June 2015
Schroders
Talking Point
Five Themes for 2015
Keith Wade, Chief Economist and Strategist
We see five key themes shaping the macroeconomic landscape over the year and beyond. In our view these
are supportive of risk assets as economic growth improves, inflation stays low and liquidity remains strong.
The challenge for markets will come from Federal Reserve (Fed) tightening, but will be tempered by ongoing
liquidity provision from the European Central Bank (ECB) and the Bank of Japan (BoJ).
1. Lower oil prices mean lower inflation and stronger growth
At the end of last year we called this theme the "disinflationary boom" where we argued that lower oil prices would
bring stronger growth and lower inflation in 2015. So far the evidence has been mixed. Inflation has fallen as
expected with consumer prices either flat or lower over the past year in the UK, US and Eurozone, largely as a result
of lower energy costs (chart 1).
Chart 1: G7 headline inflation falls, but core remains stable
%
6
4
2
0
-2
-4
1996
1998
2000
Difference
2002
2004
2006
G7 Headline CPI, y/y
2008
2010
2012
2014
G7 Core CPI, y/y
Source: Thomson Datastream, Schroders, 29 April 2015.
However, we recognise that the evidence for stronger growth has been disappointing so far. US GDP growth dipped
to just 0.2% q/q annualised in the first quarter as consumer spending slowed and capital spending dipped. UK GDP
growth also cooled, to 0.3% q/q as the retail and service sectors failed to offset weakness in construction and
manufacturing.
For the US it would seem that the slowdown in the energy sector is having a more immediate impact than the boost
to consumers from lower energy costs. Bad weather and faulty seasonal adjustment have also played a role, but we
recognise that the lags from lower oil prices to stronger consumption could be longer as a result of continued
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consumer caution post the financial crisis.
Nonetheless, with the fundamentals still in place (improving real income and wealth), consumption in the US should
pick up again. More encouragingly, retail sales volumes in the Eurozone are accelerating with the latest figures
showing a gain of 6% y/y in the region and it is likely that the Euro region will outpace both US and UK GDP.
2. Oil and currency are rebalancing the world economy
We still see a desynchronised monetary cycle where central bank policy diverges this year and we believe that a
recovery in the Eurozone and Japan would have further to run than in the US or UK given respective deflationary
pressures. However, we are seeing more convergence in growth this year as the US has slowed whilst Europe and,
to some extent, Japan have picked up.
Part of the story here is to do with oil as lower energy costs have been supporting growth across the developed
world (which is primarily an oil importing economy) and Europe and Japan have taken less of a hit from energy
industry cutbacks, compared to the US. Another part of the story is to do with currency with the stronger US
dollar/weaker euro and yen acting to skew growth away from the US towards Eurozone and Japan. The swing in the
trade-weighted euro has been dramatic over the past year, from overvalued to cheap (chart 2).
Chart 2: Trade-weighted exchange rates: euro winning the currency war
4
Expensive
3
2
1
0
-1
-2
Cheap
-3
EUR
Upper quartile
JPY
Lower quartile
GBP
USD
Current TW exchange rate (10yr z-score)
Last year
Source: Thomson Datastream, Schroders, 28 April 2015.
3. Fed to tighten as US economy normalises
Although US growth slowed in the first quarter, we still expect the Fed to raise interest rates this year with the first
move coming in September. Dollar strength has helped tighten monetary conditions for the Fed, but we still see
labour market developments underpinning the need to move away from emergency monetary policy.
For example, using the Atlanta Fed jobs calculator it is likely that the unemployment rate will fall below 5% in 12
months’ time given the current rate of participation and job growth. Should participation fall further, as is likely given
demographics, then unemployment will fall faster for any given rate of job growth. Whilst this may not immediately
translate into higher inflation, there is evidence that wages and employment costs are picking up, and most
estimates suggest that the equilibrium rate of unemployment lies between 5% – 5.5%.
Combine a more normal labour market with a banking system that is beginning to function again in terms of
providing credit to the real economy, and there seems to be little reason for the Fed to maintain interest rates at
emergency levels. We do not see the need for rates to rise as much as in previous cycles given the headwinds on
activity, but after the first move in September we would look for the Fed funds rate to be at 2.5% by the fourth quarter
of 2016 – a hike of 25 basis points at each subsequent meeting.
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4. Emerging markets: pockets of strength
The broader pattern of recovery in the developed world has not fully extended to the emerging markets where
activity remains subdued. The latest Purchasing Managers Indices (PMIs) confirm that the divergence persists
(chart 3). Underpinning this has been the weakness of commodity prices and downturn in China where growth
moderated to 7% in the first quarter on the official measure, although it was probably considerably weaker based on
other indicators such as rail freight and electricity consumption.
Chart 3: Emerging markets still lagging developed economy recovery
Balance
65
60
55
50
45
40
35
30
25
2006
2007
2008
2009
2010
2011
Developed Market PMI
2012
2013
2014
2015
Emerging Market PMI
Source: Thomson Datastream, Schroders, 28 April 2015.
On this basis, an upturn in China is needed to help support a broader emerging markets recovery. We do not think
there would be a hard landing as the authorities would not allow such a move given the social disruption which
would follow. However, the headwinds facing China in terms of overcapacity and the need to reform state-owned
enterprises (SOEs) and the banking system, mean there is little prospect of growth accelerating soon.
The situation is helped by easier monetary policy from the People's Bank of China (PBoC) and China should benefit
from stronger demand elsewhere. However, these measures will cushion the downturn rather than trigger an
acceleration, especially given the ongoing strength of the US dollar, which has helped push the Chinese yuan to the
top of its historical range in trade-weighted terms.
Nonetheless, there are pockets of strength to be found in the emerging world with the energy importers well placed
to benefit from lower oil prices. The more manufacturing-orientated countries in Asia in particular stand to benefit
from better growth in Europe and the US. With a Fed rate rise in prospect we would be focused on those economies
with strong balance sheets and low external financing requirements. We would also favour economies like India
which have seen a significant improvement in their current account and have been able to attract strong capital
inflows since the “taper tantrum” of 2013.
5. Liquidity: the search for yield continues
Last year as the Fed brought an end to quantitative easing (QE), the prospect of a subsequent increase in interest
rates raised fears over liquidity in markets, particularly in emerging markets. This remains a concern, but the search
for yield has been given fresh impetus by the start of ECB QE and continued money printing by the BoJ. In our
previous themes we emphasised the potential impact on markets like the NASDAQ, but the effects now seem
broader.
Interest rates in the Eurozone have now reached extraordinarily low levels with the German yield curve below zero
out to five years maturity, for example. As we have argued before, this is intensifying the search for yield and helping
to drive down peripheral yields in the region (with the exception of Greece), the rest of Europe and beyond. The
spread between Treasuries and Bunds remains attractive (at its widest since 1989, see chart 4) and is a key
element in driving the euro weaker. In this respect, action by the ECB is helping to anchor global bond yields and
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Page 4
should help temper some of the concerns the Fed has over higher market volatility and a repeat of the 2013
experience when they tighten policy.
Chart 4: Overspill from ECB QE drives search for yield
%
10
8
6
4
2
0
-2
90
92
96
98
00
02
94
10 year Treasury – Bund Spread
German 10Y Government bond yield
04
06
08
12
14
10
US 10Y Government bond yield
Source: Thomson Datastream, Schroders, 28 April 2015.
More generally, liquidity will continue to drive flows into real estate and equities across Europe as well as keeping
the currency weak. There has been some speculation that the ECB will soon begin to taper and close its QE
programme given the dramatic results so far. ECB President Mario Draghi has kicked such concerns into touch,
however, that does not preclude an active debate, especially as Eurozone activity revives and inflation picks up next
year. In our forecast we assume the ECB continues asset purchases through to September 2016. Although risk
premiums in bond and currency markets are in danger of disappearing, the search for yield has further to run.
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