30 October 2015
For professional investors only
Schroders
Economic and Strategy Viewpoint
Keith Wade
Recession fears haunt the US (page 2)
Chief Economist
and Strategist
(44-20)7658 6296

With the imminent arrival of Halloween, we are focussed on scary scenarios so
whilst the likelihood of a China hard landing may have receded, we examine the
vulnerability of the US expansion.
Azad Zangana

The US economy has cooled since the summer and leading indicators suggest
growth will slow further. We see the threat to activity as coming more from a
retrenchment by the corporate sector where capex is set to be slashed. Inflation
horrors are also lurking, but should be kept in check by global spare capacity,
reducing the need for the Fed to engage in shock therapy.
Senior European
Economist and
Strategist
(44-20)7658 2671
Craig Botham
Emerging Markets
Economist
(44-20)7658 2882
UK: Nightmare at no. 11 Downing Street (page 7)

The tax credits horror show highlights the difficulties the government faces in
reforming welfare spending. The House of Lords’ shocking blockage of a key
financial policy will haunt the Chancellor, sending him back to the drawing board.

However, without welfare reforms, cuts to departmental budgets may have to be
even deeper. To add to the Chancellor’s woes, the budget deficit is already offtrack, just as the economy is starting to cool. Weaker growth in 2016 could derail
the government’s austerity plans.
A very Brazilian house of horrors (page 11)

Despite tentative signs of adjustment, the Brazilian horror story is far from played
out. An early exit for a beleaguered president could be the best outcome.
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: The return of falling goods prices
%, y/y
6
4
2
0
Deflationary
pressures from
emerging markets as
supply expands
-2
Inflationary pressures
from emerging markets
as demand expands
-4
'93
'95
'97
'99
'01
'03
US core goods prices
'05
'07
'09
'11
UK goods prices
Source: Thomson Datastream, Schroders Economics Group, 29 October 2015.
'13
'15
30 October 2015
For professional investors only
Recession fears haunt the US
Markets rally as
policymakers
respond and
macro fears are
not realised
“The United States is not at the point of raising rates yet, and under its global
responsibilities it can’t raise rates” China’s Finance Minister Lou Jiwei. (Quoted
on Reuters 11 October 2015).
Markets have steadied over the past month with the S&P500 beginning to
approach previous highs and emerging market equities rallying. The concerns
over a hard landing in China, which emerged in the late summer have not been
realised and there is a sense that policymakers have become more sensitive to
the risks facing the world economy. Three factors support this:

First, the decision by the US Federal Reserve (Fed) not to raise rates in
September may have been poorly received initially, but has now helped calm
emerging markets where currencies have stabilised. The Fed mentioned
global factors in its statement and there is a sense, as illustrated by the quote
from Chinese Finance Minister Lou, that it has become the global, rather than
just the US, central bank.

Second, we seem to have reached a truce in the currency wars: the Chinese
Yuan has not devalued further and the Bank of Japan has resisted pressure
for it to increase its quantitative and qualitative easing programme (QQE) and
push the Japanese Yen lower.

Finally, recent comments from Mario Draghi at the European Central Bank
(ECB), where he opened the door to further quantitative easing (QE), and
actual rate cuts by the People’s Bank of China (PBoC) have all improved risk
appetite.
The ‘wobbly bike’
Whether this is the result of international co-ordination or a series of independent
lucky decisions, central banks have been key to restoring confidence. Continued
growth in China, Europe and the US has also helped.
World economy
remains
vulnerable to
shocks as
central bank
firepower
diminishes
However, the recent growth scare has highlighted the vulnerability of the world
economy to a downturn in activity. Leading indicators such as the Conference
Board indicator for the US have slowed of late led by a softer S&P500, building
permits, manufacturing new orders, and a shorter average work week (chart 1).
Growth concerns have been exacerbated by fears that the central banks do not
have the firepower to deal with a major adverse shock. Interest rates remain close
to zero and although further QE is an option, there are doubts about its efficacy
beyond boosting financial market prices and inflaming the debate about inequality.
Chart 1: US leading indicator slows
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
-30%
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
US recession
Conference Board Leading Economic Indicator y/y change
Conference Board Leading Economic Indicator 6m/6m annualised change
Source: Thomson Datastream, Schroder Economics Group, 29 October 2015.
2
30 October 2015
For professional investors only
In this respect investors are still focussed on downside risks and whilst the
likelihood of a China hard landing may have receded, there has been increasing
concern about a turn in the US cycle. We briefly discussed US recession risks in
the July Viewpoint where we also highlighted the vulnerability of the US economy
to shocks in the current environment and the slowdown in trend growth. These
factors combine to give a ‘wobbly bike’ view of the world economy: slow moving,
not very stable and vulnerable to pot holes. Also makes for jittery investors,
easily spooked by what can often prove to be noise.
Terrifying triggers for recession
Nonetheless, recessions need a cause and in the current environment, we need
to identify what could tip the bike over. Essentially, there are three ways a
recession can occur.
The first is as a result of an increase in inflation which prompts the central bank
to tighten policy to slow activity and bring inflation under control. There is always
talk of engineering a soft landing in such circumstances, but this is rarely
achieved and we frequently end up in recession. Sometimes the recession is
deliberate such as when inflation is out of control and the tightening cycles of the
early 1980s and 90s fall into this category.
We have
reached the
stage of the
cycle where
inflation
normally
emerges
Second, a recession can occur as a result of a build up of imbalances. Current
account and, or budget deficits build up and there is often talk of a new paradigm
where global capital flows can accommodate greater funding gaps until investors
begin to question the sustainability of the debt build up and the music stops. The
Asia and emerging markets crisis of 1997–98 and the Global Financial crisis
(GFC) of 2007–09 are recent examples of this type of recession. Balance sheet
recessions tend to be rarer, but deeper than those caused by a pick-up in
inflation and monetary tightening.
Finally, there are recessions which originate in the corporate sector through a
slowdown in profits, which triggers a retrenchment as firms cut capital
expenditure (capex) and jobs. If strong enough, there is then a knock-on effect to
consumption. These are less common, but there was a sharp dip in profits ahead
of the 2001 recession and profits did fall ahead of the GFC. More often than not
though, slower profit growth is a symptom of an economy heading toward
recession, rather than the cause.
Today, economists are divided between those who fear inflation and those who
are concerned about corporate recession risks. Certainly, we have reached the
stage of the cycle where inflation normally emerges and policy is tightened.
Chart 2 (next page) shows that unemployment is close to the level seen just prior
to the recessions of 2001 and 2007–09. It is below the rate prior to the 1990–91
recession. However, unlike the previous episodes, we have yet to see wages
accelerate in a meaningful way. The Employment Cost index (the broadest
measure of wage costs) came in at 2.1% year-on-year in Q3, a rate which is
unlikely to trouble the Fed.
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30 October 2015
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Chart 2: Unemployment approaches pre-recession levels
5.0
3
4.5
4
4.0
5
3.5
6
3.0
7
2.5
8
2.0
9
1.5
1.0
1985
10
1990
1995
2000
2005
2010
US recession
Wages and salaries (ECI report) y/y%
US unemployment rate % (rhs, inverted)
2015
Source: Thomson Datastream, Schroders Economics Group. 30 October 2015.
Low headline consumer price (CPI) inflation may be playing a role in keeping
nominal wages subdued at present, but this will reverse in coming months as the
depressing effect of lower oil prices drops out of the annual comparison. We
would not be surprised to see wages pushing higher in this environment as long
as unemployment continues to decline, or remains around current levels.
However, there is a countervailing force on inflation at present as a result of the
appreciation of the US dollar and the weakness in emerging markets. Import
prices (both with and without oil) are falling and will decline further in coming
months as a result of the currency (chart 3). The picture is similar to that seen
during the Asia crisis of 1997–98 and whilst the downturn in emerging markets
today is not as severe as at that time, we could well move back into a period
where the emerging economies weigh on global inflation once more through
lower goods prices (see chart front page). Such a development would raise the
hurdle for wage inflation to trigger higher rates from the Fed.
Global factors
to weigh on
inflation
Chart 3: Strong dollar to weigh on inflation
8
-15
6
-10
4
2
-5
Asia
crisis
0
0
5
-2
10
-4
15
-6
-8
1996
20
1998
2000 2002 2004 2006 2008 2010 2012 2014
Recessions
Import Prices ex Oil y/y%
US $ Broad Fed Index y/y% (rhs, inverted, 3m lag)
Source: Thomson Datastream, Schroders Economics Group. 29 October 2015.
4
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30 October 2015
For professional investors only
The other potential cause of recession is more deflationary: a significant
corporate sector retrenchment. There are continuing fears over company
earnings growth in the US, although yet again the earnings season is showing a
high ratio of beats to misses against analysts’ expectations (76% at the last
count). At the macro level, profits have slowed after several years of a rise in the
profit share of GDP, and in real terms are barely growing. However, they have
not turned negative as they did ahead of the last two US recessions (chart 4).
Chart 4: US profits and real GDP
%, y/y
60
%, y/y
8
50
6
40
Profits
weakness likely
to weigh on
capex
30
4
20
2
10
0
0
-10
-2
-20
-4
-30
-40
-6
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
Recessions
Real profits
US GDP, rhs
Source: Thomson Datastream, Schroders Economics Group. 29 October 2015.
As with the outlook for inflation, this may change and wages are key. Should we
see an acceleration in wages, profits will be squeezed unless firms can maintain
pricing power and pass on cost increases (i.e. inflation), or productivity
accelerates (i.e. job cuts and layoffs).
On balance we are inclined toward the latter. One indicator that companies are
becoming more cautious can be seen in the durable goods orders which are
signalling cuts in capital expenditure ahead (chart 5). This does not suggest a
corporate sector that is confident about demand and pricing power. Capex and
employment often move together so we need to be wary about the effect on the
labour market.
Chart 5: Orders signal weaker capex
%, y/y
30
20
10
0
-10
-20
-30
-40
93
95
97
99
01
03
05
07
09
11
Recessions
Real non-residential private fixed investment
Durable goods orders
Source: Thomson Datastream, Schroder Economics Group. 29 October 2015.
5
13
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Will this be enough to trigger a recession in the US? Weaker business capex
alone is not sufficient and we would need to see the malaise spreading to the
consumer through the labour market. Nonetheless, the combination of weaker
employment gains and the fading dividend from lower oil prices is likely to
moderate consumption in coming months. Meanwhile, on the plus side, housing
capex is firm and the drag from inventory is likely to fade.
We will probably trim our US growth forecast for 2016 next month, however,
none of the recession drivers have been triggered. The weakness in profits is not
acute enough and the pick-up in inflation would need to go beyond base effects
to trigger a more aggressive Fed response. We will remain vigilant but at this
stage a US recession remains a scary scenario rather than a central view.
6
30 October 2015
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UK: Nightmare at no. 11 Downing Street
Shocking political events in recent days have highlighted the difficulties the
government faces in trying to rein in a large structural deficit. To make matters
worse, the strong macroeconomic conditions required for the Chancellor to pulloff his magic trick of shifting the burden of the poorly paid back to the private
sector is already being questioned. Has George Osborne opened Pandora’s box
by trying to reform tax credits? Have the phantom peers gone too far in delaying
what is a primary power of the government to enact policy on financial matters?
Trick or treat? The tax credits horror show
Trick or treat?
Tax credit
reforms have
few supporters
The new leader of the main UK opposition party (Labour), Jeremy Corbyn, may
have galvanised his party’s membership through his unexpected victory on the
back of his more radical socialist views. However, he has failed to make much of
an impact in his weekly exchanges with David Cameron at Prime Minister’s
Questions. That was until he decided to ask Prime Minister David Cameron the
same question six times (out of a possible six opportunities) whether he would
guarantee that workers on low incomes would not be worse off once tax credits
are reformed as had been announced by the Chancellor of the Exchequer in
July. He was essentially asking Cameron whether workers should look forward to
a trick or a treat after the range of policy changes are enacted in April 2016.
Cameron seemed flustered by the fourth barrage with opposition members of
parliament jeering “answer the question!”
“The answer will be set out in the Autumn Statement when we set out our
proposals”, replied Cameron – referring to the Chancellor George Osborne’s next
economic and fiscal update due on 25 November.
Near fatal blow
dealt by the
House of Lords
The above exchange took place just two days after the House of Lords (the UK’s
unelected upper chamber) decided not to pass a ‘fatal motion’ to kill off
Chancellor Osborne’s planned reforms. Instead the Lords voted in favour of
blocking the reforms for three years with a demand for an independent review
and for the government to consider “possible mitigating actions”. This is the first
time in 100 years that the Lords have voted down a financial package backed by
members of parliament (MPs) in the House of Commons.
Tax credits were introduced at the start of the previous decade with two key
components: child tax credits and working tax credits. Spending on tax credits
has risen by £18.6 billion since 2000/01 – an increase of 177%. In 2014/15, tax
credits represented 3.9% of all government spending, compared to 2% when first
introduced. The government would like to substantially reduce the working tax
credits element, but with 55% of funds going to pensioners, it is politically
restricted to targeting cuts on workers, with the objective of saving £4.4 billion
from the current £29.1 billion bill.
The proposed changes go against the government’s narrative of helping the
working poor. Under the previous Conservative-led coalition government,
Osborne started to increase the tax-free personal allowance from £6,475 to a
planned threshold of £11,000 by 2016/17. This meant that those workers who
earn less than the given personal allowance would not pay any income tax (20%
at the basic rate).
The government argues that it is trying to remove the tax and spend illusion
conjured by the then Chancellor Gordon Brown – a master fiscal wizard. It also
argues that the government subsidy for low paid workers is distorting the labour
market, and allowing companies to get away with underpaying their staff.
Comparing the impact of the increase in the tax-free personal allowance with the
illustrative analysis of the impact of the tax credit changes from the Office for
Budgetary Responsibility (OBR), we see that the changes to taxation do not
offset the cuts in benefits, especially for those earning less than £10,000 per
7
30 October 2015
For professional investors only
annum (charts 6 and 7). The reforms will reduce the income threshold for tax
credits from £6,420 to £3,850, with the tapper rate being raised so that those
earning £21,000 and over will stop receiving the credits.
Charts 6 and 7: Slashing tax credits will not be offset by tax cuts alone
Pain is
inevitable, but
should be
considered
alongside other
softeners
Tax credit award (£ thousands)
9
Income Tax Paid (£ thousands)
5
8
4
7
6
3
5
4
2
3
2
1
1
0
0
5
10
15
20
25
Gross annual income (£ thousands)
Pre-measures
Post-measures
0
0
5
10
15
20
25
Gross annual income (£ thousands)
Tax Year 2010 – 11
Proposed for 2016 – 17
Source: OBR, Schroders Economics Group. 28 October 2015.
The government acknowledges this and argues that the tax relief has to be
considered with other measures recently announced, such as the introduction of
the National Living Wage, and the increased provision of free child care.
Back in the July Budget, Osborne announced what is essentially a rise in the
legal minimum wage from the current hourly rate by 7.5% in April 2016, with a
view to continue to raise the wage by about 6.2% per annum until 2020. For a
person working 35 hours per week, this is will be worth an additional £910 gross
per annum from April. But for those that work less hours and are more negatively
impacted by the cuts to tax credits, the benefit of the pay increase will be even
smaller.
According to the Institute for Fiscal Studies (IFS), the introduction of the National
Living Wage “simply cannot provide full compensation for the majority of losses
that will be experienced by tax credit recipients – it is just arithmetically
impossible”.1 The House of Commons Library estimated that almost 3.3 million
in-work households receiving tax credits would lose £1,300 from the changes.
Taking all the changes into account including those that began in the last
parliament, while there will inevitably be losers, the overall package to low paid
workers is broadly balanced. They are designed to incentivise more people to
work and to work more hours. The problem with the government’s strategy is that
most people have forgotten the tax cuts in past years, and are now only focused
on 2016 versus today. It is a strategic error by the Chancellor, one that he will
haunt him for some time.
Departmental budget slashing to commence
Deep cuts to
departmental
budgets may
need to be even
deeper…
1
8
Putting aside the merits of the tax credits row, the wider implications of the
government’s defeat on a key financial policy in the House of Lords raises
serious questions over its ability to implement future fiscal reforms. Now that the
Lords have tasted blood, will they change their diet? The Conservative party is
outnumbered in the upper chamber by Labour party peers and the Liberal
Democrats (yes, they continue to haunt the halls of the Palace of Westminster).
http://www.ifs.org.uk/uploads/publications/budgets/Budgets%202015/Summer/opening_remarks.pdf
30 October 2015
For professional investors only
Having had a strong start to the fiscal year, the government has seen public
finances lag behind their full-year fiscal target. Public sector net borrowing in the
fiscal year to September was 16% lower compared to the previous year, but it
means that total borrowing is set to end the fiscal year at around £77.6 billion
(4.1% of GDP) – about £8 billion (0.4% of GDP) more than projected by the OBR
(chart 8).
Chart 8: Devilish deficit off-track
General government deficit, £ billion
120
100
80
Current run rate
60
Deficit target
40
20
0
Apr
May
Jun
Jul
Aug
13/14
Sep
Oct Nov
14/15
Dec Jan
15/16
Feb
Mar
Source: Thomson Datastream, ONS, Schroders Economics Group. 28 October 2015.
With the government struggling to cut back the welfare bill, it will have to consider
deeper cuts in departmental budgets for the upcoming autumn statement which
will include a medium-term departmental spending review. With the exceptions of
health, overseas aid, defence and schools, central Whitehall departments are
being asked to cut their budgets by between 25–40% by 2019–20. Many
watchers doubt whether these cuts can realistically be achieved, which is why it
is vital the government makes progress reforming welfare spending.
…then again,
the Chancellor
could ease up
on his fiscal
target.
Of course, the Chancellor could make life easier for everyone by scaling back his
ambitious austerity plans. Rather than targeting an overall budget surplus, he
could target a small deficit, allowing growth to erode public debt. This is general
convention for most developed economies. However, with an ageing population
becoming ever more expensive, the Chancellor’s more austere targets would
create more headroom to deal with the inevitable rise in age-related spending.
Morbid manufacturers endure ghoulish growth
In case Osborne did not have enough to worry about, the latest estimate of the
health of the economy will raise more concerns. Quarterly real GDP growth
slowed from 0.7% in the second quarter to 0.5% in the third. This is by no means
a disaster, but it does suggest that the economy could be heading for a more
significant slowdown, just as fiscal tightening begins, and as the Bank of England
is considering raising interest rates.
Year-on-year GDP growth has slowed from a peak of 3.1% in the middle of 2014,
to 2.3% in the latest quarter. Looking through the sectors, manufacturing stands
out as the weakest link, despite the government’s best efforts to provide support
for the sector (chart 9 on next page). Manufacturing output contracted for the
third consecutive quarter in the third quarter, with annual growth in negative
territory. The strength of the pound, especially against the euro, will have been a
factor, but the slump cannot really be blamed on external factors, especially as
the annual growth rate of goods export volumes in the three months to August is
up 8.4% – the fastest rate of growth since April 2011. Spooky!
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30 October 2015
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Chart 9: Missing manufacturers?
Weaker growth
could spell
trouble in
2016…
Quarterly y/y
Quarterly y/y
5.0%
10%
8%
7.1%
6%
4%
4.5%
4.0%
3.5%
2.7%
2%
3.0%
0%
-0.1% 2.5%
-2%
-0.8% 2.0%
-4%
1.5%
-6%
2.3%
-8%
1.0%
0.5%
-10%
0.0%
2011
2012
GDP, rhs
Services
2013
2014
Manufacturing
Construction
2015
Other production
Source: Thomson Datastream, ONS, Schroders Economics Group. 28 October 2015.
Construction activity has also slowed significantly. This could be an early signal
of a slowdown in business investment, which should be expected ahead of the
UK’s referendum on its membership of the European Union.
Our baseline forecast assumes that a combination of austerity in 2016 and
interest rate hikes will slow GDP growth from 2.5% in 2015 to 2.1% in 2016.
However, our forecast for 2015 is likely to be revised down to around 2.4%, while
the forecast GDP for 2016 could even be below 2%.
…making
austerity less
effective.
10
Slower growth in 2016 would not only make austerity less effective, but may also
put the government’s plans to introduce the National Living Wage at its current
rate, at risk. We could see an increase in unemployment if labour market
conditions cannot accommodate the forced increase in wages, which in turn
could increase welfare spending. At present, wages are rising of their own accord
thanks to strong demand and so a rise in unemployment is not our baseline
scenario. However, the risks are significant enough to warrant careful
consideration before wages are forced higher.
30 October 2015
For professional investors only
A very Brazilian house of horrors
Corruption
continues to
cripple
With China hogging the EM limelight in recent months, it has been easy to lose
track of developments elsewhere. While next month’s Viewpoint will provide
forecast updates on each of the BRICs, with China worries calming now, it
seems a good time to review just how bad things have become in Latin
America’s biggest economy. President Dilma Rousseff has suffered a series of
painful setbacks since her election victory last year, and in many ways is now in
political exile despite being nominally in power – approval ratings signal how
rapidly the situation has deteriorated (chart 10). The corruption scandal at
Petrobras and allegations over accounting irregularities in her campaign and
government finances leave the President weakened even as the economy
continues its tailspin. The combination of political and economic paralysis has
seen a wave of growth and credit downgrades for Brazil, and it is hard to see a
rapid turnaround. It could be years before Brazil recovers meaningfully.
Chart 10: Torches and pitchforks
Government approval rating (%)
80
70
60
50
40
30
20
10
0
Mar 11 Sep 11 Mar 12 Sep 12 Mar 13 Sep 13 Mar 14 Sep 14 Mar 15 Sep 15
Great/good
Bad/terrible
Source: Trusted Sources, CNI/IBOPE. 23 October 2015.
Petrobras scandal lurches on
Dilma’s position
is increasingly
untenable
As we noted in August’s Viewpoint, fall out from the Petrobras scandal
(commonly referred to as the Lava Jato, or ‘Car Wash’), has continued to spread,
contaminating larger and larger swathes of the corporate and political sectors in
Brazil. It has now reached Dilma’s current political nemesis, Eduardo Cunha,
Speaker of the Lower House.
Unlike much of the scandal to date, this revelation presents a possible boon to
Dilma. Cunha is spearheading attempts to impeach the President, and his
removal from office would provide an opportunity for Dilma to rebuild relations
with the lower legislature. One tentative olive branch, in the form of a cabinet
reshuffle which ceded more political power to the party of Vice President Temer –
the PMDB - appears to have backfired by angering other smaller parties in
coalition with the PMDB, which were not included in the largesse. They have now
splintered from the PMDB, creating a more fractured Lower House which will be
even more difficult to reconcile.
The reshuffle, which removed a key ally of the President, also leaves Dilma
increasingly isolated within her own government, with former President Lula
steadily building control in what some have dubbed a virtual regency (though
Lula holds no position of power de jure, he remains influential within the ruling
party and popular in Brazil at large). There are concerns that Lula’s next step will
be to push for the removal of Finance Minister Levy, who has bought the
11
30 October 2015
Policy
increasingly
dictated by
anyone but
Dilma
For professional investors only
government what little fiscal credibility it has. Rumours of his resignation on
Friday 16th October prompted downward pressure on Brazilian assets but have
since been quashed – likely reflecting assurances from Dilma to Levy that the
government would continue to back his fiscal consolidation efforts. This drive by
Lula is also likely a result of the Lava Jato scandal, which has begun to implicate
family members. Political analysts at Eurasia Group suggest that Lula’s only
chance of avoiding prosecution would be if he could portray the investigations as
an attempt to undermine the left, and that to do this he needs to reinvigorate his
traditional electoral base. Attacking fiscal consolidation is one way to do this.
We mentioned above that the rumours around Levy fuelled volatility in Brazilian
assets. More generally, the backdrop for all of this power broking has been an
increased likelihood of impeachment for Dilma, forcing the concessions
discussed above. This has generated a good deal of volatility across Brazilian
markets, with participants seemingly hoping for an impeachment and fresh
government (chart 11).
Chart 11: Political risk adds to Brazilian currency volatility
Index (Jan 2014 = 100)
180
170
160
150
140
130
120
110
100
90
Jan 14
Apr 14
Jul 14
Oct 14
BRL
Jan 15
Apr 15
Jul 15
Oct 15
LatAm ex Brazil
Source: Bloomberg, Schroders Economics Group. 21 October 2015.
Impeachment is a
growing risk, but
an early exit
could help Brazil
Is this justified? Dilma is increasingly powerless and under siege from enemies
and allies alike. The corruption scandal is engulfing an ever growing share of the
political class and ensuring political energies are focused upon the investigation
rather than reform efforts or fiscal consolidation, while those politicians so far
untainted are currently deeply unhappy with Dilma – in part because they are
being egged on by the Lower House speaker, Cunha. As things stand it is difficult
to see how Dilma can lead Brazil out of the mire. Even if Cunha is forced to step
down due to the corruption allegations he faces, it is not certain that the new
speaker will be any more amenable – there is a strong incentive for the main
coalition party, PMDB, to push for impeachment. Vice President Temer, of the
PMDB, would then assume the presidency. Though good for the PMDB, this
would not necessarily be good for investors, given the exposure of that party to
the Lava Jato scandal - so more of the same political paralysis.
What would be a good outcome? One possibility is that Dilma’s re-election is
declared void. The country’s highest court has authorised an investigation into
the President’s re-election accounts, following revelations that kickbacks from a
construction firm were paid into the campaign’s coffers. If compelling evidence is
found that serious electoral violations took place and were significant enough to
impact the race for the Presidency, the election result could be revoked. Though
obviously a disruptive event, this would clear the way for a more market friendly,
and scandal free, government to be elected. They would find they had plenty
to do.
12
30 October 2015
For professional investors only
The undead economy
High inflation
and negative
growth persist
Activity continues to flatline, with corporate investment moribund in the wake of
the Lava Jato scandal, consumers crushed by their debt burdens (chart 12), and
government spending squeezed by attempts at fiscal consolidation. Yet despite
this, inflation has continued to climb, in hideous parody of a booming economy.
The Brazilian zombie economy, lifeless and yet animated, is enough to make
policymakers hide behind the sofa.
Chart 12: No signs of life in the real economy
%, y/y
25
20
15
10
5
0
-5
-10
-15
-20
03
04
05
06
Retail sales
07
08
09
10
Industrial production
11
12
13
14
15
BCB GDP proxy
Source: Thomson Datastream, Schroders Economics Group. 21 October 2015.
Some adjustment
is, finally, visible
Is there any hope for Brazil? Certainly, the current trend is a negative one, as
reflected by the recent S&P and Fitch downgrades, which take the country’s
sovereign debt within a whisker of junk status, driven by concern over the fiscal
consolidation process. We have written many times, too, on the supply side
issues plaguing the economy, contributing to the persistent inflation problem, and
the ‘Dutch disease’ inflicted by the multi year commodity boom, which drove up
unit labour costs and rendered Brazilian industry uncompetitive.
On the fiscal and supply side concerns, there is little hope for immediate relief.
The political situation all but guarantees a lack of productive legislation until a
new government comes to power, unencumbered by corruption allegations and
infighting. However, market forces are beginning – if only by a war of attrition – to
generate an improvement in other metrics. For example, unit labour costs
(chart 13) have finally begun to decline as unemployment builds, which ought to
lead to an improvement on the trade balance, as seems to be happening (chart
14 on next page).
13
30 October 2015
For professional investors only
Charts 13 & 14: The painful cure for necrosis
%
18
Index $ million
200 8,000
180
16
14
12
10
8
6
6,000
160
140 4,000
120 2,000
100
0
80
60 -2,000
40
-4,000
20
0 -6,000
03 04 05 06 07 08 09 10 11 12 13 14 15
03 04 05 06 07 08 09 10 11 12 13 14 15
Imports as share of GDP
ULC (rhs)
Trade balance
Source: Thomson Datastream, Schroders Economics Group. 21 October 2015.
All in all, Brazil’s horror story is far from its final act, but perhaps a glimmer of
hope is becoming apparent on the very distant horizon. There can though be no
painless resolution; perhaps the best case scenario is an early exit for Dilma
followed by new elections that allow a purging of the rottenness seemingly
embedded at the political core and a new energy with which to pursue reforms.
14
30 October 2015
For professional investors only
Schroder Economics Group: Views at a glance
Macro summary – October 2015
Key points
Baseline

After a poor start to the year global growth is now forecast at 2.4% for 2015, slightly lower than 2014.
Activity is still expected to pick-up as we move through the year, but parts of the world economy are taking
longer than expected to respond to the fall in energy costs.

Despite a weak first quarter, the US economy rebounded in the second and is on a self sustaining path
with unemployment set to fall below the NAIRU in 2015, however global pressures are likely to delay Fed
tightening until 2016. First rate rise expected in March 2016 with rates rising to 1% by year end.

UK recovery to continue, but to moderate in 2016 with the resumption of austerity. Interest rate
normalisation to begin with first rate rise in May 2016 after the trough in CPI inflation. BoE to move
cautiously with rates at 1.5% by end 2016 and peaking at around 2.5% in 2017.

Eurozone recovery picks up as fiscal austerity and credit conditions ease whilst lower euro and energy
prices support activity. Inflation to remain close to zero throughout 2015, but to turn positive again in 2016.
ECB to keep rates on hold and continue sovereign QE through to September 2016.

Despite weak yen, low oil prices and absence of fiscal tightening in 2015, Japanese growth has
disappointed. Modest pick-up expected in 2016 as labour market continues to tighten and wages rise, but
Abenomics faces considerable challenge over the medium-term to balance recovery with fiscal
consolidation. We do not expect the Bank of Japan to increase QQE.

US still leading the cycle, but Japan and Europe begin to close the gap. Dollar to remain firm as the Fed
tightens, but to appreciate less than in recent months as loose ECB and BoJ policy is mostly priced in.

Emerging economies benefit from advanced economy upswing, but tighter US monetary policy, a firm
dollar and weak commodity prices weigh on growth. Concerns over China’s growth to persist, further fiscal
support and easing from the PBoC is likely.
Risks

Risks skewed towards deflation on fears of China hard landing, a bad Grexit and a US recession. The risk
that Fed rate hikes lead to a tightening tantrum would also push the world economy in a deflationary
direction. Inflationary risks stem from a significant delay to Fed tightening, or a global push toward reflation
by policymakers. Although disruptive near term, lower oil prices would boost output and reduce inflation.
Chart: World GDP forecast
Contributions to World GDP growth (y/y), %
6
4.9 4.5 5.0 5.1
4.9
5
3.6
4
2.9
2.5
3
4.6
Forecast
3.3
2.5 2.6 2.6 2.5
2.2
2.9
2
1
0
-1
-1.3
-2
-3
00 01
US
BRICS
02
03
04
05 06 07 08
Europe
Rest of emerging
09 10
Japan
World
11
12
13
14 15 16
Rest of advanced
Source: Thomson Datastream, Schroders Economics Group. August 2015 forecast. Please note the forecast warning at
the back of the document.
15
30 October 2015
For professional investors only
Schroders Baseline Forecast
Real GDP
y/y%
World
Advanced*
US
Eurozone
Germany
UK
Japan
Total Emerging**
BRICs
China
Wt (%)
100
63.2
24.5
19.2
5.4
3.9
7.2
36.8
22.6
13.5
2014
2.6
1.7
2.4
0.9
1.6
3.0
-0.1
4.3
5.4
7.4
2015
2.4
1.8
2.3
1.3
1.3
2.5
0.7
3.4
4.1
6.8









Prev.
(2.5)
(1.9)
(2.4)
(1.4)
(1.6)
(2.2)
(0.9)
(3.6)
(4.2)
(6.8)
Consensus 2016
Prev.
2.4
2.9
(2.9)
1.9
2.2  (2.1)
2.5
2.7  (2.5)
1.5
1.7  (1.6)
1.8
2.1
(2.1)
2.5
2.1  (1.9)
0.6
1.8  (2.0)
3.3
4.1  (4.3)
4.0
4.7  (4.9)
6.8
6.4  (6.5)
Consensus
2.8
2.1
2.6
1.7
1.9
2.4
1.3
3.9
4.7
6.5
Wt (%)
100
63.2
24.5
19.2
5.4
3.9
7.2
36.8
22.6
13.5
2014
2.8
1.4
1.6
0.4
0.8
1.5
2.7
5.1
4.0
2.0
2015
2.9
0.5
0.6
0.0
0.2
0.0
1.1
7.0
4.8
1.4









Prev.
(2.8)
(0.6)
(0.9)
(0.2)
(0.5)
(0.4)
(0.8)
(6.4)
(4.7)
(1.4)
Consensus 2016
Prev.
3.0
3.3  (3.1)
0.3
1.7
(1.7)
0.2
2.3
(2.3)
0.1
1.1  (1.2)
0.3
1.5  (1.7)
0.1
1.6  (1.8)
0.8
1.1
(1.1)
7.6
6.1  (5.4)
4.7
3.8  (3.6)
1.6
2.0
(2.0)
Consensus
3.6
1.4
1.8
1.1
1.4
1.4
0.8
7.3
3.8
2.1
Current
0.25
0.50
0.05
0.10
4.35
2014
0.25
0.50
0.05
0.10
5.60
2015
Prev.
0.75  (1.00)
0.50
(0.50)
0.05
(0.05)
0.10
(0.10)
4.60
(4.60)
Current
4495
103
375
345
18.00
2014
4498
31
375
300
20.00
2015
Prev.
4504  (4494)
649
(649)
375
(375)
389
(389)
17.50  18.00
FX (Month of Dec)
Current
USD/GBP
1.53
USD/EUR
1.11
JPY/USD
120.6
GBP/EUR
0.72
RMB/USD
6.36
Commodities (over year)
Brent Crude
48.3
2014
1.56
1.21
119.9
0.78
6.20
2015
Prev.
1.53  (1.52)
1.08
(1.08)
120.0  (118)
0.71  (0.71)
6.30
(6.30)
Y/Y(%)
-1.9
-10.7
0.1
-9.0
1.5

-1.6
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
0.38
0.59
-0.12
0.18
-
2016
Prev.
2.00  (2.50)
1.50
(1.50)
0.05
(0.05)
0.10
(0.10)
4.00
(4.00)
Market
0.86
0.86
-0.17
0.16
-
Other monetary policy
(Over year or by Dec)
US QE ($Bn)
EZ QE (€Bn)
UK QE (£Bn)
JP QE (¥Tn)
China RRR (%)
2016
Prev.
4522  (4512)
1189
(1189)
375
(375)
406
(406)
16.00  17.00
Key variables
55.8
55.0
(64)
2016
Prev.
1.50
(1.50)
1.02  (1.00)
120.0  (115)
0.68  (0.67)
6.40
(6.40)
Y/Y(%)
-2.0
-5.6
0.0
-3.7
1.6

0.9
55.5
(71)
Source: Schroders, Thomson Datastream, Consensus Economics, October 2015
Consensus inflation numbers for Emerging Markets is for end of period, and is not directly comparable.
Market data as at 28/10/2015
Previous forecast refers to May 2015
* 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.
*** The forecast for US policy interest rates w as updated this month, w ith the previous forecast refering to the August update.
16
30 October 2015
For professional investors only
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
2015
2016
%
8
%
8
7
7
EM Asia
6
6
5
4
EM Asia
EM
5
EM
4
Pac ex Jap
Pac ex Jap
US
3
UK
2
3
Eurozone
Eurozone
2
1
1
Japan
0
Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15
0
US
UK
Japan
Jan Feb Mar Apr May Jun
Jul Aug Sep Oct
Chart B: Inflation consensus forecasts
2015
2016
%
6
%
6
EM
5
5
EM
4
4
EM Asia
Pac ex Jap
3
EM Asia
3
UK
2
Pac ex Jap
1
Eurozone
Japan
US
0
-1
Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15
2
US
UK
1
Eurozone
Japan
0
Jan Feb Mar Apr May Jun
Jul
Aug Sep Oct
Source: Consensus Economics (October 2015), 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
The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own
assumptions which may change. We accept no responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to
our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors. 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
17