Baltic macro outlook Q3 2017 Rokas Grajauskas Chief Baltic Economist Danske Bank A/S Lithuania branch rokas.grajauskas@danskebank.lt +370 674 03350 2017-09-25 Investment Research General Market Conditions www.danskebank.com/ci Important disclosures and certifications are contained from page 28 of this presentation
Key messages Economic growth is rebounding more strongly in all three Baltic states this year. In Q2 17 GDP expanded by 5.7% y/y in Estonia and 4.0% y/y in both Latvia and Lithuania. Economic growth is being driven by a rebound in investment and exports while also supported by strong domestic consumption. Exports are recovering due to stronger import demand in key exports markets the EU for products of domestic origin and Russia for reexported products. Wage growth continues to accelerate in all three economies, thus boosting domestic demand and pushing up prices. The Baltic states now have the highest inflation rates in the EU. Inflation this year is also boosted by higher energy and food prices (and alcohol in the case of Lithuania). As wage growth accelerates and as productivity growth lags behind, the risk increases that the Baltic economies might start overheating. Although indicators like the trade balance still point to relatively strong external positions of the Baltic states, the governments should increasingly aim for surplus budgets and pay attention to bottlenecks in the labour market as well as encourage productivity growth through higher investment and innovation. We expect growth momentum to slow down somewhat towards the end of the year and into 2018 but growth will nevertheless remain at higher levels compared to the last several years. We expect economic growth in 2017 to average 4.4% in Estonia, 3.9% in Latvia and 3.8% in Lithuania. In 2018 growth should respectively reach 3.2%, 3.4% and 3.5%. 1
Economic growth rebounds The Baltic states are seeing clear signs of economic recovery in 2017. In Q2 17 GDP expanded by 5.7% in Estonia and 4.0% in both Latvia and Lithuania. Economic growth is being driven by a rebound in investment and exports while also supported by strong domestic consumption. We expect growth momentum to slow down towards the end of the year and into 2018 but growth will nevertheless remain at higher levels compared to the last several years. We expect economic growth in 2017 to average 4.4% in Estonia, 3.9% in Latvia and 3.8% in Lithuania. In 2018 growth should reach 3.2% in Estonia, 3.4% in Latvia and 3.5% in Lithuania. Source: Macrobond, Danske Bank estimates 2
Economic sentiment on an upward trajectory Economic recovery has also translated into growing economic sentiment, which is now at the level seen around 2004 when all three economies started entering a more pronounced boom period. Economic sentiment has lately been supported both by growing wages and falling unemployment as well as rising business revenues and profits. Source: European Commission, Macrobond, Danske Bank 3
Strong investment recovery in Estonia After four years of consecutive contraction, investment activity in Estonia in 2017 is rebounding and pushing up overall GDP growth. In H1 17 fixed increased by 17.6% y/y and was the key driver behind economic growth. Investment this year is facilitated not only by high capacity utilisation rates and higher business confidence but also by the pick-up in the disbursement of EU funding. Private consumption in H1 17 grew by only 1.5%, the lowest rate since 2010. They key factor to drag down consumption growth this year is higher inflation, which averaged 3.2% in the first half of the year. Supported by more robust growth in key export markets, Estonian exports of goods and services expanded by 4.1% in H1 17. Exports should remain a strong driver behind growth in both 2017 and 2018. 15.0 Growth of GDP components, Estonia (%) 10.0 5.0 0.0 2012 2013 2014 2015 2016 2017E 2018E -5.0-10.0-15.0 Consumption Investment Exports Imports Source: Macrobond, Danske Bank estimates 4
Consumption growth in Latvia picks up speed After a very sharp contraction in 2016, investment this year is picking up in Latvia as well in H1 17 investment activity in the country expanded by 18.5% y/y. Investment growth is being driven by the same factors as as in the other Baltic states high capacity utilisation rates, increasing business sentiment and higher EU funding. Despite fast growth in wages, consumption in Latvia in the last years was relatively subdued. This is changing in 2017 notwithstanding higher inflation, private consumption in H1 17 expanded by 4.9% y/y, the fastest rate in four years. Consumption is the biggest contributor to GDP growth this year. Latvian exports of goods and services expanded by 6.5% y/y in H1 17, the fastest rate since 2012. 15.0 Growth of GDP components, Latvia (%) 10.0 5.0 0.0 2012 2013 2014 2015 2016 2017E 2018E -5.0-10.0-15.0 Consumption Investment Exports Imports Source: Macrobond, Danske Bank estimates 5
Balanced growth in Lithuania Economic growth in Lithuania is much more balanced in 2017. Exports are by far the biggest contributor to growth, having expanded by 10.9% y/y in H1 17. As a result, the share of exports to GDP in Lithuania has again climbed above 80%, making it the most export-oriented economy in the Baltics. Driven by the fastest wage growth in the region, private consumption in Lithuania continues to grow by a healthy 4.0% despite higher inflation, which averaged 3.2% in H1 17. After suffering a minor contraction last year, fixed investment is recovering in Lithuania as well, growing by 6.9% y/y in H1 17. 15.0 Growth of GDP components, Lithuania (%) 10.0 5.0 0.0 2012 2013 2014 2015 2016 2017E 2018E -5.0-10.0-15.0 Consumption Investment Exports Imports Source: Macrobond, Danske Bank Markets estimates 6
Factors behind GDP growth in H1 2017 2500 Contribution to GDP change in 2017H1 (EURm, constant prices) Estonia Latvia Lithuania 2000 1500 1448 1000 500 0-500 -1000 312 349 75-256 -27 402 292 203 407 478-507 -183-1432 -1500-37 -2000 Source: National statistical offices, Danske Bank Markets Consumption Investment Exports Imports Inventory change 7
Finland takes over as Estonian s most important export partner Estonian exports of goods and services grew by 4.1% y/y in H1 17. Exports of goods expanded by 2.7%, of services by 7.1%. Key markets were exports increased were the EU and other countries. The main market among other countries is China. Main categories that expanded to China were telecommunications equipment and wood products. The single country were exports expanded most was Russia (+28% y/y, mainly re-exported products). The country were exports declined most was Sweden (mainly telecommunications equipment). As a result, Sweden became Estonia s second most important trading partner, giving way to Finland. In the export of services, the key categories that expanded were transportation and business services. 400 Change in Estonian exports of goods and services, H1 2017 (y/y, EURm) 300 200 100 0-100 Baltics Nordics Other EU Russia Other CIS US Others -200 Goods (without oil) Services Source: Statistics Estonia, Bank of Estonia, Danske Bank Markets 8
EU market drives Latvian export growth Latvian exports of goods and services expanded by 6.5% y/y in H1 17 (goods expanded by 5.7%, services by 9.7%). Exports expanded most to Nordic markets and other EU countries, primarily Germany. The single country that added most to exports was Russia, to which exports grew by 31.6% y/y. The key categories to have grown overall were iron and steel products, beverages and electrical equipment. Grain exports experienced the biggest fall, declining by 10.2% y/y. In terms of services, main categories that expanded were transportation, construction and business services. The countries were the export of services expanded most were Sweden, the UK and Ireland. 300.0 Change in Latvian exports of goods and services, H1 2017 (y/y, EURm) 250.0 200.0 150.0 100.0 50.0 0.0-50.0 Baltics Nordics Other EU Russia Other CIS US Others -100.0 Goods (without oil) Services Source: Statistics Latvia, Bank of Latvia, Danske Bank Markets 9
Lithuania leads the Baltics in export growth Lithuanian exports of goods and services in H1 17 expanded by 10.9% y/y (goods expanded by 10.2%, services by 13.5%). Exports expanded to all key markets but primarily to Russia, Sweden and Belarus. The key categories to have grown were machinery, electrical and transport equipment. Russia remains Lithuania s main export market (if re-exported products are included), accounting for 14% of total exports. Services exports expanded most to Germany, France and Russia and were driven primarily by transportation, IT and business services. 600.0 Change in Lithuanian exports of goods and services, H1 2017 (y/y, EURm) 500.0 400.0 300.0 200.0 100.0 0.0-100.0 Baltics Nordics Other EU Russia Other CIS US Others Goods (without oil) Services Source: Statistics Lithuania, Bank of Lithuania, Danske Bank Markets 10
Investment recovery drives construction growth in Estonia The first half of 2017 brought growth momentum to all economic sectors in Estonia. The total turnover of companies in H1 17 expanded by 9.3% y/y, while profits grew by 19.9% y/y. Construction saw the biggest increase as EU funding picked up and investment activity rebounded after four consecutive years of contraction. Manufacturing output grew by 4.5% y/y. The sub-sector that grew most in absolute terms was metal processing, which increased its output by 90m (19.1% y/y). The sub-sector that saw the biggest decrease was optical and electronic products, largely represented by Ericsson Eesti, which declined by 17.8% ( 156m in absolute terms). Estonia - change in turnover of companies by sector, H1 2017 (%, y/y) 0 5 10 15 20 25 Estonia - change in profit of companies by sector, H1 2017 (%, y/y) -100-50 0 50 100 Agriculture 3.1 Agriculture -12.2 Manufacturing 4.5 Manufacturing 49.6 Energy 12.4 Energy 11.0 Construction 23.8 Construction 6.9 Wholesale trade 7.1 Wholesale trade 12.3 Retail trade 6.8 Retail trade -30.6 Transportation 8.8 Transportation 42.2 Accommodation and catering 6.4 Accommodation and catering -65.1 ICT 8.1 ICT -67.2 Source: Statistics Estonia, Danske Bank Markets 11
Estonian manufacturing led by metal processing Estonia - change in turnover of manufacturing companies, H1 2017 (%, y/y) Food products Beverages Textiles Wood and paper products Chemical products Pharmaceutical products Plastic products Glass and other non-metallic mineral products Metal products Optical and electronic products Electrical equipment Machinery Transport equipment Furniture -60-40 -20 0 20 40-37.9-17.8 8.7 4.6 3.7 2.6 9.8 9.8 8.6 4.5 9.7 20.2 19.1 16.8 Estonia - change in profit of manufacturing companies, H1 2017 (%, y/y) Food products Beverages Textiles Wood and paper products Chemical products Pharmaceutical products Plastic products Glass and other non-metallic mineral products Metal products Optical and electronic products Electrical equipment Machinery Transport equipment Furniture -150-100 -50 0 50 100 150-75.5-106.7-2 times -1.5-9.6-6.9-13.0 3.7 12.6 2.8 times 87.4 4.2 times 3.2 times 108.0 Source: Statistics Estonia, Danske Bank Markets 12
Impressive growth of all economic sectors in Latvia The total turnover of Latvian companies in H1 17 expanded by 15.6% y/y, while profits grew by 25.3%. Growth was broad-based but the sector that grew most in absolute terms was wholesale trade (+20.4% or 1458m). Real manufacturing output expanded by 7.7%, while nominal output grew by 14.3%, the difference being explained by price changes. The sub-sector that contributed most in absolute terms was food processing, growing by 95m. Percentage-wise the pharmaceutical industry grew most, increasing its output by more than a half. However, being a relatively small sector, in absolute terms its output expanded only by 36m. Latvia - change in turnover of companies by sector, H1 2017 (%, y/y) 0 5 10 15 20 25 30 Latvia - change in profit of companies by sector, H1 2017 (%, y/y) -20 0 20 40 60 80 100 Agriculture 13.6 Agriculture 39.4 Manufacturing 14.3 Manufacturing 20.7 Construction 27.8 Construction 31.9 Wholesale trade 20.4 Wholesale trade 53.2 Retail trade 11.9 Retail trade 8.4 Transportation 13.6 Transportation 18.1 Accommodation and catering 20.0 Accommodation and catering 2.1 times ICT 13.5 ICT-7.4 Source: Statistics Latvia, Danske Bank Markets Note: profit before taxes 13
Latvian manufacturing growth across the board Latvia - change in turnover of manufacturing companies, H1 2017 (%, y/y) 0 10 20 30 40 50 60 Latvia - change in profit of manufacturing companies, H1 2017 (%, y/y) -100-50 0 50 100 Food products 13.9 Food products 17.2 Beverages 19.8 Beverages -23.8 Textiles 14.9 Textiles 52.3 Wood and paper products 8.2 Wood and paper products -10.9 Chemical products 15.6 Chemical products 40.2 Pharmaceutical products 54.5 Pharmaceutical products 2.9 times Plastic products 16.2 Plastic products -2.0 Glass and other non-metallic mineral products 13.9 Glass and other non-metallic mineral products -4.6 times Metal products 11.0 Metal products -42.5 Optical and electronic products 27.7 Optical and electronic products 23.4 Electrical equipment 21.9 Electrical equipment 8.2 Machinery 20.2 Machinery 5.3 times Transport equipment 24.3 Transport equipment 2.8 Furniture 21.2 Furniture 12.6 Source: Statistics Latvia, Danske Bank Markets Note: profit before taxes 14
Most of Lithuanian sectors post solid results The total turnover of Lithuanian companies in H1 17 grew by 13.2% y/y, while profits increased by 11.0%. Manufacturing saw an impressive 17.4% y/y growth, however, much of it is explained by growth in prices in real terms manufacturing output increased by 7.4%. The sectors that grew most in absolute terms were food production as well as wood and paper processing. After a contraction in 2016, construction output in 2017 is seeing a strong recovery, non-residential construction being the key growth driver. Transportation posted a solid growth figure of 19.1% y/y in large part due to a recovery in exports. Lithuania - change in turnover of companies by sector, H1 2017 (%, y/y) -10 0 10 20 30 Lithuania - change in profit of companies by sector, H1 2017 (%, y/y) -150-100 -50 0 50 100 150 Agriculture 14.2 Agriculture 115.8 Manufacturing 17.4 Manufacturing -20.8 Energy -2.1 Energy -22.9 Construction 20.1 Construction -99.7 Wholesale trade 4.8 Wholesale trade 17.5 Retail trade 15.3 Retail trade 12.5 Transportation 19.1 Transportation 33.0 Accommodation and catering 25.9 Accommodation and catering -21.6 ICT 18.4 ICT 2.5 Source: Statistics Lithuania, Danske Bank Markets Note: profit before taxes 15
Lithuanian manufacturing led by the food industry Lithuania - change in turnover of manufacturing companies, H1 2017 (%, y/y) -10 0 10 20 30 40 Lithuania - change in profit of manufacturing companies, H1 2017 (%, y/y) -150-100 -50 0 50 100 150 Food products 10.7 Food products -33.8 Beverages -4.3 Beverages -88.7 Textiles 12.6 Textiles 11.1 Wood and paper products 16.7 Wood and paper products 24.2 Chemical products 10.1 Chemical products -23.7 Pharmaceutical products -4.7 Pharmaceutical products -73.1 Plastic products Glass and other non-metallic mineral products Metal products 6.6 15.1 30.5 Plastic products Glass and other non-metallic mineral products Metal products -86.9-29.9-5.0 Optical and electronic products 30.5 Optical and electronic products 56.1 Electrical equipment 31.0 Electrical equipment 104.6 Machinery 26.0 Machinery 51.2 Transport equipment 13.1 Transport equipment 77.4 Furniture 14.1 Furniture 41.0 Source: Statistics Lithuania, Danske Bank Markets Note: profit after taxes 16
Lithuania continues to lead the Baltic states in wage growth In H1 17 Lithuania continued to lead the Baltic states in wage growth. Average wages grew by 6.4% y/y in Estonia, 7.9% y/y in Latvia and 9.0% y/y in Lithuania. A rebound in economic growth and decreasing slack in the labour market should maintain considerable pressure on wage growth, which we expect to continue moderately accelerating in all three Baltic states over the forecast horizon. 35 Gross wage growth (%) 30 25 Latvia 20 15 10 5 Estonia Lithuania 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E -5-10 Source: National statistical offices, Danske Bank estimates 17
2012M01 2012M03 2012M05 2012M07 2012M09 2012M11 2013M01 2013M03 2013M05 2013M07 2013M09 2013M11 2014M01 2014M03 2014M05 2014M07 2014M09 2014M11 2015M01 2015M03 2015M05 2015M07 2015M09 2015M11 2016M01 2016M03 2016M05 2016M07 2016M09 2016M11 2017M01 2017M03 2017M05 2017M07 2017M09 2017M11 Inflation in Estonia accelerates Inflation in Estonia reached 4.2% in August and was the highest in five years. Inflation is being driven primarily by the sharp increase in food prices (+7.6% in August). Key food categories to have increased in price in August were milk products (13.2%). Core inflation in May stood at 2.4% and was significantly higher than last year, when it averaged 1.2%. Energy price inflation has remained fairly stable in 2017. It posted 5.8% August and has averaged 6.0% since the beginning of the year. We expect inflation in Estonia in 2017 to average 3.5% and 2.8% in 2018. 5.0 Inflation rate in Estonia 4.0 3.0 2.0 1.0 0.0-1.0-2.0 Core inflation Food Energy Headline inflation Forecast Source: Statistics Estonia, Danske Bank Markets 18
2012M01 2012M03 2012M05 2012M07 2012M09 2012M11 2013M01 2013M03 2013M05 2013M07 2013M09 2013M11 2014M01 2014M03 2014M05 2014M07 2014M09 2014M11 2015M01 2015M03 2015M05 2015M07 2015M09 2015M11 2016M01 2016M03 2016M05 2016M07 2016M09 2016M11 2017M01 2017M03 2017M05 2017M07 2017M09 2017M11 Core inflation still lowest in Latvia Inflation in Latvia in May was 3.2%, the lowest among the Baltics, yet still significantly higher than last year and than in most other EU countries. The key driver behind higher inflation was food prices. Milk products in August increased by 13.1% compared to a year earlier, vegetable prices rose by 13.0%. At 2.0%, core inflation in Latvia was the lowest in the Baltics but has accelerated since July when it posted only 1.0%. Energy prices in August were 3.4% higher compared to a year earlier. We expect inflation to average 3.0% in 2017. In 2018 inflation should be slightly lower and average 2.9%. 5.0 Inflation rate in Latvia 4.0 3.0 2.0 1.0 0.0-1.0-2.0 Core inflation Food Energy Headline inflation Forecast Source: Statistics Latvia, Danske Bank Markets 19
2012M01 2012M03 2012M05 2012M07 2012M09 2012M11 2013M01 2013M03 2013M05 2013M07 2013M09 2013M11 2014M01 2014M03 2014M05 2014M07 2014M09 2014M11 2015M01 2015M03 2015M05 2015M07 2015M09 2015M11 2016M01 2016M03 2016M05 2016M07 2016M09 2016M11 2017M01 2017M03 2017M05 2017M07 2017M09 2017M11 Core inflation in Lithuania reaches the post-crisis high Inflation in Lithuania posted 4.6% in August and was the highest in the EU. Contrary to the other Baltic states, inflation in Lithuania is primarily boosted by higher core inflation, which reached 3.6% in August and was the highest since 2008. High core inflation is being driven by strong wage growth. Another factor behind inflation is alcohol prices, which increased sharply since March when higher excise taxes were introduced. Beer prices in May were 30% higher compared to a year earlier, wine was on average 8.0%, spirits 6.5% more expensive. We expect inflation in Lithuania to average 3.7% in 2017 and fall to 3.1% in 2018. 5.0 Inflation rate in Lithuania 4.0 3.0 2.0 1.0 0.0-1.0-2.0 Core inflation Food Energy Headline inflation Forecast Source: Statistics Lithuania, Danske Bank Markets 20
Ar the Baltic states overheating? As wage growth accelerates and economic sentiment becomes more optimistic, the risk increases that the Baltic states will start overheating. One of the key factors to watch is unit labour costs, which show the relationship between growth in wages and productivity. Unit labour costs have been rising in all three economies lately as a result of high wage growth and poor growth in productivity. However, slow productivity growth has also been the result of weak demand and thus economic growth. As growth is picking up, productivity is set to grow at a much higher pace in 2017 as well. Nevertheless, wage growth is likely exceed productivity growth over the next few years. Source: European Commission, Danske Bank 21
Trade balances indicate still largely competitive external positions Another indicator to watch is trade balance. If domestic demand booms while productivity growth lags behind, this should translate into wider trade deficits, a trend visible in the run-up to the 2008-09 crisis. However, trade balances last year were positive in all three economies, an occurrence not seen since official records became available in early 1990s. Source: European Commission, Danske Bank 22
Output gaps positive but still close to balance Even if output gaps are still close to balance and trade balances do not yet indicate a loss of competitiveness, governments in the region should increasingly aim to have surplus budgets, accumulate fiscal reserves, seek to solve bottlenecks in the labour market and concentrate on stimulating productivity growth through higher investment and stronger innovation potential. Source: European Commission, Danske Bank 23
Unemployment in Estonia hoovering around the 6% threshold Unemployment in Estonia has been hoovering around 6% since early 2015. This is despite relatively robust job creation. The reason why unemployment is not taking a further dip down is growing labour force. Labour force is expanding due to higher immigration as well as higher activity rates among the old and the partly disabled. Employment growth in Q2 17 was positive despite the fact that public sector employment decreased by 13.4k y/y. The sectors that added most jobs to the market were wholesale, retail trade and transportation (+10.1k) as well as professional services (+4.9k). As Estonia s labour force continues to grow, unemployment should decrease only marginally. We expect unemployment to average 6.3% in 2017 and 6.2% in 2018. Source: Macrobond, Danske Bank Markets 24
Employment continues to shrink in Latvia In Q2 17 there were 12.9k less workers employed in the Latvian economy compared to a year earlier. Worker shedding was most active in agriculture (-20.1k), professional services (-14.3k) and construction (-11.3k). The public sector, on the other hand, added a whopping 43.3k workers on its payroll and achieved a record high employment of 217 thousand. Despite negative employment trends, the unemployment rate continues to edge down due to the fact that the labour force is shrinking faster than employment. As economic growth accelerates, this should serve as a positive factor for employment growth. We expect the unemployment rate in Latvia to continue falling and average 8.7% in 2017 and 8.2% in 2018. Source: Macrobond, Danske Bank Markets 25
Negative job creation in Lithuania in the first half of 2017 Employment in Lithuania shrank for the second quarter in a row. In Q2 17 there were 4.8k less employed people compared to a year earlier. The sectors that reduced employment most were construction (-5.7k) and agriculture (-4.3k). The public sector had 2k less workers. The sectors that increased employment most were finance and insurance (+2.6k) as well as arts and entertainment (+2.4k). Despite negative job creation, as labour force continues to shrink the unemployment rate continues to decline as well. In Q2 17 the unemployment rate was 7.1%. Economic recovery should encourage further job creation. We expect the unemployment rate to continue edging downward and average 7.4% in 2017 and 7.0% in 2018. Source: Macrobond, Danske Bank Markets 26
Macroeconomic forecasts Year GDP (% y/y) HICP inflation (% y/y) Private consumption (% y/y) Fixed investments (% y/y) Exports, goods & services (% y/y) Gross wage growth (% y/y) Unemployment (%) 2016 1.6 0.8 4.1-2.8 3.6 7.3 6.8 Estonia 2017E 4.4 3.5 2.1 12.5 3.9 6.8 6.3 2018E 3.2 2.8 3.2 5.3 3.2 7.0 6.2 2019E 3.4 2.9 3.4 5.9 3.4 7.2 6.0 2016 2.0 0.1 3.4-11.7 2.8 5.0 9.6 Latvia 2017E 3.9 3.0 4.4 13.8 4.9 7.6 8.7 2018E 3.4 2.9 4.2 5.8 3.4 8.2 8.2 2019E 3.3 3.0 3.9 6.2 3.5 8.4 7.8 2016 2.3 0.7 5.6-0.5 2.9 7.9 7.9 Lithuania 2017E 3.8 3.7 3.9 7.2 6.1 8.5 7.4 2018E 3.5 3.1 4.0 6.3 3.6 9.1 7.0 2019E 3.4 3.2 3.8 6.1 3.7 9.3 6.7 27
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