Nordic Outlook 26 June 2013

Sweden Summer daze

 In , we enter a long awaited summer with a sense of economic ‘je ne sais quoi’ regarding, well, just about everything. Losing market share  Fortunately, it seems we are not alone in our ambiguousness, even the Riksbank does not seem to be sure how to respond to an economy behaving like a seismograph.

 In short, and given a recent history of being caught empty handed in search of a trend, we play it safe and hold fast to our view of an economy slowly convalescing, leaving our GDP growth estimates for 2013 and 2014 more or less intact at 1.7% y/y (previously 1.7% y/y) and 2.1% y/y (previously 2.0% y/y) respectively.

 However, the volatility in the world economy leaves our forecasts for the small open economy of Sweden vulnerable to major future Sources: National Institute for Economic and Social Research revisions – not only on the downside. (NIESR), National Institute for Economic Research (KI) and Statistics Sweden (SCB). Danske Bank calculations  Nonetheless, demand growing by circa 2% y/y should be enough to keep employment growing and eventually push the unemployment rate below 8%, despite a high influx of labour.

 Considering our, admittedly, low estimate of 1.5% y/y potential GDP growth, the above developments would suffice to increase resource utilisation. However, as an excess supply of resources is likely to be sustained throughout the forecast years, inflationary pressures will probably remain very low and excluding the interest rate component we expect (CPIF) to undershoot the 2% y/y inflation target even within the three year horizon.

 The Riksbank, with a couple of new members on board, is due to convene shortly after this text is published and we are honestly very uncertain on what to think of the Riksbank’s future decisions. Up until this spring, we had been advocating a more expansive monetary policy stance but as the world economy is on the mend, we have also had a change of heart, sort of.

 To be more specific, we have chosen to look away from our more pessimistic fundamental views on, exempli gratia, the debt situation in the world as the unconventional monetary policy enacted by major central banks is at last showing signs of working. Also, from a short- term perspective, it seems unwise to fight the FED, the ECB, the Bank of Japan and so on – at least all at the same time…

Setting the global stage for a small open economy starlet The US economy in general, and the US housing market in particular, continues to be a source of optimism, where new houses are again being erected as household formation has finally depleted inventories of unsold houses and outpaced the historically low housing completions by some margin (not to mention for some time). Hence, and to no little extent thanks to apt monetary policy measures directed at the financing of house

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mortgages, house prices have posted consecutive growth for almost a year, with an apparent chance of positive dynamics through both wealth effects and a relaxation of credit conditions.

A long sought after recovery in activity in large developing economies (the BRIC countries to use a popular acronym) also seems to be underway, despite perhaps being inadequate for those expecting a new world order within a year or two. After all, a slowing growth rate is to be expected as many of the BRICs approach the Lewis turning point, where domestic demand becomes the main impetus of growth (and as they successfully steer clear of the middle-income trap). This process entails becoming more specialised and more import dependent, which should be regarded as a long- term gain for the world economy. In addition, from what we can gather, many of the measures taken to stimulate demand in growing economies are also aimed directly at increasing investments, which is an extra boon, particularly for the investment goods laden Swedish exports industry.

Even the manufacturing giant Japan seems ready for a bold step into the unknown with an(other) significant fiscal stimulus package and a new, almost foolproof, resolve by the Bank of Japan to escape the liquidity trap once and for all (herein lie significant risks too but we hope for the best).

Despite what seems a shift in tactics from unrelenting and unpopular austerity measures to longer term growth-enhancing reforms (privatisation, deregulation, etc.) southern Europe, including , is mired in and we expect little positive news from these economies near term. Alas, the downside risks of the European situation are abundant, not only from a Swedish but also from a global perspective. Luckily, the south of Europe is a miniscule part of Swedish export markets, which is why we expect growth in international import demand for Swedish exports – world market growth – to hold up relatively well over the forecast horizon.

In short, we expect Swedish world market growth to surpass 3% y/y in 2013 and be in line with historical averages, at around 6.5% y/y, in 2014.

Notwithstanding the emergence of a more positive financial market sentiment and stabilising real developments, downside risks are still predominant and the dispersion and development of risks is likely to take close scrutiny going forward. Among these risks are possible confidence effects from the rather mild fiscal contraction in the US, a more assertive stance from the ECB or other creditors (IMF, et al, etc.) on fiscal slippage in southern Europe and, of course, political upheaval in conjunction with elections or critical fiscal policy decisions in both creditor and debtor nations.

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Economic policy mix and asset prices Since April, the SEK has developed sideways measured against most Countering the “nine year soft patch” currencies and the broad trade-weighted currency index KIX has bounced back up (i.e. depreciated) in both nominal and real terms, providing some short-term relief for exporters. However, due to the fundamental strengths of the Swedish economy, we suspect this relief will prove temporary. In our view, the foreseen stronger currency will hurt profit margins and might cause Swedish stock markets to underperform global stock market indices for a protracted period.

Interest rates have continued to rise over the past few months, on almost all maturities, counteracting some of the monetary policy stimuli released over the past few months. However, (credit) risk premiums have continued to Sources: KI and SCB. Danske Bank calculations move lower, leaving corporate and housing financing rates at, or very close to, historically low levels on most horizons. As in most other countries, short- term interest rates are firmly repressed by the central bank, whereas the improved market sentiment and economic outlook have started to push longer interest rates upwards. As the tentative rise in longer term rates represents a positive change in market sentiment and the economic outlook and the absolute levels are still close to historical lows, we do not believe current interest rate levels constitute any threat to the economic recovery. Any renewed weakness in the outlook should thus be accompanied, rather than led on, by changes in market interest rates. This proposition is further underlined as the Riksbank enjoys a very high inflation fighting credibility, further negating the risk of a stifling rise in market interest rates.

Believing that a tepid economic recovery is about to unfold, it should come as no surprise that we expect the Riksbank eventually to initiate a hiking cycle. However, such actions should take place only against the background of a Swedish economy on much firmer footing, which we believe implies a first hike deep into 2014, continuing at a very slow pace for the remainder of the forecast horizon (and beyond). Under any circumstances, the foreseen hikes would keep monetary policy in expansionary territory for a very long time, even when taking account of various structural issues such as lower potential growth and higher structural unemployment.

The other, often overlooked, pillar of stabilisation policy is the economic policy mix in general and fiscal policies in particular. For even in a perfect world, where fiscal policy is concentrated on structural issues, any decision is likely to have cyclical consequences when being promulgated through the economy. According to Finance Minister Anders Borg, there is room for additional structural measures – mainly tax cuts for low- and middle-income earners – but his calculations are based on an optimistic 2.7% y/y potential growth rate, which is rather far from our own estimate of 1.5% y/y. We can understand the political rationale behind such arguments but, given the strong legal framework surrounding the sustainability of fiscal policy, the government is likely in time (pass the forecast horizon) to be forced to cut back on some of its promises or even reduce spending (or hike taxes). In our forecast, nonetheless, government expenditure is set to expand by circa 1% y/y in both 2013 and 2014, pushing central government net lending to -1% of GDP this year and -0.75% of GDP next year.

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To conclude our discussion on the economic policy mix, our estimates indicate that while monetary policy is suitably expansionary throughout the forecast Monetary Conditions seem balanced horizon, we see a risk of overly expansionary fiscal policy necessitating future austerity, perhaps at a more sensitive stage of the business cycle.

The expansionary stance of domestic monetary policy is augmented by abundant liquidity on a global scale on the back of significant quantitative measures from all central banks in major currency areas. As can be seen from statistics on, inter alia, portfolio investments, this liquidity has to some extent washed onto Swedish shores, and foreign demand for Swedish assets has been rising on trend for almost two years. Sovereign, corporate and housing financing have therefore remained cheap or have become even cheaper over the last couple of years. Despite the effect of the stronger SEK, Swedish stock Note: MCI is calculated as the deviation from a filtered trend of different interest rates and an exchange rate index (all variables markets have thus developed on a strong note, even compared with doped are normalised). stock markets such as the US, UK et al. We expect Swedish stock markets to Source: Macrobond. Danske Bank calculations develop in line with (long-term) nominal GDP, i.e. rise by 3-5% a year.

Swedish housing markets have remained afloat despite a public discourse on increased regulations of lending standards and a generally sour sentiment during autumn last year. In some areas, a small decrease in housing prices is visible but at a national level prices are more or less unchanged. We continue to expect a limited fall in house prices, amounting to between 2.5% y/y and 5.0% y/y in both 2013 and 2014. From a longer term perspective, our view is that Swedish house prices are above their fundamental value by more than 20%, underlining that something will probably have to yield; either prices demonstrate a more abrupt correction or – in a more benign scenario – household incomes rise while house prices remain stable.

Summing up economic and financial conditions, we believe that the supply and price of credit no longer places restrictions on the Swedish economy. Instead, it is a lack of demand for credit – viable investment projects – that is lacking. This probably has more to do with depressed expectations of future incomes than anything. A more pronounced shift in the income outlook– in line with our short-term forecasts – would nonetheless benefit from credit being freely available. There is even a non-negligible risk that this process will pick up steam much faster than we expect due to the extremely loose global monetary conditions, creating a not so clear cut policy dilemma for many central banks. Net exports losing its shine Under the influence The global outlook is slowly becoming more positive and demand for typically Swedish export products is on the increase. At the same time, economic conditions are mostly benign, lending support to the recovery. However, the stronger krona – though not yet at levels where it wreaks havoc on the export industry – is likely to restrain international demand growth for Swedish exports over the entire forecast horizon, which is why our forecast for exports is quite subdued from a historical perspective. In 2013, we even expect export growth to be negative, at 0.9% y/y, due largely to a very weak starting point for 2013, whereas annualised growth rates going forward Source: KI, SCB, Danske Bank calculations demonstrate export growth above 4% y/y. In 2014, we forecast export growth will improve further to 4.1% y/y.

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If Swedish exports froze in the winter months, import growth was worse still. Weak demand for industrial goods and a need to control inventories pushed The krona pushes up imports, and alters the consecutive import growth into the red over the winter. However, looking at inventory cycle demand and inventory indicators, there is evidence that this inventory cycle has run its course and we should see some recoil in imports. In addition, the stronger krona is beneficial for importers and consumers, lifting import growth throughout the forecast horizon. All in all, we expect positive import growth of 0.5% y/y and 6.8% y/y in 2013 and 2014, respectively.

Taken together, and under the influence of a structurally stronger krona, this means we expect net exports to stop being a main contributor to growth over coming years, with the net export contribution calculated at a meagre 0.5pp y/y this year and 0pp y/y in 2014. Underneath these dismal figures, we nonetheless Source: KI, SCB, Danske Bank calculations

see signs of a gradual restructuring of the export sector towards higher value added products (services), which are normally less sensitive to currency changes.

Investment outlook better than could be feared

The currently low growth in exports and consumption demand, together with Investments warranted by new economic production in the manufacturing industry running low, has produced structures considerable slack in the economy, which we expect to keep a lid on investment growth over the first few quarters of our forecast horizon. However, our long-held view is that the slack in the economy is considerably lower than generally perceived, as a lot of the capital stock has become obsolete due to large shifts in relative costs and exchange rates, etc, in the wake of the great recession. These shifts necessitate investments in productive capacity in new and growing industries. In addition, there is an excess demand for housing and in areas where market prices exceed production costs (Tobin’s Q), typically high population density areas, there should be room for additional investments, even when taking our sombre outlook on house prices into account. Source: KI, SCB, Danske Bank calculations

Public investments are another area where we expect to see positive growth. The government has previously announced large investments in infrastructure and so on and, with an election year approaching, we expect an increase in public investments.

To sum up, we expect investment growth in 2013 to be negative, falling by 2.8% y/y. In 2014, we expect the above-mentioned factors to come more clearly into play and, together with a higher overall level of demand, we believe they will produce investment growth of close to 4% y/y, on our forecasts.

Labour market developments are not so bad Despite a superficial weakening of Swedish labour markets, the lingering impression is one of relative stability. The newfound flexibility among both employers and unions has let hours worked (and thus largely also the monthly pay cheque) become a buffer instead of large layoffs at the first sign of a deceleration. This pattern has been discernible ever since the onset of the great recession and seems to have worked well, even though we initially considered this merely to be traditional labour hoarding, albeit in a somewhat more sophisticated form.

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Despite the labour market normally lagging growth by a couple of quarters, we can already see some green shoots in labour market indicators. Not only Labour markets on the mend have notices of layoffs come down close to ‘normal’ levels, employment plans and other survey data on the labour market have clearly turned a corner and are even in expansionary territory again for some business sectors. Nonetheless, investment growth has historically proven to be perhaps the most reliable indicator for employment, as investments not only demand people to construct and install them but also to operate new equipment. We do not think this time around will be much different but the large pool of people outside the labour force might keep unemployment rates higher for longer even with pronounced improvements in employment.

Another issue when judging labour market developments is how to dissect Source: KI, SCB, Danske Bank calculations that it is almost solely the group of (full-time) students looking for a job that is pushing up the unemployment rate. This is not necessarily a bad omen but rather an effect of the Swedish student financing scheme and, perhaps, too many students of liberal arts (pun intended). When allowing for students looking for work, joblessness is not as much of a problem, not even for youths, as the media (and politicians) suggest.

To conclude, the good news is that labour markets seem to be over the worst, with most indicators pointing in the right direction. Therefore, we expect employment at least to remain stable in the near term. However, growth in average hours worked has been depressed, which is why a more pronounced upturn could take some time. As investment growth picks up steam and developments in more labour-intensive industries such as construction and retail also progress, we should nonetheless see a more substantial improvement in both employment and the unemployment rate but we expect this to take place mainly next year. In numerical terms, we estimate that employment will hardly grow in 2013 and grow by more than 1% y/y in 2014. This should be enough to keep the unemployment rate stable above 8.5% for the better part of this year and see it recede below 8% over the course of 2014. However, in our view, the large number of unemployed and people returning from outside the labour force will keep unemployment rates at elevated levels for a long time, even beyond the forecast horizon.

No place like home Household confidence is improving, after reaching a nadir during the winter months. Not only was the general risk sentiment very low in anticipation of a Consumed by a stronger exchange rate number of decisive international events but notices of layoffs also shot up and the Riksbank seemed intent on driving down housing wealth. In response, households increased their savings further, from already very high levels. Now, as downward forces have receded, we expect stronger household consumption growth near term but the lack of swift progress in employment will probably keep any pent-up demand at bay for some time yet. Nonetheless, the stronger SEK is already proving to have an impact, as travel and consumption abroad have picked up and there is anecdotal evidence of improved pricing in – exempli gratia – clothing and shoes producing stronger volume growth. Source: KI, SCB, Danske Bank calculations

Next year we expect a more solid improvement in household consumption, as increased employment and slightly higher wages lift disposable incomes. In addition, we expect some decrease in precautionary savings. However, wise

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from the experiences of recent years, we have chosen not to revise this variable much. Overall, we expect household consumption growth to surpass the historical average of 2% y/y in both 2013 and 2014.

Resource utilisation and inflation

In the preceding text, we have touched on the main components involved Productivity growth weak in a historical when compiling GDP. Our lingering impression is one of an improving perspective economic environment. However, it is a recovery that is bleak by any historical comparison and one that is still laden with large downside risks, ready to push the world economy and the export-dependent Swedish economy into the doldrums without much notice. Nevertheless, and despite apparent downside risks, for the first time in many years, we are also able to identify upside risks in the nexus of very strong liquidity, rising asset prices and a more pronounced shift in sentiment.

To sum up, we expect GDP growth to accelerate in 2013 and 2014 and we have chosen to keep our optimistic forecasts in place. In 2013, we estimate Source: KI, SCB, Danske Bank calculations GDP will grow by 1.7% y/y (previously 1.7% y/y). For 2014, we have made a small revision and now expect GDP growth of 2.1% y/y versus 2.0% y/y in our previous forecast.

Optimistic in comparison with other forecasters we may be but, from a historical perspective, this is a meagre outcome for a recovery phase. Inflationary pressures are non-existent However, we believe that the great recession has altered the structure of the world economy and, hence, also of the Swedish economy. The most obvious change is an ongoing, fundamentally warranted, strengthening of the that still has some way to go. The stronger SEK pushes low value added export companies into dire straits and some of them will probably be put out of business or be forced to relocate production to other economies. Still, having a rather rigid labour market, the effects on the Swedish economy are already visible – stubbornly high unemployment rates. Eventually, we might see more decisive political measures to address this problem but given the highly sensitive ideological nature of the resolutions on offer, we suspect Source: KI, SCB, Danske Bank calculations this will take a long time. In the meantime, estimates on potential growth should recede and we have ‘guesstimated’ – with the use mainly of demographical projections – long-term GDP growth at no higher than 1.5% y/y. Beware, though, that given the very limited time series at hand, the effects on potential estimates are difficult to assess quantitatively and are also very sensitive to specifications. Interest rate costs included in CPI, make the Weak potential growth will mean that even the feeble growth rates expected Riksbank chase its own tail over the next couple of years should be able to reduce slack – increase resource utilisation – and give way to increasing inflationary pressures. Make no mistake about it though, current levels of resource utilisation are very low and this has been a restraining factor in the wage negotiations over the spring. In our view, the deflationary impact of low wage growth will, to some extent, be balanced by low productivity growth keeping cost pressures – measured in terms of unit labour costs (ULC) – around 1.5% y/y over the forecast horizon, a level deemed sufficient to pull inflation slowly from the current deflationary territory and towards the inflation target (2%). However, the structural strengthening of the SEK works in the other direction, which is Source: SCB, Riksbank, Macrobond, Danske Bank calculations

why we will probably need to move beyond 2014 to see the operational

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inflation target, CPIF (CPI excluding the impact of interest costs), being attained.

Riksbank rolling From our perspective, it should all be so simple. Contrary to many of its Riksbank to hike earlier but more slowly peers, the Riksbank successfully managed to exit all non-standard measures at the height of the and there is no need to support fiscal policy, which is why the discussion on fiscal dominance heard elsewhere has not even started in Sweden. This should make it possible for the Riksbank to focus more squarely on the inflation target.

The above situation should be the envy of most central banks, which have increased non-standard measures and run the risk of losing confidence, letting the inflation genie out of its bottle again, should they be found financing significant fiscal deficits.

However, the Riksbank has chosen to create its own, rather unique, policy Source: Riksbank, Macrobond, Danske Bank calculations

dilemma in adding financial stability considerations into its discussions on monetary policy, labelling it macro prudence. According to the Riksbank, the lack of adequate instruments to control high and rising household indebtedness might to no little extent be balanced by a higher policy rate. This thinking has led to one of the most public and heated debates on the current stabilisation policy regime Sweden has seen in a very long time, as it is seen as expanding the Riksbank’s powers and obfuscating any evaluation of the Riksbank’s performance.

We do not enter that debate here; suffice to say that it has altered the monetary policy reaction function in a macro prudential direction but has unfortunately also become a major source of uncertainty regarding future monetary policy measures. After being once bitten, twice shy on expecting a more punitive Riksbank during the spring, we have pusillanimously pushed our expectations on a first hike deep into 2014 and a projected hiking cycle, which can undoubtedly be labelled cautious, thenceforth. By year-end 2014, the repo rate is still below 2%.

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Sweden: Forecast at a glance 2011 2011 2012 2013 2014 SEK bn Vol growth in % Private consumption 1672.9 2.1 1.5 2.7 2.1 Government consumption 926.0 1.1 0.7 1.0 0.8 Fixed gross cap formation 646.0 6.4 3.2 -2.7 3.3 Stocks* 40.5 0.4 -1.1 0.2 0.2 Domestic demand 3245.0 2.7 1.6 1.1 2.0 Exports 1748.8 7.1 0.8 -0.8 3.9 Aggregate demand 3285.2 3.2 0.4 1.3 2.2 Imports 1531.5 6.3 0.0 -2.2 4.6 Net exports* 217.0 0.6 0.4 0.5 -0.1 GDP 3502.5 3.7 0.7 1.7 2.0 - GDP, Calendar adjusted 3.7 1.1 1.7 2.1 * contribution to GDP growth

2011 2012 2013 2014 Trade balance, SEK bn 91 91 116 135 in % of GDP 2.6 2.6 3.2 3.5 Current Account, SEK bn 257 238 286 318 in % of GDP 7.3 6.7 7.8 8.3

Public sector savings, SEK bn -3 -21 -41 -34 in % of GDP -0.1 -0.6 -1.1 -0.9 Public debt ratio, % of GDP* 38.4 37.7 37.7 37.8

Unemployment, % of labour force 7.8 8.0 8.6 8.4 Hourly wages, % y/y 3.2 2.7 2.7 3.0 Consumer prices, % y/y 3.0 0.9 0.1 1.5 House prices, % y/y 0.8 -1.4 -2.5 -5.0 * Maastricht definition 21/06/13 + 3 mths + 6 mths + 12 mths Repo-rate 1.00 1.00 1.00 1.00 2-yr swap yield 1.51 1.35 1.40 1.60 10-yr swap yield 2.63 1.75 1.95 2.20 SEK/EUR 8.8 8.40 8.30 8.20 SEK/USD 6.7 6.46 6.54 6.51 Source: Danske Bank

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