28 February 2014
For professional investors only
Schroders
Economic and Strategy Viewpoint
Keith Wade
Chief Economist and
Strategist
Azad Zangana
European Economist
Craig Botham
Emerging Markets
Economist
Global recovery to shrug off bad weather (page 2)
 Despite the recent wobble in the world economy and a further downgrade to
the emerging economies, we continue to forecast a year of recovery in 2014.
We attribute much of the recent weakness in US activity to adverse weather,
although recognise that there is also an inventory correction weighing on
activity. Growth should pick up in the second quarter and we expect the Fed to
continue with the taper and actually raise rates in the third quarter of next year.
Meanwhile, the ECB and BoJ are expected to ease further to support activity
and inflation, whilst the Bank of England remains on hold through the forecast.
 The risks to our forecasts are still tilted toward deflation although there is an
increased probability of a stronger reflationary outcome if animal spirits
return to the G7. On the downside, our greatest concern is a hard landing in
China emanating from the financial sector. Such an outcome would hit the
rest of the emerging markets, particularly the commodity producers.
Europe: Deflation fears to trigger ECB action (page 6)
 Eurozone GDP growth is recovering as expected with no change to our 2014
and 2015 forecast. German growth has been downgraded due to its export
exposure to emerging markets, while better results from the periphery
prompt an upgrade. The inflation forecast has been lowered, and should
prompt the ECB to cut rates in the near term. Meanwhile, UK inflation has
also been downgraded, while growth has been upgraded, although a
slowdown in activity is still forecast going forward.
BRICs: Central banks must be cruel to be kind (page 10)
 We have downgraded the growth outlook for the BRICs and EM in the face of
tighter monetary policy, and a range of country specific concerns. Central
banks are increasingly finding they must be cruel to be kind, and tame
inflation even at the cost of lower growth.
Views at a glance (page 15)
 A short summary of our main macro views and where we see the risks to the
world economy.
Chart: G7 set to lead global GDP recovery
Contributions to World GDP growth (%, y/y)
6
4.9 5.0
4.8
4.8
5
Forecast
4.4
4.1
3.6
4
3.1
2.8
3
2.6
2.4
3.0
3.1
14
15
2.0
2.2
2
1
0
-1
-0.9
-2
-3
00
01
US
BRICS
02
03
04
05
06
07
Europe
Rest of emerging
08
09
Japan
World
10
11
12
13
Rest of advanced
Source: Thomson Datastream, Schroders 24 February 2014 forecast. Previous forecast from
November 2013. Please note the forecast warning at the back of the document.
Issued in February 2014 by Schroder Investment Management Limited.
31 Gresham Street, London EC2V 7QA. Registered No. 1893220 England.
Authorised and regulated by the Financial Conduct Authority.
28 February 2014
For professional investors only
Global recovery to shrug off bad weather
Recovery forecast
intact, but
emerging markets
are downgraded
again
Our updated forecasts continue to paint a picture of recovery in the world economy,
led by the developing world. Forecasts for the latter are little changed this month,
but we have edged down our numbers for the emerging markets once again. Overall
global growth is forecast to accelerate to 3% this year after 2.6% in 2013.
In the near term this is consistent with the latest Purchasing Managers Indices
(PMI’s) which show the BRIC nations struggling to gain traction whilst the developed
economies remain firmly in expansion territory, despite having softened recently.
Looking further out, our Emerging Market downgrade is in response to the tightening
of monetary policy across the region which will weigh on growth, offsetting the
benefits of a lower exchange rate.
Chart 1: Developed markets PMIs leading the recovery
Index
60
55
50
45
40
35
30
2006
2007
2008
2009
2010
Developed
2011
2012
BRICs
2013
2014
Source: Markit, Schroders. 27 February 2014.
Weather has taken
its toll on US
growth, although it
is not the only
factor
1
For the US we have left our growth forecast at 3% for this year and next based on
the judgement that much of the recent weakness in activity has been due to the
adverse weather. The number of heating days1 this winter has been exceptionally
high (chart 2) and the cold weather has taken a toll on the economy, particularly the
construction and retail sectors. Signs are that with the cold extending into February,
the data releases in March will also be influenced by climatic conditions.
Heating degree days are a measure of temperature, weighted by population, calculated by taking the average
temperature in a day. If this number is less than 65°F (18°C), it is subtracted from 65°F to find the number of heating
degree days. If it is above 65°F, a score of zero is registered for the day. The heating degree days for a given month are
calculated by summing the total daily heating degree days.
2
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Chart 2: Cold winter in the US
50
Unusually cold daily temperatures
45
40
35
30
25
20
15
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 2 4 6 8 10 12 14 16 18 20 22 24
Jan-14
Feb-14
Heating days
± 1 StDev (Jan)
LR average for Jan
± 1 StDev (Feb)
LR average for Feb
Averages and standard deviations calculated from data from 1900. Source: National Oceanic and
Atmospheric Administration. 27 February 2014.
Not all of the weaker data in the US can be attributed to the weather: we expect
some payback in the first quarter as a result of a surge in inventory building and
capital expenditure in the second half of 2013. As a result the quarterly profile for
growth has altered with a softer first quarter than previously expected (see chart 3).
Nonetheless, we continue to look for a recovery as housing improves and the fiscal
drag which weighed on growth in 2013 fades.
Chart 3: US GDP forecast profile
US GDP forecast (%, Q/Q annualised)
+4.5
+4.0
+3.5
+3.0
+2.5
+2.0
+1.5
+1.0
+0.5
+0.0
i
ii
iii
2012
iv
i
ii
iii
iv
2013
Previous forecast
i
ii
iii
iv
i
2014
ii
iii
iv
2015
Current forecast
Source: Thomson Datastream, Schroders 24 February 2014 forecast. Previous forecast from
November 2013. Please note the forecast warning at the back of the document.
Now looking for
the ECB to cut
rates and the Fed
to tighten earlier
Elsewhere, we have pushed up our UK growth forecast to 2.6% for this year (from
2.4%) and have raised that for Japan slightly. Both changes assume that some of
the momentum from 2013 spills over into 2014. However, we expect the UK to find
2015 challenging as political uncertainty weighs on activity. Japan is expected to
experience a more immediate setback as the consumption tax increases. Our
Eurozone forecasts are largely unchanged, but within the region we have raised the
peripheral economies at the expense of the core (see next section for more detail).
3
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On the policy front, we are now assuming an ECB rate cut of 15 basis points to
0.1% in the second quarter as the central bank acts to reinforce the recovery and
head off fears of deflation. Elsewhere we have brought forward our first US policy
rate hike to the third quarter of 2015, to reflect a faster than previously forecast fall
in unemployment. We still expect the Fed to end QE by October this year. By
contrast, the Bank of Japan is expected to step up asset purchases in the second
quarter of this year as the economy weakens in response to the consumption tax
increase. Contrary to market expectations we do not expect the Bank of England to
raise interest rates until 2016.
Since the US is the only of the major developed economies tightening policy over
the forecast horizon, our forecasts factor in a stronger US dollar.
Risks and scenarios
Balance of risks
still in a
deflationary
direction led by a
hard landing
scenario in China
The distribution of global risks is still skewed toward the downside for growth and
inflation. Top of the list on the downside is a hard landing in China which then
impacts the rest of the emerging markets, particularly the more vulnerable deficit
economies – the China financial crisis scenario. While all but the most bullish
commentators have recognised that China is going through a period of structural
reform which will necessitate weaker growth, views diverge on the ability of the
authorities to restructure the financial sector without a significant hit to growth.
Recent experience in the West suggests that de-leveraging an economy is fraught
with systemic risks as, like a gigantic game of Jenga where players remove blocks
from a tower, it is not always clear which loan default will prove to be the one which
brings the whole structure tumbling down. We take comfort from arguments that the
Wealth Management products which constitute the bulk of the shadow banking
system are not leveraged and are more like fund management products than bank
loans. Nonetheless, the reluctance of the authorities to allow a significant default
suggests that there may be more risk in the system than widely perceived. Even
without leverage the losses incurred by investors are likely to be a drag on activity
as households try to make good their savings whilst making it more difficult to
finance future projects.
If China does experience a hard landing the spill overs would be significant, but
largely felt in the emerging world. For example, one recent model suggests a
negative impulse of 1% in China’s GDP would reduce global growth by just under
0.5% after 4 quarters (see table 1). Of this, 12 basis points would be the direct
impact on China with the remainder coming from the rest of the world. Breaking this
down further the emerging markets would experience a slowdown of about 75 basis
points with the greatest losses in Latin America and EMEA. The developed world
would lose 20 basis points in growth, a smaller hit as part of the shock from China is
mitigated by lower commodity prices, which act like a tax cut to consumers.
Table 1: Impact and spill over from a 1% GDP growth impulse by region
Source of impulse
Global
Direct
Spill over
Developed
Emerging
Asia
Latin America
EMEA
USA
EMU
JPN
CHN
1.01
0.24
0.77
0.86
0.68
0.39
0.92
1.31
0.65
0.21
0.44
0.32
0.60
0.50
0.48
1.06
0.28
0.09
0.19
0.20
0.16
0.10
0.22
0.32
0.46
0.12
0.35
0.21
0.73
0.51
0.82
0.92
Table shows effect after 4 quarters
Source: JP Morgan, Schroders. 27 February 2014.
4
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28 February 2014
On the upside,
animal spirits
could drive a G7
boom
For professional investors only
Our other deflationary risk scenarios include the Eurozone dropping into outright
price deflation (see next section for more on Eurozone deflation) and one where
Abenomics results in a significant move in the JPY to 130 against the USD
(Abenomics squared). Our final downside scenario – Trade war - would take us in
a stagflationary direction as the territorial island dispute between China and Japan
escalates. Trade barriers increase resulting in weaker growth, whilst firms hoard
commodities pushing up prices and inflation.
On the upside we see a G7 boom, an extension of our previous US boom scenario
to Europe and Japan. The combination of pent up demand in the household sector
combined with increased capital expenditure by the corporate sector results in a
much stronger increase in activity. Such a scenario would require a significant shift
in animal spirits and there is also likely to be higher inflation and tighter monetary
policy (see chart 4).
Chart 4: Scenario growth-inflation grid
2015 Inflation vs. baseline forecast
+2.0
Stagflationary
Reflationary
+1.5
Trade war
+1.0
G7 boom
+0.5
+0.0
-0.5
China financial
crisis + Fragile
5
Abenomics2
-1.0
Baseline
Eurozone
deflation
-1.5
Deflationary
-2.0
-2.0
-1.5
Productivity boost
-1.0
-0.5
+0.0
+0.5
+1.0
2015 Growth vs. baseline forecast
+1.5
+2.0
Source: Thomson Datastream, Schroders February 2014 forecast. Please note the forecast
warning at the back of the document.
The probabilities we put on the different scenarios are shown below with the highest
individual risk being the G7 boom (at 10%) and China financial crisis (at 6%).
Chart 5: Scenario probabilities
Eurozone
deflation, 5%
G7 boom, 10%
Baseline, 70%
Trade war, 3%
Abenomics2,
4%
China financial
crisis + Fragile
5, 6%
Other, 2%
Source: Thomson Datastream, Schroders February 2014 forecast. Please note the forecast
warning at the back of the document.
5
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Europe: Forecast update
Activity in Europe has been fairly robust of late, supporting our forecast of an
ongoing but slow recovery. However, inflation has been lower than expected, largely
as a result of external factors. While we do not forecast a protracted period of falling
prices, low inflation in itself increases the risk of a self perpetuating deflationary
spiral. The backdrop is unhelpful. Aggressive fiscal and banking deleveraging is
placing immense pressure on households and corporates to cut back, in itself
imposing deflationary pressures.
Meanwhile, the Bank of England has found reason to significantly upgrade its
growth forecast, and yet, remains relaxed on when interest rates need to rise.
The Bank of England (BoE) and European Central Bank (ECB) will face increasing
pressure to act on policy in the coming months, albeit in opposite directions.
Whether those actions are delivered are important questions for investors.
Recovery solidifying
Eurozone aggregate growth rose to 0.3% in the three months to December - a slight
acceleration compared to the 0.1% growth recorded in the third quarter (see chart
6). The results were in line with our forecast, but slightly above the Bloomberg
consensus of 0.2%.
Within Europe, the UK delivered the strongest performance for the second
consecutive quarter amongst the largest member states. Germany saw quarterly
growth pick up from 0.3% to 0.4% in the fourth quarter, while France surprised the
consensus by achieving 0.3% growth. Spain’s 0.2% was slightly lower than the
earlier flash estimate, while Italy achieved 0.1% growth, the first quarterly rise in
activity since the second quarter of 2011. Elsewhere, both the Netherlands and
Portugal outperformed expectations by growing by 0.7% and 0.5% respectively.
Austria grew by a solid 0.3%, but Finland disappointed with a 0.8% contraction,
taking it back into recession.
Chart 6: European growth accelerating
Q/Q
Growth at the end
of 2013 was
largely as
expected, showing
a continuation of
the recovery
1.0%
0.8%
0.6%
0.4%
0.2%
0.0%
-0.2%
-0.4%
-0.6%
-0.8%
-1.0%
Fin
Ita
Spa
Fra
Aus
EZ
Bel
Ger
Q3
Q4
Source: Thomson Datastream, Eurostat, Schroders. 27 February 2014.
Por
Neth
UK
The data available on the expenditure breakdown of GDP paints a mixed picture.
For example, while France saw all the major final demand indicators improving in
the fourth quarter, Germany experienced a contraction in household consumption
and flat government spending. Spain saw household consumption and total
investment rise, however, government spending fell by a huge 3.9% on the quarter,
which is a drag of approximately 0.8 percentage points in the fourth quarter. There
6
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28 February 2014
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were similarities in the external performance. Net trade was a positive contributor
across the mentioned three as export growth outpaced growth in imports. Finally,
France and Germany reported falls in inventories which coupled with the already
low levels suggest that the turn in the inventory cycle could help support growth in
the coming quarters. Indeed, this is our central case scenario for 2014. Support from
the inventory cycle will be very important to pushing growth back above 1% in 2014.
Meanwhile, the breakdown of UK GDP showed a better balance of growth as
household consumption more than halved, while total investment increased by 2.4%
on the quarter – a long overdue pick up from very depressed levels as we have
highlighted in the past. Inventories made a slightly negative contribution, but the fall
was not enough to unwind the build up from the middle of last year. We continue to
expect UK growth to ease in order for inventories to be run down. Finally, UK
exports also grew, while imports declined, yielding a positive contribution from net
trade.
Eurozone forecast update
Our Eurozone
growth forecast is
unchanged at the
headline level…
…although
Germany has been
downgraded, while
peripheral Europe
upgraded.
Overall, our forecast for Eurozone aggregate GDP is unchanged at 1.1% for 2014
and 1.4% for 2015 (chart 7). However, the forecast for German growth has been
lowered from 2.1% in 2014 to 1.9%, and from 2.3% in 2015 to 2.2%. This reflects
the downgrade in the growth forecast for China and emerging markets, which
Germany has a larger export exposure to than its European partners. Excluding
Germany, the remaining Eurozone countries mostly saw upgrades, in particular
Spain and France. This has been driven by a softer stance from banks on their
willingness to lend this year. Our equity analysts suggest that banks in peripheral
Europe, but especially in Spain, are looking to expand lending this year. We
continue to expect lending to be weak due to the deleveraging pressure imposed by
the European Central Bank’s asset quality review (AQR) and stress tests, however
at the margin, this is a more positive signal for domestic demand. It means that the
risks to the forecast are shifting to the upside. To reflect this, we have dropped the
previous ‘Spanish bailout’ scenario, and incorporated a stronger Eurozone recovery
in the ‘G7 boom’ scenario.
Chart 7: Eurozone GDP forecast
Chart 8: Eurozone CPI forecast
%, Q/Q
+0.6
%, Y/Y
+3.0
+0.4
+2.5
+0.2
+2.0
+0.0
+1.5
-0.2
Real GDP
forecast
-0.4
HICP inflation
forecast
+1.0
+0.5
-0.6
i ii iii iv i ii iii iv i ii iii iv i ii iii iv
2012
2013
2014
+0.0
i ii iii iv i ii iii iv i ii iii iv i ii iii iv
2015
2012
2013
2014
2015
Current forecast
Previous forecast
Source: Thomson Datastream, Schroders 24 February 2014 forecast. Previous forecast from
November 2013. Please note the forecast warning at the back of the document.
Current forecast
Previous forecast
While the growth outlook is improving, the outlook for inflation is becoming more
complex. We have lowered our forecast for inflation in the coming months due to
increased deflationary pressures from food and energy prices, but also due to the
significant depreciation of many emerging market currencies, and the likely
weakness that will follow (chart 8). The latter is likely to lower import price inflation,
7
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Authorised and regulated by the Financial Conduct Authority
28 February 2014
Lower Eurozone
inflation should
prompt the ECB to
cut interest rates
in the near future
For professional investors only
and therefore feed through to consumer prices in the Eurozone with a lag.
We have also changed our forecast for ECB interest rates. We expect the ECB to
react by cutting the main refinancing rate from 0.25% to 0.1% in the coming months.
There is a high chance the cut is made following the ECB’s March meeting where
new internal forecasts are presented. However, with growth picking up, and credit
growth improving, the ECB may opt to wait and see in March, minded that much of
the drivers of recent low inflation should be temporary. We believe a rate cut will
however follow by June in response to the lower inflation data as it is published.
A cut in the main refinancing rate should be accompanied by a cut in the marginal
lending rate (penal rate for excess reliance on the central bank), but the deposit rate
is unlikely to be cut from its current level of zero. Taking the deposit rate into
negative territory would encourage the currency to depreciate, but it would impose
an additional cost to banks, which will undoubtedly be passed on to households and
businesses. Instead, we expect the ECB to continue to explore the possibility of
purchasing asset backed securities, but is unlikely to pursue the policy until after the
AQR has been completed. This would help overcome German objections to banking
legacy assets being purchased or used to bail-out banks directly.
A further development worth watching is the interaction between the German
Constitutional Court (GCC) and European institutions. Earlier this month, the GCC
referred a decision on the legality of the ECB’s Outright Monetary Transactions
(OMT) programme to the European Court of Justice (ECJ), with a strong opinion
that in its current state (unlimited and targeted programme of bond buying) is illegal
based on the ECB’s mandate. The referral could open up a can of worms as if the
ECJ agrees with the GCC’s opinion, then it could force the Bundesbank to consider
withdrawing from its partnership/subscription with the ECB – implying a German exit
from the Euro. This is an extreme interpretation, and would only follow if the ECJ
fully ruled against the ECB’s use of the OMT, and importantly, the ECB refused to
back away from the programme. A far more likely outcome would be for the ECJ to
acknowledge some of the points the GCC makes, and possibly to
accept/recommend some limitations on the OMT in order to keep Germany happy.
This could risk resurrecting negative sentiment towards peripheral Europe,
especially if investors start to believe that the ECB has no effective safety net at its
disposal. However, given the market’s lack of response to the news, either investors
are oblivious to the risks, or they continue to believe Mr Draghi’s commitment to do
whatever it takes to save the Euro. In our view, the latter is more likely, and we too
believe that the ECB could introduce new programmes to side-step a GCC/ECJ
ruling if market conditions were to worsen. In any case, with both Spanish and
Italian 10-year government bond yields falling below 3.5% this month, investors
seem much more relaxed about peripheral government debt than last year.
UK growth
remains strong,
and has become a
little more
balanced
UK forecast update
The forecast for UK real GDP growth has been revised up slightly from 2.4% to
2.6% in 2014, and from 1.9% to 2.1% for 2015 (see chart 9 on next page). This is
partly driven by better than forecast results for the end of 2013, but also the pick up
in business investment, which should continue in the coming quarters. We continue
to forecast a slowdown from the recent peak in quarterly growth, and are very
sceptical of the Bank of England’s 3.4-3.8% 2014 GDP forecast.
8
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28 February 2014
Our UK growth
forecast has been
upgraded, while
inflation forecast
downgraded
For professional investors only
Chart 9: UK GDP forecast
Chart 10: UK CPI forecast
%, Q/Q
+1.0
%, Y/Y
+4.0
CPI inflation
forecast
+0.8
+3.5
+0.6
+3.0
+0.4
Real GDP
forecast
+0.2
+2.5
+0.0
+2.0
-0.2
-0.4
i ii iii iv i ii iii iv i ii iii iv i ii iii iv
2012
2013
2014
2015
Current forecast
Previous forecast
+1.5
i ii iii iv i ii iii iv i ii iii iv i ii iii iv
2012
2013
2014
2015
Current forecast
Previous forecast
Source: Thomson Datastream, Schroders 24 February 2014 forecast. Previous forecast from
November 2013. Please note the forecast warning at the back of the document.
The debate on
when UK interest
rates will rise is
intensifying, with
some calling for
early 2015
Inflation on the other hand has been surprising to the downside. The annual rate of
CPI inflation fell to 1.9% in January, which was the first fall below the BoE’s central
2% inflation target since November 2009. Like in the rest of Europe, lower fuel and
food price inflation has pushed headline inflation lower. However, a major factor
behind the lower inflation at the end of 2013 compared to our November forecast
was the smaller than previously announced increases in home energy prices. Under
pressure from the opposition, the government has temporarily reduced green
energy levies on energy providers, which in turn have passed on the savings.
Looking ahead, inflation should fall further in coming months before rebounding in
the second half of the year as base effects begin to reverse.
As for interest rates, we continue to forecast no change until the start of 2016, which
is predicated on GDP growth disappointing the BoE in the coming year. Our forecast
assumes fiscal tightening resumes after the May 2015 general election (which has
generally been absent this year), while the powerful Help-to-Buy housing scheme is
also expected to expire at the same time.
The Bank backed away from its previous 7% unemployment threshold, but instead
confused most with a wide array of indicators that it will now comment on. We
support the holistic approach the Bank is emphasising, but the ongoing commentary
is unhelpful, especially in trying to judge the degree of spare capacity in the
economy. See the Schroders Quickview: BoE bamboozles with changes to forward
guidance. The risk to our forecast is that the Bank hikes rates earlier rather than
later. In recent press interviews, Monetary Policy Committee member Martin Weale
said that “…the first rise will come perhaps in the spring of next year.” It is worth
pointing out that Weale is one of the more hawkish members of the committee, but
nevertheless, it highlights the risk of an earlier rise in interest rates.
9
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28 February 2014
We expect lower
EM growth on
tighter monetary
policy
For professional investors only
BRICs: Central banks must be cruel to be kind
This forecast update sees a round of downgrades for emerging market growth, as
central banks are forced to tighten more than anticipated, partly as a consequence
of earlier than expected QE tapering. On top of this there are also growth negative
country specific issues to be concerned with. Commodity prices offer some relief on
inflation, but supply side constraints will continue to exert upward pressure on prices
in many EM economies.
Table 2: Summary of BRIC forecasts
GDP
% per
2012
2013f
2014f
annum
7.8
7.7
7.1 ↓
China
0.9
2.3
1.8 ↓
Brazil
5.1
4.7
5.0 ↓
India*
3.4
1.3
1.8 ↓
Russia
2015f
7.3 ↓
2.2 ↓
5.5 ↓
2.4 ↓
2012
2.6
5.4
9.7
5.1
Inflation
2013
2014f
2.6
2.7 ↑
6.2
6.3 ↑
10.1
7.1 ↓
6.8
6.3 ↑
2015f
2.9 ↓
5.8 ↑
6.1 ↓
5.8 ↓
*In this Viewpoint, we have switched to forecasting CPI, instead of WPI as previously for India,
following a change in stance by the central bank. Source: Bloomberg, Thomson Datastream,
Schroders. 24 February 2014. Previous forecast from November 2013. Please note the forecast
warning at the back of the document.
China has had a
troubled start this
year
Investment and
exports are likely
to be softer
China: Colic in the year of the horse
2014 has started with unpromising data for China, The HSBC manufacturing PMI
slipped into contractionary territory in January, and continued its decline in
February. There are also signs that the housing market, a key support of growth in
recent years, is cooling, with fewer cities reporting price rises. The only positive
piece of data has been stronger than expected export growth, but this figure is likely
distorted by the New Year holiday, and we expected a much weaker print in
February. The government has reportedly also lowered its export growth target for
this year, to 7.4% from the 7.9% achieved last year.
Meanwhile, this also looks likely to be a very testing year for the authorities on the
financial front. Two high profile trust product defaults have already occurred this
year, and over 5000 trust products will mature at some point over 2014, far more
than in previous years and at a time of tightening monetary conditions. The
government faces a difficult balancing act: it wants to reduce moral hazard in the
system, which means private investors must bear losses in event of default, but it
does not want to spark a run on the financial system. A gradual approach seems
likely; the defaults this year have seen investors forced to take small losses,
compared to full reimbursement in previous years. Still, some impact on sentiment
and investment is unavoidable.
With both exports and investment looking weaker, and no sign of a significant pick
up in consumption, it is difficult to see where growth will come from (chart 11 on next
page). Consequently, we have reduced our growth forecast for China from 7.3% to
7.1% this year, retaining our path of a small bounce in 2015 as growth friendly
reforms come into effect. Though growth could temporarily dip below 7% this year,
we believe this would prompt government stimulus to keep the economy above the
7% level. This need not take the form of credit stimulus, which would only worsen
existing problems of excess capacity and leveraging. Lower interest rates (reducing
servicing costs for embattled corporates) and a direct fiscal stimulus package
comprised of tax cuts and outright expenditures seem likely to be a more effective
mix.
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Chart 11: Net exports have dragged on Chinese growth
Contribution to GDP annual growth, ppt
12
10
8
6
4
2
0
-2
2011
2012
Consumption
Monetary policy is
free to focus on
finance rather than
inflation
Net exports
2013
Investment
Source: Thomson Datastream, Schroders. 25 February 2014
Inflation should remain well below the 3.5% target this year, helped by lower
commodity prices, particularly oil and food, and the prevailing tighter monetary
conditions in China. Recent prints have been subdued, at 2.5% (chart 12),
reportedly driven in part by the effect of the anti-corruption drive on luxury foods.
Producer prices remain in deflationary territory in a sign of continued overcapacity
issues. In any event, monetary policy will likely remain focused on controlling the
financial system this year, so even though lower inflation provides scope for easing,
don’t expect it unless the economy looks set to miss its growth target, due to be
announced in March. A financial crisis is the biggest risk to Chinese growth, and the
authorities are determined to squeeze the shadow financing system to a more
manageable size. Expect maintenance of a tight stance this year.
Chart 12: Chinese inflation pressures remain subdued
%
20
15
10
5
0
-5
-10
Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14
Headline CPI (y/y)
CPI Food (y/y)
Source: Thomson Datastream, Schroders. 25 February 2014.
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PPI (y/y)
28 February 2014
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Brazil: Inflation gets political
Brazil’s problems
multiply, with
weakness on most
fronts
Brazil’s growth number has been downgraded to 1.8% from 2.0% largely on tighter
monetary policy aimed at controlling inflation, though events in Argentina and a
recent drought will also have an impact. Activity data so far this year has not been
encouraging. Though we have seen improvement in the manufacturing PMI, the
services PMI, industrial production growth, and the central bank’s economic activity
index are all showing signs of weakness (chart 13).
Chart 13: Bleakness in Brazil
%, 3mma
5
Index
55
4
54
3
53
2
52
1
51
0
50
-1
49
-2
48
-3
47
-4
46
-5
May 12
45
Aug 12
Nov 12
Feb 13
BCB activity indicator
Fiscal and
inflation issues
key politically
May 13
Aug 13
Industrial production
Nov 13
Feb 14
Services PMI (rhs)
Source: Thomson Datastream, Markit, Schroders. 25 February 2014
Politics continues to play a key role with elections in October. The latest poll showed
a declining approval rate for Rousseff’s government, down from the 43.0% recorded
in December. There are signs both that the electorate cares more about inflation
and the cost of living than growth, and also that the government recognises this.
Both the central bank and government officials have been taking a more hawkish
stance, and inflation has been gradually pushed down, though at the cost of lower
growth. Fiscal policy is now more supportive of the monetary stance, with spending
cuts announced in the latest budget. Though this is as much to forestall a ratings
downgrade as it is to address inflation, it reflects a welcome if belated change of
stance from the government.
Inflation itself has begun to respond to tighter monetary policy, with 250 basis points
of hikes now since April last year. Nonetheless, interest rate hikes can only do so
much to contain inflation in an economy with supply side problems, and Brazil will
need investment to resolve its inflation problem in the long run, and as we have said
in past Viewpoints, there seems little prospect of an investment recovery until after
October’s elections. The recent drought is also likely to cause higher food and
electricity prices in the coming months. We expect monetary policy to remain tight
this year, as the central bank continues attempts to anchor expectations and reestablish credibility.
The new inflation
targeting
approach ensures
tight policy
India: Growth’s not in the bank
India’s economy has been picking up recently, and higher growth this year seems
assured. Exports have responded well to the weaker rupee, which is now broadly
stable, while imports have contracted on restrictions and demand suppression.
Governor Rajan is seeing the first signs of success in his campaign against inflation,
having hiked rates again in January, to 8% (chart 14). However, this tighter
monetary policy seems likely to have a negative impact on economic growth. Rajan,
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who wants to focus on CPI inflation in the future instead of WPI (producer prices),
believes that at present there is no negative growth-inflation trade off because
inflation is so high it is reducing real incomes and confidence. While that may be
true, it will still take time to hit the mooted target of 4% (+/- 2% to allow for supply
side shocks), and the transition period is likely to see subdued domestic demand.
Growth last year was also helped by a stronger harvest induced by better weather
conditions, and there is a risk of the El Nino weather pattern having the opposite
effect this year. Finally, the banking system remains strained, and India’s high
corporate leverage combined with poor provisioning could see slow credit growth
acting as a drag on GDP this year.
Chart 14: India’s tightening is beginning to work
%
9.0
%, y/y
11.5
11.0
10.5
8.5
10.0
9.5
8.0
9.0
8.5
7.5
8.0
7.5
7.0
Jan 12 Apr 12
7.0
Jul 12
Oct 12 Jan 13 Apr 13
Bank rate
Political concerns
are clouding the
growth outlook
Jul 13
Oct 13 Jan 14
CPI (rhs)
Source: Thomson Datastream, Schroders. 27 February 2014
Opinion polls continue to point to a BJP victory in May’s elections, under Narenda
Modi, and we still see this as a positive outcome given Modi’s success in Gujarat.
However, we are concerned that voters remain easily swayed by populist policy and
subsidies, as exemplified by the success of the AAP (Common Man Party) in New
Delhi which offered free water and electricity to the poor. We had thought voters
would have appetite for change after years of poor progress under this model, and
must now reassess our view. The risk of a “Third Front” government (an alliance of
smaller parties) can not be discounted, and if realised would likely see a less
effective and more unstable government. The increased political uncertainty and
challenges to domestic demand mentioned above have caused us to downgrade
our growth expectations for India this year, though we still think investment will pick
up after the elections.
On inflation, eagle eyed and eidetic readers may notice a considerable change in
our inflation numbers. As mentioned above, this is due to Rajan’s preference for
targeting the CPI and the likely formalisation of this position post-election (formation
of an MPC and the creation of an official CPI target requires legislation). CPI, like
WPI, has been elevated in recent years, but we think the tighter monetary policy
from the RBI will remain in place this year, and succeed in gradually pushing
inflation down toward the target range towards the end of 2015.
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Still no hope of
monetary easing
despite stagnant
growth
For professional investors only
Russia: Reform required
Data suggests that Russia slowed coming into 2014, with industrial production
falling, retail sales growth slowing, and no change in agricultural output. PMI data is
similarly uncheerful. Although this slowdown has at least been accompanied by a
moderation of inflation, from 6.5% in December to 6.1% in January, the ruble has
depreciated around 8% against the dollar so far this year, which will provide a fresh
inflation impulse to the economy. There is therefore little hope for a rate cut to
support growth. If anything, the bank’s stance is becoming more hawkish; in its most
recent statement it said it would tighten policy if the weaker currency impacted on
inflation. It looks like more of the same low growth, high inflation scenario for
Russia.
Russia’s problem, similar to Brazil’s, is a lack of investment leading to supply side
constraints and poor productivity. Fixed investment fell 7% in January and has been
weak in Russia for some time. Consumption, the previous driver of growth, is still
relatively strong, but is now beginning to simply boost imports rather than domestic
growth. Meanwhile, oil prices will likely remain soft this year, hitting Russia’s current
account and exchange rate. How does this get turned around? We don’t know if it
will. At least one driver for the lower investment is undeniably a host of governance
issues which have been recognised for some time, but not addressed. Reforms are
badly needed.
Absent reforms or investment, we see inflation persisting at elevated levels, though
tightening should feed through later this year and into 2015. Lower commodity
prices could help, particularly in agriculture (chart 15) but falling oil prices will likely
be mitigated by a depreciating rouble.
Chart 15: Inflation remains elevated despite relief from food prices
y/y, %
16
14
12
10
8
6
4
2
0
2010
2011
CPI inflation
2012
CPI core inflation
Source: Thomson Datastream, Schroders. 27 February 2014.
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2013
CPI food inflation
2014
28 February 2014
For professional investors only
Schroder Economics Group: Views at a glance
Macro summary – February 2014
Key points
Baseline

World economy on track for modest recovery as monetary stimulus feeds through and fiscal
headwinds fade in 2014. Inflation to remain well contained.
Recent upswing driven by lower inflation supporting real incomes and consumption, the manufacturing
inventory cycle and, in the US and UK, reviving housing markets.
US economy still faces fiscal headwind, but gradually normalising as banks return to health and
private sector de-leverages. Fed to complete tapering of asset purchases by October 2014, possibly
earlier, with the first rate rise expected in the third quarter of 2015.
UK recovery risks skewed to upside as government stimulates housing demand, but significant
economic slack should limit any tightening of monetary policy. No rate rises 2014 or 2015.
Eurozone recovery becomes more established as fiscal austerity and credit conditions ease in 2014.
Low inflation likely to prompt ECB to cut rates in coming months, otherwise on hold from then on
through 2015. More LTRO’s likely in 2014.
"Abenomics" achieving good results so far, but Japan faces significant challenges to eliminate
deflation and repair its fiscal position. Bank of Japan to step up asset purchases to offset consumption
tax hikes in 2014 and 2015. Risk of significantly weaker JPY.
US leading Japan and Europe. De-synchronised cycle implies divergence in monetary policy with the
Fed eventually tightening ahead of others and a stronger USD.
Tighter monetary policy weighs on emerging economies. Region to benefit from current cyclical
upswing, but China growth downshifting as past tailwinds (strong external demand, weak USD and
falling global rates) go into reverse, and the authorities seek to deleverage the economy. Deflationary
for world economy, especially commodity producers (e.g. Latin America).







Risks

Risks are still skewed towards deflation, but are more balanced than in the past. Principal downside
risk is a China financial crisis triggered by defaults in the shadow banking system. Upside risk is a
return to animal spirits and a G7 boom (see page 17 for details).
Chart: World GDP forecast
Contributions to World GDP growth (%, y/y)
6
4.9 5.0
4.8
4.8
5
Forecast
4.4
4.1
3.6
4
3.1
2.8
3
2.6
2.4
3.0
3.1
14
15
2.0
2.2
2
1
0
-1
-0.9
-2
-3
00
01
US
BRICS
02
03
04
05
06
07
Europe
Rest of emerging
08
09
Japan
World
10
11
12
13
Rest of advanced
Source: Thomson Datastream, Schroders 24 February 2014 forecast. Previous forecast from November 2013. Please note
the forecast warning at the back of the document.
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Schroders Baseline Forecast
Real GDP
y/y%
World
Advanced*
US
Eurozone
Germany
UK
Japan
Total Emerging**
BRICs
China
Wt (%)
100
64.0
24.0
18.7
5.2
3.7
9.1
36.0
22.2
12.8
2013
2.6
1.3
1.9
-0.4
0.5
1.9
1.6
4.9
5.5
7.7
2014
3.0
2.1
3.0
1.1
1.9
2.6
1.4
4.5
5.3
7.1
Wt (%)
100
64.0
24.0
18.7
5.2
3.7
9.1
36.0
22.2
12.8
2013
2.7
1.4
1.5
1.4
1.6
2.6
0.1
5.2
4.7
2.6
2014
2.8
1.4
1.5
0.8
1.3
2.3
1.9
5.3
4.3
2.7
Current
0.25
0.50
0.25
0.10
6.00
2013
0.25
0.50
0.25
0.10
6.00
2014
Prev.
0.25
(0.25)
0.50
(0.50)
0.10  (0.25)
0.10
(0.10)
6.00
(6.00)
Current
2864
325
NO
20.00
2013
4033
375
YES
20.00
2014
4443
375
YES
20.00
Current
1.67
1.38
102.2
0.82
6.08
2013
1.61
1.34
100.0
0.83
6.10
2014
Prev.
1.63  (1.58)
1.34  (1.32)
110.0
(110)
0.82  (0.84)
6.00
(6.00)
Y/Y(%)
1.2
0.0
10.0
-1.2
-1.6
110.9
109.0
107.6  (104)
-1.3






Prev.
(3.0)
(2.1)
(3.0)
(1.1)
(2.1)
(2.4)
(1.3)
(4.7)
(5.5)
(7.3)
Consensus 2015
Prev.
3.0
3.1
(3.1)
2.1
2.2  (2.1)
2.9
3.0
(3.0)
1.0
1.4
(1.4)
1.8
2.2  (2.3)
2.7
2.1  (1.9)
1.6
1.3  (0.9)
4.6
4.7  (4.9)
5.5
5.6  (5.9)
7.5
7.3  (7.5)
Consensus
3.2
2.2
3.0
1.4
2.0
2.4
1.3
5.0
5.7
7.3
Prev.
(2.7)
(1.5)
(1.5)
(1.0)
(1.5)
(2.9)
(1.9)
(4.8)
(4.0)
(2.6)
Consensus 2015
Prev.
3.0
2.8
(2.8)
1.6
1.5  (1.6)
1.6
1.4  (1.5)
1.0
1.2  (1.5)
1.5
1.7  (1.9)
2.2
2.7  (3.0)
2.4
1.5  (1.4)
5.5
5.1  (4.9)
4.7
4.1
(4.1)
3.1
2.9  (3.0)
Consensus
3.0
1.8
1.9
1.4
1.9
2.3
1.7
5.2
4.5
3.2
Inflation CPI
y/y%
World
Advanced*
US
Eurozone
Germany
UK
Japan
Total Emerging**
BRICs
China








Interest rates
% (Month of Dec)
US
UK
Eurozone
Japan
China
Market
0.32
0.74
0.25
0.21
-
2015
Prev.
0.50
(0.50)
0.50
(0.50)
0.10  (0.25)
0.10
(0.10)
6.00
(6.00)
Market
0.96
1.52
0.45
0.23
-
Other monetary policy
(Over year or by Dec)
US QE ($Bn)
UK QE (£Bn)
Eurozone LTRO
China RRR (%)
Key variables
FX
USD/GBP
USD/EUR
JPY/USD
GBP/EUR
RMB/USD
Commodities
Brent Crude
Prev.
(375)
YES
20.00
2015
4443
375
YES
20.00
Prev.
(375)
YES
20.00
2015
Prev.
1.55  (1.50)
1.27  (1.25)
120.0
(120)
0.82  (0.83)
5.95
(5.95)
102.7 
(99)
Y/Y(%)
1.2
0.0
10.0
-1.2
-1.6
-1.3
Source: Schroders, Thomson Datastream, Consensus Economics, February 2014
Consensus inflation numbers for Emerging Markets is for end of period, and is not directly comparable.
Market data as at 19/02/2014
Previous forecast refers to November 2013
* Advanced m arkets: Australia, Canada, Denmark, Euro area, Israel, Japan, New Zealand, Singapore, Sw eden, Sw itzerland,
Sw eden, Sw itzerland, United Kingdom, United States.
** Em erging m arkets: Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela, China, India, Indonesia, Malaysia, Philippines,
South Korea, Taiw an, Thailand, South Africa, Russia, Czech Rep., Hungary, Poland, Romania, Turkey, Ukraine, Bulgaria,
Croatia, Latvia, Lithuania.
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Schroders Forecast Scenarios
Global vs. 2014 baseline
Scenario
Summary
Macro impact
Baseline
Our updated forecasts continue to paint a picture of recovery in the world
economy, led by the developed world. Forecasts for the latter are unchanged
this month, but we have edged down our forecasts for the emerging markets
once again. In the near term this is consistent with the latest Purchasing
Managers' Indices (PMI’s) which show the BRIC nations struggling to gain
traction whilst the developed remain firmly in expansion territory. Looking
further out, our EM downgrade is in response to the tightening of monetary
policy and a range of country specific issues. Inflation is expected to remain
stable and our forecasts are unchanged as a cut in the DM forecast is offset
by an increase in the EM.
Global growth is forecast to pick up to 3% in 2014 led by the US. After declerating in
2013, emerging markets are expected to stabilise, but still record a year of relatively
subdued growth by past standards. Weaker commodity prices and a reduced fiscal
headwind help support activity in the developed world which began to strengthen in the
second half of 2013. The exception is Japan where higher taxes are expected to slow
growth in 2014. Despite the pick-up in global activity, inflation is expected to remain
quiescent reflecting spare capacity in the world economy.
Weak economic activity weighs on Eurozone prices with the region slipping
into deflation. Households and companies lower their inflation expectations
and start to delay spending with the expectations that prices will fall further.
The rise in savings rates deepens the downturn in demand and prices, thus reinforcing the fall in inflation expectations.
Deflationary: weaker growth and lower inflation, which persists throughout the forecast.
As a significant part of the world economy, Eurozone weakness drags on activity
elsewhere, while some of the defaltionary impact is imported by trade partners. ECB
reacts by undertaking QE, but the policy response is too small and too slow to avert the
outcome.
US growth picks up more rapidly than in the base as the corporate sector
increases capex and consumers spend more rapidly in response to the
recovery in house prices. Banks increase lending, reducing their excess
reserves and asset prices accelerate. Europe and Japan benefit from stronger
demand which helps boost spending further through greater capex and
confidence.
Reflationary: stronger growth and moderately higher inflation vs. baseline. Stronger US
growth increases pressure on the Fed to unwind QE and bring forward interest rate
increases. Central banks elsewhere also experience pressure to tighten resulting in
higher rates globally.
The dispute between China and Japan over the Senkaku islands escalates to
a trade war which then spreads as nations take sides and cut their trade with
each other.
Stagflationary: global growth weakens as a large part of world trade shuts down. However,
inflation is likely to be higher as firms hoard commodities pushing up energy, metals and
food prices.
After some initial success at boosting growth and inflation through the fall in
the JPY, activity in Japan moderates and then slumps as the consumption
tax is raised. In response the BoJ steps up asset purchases aggresively,
driving the JPY to 130. Competitors complain at the further devaluation of the
JPY and react by raising tarrif barriers.
Deflationary: slower growth in Japan is transmitted abroad through the devaluation of the
JPY as competitors lose market share to Japanese firms. Primarily deflationary, toward
the end of the period the subsequent increase in tariffs will push up import prices and
CPI, reducing real incomes and demand, so taking the world economy in a more
stagflationary direction.
An implosion in the wealth management products area results in a major cut
in Total Social Financing depriving Chinese industry of funds. The resulting
downturn in capex spending and the adverse impact on consumer confidence
results in a sharp slowdown in Chinese growth. The negative sentiment in
markets spreads to other emerging markets, causing a dominoe effect of
defaults in the Fragile 5.
Deflationary: global growth slows as China demand weakens with commodity producers
hit hardest. Pressure builds on the weaker EM countries (Fragile 5) resulting in futher
currency weakness and higer interest rates. However, the fall in commodity prices will
push down inflation to the benefit of consumers. Developed market monetary policy is
likely to ease/ stay on hold while the deflationary shock works through the world
economy.
1. Eurozone
deflation
2. G7 boom
3. Trade war
4. Abenomics2
5. China financial
crisis + Fragile 5
8. Other
*Scenario probabilities are based on mutually exclusive scenarios.
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Probability* Growth
Inflation
70%
-
-
5%
-0.3%
-0.4%
10%
+0.5%
+0.5%
3%
-0.5%
+0.4%
4%
-0.3%
-0.3%
6%
-0.8%
-0.5%
2%
-
-
28 February 2014
For professional investors only
I. Updated forecast charts - Consensus Economics
For the EM, EM Asia and Pacific ex Japan, growth and inflation forecasts are GDP weighted and
calculated using Consensus Economics forecasts of individual countries.
Chart A: GDP consensus forecasts
2014
2015
%
%
8
8
7
7
EM Asia
6
EM Asia
6
EM
5
EM
5
4
4
Pac ex JP
Pac ex JP
3
3
US
2
UK
Eurozone
1
Japan
US
UK
2
Japan
1
Eurozone
0
0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb
Jan
Feb
Month of forecast
Month of forecast
Chart B: Inflation consensus forecasts
2014
2015
%
%
6
6
EM
EM
5
5
EM Asia
EM Asia
4
4
Pac ex JP
3
3
Pac ex JP
Japan
UK
2
UK
2
US
Japan
Eurozone
US
1
Eurozone
0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb
Month of forecast
1
0
Jan
Month of forecast
Source: Consensus Economics (February 2014), Schroders
Pacific ex. Japan: Australia, Hong Kong, New Zealand, Singapore
Emerging Asia: China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan, Thailand
Emerging markets: China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan, Thailand, Argentina, Brazil,
Colombia, Chile, Mexico, Peru, Venezuela, South Africa, Czech Republic, Hungary, Poland, Romania, Russia, Turkey,
Ukraine, Bulgaria, Croatia, Estonia, Latvia, Lithuania
This document contains forward looking forecasts which by their nature are inherently predictive, and involve risk and uncertainty.
While due care has been used in the preparation of forecast information, actual results may vary considerably. Accordingly
readers are cautioned not to place undue reliance on these forecasts. The views and opinions contained herein are those of
Schroder Investments Management's Economics team, and may not necessarily represent views expressed or reflected in other
Schroders communications, strategies or funds. This document does not constitute an offer to sell or any solicitation of any offer
to buy securities or any other instrument described in this document. The information and opinions contained in this document
have been obtained from sources we consider to be reliable. No responsibility can be accepted for errors of fact or opinion. This
does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act
2000 (as amended from time to time) or any other regulatory system. Reliance should not be placed on the views and informatio n
in the document when taking individual investment and/or strategic decisions. For your security, communications may be taped or
monitored.
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