Outlook 2016: UniCredit Research expects Europe to gain traction thanks to domestic demand

• In the eurozone, GDP should accelerate to 1.9% in 2016, mostly powered by domestic demand
• Italy is set to expand by 1.4% in 2016
• The US economy will remain one of the major engines of global growth in 2016 (GDP +2.6%)
• Monetary policy in the US and the eurozone will likely start to diverge in December 2015, with the Fed beginning its tightening cycle and the ECB adding           further stimulus (EUR 500bn QE expansion and 10-15bp cut in the deposit rate)
• EUR-USD exchange rate to weaken in the short term, but is expected to recover back to 1.12 by end-2016
• The UST curve should move higher at a faster clip than what is presently priced by forwards, while the Bund curve will be at least temporarily compressed by QE2.  It could well be spring or summer 2016 before it begins to reconnect to the treasuries
• The stronger than generally expected recovery, and an aggressive ECB will lend support to European equities and higher yielding credits

• In this report, we present our revised 2016 and brand new 2017 forecasts for the global economic outlook and financial markets. Importantly, our calibrations were concluded shortly before the terrorist attacks in Paris on 13 November. These tragic events add uncertainty to the outlook, as both the policy response and private sector sentiment remain unknown. However, on balance, we think the baseline forecast for the trend through 2016-17, as discussed here, remains broadly correct.
• We expect that the eurozone recovery will gain strength in 2016, reaching an annual average GDP growth rate of 1.9%. This above-trend (and above-consensus) growth outlook will continue to be powered mainly by domestic demand, which should make up for a difficult external environment. This year's boost to real income from low inflation will be replaced by income growth from stronger labor markets. Fiscal policy has also now turned slightly expansionary, partly due to the refugee crisis, and fixed investment is beginning to take off.
• This growth outlook will make further inroads into the eurozone's still excessively large output gap. Core inflation will therefore continue to climb higher, but at a snail's pace. In our forecasts, headline inflation is unlikely to reach the ECB's target of below, but close to, 2% in the next two years. This leaves the ECB little choice but to add more stimulus to the economy. We expect QE2 in the order of EUR 500bn and a deposit rate cut of 10-15bp into still deeper negative territory to be announced in December.
• The Italian economy is set to expand by 1.4% in 2016 and by 1.2% in 2017, thus reducing the growth gap to the eurozone to about -0.5pp, from -2.0pp in the wake of the sovereign debt crisis. Private consumption will hold up well in 2016, which is set to be mainly a positive year for fixed investment - thanks to restored business confidence, improving profitability and the significant decline in lending rates, together with tax incentives for investment in machinery. Exports will remain a growth drive, reflecting a similar trend throughout the eurozone. The recovery in the labor market is expected to continue, with job creation which is set to grow at a pace similar to that in 2015, as the fiscal incentives to hire new staff will be scaled back in 2016. The unemployment rate will decline gradually towards 11.0% in 2017 (about 1.0pp less than in 2015). We see the public deficit to continue declining over the forecast horizon (to 2.4% in 2016 and 1.4% in 2017) and the debt-to-GDP ratio to peak in 2015. The pace of public debt reduction will significantly accelerate in 2017.
• Outside the eurozone, we expect the picture to remain mixed. The US economy will remain one of the major engines of global growth in 2016. We expect real GDP growth to average 2.6%. With a narrowing output gap and tighter labor market, we expect the Federal Reserve to start raising its target rate at the upcoming meeting in mid-December, followed by three more rate hikes in 2016.
• The combination of these developments will put temporary downward pressure on the euro. However, in clear contrast to present market sentiment, we think we are near the bottom for the euro, and that it will be stronger again in the second half of 2016. The current account surplus and real money flows into cheap European assets provide on-going support for the euro, whose weakness remains largely the product of the ECB - in a world of competitive depreciations and of hot money that obeys the ECB. History suggests that such moves are unlikely to be long lived.
• Central Europe is also likely to enjoy another year of above-trend growth in the 3.0-3.5% range, while the contraction in Russia is likely nearing an end. We expect slightly higher growth rates also in Turkey, but they will remain well below their pre-2013 heydays.
• Emerging markets will continue to be laggards in the global growth picture. We expect EM to be through the trough, which should be followed by marginally higher growth rates in 2016 than in 2015. China will probably continue to slow moderately, but significant policy easing will no doubt be employed in an attempt to keep growth above 6%. Meanwhile, growth in other EM countries is likely to pick up moderately.
• This global outlook should lead to a gradual restoration of world trade to growth rates close to those of world GDP in the 3.5% range, a process we think could take two to three years, however.
• The first divergence in monetary policy between the world's two biggest central banks in many years should push the UST curve higher at a faster clip than what is presently priced. Meanwhile, the bund curve will be at least temporarily compressed by QE2. It could well be spring or early summer 2016 before it begins to reconnect to the treasuries, with the 10Y bund yield reaching 0.75% by yearend. We expect core-periphery spreads to keep tightening in the medium term.
• In credits and equities, we like risk. The stronger-than-generally-expected recovery and an aggressive ECB will lend measurable support to European equities and higher yielding credits.

Milan, November 17, 2015

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