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12 March 2015

CIO WM Research

European economy
Economic outlook: Dawn in
Europe

Ricardo Garcia-Schildknecht, economist, UBS AG


Daniel Trum, analyst, UBS AG
Dean Turner, CFA, economist, UBS AG
Roberto Luis Scholtes Ruiz, economist, UBS Bank, S.A.
Bernd Aumann, economist, UBS AG

A number of macro factors have improved since our last


report. Hence, we upgrade our optimistic outlook still further
and expect the Eurozone economy to accelerate above
consensus, to around 2% GDP growth by the end of 2015,
which is supportive of our overweight in Eurozone equities.
Consumption should remain strong, as foreign trade benefits
from a one off boost to growth from the lower euro, but the
improvement over the next two years should, on average,
be driven more by investments. As such, we expect the
Eurozone purchasing manager indices to cross the 55 level
by 2H 2015.
Despite expected very strong fundamentals over the forecast
horizon, a number of risks have the potential to derail our
outlook. Chief among them is the potential exit of Greece
from the Eurozone, although we still assign a low probability
for an exit. Other risks include a sharp escalation of the
Ukraine crisis, a break in Chinese growth and an overly
restrictive ruling in the OMT case.
On inflation, the sharp 2H 2014 fall in the oil price should
dissipate from inflation rates in 2H 2015, bringing Eurozone
inflation back to almost 1% by the end of this year and 1.7%
by the end of 2016. On this basis, the ECB is likely to keep the
QE program running until September 2016, but reconsider
it early in 2016, should the overall outlook turn out even
stronger than anticipated.
On a country level, we expect Germany, the UK, Sweden
and Spain to outperform the Eurozone, while France, Italy,
Switzerland and Norway are expected to underperform.
Eurozone economy: Macro factors even more supportive now
In our last European Economic Outlook on November 3, we wrote
that the consolidation of the European economy should bottom
out around the turn of the year, which has meanwhile been
confirmed by economic data. However, a number of macro drivers
have improved since our last European Economic Outlook, requiring
us to lift our optimistic outlook even further. While fiscal policy
is expected to remain broadly unchanged with fiscal measures
amounting to roughly half a percentage point per year on average,
the oil price fall following the November OPEC meeting has forced
the ECB to engage in a full blown quantitative easing program
(QE), pushing the euro even lower than anticipated. That said, the
monetary impulse in the Eurozone has accelerated even further
and reached very high levels, with further increases in monetary
aggregates very likely in the coming months.

Source: Bigstockphoto

Table of Contents

Eurozone: pages 1-4


Country level outlook: pages 5-12
Glossary: pages 13-15
Related research

Greece: scraping together cash, 11 March


2015
Greece to generate headlines, not
headaches, 26 February 2015
Greece: negotiations formally launched,
15 February 2015
ECB QE: A Historic Day, 22 January 2015
Greek default risk overestimated, 12
January 2015
European Court of Justice and ECB
government bond purchases, 14 January
2015
The Investment Plan for Europe, 1
December 2014
European Economic Outlook, 3 November
2014

This report has been prepared by UBS AG and UBS Bank, S.A.. Please see important disclaimers and disclosures at
the end of the document.

European economy

Investment: Corporates to take growth to the next level


Following two years of stagnation, construction investment is set to start
contributing positively to economic growth. With real house prices now
moving up, a key ingredient for more construction activity has taken hold.
What's more, mortgage rates are falling like a stone (and meeting
demand), with construction orders showing signs of life and construction
employment expectations clearly on the rise. Although we do not expect
a sharp turnaround in the construction sector, some modest growth here
means that one of the key growth headwinds should fade over the
forecast horizon. On the corporate side, with business confidence
increasing as illustrated by higher business surveys and hiring intentions,
the stage is set for a recovery of corporate capital expenditure. We expect
the purchasing manager indices (PMIs) to exceed 55 during the second
half of 2015 (see Fig. 2), which would be consistent with investment
growth averaging an annualized quarter on quarter growth rate of 2% by
2016, twice as much as seen in 2014. In addition, higher corporate
spending should be supported by a turn in the inventory cycle following
the consolidation seen in 2014. As a matter of fact, inventories are
getting stretched as new orders have already turned around sharply.
Foreign trade: Temporary boost from fall in euro
The sharp fall of the euro since spring 2014, is expected to support
exports in 2015. Indeed, the growth impulse stemming from the fall in
the euro is one of the highest since inception of the monetary union (see
Fig. 3). However, lackluster global growth probably means that the
impact on Eurozone exports won't be as high as in other instances and
could be driven more by a redistribution of market share globally. The
positive impulse from exports will over time likely be offset more and

Source: UBS, ECB, Haver. Note: Loans are net of redemptions.

Fig. 2: Manufacturing PMI


Economic momentum set to accelerate
60
12%

58
56

10%

54
8%

52
50

6%

48
4%

46

44

2%

42
40
2001

Money supply y/y change SA (%)

Consumption: To remain strong after temporary energy windfall


Against the backdrop of the recovery, consumer confidence has reached
the highest level since the Global Financial Crisis. This has helped
consumer spending in the second half of 2014 to print the best two
quarters in a row since 2007, running at an annualized 2%. Looking
forward, the sharp fall in energy prices is resulting in a one off boost to
consumption growth in the first half of 2015. Although temporary,
consumption should remain strong as the end of consolidation in
economic momentum should herald a faster decline in the
unemployment rate and with it improved consumer confidence. That
said, the unemployment rate (currently at 11.2%) is expected to fall to
10.5-10.8% by the end of 2015 and to around 10% in 2016. Although
wage growth should not change much, the faster decline in the
unemployment rate over the forecast horizon should support strong
consumption via a lower household savings rate.

Fig. 1: New loans increasing


Loans to households and non-financial corporates

Manufacturing PMI Index

Monetary policy is finally feeding through to bank loan rates (including in


the periphery), as loans to households and non-financial corporations
have turned positive, net of redemptions. Looking ahead, the ECB bank
lending survey suggests further improvements in loans (see Fig. 1). In our
baseline scenario, we expect loans net of redemptions to accelerate in
2015 to levels last seen in 2010/2011, pushing the credit impulse back up
to the highest levels seen since the Global Financial Crisis. Combined with
robust demand for consumer, mortgage and business loans, consumption
and investment should be well supported in the process.

0%

2003

2005

2007

Manufacturing PMI

2009

2011

2013

2015

Money supply (7m lead, rhs)

Source: UBS, ECB, Markit, Haver. Note: Includes a simulation


until year end (shaded area).

Fig. 3: Trade vs REER


Exports will be supported by a weaker EUR

Source: UBS, ECB, Haver. Note: REER refers to Real Effective


Exchange Rate.

CIO WM Research 12 March 2015

European economy

10

10

Forecast

EURUSD (lhs)

4Q15

3Q15

2Q15

1Q15

4Q14

-60

3Q14

-50

-60

2Q14

-40

-50

1Q14

-30

-40

4Q13

-20

-30

3Q13

-10

-20

2Q13

-10

Percentage (y/y)

1Q13

Eurozone inflation: Turnaround expected


If there has been one surprise in recent times, it has been the fall in oil
prices and the resulting plummeting of inflation rates. Notably, the
decline in Eurozone energy prices has been comparable to that seen
during the Global Financial Crisis. That said, the Brent oil price has more
recently stabilized at the level it traded at the end of 2014. This likely
means that January 2015 marks the low point in inflation over the
forecast horizon. In terms of core inflation, resilient wage growth coupled
with the re-acceleration of economic growth should limit the spillover
from non-core to core inflation. This should be supported by the fall in
the euro, which has made imported goods and services more expensive.

Fig. 4: Oil price and euro


Bulk of the impact on activity in 2015

Percentage( y/y)

more by imports. Indeed, stronger economic growth and job creation will
likely lead to more demand for imports, even if imported goods and
services have become more expensive following the decay of the euro.
The sharp fall in oil prices in turn has already led to a windfall in the
Eurozone trade balance in the second half of 2014 as energy constitutes
a quarter of goods imports in the Eurozone. In the meantime, Brent oil is
trading approximately at the same level as at the end of 2014, so that we
see little further support from that side for the trade balance in 2015.
What's more, the increase in oil prices that the futures market is
reflecting for 2016 means a modest headwind for the trade balance next
year.

Brent crude oil (EUR, rhs)

Source: UBS, Haver, Bloomberg. Note: Brent Oil Blended, 1st


expiring contract (EUR/bbl).

Fig. 5: Eurozone inflation


Shocked by oil price falls, core inflation resilient

Further out, it will take 12 months for the oil price shock to filter out of
year-over-year comparisons. This means that the inflation rate is set to
move up very quickly once the negative base effects filter out. Therefore,
we believe that inflation should move above zero during the summer, to
around 1% by end of 2015 and to 1.7% by end of 2016.
ECB: To stay easy, for now
With large scale asset purchases, the ECB has embarked on the only key
alternative to interest rate reductions. However, this does not mean that
the ECB has no ammunition left. Indeed, the asset purchase programs
can be redesigned at any time in terms of size, composition and pace for
instance. Nevertheless, it is imperative that the courts rule favorably this
year regarding asset purchases. With a low trend growth rate of around
1%, the ECB will have to rely on this tool probably again and again over
the long term.

Source: UBS, ECB, Haver. Note: REER = Real Effective Exchange


Rate.

Fig. 6: Central banks' balance sheet


ECB as rear light

In the short term, the ECB will be faced with an increasingly stronger
economy and be challenged by the hawks in the governing council to
prematurely scale down the QE program. By early 2016 inflation should
have moved beyond 1% and the unemployment rate should be relatively
close to the structural unemployment rate of about 10%. However,
Mario Draghi recently pointed out that the new ECB economic staff
projections assume a full implementation of the asset purchases at least
until September 2016. It will therefore probably require growth even
stronger than 2% to scale down QE, which is not likely but not
impossible.
Conclusion: Eurozone economy to re-accelerate
Given the very favorable fundamental backdrop over the forecast horizon,
we expect the Eurozone to grow well above trend growth (estimated at
approximately 1%). The growth enhancing effect from the monetary side
should intensify sharply in the second half of 2015, given the lead of the
monetary impulse. This should propel the year-over-year GDP growth rate
from 0.9% currently to 1.9% by the fourth quarter of 2015.

Source: UBS, Haver. Note: January 2007=100.

CIO WM Research 12 March 2015

European economy

This outlook assumes that key risks do not materialize. Greece and a
potential exit from the Eurozone is certainly a key risk. As the President of
the European Commission put it, an exit would be an "irreparable loss of
reputation". What's more, as we laid out in our note "Greece:
negotiations formally launched" on 15 February 2015, an exit could
shave off 5 points from the manufacturing PMI within 3-6 months despite
the strong fundamental backdrop. Given that 70-80% of Greeks want to
remain in the euro and given that 70% of Greeks want their government
to reach an "honorable compromise" with its partners, we continue to
believe that a deal for a new "program/contract" will be made by June
2015 even if negotiations should remain difficult and bumpy. That said,
we continue to see the exit risk at a low 10-20%.
Other than that, a sharp escalation of the Ukraine crisis and in particular a
break in Chinese growth would also act as a serious headwind.
Furthermore, the final ruling on the OMT case has not been issued yet,
while a too restrictive ruling could seriously hamper the effectiveness of
ECB asset purchases. We expect the European Court of Justice's
preliminary ruling during the next 1-2 quarters, with the final ruling by
the German constitutional by the second half of 2015. We continue to
assume a "yes, but" ruling.

Fig. 7: Turning points


Economic activity set to shoot up

Source: UBS, ECB, Markit, Haver.

Fig. 8: Recovery from Global Financial Crisis


Expected for end of 2016
140
135
130
125

120
115
110
105
100

95

97

99

01

03

05

07

09

11

13

15

Gross Domestic Product (SWDA, index, 1995=100)


Gross Domestic Product forecast (UBS)

Source: UBS, Eurostat.

Table 1: Eurozone growth and inflation forecasts


Growth acceleration expected in 2015
Annual real GDP growth
2014
2015E 2016E
Year over year

0.9%

1.6%

2.0%

2014
0.9%

Consensus
2015E 2016E
1.2%

1.6%

2014

Inflation
2015E

2016E

2014

0.4%

0.1%

1.5%

0.4%

Consensus
2015E
2016E
-0.1%

1.2%

Source: UBS estimates, Bloomberg.

CIO WM Research 12 March 2015

European economy

Country level outlook


Germany
The strong growth acceleration of the German economy in the fourth
quarter 2014 showed that fears of a potential recession in the second
half 2014 were overdone. The German economy remains in a
fundamentally solid condition and we expect it to strengthen further this
year compared to last year. As a result, German economic growth should
continue to outpace the Eurozone average. We expect consumer demand
to remain the key growth driver, supported by strong wage growth, high
immigration, and low interest rates. Furthermore, rising house prices will
add to consumers' wealth and should support ongoing high consumer
confidence.
For the third year in a row, the general government budget balance was
in surplus for 2014. The German government also benefits from record
low interest rates on its debt, which, to some degree, hides a structural
deterioration in the financing of rising social spending. Nevertheless,
compared to most other countries in the Eurozone, German public
finances are in good shape for the coming years. We expect the
government's debt-to-GDP ratio to continue falling in 2015 and 2016.
The fiscal stance should continue to be close to neutral. Promoting fiscal
prudence will continue to be a key part of its European policy, thus we do
not expect it to further stimulate domestic demand substantially.

Fig. 9: Investments to continue to pick up


Investments should benefit from low energy prices
and stronger overall activity in the Eurozone

Source: UBS, Haver.

Fig. 10: German real GDP


Germany still the growth engine of Eurozone

German companies benefit from the weaker euro and a strong US


economy. Investment picked up in the fourth quarter 2014 and we
expect this to continue in 2015, as low oil prices and a general upswing
in Eurozone economic activity lend further support to German industry.
Eventually, rising business confidence should also lead to a turnaround in
inventories, with companies restocking them, thereby further supporting
GDP growth. German exports should also profit from the weaker euro
and the stronger momentum in neighboring Eurozone countries, but
strong domestic demand should lead to rising imports, at least partly
offsetting stronger exports.
The main risks to our outlook on Germany include a lack of reforms in
other Eurozone countries and a stronger than expected euro. Both would
reduce demand for German export goods. Moreover, a further escalation
of the Russia-Ukraine crisis would weigh on German exports and business
confidence, while a potential exit of Greece from the Eurozone would hit
Eurozone and German sentiment, in our view.

Source: UBS, IFO, Haver.

Table 2: German growth and inflation forecasts


Economic growth to pick up
Annual real GDP growth
2014
2015E 2016E
Year over year

1.6%

2.1%

2.4%

2014
1.6%

Consensus
2015E 2016E
1.5%

1.7%

2014

Inflation
2015E

2016E

2014

0.8%

0.1%

1.4%

0.8%

Consensus
2015E
2016E
0.3%

1.6%

Source: UBS estimates, Bloomberg.

CIO WM Research 12 March 2015

European economy

France
Ongoing fiscal tightening and a lack of competitiveness will likely keep
French growth rates below the Eurozone average in 2015. Contrary to
Spain, Portugal, Ireland and Greece, France has not been able to
materially reduce its labor costs relative to Germany since the Global
Financial Crisis (see Fig. 11). However, a weaker euro, lower oil prices,
and a bottoming in the construction sector in 2015 should lead to a
significant acceleration of economic growth to 1.0%, compared to just
0.4% in 2014.
The downturn in the construction sector exacerbated the weakness in
investments last year. This should change in 2015 in response to various
changes in housing legislation (Loi Pinel, prt taux zero), the sharp fall in
mortgage rates and the already depressed level of activity. House prices
are already in a bottoming process after an almost three year long
downturn, while construction orders have yet to pick up. Low interest
rates should lend further support, so that private investments should
grow this year. Private consumption was the main driver of growth in
2014. For 2015, we expect private consumption to continue to grow
positively, supported by low oil prices and positive wealth effects from the
ECB's quantitative easing program. Meanwhile, net trade should benefit
from the weaker euro and solid demand from key trading partners.
Spending cuts by the French government should act as a slight brake on
economic growth, though. We expect the debt-to-GDP ratio to start
coming down from 2016, but the 3% deficit target is still out of reach for
France, despite the government planning spending cuts. The European
Commission estimates the French deficit at 4.3% for 2014 (see Fig. 12)
and is giving France two additional years (until 2017) to leave the
Excessive Deficit Procedure. In exchange, the French government has to
deliver additional fiscal tightening and to strengthen its reform efforts,
otherwise it could face sanctions. The new fiscal guidelines by the
European Commission are allowing for more flexibility, taking into
account economic circumstances, which should partly placate French
demands for a more balanced mix of fiscal, monetary, and structural
policies.
President Francois Hollande and Prime Minister Manuel Valls have
strengthened efforts to reform the French economy to make it more
competitive. The "Macron" law was pushed through in conjunction with
a vote of confidence according to Article 49.3. The law is aimed at
reducing overregulation in order to stir growth and activity. Important
points include extending shop trading hours, facilitating the creation of
new businesses, easier layoffs, and the deregulation of some professions.
Although by far not revolutionary, this is causing internal conflict in the
ruling Socialist Party. There is potential risk of the government facing a
loss of majority as a result. Upcoming departmental and regional elections
this year are contributing to this risk. Nevertheless, we believe that the
government will follow up with a reform of labor laws to reduce
bureaucratic hurdles. The key risk for the outlook on France is thus a
failure to push through necessary reforms.
With contributions from Thomas Veraguth

Fig. 11: Unit labor costs


No adjustment yet

Source: UBS, Eurostat, Haver.


Note: Unit labor costs for the total economy vs. Germany.

Fig. 12: Government budget deficits


In % of GDP

Source: UBS, Eurostat, Haver.

Table 3: French growth and inflation forecasts


Better but still set to fall short of its own growth potential
Annual real GDP growth
2014
2015E 2016E
Year over year

0.4%

1.0%

1.5%

2014
0.4%

Consensus
2015E 2016E
0.9%

1.4%

2014

Inflation
2015E

2016E

2014

0.6%

0.3%

1.6%

0.6%

Consensus
2015E
2016E
0.1%

1.1%

Source: UBS estimates, Bloomberg.

CIO WM Research 12 March 2015

European economy

UK: Keep calm and carry on


The UK economy is set for another year of solid expansion in 2015, which
should continue into 2016 gradually closing what remains of the output
gap. The economy has thus far been supported by vigorous consumption,
fuelled by a remarkably strong labour market, recovering consumer
confidence, and rising real incomes. Still, this isn't the whole story, as
business investment has also been a key factor in the UK recovery. For
2015, we expect that consumption growth will continue to support the
economy, aided by lower fuel prices boosting disposable income, and
labour market slack eroding further, forcing earnings higher. The
downside to lower oil prices will likely be seen in business investment
where growth is now expected to be weaker, as North Sea investment
plans are shelved outside of this sector expansion should remain brisk.
Fiscal policy will remain contractionary, with current projections of a
tightening of around 1% of GDP for the next few years. This should see
the budget deficit shrink further, with the UK's debt-to-GDP ratio peaking
just above 80% in 2015/6. The monetary policy outlook is clouded by the
recent weaker-than-expected inflation outturns. However, once the
temporary external effects of falling food and energy prices fade,
domestically generated inflation will, driven by higher wages, push
headline indices higher. We expect the Bank of England will hike rates in
November, but the path beyond this is likely to be gradual, with only two
further hikes in 2016.

Fig. 13: Robust economic growth to continue


UK GDP (%) and UBS Forecasts
2

4
3

-1

-1

-2
-3

-1

-4

-2

-5

-2

-6

-3

-7
07

08

09

10

11

12

13

GDP q-o-q (lhs)

14

15

16

GDP y-o-y (rhs)

Source: Haver, UBS as of February 2015.

Fig. 14: The sharp deterioration of the UK's


current account can be explained by income
flows, not a worsening trade position
UK current account deficit in % of GDP
3
2
1
0

A blot on the UK's copybook is the marked deterioration in its external


position. The current account deficit has expanded sharply, with the -6%
print for the end of 3Q14, the joint worst position ever recorded (see Fig.
14). The deterioration can be explained by the income account; the trade
balance has been remarkably stable. The change in the income balance is
explained by the falling returns that the UK receives from overseas
investments, especially when compared to what foreigners earn on their
UK assets. We expect that this position should naturally reverse over time
as the global economy recovers, but it may persist for some quarters yet.
Sterling has continued to find support on the forex markets, chiefly
against the euro where it has gained over 6% since the start of the year.
Diverging paths for monetary policy explain this move. Nevertheless, in
the short-term sterling may face some headwinds, especially around the
general election (see below). Beyond this, the gradual path of interest
rate rises should once again support the currency.

-1

-2
-3

-4
-5
-6
-7
04

05

06

07

08

Trade balance

09

10

Income balance

11

12

13

14

Current account balance

Source: Haver, ONS, UBS as of February 2015.

Fig. 15: Current polling points to an unusually


uncertain outcome at the UK general
election
UK voting intentions, 10 poll average
50
45
40

In our view, the risks around the UK outlook are primarily centered on the
7th May general election. Current polling points to neither of the major
UK parties gaining a majority, which suggests that another coalition
government or perhaps a less stable arrangement is the most likely
outcome. For markets, the key areas of focus will be the fiscal policy, EU
membership, and the potential for further devolution. These matters have
the potential to weigh on consumer, and crucially, business confidence as
the election approaches and after. Especially if there is a lack of certainty
about the direction and pace of travel on these major issues.
Dean Turner

35
30
25
20
15
10
5
0
Apr 12

Okt 12

CON (%)

Apr 13
LAB (%)

Okt 13
LD (%)

Apr 14
UKIP (%)

Okt 14
Grn (%)

Source: ukpollingreport.co.uk, UBS as of February 2015. CON:


Conservative, LAB: Labour, LD: Liberal Democrats, UKIP: UK
Independence party, Grn: Green Party.
Note: Line colors in chart represent colors parties are typically
associated with.

Table 4: UK growth and inflation forecasts


Losing pace, but still at the head of the pack
Annual real GDP growth
2014
2015E 2016E
Year over year
2.6%
Source: UBS estimates, Bloomberg.

2.4%

2.9%

2014
2.6%

Consensus
2015E 2016E
2.6%

2.4%

2014

Inflation
2015E

2016E

2014

1.5%

0.1%

1.7%

1.5%

Consensus
2015E
2016E
0.5%

1.7%

CIO WM Research 12 March 2015

European economy

Italy
Italian GDP fell once again in 2014, contracting 0.4%. After more than
three years, we expect Italy to leave recession behind, posting positive
growth rates from the first quarter 2015 onwards. Nevertheless,
compared to the Eurozone average, Italian growth is going to remain
subdued, as we expect the economy to grow only by 0.7% this year. A
lack of competitiveness is still keeping potential growth rates low. The
government of Matteo Renzi finally addressed this in part with labor
market reform, but more needs to be done. To that effect, the rise of the
Lega Nord in polls as well as the termination of the collaboration
(Nazareno pact) between Renzi's PD party and Forza Italia serve as a
reminder for the challenges ahead. The Italian government plans only a
marginal fiscal tightening this year. Nevertheless, the debt-to-GDP ratio
should start to come down by 2016.
Private consumption is set to grow marginally in 2015 on the back of a
moderately falling unemployment rate and positive wealth effects from
the ECB's quantitative easing program. Investments continue to be the
weak point, but we expect a gradual stabilization in 2015 on the back of
the government repaying arrears and easier financial conditions. As
inflation has fallen into negative territory, relatively high real interest rates
are a drag on investments. The longer term outlook is better, though, as
the labor market reform should somewhat increase flexibility for
companies and raise long-term economic growth potential. Additionally,
we expect Italy to be one of the main beneficiaries from the "Juncker
fund" for investments, especially in 2016, as the fund is only fully
operational from summer 2015 onwards. House prices show tentative
signs of a bottoming and falling mortgage rates and better loan demand
should lead to a bottoming in construction activity, with a rebound
conceivable in 2016. Finally, we expect net trade to contribute
moderately to economic growth in 2015, as a weaker euro and lower oil
prices should keep Italian imports in check and support competitiveness
of exports.
The main risks for our Italian outlook are fewer than expected structural
reforms, further weakness in the construction sector and a stronger than
expected euro. Moreover, even more negative inflation rates than
expected could push real interest rates higher, thereby making loans
effectively more expensive and acting as a drag on investments and
consumption.

Fig. 16: Italian investments


Main culprit behind economic stagnation

Source: UBS, Haver, Istat.

Fig. 17: Economic momentum improving


Consumer and business surveys

Source: UBS, Haver.

Table 5: Italian growth and inflation forecasts


Better growth but still underperforming
Annual real GDP growth
2014
2015E 2016E
Year over year

-0.4%

0.7%

1.3%

2014
-0.4%

Consensus
2015E 2016E
0.4%

1.0%

2014

Inflation
2015E

2016E

2014

0.2%

0.6%

1.6%

0.2%

Consensus
2015E
2016E
-0.1%

0.9%

Source: UBS estimates, Bloomberg.

CIO WM Research 12 March 2015

European economy

Spain
The recovery of the Spanish economy is gathering pace, helped by
improving external conditions. Domestic demand is growing by more
than 2% y/y already as the initial pull from export-related activities was
followed by significant job creation and a swift recovery in household
consumption. Meanwhile, fiscal restraint has been much lower than
budgeted as Spain enters in an intense election year. Furthermore, the
construction sector has been contributing positively to GDP in the last
three quarters, at an increasing rate.
Besides, three key external elements are materially improving the
economic outlook in the Eurozone, particularly in Spain. First, the
depreciation of the euro will support exports and restrain imports and,
even more important for Spain, will foster the recovery in France,
Germany and Italy, its main trade partners. Secondly, the slump in oil
prices provides a big boost to the Spanish economy, whose energy trade
deficit amounted to 4% of GDP in 2014. As oil and gas imports cheapen,
the goods trade balance will temporarily register a boost while real
disposable income jumps and consumption accelerates temporarily. The
overall positive effect could surpass 0.5% of GDP, supporting continued
strong growth in 2015.
Thirdly, the expected improvement in credit conditions is feeding through
to the real economy. The ECB's QE announcement has helped the
sovereign spread to fall and credit standards to ease. The net flow of
loans is improving and should start to trend in positive territory during
2015, providing a very favorable credit impulse that will contribute to the
cyclical bounce. What's more, we expect Spain to be one of the main
beneficiaries of the forthcoming European Fund for Strategic Investments
(EFSI).
As a result, we now expect quarter-on-quarter growth to remain at
around 0.6% in 2015, with a significant probability of even stronger
readings in the next 1-2 quarters as the positive effect of a more
competitive euro and low oil prices provide an additional boost to net
exports and to consumption. This could translate into 2.4% GDP growth
in 2015 (1.4% last year) and 2.3% in 2016. Given this hefty economic
recovery, despite a clear relaxation in the fiscal tightening efforts, the
budget deficit should only miss its target of 4.2% in 2015 and 2.8% in
2016 by a few tenths of a percentage point. Nevertheless, Spain won't
register a primary fiscal surplus until 2016/2017. Therefore, debt-to-GDP
will only stabilize in 2016 at close to 100% of GDP, meaning that longterm fiscal sustainability has not yet been achieved.

Fig. 18: Strong job creation augurs a


sustained GDP recovery
Employment and real GDP annual growth and
Services PMI
6

65

60

55

50

-2

45

-4

40

-6

35
30

-8
01

02

03

04

05

06

07

08

09

Employment growth (% YoY)

10

11

12

13

14

15

Real GDP growth (% YoY)

Services PMI (3m mov.av; rhs)

Source: UBS, Markit, INE.

Fig. 19: Exports revive but imports rise with


domestic demand
Real goods imports and exports and fixed
investment (real terms index)
Forecast

140

140

130

130

120

120

110

110

100

100

90

90

80

80

70

70

60

60

Goods imports

50

50

Goods exports

40

40

Gross fixed investment

30

30

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Source: UBS, INE.

Despite this very positive cyclical backdrop, Spain's healing remains fragile
and highly dependent on external economic and financial conditions,
especially as consumption growth is outpacing income growth by a wide
margin, which is not sustainable. Besides, the recovery could be
threatened by rising political instability as local and regional (May) and
national (November) elections in 2015 will likely result in weaker
governments, while Podemos is unlikely to win a majority.
Roberto Ruiz-Scholtes, Ricardo Garcia-Schildknecht
Table 6: Spanish growth and inflation forecasts
Past reforms should continue helping to outperform the Eurozone
Annual real GDP growth
2014
2015E 2016E
Year over year
1.4%
Source: UBS estimates, Bloomberg.

2.4%

2.3%

2014
1.4%

Consensus
2015E 2016E
2.1%

2.2%

2014

Inflation
2015E

2016E

2014

-0.2%

-0.3%

1.4%

-0.2%

Consensus
2015E
2016E
-0.4%

1.1%

CIO WM Research 12 March 2015

European economy

Switzerland
At 0.6%, quarterly growth in Switzerland in 4Q surprised to the upside
(consensus estimate 0.3%). However, after the Swiss National Bank (SNB)
withdrew the exchange rate floor of EURCHF 1.20 on 15 January, this all
seems like water under the bridge. Leading economic indicators from 1Q
2015 point to an economic slowdown after the Swiss franc's jump of
12% against the euro since mid-January. The strengthening of the Swiss
franc represents a serious hit to the Swiss economy. Switzerland's exports
value 50% of its GDP; 60% of these exports go to the Eurozone.
We expect the government not to initiate any fiscal stimulus to support
the economy. Slower tax revenues will be offset by lower government
expenditure that should keep the budget well-funded and the debt-toGDP ratio constant at 36%. Negative interest rates have become the
SNB's instrument of choice to weaken the Swiss franc, a measure that
seems to have worked well in the relative calm of the recent market
environment. We assume no further tightening of the negative interest
rates in 2015. However, we expect further bumpy discussions between
the Eurozone and Greece regarding the debt program that could again
trigger safe haven flows strengthening the Swiss franc. The SNB will keep
a close eye on the EURCHF exchange rate and we expect further
interventions from the SNB trying to weaken the Swiss franc if the pair
trades substantially lower, especially if EURCHF moves well below parity.
Accelerating growth in the Eurozone and the US should attenuate the
negative effects of the strong Swiss franc and give some support to Swiss
exports. All in all, we expect negative export growth of -1.0% for 2015
and a negative growth impact of -0.5 percentage points from net
exports. The uncertainty surrounding the introduction of immigration
quotas and the strength of the Swiss franc create an unfavorable
environment for business investment. We expect equipment investments
to be down by -0.3% in 2015. A higher expected unemployment rate of
3.6% on average in 2015 up from 3.2% in 2014 and slightly slower
expected population growth of 0.9% in 2015 down from 1.2% in 2014
will weigh on private consumption. Nevertheless, we expect private
consumption and construction investment to increase by 1.4% and
1.6%, respectively and, therefore, to support growth in 2015. Overall, we
forecast 0.5% GDP growth in 2015 and 1.1% in 2016.

Fig. 20: SNB so far but no further


Central bank money, in % of GDP

Source: UBS, Reuters EcoWin

Fig. 21: Downtrend turns into landslide


EURCHF

Source: UBS, Reuters EcoWin

Political risk stems from the uncertainty about how the mass immigration
initiative will be implemented and whether a solution will trigger a
cancelation of the bilateral treaties with the EU. We expect difficult
negotiations with the EU and no breakthrough in 2015. A further
referendum on the issue is likely to take place in 2016/2017. General
elections will be held in October 2015, which is expected to have no
considerable market impact. A strong appreciation of the Swiss franc in
the case of more Eurozone troubles and the EURCHF hovering around
0.95 for a sustained period of time represents a risk to our GDP forecast.
This might lead to a deep recession, much lower immigration and a
decline in real estate prices of up to 20%.
Bernd Aumann
Table 7: Swiss growth and inflation forecasts
Solid growth, inflation sharply down
Annual real GDP growth
2014
2015E 2016E
Year over year

1.9%

0.5%

1.1%

2014
2.0%

Consensus
2015E 2016E
0.8%

1.2%

2014

Inflation
2015E

2016E

2014

0.0%

-1.0%

0.2%

0.0%

Consensus
2015E
2016E
-0.9%

0.2%

Source: UBS estimates, Bloomberg.

CIO WM Research 12 March 2015

10

European economy

Sweden
We expect the Swedish economy to grow above its long-term trend in
2015 on the back of broad-based improvement in consumption,
investments, and net trade. Although some normalization of the
extraordinary 4Q2014 growth rate of 1.1% q/q is likely in the first half of
2015, we believe that the average q/q growth rate of the Swedish
economy in 2015 will be able to stay close to the second half of 2014.
Supportive factors are high business confidence indicated by the
purchasing managers' indices, low oil prices, an improving Eurozone
economy, and further monetary easing by the Swedish Riksbank.
However, with a size of only SEK 10bn and a duration of one month, the
recently launched sovereign bond purchase program (QE) is too small and
too short to be able to turn around the downward trend in inflation
expectations (see Fig. 22) and the low inflation. Negative rates should be
an effective tool to depreciate the Swedish krona (SEK). However, the
currency is already weak and the 1Q2015 Riksbank business survey has
shown that Swedish companies are hesitant to pass on higher import
prices due to strong competition. As such, we expect the Riksbank to
ease further by cutting the repo rate further into negative territory and by
extending the QE program at least until the end of 2015. This should
keep the SEK weakening against major currencies, including the euro.
Unemployment is still relatively high at almost 8%, since growth in
2013/14 has not been strong enough to compensate strong immigration
(see Fig. 23). We expect unemployment to fall more rapidly in 2015 given
strong growth rates. This should lend further support to consumer
confidence, along with lower oil prices and higher household wealth after
recent strong house price increases. Therefore, consumption should
remain the main growth driver in 2015, although high household debt
levels will likely prevent even stronger growth. The Swedish government's
fiscal policy is likely to be a slight drag, however. It ran a sizeable budget
deficit of 2.1% in 2014. Initial plans to reduce the deficit to 1.1% in
2015 could be loosened, as the government intends to drop the 1%
budget surplus target. However, the proximity to the 3% limit set by the
European Union does not give much room on the easing side.
Despite immigration-led strong demand pushing house prices higher by
over 8% y/y recently, construction investment remains rather sluggish,
partly due to extensive rent control. Swedish total investments, however,
have improved sharply in 2014 and we expect this to continue in 2015.
Drivers will be persistent high business confidence and the general
rebound in its biggest trading partner, the Eurozone, which is already
feeding through to the export-heavy Swedish industry (see Fig. 24).
Exports will also benefit from the Eurozone acceleration and are
additionally supported by the weak SEK. As such, the net trade drag on
growth that was observed in 2014 will likely be much lower in 2015.
Key risks to our outlook for Sweden are a serious escalation of the RussiaUkraine crisis hurting Swedish exports and investments in Russia and a
resurgence of political and economic uncertainty in the Eurozone.
Daniel Trum
Table 8: Swedish growth and inflation forecasts
Ultra-strong growth, but inflation too low
Annual real GDP growth
2014
2015E 2016E
Year over year
2.3%
Source: UBS estimates, Bloomberg.

3.0%

3.7%

2014
2.3%

Consensus
2015E 2016E
2.3%

2.7%

Fig. 22: Inflation expectations


Downtrend accelerating lately

Source: UBS, TNS Prospera, Haver.

Fig. 23: Unemployment


Lagging the economic improvement

Source: UBS, Statistics Sweden, Haver.

Fig. 24: Swedish exports and imports


Exports finally picking up

Source: UBS, Statistics Sweden, Haver.

2014

Inflation
2015E

2016E

2014

-0.2%

0.2%

1.5%

-0.2%

Consensus
2015E
2016E
0.3%

1.5%

CIO WM Research 12 March 2015

11

European economy

Norway
After three years of strong GDP growth above 2%, the Norwegian
Mainland economy is coming under pressure from low oil prices. We
expect Brent crude oil prices to fall again over the next three months and
to rebound only to around 70 USD by the end of 2015. Against this
background, we believe that the Norges Bank will lower its key policy rate
further from 1.25% to 0.75%, most likely at its 19 March meeting. The
inflation rate has remained close to target throughout 2014, but the
weak oil price is also putting this stability into doubt (see Fig. 25).
Contrary to other European countries, Norwegian consumers are set to
suffer from the low oil prices, as employment prospects in the oil and gas
sector are already deteriorating sharply (see Fig. 26). Given that this sector
makes up more than 20% of the total economy, employment in the
Mainland economy is likely to be dragged down, too. Consumer
confidence has already weakened to the lowest level since the Global
Financial Crisis in 2009 (see Fig. 27). At that time, the Norwegian
government supported the economy with higher spending. This is likely
to happen again in 2015, but to a much smaller extent. The center-right
government has its focus on long-term initiatives to make Norway less
dependent on oil. Furthermore, they declared that it is the central bank's
job to react to short-term fluctuations such as the current drop in oil
prices. If the economic downturn should last into 2016, though, more
fiscal stimulus is likely. They certainly have enough firepower with a
government debt-to-GDP ratio around 30% and some leeway left in
using returns from the over 800bn USD large government pension fund.
The downturn will be felt even more sharply in investments. A 2012
Norges Bank survey among Norwegian companies indicates that oil prices
below 70 USD are likely to have severe negative effects on economic
growth. The construction sector already weakened in 2014 despite
further strong increases in house prices of over 8% y/y recently. With
lower growth in Mainland economic activity, we also expect house prices
to trend sideways and the construction sector to be a drag on growth.
We expect the huge net trade surplus (oil and gas make up around 50%
of exports) to deteriorate in 2015. However, the anticipated improvement
in Eurozone economic momentum should help Norway Mainland's
exports, leading to a positive contribution to its GDP in 2015. We expect
the Norwegian krone (NOK) to stay weak against the euro, as the ECB's
QE policy is matched by Norges Bank rate cuts, thereby more than
offsetting the effects on the currency pair . Moreover, an oil price below
70 USD increases the need for a weaker NOK to offset falling oil revenues
from abroad. Beginning in the second half of 2015 we expect the Brent
oil price to rebound to around 70 USD in 12 months. This should reaccelerate Norway Mainland growth again from 1.1% in 2015 to 2.2% in
2016.
Key risks to our outlook on the Norwegian economy pertain to a longer
than expected period of oil price weakness, a stronger housing market
downturn as a result of the general economic weakness, and a weaker
than expected Eurozone economy.
Daniel Trum

Fig. 25: Inflation


Producer prices pointing to lower inflation

Source: UBS, Statistics Norway, Haver.

Fig. 26: Employment


Oil sector already feeling the pinch

Source: UBS, Statistics Norway, Haver.

Fig. 27: Consumer confidence


Lower oil prices affecting the whole economy

Source: UBS, TNS Gallup, Haver.

Table 9: Norway Mainland1 growth and inflation forecasts


Low oil prices hurting growth in 2015
Annual real GDP growth
2014
2015E 2016E

2014

Consensus
2015E 2016E

2014

Inflation
2015E

2016E

2014

Year over year


2.3%
1.1%
2.2%
2.3%
1.8%
2.2%
2.0%
1.3%
1.3%
Source: UBS estimates, Bloomberg. 1 Norway Mainland refers to the domestic economy excluding oil and gas sectors.

2.0%

Consensus
2015E
2016E
2.2%

2.2%

CIO WM Research 12 March 2015

12

European economy

Bank Recovery and Resolution Directive (BRRD)


The Bank Recovery and Resolution Directive (BRRD) harmonises the tools used in the recovery and resolution of credit
institutions in the EU. The BRRD stipulates that, should a bank fail, its shareholders and creditors should normally be first in line
to absorb any risks and losses. Only then should a resolution fund financed by the entire banking industry (Single Bank
Resolution Fund, or SBRF) step in. In extreme cases, government institutions can still be financially involved in the recovery or
resolution of an institution ("bail-out").
Current account
The current account measures the cross border flow of goods, services, net investment income and cash transfers in a given
period. Usually, the trade balance is the largest component of the current account. A current account surplus (normally
associated with a trade surplus) means that the respective country has increased its net foreign assets, or in case of net liabilities
reduced it in a specific period.
Deposit Guarantee Schemes Directive (DGSD)
The new European Directive on Deposit Guarantee Schemes entered into force on 2 July 2014. It replaces the previous Deposit
Guarantee Scheme Directive from 1994. Its main elements include: simplification and harmonization, in particular relating to
coverage and payout arrangements; further reduction, to one week, of the time limit for paying out depositors, and better
access for DGSs to information about their members (i.e. banks); harmonization of minimum ex ante financing requirements for
DGSs; mutual borrowing between DGSs, i.e. a borrowing facility in certain circumstances.
ECB Deposit Facility
A standing facility of the Eurosystem which counterparties may use to make overnight deposits at a national central bank. Such
deposits are remunerated at a pre-specified interest rate ("deposit rate").
ECB Executive Board
One of the decision-making bodies of the ECB. It comprises the President and the Vice-President of the ECB and four other
members, all of whom are appointed by common accord by the Heads of State or Government of the EU Member States whose
currency is the euro.
ECB Governing Council
The supreme decision-making body of the ECB. It comprises the President and the Vice-President of the ECB plus the other
members of the Executive Board and the governors of the national central banks of those EU Member States whose currency is
the euro.
ECB longer-term refinancing operation (LTRO)
A regular open market operation executed by the Eurosystem in the form of a reverse transaction. Longer-term refinancing
operations are carried out through monthly standard tenders and normally have a maturity of three months.
European Fund for Strategic Investments (EFSI)
An investment plan from the European Commission aimed at relaunching public and private investment in the real economy
over the next three years (2015 2017). The fund will be operated by the European Investment Bank.
European Semester
A six-month period each year when member states' budgetary, macro-economic and structural policies are coordinated so as to
allow member states to take EU considerations into account at an early stage of their national budgetary processes and in other
aspects of their economic policymaking.
European Stability Mechanism (ESM)
The European Stability Mechanism is an intergovernmental institution based in Luxembourg, set up to provide financial
assistance to eurozone member states experiencing, or being threatened by, severe financing problems, if this is indispensable
for safeguarding financial stability in the eurozone as a whole. The maximum lending capacity of the ESM is set at 500 billion.
This is achieved with a subscribed capital of 700 billion ( 80 billion paid-in capital, the rest callable). The ESM entered into
force on 27 September 2012. It takes over the tasks fulfilled by the European Financial Stability Facility (EFSF).
European System of Financial Supervision (ESFS)
The group of institutions in charge of ensuring the supervision of the EUs financial system. It comprises the European Systemic
Risk Board, the three European Supervisory Authorities (the European Banking Authority, the European Securities and Markets
Authority and the European Insurance and Occupational Pensions Authority), the Joint Committee of the European Supervisory
Authorities, and the national supervisory authorities of the EU Member States.

CIO WM Research 12 March 2015

13

European economy

European Systemic Risk Board (ESRB)


An independent EU body responsible for the macro-prudential oversight of the financial system within the EU. It contributes to
the prevention or mitigation of systemic risks to financial stability that arise from developments within the financial system,
taking into account macroeconomic developments, so as to avoid periods of widespread financial distress.
Eurosystem
The central banking system of the euro area. It comprises the ECB and the national central banks of those EU Member States
whose currency is the euro.
Excessive Deficit Procedure (EDP)
The corrective arm of the Stability and Growth Pact (SGP) ensures that Member States adopt appropriate policy responses to
correct excessive deficits by implementing the Excessive Deficit Procedure (EDP). The EDP operationalizes the limits on the
budget deficit and public debt given by the thresholds of 3% of deficit to GDP and 60% of debt to GDP not diminishing at a
satisfactory pace.
Full allotment policy
This policy provides banks with access to unlimited ECB liquidity, as long as eligible collateral is delivered to the ECB. The MRO
interest rate applies to the liquidity lent out under fixed allotment policy.
HICP Inflation
Consumer price inflation in the euro area is measured by the Harmonized Index of Consumer Prices (HICP). The HICP is compiled
by Eurostat and the national statistical institutes in accordance with harmonized statistical methods. The headline inflation refers
to the inflation rate including core and non-core inflation.
Main refinancing operation (MRO)
A regular open market operation executed by the Eurosystem (in the form of a reverse transaction) for the purpose of providing
the banking system with the amount of liquidity that the former deems to be appropriate. The interest rate on MROs represents
the key policy rate for the ECB to implement its monetary policy stance.
Marginal lending rate
The interest rate on the Eurosystem's marginal lending facility which banks may use for overnight credit from a national central
bank that is part of the Eurosystem.
Monetary aggregate
Currency in circulation plus outstanding amounts of certain liabilities of monetary financial institutions (MFIs) that have a
relatively high degree of liquidity and are held by non-MFI euro area residents outside the central government sector. The
Governing Council has announced a reference value for the growth of M3.
Outright monetary transactions (OMT)
A program under which the ECB makes purchases ("outright transactions") in secondary, sovereign bond markets, under certain
conditions, of bonds issued by eurozone member states. Conditions for eligibility are that the government has asked for
financial assistance through the ESM or EFSF and that it agrees to implement certain domestic economic measures.
Purchasing Manager Index (PMI)
The Markit PMI series are monthly economic surveys of carefully selected companies compiled by Markit. They provide
advance insight into the private sector economy by tracking variables such as output, new orders, employment and prices across
key sectors.
Securities Markets Programme (SMP)
Interventions by the Eurosystem in public and private debt securities markets in the eurozone to ensure depth and liquidity in
those market segments that are dysfunctional. The objective is to restore an appropriate monetary policy transmission
mechanism, and thus the effective conduct of monetary policy oriented toward price stability in the medium term.
Single Resolution Mechanism (SRM)
The Single Resolution Mechanism complements the Single Supervisory Mechanism. It is set to centralize key competences and
resources for managing the failure of any bank in the eurozone and in other Member States participating in the Banking Union.
Single Supervisory Mechanism (SSM)
The Single Supervisory Mechanism (SSM) is a new system of banking supervision for Europe. It comprises the ECB and the
national supervisory authorities of the participating countries. Its main aims are to ensure the safety and soundness of the
European banking system, increase financial integration and stability, and ensure consistent supervision. The SSM is one of the
two pillars of the EU banking union, along with the Single Resolution Mechanism.

CIO WM Research 12 March 2015

14

European economy

Six-pack
A set of six legal acts adopted in 2011, strengthening procedures for the surveillance of the member states' fiscal policies (the
"Stability and Growth Pact") and introducing new ones for their macroeconomic policies. The aim is to better control public
deficits and national debt and to better address macroeconomic imbalances.
Stability and Growth Pact
The Stability and Growth Pact (SGP) is a rule-based framework for the coordination of national fiscal policies in the European
Union. It was established to safeguard sound public finances, based on the principle that economic policies are a matter of
shared concern for all Member States.
TARGET2
The second-generation TARGET system. It settles payments in euro in central bank money and functions on the basis of a single
IT platform, to which all payment orders are submitted for processing. This means that all payments are received in the same
technical form.
Targeted Long-Term Refinancing Operations (TLTRO)
A new LTRO (see above) announced on June 2014 targeted at business loans, consisting of eight LTROs. The aim of this
refinancing operations is to improve bank lending to the Eurozone non-financial private sector in order to ensure that the supply
of credit will not endanger the recovery of the real economy. TLTROs should also improve the distortions in the monetary
transmission channel. TLTROs will be accessible on a quarterly basis from September 2014.
Treaty on stability, coordination and governance (fiscal compact)
The fiscal compact is an intergovernmental treaty signed by euro area members and other EU member states at the European
Council meeting on 2 March 2012. The treaty requires structural government deficits not to exceed 0.5% of GDP and the
budget to be in balance or surplus. In addition, debt to GDP ratios above 60% of GDP must be reduced over a 20- year period
(subject to a three-year grace period following compliance with the deficit objective).
Two-pack
The second package of proposals on economic governance was presented by the Commission in November 2011 and builds on
the so-called "six-pack" of economic governance proposals. Once adopted, the two draft regulations will introduce provisions
for enhanced monitoring of eurozone countries' budgetary policies.
Unit labor costs
Unit labor costs (ULC) measure the average cost of labor per unit of output and are calculated as the ratio of total labor costs to
real output. A rise in an economys unit labor costs represents an increased reward for labors contribution to output.
Source: BaFin, Bundesbank, ECB, European Union, Markit, OECD.

CIO WM Research 12 March 2015

15

European economy

Appendix
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is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained
herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies,
financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially
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Version as per May 2014.
UBS 2015. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

CIO WM Research 12 March 2015

16