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Global Economics 2017 Year Ahead Regime shift

20 November 2016

Global: regime shift We look for another year of muddling through, with a slight pick-up in both global growth and core inflation. The main risk comes from the US: a big fiscal push could cause the economy to overheat; a big change in trade policy could trigger a recession.

United States: things can go so right…and so wrong The story of 2017 will be the change in leadership in DC. We expect a slow start to the year but acceleration in H2 as tax cuts kick in. We also think that the long awaited uptrend in inflation has already arrived.

Euro Area: the cost of wasted years The Euro area will not grow at a faster pace than in 2016 while inflation will remain weak. We expect more QE in December, but the risk of a policy mistake and premature normalization of monetary policy by the end of 2017 or early 2018 is now high.

Japan: ready for reignition We are upbeat on Japan’s outlook and think consensus is under-estimating the strength of 2017 GDP and inflation. Fiscal policy is poised to turn expansionary, as earlier stimulus measures kick in. The BoJ will likely keep policy settings on hold.

China: a test on transition rather than stability Without further policy easing, we expect GDP growth to inch down to 6.6% in 2017. Our baseline scenario for 2017 is muddling through, to pave the way for the 19th Communist Party Congress election in November 2017.

India: shallow recovery: lower rates vs. black money drive We expect 2017 to see a shallow recovery. Domestic growth will likely be constrained by PM Modi's drive against black money in 1H17, although the bumper harvest will be a buffer. We reiterate our call that recovery will swing on lending rate cuts.

Russia: positive news should be in the pipeline Slowing inflation should support domestic demand and drive modest 1.1% recovery. CBR will likely cut a cumulative 200bp in 2017.

Brazil: don’t let the music stop Confidence and activity data signal a weaker recovery in 2017 with sluggish inflation. Monetary easing is to reach 450bp by 2018, conditional on the external backdrop.

Mexico: an unfriendly external environment Mexico is facing a tough external environment with higher US interest rates, uncertainty regarding US anti-trade and anti-immigration policies, which will dry dollar inflows.

Korea: cautious optimism at time of great uncertainty Policy stimulus should support a continued moderate recovery in Korea. Inflation will gradually rise towards 2% inflation target amid a modest growth...

UK: post-mortem: Brexit has not been as bad as feared The next two years will likely see only weak expansion while sterling driven inflation should peak around 3.0%. We expect the BoE to ease further.

Canada: slip slidin’ away Canada’s growth could improve on government stimulus, but inflationary pressure could dissipate. We expect the Bank of Canada (BoC) to cut rates by 25 bps in 2H 2017.

Australia: record growth, but a weak domestic economy We see another year of sub-trend growth before a rebound in 2018. Weak structural inflation was the surprise this year, prompting another round of policy easing.

Economics Global

Ethan S. Harris Global Economist MLPF&S

Global Economics Team MLPF&S

See Team Page for Full List of Contributors

Timestamp: 20 November 2016 04:00PM EST

http://research1.ml.com/C?q=FhbmNu-qaOibfCEqPcQVLQ

2 Global Economics 2017 Year Ahead | 20 November 2016

Global Ethan S. Harris Global Economist MLPF&S

Regime shift

• We look for another year of muddling through, with a slight pick-up in global growthand a normal risk of recession.

• Aggregate demand is starting to outstrip feeble aggregate supply: look for amodest pick-up in global core inflation.

• The main risk to global growth comes from US: a big fiscal push could cause theeconomy to overheat; a big change in trade policy could trigger a recession.

Growth: the intersection of supply and demand 2016 has been another year of modest downside disappointment (Table 1). For 5 years in a row, we and the consensus came into the year expecting global growth to return to its 3.5%-plus trend, only to see it remain stuck at about 3%. Despite the growth disappointment, however, we correctly forecast a pick-up in global inflation, reflecting a combination of higher core inflation in the US and the stabilization of commodity prices. How is that possible? How can core inflation be stable or rising in an environment of weak growth? In our view, economists and investors need to pay more attention to the supply side of the economy.

When Larry Summers introduced the idea of secular stagnation in 2013 we had three reactions. First, his story of chronic weakness fit Europe and Japan much better than the US. Second, part of the stagnation was cyclical—the result of post-crisis healing and tightening fiscal policy—rather than secular or permanent. And third, the stagnation mainly emanated from the supply-side of the economy—weak demographics and productivity—not the demand side—unwillingness to spend.

Three years later and that third argument seems stronger than ever. In the US, despite weak GDP growth, the unemployment rate has dropped 2.3 pp, and inflation pressures are starting to build. Clearly that is inconsistent with a story of chronic inadequate demand. A similar story holds at the global level: despite repeated growth disappointments, core inflation remains steady (Chart 1).

Table 1: Old and new estimates of 2016 growth and inflation

GDP CPI Current Last year Current Last year

Global 3.0 3.4 2.6 2.8 Developed markets 1.5 2.1 0.8 1.4 Emerging markets 4.1 4.3 4.0 3.8

US 1.6 2.5 1.3 1.6 Euro Area 1.5 1.7 0.2 1.0 Japan 0.7 1.2 -0.1 1.0 China 6.7 6.6 2.0 1.6 India 7.6 7.6 5.6 5.5 Source: BofA Merrill Lynch Global Research Note: “Last year” our forecast for 2016 as of 22 November 2015

Chart 1: Core inflation (% yoy)

Source: BofA Merrill Lynch Global Research, Haver Analytics

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Global Economics 2017 Year Ahead | 20 November 2016 3

Each year forecasters have found a new demand-side explanation for weak growth. They have only reluctantly to cut estimates of potential growth and the global output gap. However, given the stability of core inflation, perhaps they haven’t cut enough. Perhaps the 3% global growth numbers we have been getting every year is the new normal?

Inflation: core call In light of the above, two of our key out-of-consensus calls are on core inflation. As we have argued since the start of the year, the Fed can, will and should allow inflation to overshoot its 2% target. It can because the economy has hit full employment; it will because averaging 2% inflation requires overshooting when the economy is hot, and it should because both the US and the world need a period of modestly above target inflation to help heal the wounds of recent years. The data confirm our call, with many measures of core prices and wages accelerating and Michelle Meyer and team forecasting core PCE inflation to nearly reach 2.0% by end of next year.

This idea of US inflation eventually overshooting has become more accepted over time; an even more out-of-consensus view is that we expect Japan to achieve sustained 1%-plus inflation. After years of disappointment, it is hard to find an optimist in Japan, but our new Japan chief, Izumi Devalier sees reasons for optimism. With a tight labor market and with monetary and fiscal policy working together for a change, Japan is ripe for better growth and a more sustained pick-up in inflation. Netting out the temporary impact of oil price swings, currency moves and consumption taxes, underlying inflation in Japan has already increased from a low of -1.5% in 2010 to slightly positive today. If Abe delivers a real fiscal package and if Trump does not deliver a major blow to trade, the recently strong Japanese data should push core inflation higher.

In other economies we expect a mixture of rising and falling inflation. Inflation is high in countries whose central banks have limited independence and changes in exchange rates have redistributed inflation around the world, but the net effect of all of this is steady, but generally below-target inflation globally.

Policy: finally fiscal Our inflation call is closely tied to the fiscal forecast. We expect modest fiscal easing in developed market (DM) economies and mixed easing and tightening in emerging markets (EM). In the US, president-elect Trump has proposed massive fiscal stimulus, but he still has to deal with the fiscally conservative Congress. Moreover, with the US economy already at full employment, a big stimulus will eventually trigger a much faster Fed hiking cycle. Fiscal plans in Japan always include a lot of “old water” and could disappoint. Fiscal constraints in Europe have eased in the past couple years, but Gilles Moec and team expect ongoing, rather than increasing stimulus next year. Hence one of the regions that needs a major stimulus probably won’t get it.

Chart 2: 10-year yields

Source: Tullett Prebon Information

Chart 3: Unemployment gap and wage growth

Source: Congressional Budget Office, Bureau of Labor Statistics

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Meanwhile the slow monetary policy divergence is likely to continue. We expect the Fed to continue slow hikes in the near term—raising rates this December and again late next year—but we see 3 hikes in 2018 fiscal stimulus kicks in. In Europe maintenance of very easy policy seems more likely than a further experiment with negative rates. We are particularly encouraged by recent BOJ policy. By moving to yield targeting they have insulated Japan from most of the global bond market sell-off of recent weeks (Chart 2). The ECB should be able to reverse some of the sell-off by extending QE at their December meeting. However, QE has become less effective in controlling the bond market in Europe because the commitment is much less clear than in Japan. We expect some easing of monetary policy in countries with high policy rates such as Brazil and Russia, but we expect monetary policy to be on hold in most of EM.

Rotating risks Each year in this recovery has brought a new modest shock: the Euro area crisis, US budget brinkmanship, China hard landing worries, Japan’s consumption tax, and the collapse in oil prices have each taken turn on stage. In the year ahead, the US is back in the spotlight. We see two risks from a Trump presidency. First, with the economy at full employment (Chart 3), the US could get too much of a good thing: a big fiscal stimulus, an overheating economy, faster Fed tightening and a boom-bust outcome. Second, Trump could adopt aggressive populist measures around trade, immigration and the Fed, hurting confidence and growth. Michelle Meyer and team expect a modest dose of both fiscal stimulus and populist measures, but we will not know for sure until campaign rhetoric is translated into detail proposals.

Outside the US a number of risks remain. Chinese debt continues to grow as a share of GDP although it is by no means clear if and when there will be a day of reckoning. Populists pressures are building globally and could eventually threaten the stability of Europe in particular. The Middle East is an ongoing source of concern. For example, if the Iran nuclear deal is overturned what will replace it? Back to sanctions or some kind of military action? Emerging markets are vulnerable to both extremes on US policy: big a big fiscal stimulus could drive up US rates even further drawing capital out of EM; big trade restrictions would likely hurt countries that are heavily dependent on US markets.


United States Things can go so right…and so wrong • The story of 2017 will be the change in leadership in DC. We expect a slow start to

the year but acceleration in H2 as tax cuts kick in.

• The long awaited uptrend in inflation has already arrived. Core PCE inflation willlikely come just shy of the 2.0% target by year-end.

• Heightened uncertainty at the beginning of the year combined with tighter financialconditions should result in only one hike next year, in H2.

What happened this year? It has been a wild ride. The beginning of 2016 was defined by significant risk-off in the markets and concerns over a looming recession in the US. We adamantly argued against the call of an imminent recession, but we did acknowledge that the economy was slowed by the deterioration in financial markets and spillover from weaker global growth. We slashed our forecast for growth this year by nearly a percentage point to the current estimate of 1.6%. Our view on inflation was largely on point, although we did not see quite as much wage pressure as expected since the unemployment rate held steady amid a surprising gain in the labor force participation rate.

Given the backdrop of weaker growth, greater sensitively to global financial conditions and uncertainty as to whether the economy hit full employment, the Fed became increasingly cautious. The Fed has penciled in a shallow cycle with a lower equilibrium and terminal rate, revising the long-term Fed Funds rate to 2.875%.

Themes for 2017 We see three economic themes for the upcoming year:

1. Monetary easing fiscal stimulus.

The Fed is likely to remain cautious at the start of the year, particularly given thatthe composition of voting members is more dovish. However, if and when fiscalstimulus is passed and it starts to filter into the real economy, the Fed's rhetoricwill become more hawkish, setting up for a faster hiking cycle in 2018.

2. Disinflation Inflation:

We expect core inflation to continue to creep higher nearly touching the 2% target.The potential policy changes are generally inflationary including fiscal stimulus,restricted immigration (lower labor force participation rates) and restricted trade(higher import prices). The offset is a stronger dollar.

3. Uncertainty Uncertainty:

We continue to believe that the only certainty is uncertainty. The big risk factorsinclude significant shifts in government policy both here and globally as well aspotential market volatility.

Policy: a seismic change The main source of risk for the next few years – in both directions – comes from policy changes in Washington. Despite the move to single-party government there is a great deal of uncertainty about the actual policies to be implemented. As we noted in the “The Trump economy”, the campaign included a very wide range of policies, including tax reform, infrastructure/defense spending, anti-free trade policies, repeal/replace the Affordable Care Act, restrictions to immigration and changes to the Federal Reserve. We run simulations for the economy under three scenarios:

Baseline: tax reform based on the House plan with a small amount of infrastructure and defense spending, China declared to be a currency manipulator and possible


renegotiation of NAFTA and small changes to immigration policy, but no new tariffs, no attempt to compromise the independence of the Fed and no mass deportations.

Upside for the economy: tax reform is a compromise between the House and Trump plan, $550bn outright in infrastructure spending over 5 years, additional defense/veterans spending, no significant changes to trade or immigration policies. Business and consumer confidence improves.

Downside for the economy: small tax reform possible but with a struggle to come to a deal, no infrastructure spending, declares China to be a currency manipulator, renegotiates NAFTA and threatens tariffs with China and Mexico, much faster deportation of illegal immigrants. This creates greater policy uncertainty

Let’s focus first on the baseline and then on the risks:

Growth: redistribution from H1 to H2 When considering the outlook for 2017 we have to account for the fact that policy changes are unlikely to be implemented until the spring. This means that growth in the beginning of the year will be a function of expectations about policy, which will impact the economy through financial conditions and confidence. The markets are so far taking a glass half-full interpretation with a rally in equities, sell-off in Treasuries and rally in the dollar. David Woo and team expect the trade-weighted dollar to appreciate 8-10% from pre-election levels through June 2017. They expect the 10year Treasury rate to reach 2.6% by middle of next year (up a total of 80bp from pre-election).

This would tighten financial conditions and weigh on economic growth. Based on research from the OECD and simulations of the FRB-US model, a 10% appreciation of the dollar slices an average of 0.5pp from annual real GDP growth over the next two years. And given the most recent experience, we think the economy will start to feel the drag quickly. As we show in Chart 4, there was nearly an immediate impact from the strengthening in the dollar and the widening in the trade deficit.

The combination of tighter financial conditions and heighted policy uncertainty will restrain growth in the first half 2017, leaving us to forecast only 1.5% growth, on average. But we expect a rebound in growth in the second half of the year as tax cuts kick in and stimulate growth, offsetting the drag from the stronger dollar. We are forecasting 2.3% growth in the second half of the year. On net, this leaves growth of 2.0% for full year. The robust end to 2017 also kicks off 2018 on a strong footing; we are forecasting 2.5% growth for 2018.

Chart 4: Dollar strength leads to immediate trade drag (inverse relationship)

Source: Federal Reserve Board, Bureau of Economic Analysis

Chart 5: Expected path of fed hiking cycle (bp)

Source: BofA Merrill Lynch Global Research, Federal Reserve, Bloomberg

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Inflation: approaching target This time last year there was still a fear of disinflation in the markets – concern that low commodity prices, global output gaps and depressed inflation expectations would keep inflation low or falling. By contrast, we saw the seeds of rising inflation. In reality, core PCE inflation has increased 0.3pp over this year to 1.7% yoy. We expect another 0.2pp gain in 2017 to 1.9% and think it is possible that core PCE inflation could hit the target of 2% next year.

It is useful to consider three types of inflation – asset price inflation, wage inflation and price inflation. We have clearly seen the former with the stock market touching record highs and home price appreciation running in excess of income growth. We are now starting to see more sustained gains in wage inflation, although it has been a slow process. After being stuck at 2%, average hourly earnings are up 2.8% but the Employment Cost Index (ECI) is only up 2.3% yoy. The unemployment rate held steady for the better part of this year, limiting the upside to wage inflation, but also suggesting that the economy might have stabilized at full employment. Price inflation is the last to move but we see signs of acceleration, particularly with the edge up in inflation expectations, both market measures and surveys.

Fed: slow for now, faster later We think the Fed is likely to deliver a hike this December but will wait until September 2017 to hike again. That said, we see a risk of the Fed delivering two hikes next year–in June and December – if the weakness in H1 doesn’t materialize. Looking ahead to 2018, we think the Fed will hike three times as GDP growth accelerates to a mid-2% pace, the unemployment rate falls further below NAIRU and core inflation exceeds the 2% target.

The composition of the FOMC is set to change, in a dovish direction next year. However, this could prove temporary as Trump will look to fill the two vacancies on the Federal Reserve Board, and will likely not reappoint Chair Yellen’s when her term ends in February 2018. We would expect relatively hawkish replacements who tend to lean toward rules-based policymaking. Speculation of a more hawkish FOMC in 2018 should prompt the market to price in a faster hiking cycle by the end of 2017.

Risks: scenarios for 2018 and beyond Given the uncertainty around policy changes, the risks to the economic outlook are larger than normal. We see two major tail risks.

In the upside scenario, we think the economy could grow by 3% in 2017 and 3.5% in 2018 while inflation accelerates. This scenario assumes considerable infrastructure spending - the full $550bn over a 5 year period – which is the main reason for the further acceleration in growth in 2018. New infrastructure could boost productivity and increase estimates of potential growth once projects are complete. But in the interim, the substantial increase in actual growth relative to potential (of 1.7% or so) should push wages and inflation higher, raising the risk of a pronounced “boom-bust” cycle. This would be accompanied by a faster pace of Fed hikes would likely result in a slowing in growth in 2019 and beyond.

In the downside scenario a recession is possible if dysfunction in Washington and a focus on trade restrictions and the deportation of illegal immigrants undercuts growth. In this case the economy would start to contract by the middle of next year and be in a full-fledged recession by 2018.

Again, our baseline forecast is benign, but risks are elevated.


Euro Area Gilles Moec Europe Economist MLI (UK)

The cost of wasted years

• The Euro area will not grow at a faster pace than in 2016; 1.4% in 2017 and 1.5% in2018. Inflation will remain weak, 1.2% in 2017 and 1.3% in 2018.

• We expect more QE in December, but the risk of a policy mistake and prematurenormalization of monetary policy by the end of 2017 or early 2018 is now high

• EA “existential issues” will come back to the fore-front, generating volatility. Italywill remain the clearest challenge

The cost of wasted years 2016 was not a bad year for European growth by its own mediocre standards. We expect 1.6% in annual average, a good half-point above what we think is the new potential, and only marginally below our forecasts from December 2015 (1.7%). Achieving this in spite of low foreign traction is all the more remarkable for such a widely open region (exports stand at 30% of GDP, more than twice the US ratio). Indeed, although the Euro area shipments to China have rebounded lately, demand from the US remains low. The Euro area, uncharacteristically, owes most of its decent performance of 2016 to domestic demand, spurred by first and foremost an uncoordinated but very real fiscal push, but also by some recovery in credit origination while consumer spending was buoyed by low energy prices.

The key to the next two years is to identify where the next impetus could come from, in a more constrained context for monetary policy. The ECB provided a nice window of opportunity for governments to improve the Euro area’s institutional set up, while allowing governments some fiscal room for manoeuvre to ease the political cost of unpopular structural reforms.

While we think that in the short run the central bank should be able to maintain the magnitude of its stimulus, the risk of a policy mistake and a premature gradual normalization of monetary policy by the end of 2017 or early 2018 is now high. Then the Euro area would discover very rapidly that the “window of opportunity” has been wasted. We think that the Euro area will not be able to grow at a faster pace than in 2016, and that its “existential issues” will come back to the fore-front, generating significant volatility. Italy, in our view, will remain the key battle-field in the next two years.

We do not expect miracles from foreign traction Of course, the incoming US administration’s policies matter for the Euro area. It is always dangerous to extrapolate from a few days of market reaction, but so far we do not think that the current mix - expectations of a decisive fiscal push in the US, higher market interest rates globally and trade and financial headwinds in emerging markets - is all that positive for the Euro area.

Our US colleagues count on an acceleration in US GDP in the second half of 2017 responding to the fiscal stimulus. This is obviously positive for European exports, but one should not overplay the order of magnitude. According to the OECD's Interlink model, an increase in the US structural deficit of 1% of GDP raises GDP in the Euro area by only 0.1% after one year. If at the same time the volume of demand from EM slows down - either because activity there is hit by observed or expected restriction to free


trade, or because their exchange rate falls - overall foreign traction may not increase that much next year. Recall in addition that we expect a Brexit-driven negative shock to UK demand shaving 0.2% off Euro area GDP growth in 2017.

Weak engines of domestic demand Domestic demand will thus have to remain the main source of support for the European economy next year. While a return to the pre-2014 focus on fiscal austerity is very unlikely in our view, we do expect any significant fiscal push either. In 2016 the four biggest countries of Euro area all engaged in fiscal reflation. In France, Italy and Spain the political cycle – with looming elections and/or the need to buy public opinion support for structural reforms – played a major role, while in Germany the flow of refugees forced unexpected spending worth c.0.5% of GDP. For 2017, while we believe the political cycle will produce more fiscal push in Italy and France, Spain will probably have to contain spending after this year’s and last significant deviation from target while Germany will at a stretch produce the same overall fiscal push as last year between the small tax cuts and additional spending planned in the budget bill for 2017.

We are not very optimistic for the credit impulse either. After a great start to 2016 it has faded in the last few months, especially in the periphery. Expectations of a major regulatory roll-back in the US may spur some animal spirits in European banks, but idiosyncratic issues abound, in particular the degree of flexibility of the new resolution framework, as well as the cost of negative interest rates on banks’ profitability.

Table 2: GDP and HICP forecasts for the Euro area

YA 2016 YA 2017 GDP HICP GDP HICP

2016F 2017F 2016F 2017F 2016F 2017F 2018F 2016F 2017F 2018F Euro area 1.7 1.8 1.0 1.5 1.6 1.4 1.5 0.2 1.2 1.3 France 1.7 1.8 0.8 1.5 1.2 1.1 1.3 0.3 1.2 1.3 Germany 1.5 1.6 1.2 1.8 1.8 1.6 1.5 0.4 1.6 1.6 Italy 1.3 1.6 1.0 1.2 0.8 0.9 1.1 -0.1 0.4 0.6 Spain 2.6 2.2 0.9 1.5 3.3 2.4 1.9 -0.4 1.4 1.3 Source: BofA Merrill Lynch Global Research

Too slow a pace of slack absorption to elicit proper reflation All in all, between mediocre world demand and a lack of momentum in domestic demand, we expect GDP to decelerate in 2017 at 1.4%, thus providing only a marginal reduction in the output gap. We still expect inflation at 0.2 in 2016 and we now expect 1.2% in 2017. With still a decent output gap core inflation should only move a few bps higher in 2017 driven by the weakening currency and the slightly higher growth, not far from the (new normal) 1% (Chart 6).

Headline inflation should reach 1.5% in April next year helped by energy base effects, something that could make market participants and the hawks at the ECB governing council nervous (feeding our concerns of a policy mistake later that year). But this should fade a bit in the second half of the year.

For 2018 we still expect inflation at 1.3%. Core inflation should move 30bps higher, with goods inflation helped by the weaker currency and service inflation gaining some traction as the output gap keeps closing. We expect average core inflation of 1.3%. But the smaller contribution of more volatile items will keep overall inflation subdued.

And even if the central scenario is one of very subdued inflation we will warn, once again, that risks are clearly biased to the downside. Wage evolution remains weak, and as ECB´s vice-president Constancio highlighted recently “core inflation, depending on domestic factors, is not recovering which may affect the dynamics of headline inflation going forward.” We remain worried about the potential presence of second round effects on wage formation. 2017 will be the year that will show whether those second round effects are becoming entrenched. Also, the de-anchoring of inflation expectations


we have highlighted will be another source of concern regarding the evolution of (core) inflation (Chart 7).

Monetary stimulus safe for now If one ignores the unique political environment of the ECB, we don’t think there can be much of a debate on the monetary policy stance: at least the same quantum of QE, for long, should be the straightforward answer to a period of protracted below-target inflation which we think will continue across our entire forecasting horizon. In addition, ultra-low borrowing costs for governments are in our view the only way to avoid a return to the pre-2014 austerity.

More fundamentally, the expectations of higher inflation and higher fiscal deficits in the US are contributing to a market-led tightening in financial conditions in Europe. Inferring from past responses of the ECB’s forecasts to changes in long term interest rates assumptions, a 30bps increase in 10 year yields on average on the European markets would reduce GDP growth in the Euro area by 0.1%. We are already there relative to the ECB’s September forecasts, and beyond in fragile countries such as Italy.

We think that the ECB’s stimulus is safe for now and that, given the mounting uncertainty, the Governing Council in December will choose to maintain QE at the current pace of EUR80bn until September 2017. We are more nervous about “the one after next” with the political pressure on the ECB mounting.

ECB torn between the two forms of European populism Just like everywhere else in the developed world the Euro area is facing mounting populist forces which reject the consensual economic management of the Great Recession and its consequences. Those forces are not necessarily consistent though, and monetary policy is at the heart of these inconsistencies.

One form of populism – promoted among others by emerging far left forces such as Podemos in Spain – insists on a more complete reversal of the fiscal stance towards a more ambitious reflation, combined with a roll-back of the structural reforms conducted since the crisis. This form of populism is usually not anti-European, but requires a further re-thinking of the European fiscal rules, with some form of transfer union as well as “loose monetary policy forever”.

A second form – epitomized for instance by far-right forces such as AfD in Germany – rejects any progress towards fiscal union, and would actually roll-back on what has already been painfully achieved – such as the embryonic banking union. The potion for the periphery is basically a swift return to fiscal austerity and far-reaching structural

Chart 6: Euro area headline and core inflation – BofAML forecasts

Source: BofA Merrill Lynch Global Research

Chart 7: Current core inflation increasingly impacting long term expectations in the Euro area

Source: BofA Merrill Lynch Global Research Note: The chart shows the slope of the regression of LT SPF forecasts on current core inflation, with rolling windows of 29 quarters

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reforms, while monetary policy should move away from negative or zero interest rates but conversely promote saving.

On balance, we think the ECB will ultimately err towards accommodating the first brand of populism, because the second one is probably more quickly conducive to a dislocation of the monetary union, an because in context of protracted low inflation this will be more consistent with its mandate, but market pressure will probably be needed to focus minds in the Governing Council. In other words, after the December 2016 instalment, we do not think the ECB will have the luxury of being pro-active. Volatility will rise. Europe will once again find that it delivers progress only as a response to existential crises.

Italy is the clearest challenge Since Brexit and the election of Donald Trump the market is likely to raise the probability of fringe scenarios on every major political events in the near future. We can already see how investors have become more inquisitive than usual on the looming Dutch, French and German elections (March, April/June, September 2017). Italy, with the Constitutional referendum looming on 4 December, is the most immediate challenge.

The configuration there is complicated. Growth has been back in positive territory but remains weak. Progress on structural reforms has stalled after swift efforts last year, while the cycle is dependent on repeated deviations from fiscal targets, which support domestic demand but slows down the reduction in public debt (Chart 9). The banking sector is fragile. Local actors are quick to blame the European rules for this, while out of Italy impatience around the lack of decisive progress on NPL in mounting.

The referendum though is less binary than what a lot of observers believe, in our view. Immediate concerns over political stability, in case of a rejection of the government sponsored reform, are not necessarily warranted since the parliamentary majority would likely remain intact. The elections in 2018 are probably more a concern, especially if the new electoral system (“Italicum”) is enforceable by then, which would make it easier for a eurosceptic movement to get to power, but we note that the commitment to Europe of the mainstream parties remain strong.

Chart 8: Percentage of respondents that tend not to trust the ECB?

Source: Eurobarometer, BofA Merrill Lynch Global Research

Chart 9: Debt sustainability analysis, Italy (% GDP)


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Japan Izumi Devalier Japan Economist Merrill Lynch (Japan)

Ready for reignition

• We are upbeat on Japan’s outlook and think consensus is under-estimating thestrength of 2017 GDP and inflation

• We forecast GDP to rise 1.4% in CY2017, led by domestic demand. Fiscal policy isalso poised to turn expansionary, as earlier stimulus measures kick in

• Japan-style core inflation to rebound to 1.0% in CY2017, from -0.3% in CY2016.With inflation moving in the right direction, the BoJ will keep policy settings on hold

Out of the sideways channel Japan’s economy got off to a strong start in 2016 with growth jumping 2.1% q-o-q saar in Jan-Mar on the back of a robust expansion in private consumption. However, household spending lost steam in Apr-Jun and Jul-Sep. Instead, it’s external demand that has helped pull Japan out of the de facto zero growth channel of recent years. Having bottomed out earlier this year, Japanese manufacturing activity has been picking up, thanks to a synchronized acceleration in global growth. Net exports helped boost Jul-Sep growth to 2.2% q-o-q saar—the fastest expansion since Jan-Mar 2015. In contrast, domestic demand has stayed weak. However, we are increasingly confident that domestic demand will become a reliable growth engine in 2017 and believe consensus is underestimating the strength of inflation and growth next year. With the economy firing on all cylinders for the first time since the consumption tax hike, we expect growth to accelerate to 1.4% in CY2017 (consensus: 0.8%), up from 0.8% in CY2016. Japan-style core inflation will likely rebound to 1.0% in CY2017, up from -0.3% in CY2016, allowing the Bank of Japan to keep policy on hold for the foreseeable future.

Goodbye fiscal austerity Why the optimism? The most obvious driver is a change in the increased level of policy support: for the first time since 2013, both fiscal policy and monetary policy will be stimulative in 2017. On the monetary policy front, the BoJ’s transition to yield-pegging ensures that real yields will stay low, even as inflation picks up. Meanwhile, the government recently passed a second supplementary budget, comprising roughly JPY7.5trn (1.5% of GDP) of “real water” spending. This should ensure that Japan’s fiscal impulse turns expansionary next year, following three years of tightening. The risk of another policy error is low. Policymakers now recognize that premature fiscal tightening

Chart 10: Contribution to Japan GDP growth (ppt)

Source: BofA Merrill Lynch Global Research forecasts, CAO

Chart 11: After 3 years of tightening, fiscal policy to turn loose in FY17

Source: BofA Merrill Lynch Global Research, IMF, CAO

-2.0

0.0

2.0

4.0

2011 2012 2013 2014 2015 2016 2017Private demand Public demandNet exports Real GDP growth %YoY

Forecasts

-1.0

0.0

1.0

2.0

3.0

FY 10 FY 11 FY 12 FY 13 FY 14 FY 15 FY 16 FY 17Fiscal impulse (change in cyclically-adjusted primary balance), % GDP

Contractionary

Expansionary

Forecasts


and stop-gap stimulus are counterproductive when private sector credit demand is still in its nascent stages of recovery. If anything, we see upside risks from greater fiscal stimulus. Though not part our forecasts, we see a good chance that the government will deliver further fiscal easing via a third supplementary budget or a relatively aggressive ordinary budget, especially if downside risks to the external outlook materialize.

The return of domestic demand Pragmatic policymaking is only one pillar of our call for Japan’s outperformance in 2017.

Instead, our confidence in the sustainability of the current recovery is also based on the belief that the stars are aligning for an organic improvement in domestic demand. Specifically, we see three catalysts:

1. Consumer comeback: Beyond the direct shock from the 2014 tax hike, two factorsare responsible for the recent consumption slump: 1) a squeeze on disposableincome from higher taxes and social security contributions; and 2) a surge in thesaving rate. We expect both headwinds to ease in the coming quarters: wage andemployment trends have been firm, and consumer confidence is improving.

2. Capex recovery: Meanwhile, the combination of 1) low for longer real rates, 2) animproved demand outlook, and 3) deepening supply-side constraints offer a strongincentive for Japan inc. to accelerate productivity-enhancing capex. The impetusshould be stronger in the non-manufacturing sector, where capacity utilization ratesare higher, and labor shortages (and hence wage pressures) are more acute.

3. Policy priorities and redistribution: We also think a shift in government policypriorities should speed up income redistribution at the margin, ensuring that moneycirculates to agents with a higher propensity to consume. For example, thegovernment will use further sticks and carrots to encourage corporates’ to disgorgetheir cash/liquid assets. Reducing labor market duality has also become a policyfocus, with the government aiming to boost the incomes of non-regular and part-time workers. However, it is too early to say whether the reforms would besufficiently aggressive to make a significant impact.

What’s missing? Missing in all of this is visibility on further supply-side reforms to boost productivity. While we think there is still some runway for wages to rise before threatening profits, we’ll need to see more evidence of productivity improvements to have confidence that the current expansion is durable. The government should focus on increasing labor market flexibility, providing job training opportunities, and accelerating deregulation.

Risk factors External developments pose the greatest risks to our forecasts. Specifically, we are monitoring how political transitions in the US and Eurozone affect the outlook for global trade growth, as well as FX. Main downside risks include another leg down in global trade and strengthening of the yen. This could happen if the US pursues aggressively protectionist trade measures under President-elect Donald J. Trump. We also remain cautious about political risks in the Eurozone. On the positive side, increased fiscal spending and higher rates in the US could be a boon for Japanese exports and corporate profits, raising upside risks to our external demand forecasts.


China

Yin Zhang China Economist Merrill Lynch (Hong Kong)

Helen Qiao China & Asia Economist Merrill Lynch (Hong Kong)

Xiaojia Zhi China Economist Merrill Lynch (Hong Kong)

China: A test on transition rather than stability • Without further policy easing, we expect GDP growth to inch down to 6.6% in 2017,

as growth driver shifts from investment to consumption.

• Despite lower real interest rates, investment demand will likely soften due toproperty policy tightening and weaker support on infrastructure funding.

• Our baseline scenario for 2017 is muddling through, to pave the way for the 19th

Communist Party Congress election in November 2017.

Reversal of rebalancing? China seemed to have witnessed a surprising reversal of rebalancing in the year of 2016. From the trough level in late summer 2015, growth has rebounded with the help of stronger infrastructure and property investment demand. While consumption growth held up relatively well, policy loosening gave a notable boost to investment growth, lifting PPI inflation back into positive territories.

Meanwhile, China also managed to add more leverage in government and household sectors this year, despite deleveraging efforts by private firms. If we take into account the bond swap for local government financing vehicles and the special infrastructure construction fund from policy banks, the pace of total social financing growth has picked up notably from last year’s levels (see Chart 12).

But all is not lost… Perhaps nothing different from during the previous mini cycles, policy intervention helped ease the pain from downward pressure on growth, but it hasn’t reversed the trend of structural transition. We think the economy is still undergoing important transitions while China awaits future reforms:

Chart 12: Credit expansion has picked up its pace since 2H15

Source: BofA Merrill Lynch Global Research, PBoC, CEIC

Chart 13: The share of consumption and services in GDP to continue rising

Source: BofA Merrill Lynch Global Research, NBS, CEIC

10

14

18

22

26

30

2011 2012 2013 2014 2015 2016RMB loans Adjusted TSF

%, yoy

30%

35%

40%

45%

50%

55%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016F

Household ConsumptionServices

% share of GDP


1. Consumption vs. investment: Even with stronger investment this year, the trend ofChina transitioning into a consumption-oriented, service-driven economy remainsunchanged, as we still expect the share of consumption and service in GDP to risefurther this year (see Chart 13). In the coming year, investment demand will likelysoften due to property policy tightening and weaker support on infrastructure funding.

2. Deleveraging vs. releveraging: The pace of leverage buildup relative to outputgrowth has likely slowed. Despite releveraging of government and householdsectors, nominal GDP growth has edged up with the help of PPI deflation turninginto inflation. As a result, leverage as measured by credit to nominal GDP ratio stilledged up this year, but at a slower pace than before (see Chart 14).

2017: time for redemption Going into 2017, we believe the policy support has already tapered and will remain weak unless growth surprises on the downside. After seeing growth rebounding in 2016, policy makers have become more confident of fundamental growth resilience, and thus more complacent about countercyclical policy management. Consequently, in the absence of a notable growth deceleration, it is hard to make a strong case for further easing in monetary policy, fiscal policy or property policy in the near future.

Payback of previous easing may not be avoidable. With tightening measures adopted on housing purchase and mortgage lending, home sales is reported to have dropped notably in the early weeks of Oct. Foreseeing continued weakness in sales, developers will likely cut residential investment as early as in 1Q2017, in our view (see Chart 15). In addition, the debate on Special Infrastructure Fund through policy banks will likely weaken the funding support for infrastructure investment going forward (see Infrastructure investment to hold up in 2H before tapering off in 2017, 07 Sep 2016).

A moderate growth slowdown with mild inflation Our baseline scenario for 2017 is muddling through, to pave the way for the 19th Communist Party Congress (CPC) election in November 2017. The election will be key to watch, given as many as 5 standing committee members (out of a total of 7) of the Central Politburo could be replaced. With the cabinet reshuffling already under way since 3Q2016, we expect policy implementation to become more effective from early 2018 onwards, as the newly appointed officials will potentially enjoy a higher level of trust from higher leadership.

But in the near term, we expect GDP growth to inch down to 6.6% YoY in 2017, as growth driver shifts back towards consumption. For 2018, with a new cabinet in place, we expect GDP growth to remain stellar at 6.6% YoY, helped by more fiscal easing. With lower interest rates in real terms (see Chart 16), we also believe private sector investment has bottomed out and will strengthen further (see Chart 17).

Chart 14: The pace of leverage buildup to GDP growth has likely slowed

Source: BofA Merrill Lynch Global Research estimates, NBS, CEIC

Chart 15: Residential FAI growth usually lags sales recovery by 2qtrs


87 84 80 80 95 93 94 102 106 112 121 126 17 18 18 19

28 29 25 29 33 37 41 46 30 28 23 20

22 21 20 20 21 21 23 24

12 11 12 12 16 18 18 19 22 24

28 32 146 141 134 131

161 161 157 171 182 194213

0

50

100

150

200

250

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

3Q16

Corporate debt Local govt debtCentral govt debt Household debt

% GDP 229

-10

0

10

20

30

40

-40-20

020406080

1Q07

1Q08

1Q09

1Q10

1Q11

1Q12

1Q13

1Q14

1Q15

1Q16

Home sales in floor space

Residential FAI lagged by 2qtrs (RHS)% yoy % yoy


In both years, we expect trade growth to improve. We admit there is increasing uncertainty on trade imposed by potential protectionist policies overseas, but remain hopeful the actual US trade policy mix will be less hostile than that in campaign rhetoric (see Too early to worry about trade barriers, 10 Nov 2016). In addition, the highly integrated global supply chain and the dependence of US corporate and households on imports from China keep the risks of an outright trade war low, our view.

With weaker investment demand, we expect CPI inflationary pressure to remain subdued in the coming years. As investment growth decelerates in 2017, income growth will likely decelerate, which keeps inflationary pressure at bay, before it picks up slightly in 2018. Meanwhile, we believe PPI inflation will be here to stay in the next two years, although at rather low levels. Our forecast for CPI inflation is 1.8% YoY for 2017 and 2.1% for 2018, and PPI inflation is 1.8% for 2017 and 2.0% for 2018.

Risk scenario will test policy makers’ resolve on transition The importance of the upcoming CPC election implies policy makers will likely leave major reforms for the next term, to ensure a stable economic environment in 2017.

In our view, the potential risks will arise from the external front, such as trade disputes with the U.S., exchange rate management and capital outflow. But even in a downside scenario where macro stability is challenged, we believe the government has the resources needed and willingness to use them to regain control, which include but are not limited to demand-boosting measures (especially through infrastructure investment), tightening capital control and using remaining room in monetary and fiscal policy to support growth.

Therefore, we view the real challenge for Chinese policy makers as to avoid derailing the ongoing transition towards consumption and services, rather than to maintain stability. To further promote this trend, we hope to see more progress in deregulation and SOE reforms going forward.

Chart 16: Real interests rates for corporates eased as PPI turned positive

Note: Real 1y lending rate = 1y benchmark lending rate - PPI inflation Source: BofA Merrill Lynch Global Research, NBS, CEIC

Chart 17: Private investment may stabilize, instead of weakening further


-10

-5

0

5

10

15

20

2008 2009 2010 2011 2012 2013 2014 2015 2016

PPI 1y benchmark lending Real 1y lending%

05

101520253035

Mar-1

2

Jul-1

2

Nov-1

2

Mar-1

3

Jul-1

3

Nov-1

3

Mar-1

4

Jul-1

4

Nov-1

4

Mar-1

5

Jul-1

5

Nov-1

5

Mar-1

6

Jul-1

6

Private investmentInfrastructure investment

% yoy


India Indranil Sen Gupta India Economist DSP Merrill Lynch (India)

Shallow recovery: Lower rates vs black money drive

• We expect the RBI to cut 50bp by April. This should translate into 50-75bp oflending cuts by September.

• We see a shallow recovery driven by lending rate cuts and 7th Pay Commissionstimulus. The adverse wealth effect from demonetization will be a dampener.

• The main risks are poor rains, higher oil prices and any failure of the drive againstblack money.

We expect 2017 to continue to see a shallow recovery, like 2016. We, in fact, are cutting down our growth forecasts by 30bp to 7.4% in FY17 and by 70bp to 7.6% in FY18 in the new GDP series (Chart 18). In the old GDP series as well, we cut our growth forecasts by 50bp to 5% in FY17 and 75bp to 5.3% in FY18. Besides, weak global environment, domestic growth will likely be constrained by PM Modi's drive against black money in 1H17, although the bumper harvest will be a buffer. Lending rate cuts, sparked off by the shift of black money to the banking channel, should support growth towards end-2017. On balance, we reiterate our standing call that recovery will swing on lending rate cuts. (See, 7.1%/4.2% GDP: Lending-rate cuts key to recovery 31 August 2016.)

Consumption over investment: We remain bullish on consumption relative to investment, although adverse wealth effect from PM Modi’s black money drive will hit demand. The proposed implementation of the Goods and Services Tax in April could also lead to some postponement of discretionary demand. Other key drivers - lower lending rates, continuing fiscal stimulus in the form of the 7th Pay Commission outgo, lower oil import bill and well as revival of rural demand on a good harvest - will provide a buffer. High lending rates as well as weaker growth prospects will continue to constrain investment. See, BofAML India Rural ACT firming up 18 September 2016.)

5% inflation to lead to 50bp RBI repo rate cut by April We expect the RBI to cut a final 50bp to 5.75% by April with inflation set to remain in its 2-6% CPI inflation target (Chart 19). This assumes normal rains. The RBI MPC should

Chart 18: 50 bp rate cuts by April…

Source: BofA-ML Global Research Estimates, RBI

Chart 19: CPI Inflation on track to meet RBI’s 5% March 2017 target

Source: BofA-ML Global Research Estimates, MoSPI

5.5

6

6.5

7

7.5

8

Jan-

14Ma

r-14

May-1

4Ju

l-14

Sep-

14No

v-14

Jan-

15Ma

r-15

May-1

5Ju

l-15

Sep-

15No

v-15

Jan-

16Ma

r-16

May-1

6Ju

l-16

Sep-

16No

v-16

Jan-

17Ma

r-17

May-1

7Ju

l-17

Sep-

17No

v-17

Jan-

18Ma

r-18

%

Repo rate

3

4

5

6

7

8

May-1

4Au

g-14

Nov-1

4Fe

b-15

May-1

5Au

g-15

Nov-1

5Fe

b-16

May-1

6Au

g-16

Nov-1

6Fe

b-17

May-1

7Au

g-17

Nov-1

7Fe

b-18

CPI inflation BofAML forecast


be able to meet its March 2017 5% RBI target. In 2017, as well, we expect inflation to average 5% within the RBI’s 2-6% band.

We expect the RBI to cut 25bp each on December 7 and April to support growth in view of low inflation (Chart 19). Although we have been ahead of the Street calling for RBI rate cuts, we see limited downside from the current 5.75%. After all, the RBI repo rate, at 6.25% currently, has already dipped below the medium-term average 7% CPI inflation.

(Do read 7.1%/4.2% GDP: Lending-rate cuts key to recovery 31 August 2016.)

Black money deposits, RBI OMO to cut lending rates 75bp We expect lending rates to come off 50-75bp by September driven by sufficient liquidity. Our estimates suggest that banks should be able to fund loan offtake of 15-16%. In our view, lending rate cuts hold the key to recovery. After all, real lending rates are running at a 20-year high at a time of weak growth (Chart 20-Chart 21). (see, Modi’s fight against black money to cut rates 09 November 2016.)

Demonetization to lead to lower RBI OMO. We expect the RBI to cut down OMO to offset demonetization as it should be able to meet cash demand by a smaller expansion of balance sheet/reserve money. Y-o-y currency offtake, for example, is currently running at US$39bn in line with our forecast of FY17 reserve money requirement of US$40bn. If there is US$5-10bn of demonetization, the RBI will can cut down OMO to that extent, if permitted by the RBI Act to write off at all (see RBI: Demonetization = Lower RBI OMO 11 November 2016).

Chart 20: Industrial lead indicator has weakened in recent months

Source: BofA Merrill Lynch Global Research, MoSPI

Chart 21: Real lending rates are running at historical highs…

Source: BofA Merrill Lynch Global Research, CSO, Bloomberg

Chart 22: Fiscal deficit is under control…

Source: BofA Merrill Lynch Global Research estimates, MoSPI

Chart 23: … as is the current account deficit

Source: BofA Merrill Lynch Global Research estimates, RBI

-4

0

4

8

12

16

Aug-

07Ma

r-08

Oct-0

8Ma

y-09

Dec-0

9Ju

l-10

Feb-

11Se

p-11

Apr-1

2No

v-12

Jun-

13Ja

n-14

Aug-

14Ma

r-15

Oct-1

5Ma

y-16

Avg. IIP growth (current & corresponding month last year, %…

0

5

10

15

7

9

11

13

15

17

Jan-

97Oc

t-97

Jul-9

8Ap

r-99

Jan-

00Oc

t-00

Jul-0

1Ap

r-02

Jan-

03Oc

t-03

Jul-0

4Ap

r-05

Jan-

06Oc

t-06

Jul-0

7Ap

r-08

Jan-

09Oc

t-09

Jul-1

0Ap

r-11

Jan-

12Oc

t-12

Jul-1

3Ap

r-14

Jan-

15Oc

t-15

Jul-1

6

SBI prime lending rateSBI base / 1y MCLR rate

%

2.03.04.05.06.07.08.0

FY81

FY83

FY85

FY87

FY89

FY91

FY93

FY95

FY97

FY99

FY01

FY03

FY05

FY07

FY09

FY11

FY13

FY15

FY17

E

Central Govt Fiscal Deficit (% of GDP)

0.01.02.03.04.05.06.0

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

FY18

CAD(% of GDP)


Table 3: Poor global growth compressing CAD

Item

FY15 (US$

84/bbl) 1QFY

16 2Q

FY16 3Q

FY16 4Q

FY16

FY16 (US$

45.7/bbl) 1Q

FY17

FY17E (US$

49.5/bbl)

FY18E (US$

61/bbl) Current Account -26.8 -6.13 -8.56 -7.12 -0.34 -22.15 -0.30 -29.3 -56.5% of GDP -1.3 -1.2 -1.7 -1.3 -0.1 -1.1 -0.1 -1.3 -2.2Trade balance -144.9 -34.2 -37.2 -34.0 -24.8 -130.1 -23.8 -131.2 -170.5 - Exports 316.5 68.0 67.6 64.9 65.8 266.4 66.6 268.0 286.7 - Imports 461.5 102.2 104.7 98.9 90.6 396.4 90.4 399.2 457.2 o/w Oil imports 138.3 24.7 23.5 19.9 14.6 82.8 18.9 88.0 118.7o/w Gold imports 34.4 7.5 10.0 9.0 5.3 31.8 3.9 31.5 35.1Invisibles 118.1 28.0 28.6 26.9 24.4 107.9 23.5 101.9 114o/w private transfers 66.3 16.2 16.3 15.2 15.0 63.1 14.0 65.0 75.0 o/w income from reserve assets 3.2 0.7 1.0 0.8 0.8 3.3 0.8 6.0 10.0Capital Account 89.4 18.7 8.1 10.9 3.5 41.2 7.1 57.5 95.0Foreign investment 73.5 10.2 3.2 11.3 7.3 31.9 6.2 55.0 70.0 - FDI 31.3 10.0 6.5 10.7 8.8 36.0 4.1 35 40 - FII+ 42.2 0.2 -3.4 0.6 -1.5 -4.1 2.1 20 30Banking capital 11.6 11.0 7.3 1.3 -9.0 10.6 -0.1 -6.5 10 - NRI deposits 14.1 5.9 4.2 1.6 4.4 16.1 1.4 0 10External assistance 1.7 0.3 -0.1 0.3 1.0 1.5 0.7 2 2 ECBs 1.6 0.4 -1.7 -0.9 -2.4 -4.5 -2.1 5 8 Short term credit -0.1 -2.4 -0.1 -1.8 2.6 -1.6 -0.3 2 5 Other Capital 1.1 -0.9 -0.4 0.7 4.0 3.3 2.9 0.0 0.0 Errors and Omissions -1.1 -1.1 -0.4 0.3 0.2 -1.1 0.2 0.0 0.0 Overall balance 61.5 11.5 -0.8 4.1 3.3 18.0 7.0 28.2 38.5 Memo RBI's forex intervention 56.5 10.4 -1.7 3.0 1.5 13.2 5.5 20.2 26.5 Import Cover (in months) 8.9 10.9 11.7 11.2

Source: RBI, BofA Merrill Lynch Global Research estimates.

Twin deficits remain under control We expect India's twin deficits to remain under control. Finance Minister Jaitley should be able to contain the Centre's fiscal deficit at about 3% of GDP if he can raise about 1% of GDP of additional income tax from unearthing black money. With oil set to average at US$61/bbl, the current account deficit will likely end FY18% at 2.2% of GDP, slightly higher than 1.3% of GDP in FY17 (Table 3).

RBI to continue to recoup FX; Rs68/US given strong USD We continue to expect the RBI to recoup FX reserves to guard against contagion. Yes, the import cover has risen to 9.5 months, on 1-year forward basis, above the 8 months we see necessary for INR stability. At the same time, the ratio of FPI equity and debt portfolio to FX reserves has jumped to 121% from 71% in 2007. Against this backdrop, our FX strategists expect the INR to ease to slip to Rs68-69/USD levels with the US Dollar strengthening to 1.02/euro. (See, Zero CAD: RBI to buy FX 22 September 2016.)

UP polls kick off 2019 political cycle We advise investors to track the early 2017 Ounjab and all-important summer 2017 Uttar Pradesh polls that will kick off the next political cycle culminating with the mid-2019 general elections (Table 4). Markets will likely look through the other state elections – in Goa, Manipur, Uttarakhand – held alongside. See, India Economic Watch: Opinion polls: Uttar Pradesh 2017 clouded picture 29 August 2016

Table 4: 1H17 will see key polls in UP and Punjab

States Election dates State government Chief Minister Opposition Leaders Rajya Sabha Seats Punjab Feb-Mar 2017 SAD Prakash Singh Badal Aam Aadmi Party (AAP), Amarinder Singh (INC) 7 Manipur Feb-Mar 2017 INC Okram Ibobi Singh Ibohalbi Singh (TMC) 1 Goa Feb-Mar 2017 BJP Laxmikant Parsekar Pratapsingh Rane (INC) 1 Uttarakhand Feb-Mar 2017 INC Harish Rawat Ajay Bhatt (BJP) 3 Uttar Pradesh Apr-May 2017 SP Akhilesh Yadav Mayawati (BSP), Om Prakash Singh (BJP), Rahul Gandhi (INC) 31 Source: Media reports


Russia Vladimir Osakovskiy Russia, CIS Economist Merrill Lynch (Russia)

Positive news should be in the pipeline

• Our calls: Political news flow should turn more market-positive, as Russia will likelybe more conciliatory with the new US president. Inflation to reach CBR’s 4% target,pushing the CBR to resume its monetary easing already in 1Q17.

• Main view: Slowing inflation should support domestic demand and drive modest1.1% recovery. CBR will likely cut a cumulative 200bp in 2017 as RUB will likelystabilize further on stronger oil and even despite structurally weaker CA.

• Main risks. Oil and the lingering political crises remain the key risks to our outlook.An escalation of tensions or an oil price decline could trigger a new round of capitalflight and a decline in investment, while the reverse could boost the growth outlook.

Geopolitical noise should start to fade After volatile 2014-2016 the political news flow on Russia should start to be more positive for the market going forward. We reiterate our view (see: Politics to replace geopolitics) that Russia has historically tended to adopt “market-friendly” government policy whenever oil prices have been relatively low and fiscal conditions tight (Chart 28). As fiscal tensions will most likely remain in place for the near future, this should keep Russian foreign and domestic policy less disruptive for the economy than in the past. The recent political change in the US could become an important trigger for such a change. Russian foreign policy stance needed review regardless of the US election outcome. However, with the likely general re-set of US-Russia relations under a new US administration, such a change could be easier to implement from a political perspective.

Sanctions sustainability in focus The potential removal of Russia sanctions by the EU and/or the US will likely be one of the important themes of 2017. Although it is hard to expect drastic reversal of Western stance towards Ukrainian crisis, we note that a new administration in the US could put additional pressure on Ukraine to deliver on its side of the Minsk agreement (see: Another re-set?). On top of that likely review of the Russia’s approach to all geopolitical issues, this could increase the possibility of an eventual resolution of the crisis in any

Chart 24: Russia tends to be more market-friendly with lower oil

Source: Bloomberg, BofA Merrill Lynch Global Research

Chart 25: CPI to hit 4% target opening doors for 200bp cut in 2017

Source: CBR, BofA Merrill Lynch Global research

0

20

40

60

80

100

120

140

Jan-

70Ju

l-72

Jan-

75Ju

l-77

Jan-

80Ju

l-82

Jan-

85Ju

l-87

Jan-

90Ju

l-92

Jan-

95Ju

l-97

Jan-

00Ju

l-02

Jan-

05Ju

l-07

Jan-

10Ju

l-12

Jan-

15

Oil price, $/bbl 10y MA

Privatization, Gaidar reforms Start of

Perestroika

Georgia war

Yukos case

US-Russia “Reset”

Ukraine crisis

Afganistan war

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Jan-

16

Mar-1

6

May-1

6

Jul-1

6

Sep-

16

Nov-1

6

Jan-

17

Mar-1

7

May-1

7

Jul-1

7

Sep-

17

Nov-1

7CPI (% yoy) 2017 CPI target

CBR key rate


way. One of the main implications of the theoretical removal of Western sanctions would be a further reduction of forced political deleveraging. This could provide stronger support to the RUB through further reduction of structural capital outflows.

Monetary easing to resume already from 1Q17 Inflation is expected to reach ambitious CBR’s target of 4% by 2017 eop. The existing disinflation trend will likely continue to benefit from the persistent weakness of domestic demand, further strengthening of the RUB as well as the relatively robust base effect and provided lack of negative surprises like any major crop failure (see: The real policy rate). With an implicit real policy rate target of over 3% such an outlook continues to suggest that the CBR could still cut its policy rate by at least 200bp in 2017 eop (Chart 24), Moreover, there will also be a good case for the CBR to deliver a 25-50bp rate cut as early as in February. By then the headline inflation will lose about 150bp from its level at the moment of the last rate cut in September. Trend inflation as well as inflationary expectations will likely show similar dynamics. The CBR will also have all the information about 2017-19 budgets as well as tax and tariff policies. As a result, the outlook for 2017 should therefore be clearer, which should give reasons for a cut.

Disinflation as driver for consumer recovery We also think that such pronounced disinflation throughout the year will likely become an important driver of the expected economic stabilization and modest recovery. Nominal wage growth has never interrupted even in the worst periods of the recession and is expected to continue to quite modest 5%-6% growth in 2017 with a considerable upside risk (Chart 25). Such nominal growth should start to exceed projected inflation, effectively pushing real wages into positive growth territory. An additional support to consumer incomes is expected to come from the planned indexation of pensions and one-off transfer in January. As a result, stabilization and recovery of real incomes dynamics should quickly translate into a stabilization and recovery of consumer spending (see: Disinflation as driver of recovery).

Profits and the end of deleveraging to boost investment Slowing inflation should also provide additional support to investment demand. Thus, the main for investment recovery should be corporate profits, as they remain the key source of investment resources. Profits jumped by over 70% in 2015 and remain strong in 2016, which in itself should eventually bring stabilization and recovery of investment spending (Chart 26). Slowing inflation should provide additional support to investment by further stabilizing the macroeconomic background, support real value of profits and helping to bring down borrowing costs. Over the past two years, the positive impact of profits might have been limited by forced deleveraging. However, the impact of these factors should further fade, potentially opening doors for investment recovery.

Chart 26: Strong profits should eventually stabilize and boost investment

Source: RosStat, BofA Merrill Lynch Global research

Chart 27: Consumer incomes to outpace inflation from 2H16 onwards


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Fiscal policy a source of possible surprises Fiscal policy is set to remain in the consolidation mode with the resulting negative contribution to growth even despite 2016 slippage, which should be one-off in nature (Chart 29). However, we emphasize that the approved fiscal framework could be a subject to change during the year, given the approaching presidential elections in early 2018. The likelihood of such adjustments could increase either in case of a tentative deterioration of political support to the incumbent or in case of a major recovery in oil prices. However, with a very conservative $40/bbl assumption in the approved budget, the latter will bring sizeable additional revenues, potentially opening doors for higher spending even with an unchanged 3% of GDP deficit target. In this case, we think that fiscal policy could provide an additional support to consumer demand as spending hikes will most likely be targeted at boosting consumer incomes. However, our baseline expectation is that the government will use such additional spending to cut budget deficit and preserve the remaining fiscal buffers, which is the main reason for our optimistic outlook of 1.4% budget deficit next year.

Reforms agenda is linked to elections Presidential elections will also likely impact the potential reform agenda for the next several years. We reiterate our view (see: Changing under pressure) that the government will primarily focus on the measures with a tangible fiscal benefits, as weak economic growth is largely acceptable from the domestic political perspective. Some of the measures like privatization, optimization of public sector and even part of pension reform might proceed already next year. However, much needed structural reforms will likely be postponed until at least 2018 elections. However, we also see a chance for early elections in 2017 as a way to reduce fiscal slippage risks and speed up reforms.

Current account – slowing inflows and outflow Russia’s CA will likely remain weak in 2017-2018 even despite our bullish oil outlook. Thus, CA expected to recover only to just about 3% of GDP in 2017-2018 even despite the expected recovery in oil prices to over US$55-60/bbl over the period. Sharp reduction of structural or forced capital outflows is seen as the major reason for such structural deterioration, as Russia no longer needs to finance strong political deleveraging of 2015-2015 as well as massive illegal outflows, which have dropped by close to 90% in 2-3 years. (see: Slowing (in/out)flows). Such structural nature of the CA decline should limit negative impact of this trend on the RUB as its further stability will no longer require CA inflows and will likely be more dependent on the financial flows.

Chart 28: Domestic demand to drive the recovery in 2017-2018


Chart 29: 2016 slippage is due to one-off defense ticket

Source: MinFin, BofA Merrill Lynch Global Research Total undisclosed spending is a difference between total spending and sum of all disclosed items

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Brazil

Ana Madeira Brazil Economist Merrill Lynch (Brazil)

David Beker Brazil Economist, FI Strategy Merrill Lynch (Brazil)

Don’t let the music stop

• Our calls: We forecast a moderate recovery in 2017 with GDP growing 1% (vs-3.5% expected in 2016), inflation nearing the target at 4.7% and the easing cycleto continue with the Selic ending 2017 at 11.25% and BRL at 3.90.

• Main view: Confidence and activity data signal a weaker recovery in 2017. Inflationto continue decelerating pressured by the large output gap and fiscal reforms.Monetary easing is to reach 450bp by 2018, conditional on the external backdrop.

• Main risks: Given the change in the US backdrop, risks are asymmetric to thedownside. Fiscal reforms and monetary easing are key to sustain growth. Politicalnoise is still a concern. It is key for the government to remain committed toimplementing reforms.

A (paced) recovery from lows We expect the recession to be over in 2017, in line with economic activity indicators that have been improving from lows throughout the year showing an inflexion (Chart 30). Next year should register mild GDP growth of 1.0% after the 3.5% contraction we forecast for this year. Confidence levels partially retraced their improvement at the margin, and activity indicators have been surprising on the downside (Chart 31).

Investment will be driver of the recovery since private consumption should remain repressed on the back of increasing unemployment and restrictive credit conditions. We expect the unemployment rate to peak only in 2Q17 at 12.9% and remain at high levels still throughout next year (Chart 32). Real wages should continue to decline, squeezing disposable income and individual indebtedness will remain high. We expect credit conditions to improve throughout next year, albeit gradually. Retail sales and services should take longer to recover, while industrial production should be the first sector to register improvements next year, in our view.

Chart 30: GDP will turn positive in 2017, after a two-year recession

Source: BofA Merrill Lynch Global Research, IBGE

Chart 31: Slowdown in activity recovery signals lower growth prospects

Source: BCB

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We expect investment growth to turn positive in 2017, after three years of declines. The decompression of the recession should help the increase in investments and the economic agenda promoted by the government as well. The government has been signaling commitment toward a more open economy, the fostering of investment agreements with partner countries, and announced nationwide concessions and privatization such as the Privatizations and Investments Program (PPI).

External sector will maintain good momentum The external sector adjusted rapidly throughout 2016, and although the pace should slow, we still expect the current account deficit to remain close to 1% of GDP in 2016-17compared to -3.3% of GDP in 2015 Chart 33). We expect the current account to deteriorate marginally to -1.1% of GDP in 2017 (vs -0.9% of GDP in 2016) due to a smaller trade surplus of R$47.0bn in the year (from R$48.4bn). We expect imports to increase due to more greenfield projects and investment backed by a recovering internal production, which should offset the rise in exports, leading the trade balance to fall marginally.

We anticipate the BRL to end next year at 3.90 given the prospects for fiscal expansion and higher yields in the US. Combined with better economic and political prospects in Brazil, this should attract M&A deals and greenfield projects. We expect FDI to reach US$77.0bn in 2017 (vs US$70.1bn expected in 2016).

Fiscal reforms in the pipeline for a rosier future The government has been making progress on fiscal reforms. The Lower House approved the spending cap bill, and we expect the final round vote in the Senate before year-end. Government officials suggested the social security reform proposal will be comprehensive and would be sent to Congress before year-end. We expect the social security reform to be approved in 2H17 and to improve fiscal prospects significantly. The government also noted other reforms to be pursued, including labor market and microeconomic reforms as well as political reform, which is already up for vote in Congress.

Fiscal dynamics will remain weak in the short term. We expect the public sector to post mild improvement in its primary fiscal deficit, reducing it to 2.1% of GDP in 2017 from our expected 2.3% in 2016 (Chart 34). Accommodation in tax collections driven by the recovery in GDP growth and the ongoing fiscal adjustment will drive the improvement in fiscal accounts, in our view.

We forecast primary fiscal deficits will drive gross debt to 80% of GDP in 2017 (vs 74.1% expected in 2016). Nevertheless, the approval of the spending cap bill will pave

Chart 32: Unemployment to peak in 2Q17, leading to lower real wages

Source: BofA Merrill Lynch Global Research, IBGE

Chart 33: External sector will maintain good momentum in 2017

Source: BofA Merrill Lynch Global Research, BCB

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the way for more sustainable debt dynamics in the medium term. We did a simulation exercise showing that gross debt could reach its peak at around 90% of GDP in 2021 and decelerate thereafter under the implementation of the spending cap rule. Without the spending cap, results suggest gross debt would keep growing at an unsustainable rate in the years to come.

Declining inflation is paving the way for a big easing cycle We expect inflation to continue decelerating in 2017 and reach close to the target at 4.7% (vs 6.9% expected for 2016). A risk for this forecast is the ongoing depreciation pressure for the BRL. The 4.7% is pretty much in line with the 4.5% target, showing that the Brazilian Central Bank (BCB) was successful in re-anchoring expectations and in bringing inflation down. Activity data have been weak at the margin, the labor market continues loosening, and credit conditions remain restrictive. Food inflation was the main upside pressure on the headline due to El Niño effect in 2016, but has started a rapid deceleration in 3Q16 adding downside pressures to the headline. FX pass-through has declined with the low domestic absorption. Inflation expectations have also been trending down amid a hawkish BCB that started a more gradual than expected monetary easing cycle (Chart 35). We expect the BCB to keep the 25bp pace until mid-next year.

We anticipate the progress on fiscal reforms and ongoing disinflationary pressures to lead to a big monetary easing cycle that could reach 450bp by 2018, conditional on the external backdrop. We expect the Selic rate to end 2017 at 11.25% (from 13.75% expected in 2016) and reach single digits by 2018. The BCB has maintained focus on services inflation as a condition to accelerate the pace of easing, along with progress on fiscal measures. We expect the ongoing deterioration in the labor market and slow economic recovery to allow the BCB to keep easing monetary policy despite the increase in US yields.

Risks: external backdrop and reforms Risks are biased to the downside as the weaker BRL could add pressures on inflation reducing the expected rate cuts. This, combined with a more challenging global backdrop could lead to lower GDP growth. Growth and approval of fiscal reforms are key for public debt sustainability in the medium and long runs. The pillar for approving reforms rests on governability, which could be shaken by political noise.

Car Wash investigations are ongoing, and eventual plea bargaining by politicians is a risk to the political support to approve the fiscal reforms in Congress. The window to approve the unpopular social security reform also plays against the government. It needs to be approved by 3Q or 4Q of next year before it gets too close to the presidential election in 2018, affecting the political forces and the strength of the government coalition.

Chart 34: Fiscal accounts will remain weak in the short term

Source: BofA Merrill Lynch Global Research, BCB, National Treasury

Chart 35: Monetary easing cycle will accelerate in 2017

Source: BofA Merrill Lynch Global Research, BCB, IBGE

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Mexico Carlos Capistran Mexico Economist Merrill Lynch (Mexico)

An unfriendly external environment

• Our calls: We expect growth to decelerate to 1.25% in 2017, with inflationincreasing to 4% and Banxico hiking rates to 6%. We expect the public sector toreduce its deficit. The great buffer will continue to be the MXN.

• Main view: Mexico is facing a tough external environment with higher US interestrates, uncertainty regarding US anti-trade and anti-immigration policies and apotentially large reduction in external demand, which will dry dollar inflows.

• Main risks: Risks are skewed to downside. Main external risks are a sharp reductionof FDI and capital inflows and potential US anti-trade and anti-immigration policies.Main domestic risks are lower oil production and social unrest.

An already difficult external environment… Mexico faced an adverse external environment in 2016 that caused exports to fall 4% ytd. The drop in exports goes a long way in explaining why we now expect growth of 1.9% for 2016 instead of the 2.5% that we expected a year ago. Lower-than-expected growth in the US in the first half of 2016 as well as a contraction in US industrial production caused non-oil exports to drop 2% ytd. Lower oil prices and lower domestic oil production lead to a drop in oil exports of 28% ytd.

Fewer dollar inflows created vulnerabilities in external and fiscal accounts, inducing a 25% yoy depreciation of the peso (Chart 36). The growing deficit in the oil trade balance put the current account deficit (CAD) at 3% of GDP in 1H 2016. It also worsened fiscal accounts, as the government had to capitalize Pemex. Banxico responded by hiking rates 150bp to prevent the MXN depreciation to un-anchor inflation expectations.

The domestic component of the economy had a nice run in 2016, despite the drop in exports. The large MXN depreciation pushed consumption toward local goods and services and caused remittances to increase 26% ytd in pesos. Inflation remained low, which allowed real wages and credit to growth, helping retail sales increase 8% ytd.

Chart 36: Oil slump

Source: BofA Merrill Lynch Global Research, Bloomberg, Ministry of Energy, Ministry of Finance forecasts

Chart 37: Rates spiking after election night

Source: BofA Merrill Lynch Global Research, Bloomberg

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…turned into an unfriendly external environment The election of Donald Trump as US president further complicates the external situation for Mexico. Trump proposed policies that could have an adverse impact on Mexico. On trade, Trump says he will renegotiate or withdraw from the North American Free Trade Agreement (NAFTA). On immigration, Trump proposes “removing the more than two million criminal illegal immigrants” and to construct a “wall on our southern border…”

The more immediate impact of potential anti-trade and anti-immigration policies will be to increase uncertainty and to delay or reduce foreign direct investment (FDI) into Mexico. If implemented, higher tariffs on Mexican products would reduce Mexican exports, which would in turn worsen the CAD and decelerate growth. Anti-immigration policies would reduce remittances, also worsening the CAD, and would increase the labor force in Mexico, which could lead to social unrest if there is no demand for it.

For now we incorporate into our forecast the uncertainty and the reduction in FDI, leaving downside risks to our forecasts if harsh anti-immigration and anti-trade policies are implemented. Trump has softened his stance on some of these issues since the election, but it will take months to find out what is eventually implemented.

We also incorporate into our forecasts higher US growth (positive for Mexico) and higher US interest rates (negative for Mexico), which is what we as a House expect from the policy mix announced by Trump. Our house view is that the Republican sweep will lead to significant fiscal stimulus, increasing interest rates (Chart 37). And fiscal reforms, repatriation, and deregulation could boost the US economy and dollar even further. So we are on the camp that Keynesianism will ultimately triumph over protectionism.

Higher US growth is positive for Mexico, but we believe the adverse impact of higher US rates and stronger US dollar will dominate in 2017 and 2018 (Chart 38). The main channel will be through a reduction of capital inflows into Mexico which, along with the reduction in FDI, will induce a contraction of domestic expenditure and will put upward pressure on domestic interest rates and downward pressure on the peso (Chart 39)

We expect lower growth… We expect the economy to growth 1.25% in 2017 and in 2018, with downside risks. The deceleration will come about as the country adjusts to lower external financing. The deceleration of consumption and investment may take some time, because the peso will continue acting as a buffer switching expenditure toward local goods and services, but it will be noticeable by mid 2017. Lower oil production (-9% yoy expected by Pemex) and lower public expenditure (a reduction of 1-1.5% of GDP) will decelerate the supply side of the economy and the demand side of it in 2017, respectively.

Chart 38: Temporary parting of the ways

Source: BofA Merrill Lynch Global Research, Bloomberg, Bureau of Economic Analysis, INEGI

Chart 39: Reduction of capital inflows on the way

Source: BofA Merrill Lynch Global Research, Banxico

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…and higher inflation Inflation will continue to trend up, reaching 4% by end 2017 although it may back to 3.5% by 2018 (Chart 40). Core inflation will also trend up as merchandise inflation increase following the large MXN depreciation, although services inflation will remain contained by the deceleration of domestic expenditure. One upside risk to inflation is that agricultural inflation moves above its historic average. Another upside risk is the liberalization of the price of gasolines in January 2017. The government wants to phase in the liberalization across the country to limit price increases. A benefit of higher gasoline prices is that it will help contain the gasoline imports (Chart 41).

Tighter policies to maintain stability Monetary and fiscal policies will continue tightening to help the economy adjust to less external financing and slower growth. We expect Banxico to hike 50bps in November and then 25bps in December with the Fed in order to prevent the large depreciation since the US elections (-13%) to un-anchor inflation expectations. We expect Banxico’s rate target to reach 6% by end 2017 and 6.5% by end 2018, mostly moving in tandem with the Fed with an upward bias. Banxico could hike more given the pressures for the MXN. Another way in which Banxico may help the adjustment is by reducing its international reserves, replacing external sources of finance.

The fiscal consolidation will continue, with the government and Pemex reducing the primary deficit through lower expenditure. Pemex’s business plan requires enactment of the farm-outs with the private sector, which will begin on December 5. Both the government and Pemex will face headwinds from the peso depreciation and from higher interest rates. A substantial transfer from Banxico’s extra profits is likely to occur again in 2017. Our overall view is that fiscal challenges remain and that a one-notch downgrade from rating agencies will be difficult to avoid given our GDP growth outlook.

Risks are to the downside Risks are to the downside mostly through the eventual realization of US anti-trade and anti-immigration policies. Another potential downside risk is a more pronounced reduction in external sources of financing which would lead to a larger deceleration or even a contraction of the economy. Domestically, lower-than-expected oil production would put extra stress to the CAD by deteriorating the oil trade balance. The political and insecurity situation in Mexico is delicate, and a low growth environment and the potential return of migrants only make the situation worse. There is a busy electoral calendar in 2017 (local elections) and 2018 (federal elections, including president) and risks are for a repudiation of the establishment as we have seen around the world.

Chart 40: Inflation at 4% in 2017

Source: BofA Merrill Lynch Global Research, INEGI

Chart 41: Liberalization of gasoline prices could help correct trade balance

Source: BofA Merrill Lynch Global Research, Banxico

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Korea Jaejoon Woo Korea Economist Merrill Lynch (Hong Kong)

Cautious optimism at time of great uncertainty

• Policy stimulus should support a continued moderate recovery in Korea. However,the recovery will be uneven across sectors.

• Inflation will gradually rise towards 2% inflation target amid a modest growth.

• BoK will maintain its accommodative monetary stance for some time even after theFed’s resuming hike on account of strong external buffers (eg, large current accountsurplus and FX reserves). ..

Economy has weathered challenging environment well so far The Korean economy regained traction on expansionary macro policies beginning in March, after a poor start to the year marked by weakness in global stock markets, exports and oil prices. The domestic economy has shown resilience so far this year, despite a number of headwinds (eg, concerns over China’s growth slowdown, sluggish exports, post-Brexit uncertain and fragile global outlook). GDP growth moderately increased from 0.5% qoq sa in 1Q16 to 0.8% and 0.7% qoq sa in 2Q16 and 3Q16, resp (equivalently, 2.8%, 3.3%, 2.7% yoy). We expect a slowdown in 4Q16 due to negative shocks mostly of domestic origin (eg, corporate restructuring, anti-corruption law, political turmoil amid growing calls for President’s resignation), leaving growth for the year at 2.7%. See Implications of political upheaval facing the President Park administration. A pattern of domestic demand-driven growth (not export-driven) has continued in 2016, led by consumption and construction investment on strong credit growth, robust housing market activities and expansionary policy mix.

Hope for the better amid great uncertainty Going into 2017, we expect our original narrative for this year will continue to be in play – that is, the domestic economy will likely continue its recovery at modest pace on policy stimulus, with exports slowly improving on account of rises in export and oil prices. In particular, the prospect of EM-led global growth recovery along with gradually rising oil and commodity prices next year will be conducive to further improvement in exports growth (note about 57% of Korean exports go to EMs). Barring a worst-case scenario of global financial instabilities, say, due to a faster Fed hiking cycle on higher inflation expectations in the US (due to fiscal stimulus, protectionist trade and anti-immigration policies), it will help support global trade volume. Under this central scenario, the combined global effects on Korea may be mildly positive, as Korea’s growth tends to move with global trade volume. Taken together, we project output growth will rise to 2.9% in 2016 from 2.7% in 2016.

Yet, overall picture will be more nuanced with GDP components likely displaying different trajectories and timing of further strengthening (or weakening). The contribution from private consumption and construction will likely continue, albeit at a slower pace relative to 2016, with the former on stable consumer sentiment, income growth and wealth effects (from housing markets and stocks) along with the trend of rising employment rates, and the latter on still active yet weaker-than-this-year housing market activities. In our view, the recent efforts to curb the pace of household debt increase represent a piece-meal approach, and their impact on household debt and housing markets will be limited. That said, we expect facilities investment will gradually recover during 2017 (from currently low levels and pent-up demand), with some large


scale investment plans in the pipeline and expansion in R&D expenditure, aided by government policies that support new growth engine industries. But then, when and how strongly the facilities investment will rebound would depend on the future path of exports (see Why has investment been so weak lately?). Recently, exports have shown an improving trend on account of rising export prices (see How sustainable will the Korean export turnaround be?).

Policy support will remain in place to support growth recovery. Korea’s public finance is in a sound footing, allowing for sufficient room for counter-cyclical fiscal policy, if data warrant (eg, Korea’s government debt of 39.3% vs. 117.4% of GDP in G-20 DMs for 2016E). On the monetary front, given low inflation and slack in the economy, we expect the BoK will maintain its accommodative monetary stance for some time even after the Fed’s resuming hike on account of strong external buffers. We still think the BoK has room for additional rate cuts if needed, but the hurdle for further easing looks high, given the risk of a faster Fed hiking, concerns over the already high and fast rising household debt, and political uncertainty. In our baseline case, the BoK will stay on hold until 4Q17 when it is expected to start considering raising rates (see Korea: Three key questions facing the BoK ahead of Fed hike).

Inflation on the rise Our growth forecast represents sub-par growth for Korea, with its negative output gap being gradually closed. So, the effect on inflation or the labor market is expected to be quite modest. One important caveat is that the future inflation path will depend on the evolution of oil and commodity prices, the strength of domestic demand, and other factors including KRW exchange rate movements. Near term, inflation will gradually rise amid a gradual growth recovery, as the transitory effects of past declines in oil and commodity prices dissipate. Medium term, we expect inflation to rise gradually towards the inflation target 2% as the economy returns to long-term trend (see Philips curve is alive and well). We project inflation will rise to 1.9% in 2017 from 1% in 2016.

Risks to Outlook Our baseline forecast carries sizeable downside and upside risks. At this point, there is a high degree of uncertainty regarding domestic political situation and likely U.S. policies under Trump presidency. The downside risks are still significant and mostly of external origin, such as risks from further protracted slow growth in DMs and EMs, higher USD and US rates, disruptive financial market volatilities, and trade protectionism. The biggest domestic risk entails a case of state affairs coming to a standstill amid power struggles (say, due to President’s resignation or impeachment), and further aggravation of geopolitical risk arising from North Korea’s nuclear program. Upside risks include stronger-than-expected recovery in the US and EMs, stabilizing China growth, further rises in oil and commodity prices, and domestically, large fiscal stimulus and pro-growth initiatives. Plus, the presidential election scheduled in Dec 2017 may bring sweeping political and economic reforms, ending the five year of political gridlock.

Chart 42: Korea: Domestic demand vs. Exports

Source: CEIC, BofA Merrill Lynch Global Research

Chart 43: Korea: Improving trends of exports and imports

Source: CEIC, BofA Merrill Lynch Global Research

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United Kingdom Robert Wood UK Economist MLI (UK)

Post-mortem: Brexit has not been as bad as feared

• Post-referendum growth has held up better than expected but the next two yearswill likely see only weak expansion.

• Sterling driven inflation should peak around 3.0% in early-2018 squeezing consumerspending power.

• We expect the BoE to ease monetary policy further.

Brexit was not our central case, but we warned that markets were too complacent (see, for instance, here, here, here and here). The mistake with Brexit was not so much the polls as observers’ unwillingness to believe the polls’ signal that the vote was close.

UK economic growth has held up better than we expected. We cut our 2017 growth forecast from 2.3% to 0.2% after the referendum. We have since raised it to 0.9%. That stabilisation was not inevitable in our view. Remember the post-referendum days: no Prime Minister expected for three months and mass resignations of shadow ministers. Uncertainty spiked to unprecedented levels (Chart 44) and business surveys tanked (Chart 45). The Brexit uncertainty shock happened and growth indicators responded.

Events post mid-July helped the economy we think. Equities rallied, for instance, when the less experienced candidates for Prime Minister (Boris Johnson, Andrea Leadsom) dropped out. Mark Carney’s steadying probably mattered too, as did delaying triggering Article 50. These factors helped to soothe the fallout, preventing a sharp drop in business investment (see here). But all is not well with the UK economy.

Growth Now the focus switches to the ‘insidious’ drag of uncertainty on investment and a sterling driven squeeze to real incomes. We could think of this as Brexit phase II. We outline our view below. Of course we face considerable uncertainty in forecasting in this environment: we need to watch the data carefully over the coming months.

Sterling’s fall is a ‘real’ phenomenon – a way of helping the UK adjust to weaker potential output – rather than a straight monetary stimulus, as was the case after ERM

Chart 44: The Brexit uncertainty shock happened

Standard deviations from average. Source: BofA Merrill Lynch Global Research, Policyuncertainty.com

Chart 45: PMI better than expected, but not strong

Source: BofA Merrill Lynch Global Research, ONS, Markit.

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exit in 1992 (see here and here). So it will not boost growth, we think, and may do rather less than generally expected. UK exports are price insensitive and firms are unlikely to expand capacity until they have clarity about future tariffs. Households are likely to respond to the inflation squeeze on spending power because the saving rate is low and interest rates facing households are no lower than before the referendum (see here).

Hard Brexit is our base case A ‘hard Brexit’ – leaving the single market and customs union – is our base case and could detract 5-10% off GDP over 15 years. We expect Article 50 EU exit procedures to be triggered in the first half of 2017 meaning formal exit comes in 2019.

We expect 1.2% growth in 2018, an improvement on 2017 as the real income squeeze eases a little and fiscal policy turns more neutral. But uncertainty will likely keep investment growth weak, particularly as formal EU exit approaches, and the BoE is almost out of ammunition. Trend growth may drop on weaker immigration.

Inflation Sterling’s fall since the referendum will in our view push inflation to a peak of 3.0% in early-2018. We forecast 0.7% CPI inflation for 2016, 2.5% for 2017 and 2.9% for 2018, the first two unchanged from our previous forecasts. We think the evidence points to large and persistent passthrough so our 2018 forecast lies well above consensus.

Central bank Brexit is, we think, a ‘supply shock’: it pushes inflation and output in opposite directions. The BoE can choose to allow either higher inflation or higher unemployment to drive the required cut in real incomes. We expect the BoE to choose inflation as long as expectations remain anchored (which we expect). Inflation overshoots would anyway be justified absent Brexit given interest rates close to the zero bound. So we look for another rate cut and more QE. Without it growth could slow more. We pencil it in for February. Easing could easily come later or not at all if sterling falls very sharply. We think rate hikes, however, are unlikely for the next few years.

Risks We see growth risks skewed to the downside and inflation to the upside on Brexit. Brexit costs are clearer for the long-term than short-term, perhaps making it easier for firms and households to ignore for now. But consumers may react to higher inflation more than we have assumed, given already low saving rates, or sterling could fall more.

Elevated political risk could also weigh on growth. Whether that is expressed via uncertainty or a greater risk premium on UK assets, models suggest investment will be the casualty. The UK’s large current account deficit is unlikely to cause a crisis, in our view, but it is an ever present danger that we need to watch. Finally, the chance of a ‘hard Brexit’ seems to be underappreciated now (see here). So there will likely be some (negative) shock value when Article 50 is triggered.

On the upside, Brexit could be delayed or ‘smoothed’ meaning we are conditioning our forecasts on too pessimistic a base case. The UK and EU could, for instance, agree a transitional deal to keep trading terms unchanged for several years after formal ‘Brexit’ in 2019. We do not see a good chance of such a deal coming early in the negotiation process, but if it did, or the government announced a large fiscal stimulus, we would become more positive on the growth outlook.

Alternatively, our economic assessment of the implications of any type Brexit may just be wrong. A bonfire of red-tape, untrammelled economic sovereignty and trade deals with a huge number other countries could deliver an economic positive. But we don’t think that is likely. The long-run economics of Brexit are clear, we think: undermining free trade with the UK’s largest export partner, politicising monetary policy (see here), and worrying foreign investors does not, to our mind, equate to a long-term growth positive economic plan.


Canada Emanuella Enenajor North America Economist MLPF&S

Year ahead: slip slidin’ away

• Canada’s economy is set to expand at a near-potential rate of 1.5% in 2017,accelerating slightly from the previous year due to government stimulus.

• Headline inflation could speed up in 2017 driven by energy prices, but underlyinginflation is set to gradually decelerate.

• We expect the Bank of Canada (BoC) to cut rates by 25 bps in 2H 2017.

Good riddance to stagnant 2016 Canada’s economy proved to be much weaker than expect in 2016, as both growth and inflation underperformed our expectations from last year’s “Year Ahead” publication. On the growth front, although consumer spending and housing investment held up, business capital spending and exports were softer than anticipated (Table 5). Energy companies continued to lower headcounts and capex, while the factory sector shed jobs. On the inflation front, weak wages, slow growth and a rising jobless rate have all slowed the pace of rebound. Furthermore, the pass-through of elevated import prices to consumer prices diminished in 2016, removing a key source of upward pressure on inflation.

2017: The only hope is stimulus We envision a meager improvement in growth from 1.1% in 2016 to 1.5% in 2017, well below the median economist projection of 1.9%. The decline in business capital spending could slow, but export weakness could persist, as the BoC’s foreign activity indicator—a measure of external demand for Canada’s exports—has been worsening heading into 2017 (Chart 46). A gradual increase in energy prices could help stem the decline in natural resources hiring and capital expenditures. Services activity will likely continue to expand, but probably at a slower pace, with finance and real estate sectors likely to come under pressure due to new mortgage rules.

Offsetting those drags, we expect Federal government stimulus via infrastructure spending and child care benefit checks to add 0.4pp to growth next year, accounting for the bulk of the acceleration in GDP. Although hiring will likely remain slow, and wage growth stagnant, household spending growth could accelerate to 2.4% (from 2.1% in 2016), owing to the additional “stimulus” income.

Table 5: BofAML forecasts for Canada in 2016

Then* Now GDP 1.5% 1.1%

Household consumption 1.9% 2.1% Residential investment 1.0% 3.6% Business investment -2.6% -7.8%Exports 3.0% 0.5%

Unemployment rate 6.9% 7.1%Headline CPI 1.8% 1.5%Source: BofA Merrill Lynch Global Research, Statistics Canada *Then = 08 December 2015

Chart 46: Demand for Canada’s exports is diminishing Bank of Canada foreign activity indicator (yoy growth rate)

Source: Bank of Canada

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Headline inflation pops masks core meltdown While headline inflation will likely increase to 1.9%, reflecting energy prices, core could move lower given a large output gap and fading currency effects. With potential growth likely around 1.5%, matching the economy’s forecasted growth rate in 2017, the output gap is set to remain wide (Chart 47). In this environment, underlying inflation may ease, even as headline inflation pops to 1.9% in 2017, on the back of energy base effects. The boost to CPI from the currency is fast fading: goods ex-food and energy (a decent proxy for the FX pass-through effect) has been fading sharply (Chart 48), suggesting the boost to core inflation from import prices is diminishing. We see ex-food/energy CPI slipping to 1.7% in 2017 from 1.9% in 2016. The BoC’s preferred measures of “underlying” inflation including median CPI, trimmed mean CPI and the CPI common component, could also soften.

BoC: An ease in 2017 as reality sets in The BoC appears to be coming around to the realization that exports may fail to rebound strongly. Indeed, at the October meeting, Governor Poloz admitted that the Governing Council debated whether or not to ease at the meeting, but opted to stay on hold given uncertainty. However, our downbeat 2017 growth forecast of only 1.6% is lower than the BoC’s call for 1.9% growth, suggesting ample justification to ease. This past year, the BoC has been hesitant to ease despite data disappointments, citing lower trend growth, upcoming stimulus spending, and the risks of a fast-depreciating currency. But the reasons to stay on hold are shrinking, and the Federal government’s recent tightening of mortgage rules limits the risk of a further build-up of housing market risk if rates fall further.

We see an ease in mid-to-late 2017 as most likely. In the near-term, the BoC is likely to stand pat. After all, the scope for disappointment in the near-term is limited given recent downgrades to growth. Indeed, the BoC expects the hit to housing from the new mortgage measures to be front loaded, suggesting weakness for the next few months should not be a surprise. For now, we have penciled in an ease at the July 2017 meeting, but admit this is hard to predict so far in advance. The most important takeaway is that the BoC seems more willing than before to admit that the economy may not be able to pull itself up by its bootstraps and instead, may need further policy stimulus. For now, we have penciled in only one rate cut: the BoC is risk-averse and given limited signs of FX pass-through, the benefits of aggressive easing may be limited. However if the economy deteriorates further, the risk of additional easing would rise as an on-hold stance would be harder to justify.

Chart 47: Economic slack to remain wide Output gap (% of potential GDP)

Source: BofA Merrill Lynch Global Research, Bank of Canada

Chart 48: Import-price sensitive inflation is slowing Year-on-year growth rate

Source: BofA Merrill Lynch Global Research, Statistics Canada

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Australia Tony Morriss Rates Strategist/Economist Merrill Lynch (Australia)

Alexandra Veroude Australia Economist Merrill Lynch (Australia)

Record breaking growth, but a weak domestic economy • Australia will post the 25th consecutive year of growth in 2016.

• This shouldn’t hide a domestic economy growing below trend. We see another yearof sub-trend growth before a rebound in 2018.

• Weak structural inflation was the surprise this year, prompting another round ofpolicy easing that has intensified concern over housing sector imbalances.

The diverse drivers of growth This year Australia will surpass the Netherlands’ 25-year modern day record of consecutive growth in a developed economy. The Australian economy continues to face the challenges of the transition from the resources investment boom that is now moving into a major export phase. This will help to boost headline growth into 2018 that would extend the current uninterrupted run of growth to 27 years. Not bad for a commodity exporting economy.

Currency flexibility has been important in meeting these challenges, and will continue to do so. Weak underlying inflation in 2016 was the surprise of the year that prompted two further rate cuts from the Reserve Bank of Australia. A 26% decline in the AUD trade weighted index since 2013 failed to result in any meaningful pass-through to final prices. In fact, core inflation hit a record low in Q3. However, currency depreciation has helped to stimulate activity and job creation in the services sector to offset the decline in investment lead growth in resources.

The growth outlook We forecast growth of 2.6% in 2017 and 3.2% in 2018. GDP is again expected to be dominated by external drivers as the economy enters the production phase of the mining boom. Resources exports are expected to add 1.9ppts and 2.2ppts to GDP in 2017 and 2018, respectively, with growth shifting from iron ore and coal towards LNG.

Domestic demand has been weighed by the resources investment downturn but is expected to gain momentum as this drag slows substantially into 2017 before a base

Chart 49: Contributions to annual growth The drag from mining investment wanes into 2017 & 2018

Source: BofA Merrill Lynch Global Research, ABS

Chart 50: Headline and core inflation Core inflation only expected to return to the target band by end 2018

Source: BofA Merrill Lynch Global Research, ABS

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level emerges in 2018. This is expected to be the key driver of growth in domestic demand. We see the dwelling construction cycle fading into 2017 and 2018, and a more modest pace of growth in household consumption, in line with expectations of subdued wages growth and slower house price appreciation.

Table 6: Key economic forecasts % 2016 2017 2018

GDP 2.9 2.6 3.2 Domestic demand 1.4 1.7 2.3 CPI 1.2 2.2 2.1 Policy rate (year-end) 1.5 1.5 1.5 Source: BofA Merrill Lynch Global Research

However, once the drag from mining investment has passed, we see scope for business investment to expand for the first time since 2012, as the non-mining economy responds to more favourable conditions. The scope for increased state government infrastructure spending remains open to question even with some windfall gains from resource royalties.

Inflation and interest rates The rise in service sector work has meant that almost all growth in the labour market over 2016 is in lower paying part-time jobs. There are also structural pressures on retail via new entrants, technology and new business models. Added to this an oversupply of new apartments to push rents lower and we see inflation rising only to the bottom of the RBA’s target band into 2018.

The key domestic issue is the persistence of spare capacity in the economy so the performance of the labour market is central to the outlook for domestic inflation, although a lower AUD could yet remove downside risks. There appears to be less scope for the Bank to consider easier policy in 2017 considering the recent boost to the resource sector, especially if the AUD weakens in the face of a stronger USD, as we expect. So we now see rates on hold for a more extended period. Moreover, it would also be prudent for the RBA to save some policy flexibility in case of exogenous shocks or an unexpected weakening of the housing market.

In fact, a lower AUD and global reflation, if sustained creates the risk that the next move in rates is higher. This looks more of a distant prospect and would bring a fresh range of challenges for the domestic economy.

Risks The main domestic risk is centred on the housing sector where low rates and favourable tax treatment have generated some imbalances, oversupply of apartments in some market segments and a high household debt/income ratio by international standards. However, the housing outlook is mixed across the country and risks look localised at this point in the cycle and regulators to continue to use targeted and selective measures to address these imbalances. We would be more concerned if financial conditions tightened significantly (hard to see without higher policy rates) or if household incomes weakened due to a rise in unemployment. The RBA has scope for further policy support if required.

Sustained strength for the currency on the back of recent gains for commodity prices would also “complicate” the transition of the domestic economy from reliance on investment in the resources sector. However, government revenues are set to benefit from this rise and would appear to raise the bar for a possible sovereign downgrade that would impact the cost and availability of credit to the banking sector.

External risks mostly focus on the potential for a transmission of slower growth in China considering Australia’s direct and indirect exposure via exports. There are also risks around the sustainability of recent commodity price gains and the potential for trade frictions to intensify once the new US administration is in place.


Global Economic forecasts Global economic forecasts

GDP growth, % CPI inflation*, % Short term interest rates**, % 2015 2016F 2017F 2018F 2015 2016F 2017F 2018F Current 2016F 2017F 2018F

Global and Regional Aggregates Global 3.2 3.1 3.5 3.8 2.5 2.4 2.8 3.0 3.44 3.41 3.43 3.57 Global ex US 3.4 3.4 3.8 4.1 3.1 2.6 3.0 3.2 4.13 4.03 3.98 3.98 Developed Markets 2.1 1.5 1.7 1.9 0.3 0.7 1.7 1.8 0.23 0.34 0.44 0.76 G5 2.0 1.5 1.7 1.9 0.2 0.7 1.7 1.8 0.19 0.30 0.40 0.73 Emerging Markets 4.1 4.1 4.7 5.1 4.2 3.6 3.6 3.8 5.80 5.62 5.51 5.47 Emerging Markets ex China 2.6 2.7 3.6 4.2 5.7 4.5 4.6 4.8 6.57 6.32 6.17 6.11 Europe, Middle East and Africa (EMEA) 1.5 1.6 1.6 1.7 3.8 2.5 3.3 3.5 2.83 2.70 2.55 2.51 European Union 2.2 1.8 1.6 1.5 0.0 0.2 1.5 1.6 0.17 0.17 0.15 0.21 Emerging EMEA 0.7 1.4 1.9 2.2 8.9 5.5 5.7 6.2 6.65 6.36 6.00 5.88 PacRim 5.5 5.4 5.6 5.8 2.2 2.2 2.7 2.9 3.89 3.77 3.82 3.85 PacRim ex Japan 6.1 6.0 6.1 6.3 2.4 2.5 2.8 3.1 4.40 4.24 4.27 4.28 Emerging Asia 6.2 6.1 6.2 6.4 2.4 2.6 2.9 3.1 4.49 4.32 4.36 4.36 Americas 1.6 0.7 1.9 2.4 3.5 5.0 4.1 3.6 3.34 3.57 3.66 4.14 Latin America -0.4 -1.2 1.5 2.5 6.0 6.0 4.3 3.9 10.26 10.59 10.42 10.45 G5 US 2.6 1.6 2.0 2.5 0.1 1.3 2.0 2.1 0.38 0.63 0.88 1.63 Euro area 1.9 1.6 1.4 1.5 0.0 0.2 1.2 1.3 0.00 0.00 0.00 0.00 Japan 0.6 0.7 1.4 1.2 0.8 -0.1 1.3 1.2 -0.10 -0.10 -0.10 -0.10UK 2.2 2.0 0.9 0.7 0.0 0.7 2.5 2.9 0.25 0.25 0.10 0.10Canada 1.1 1.1 1.5 1.6 1.1 1.5 1.4 1.4 0.50 0.50 0.50 0.25Euro area Germany 1.5 1.7 1.6 1.5 0.1 0.4 1.6 1.6 0.00 0.00 0.00 0.00 France 1.2 1.2 1.1 1.3 0.1 0.3 1.2 1.3 0.00 0.00 0.00 0.00 Italy 0.6 0.9 0.9 1.1 0.1 -0.1 0.4 0.6 0.00 0.00 0.00 0.00 Spain 3.2 3.3 2.4 1.9 -0.6 -0.4 1.4 1.3 0.00 0.00 0.00 0.00 Netherlands 2.0 2.0 1.7 1.5 0.2 0.1 1.0 1.2 0.00 0.00 0.00 0.00 Belgium 1.5 1.2 1.4 1.6 0.6 1.7 1.9 2.0 0.00 0.00 0.00 0.00 Austria 0.8 1.5 1.6 1.5 0.8 0.9 1.8 1.9 0.00 0.00 0.00 0.00 Greece -0.3 -0.2 1.4 1.9 -1.1 0.1 0.7 1.0 0.00 0.00 0.00 0.00 Portugal 1.6 1.2 1.2 1.2 0.5 0.7 1.1 1.1 0.00 0.00 0.00 0.00 Ireland 24.4 3.4 3.3 3.0 0.0 -0.2 0.7 1.1 0.00 0.00 0.00 0.00 Finland 0.2 0.8 0.9 1.0 -0.2 0.4 1.2 1.3 0.00 0.00 0.00 0.00 Asia Pacific China 6.9 6.7 6.6 6.6 1.4 2.0 1.8 2.1 4.35 4.35 4.35 4.35 India 7.6 7.4 7.6 8.3 4.9 4.8 5.6 6.0 6.25 6.00 6.00 5.75 Indonesia 4.8 5.1 5.3 5.6 6.4 3.6 4.5 4.0 4.75 4.75 4.75 4.75 Korea 2.6 2.7 2.9 3.0 0.7 1.0 1.9 2.1 1.25 1.25 1.50 2.00 Australia 2.4 2.9 2.6 3.2 1.5 1.2 2.2 2.1 1.50 1.50 1.50 1.50 Taiwan 0.6 1.2 1.7 1.9 -0.3 1.2 1.2 1.3 1.38 1.38 1.38 1.50 Thailand 2.8 3.2 3.2 3.2 -0.9 0.2 1.6 2.0 1.50 1.50 1.50 2.00 Malaysia 5.0 4.1 4.2 4.4 2.1 2.0 2.5 2.5 3.00 3.00 3.00 3.00 Philippines 5.9 6.6 6.3 5.9 1.4 1.8 3.1 3.0 3.00 3.00 3.25 3.50 Singapore 2.0 1.1 1.4 1.8 -0.5 -0.5 0.7 1.5 - - - - Hong Kong 2.4 1.5 1.7 2.0 3.0 2.6 2.6 2.9 - - - -


Global economic forecasts GDP growth, % CPI inflation*, % Short term interest rates**, %

2015 2016F 2017F 2018F 2015 2016F 2017F 2018F Current 2016F 2017F 2018F Latin America Brazil -3.8 -3.5 1.0 3.0 9.0 8.8 5.1 4.6 14.00 13.75 11.25 9.75 Mexico 2.5 1.9 1.3 1.3 2.7 2.8 3.7 3.4 5.08 5.50 6.00 6.50 Argentina 2.5 -2.0 2.7 3.0 26.1 38.7 24.1 16.6 21.13 25.75 21.00 17.25 Colombia 3.1 1.8 2.5 3.0 5.0 7.5 4.3 3.9 7.75 7.75 6.50 5.50 Venezuela -5.7 -11.3 0.0 1.3 121.7 525.1 544.7 416.1 6.40 6.40 30.00 50.00 Chile 2.1 1.5 2.0 2.5 4.3 3.9 2.8 2.9 3.50 3.50 3.00 3.00 Peru 3.3 4.0 4.5 4.5 3.5 3.5 3.1 2.9 4.25 4.25 4.25 4.25 Ecuador 0.2 -2.7 -0.5 1.5 3.4 1.4 1.5 2.6 0.20 0.20 0.20 0.20 Uruguay 1.0 0.3 1.6 2.5 9.4 9.5 8.3 7.5 - - - - EEMEA Russia -3.7 -0.5 1.1 1.4 15.5 7.1 5.0 4.0 10.00 10.00 8.00 7.00 Turkey 4.0 2.5 3.2 3.5 7.7 7.7 7.8 8.0 7.50 7.50 7.50 7.50 Egypt 4.2 3.8 3.0 4.0 11.0 10.2 18.9 22.8 14.75 11.75 15.50 15.50 Poland 3.6 2.7 3.5 3.2 -0.9 -0.7 1.1 1.6 1.50 1.50 1.50 2.00 South Africa 1.3 0.7 1.2 1.5 4.6 6.2 5.8 5.5 7.00 7.00 7.00 7.00 Romania 3.8 5.2 3.7 3.2 -0.6 -1.4 2.3 2.9 1.75 1.75 1.75 2.50 Ukraine -9.9 1.0 2.5 3.0 48.7 14.5 8.0 7.0 14.00 14.00 10.00 10.00 Czech Republic 4.6 2.7 2.9 2.7 0.3 0.6 1.8 2.2 0.05 0.05 0.05 0.00 Israel 2.5 3.0 3.4 3.2 -0.6 -0.5 0.8 1.6 0.10 0.10 0.10 1.00 Hungary 3.0 2.1 2.6 2.5 -0.1 0.4 2.5 2.6 0.90 0.90 0.90 1.40 Saudi Arabia 3.5 1.3 -0.1 0.5 2.2 3.7 3.0 5.0 0.50 0.50 0.75 1.25 Notes: Global and regional aggregates are based on the IMF PPP weights unless stated otherwise. Countries within each region are ordered according to these weights.

* Annual averages. The HICP measure of inflation is used for Euro area economies. CPI aggregates exclude Argentina and Venezuela. ** Central bank target rate, year-end, where available, short-term rates elsewhere.



Monetary policy forecasts Key meeting dates and expected rate change (bp)

Current Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Developed Markets Fed 0.50 — unch +25 (21st) — 1st 15th ECB 0.00 unch — 8th 19th — 9th BoJ -0.10 — unch 20th 31st — 16th BoE 0.25 — unch 15th — -15 (2nd) 16th BoC 0.50 unch — 7th 18th — 1st Riksbank -0.50 unch — 21st — 15th — SNB -0.75 — — 15th — — 16th Norges Bank 0.50 unch — 15th — — 16th RBA 1.50 unch unch 6th — 7th 7th RBNZ 1.75 — -25 — — 9th 23rd Emerging Asia China (lending rate) 4.35 — — — — — —

Req. res. ratio* 17.00 — — — — — — India** Repo rate 6.25 -25 — -25 (7th) TBA TBA TBA Cash res. ratio 4.00 — — — TBA TBA TBA

Korea 1.25 unch unch 12th TBA TBA TBA Indonesia 4.75 -25 unch 15th TBA TBA TBA Taiwan 1.38 — — 22nd — — 23rd Thailand 1.50 — unch 21st TBA TBA TBA Malaysia 3.00 — 23rd — TBA — TBA Philippines 3.00 — unch 22nd TBA TBA TBA Latin America Brazil 14.00 -25 -25 (30th) — -25 (11th) -25 (22nd) — Chile 3.50 unch unch 15th 19th -25 (14th) 16th Colombia 7.75 unch 25th 16th 27th 24th 31th Mexico 5.25 — +50 +25 (15th) — 4th 18th Peru 4.25 unch unch 15th 12th 9th 9th Emerging EMEA Czech Republic 0.05 — unch 22nd — 2nd 30th Hungary 0.90 unch 22nd 20th 24th 21st 21st Israel 0.10 unch 28th 26th 23rd 20th 27th Poland 1.50 unch unch 7th 12th 1st 1st Romania 1.75 — unch — 6th 7th — Russia 10.00 unch - 16th - -25 (3rd) -25 (24th)South Africa 7.00 — 24th — 26th — 16thTurkey 7.50 unch 24th 20th 30th 22nd 24th Note: Bolded data are expectations in basis points. “—“ denotes no meeting. TBA: MPC meeting not yet set. *Major five banks. **Reverse repo rate.

Source: BofA Merrill Lynch Global Research, Central Banks


FX forecasts

Quarterly forecasts – G10 currencies Spot 16-Dec 17-Mar 17-Jun 17-Sep 17-Dec 18-Mar

G3 EUR-USD 1.06 1.08 1.05 1.02 1.02 1.05 1.06 USD-JPY 110 108 112 115 117 120 117 EUR-JPY 117 117 118 117 119 126 124 Dollar Bloc USD-CAD 1.35 1.36 1.38 1.40 1.41 1.43 1.43 AUD-USD 0.74 0.74 0.73 0.72 0.71 0.70 0.70 NZD-USD 0.70 0.70 0.69 0.68 0.68 0.67 0.67 Europe EUR-GBP 0.86 0.88 0.91 0.89 0.88 0.88 0.88 GBP-USD 1.23 1.23 1.15 1.15 1.16 1.19 1.20 EUR-CHF 1.07 1.08 1.09 1.10 1.11 1.12 1.12 USD-CHF 1.01 1.00 1.04 1.08 1.09 1.07 1.06 EUR-SEK 9.81 9.50 9.40 9.30 9.20 9.15 9.10 USD-SEK 9.26 8.80 8.95 9.12 9.02 8.71 8.58 EUR-NOK 9.10 9.00 8.90 8.80 8.70 8.60 8.50 USD-NOK 8.59 8.33 8.48 8.63 8.53 8.19 8.02 Source: Spot exchange rate as of day of publishing. The left of the currency pair is the denominator of the exchange rate. Currency forecasts are for end of period. Source: BofA Merrill Lynch Global Research

Quarterly forecasts – EM currencies Spot 16-Dec 17-Mar 17-Jun 17-Sep 17-Dec 18-Mar

Latin America USD-BRL 3.38 3.60 3.65 3.70 3.80 3.90 3.90 USD-MXN 20.37 21.00 21.25 21.50 21.75 22.00 22.25 USD-CLP 679 670 685 700 715 730 740 USD-COP 3146 3150 3200 3250 3300 3350 3400 USD-ARS 15.49 15.80 16.00 17.00 17.50 18.00 18.50 USD-VEF 9.99 10.00 31.10 31.10 84.80 84.80 84.80 USD-PEN 3.40 3.45 3.47 3.50 3.52 3.55 3.60 Emerging Europe EUR-PLN 4.45 4.30 4.25 4.20 4.20 4.20 4.10 EUR-HUF 309 310 310 305 300 300 300 EUR-CZK 27.04 27.00 27.00 27.00 26.50 26.00 26.00 USD-UAH 25.82 25.80 25.80 25.80 25.80 25.80 25.80 USD-RUB 64.68 65.00 65.00 65.00 65.00 65.00 65.00 USD-ZAR 14.37 14.50 14.50 14.50 14.50 14.50 14.25 USD-TRY 3.37 3.15 3.10 3.15 3.20 3.20 3.20 EUR-RON 4.51 4.50 4.50 4.45 4.40 4.40 4.40 USD-EGP 15.95 11.50 11.50 11.50 11.50 11.50 11.50 USD-ILS 3.88 3.85 3.85 3.85 3.85 3.85 3.85 USD-AED 3.67 3.67 3.67 3.67 3.67 3.67 3.67 USD-KWD 0.30 0.28 0.28 — — — — USD-SAR 3.75 3.75 3.75 3.75 3.75 3.75 3.75 USD-QAR 3.64 3.64 3.64 3.64 3.64 3.64 3.64 Asian Bloc USD-KRW 1183 1,200 1,200 1,220 1,250 1,270 1,270 USD-TWD 32.06 32.10 32.40 32.70 33.10 33.40 33.40 USD-SGD 1.42 1.44 1.45 1.49 1.50 1.51 1.51 USD-THB 35.51 36.00 36.50 37.50 37.80 38.20 39.00 USD-HKD 7.76 7.76 7.77 7.78 7.79 7.80 7.80 USD-CNY 6.89 7.00 7.05 7.10 7.15 7.25 7.35 USD-IDR 13,428 13,700 13,900 14,200 14,400 14,600 14,500 USD-PHP 49.74 50.50 51.00 52.00 53.00 53.50 54.00 USD-MYR 4.42 4.41 4.45 4.55 4.65 4.71 4.68 USD-INR 68.14 68.25 68.10 68.50 69.00 70.00 69.50 Source: Spot exchange rate as of day of publishing. The left of the currency pair is the denominator of the exchange rate. Currency forecasts are for end of period. Source: BofA Merrill Lynch Global Research


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Research Analysts Global Economics Ethan S. Harris Global Economist MLPF&S

North America Economics Michelle Meyer US Economist MLPF&S

Emanuella Enenajor North America Economist MLPF&S

Lisa C. Berlin US Economist MLPF&S

Alexander Lin US Economist MLPF&S

Developed Europe Economics Gilles Moec Europe Economist MLI (UK)

Ruben Segura-Cayuela Europe Economist MLI (UK)

Robert Wood UK Economist MLI (UK)

Evelyn Herrmann Europe Economist MLI (UK)

Chiara Angeloni Europe Economist MLI (UK)

Japan Economics Izumi Devalier Japan Economist Merrill Lynch (Japan)

Australia Economics Tony Morriss Rates Strategist/Economist Merrill Lynch (Australia)

Alexandra Veroude Australia Economist Merrill Lynch (Australia)

Emerging Asia Economics Helen Qiao China & Asia Economist Merrill Lynch (Hong Kong)

Indranil Sen Gupta India Economist DSP Merrill Lynch (India)

Jaejoon Woo Korea Economist Merrill Lynch (Hong Kong)

Yin Zhang China Economist Merrill Lynch (Hong Kong)

Sylvia Sheng China Economist Merrill Lynch (Hong Kong)

Xiaojia Zhi China Economist Merrill Lynch (Hong Kong)

Jojo Gonzales ^^ Research Analyst Philippine Equity Partners

Supavud Saicheua Emerging Asia Economist Phatra Securities

EEMEA Strategy and Economics David Hauner, CFA EEMEA Cross Asset Strategist MLI (UK)

Vladimir Osakovskiy Russia, CIS Economist Merrill Lynch (Russia)

Arko Sen EEMEA FI/FX Strategist MLI (UK)

Mai Doan CEE, Israel Economist MLI (UK)

Jean-Michel Saliba MENA Economist/Strategist MLI (UK)

Gabriele Foa EEMEA Cross Asset Strategist MLI (UK)

Latin America Strategy and Economics Claudio Irigoyen LatAm FI/FX Strategy/Economist MLPF&S

David Beker Brazil Economist, FI Strategy Merrill Lynch (Brazil)

Jane Brauer Sovereign Debt FI Strategist MLPF&S

Carlos Capistran Mexico Economist Merrill Lynch (Mexico)

Ezequiel Aguirre LatAm FI/FX Strategist MLPF&S

Herve Belmas LatAm FI/FX Strategist MLPF&S

Ana Madeira Brazil Economist Merrill Lynch (Brazil)

Sebastian Rondeau LatAm FI/FX Strategist MLPF&S

BofA Merrill Lynch participated in the preparation of this report, in part, based on information provided by Philippine Equity Partners, Inc. (Philippine Equity Partners). ^^Philippine Equity Partners employees are not registered/qualified as research analysts under FINRA rules.

>> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules. Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take responsibility for this report in particular jurisdictions.

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