this year will command only 1.5% of

vehicles sold in 2017. And battery technology is evolving quickly and some commodities

might fall by the wayside.

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2016 2017F 2018F 2019F 2020F 2021F 2022F

EV/PHEV/HV battery demand vs total demand (%)

LCE Co Ni Mn

Matthew Turner +44 20 3037 4340 [email protected] Vivienne Lloyd +44 20 3037 4530 [email protected] Serafino Capoferri +44 203 037 2517 [email protected] Lynn Zhao +86 21 2412 9035 [email protected]


27 November 2017 74

Summarising our 2018 views:

Steel, iron ore and coal have fuelled Chinese growth for the past 15 years but are now the

most exposed to a changing economic model. Bulk commodities face structural headwinds

which include a slowdown in the Chinese construction sector, an increase in steel scrap

recycling and rapidly falling renewable power costs. The demand outlook is not exciting, but

that does not mean opportunities have ceased to exist in the space. Bulk commodities have

an important role to play in China’s fight against pollution: higher-grade iron ore, lower

impurities coal and more efficient steel mills are critical to clean up Chinese air, soil and

water. A shift to quality will dominate the next cycle and will present opportunities for agile

miners capable of adapting their business models accordingly.

For base metals, the past year’s stronger-than-expected Chinese growth has buoyed up

prices, while certain commodity markets like zinc and aluminium have also tightened on

insufficient supply conditions. Aluminium, in particular, has seen a sea change in its

fundamental conditions since the Chinese authorities moved to address overcapacity by

ordering illegal and winter smelter capacity cuts in 2017, and we see further support for prices

into next year as ingot production in China falls. For copper we are less constructive, as

prices have moved up at a similar rate without any particular supply story of this stature.

Speculators have been buoyed by improved macro data, but underlying demand conditions

are more fragile, as consumer pushback on two recent rallies towards $7,000/t has shown.

Elsewhere optimism around the EV revolution has spilled out into roaring prices for certain

metals, but we caution that both nickel and lithium are some years away from true tightness

being driven by this story. Cobalt looks more compelling, but again a little further out than

current levels of excitement seem to be factoring in.

Finally for precious metals, we continue to favour gold and silver on expectations that the

dollar is in a multi-year bear cycle, with elevated political risks likely to stoke up investment.

Silver is our preferred long as we expects its industrial side to benefit from the better

economy and any earlier signs of inflation. We think palladium – which despite being under

threat from EVs has been one of the strongest performers – will remain high but should fade

as global car sales weaken, while platinum should rally with gold.


27 November 2017 75

Fig 118 Commodity price forecasts (quarter average, forecasts shaded)

2017 2018 2019 Unit 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q

Base metals Copper $/tonne 6,349 6,250 6,100 5,900 5,900 5,900 5,900 5,900 5,900 5,900 Aluminium $/tonne 2,012 2,200 2,100 2,000 2,000 2,000 2,000 2,000 2,000 2,000 Zinc $/tonne 2,963 3,200 3,300 3,100 3,100 3,100 3,100 3,100 3,100 3,100 Nickel $/tonne 10,528 10,500 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 Lead $/tonne 2,334 2,550 2,650 2,650 2,650 2,650 2,650 2,650 2,650 2,650 Tin $/tonne 20,566 20,200 20,500 21,000 21,000 21,000 21,000 21,000 21,000 21,000 Steel and Raw Materials Iron ore - 62% Fe $/t CFR 71 63 60 53 53 53 53 53 53 53 Hard coking coal $/t FOB 187 175 130 130 130 130 130 130 130 130 Steel - World Export HRC $/tonne 527 510 450 430 430 430 430 430 430 430 Energy Crude Oil - Brent $/barrel 54 54 53 48 47 50 51 51 54 55 Crude Oil - WTI $/barrel 52 52 50 45 44 46 47 47 50 51 Henry Hub Gas $/MMBTU 2.9 3.1 3.2 3.1 3.0 2.8 2.9 2.7 2.6 2.8 Thermal coal - Aus Spot $/t FOB 93 85 78 72 72 72 72 72 72 72 Uranium $/lb 20 22 24 24 24 24 24 24 24 24 Lithium carbonate $/t CFR China 11,655 11,500 10,500 9,000 9,000 9,000 9,000 9,000 9,000 9,000 Precious Metals Gold $/oz 1,278 1,275 1,300 1,325 1,325 1,325 1,325 1,325 1,325 1,325 Silver $/oz 17 18 19 20 20 20 20 20 20 20 Platinum $/oz 953 925 975 1,050 1,050 1,050 1,050 1,050 1,050 1,050 Palladium $/oz 900 925 925 875 875 875 875 875 875 875


Fig 119 Commodity prices in 2017, YTD, %

Source: Bloomberg, Macrobond, Macquarie Research, November 2017

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Commodities & financial assets price performance, YTD, %

Equity indicesFXBondsIndustrial metalsPrecious metalsAgricommoditiesEnergy

Cobalt 83%Rhodium 79%


27 November 2017 76

Global equity outlook – Year of choices & consequences As discussed in our Global Equity preview (refer Rights, Wrongs & Returns, 2018 – Year of

choices & consequences, 14 Nov 2017), we believe that 2018 might truly deserve shrill

voices and predictions of dislocations that have filled almost every annual preview since the

GFC. In our view, there are three factors that will determine whether in fact it would be

another year of steady gains with limited volatility or whether investors would experience a far

more volatile ride.

1. First, our key concern is the impact of liquidity withdrawal and persistence by

Central Banks in trying to raise the cost of capital, irrespective of evidence that

neither supply nor demand can support higher rates. If we take current rhetoric at

face value, it is likely that liquidity injections could compress by more than US$1 trillion

in 2018 (with growth rates falling from 12%-13% in 2017 to only ~5% in 2018) and

potentially turning negative into 2019. While Central Banks promise to be careful, this

represents a fundamental shift, akin to mixing combustible elements, with highly

uncertain results. While most economists are focused on aggregate demand and

inflation, it is liquidity that drives asset prices, and incremental flows are far more

important than the overall stock of accommodation.

2. Second, we are concerned that China might not fully realize the extent to which

global recovery is contingent on its ability to maintain commodity-intensive

growth. This is particularly critical, following recent power consolidation. It is the old

‘quantity’ vs. ‘quality’ argument, with China in the past (e.g. 2014-15) violently shifting

towards far more robust form of actual de-leveraging, rather than being content

managing asset bubbles. Considering that since 2011, China was responsible for as

much as two-thirds of all of the global non-financial sector credit creation and it is a

consumer of 30%-70% of all commodities, the impact of the tactical decisions by

China could have just as significant impact as they did in 2015.

3. Third, any signs of an even mild stagflation (due to a mix of supply side

reforms and/or pockets of tightness) might prompt Central Banks to overreact,

trying to get ahead of ‘behind the curve’ narrative. Since the Feb’16 G20 meeting,

Central Banks ensured a high degree of policy convergence, thus reducing volatility

and precluding a potentially far more robust shifts in the US$. As we have highlighted

in our prior notes (here), the global economy is still residing on what essentially is the

US$ standard, and hence a growing divergence of monetary policies could result in a

significant contraction of global liquidity and global US$ denominated demand. Given

historically low supply of global US$, currency shifts could be rapid and far more

pronounced.

Fig 120 G4+Swiss Central Bank Assets (US$ bn)

Fig 121 G5+Swiss Central Bank Assets (US$ bn)

Source: Bloomberg, Macquarie Research, November 2017 Source: Bloomberg, Macquarie Research, November 2017

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Viktor Shvets +852 3922 3883 [email protected]


27 November 2017 77

Fig 122 Global non-financial sector incremental debt – China share (US$ bn) (%)

Fig 123 G4+Swiss – Central Bank Balance Sheet (US$ bn, %YoY) - CBs are preparing to reduce liquidity

Source: BIS, Macquarie Research, November 2017 Source: Bloomberg, Macquarie Research, November 2017

The above risk factors imply a potentially sharp fork in a road for every financial asset class,

with high risk of policy errors. Where do we stand?

In our view the key is whether global private sector productivity rates are likely to recover

and hence velocity of money improve. Private sector productivity rates have been declining

globally for at least a decade and, in the case of some developed economies, for two to three

decades. Although there is an argument that we might be mismeasuring productivity,

it appears unlikely, as stagnating productivity coincided with stagnant incomes and rising

income and wealth inequalities. Instead, our view is that we are probably mismeasuring

value of the new economy and significantly over-stating the value of the conventional

private sector.

If the current reflation has strong private sector underpinnings, then not only would it be

appropriate for CBs to withdraw liquidity and raise cost of capital, but indeed these would

bolster confidence, and erode pricing anomalies without jeopardizing growth or causing

excessive asset price displacements. The strength of private sector would determine the

extent to which incremental financialization and public sector supports are required. If on the

other hand, one were to conclude that most of the improvement has thus far been driven by

CBs nailing cost of capital at zero (or below), liquidity injections and China’s debt-fuelled

growth, then any meaningful withdrawal of liquidity and attempts to raise cost of capital would

be met by potentially violent dislocations of asset prices and rising volatility, in turn, causing

contraction of aggregate demand and resurfacing of disinflationary pressures.

Our base-case scenario remains that the world would continue to critically depend on

asset prices and ongoing financialization, and hence any liquidity tightening could cause

sharp value reversals, undermining growth and financial stability. Indeed as discussed in our

2018 preview (here), the volatility could be significantly amplified by the fact that none of

asset classes are prepared for return to conventional price discovery and volatilities.

This applies to the fixed income, currency, real estate and equity markets. Whether we look

at TED and IOS spreads, high yield markets or currency and bond market volatilities, and

indeed perceived equity risks and valuations, the answer is the same. Asset classes are

highly valued and do not factor volatility spikes.

In terms of equity markets, while there are significant cross-regional differentiations, global

equities are now valued at one of the highest levels ever, while VIX has a problem getting out

of 11-13 range. As one of the broadest measures, we can look at the global equity market

capitalization relative to the size of the global economy. All global equity markets are currently

valued at US$94 trillion, this is almost 18% larger than global GDP, and the highest level

ever. For example, at the recent bottom (2010-11), the ratio was only 60%-70% of global

GDP and even at its recent peak (2007), it was barely above 100%. The same picture

complacency and relatively high valuations are apparent when we examine valuations for

both developed and emerging markets.

Non-Financial sectors World China China Share (%)

2001-2005 27,316 1,587 5.8%

2006-2010 48,397 8,019 16.6%

2011-2017 (1Q) 28,315 17,265 61.0%

Non-Financial Corporates

2008-2013 12,973 9,874 76.1%

2014-2017 (1Q) 4,878 4,529 92.8%-10.0%

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27 November 2017 78

Fig 124 MSCI World – forward PER (x) Fig 125 MSCI EM – forward PER (x)

Source: Thomson Reuters, Macquarie Research, November 2017 Source: Thomson Reuters, Macquarie Research, November 2017

Fig 126 Global equity market capitalization (US$ bn) (% GDP)

Source: Bloomberg; Macquarie Research, November 2017

High valuations, low volatilities and the prospective regime change could lead to highly

volatile and bumpy 2018; so why do we remain constructive on most financial assets, and in

particular equities? While policy errors cannot be ruled-out, we believe that at any sign of

volatilities, CBs and China would have no choice but to reverse. Not a permanent answer, but

neither is there a reason to believe that ’18 is when the dam finally breaks. Our base case is

one of ‘Kondratieff autumn’ persisting, and hence we remain constructive not because

we believe in a sustained recovery, but because we do not see realistic alternatives to excess

liquidity and declining cost of capital.

US equities – the world’s best corporates but also highest values…

As discussed in our prior notes, we tend to use a mix of long-term secular and more primitive

point-in-time forward valuation measures. On a longer-term basis, we use three different

criteria: (a) CAPE (or Shiller cyclically and inflationary adjusted multiples); (b) Tobin Q

(rigorous alternative to conventional Price to Book value); and (c) equity market capitalization

to GDP ratios.

In terms of CAPE, the US equity market is currently trading at 31x 10-year, inflationary

adjusted earnings. Although CAPE has never been very useful in signalling trading strategies,

it has an excellent track record in predicting when the market is massively over or under

valued. For example CAPE was screaming overvaluation at least two years before the

dot.com collapse and equally it highlighted severe undervaluations when forward multiples

rose due to depressed earnings, such as February ‘03 or March ‘09. However, in between

extremes we think CAPE does not offer much. What does 31x mean? It basically implies

that investors have reached the high point of September 1929 (before the crash that ushered

the Great Depression), and there is only one ‘peak’ left yet to be conquered. Between

September 1998 and November 2000, CAPE was gyrating between 33x and 43x. The

average CAPE between 1881 and 2016 was ~17x, and the average for the more recent

period (1950 to 2016) was closer to 19x. So, no matter how one cuts it, CAPE is signalling

a significant market over-valuation.

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US equities are

vulnerable, no

matter how one cuts

the numbers


27 November 2017 79

Fig 127 S&P – CAPE (x) – at ~31x….only one peak left to conquer

Source: Robert Shiller; Macquarie Research, November 2017

A similar message is sent by another long-term valuation measure: Tobin Q. Just as CAPE is

not meant to provide trading points, Tobin Q is based on fundamental assessment of

underlying corporate assets. It measures the market value of assets (as measured by

valuation of equity and debt) and compares it to replacement value. For some time, it has

been derived by the Federal Reserve, as part of its quarterly US cashflow statement (Z) with

the latest numbers referring to 2Q’17. Most academics not only agree with its consistency, but

also highlight that fair valuation usually occurs when Tobin Q is around 0.65-0.7.

What is it today? As of 2Q17, the ratio stands at 1.09 (implying ~50% over-valuation). As in

the case of CAPE, the only other time (at least since 1951) that Tobin Q was higher was in

the 1998-2000 dot.com bubble. There were several attempts to resurrect a much longer time-

series, extending beyond modern statistics (post-1947). One such study, estimated Tobin Q

to 1900. It appears that the current Tobin Q is still a little bit short of 1929 estimates of 1.29.

Fig 128 Tobin Q (1951-2017) (x)

Fig 129 Tobin Q (LT series) (1990-2017)

Source: Federal Reserve, Macquarie Research, November 2017 Source: Stephen Wright, Fed, Macquarie Research, November 2017

Finally, we can examine Warren Buffet’s favourite measure of Equity market capitalization

to GDP. As at 2Q17, this ratio stood at 178% (vs 87% average since 1950), matching the

high point achieved during the dot.com. Given that equity valuations have further improved in

3Q17, it is quite likely that the current measure is probably above 180%. Since World War II,

there has never been a time of a higher relationship between equity market capitalization and

the value of the underlying economy. Even if we strip out financials, the non-financials market

capitalization to GDP exceeds 131%, and it represented the second-highest level ever.

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-

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

19

51

Q4

19

53

Q4

19

55

Q4

19

57

Q4

19

59

Q4

19

61

Q4

19

63

Q4

19

65

Q4

19

67

Q4

19

69

Q4

19

71

Q4

19

73

Q4

19

75

Q4

19

77

Q4

19

79

Q4

19

81

Q4

19

83

Q4

19

85

Q4

19

87

Q4

19

89

Q4

19

91

Q4

19

93

Q4

19

95

Q4

19

97

Q4

19

99

Q4

20

01

Q4

20

03

Q4

20

05

Q4

20

07

Q4

20

09

Q4

20

11

Q4

20

13

Q4

20

15

Q4

Tobin Q

-

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

19

00

19

05

19

10

19

15

19

20

19

25

19

30

19

35

19

40

19

45

19

50

19

55

19

60

19

65

19

70

19

75

19

80

19

85

19

90

19

95

20

00

20

05

20

10

20

15

Tobin Q Avg (1900-2016)


27 November 2017 80

Fig 130 US equity market capitalization/GDP (%)

Fig 131 US equity market capitalization/GDP (%) –

financials vs. non-financial corporates

Source: Federal Reserve, Macquarie Research, November 2017 Source: Federal Reserve Macquarie Research, November 2017

What about shorter-term and point-in-time valuations, such as forward multiples?

Unfortunately, the message is pretty much the same. Whether we examine forward PERs or

Price to Book values, the US equities are at least one standard deviation above the historical

mean. S&P and MSCI US are currently trading at a forward PER of more than 18x vs the

historical averages of closer to 15x. At the same time, the market is trading almost two

standard deviations above mean on price to book value (3x vs. historical average of 2.3x).

The above high valuation multiples are also present at the time of historically high

earnings, margins, ROEs and share buy-backs and historically low interest rates.

Fig 132 S&P 500 – forward PER (x) – above 18x

Fig 133 S&P 500 – price to book (x) – above 3x


Fig 134 US – national corporate profits (US$ bn)

Fig 135 US – national corporate profits ex petroleum

Source: BEA, Macquarie Research, November 2017 Source: BEA, Macquarie Research, November 2017

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

19

51

Q4

19

53

Q4

19

55

Q4

19

57

Q4

19

59

Q4

19

61

Q4

19

63

Q4

19

65

Q4

19

67

Q4

19

69

Q4

19

71

Q4

19

73

Q4

19

75

Q4

19

77

Q4

19

79

Q4

19

81

Q4

19

83

Q4

19

85

Q4

19

87

Q4

19

89

Q4

19

91

Q4

19

93

Q4

19

95

Q4

19

97

Q4

19

99

Q4

20

01

Q4

20

03

Q4

20

05

Q4

20

07

Q4

20

09

Q4

20

11

Q4

20

13

Q4

20

15

Q4

Market Cap (including financials) / GDP

Market Cap to GDP (avg 1950-2016)

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

19

51

Q4

19

53

Q4

19

55

Q4

19

57

Q4

19

59

Q4

19

61

Q4

19

63

Q4

19

65

Q4

19

67

Q4

19

69

Q4

19

71

Q4

19

73

Q4

19

75

Q4

19

77

Q4

19

79

Q4

19

81

Q4

19

83

Q4

19

85

Q4

19

87

Q4

19

89

Q4

19

91

Q4

19

93

Q4

19

95

Q4

19

97

Q4

19

99

Q4

20

01

Q4

20

03

Q4

20

05

Q4

20

07

Q4

20

09

Q4

20

11

Q4

20

13

Q4

20

15

Q4

Market Cap Non financials businesses / GDP

Market Cap (including financials) / GDP

5.0

10.0

15.0

20.0

25.0

30.0

Jan

-85

Oct

-86

Jul-

88

Ap

r-9

0

Jan

-92

Oct

-93

Jul-

95

Ap

r-9

7

Jan

-99

Oct

-00

Jul-

02

Ap

r-0

4

Jan

-06

Oct

-07

Jul-

09

Ap

r-1

1

Jan

-13

Oct

-14

Jul-

16

US S&P500 - 12M fw PER

Mean + 1sd

Mean

Mean - 1sd

1.0

1.5

2.0

2.5

3.0

3.5

Jan

-03

No

v-0

3

Sep

-04

Jul-

05

May

-06

Mar

-07

Jan

-08

No

v-0

8

Sep

-09

Jul-

10

May

-11

Mar

-12

Jan

-13

No

v-1

3

Sep

-14

Jul-

15

May

-16

Mar

-17

US S&P500 - 12M fw PBR

Mean + 1sd

Mean

Mean - 1sd

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

1,500

1,600

1,700

1,800

1,900

2,000

2,100

2,200

2,300

2,400

Mar-

10

Sep

-10

Mar-

11

Sep

-11

Mar-

12

Sep

-12

Mar-

13

Sep

-13

Mar-

14

Sep

-14

Mar-

15

Sep

-15

Mar-

16

Sep

-16

Mar-

17

Corporate Profits % YoY

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

700

800

900

1,000

1,100

1,200

1,300

1,400

Mar-

10

Sep

-10

Mar-

11

Sep

-11

Mar-

12

Sep

-12

Mar-

13

Sep

-13

Mar-

14

Sep

-14

Mar-

15

Sep

-15

Mar-

16

Sep

-16

Mar-

17

Domestic non-Financial ex Petroleum, Oil/Coal % YoY


27 November 2017 81

Fig 136 US – corporate margins (%)

Fig 137 US – corporate dividends & net share

buybacks (US$ bn) – ~US$1.1 trillion


The markets are not just counting on US corporates to be able to maintain earnings

growth and margins but also on the ability to benefit from a mix of regulatory and

taxation changes.

However, as highlighted (here) in our past reviews, we do not believe that there will be

significant simplification of the tax code, and although we expect tax rates will be cut, we

believe there will also be an elimination of the number of loopholes and deductions (in order

to keep the overall package within US$1.5 trillion limit). Hence, the net benefit is unlikely to be

large, particularly considering that the US effective corporate tax rate is already ~21%-22%.

Fig 138 US – Effective Corporate Tax Rate (%)

Source: BEA; Macquarie Research, November 2017

While equity investors are not currently discounting any negative news (such as a potentially

sharp shift in interest rates) and assuming a lot of positives, it should be highlighted, that in

terms of quality, sustainability and Thematics (our key investment ideas – refer to discussion

below), the US has more corporates that satisfy criteria for stocks that one should be

investing in than any other equity market.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

De

c-8

0

De

c-8

2

De

c-8

4

De

c-8

6

De

c-8

8

De

c-9

0

De

c-9

2

De

c-9

4

De

c-9

6

De

c-9

8

De

c-0

0

De

c-0

2

De

c-0

4

De

c-0

6

De

c-0

8

De

c-1

0

De

c-1

2

De

c-1

4

De

c-1

6US market - Net margins

0

200

400

600

800

1,000

1,200

1,400

19

52

Q1

19

54

Q3

19

57

Q1

19

59

Q3

19

62

Q1

19

64

Q3

19

67

Q1

19

69

Q3

19

72

Q1

19

74

Q3

19

77

Q1

19

79

Q3

19

82

Q1

19

84

Q3

19

87

Q1

19

89

Q3

19

92

Q1

19

94

Q3

19

97

Q1

19

99

Q3

20

02

Q1

20

04

Q3

20

07

Q1

20

09

Q3

20

12

Q1

20

14

Q3

20

17

Q1

Net dividends & Share Buy backs

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

19

60

19

63

19

66

19

69

19

72

19

75

19

78

19

81

19

84

19

87

19

90

19

93

19

96

19

99

20

02

20

05

20

08

20

11

20

14

20

17

Effective Corporate Tax Rate (%)

21%

However,

corporates could

benefit from tax

changes and…


27 November 2017 82

Another key factor to consider is the role that US consumers play in global

consumption and growth, and the importance of financial assets and investments in

keeping personal savings down, and hence, supporting consumption. Whereas prior to

the 1980s, consumption and income were closely linked, since the start of the US and global

financialization, a much closer relationship evolved between the US net household wealth

and saving rates. In other words, over the last three decades, US households were

increasingly using leverage and asset prices in making their decisions on spending. As at 2Q

2017, the US household net worth to disposable income ratio has reached the highest level

ever (even bypassing the dot.com and 2006-07 highs). Household net worth to disposable

income now exceeds 6.7x. It implies that unless productivity and income levels accelerate in

a meaningful manner, the Fed cannot allow a significant dislocation in three key asset

classes: (a) real estate; (b) equity; and (c) bond markets, without running the risk of a

potentially significant set-back to consumption.

Fig 139 US – Personal Saving Rate (%)

Fig 140 US – Net Household Wealth/Disposable

Income vs. US Personal Saving Rate

Source: CEIC, Macquarie Research, November 2017 Source: Federal Reserve, Macquarie Research, November 2017

Thus, the US equity markets present an ongoing investment conundrum. On the one

hand, the market boasts some of the world’s best managed and the most prospective

corporates, and although one could debate the extent of changes in either the regulation or

taxation arena, there should be at least some benefit flowing to corporates. There is also a

much keener understanding in the US of the symbolic and wealth impact of equities, and

hence, whether it is the Government or the Fed, there is a substantial reluctance to upset the

‘applecart’. But on the other hand, there is no room for disappointment, either in performance,

rates or valuations.

…but it is little bit less hyped in other equity markets and…

Although overall global equity valuations are quite high almost everywhere, the degree of

overvaluation varies considerably.

For example European equities currently trade at just under 15x forward earnings, vs the

historical average of ~14x, and the region’s EPS growth rates and margins are improving

(albeit from a much lower base). Similarly, the region currently trades at 1.6x book, only

slightly ahead of the 1.5x book historical average. Although it is hard to do CAPE (as it

requires multi-decade history), nevertheless, on a much more restrictive sample, European

equities currently trade on CAPE of ~16x vs. the historical average of ~17x.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

Mar-

47

Apr-

50

May-5

3

Ju

n-5

6

Ju

l-59

Aug

-62

Sep

-65

Oct-

68

No

v-7

1

De

c-7

4

Ja

n-7

8

Feb

-81

Mar-

84

Apr-

87

May-9

0

Ju

n-9

3

Ju

l-96

Aug

-99

Sep

-02

Oct-

05

No

v-0

8

De

c-1

1

Ja

n-1

5

Personal Saving Rate Average (1947-2015)

Average (1980-2015)

0

5

10

15

400

450

500

550

600

650

700

19

53Q

3

19

56Q

3

19

59Q

3

19

62Q

3

19

65Q

3

19

68Q

3

19

71Q

3

19

74Q

3

19

77Q

3

19

80Q

3

19

83Q

3

19

86Q

3

19

89Q

3

19

92Q

3

19

95Q

3

19

98Q

3

20

01Q

3

20

04Q

3

20

07Q

3

20

10Q

3

20

13Q

3

20

16Q

3

Net Worth/Disposable IncomeNet Worth/Disposable Income (average)Personal Saving rate, rhs

…US consumption

is very dependent

on asset markets

Finally US

corporates are

best-in-class

European and

Japanese equities

less hyped


27 November 2017 83

Fig 141 Eurozone – profit margin (%) Fig 142 Eurozone – ROE (%)


Fig 143 MSCI EMU – forward PER (x)

Fig 144 MSCI EMU – forward price/book (x)


Fig 145 Eurozone – CAPE (x)

Fig 146 Eurozone – trailing historical price/ book (x)


The same applies to Japan. Although as in Europe, it is highly sensitive to exchange rates,

and if there is a sustained appreciation of yen, then TOPIX average margins could easily

revert back towards 4%-5% (at yen closer to 85-90), Japan (as the US) has an excellent

collection of corporates that play into a number of what we believe to be most perspective

themes (refer discussion below). Also as discussed in our prior notes (refer What caught my

eye? v.80 - Japan Debt Mountain: does it matter? 22 Sep 2017), we believe that Japan is

around ten years ahead of the rest of the world in proving that demographics do not have to

be the country’s destiny, and it is the first country to quietly and consistently liquidate public

sector debt. We continue to view Abenomics not as a means of reflating the economy but

rather as a way to liquidate debt with a minimum market disruption.

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

De

c-8

0

De

c-8

2

De

c-8

4

De

c-8

6

De

c-8

8

De

c-9

0

De

c-9

2

De

c-9

4

De

c-9

6

De

c-9

8

De

c-0

0

De

c-0

2

De

c-0

4

De

c-0

6

De

c-0

8

De

c-1

0

De

c-1

2

De

c-1

4

De

c-1

6

Eurozone - Net margins

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

De

c-8

0

De

c-8

2

De

c-8

4

De

c-8

6

De

c-8

8

De

c-9

0

De

c-9

2

De

c-9

4

De

c-9

6

De

c-9

8

De

c-0

0

De

c-0

2

De

c-0

4

De

c-0

6

De

c-0

8

De

c-1

0

De

c-1

2

De

c-1

4

De

c-1

6

Eurozone - ROE

5.0

10.0

15.0

20.0

25.0

30.0

De

c-8

7

Jul-

89

Feb

-91

Sep

-92

Ap

r-9

4

No

v-9

5

Jun

-97

Jan

-99

Au

g-0

0

Mar

-02

Oct

-03

May

-05

De

c-0

6

Jul-

08

Feb

-10

Sep

-11

Ap

r-1

3

No

v-1

4

Jun

-16

MSCI EMU - 12M fw PER

Mean + 1sd

Mean

Mean - 1sd

0.80.91.01.11.21.31.41.51.61.71.81.92.02.12.2

Jan

-04

Oct

-04

Jul-

05

Ap

r-0

6

Jan

-07

Oct

-07

Jul-

08

Ap

r-0

9

Jan

-10

Oct

-10

Jul-

11

Ap

r-1

2

Jan

-13

Oct

-13

Jul-

14

Ap

r-1

5

Jan

-16

Oct

-16

Jul-

17

MSCI EMU - 12M fw PBR

Mean + 1sd

Mean

Mean - 1sd

5

10

15

20

25

30

35

Sep

-85

Sep

-87

Sep

-89

Sep

-91

Sep

-93

Sep

-95

Sep

-97

Sep

-99

Sep

-01

Sep

-03

Sep

-05

Sep

-07

Sep

-09

Sep

-11

Sep

-13

Sep

-15

Sep

-17

Eurozone - CAPE

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Jan

-80

Jan

-82

Jan

-84

Jan

-86

Jan

-88

Jan

-90

Jan

-92

Jan

-94

Jan

-96

Jan

-98

Jan

-00

Jan

-02

Jan

-04

Jan

-06

Jan

-08

Jan

-10

Jan

-12

Jan

-14

Jan

-16

Eurozone - price to book

Mean + 1sd

Mean

Mean - 1sd


27 November 2017 84

In terms of valuations, Japan’s multiples (whether PER, P/Book or CAPE) are at broadly

average levels (adjusting for extreme highs of late 1980s-early 1990s). Essentially investors

kept Japanese market multiples broadly flat, with equity performance reflecting improving

fundamentals and earnings. If indeed investors eventually agree with us that there is also a

strong productivity and debt eradication story, then multiples could expand.

Fig 147 Japan – profit margin (%)

Fig 148 Japan – ROE (%)


Fig 149 MSCI Japan – forward PER (x)

Fig 150 MSCI Japan – Forward P/Book (x)


What about EM equities? In the year to date, EM equities outperformed DMs by 12% and

since the low in late January 2016, EM equities have outperformed DM equities by 20%

(US$). As can be seen below, this has been one of the best periods of EM outperformance

since at least ‘07-08. Nevertheless, since an absolute peak in Oct ’10 (not many investors

remember the half-baked ideas of de-coupling of EMs from problem plagued DMs that were

prevalent after GFC), EM equities are still down more than 39% in relative value.

As discussed in our prior notes, there were several reasons for improved relative

performance of EM equities: (a) stabilization and moderate depreciation of US$, following

policy convergence in the wake of the G20 meeting in Feb ’16; (b) China stimulus and hence

accelerated global growth rates, and more importantly global trade; (c) relative undervaluation

in early ‘16. As can be seen below, EM equities were trading at a ~35%-40% discount to DM

equities vs the historical average of closer to 15%-20%; and (d) EMs were oversold.

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

De

c-8

0

De

c-8

2

De

c-8

4

De

c-8

6

De

c-8

8

De

c-9

0

De

c-9

2

De

c-9

4

De

c-9

6

De

c-9

8

De

c-0

0

De

c-0

2

De

c-0

4

De

c-0

6

De

c-0

8

De

c-1

0

De

c-1

2

De

c-1

4

De

c-1

6

Japan market - Net margins

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

De

c-8

0

De

c-8

2

De

c-8

4

De

c-8

6

De

c-8

8

De

c-9

0

De

c-9

2

De

c-9

4

De

c-9

6

De

c-9

8

De

c-0

0

De

c-0

2

De

c-0

4

De

c-0

6

De

c-0

8

De

c-1

0

De

c-1

2

De

c-1

4

De

c-1

6

Japan market - ROE

5.0

15.0

25.0

35.0

45.0

55.0

65.0

75.0

85.0

De

c-8

7

Jul-

89

Feb

-91

Sep

-92

Ap

r-9

4

No

v-9

5

Jun

-97

Jan

-99

Au

g-0

0

Mar

-02

Oct

-03

May

-05

De

c-0

6

Jul-

08

Feb

-10

Sep

-11

Ap

r-1

3

No

v-1

4

Jun

-16

MSCI Japan - 12M fw PER

Mean + 1sd

Mean

Mean - 1sd

0.6

1.0

1.4

1.8

2.2

Jan

-04

Oct

-04

Jul-

05

Ap

r-0

6

Jan

-07

Oct

-07

Jul-

08

Ap

r-0

9

Jan

-10

Oct

-10

Jul-

11

Ap

r-1

2

Jan

-13

Oct

-13

Jul-

14

Ap

r-1

5

Jan

-16

Oct

-16

Jul-

17

MSCI Japan - 12M fw PBR

Mean + 1sd

Mean

Mean - 1sd

As long as

volatilities and US$

remain contained,

EMs also look

reasonable


27 November 2017 85

Fig 151 MSCI EM/DM relative performance

Fig 152 MSCI EM/DM relative performance – short

cycles


Fig 153 MSCI EM/DM relative forward PER (x)

Fig 154 MSCI EM/DM relative P/book (x)


We were expecting that the above mix of reasons should continue to support EM equities in

the early part of 2017, but by mid-17 as China stimulus was expected to recede and monetary

policy divergence re-emerge, we had expected that EM outperformance would erode.

Instead, EM equities have continued to add marginal outperformance through 3Q’17, as both

China stimulus remains stronger than expected, prompting more coordinated global growth,

and monetary policy divergences remains relatively moderate.

We discuss our portfolio allocations below. However, as a general statement, EMs no longer

look either too cheap or expensive from a valuation perspective, while the asset class is no

longer oversold (although neither is it significantly over-bought). Also, EMs’ and Asia’s

negative earnings revisions cycle, which was on a steep declining curve over the previous

five years, has stabilized (here). While only a reflection of the above outlined fundamental

forces, it nevertheless provides a great deal of conformational support.

Perhaps even more importantly, EMs (or principally Asia ex Japan) are now far more driven

by secular growth dynamics rather than traditional considerations of global cyclicality,

infrastructure investment and consumption. As discussed in our notes (here), ~26% of MSCI

EM and in excess of 32% of Asia ex Japan index consists of technology and IT.

…equities benefit from its position between macros & cash flows

As discussed in our recent note (Why equities are different - The old value vs. growth dilemma

14 Sep 2017), we view equities as much better positioned than bonds or global markets, not

because we are bond bears (on the contrary, we maintain that over time interest rates must

continue to fall), but because unlike global market investors, equity holders are one level

below macro and only one level above management and cash flows. As we discuss

below, we believe that it has significant implications for investment strategies and provides

options that are not available to either fixed income or currency investors.

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MSCI EM / MSCI DM MSCI EM $ / MSCI DM $

+8%+11%

-14%

-14%

+9%

-18%

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EM/DM - 12M Fw PBR Avg (since 2004) Avg (since 2010)


27 November 2017 86

US equities are vulnerable to any disappointment either on taxation or the regulatory

front. There is simply not a single valuation or measurement criteria that does not indicate

significant overvaluation. Having said that, the US has the best quality and the most

prospective corporate sector, and that’s why our Thematics and Quality portfolios are

dominated by the US names. There is also a much tighter relationship between personal net

worth and personal saving rates, with equities in the US (vs other jurisdictions) being far more

prominent as a symbol of success and good policies. This implies much greater policy

sensitivity.

European and Japanese equities continue to be better positioned on valuation, growth

and an improving ROE basis. The key risk for both regions is the possibility of sharp

currency appreciation. If the ECB and BoJ largely abandon their programs to reflate their

respective economies, then in that scenario, surplus of domestic savings (reflected in current

account surpluses) would drive both currencies potentially much higher, causing a correction

in corporate ROEs. However, in the absence of this, both regions should report higher

returns, while valuation multiples are nowhere near as stretched. We particularly like how

Japan is managing to deliver steady multi-factor productivity (higher than the US or Europe)

and we like its interesting Thematic plays.

EM equities have significantly outperformed DMs (particularly in 1H’17), with stronger

momentum driven by an accelerating global reflation, contained US$, ample liquidity

and a growing impact of technology cycles. What about the future? Our current base case

scenario assumes that China’s reflationary pulse would get weaker while liquidity could

become more compressed (although we do not envisage a dislocating jump in volatilities).

On the other hand, we remain strong believers that the technology cycle is only (at best) mid-

stream and neither growth prospects nor valuation measures makes us currently nervous.

Given that technology now accounts for ~32% of MSCI Asia ex Japan (double the level of five

years ago), we believe this is both the greatest opportunity and risk for EM equities. It is no

longer financials, infrastructure, or consumption that determine index performance. Normally,

weakening reflation and tighter liquidity could lead to potential significant EM

underperformance. However, changes in the index drivers make us more comfortable,

expecting a neutral performance, with Asia ex outperforming the rest of EMs.

In terms of Asia ex markets, we continue to double down on our winners. We highlight

countries that have stronger domestic liquidity, a low degree of external vulnerability

and higher exposure to technology cycle. We remain overweight on China, Korea and

India, with broadly neutral positions in the Philippines, Taiwan and Singapore. We continue to

underweight terms of trade countries or countries that could be dislodged in any dislocation

(such as Indonesia, Thailand and Malaysia).

Fig 155 MQ – Asia ex Japan – country tilt


-3 -2 -1 0 1 2 3

China

India

Korea

Philippines

Taiwan

Hong Kong

Singapore

Malaysia

Thailand

Indonesia


27 November 2017 87

Our stock-picking portfolios remain non-mean reversion….

Over the last five years, we have consistently advocated equity investors to pay attention to

macro only to the extent necessary to form a general, overarching view of the world and how

it functions. However, unlike the 1980s-90s, when micro and macro usually moved together,

over the last ten to fifteen years that was no longer the case. We have argued that macro

and micro have gotten largely disconnected because we no longer have conventional

and identifiable business and capital cycles. Hence, it is impossible to determine whether

we are in an early, mid or late part of the cycle, making conventional country and sector

rotations redundant.

There are a number of complex and interconnected reasons as to why conventional

investment styles no longer work. We tend to highlight three:

(a) An accelerating pace of technological disruption, which depresses aggregate

productivity while amplifying income and wealth inequalities;

(b) Political response to the above, with much more aggressive public sector policies

(particularly monetary) that over the last three decades fostered financialization and

compression of business and capital market cycles;

(c) Eventually, neither the governments nor populace could any longer accept either

price discovery or volatilities. However, as in a reflex reaction, a desire to contain and

control, ends-up creating an environment demanding ever greater control and further

tightening of cycles, with neither debt repudiation, de-leveraging or clearance of

excess any longer allowed.

In our view, it is a mix of technology and over financialization and persistent overcapacity,

which created a climate of what Larry Summers described as secular stagnation. It has been

our core belief that although regular reflationary cycles are likely, these cannot be sustained

for any length of time, and disinflationary pressures will prove to be stronger.

Indeed, over time, it is likely that marginal cost of almost everything is likely to

gravitate to near zero (see Cambrian explosion - Birth of the new; extinction of the old

10 July 2017). What MacAfee and Brynfjolfsson described as DANCE (or data, algorithms,

networks, cloud computing and exponential improvement in digital hardware) is increasingly

driving everything from sharing services (Wikipedia, Dollar Shave club), e-retail (Amazon and

Alibaba), robots and automation, autonomous cars to 3D printing. It has already ripped

through entertainment, media, information, retail and financial services and is starting to

disintermediate manufacturing (including global supply and value chains). What we believe

makes DANCE so deadly to existing economies, countries and business models is that it is

based on the ability of technology to create platforms that can deliver the same (or better)

product or service, at a fraction of the original cost. Given more limited capital requirements

and an almost unlimited scale, these business models drive marginal costs to near zero and

neither economies nor conventional businesses have defence against zero. Hence, industries

are disrupted, and we expect many over time will go extinct, and the same applies to the

labour force, and its relationship with technology and society at large.

While many investors suggest that this is a very long-term development, our view

remains that the ‘new world’ has already arrived, and the pace of change is accelerating

at a geometric rate, and the Information revolution (which started in 1971) is far more

disruptive than previous Industrial revolutions, primarily because it has a much wider

waterfront, and is increasingly impacting not routine but cognitive functions. We are already

in the ‘eye of the storm’, and it is likely to get much more dislocating.

As jarring as the technological progression path is, the challenge facing investors is that

the outcomes are further confused and aggravated by our own attempts to delay,

derail and/or soften the impact. As a result, increasingly most of the signals are emanating

from public rather than private sectors. Given our view that the public sector does not function

along a conventional business and capital market cycles, but is instead focussed on political

and social issues, it empties macro signals of most of their informational value. It is clear what

a flattening yield curve means when the private sector does it; it is however meaningless

when public sector does it. For example, for all practical purposes, neither Japan nor China or

Eurozone have a yield curve. The same applies to a multitude of leading indicators, which are

premised on private sector primacy.


27 November 2017 88

In our view, these are the structural reasons as to why conventional growth, value and

quality rotations have largely stopped working and why mean-reversion no longer

works. In most cases, markets and asset classes tend to be stuck in a single mode. For

example, even though the world has experienced the most coordinated global recovery, since

2008, it was not value but rather quality and growth that have significantly outperformed the

benchmarks. Apart from Trump initiating a short burst between Nov’16 and Feb’17, value

continued to underperform, across most jurisdictions (global, SPX, Asia ex, EM etc).

Fig 156 Value over Growth – Growth consistently has an edge

Fig 157 Value over Quality – Quality consistently has

an edge

Source: Bloomberg, Macquarie Research, November 2017 Source: Bloomberg, Macquarie Research, November 2017

While it is not hard to argue that, at some point in time, value will jump against quality and

growth, we doubt that this will be sustainable. Rather, we believe it should be quickly

replaced by return to quality, sustainability, growth and thematics. There are several

reasons for this:

1. The world and global trade are no longer driven by 19th-20th century conventional

industrial and commodity-sourced factors. Instead, it is increasingly driven by a

technology complex while economies grow through services rather than merchandise

trade. Whether it is haircuts, restaurants, education or healthcare, these are very low

global multiplier activities. In our view, this explains why India and Indonesia did not

participate in global reflationary trade, the way either countries would have in the past.

2. This implies that value stocks that would have traditionally reacted to stronger growth

and the expectation of potential steepening of the yield curve, no longer do so

(at least not to the same degree). In other words, value has gone from stocks

awaiting a global ‘tide’ to stocks that are simply poor quality with a limited ability to

meaningfully and sustainably recover.

3. Finally, we do believe that we are increasingly residing in a world where conventional

corporates, operating conventional businesses and brands are increasingly attacked

by a mix of older and new competitors. Hence, as earnings disappoint, investors

eventually come to the conclusion that although there could be some temporary

recovery, it won’t be sustained and thus investors do not wish to fully participate in

these recoveries, thus limiting value upside.

Does it mean that valuations are completely irrelevant?

We believe that to some extent this is true, but it is contingent on the basic premise of ample

liquidity and declining cost of capital holding true. Hence, quality, thematics and growth are

vulnerable to policy errors that might suddenly lead to higher volatilities, less liquidity and

higher cost of capital. These portfolios would be also exposed, if in fact we were to return

back to conventional business and capital market cycles, and hence more conventional

sector and country rotations.

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SPX Value over Growth ASXJ Value over Growth

MSCI World Value over Growth

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SPX Value over Quality ASXJ Value over Quality

MSCI World Value over Quality

Hence, we think

that value is

permanently

impaired


27 November 2017 89

…emphasizing quality, sustainability, growth and thematics

However, if we assume that normality is very unlikely, then any significant pick-up in

volatilities would damage value as much as quality, growth or thematics and hence after

an initial set back, we believe these styles would come back into favour even stronger than

before. Hence, our investment style remains anchored in two key styles:

1. ‘Quality Sustainable Growth (QSG)’, which attempts to combine quality,

sustainability and growth. Refer (here) for detailed selection criteria, but in general,

we try to screen stocks that can deliver a minimum 12% ROE, driven primarily

through margins (we insist on at least flat margins) and without excessive leverage

(net debt to EBITDA 2x, and declining over time). In other words, we ask corporates

to deliver some growth, without dropping margins and without leveraging returns.

We are agnostic as to sectors (apart from financials) or countries and currencies,

and we do not pay much attention to multiples.

The way we look at QSG portfolios is that represents companies that still appear to

have some ‘runway’ left. Given our underlying belief that most corporates would

eventually come under pressure from a technological and globalization perspective,

and hence even the best regarded companies would end up as ‘castles on fire’,

we want to find some companies that seem to be exhibiting greater-than-average

resilience. The biggest concern that we have is that increasingly the companies that

qualify for our QSG portfolios are focused in narrower fields (predominantly

technology and some of the least developed markets). At some stage, this would

imply that ‘exit doors’ could get much narrower.

2. ‘Thematic Winners’. Unlike QSG, our thematics portfolios do not have any quality

criteria, and instead we attempt to identify corporates that represent the best and the

purest exposure to the key themes that we would like to have exposure to.

As we discussed in our prior notes, we prefer to describe our portfolios as a play on

‘declining returns on humans and conventional capital and rising returns on

social and digital capital’. We have identified seven key themes including:

(a) ‘replacement of humans’ (robotics, automation and AI); (b) ‘augmentation of

humans’ (biotechnology, gene slicing and sequencing); (c) ‘opium of the people’

(entertainment, games, artificial reality and gambling); (d) ‘bullets and prisons’

(weapon manufacturers, drones, security firms, operators of prisons and places of

incarceration); (e) skilling and education; (f) ‘morbid demographics’ (funeral parlours,

psychiatric institutions); and (g) pure disrupters (companies that are focused on

disrupting today’s businesses). Not surprisingly, over time, we have noticed an

increasing overlap between our Thematic and QSG portfolios, as disrupters

and new technology started to qualify for quality.

We continue to run the above portfolios on an Asia ex Japan and Global basis, and we

maintain a relatively tight range of stocks. We usually have between 20 and 30 stocks in our

Asia ex Japan QSG and Thematics portfolios, and usually not much more than 35-40 stocks

each in our Global QSG and Thematic portfolios. We have limitations on market capitalization

(minimum ~US$2bn in Asia ex and ~US$5bn globally), and we only review our Portfolios

three times per annum. The latest review was completed on 1 November 2017

(Portfolio update – out with the old, in with the new). Please refer to the note above for more

comprehensive details, but here we provide a short summary of stocks that we currently have

in our Asia ex as well as Global Portfolios.

We continue to

focus on the key

themes of Quality,

Sustainability,

Growth and

Thematics


27 November 2017 90

Fig 158 Macquarie Global ‘Quality Sustainable Growth’ Portfolio (Nov’17)

Source: Bloomberg, FactSet; Macquarie Research, November 2017

Fig 159 Macquarie Asia ex Japan ‘Quality Sustainable Growth’ Portfolio (Nov’17)


Ticker Name Reco. Country Ticker Name Reco. Country

GOOGL US Alphabet A OP US RMS FP Hermes N/R FRANCE

AMZN US Amazon.com OP US ADP US ADP N/R US

700 HK Tencent OP HK/China ADS GR adidas OP GERMANY

FB US Facebook A OP US 6594 JP NIDEC Neutral Japan

JNJ US Johnson & Johnson N/R US MSIL IN Maruti Suzuki India OP INDIA

005930 KS Samsung Electronics OP SOUTH KOREA EA US Electronic Arts OP US

V US Visa A N/R US MNST US Monster Beverage OP US

2330 TT Taiwan Semicon Mfg OP TAIWAN ILMN US Illumina N/R US

DIS US Disney Neutral US 8035 JP Tokyo Electron OP JAPAN

MC FP LVMH Moet Hennessy N/R FRANCE SWK US Stanley Black & Decker OP US

AMGN US Amgen N/R US HO FP Thales N/R FRANCE

SIE GR Siemens N/R GERMANY RACE IM Ferrari N/R ITALY

HON US Honeywell N/R US NOW US ServiceNow OP US

BAYN GR Bayer N/R GERMANY CAP FP Capgemini N/R FRANCE

AVGO US Broadcom OP UNITED STATES MHK US Mohawk Industries OP US

2317 TT Hon Hai Precision Ind OP TAIWAN ADEN SW Adecco Group N/R Swiss

FDX US FedEx N/R UNITED STATES HMCL IN Hero MotoCorp OP INDIA

SYK US Stryker N/R US

Ticker Name Reco. Country

BABA US Alibaba Group Holding OP CHINA

700 HK Tencent OP HK/China

005930 KS Samsung Electronics OP Korea

2330 TT Taiwan Semicon Mfg OP TAIWAN

2317 TT Hon Hai Precision Ind OP TAIWAN

002415 CH Hangzhou Hikvision A OP CHINA

HUVR IN Hindustan Unilever OP INDIA

002352 CH SF Holding A OP CHINA

MSIL IN Maruti Suzuki India OP INDIA

NTES US NetEase ADR OP CHINA

288 HK WH Group OP HK/China

EIM IN Eicher Motors OP INDIA

EDU US New Oriental Education ADR OP CHINA

HMCL IN Hero MotoCorp OP INDIA

669 HK Techtronic Industries OP HK/China

SRCM IN Shree Cement OP INDIA

300124 CH Shenzhen lnovance Tech OP CHINA

GCPL IN Godrej Consumer Products OP INDIA

UNTR IJ United Tractors N/R INDONESIA

1590 TT Airtac Grp OP TAIWAN

PGOLD PM Puregold Price Club OP PHILIPPINES


27 November 2017 91

Fig 160 Macquarie Global ‘Thematic Winners’ Portfolio (Nov’17)


Fig 161 Macquarie Asia ex Japan ‘Thematic Winners’ Portfolio (Nov’17)



ABBN SW ABB N/R SWITZERLAND 002415 CH Hangzhou Hikvision A OP CHINA

6506 JP Yaskawa Electric UP JAPAN LMT US Lockheed Martin N/R US

6954 JP FANUC OP JAPAN RTN US Raytheon Co N/R US

ISRG US Intuitive Surgical N/R UNITED STATES NOC US Northrop Grumman N/R US

SYK US Stryker N/R UNITED STATES HO FP Thales N/R FRANCE

SIE GR Siemens N/R GERMANY ESLT IT Elbit Systems N/R ISRAEL

HON US Honeywell N/R UNITED STATES

6503 JP Mitsubishi Electric OP JAPAN

1590 TT Airtac Grp OP TAIWAN Theme 5: "Education & Skilling"

300124 CH Shenzhen lnovance Tech OP CHINA EDU US New Oriental Education ADR OP CHINA

NVDA US NVIDIA Neutral UNITED STATES TAL US TAL Education Group ADR Neutral CHINA

AMGN US Amgen N/R UNITED STATES 1448 HK Fu Shou Yuan Intl Group N/R HONG KONG

BIIB US Biogen Idec MA N/R UNITED STATES SCI US Service Corp Intl N/R UNITED STATES

ABBV US AbbVie N/R UNITED STATES UHS US Universal Health Services B N/R UNITED STATES

ILMN US Illumina N/R UNITED STATES

Theme 7: "Disruptors & Facilitators"

700 HK Tencent OP HONG KONG AMZN US Amazon.com OP UNITED STATES

ATVI US Activision Blizzard OP UNITED STATES FB US Facebook A OP UNITED STATES

EA US Electronic Arts OP UNITED STATES CRM US Salesforce.com OP UNITED STATES

NTES US NetEase ADR OP CHINA GOOGL US Alphabet A OP UNITED STATES

7974 JP Nintendo OP JAPAN BABA US Alibaba Group Holding OP CHINA

MGM US MGM Resorts OP UNITED STATES

1128 HK Wynn Macau OP HONG KONG

Theme 1: "Replacing Humans": Robots, Industrial Automation & AI Theme 4: "Bullets and Prisons": Defense, Security, Prisons/Correction

Theme 2: "Augmenting Humans": Genome/Biotechnology/DNA

sequencing

Theme 6: "Demographics": Funeral Parlours, Psychiatric Centres

Theme 3: "Opium of the people": Games, Casinos/Virtual Reality


300124 CH Shenzhen lnovance Tech OP CHINA 002415 CH Hangzhou Hikvision A OP CHINA

1590 TT Airtac Grp OP TAIWAN 079550 KS LIG Nex1 OP SOUTH KOREA

2317 TT Hon Hai Precision Ind OP TAIWAN STE SP Singapore Techs Eng Neutral SINGAPORE

300024 CH SIASUN Robot & Automation AOP CHINA

002527 CH Shanghai Step Electric A OP CHINA Theme 5: "Education & Skilling"

Theme 2: Asia's High Technology niches EDU US New Oriental Education ADR OP CHINA

TAL US TAL Education Group ADR Neutral CHINA

2330 TT Taiwan Semicon Mfg OP TAIWAN

981 HK SMIC OP HONG KONG

2382 HK Sunny Optical Tech Grp OP HONG KONG 300015 CH Aier Eye Hospital Group A N/R CHINA

INRI MK Inari Amertron OP MALAYSIA 1448 HK Fu Shou Yuan Intl Group N/R HONG KONG

000660 KS SK hynix OP SOUTH KOREA RFMD SP Raffles Medical Group N/R SINGAPORE

BDMS TB Bangkok Dusit Medical OP THAILAND

MIKA IJ Mitra Keluarga Karyasehat N/R INDONESIA

700 HK Tencent OP HONG KONG Theme 7: "Disruptors & Facilitators"

NTES US NetEase ADR OP CHINA BABA US Alibaba Group Holding OP CHINA

002241 CH GoerTek A Neutral CHINA BIDU US Baidu ADR OP CHINA

1128 HK Wynn Macau OP HONG KONG

Theme 1: "Replacing Humans": Robots, Industrial Automation & AI Theme 4: "Bullets and Prisons": Defense, Security,

Prisons/Correction Centres

Theme 6: "Demographics": Funeral Parlours, Hospitals and

Psychiatric Centres

Theme 3: "Opium of the people": Games, Casinos/Virtual Reality


27 November 2017 92

Australian equity outlook – Beauty and the beast We believe 2018 will be a solid year for Australian equities. We forecast the ASX200 to rise

9% to 6500 but it will be a bumpy road. Fundamentals should get marginally better but this

will be enough in combination with little or no increase in policy rates to see a further push

higher in PE multiples. This is a combustible combination – modest earnings growth and

higher PE multiples – but we see greater risks for the market emerging in 2019 rather than

over the coming 12 months.

We think Australia is in a sweet spot and similar to where the US market was 18–24 months

ago. That is, before the Fed began to raise policy rates, before there was any hint around

rising wage costs (profit share pressures) and when the full benefits of a weaker currency

were flowing through to corporate earnings.

Fig 162 2017 was a low return year for the ASX200

Fig 163 …dragged lower by Telco’s and rate sensitives

Source: FactSet, Macquarie Research, November 2017 Source: FactSet, Macquarie Research, November 2017

Australia to benefit from a desynchronized rate tightening cycle

Growth in the Australian economy is expected to improve moderately in 2018. Better global

growth is supporting this outlook as are supportive domestic monetary and fiscal policies.

In particular, the investment outlook is relatively bright amid a sharp pick-up in infrastructure

spending. The significant drag on overall growth in recent years from falling mining

investment is also diminishing and will cease later next year. Both of these factors are also

helping to support improving non-mining business investment.

While dwelling investment has passed the peak, it is likely to remain at elevated levels

through 2018 and should only be a mild drag on overall growth. Labour market conditions will

tighten modestly but ample labour market spare capacity is expected to persist heading into

2019 and cap upside to wages growth. Household spending remains a dark spot and is

unlikely to improve much through 2018 due to weak income growth and a reduced tailwind

from strong housing market activity on the eastern seaboard.

The absence of inflationary pressures should keep the RBA tilted to the dovish side against a

backdrop of gradually rising global policy rates. This rate divergence will help keep A$ upside

capped as Chinese growth remains robust, but continues to edge lower. A period of US$

strength will likely keep the A$ from moving meaningfully higher. Globally, fiscal policy has

shifted from being contractionary to expansionary, but domestically there is limited capacity

for additional fiscal support. The slimmest of government majorities likely prevents any major

negative policy swings and should allow the market to look through any potential rise in

political uncertainty. We see domestic politics as a continuation of the heavy handed industry

intervention/regulation rather than offering a positive or negative upside surprise.

3000

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Sep-06 Sep-08 Sep-10 Sep-12 Sep-14 Sep-16

ASX200Price Performance

0.6

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1.1

1.2

Sep-06 Sep-08 Sep-10 Sep-12 Sep-14 Sep-16

IR Sensitives vs ASX200Relative Price Performance

* Equal weighted price index - REIT's, Telco's, Utilties

Jason Todd, CFA +61 2 8237 3134 [email protected]


27 November 2017 93

Fig 164 ASX200 return forecast

Fig 165 Australia is not expensive vs. World Equities


If the domestic economy can deliver on current growth expectations (2.7% forecast for 2018

and 2.4% for 2019), then we see the potential for some minor upside in earnings growth

estimates via banks, construction and resources. However, 2018 will be about incrementalism

(non-mining business investment) and a further improvement in areas of weakness (i.e. mining)

rather than expecting to see a large positive revenue shock. This implies earnings are unlikely

to surprise meaningfully on the upside, but downside risks should be mitigated by strong cost

growth (corporates being the beneficiaries of weak wage and salary growth) and further

capital for labour substitution which continues to provide a solid cost control lever across a

broad range of old-economy industry (banks, insurance, telcos).

Fig 166 Value has hit “distressed” levels…

Fig 167 …but driven by just a few stocks/sectors


Value de-rating has been front-end loaded but stick with growth. A combination of

earnings and interest rate risk has driven valuation dispersion to “distressed” levels. Typically

this results in a performance snap-back but valuation convergence is not mean reversion and

sustainable re-rating requires improving earnings which does not look likely through 2018

particularly for consumer exposed areas. We continue to recommend being overweight

growth at the expense of valuation.

Technology and not Amazon is the disrupter: The pace of technological change is

accelerating at an exponential rate. Australia is in the early stages of price discovery and

technology driven disruption. We are positive on stocks investing for growth and structurally

bearish on the current consumer model where pricing pressures will seep into previously

untouched areas (i.e. hardware and food retailing). We hold no retail or food staples.

Current Forward PE (x) 16.0

20th November ASX200 Level 5931

CY18 12 month Forward PE 16.8

CY18 EPS Interger 387

(assuming 5% growth in CY18)

Dividend Yield (%) 4.6

CY18 Implied Index Level 6502

Capital Return 9.6%

Total Return (Capital + Dividend Yiled) 14.2%0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

Dec-96 Dec-99 Dec-02 Dec-05 Dec-08 Dec-11 Dec-14

Relative PE RatioMSCI Australia vs MSCI World

0

1

2

3

4

5

6

7

8

Jan-88 Jan-92 Jan-96 Jan-00 Jan-04 Jan-08 Jan-12 Jan-16

12 Month Fwd PEs for Industrials(75th percentile vs median)

Growth stocks at post TMT

highs

-12

-10

-8

-6

-4

-2

0

Nov-88 Nov-92 Nov-96 Nov-00 Nov-04 Nov-08 Nov-12 Nov-16

25th less 75th PE Dispersion

Value stocks hit "distressed" levels


27 November 2017 94

Miners losing earnings support & banks in the govt. crosshairs. Miners are momentum

stocks and despite high free cashflow generation we see limited potential for outperformance

if spot prices weaken. We lower our view from overweight to neutral. Banks should emerge

from 2018 in solid shape. However, gov’t oversight risks will not disappear as public concerns

drive greater levels of intervention and raise the risk premium for the sector.

Industrials offer both cyclical and structural upside. Industrials are our preferred way to

get exposure into both cyclical and structural onshore/offshore growth. The domestic

infra/capex thematic has longevity; we like the US home building cycle and exposure into

industrial activity upside via soft commodities. A period of A$ weakness offers an additional

tailwind for these stocks.

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Fig 168 Economic and Market Forecasts

GDP, QoQ SAAR Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

US (0.9) 4.6 5.2 2.0 3.2 2.7 1.6 0.5 0.6 2.2 2.8 1.8 1.2 3.1 3.0 2.5 2.3 2.4 2.3 2.3 2.1 2.1 1.9 1.9 China 7.0 7.4 7.4 7.0 7.0 7.0 7.0 6.6 5.3 7.8 7.4 7.0 5.7 7.4 7.0 6.6 6.3 6.1 6.1 5.9 5.7 5.7 5.5 5.5 Eurozone 2.6 0.5 1.8 2.0 4.4 1.2 1.9 1.8 2.0 1.4 1.8 2.6 2.2 2.6 2.5 2.0 2.4 2.0 2.4 2.0 2.0 1.6 2.0 1.6 Japan 4.5 (7.0) (0.9) 2.7 5.3 (0.0) 0.6 (1.0) 1.9 2.2 1.2 1.2 1.2 2.4 1.2 1.2 0.8 1.4 1.2 0.8 0.6 1.4 0.8 0.0 India 4.8 9.6 7.8 6.1 7.3 9.1 8.5 7.2 9.9 6.1 6.5 5.9 5.4 5.6 8.7 8.1 7.4 4.5 8.6 7.9 8.1 6.9 8.8 7.7 UK 3.5 3.5 3.1 3.1 1.4 2.3 1.7 2.9 0.6 2.1 1.5 2.3 1.0 1.2 1.6 1.8 1.2 1.2 1.6 1.4 1.6 1.6 1.6 1.2 Canada 0.2 4.2 1.9 2.4 (1.0) (0.4) 2.3 0.5 2.8 (1.4) 4.1 2.7 3.7 4.6 (1.1) 2.0 1.5 1.4 1.4 1.3 1.3 1.3 1.3 1.3 Australia 3.3 2.5 1.8 1.7 4.0 0.6 3.4 2.3 3.8 3.1 (1.7) 4.4 1.3 3.3 2.0 2.6 3.4 2.6 2.1 2.7 2.0 2.7 2.5 2.1 South Africa (1.6) 0.7 2.2 4.1 1.9 (1.8) 0.4 0.5 (1.5) 3.1 0.4 (0.3) (0.6) 2.5 1.9 1.0 0.9 1.0 1.0 1.1 2.1 3.0 2.6 2.3 Global (MER) 2.4 2.0 3.0 2.7 2.6 2.4 2.6 1.9 2.0 2.8 2.7 3.2 2.7 3.6 3.2 3.1 3.1 2.9 3.1 2.9 2.8 2.8 2.8 2.6 GDP, YoY Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

US 1.7 2.7 3.2 2.7 3.8 3.3 2.4 2.0 1.4 1.2 1.5 1.8 2.0 2.2 2.3 2.4 2.7 2.6 2.4 2.3 2.3 2.2 2.1 2.0 China 7.4 7.5 7.1 7.2 7.0 7.0 6.9 6.8 6.7 6.7 6.7 6.8 6.9 6.9 6.8 6.7 6.8 6.5 6.3 6.1 6.0 5.9 5.7 5.6 Eurozone 1.7 1.4 1.5 1.7 2.2 2.4 2.4 2.3 1.7 1.8 1.7 1.9 2.0 2.3 2.5 2.3 2.4 2.2 2.2 2.2 2.1 2.0 1.9 1.8 Japan 2.6 (0.3) (1.1) (0.3) (0.1) 1.7 2.1 1.2 0.4 0.9 1.1 1.6 1.5 1.4 1.0 0.9 0.9 0.9 0.8 0.8 0.7 0.6 0.5 0.4 India 5.3 7.9 8.8 6.1 7.3 7.6 8.0 7.2 9.1 7.9 7.5 7.0 6.1 5.7 6.4 6.9 7.5 7.2 7.1 7.1 7.3 7.9 7.9 7.9 UK 2.8 3.1 3.0 3.3 2.7 2.5 2.1 2.1 1.9 1.8 1.8 1.6 1.8 1.5 1.5 1.4 1.4 1.5 1.5 1.4 1.5 1.6 1.6 1.5 Canada 2.5 2.9 2.6 2.2 1.9 0.7 0.8 0.4 1.3 1.1 1.5 2.0 2.3 3.7 2.4 2.3 1.7 1.0 1.6 1.4 1.3 1.3 1.3 1.3 Australia 3.0 3.0 2.8 2.3 2.5 2.0 2.5 2.6 2.6 3.2 1.9 2.4 1.8 1.8 2.8 2.3 2.8 2.7 2.7 2.7 2.4 2.4 2.5 2.3 South Africa 1.9 1.6 1.8 1.6 2.6 1.3 0.9 0.6 (0.6) 0.3 0.7 0.7 1.0 1.1 0.7 0.8 1.6 1.2 1.0 1.0 1.3 1.8 2.2 2.5 Global (MER) 2.9 2.7 2.6 2.5 2.6 2.7 2.6 2.4 2.3 2.4 2.4 2.7 2.9 3.1 3.2 3.2 3.3 3.1 3.1 3.0 3.0 2.9 2.8 2.8 CPI, QoQ SAAR Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

US 2.6 1.9 1.0 (0.7) (2.5) 2.4 1.5 0.4 0.1 2.3 1.8 3.0 3.1 (0.3) 2.0 3.1 2.0 2.1 2.2 2.3 2.3 2.3 2.3 2.3 China 1.3 (0.4) 0.4 0.4 1.1 (0.3) 0.6 0.1 1.8 (0.3) 0.2 0.5 1.0 (0.3) 0.4 0.0 2.4 2.4 2.4 2.4 2.2 2.2 2.2 2.2 Eurozone (1.6) 3.4 (1.6) 0.5 (3.4) 5.5 (1.9) 0.8 (3.9) 5.0 (0.5) 2.7 0.0 4.0 (0.8) 2.2 0.0 4.5 (0.8) 2.4 0.0 4.1 (0.4) 2.8 Japan 1.6 3.6 3.3 2.6 2.4 0.6 0.1 0.1 0.1 (0.4) (0.5) 0.3 0.2 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.0 (0.2) 1.0 UK 0.4 2.8 0.1 0.3 (2.8) 2.3 0.4 0.5 (1.8) 2.3 1.9 2.5 2.0 4.7 2.1 3.4 0.8 3.4 0.4 2.1 0.4 4.1 1.2 1.8 Canada 3.2 3.0 1.2 0.5 (0.4) 2.5 2.2 1.1 0.5 2.2 1.0 1.7 2.6 0.1 1.2 1.5 1.5 1.7 1.8 1.9 2.0 2.0 2.0 2.0 Australia 2.3 1.9 1.9 0.8 0.8 2.6 1.9 1.5 (0.7) 1.5 2.9 2.2 1.8 0.7 2.5 2.0 2.2 1.1 2.8 2.2 2.6 1.5 2.4 1.8 South Africa 8.6 8.0 5.3 1.1 2.4 9.7 5.9 1.6 9.0 8.6 5.0 3.8 7.8 4.5 3.0 3.2 6.1 6.3 5.3 3.2 6.1 6.3 5.3 3.2 CPI, YoY Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

US 1.5 2.0 1.8 1.2 (0.1) 0.0 0.1 0.4 1.1 1.1 1.1 1.8 2.6 1.9 2.0 2.0 1.7 2.3 2.4 2.2 2.2 2.3 2.3 2.3 China 2.3 2.2 2.0 1.5 1.2 1.4 1.7 1.5 2.1 2.1 1.7 2.1 1.4 1.4 1.6 1.9 2.6 2.4 2.4 2.3 2.2 2.2 2.2 2.2 Eurozone 0.7 0.6 0.4 0.2 (0.3) 0.2 0.1 0.2 0.0 (0.1) 0.3 0.7 1.8 1.5 1.4 1.3 1.3 1.5 1.5 1.5 1.5 1.4 1.5 1.6 Japan 1.6 3.6 3.3 2.6 2.4 0.6 0.1 0.1 0.1 (0.4) (0.5) 0.3 0.2 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.0 (0.2) 1.0 India 8.2 7.8 6.7 4.1 5.3 5.1 3.9 5.3 5.3 5.7 5.2 3.7 3.6 2.2 3.0 4.2 4.8 5.6 4.3 3.2 3.2 3.9 4.6 4.9 UK 1.8 1.8 1.5 0.9 0.1 (0.0) 0.0 0.1 0.3 0.3 0.7 1.2 2.2 2.8 2.8 3.0 2.7 2.4 2.0 1.7 1.6 1.7 1.9 1.9 Canada 1.3 2.3 2.1 2.0 1.1 0.9 1.2 1.3 1.6 1.5 1.2 1.4 1.9 1.4 1.4 1.4 1.1 1.5 1.6 1.7 1.8 1.9 2.0 2.0 Australia 2.9 3.0 2.3 1.7 1.3 1.5 1.5 1.7 1.3 1.0 1.3 1.5 2.1 1.9 1.8 1.8 1.9 2.0 2.1 2.1 2.2 2.3 2.2 2.1 South Africa 5.9 6.5 6.3 5.7 4.1 4.6 4.7 4.9 6.5 6.2 6.0 6.6 6.3 5.3 6.0 4.6 4.2 4.5 5.2 5.2 5.2 5.2 5.2 5.2

Core CPI, QoQ AR Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

US 1.7 2.1 1.6 1.6 1.6 2.3 1.9 2.2 2.5 2.1 2.1 2.0 2.5 0.6 2.1 1.8 2.0 2.1 2.2 2.3 2.3 2.3 2.3 2.3 China 1.3 1.3 1.3 1.6 1.7 1.7 1.3 1.2 1.6 1.6 2.4 2.0 2.7 1.7 2.5 2.7 2.9 2.7 2.7 2.5 2.5 2.5 2.5 2.5 Eurozone (3.0) 5.4 (1.6) 2.2 (3.2) 5.9 (1.0) 2.4 (3.2) 5.3 (0.9) 2.2 (3.2) 6.5 (0.7) 2.4 (3.0) 6.7 (0.5) 2.6 (2.8) 6.9 (0.3) 2.8 Japan 0.1 1.8 0.2 0.1 0.2 0.1 0.3 0.2 0.0 0.1 (0.1) 0.0 (0.0) (0.1) 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 UK (1.1) 4.4 0.5 1.5 (1.3) 2.6 1.5 2.4 (1.3) 2.5 1.9 2.5 0.3 5.5 2.2 2.7 (0.5) 4.3 1.0 2.3 (0.5) 4.4 1.0 2.3 Canada 1.9 3.3 1.1 1.5 1.7 3.1 1.2 0.8 1.8 4.4 1.0 0.1 2.5 2.2 0.7 2.1 1.5 1.7 1.8 1.9 2.0 2.0 2.0 2.0 Australia 2.2 2.6 1.8 2.5 2.6 2.0 1.5 1.7 0.8 1.8 1.4 1.9 1.9 2.3 1.4 1.7 1.8 1.8 1.9 2.0 2.0 2.0 2.0 2.0 Core CPI, YoY Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

US 1.6 1.9 1.8 1.7 1.7 1.8 1.8 2.0 2.2 2.2 2.2 2.2 2.2 1.8 1.8 1.7 1.6 2.0 2.0 2.2 2.2 2.3 2.3 2.3 China 1.8 1.7 1.6 1.3 1.4 1.6 1.7 1.5 1.4 1.6 1.7 1.9 2.0 2.1 2.2 2.5 3.0 2.8 2.8 2.6 2.5 2.5 2.5 2.5 Eurozone 0.8 0.8 0.8 0.7 0.7 0.8 0.9 1.0 1.0 0.8 0.8 0.8 0.8 1.1 1.2 1.2 1.3 1.3 1.4 1.4 1.5 1.5 1.6 1.6 Japan 0.7 2.3 2.3 2.1 2.2 0.5 0.6 0.7 0.6 0.6 0.2 0.0 (0.0) (0.2) (0.0) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 UK 1.6 1.9 1.7 1.3 1.3 0.8 1.0 1.3 1.3 1.3 1.4 1.4 1.8 2.5 2.6 2.6 2.4 2.2 1.9 1.8 1.8 1.8 1.8 1.8 Canada 1.2 1.5 1.8 2.0 1.9 1.8 1.9 1.7 1.7 2.0 2.0 1.8 2.0 1.4 1.4 1.9 1.6 1.5 1.8 1.7 1.8 1.9 2.0 2.0 Australia 2.7 2.7 2.5 2.3 2.4 2.2 2.1 2.0 1.5 1.5 1.5 1.5 1.7 1.9 1.9 1.8 1.8 1.7 1.8 1.9 2.0 2.0 2.0 2.0

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Fig 168 Economic and Market Forecasts

FX Rates Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

EUR USD 1.38 1.37 1.26 1.21 1.07 1.12 1.12 1.09 1.14 1.11 1.12 1.06 1.07 1.14 1.18 1.17 1.15 1.18 1.22 1.25 1.27 1.29 1.32 1.35 USD JPY 103.0 101.4 109.4 119.8 120.2 122.2 120.0 120.4 112.4 102.7 100.9 117.1 111.8 110.0 110.0 112.0 116.0 116.0 113.0 110.0 110.0 110.0 105.0 100.0 USD CNY 6.22 6.21 6.14 6.20 6.20 6.20 6.36 6.49 6.45 6.68 6.67 6.94 6.88 6.78 6.65 6.70 6.60 6.60 6.50 6.40 6.30 6.20 6.00 6.00 USD INR 59.95 60.11 61.88 63.25 62.47 63.65 65.59 66.22 66.28 67.50 66.61 67.92 64.82 64.63 65.34 64.75 65.50 66.00 66.25 66.50 66.75 67.00 67.25 67.50 GBP USD 1.67 1.71 1.62 1.56 1.48 1.57 1.51 1.47 1.44 1.34 1.30 1.24 1.25 1.30 1.34 1.30 1.28 1.32 1.36 1.38 1.40 1.42 1.45 1.45 USD CAD 1.10 1.07 1.12 1.16 1.27 1.25 1.34 1.39 1.29 1.30 1.31 1.34 1.33 1.30 1.25 1.30 1.36 1.38 1.36 1.36 1.36 1.36 1.36 1.36 AUD USD 0.93 0.94 0.87 0.82 0.76 0.77 0.70 0.73 0.77 0.75 0.77 0.72 0.76 0.77 0.78 0.76 0.74 0.74 0.76 0.76 0.77 0.77 0.77 0.77 USD ZAR 10.52 10.64 11.30 11.56 12.11 12.14 13.82 15.49 14.71 14.65 13.76 13.68 13.42 13.10 13.50 14.60 14.60 14.30 14.15 14.00 14.11 14.21 14.32 14.42

Policy Rate Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

US (Fed Funds rate) 0.13 0.13 0.13 0.13 0.13 0.13 0.13 0.38 0.38 0.38 0.38 0.63 0.88 1.13 1.13 1.38 1.63 1.88 2.13 2.13 2.38 2.63 2.63 2.63 China 1-yr deposit rate 3.00 3.00 3.00 2.75 2.50 2.00 1.75 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 Eurozone (Deposit rate) 0.00 0.00 (0.10) (0.20) (0.20) (0.20) (0.20) (0.20) (0.30) (0.40) (0.40) (0.40) (0.40) (0.40) (0.40) (0.40) (0.40) (0.40) (0.40) (0.40) (0.20) 0.00 0.25 0.25 Japan deposit rate 0.04 0.06 0.03 0.07 0.02 0.01 0.01 0.04 (0.00) (0.06) (0.06) (0.06) (0.06) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 India RBI repo rate 8.0 8.0 8.0 8.0 7.5 7.3 6.8 6.8 6.8 6.5 6.5 6.3 6.3 6.3 6.0 6.0 6.0 6.0 6.0 6.0 6.0 6.0 6.3 6.3 UK base rate 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.25 0.25 0.25 0.25 0.25 0.50 0.50 0.75 0.75 1.00 1.00 1.25 1.25 1.25 Canada overnight rate 1.00 1.00 1.00 1.00 0.75 0.75 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 1.00 1.00 1.00 1.00 1.00 1.25 1.50 1.50 1.50 1.50 Austr. RBA cash rate 2.50 2.50 2.50 2.50 2.25 2.00 2.00 2.00 2.00 1.75 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.75 2.00 2.25 2.50 2.50 2.50 South Africa repo rate 5.50 5.50 5.75 5.75 5.75 5.75 6.00 6.25 7.00 7.00 7.00 7.00 7.00 7.00 6.75 6.75 6.75 6.75 6.75 6.75 6.75 6.75 6.75 6.75

Short-term yield Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

US 2yr yield 0.4 0.5 0.6 0.7 0.6 0.6 0.6 1.1 0.7 0.6 0.8 1.2 1.3 1.4 1.5 1.8 2.0 2.3 2.5 2.7 2.7 2.7 2.7 2.7 China 2-yr yield 3.5 3.6 3.8 3.3 3.3 2.3 2.7 2.4 2.2 2.5 2.3 2.7 3.0 3.5 3.5 3.5 3.6 3.4 3.3 3.2 3.2 3.1 3.0 2.9 Eurozone 2yr yield 0.4 0.3 0.1 0.2 (0.1) 0.1 (0.1) (0.1) (0.3) (0.4) (0.4) (0.5) (0.3) (0.3) (0.4) (0.3) (0.1) 0.1 0.2 0.3 0.5 0.5 0.7 0.7 Japan 2-yr yield 0.1 0.1 0.1 (0.0) 0.0 (0.0) 0.0 (0.0) (0.2) (0.3) (0.3) (0.2) (0.2) (0.1) (0.1) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2) (0.2) UK 2-yr yield 0.7 1.0 1.0 0.5 0.4 0.7 0.6 0.7 0.4 0.1 0.1 0.0 0.1 0.3 0.5 0.5 0.7 0.8 1.0 1.3 1.4 1.6 1.6 1.8 Canada 2yr yield 1.1 1.1 1.1 1.0 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.8 0.8 1.1 1.6 1.4 1.3 1.4 1.7 1.7 1.7 1.7 1.7 1.7 Australia 3yr yield 3.0 2.6 2.7 2.1 1.7 2.0 1.8 2.0 1.9 1.6 1.5 2.0 1.9 1.9 2.1 1.9 2.0 2.4 2.7 3.1 2.8 2.8 2.8 2.8

Long-term yield Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

US 10yr yield 2.7 2.5 2.5 2.2 1.9 2.4 2.0 2.3 1.8 1.5 1.6 2.4 2.4 2.3 2.3 2.4 2.6 2.7 2.7 2.8 2.8 2.8 2.8 2.8 China 10yr-yield 4.6 4.1 4.0 3.6 3.6 3.6 3.2 2.8 2.8 2.8 2.7 3.0 3.3 3.5 3.6 3.6 3.8 3.7 3.6 3.5 3.5 3.4 3.3 3.2 Eurozone 10yr yield 2.6 2.1 1.7 1.2 0.8 1.7 1.3 1.3 0.8 0.6 0.4 0.9 1.2 1.2 1.2 1.0 1.4 1.3 1.5 1.7 1.9 1.9 1.9 2.0 Japan 10yr-yield 0.6 0.6 0.5 0.3 0.4 0.5 0.3 0.3 (0.0) (0.2) (0.1) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 India 10yr-yield 8.4 8.2 8.3 7.8 7.6 7.7 7.4 7.3 7.1 7.0 6.6 6.3 6.3 6.3 6.2 6.9 6.9 7.0 7.0 7.1 7.1 7.1 7.3 7.3 UK 10-yr yield 2.8 2.8 2.5 1.8 1.7 2.1 1.8 2.0 1.5 1.0 0.8 1.3 1.1 1.3 1.4 1.5 1.6 1.7 1.7 1.8 1.8 1.9 1.9 2.0 Canada 10yr-yield 2.5 2.2 2.2 1.8 1.4 1.7 1.5 1.4 1.2 1.1 1.0 1.6 1.6 1.8 2.1 1.9 1.9 1.9 2.0 2.0 2.0 2.0 2.0 2.0 Australia 10yr yield 4.1 3.5 3.5 2.7 2.3 3.0 2.6 2.9 2.5 2.0 1.9 2.8 2.7 2.6 2.8 2.6 2.7 2.8 2.9 3.2 3.3 3.2 3.2 3.2 South Africa 10yr yield 8.3 8.2 8.1 7.8 7.9 8.3 8.5 9.8 9.1 8.8 8.7 8.9 8.8 8.8 8.6 9.5 9.4 9.3 9.2 9.2 9.2 9.2 9.2 9.2

Shading represents forecasts

Source: FactSet, Macquarie Research, November 2017

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Fig 169 Commodity price forecasts (quarter average, forecasts shaded)

2017 2018 2019 Unit 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q

Base metals Copper $/tonne 6,349 6,250 6,100 5,900 5,900 5,900 5,900 5,900 5,900 5,900 Aluminium $/tonne 2,012 2,200 2,100 2,000 2,000 2,000 2,000 2,000 2,000 2,000 Zinc $/tonne 2,963 3,200 3,300 3,100 3,100 3,100 3,100 3,100 3,100 3,100 Nickel $/tonne 10,528 10,500 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 Lead $/tonne 2,334 2,550 2,650 2,650 2,650 2,650 2,650 2,650 2,650 2,650 Tin $/tonne 20,566 20,200 20,500 21,000 21,000 21,000 21,000 21,000 21,000 21,000 Steel and Raw Materials Iron ore - 62% Fe $/t CFR 71 63 60 53 53 53 53 53 53 53 Hard coking coal $/t FOB 187 175 130 130 130 130 130 130 130 130 Steel - World Export HRC $/tonne 527 510 450 430 430 430 430 430 430 430 Energy Crude Oil - Brent $/barrel 54 54 53 48 47 50 51 51 54 55 Crude Oil - WTI $/barrel 52 52 50 45 44 46 47 47 50 51 Henry Hub Gas $/MMBTU 2.9 3.1 3.2 3.1 3.0 2.8 2.9 2.7 2.6 2.8 Thermal coal - Aus Spot $/t FOB 93 85 78 72 72 72 72 72 72 72 Uranium $/lb 20 22 24 24 24 24 24 24 24 24 Lithium carbonate $/t CFR China 11,655 11,500 10,500 9,000 9,000 9,000 9,000 9,000 9,000 9,000 Precious Metals Gold $/oz 1,278 1,275 1,300 1,325 1,325 1,325 1,325 1,325 1,325 1,325 Silver $/oz 17 18 19 20 20 20 20 20 20 20 Platinum $/oz 953 925 975 1,050 1,050 1,050 1,050 1,050 1,050 1,050 Palladium $/oz 900 925 925 875 875 875 875 875 875 875



27 November 2017 98

Important disclosures:

Recommendation definitions

Macquarie - Australia/New Zealand Outperform – return >3% in excess of benchmark return Neutral – return within 3% of benchmark return Underperform – return >3% below benchmark return Benchmark return is determined by long term nominal GDP growth plus 12 month forward market dividend yield

Macquarie – Asia/Europe Outperform – expected return >+10% Neutral – expected return from -10% to +10% Underperform – expected return <-10%

Macquarie – South Africa Outperform – expected return >+10% Neutral – expected return from -10% to +10% Underperform – expected return <-10%

Macquarie - Canada Outperform – return >5% in excess of benchmark return Neutral – return within 5% of benchmark return Underperform – return >5% below benchmark return

Macquarie - USA Outperform (Buy) – return >5% in excess of Russell 3000 index return Neutral (Hold) – return within 5% of Russell 3000 index return Underperform (Sell)– return >5% below Russell 3000 index return

Volatility index definition*

This is calculated from the volatility of historical price movements. Very high–highest risk – Stock should be expected to move up or down 60–100% in a year – investors should be aware this stock is highly speculative. High – stock should be expected to move up or down at least 40–60% in a year – investors should be aware this stock could be speculative. Medium – stock should be expected to move up or down at least 30–40% in a year. Low–medium – stock should be expected to move up or down at least 25–30% in a year. Low – stock should be expected to move up or down at least 15–25% in a year. * Applicable to Asia/Australian/NZ/Canada stocks only

Recommendations – 12 months Note: Quant recommendations may differ from Fundamental Analyst recommendations

Financial definitions

All "Adjusted" data items have had the following adjustments made: Added back: goodwill amortisation, provision for catastrophe reserves, IFRS derivatives & hedging, IFRS impairments & IFRS interest expense Excluded: non recurring items, asset revals, property revals, appraisal value uplift, preference dividends & minority interests EPS = adjusted net profit / efpowa* ROA = adjusted ebit / average total assets ROA Banks/Insurance = adjusted net profit /average total assets ROE = adjusted net profit / average shareholders’ funds Gross cashflow = adjusted net profit + depreciation *equivalent fully paid ordinary weighted average number of shares All Reported numbers for Australian/NZ listed stocks are modelled under IFRS (International Financial Reporting Standards).

Recommendation proportions – For quarter ending 30 September 2017

AU/NZ Asia RSA USA CA EUR Outperform 50.38% 56.22% 40.70% 46.21% 63.85% 41.61% (for global coverage by Macquarie, 4.18% of stocks followed are investment banking clients)

Neutral 37.50% 28.16% 43.02% 47.52% 30.00% 39.51% (for global coverage by Macquarie, 2.68% of stocks followed are investment banking clients)

Underperform 12.12% 15.62% 16.28% 6.27% 6.15% 18.88% (for global coverage by Macquarie, 1.08% of stocks followed are investment banking clients)

Company-specific disclosures: Important disclosure information regarding the subject companies covered in this report is available at www.macquarie.com/research/disclosures. Vikas Dwivedi invests from time to time in oil and gas commodities and/or related derivative and futures products consistent with published views.

Analyst certification: We hereby certify that all of the views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. The Analysts responsible for preparing this report receive compensation from Macquarie that is based upon various factors including Macquarie Group Ltd total revenues, a portion of which are generated by Macquarie Group’s Investment Banking activities. General disclaimers: Macquarie Securities (Australia) Ltd; Macquarie Capital (Europe) Ltd; Macquarie Capital Markets Canada Ltd; Macquarie Capital Markets North America Ltd; Macquarie Capital (USA) Inc; Macquarie Capital Limited and Macquarie Capital Limited, Taiwan Securities Branch; Macquarie Capital Securities (Singapore) Pte Ltd; Macquarie Securities (NZ) Ltd; Macquarie Equities South Africa (Pty) Ltd; Macquarie Capital Securities (India) Pvt Ltd; Macquarie Capital Securities (Malaysia) Sdn Bhd; Macquarie Securities Korea Limited and Macquarie Securities (Thailand) Ltd are not authorized deposit-taking institutions for the purposes of the Banking Act 1959 (Commonwealth of Australia), and their obligations do not represent deposits or other liabilities of Macquarie Bank Limited ABN 46 008 583 542 (MBL) or MGL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of any of the above mentioned entities. 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