29 April 2014
For professional investors only
Schroders
Economic and Strategy Viewpoint
Keith Wade
Chief Economist and
Strategist
(44-20)7658 6296
Azad Zangana
European Economist
(44-20)7658 2671
Craig Botham
Emerging Markets
Economist
(44-20)7658 2882
The US leads the recovery, but the world’s locomotive is fading (page 2)
 US economic activity is strengthening after a harsh winter and the economy is
leading the global upswing in the developed world. Whilst good news for
global growth, the US economy which is emerging from the financial crisis will
make less of a contribution to the rest of the world. Signs of this are already
apparent as despite leading the upswing, the US trade deficit has not
deteriorated as in the past.
 This is not a US “stagnation” forecast as although weaker consumer
spending is an element, we also see better trade performance from the US.
Instead the greater pressure will be felt in the rest of the world particularly the
emerging markets. Deflationary pressures which have been apparent in
recent CPI figures are also likely to persist.
UK: Taming the housing market (page 8)
 UK house prices are rising strongly again despite very weak growth in
earnings. Low interest rates and various forms of monetary and fiscal
stimulus schemes have reignited confidence. While rising house prices are
indicative of a recovering economy, questions are being asked over its
sustainability. We find that a chronic lack of supply is to blame and believe it
is time for the government to enter the market to provide additional supply.
South Africa: Zuma zooms on (page 13)
 Elections in South Africa next week are certain to return an ANC majority
despite corruption allegations. The race for second place though could sway
the future direction of policy at a crucial time for an economy struggling with
a febrile labour situation and anaemic exports. Reform is needed but far from
guaranteed.
China: The dragon begins its descent (page 16)
 China has begun to slow but we do not believe significant stimulus is likely.
Measures so far have been for support rather than acceleration in activity.
Views at a glance (page 17)
 A short summary of our main macro views and where we see the risks to the
world economy.
Chart: UK housing supply growth has been woefully inadequate
UK permanent dwellings completed by tenure (thousands)
600
500
400
300
200
100
0
-100
'52
'57
Private
'62
'67
'72
'77
Housing Associations
'82
'87
'92
Local Authorities
'97
'02
'07
'12
Annual population growth
Source: Department for Communities and Local Government (DCLG), ONS, Schroders. 25 April 2014.
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29 April 2014
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The US leads the recovery, but the world’s locomotive is
fading
US growth is
picking up again
and the economy
is leading the
upswing in
developed market
activity
For all the talk of the US losing its pre-eminence and influence, its economy is
leading the recovery in the developed world and its equity market continues to
outperform the global index. Growth in the world’s largest economy now seems to
be picking up again after a harsh winter and activity looks set to accelerate as we
head into the summer.
Whilst this is good news for global growth, there are signs that the US economy
which is emerging from the financial crisis is playing less of a role in driving global
growth than in previous cycles. The engine which drove the world economy for
much of the past two decades has become more orientated toward domestic
producers and is likely to be weaker than in the past. Clearly such an outcome has
important implications for global trade, the emerging markets and inflation.
Taking the last quarter of 2007 as a starting point, the US economy regained its precrisis level of activity in 2011 and real GDP is now some 6% higher than at the end
of 2007. Only Germany of the major developed economies has come anywhere
close to this performance, but having led the US for much of the period it now finds
itself some 2% behind (chart 1).
Chart 1: Recession and recovery (real GDP since the start of the global
financial crisis)
Index (100 = 2007 Q4)
108
US
106
Ger
104
102
100
Jap
98
EZ
UK
96
94
Spa
92
90
Ita
2008
2009
2010
2011
2012
2013
2014
Source: Thomson Datastream, Schroders. 24 April 2014.
UK may be about
to regain its precrisis level of
GDP, but is some
three years behind
the US
On this basis, the UK, which may be about to celebrate a return to pre-crisis levels
of activity, is some 3 years behind the US. Before looking at the prospects for the
US as a global locomotive, it is interesting to briefly reflect on the reasons for this
gap. Despite popular perceptions, one argument which does not fit the facts is
greater austerity in the form of public spending cuts in the UK. From the trough in
2009q2 all of the recovery in the US can be attributed to the private sector with
consumption and investment driving the increase in output. Government spending
has been a drag of 1.6% of GDP. Meanwhile, the weaker recovery in the UK was
supported by government spending to the tune of 0.7% of GDP (see table 1 on next
page).
2
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Table 1: Recovery drivers in the US and UK
2009 Q2 - 2013 Q4
US
%
Contribution
change
ppt
GDP
11.2
11.2
Consumer spending
10.5
7.2
Private Investment
24.3
3.4
Government
-7.3
-1.6
Inventory (real $m, £m)
317.3
2.2
Exports
34.8
3.7
Imports
28.7
-3.8
Net exports (real $m, £m)
-10.0
-0.1
%
change
6.2
5.7
0.4
2.3
5147
18.4
-14.9
2552
UK
Contribution
ppt
6.2
3.8
0.7
0.7
1.4
5.2
-4.5
0.7
Note: Government includes public consumption and investment.
Source: BEA, ONS. 24 April 2014.
It is more likely that the lag in performance reflects the UK's greater dependence on
the banking sector in terms of share of GDP, which helped make the UK recession
deeper than in the US, and then made the upswing weaker as firms and households
have struggled to obtain finance.
Both governments had to take stakes in their banks, but whereas the US has now
largely off-loaded these, the UK taxpayer still has a substantial stake in Lloyds and
looks like being stuck with RBS for some time to come. More generally, the UK's
bank-based system of finance contrasts with the market-based system in the US
where much of the private sector’s funding ends up being quoted in equity and debt
markets. The latter system may be more brutal, but its transparency means that
lenders have to take their losses upfront and hence can either close or be
recapitalised more rapidly. The net result is that US banks resumed lending activity
sooner. Contrast this with the long period taken to recognise losses, recapitalise and
resume lending in the UK (or the Eurozone).
The improvement in US trade performance
The US net trade
position has not
deteriorated
despite the US
leading the global
recovery
Coming back to the global picture, despite leading the recovery the US has not
suffered a deterioration in its trade position. This is unusual as normally one would
expect the economy leading the upswing to suck in imports and experience a drag
on GDP growth from the trade sector. Instead, the gap between exports and imports
(net exports) in the US has been roughly stable (see table 1 above) and has been
running at -2.5% GDP during the recovery phase from 2009 onward.
This is in contrast to the recovery from the last recession when the US trade deficit
steadily deteriorated from -3.5% to -5.5% of GDP, where it stood in 2006. Thus,
there has been an improvement of some 3% of GDP in the US net export position
since the crisis. Such an outcome is made more remarkable by the sluggishness of
global demand during this period which will have hampered export growth.
Part of the explanation for this performance lies with the fracking revolution and
increase in oil production in the US which has reduced demand for imported oil.
However, oil is not the whole story as the non-oil deficit has also narrowed
significantly (see chart 2 on next page).
3
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Chart 2: US net exports, narrowing despite recovery
% of GDP
-2.0
-2.5
-3.0
-3.5
-4.0
-4.5
-5.0
-5.5
-6.0
99
00
01
02
Recessions
03
04
05
06
Net total exports
07
08
09
10
11
12
13
14
Net total exports excluding energy
Source: Thomson Datastream, Schroders. 24 April 2014.
Import penetration
has stopped rising
in the US and
exports are
gaining market
share
The improvement in US trade performance is also apparent in metrics such as
import penetration which measures the level of imports relative to domestic demand.
Between 2002 and 2007 this rose from 12.5% to 15% as imports outpaced domestic
demand. The ratio collapsed during the recession as trade finance dried up post
Lehman, but then recovered back to 15% where, rather than continuing to increase,
it has stabilised (chart 3). Meanwhile, exports as a share of GDP have continued to
move ahead and figures from the OECD suggest that the US has increased its
share of world trade after years of decline.
Chart 3: Import penetration has stabilised in the US
15.5%
15.0%
14.5%
14.0%
13.5%
13.0%
12.5%
12.0%
99
00
01 02 03 04
Recessions
05 06 07 08 09 10 11 12
Imports as a % of domestic demand
Source: Thomson Datastream, Schroders. 24 April 2014.
13
14
Several explanations have been put forward to explain the change in trade
behaviour. These include the shifting pattern of US demand with consumption being
increasingly driven by a small group of wealthy consumers (who tend to spend more
at the margin on domestically produced services than goods), the shift from PC's to
tablets and mobile phones (which tends to mean more value added resides in the
US with firms such as Apple) and the argument that trade finance has never fully
recovered (forcing companies to source more from home).
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All have merit, however, one over arching explanation is that the US dollar is more
competitive today than during the last recovery. Since 2002, the dollar is down by
one third in both real and nominal terms and the competitiveness of the US is
reflected in the growing phenomenon of on-shoring (bringing production back from
overseas to the US).
Chart 4: Competitive gain, the USD
A competitive USD
is a factor
Index (100 = Jan 1997)
135
130
125
120
115
110
105
100
95
90
99
00 01 02
Recessions
03 04 05 06 07 08 09
Broad trade weighted US $
10 11 12 13 14
1-year moving average
Source: Thomson Datastream, Schroders, 25 April 2014
The evidence so far points to a world where an increase in US demand has less
effect on growth elsewhere as more of it is staying within the economy. However,
the impact on the rest of the world will also depend on the growth of that demand. If
US demand rose strongly enough it could still drive global growth. Unfortunately the
prospects for this look remote in the post financial crisis economy.
Long run consumer spending drivers
Focusing on the consumer, real expenditure was weakened by the recession, but
the trend has been slowing for some time. For example, the five year trend is
currently less than 2% per annum compared with around 4% in the past (chart 5).
Chart 5: US consumer spending trending lower
%, Y/Y
9
8
7
6
5
4
3
2
1
0
-1
-2
-3
65
70
75
80
85
90
Personal consumption growth
Source: Thomson Datastream, Schroders, 25 April 2014.
5
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95
00
05
10
5-year moving average
29 April 2014
The financial crisis
has exposed the
underlying
weakness in US
consumer
spending
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Underlying this is a very weak performance from real income and upward pressure
on the savings ratio as households lost access to credit (see chart 6). Going
forward, incomes should get a boost from better employment and a tightening of the
labour market, whilst rising wealth will encourage/ enable households to borrow
again. However, although they have fallen, debt levels remain high in the household
sector and the economy’s overall debt has been boosted by the surge in
government borrowing, indicating that household borrowing and income growth will
remain subdued.
Chart 6: Fading drivers, real income and savings rate
% (5-year moving average)
14
12
10
8
6
4
2
0
65
70
75
80
85
90
95
00
05
10
Recessions
Savings as % of disposable income
Growth in real disposable income (Y/Y)
Source: Thomson Datastream, Schroders, 25 April 2014.
This outlook would have been with us sooner had we not had the boom in credit
which masked long running weakness in wage and salary growth in the US. From
this perspective the boom in sub-prime lending only masked an inevitable slowdown
in consumer incomes and expenditure. And, arguably the Fed is now trying to
trigger a return to borrowing through boosting asset prices and wealth with the risk
that they create another bubble.
Conclusion
Pulling this together the conclusion is that the US is likely to be less of a locomotive
for global growth than it has been in previous cycles. Consumer spending is likely to
be more lacklustre and, of the demand generated by the US, more is likely to be met
by domestic rather than overseas production. This is not necessarily a “stagnation
thesis” as the US could perform well as it trade performance drives growth.
Nonetheless, it is not good news for the rest of the world particularly those
economies which have relied on selling to the US. The emerging markets are
vulnerable in this respect and it is notable that the surplus in these economies has
declined significantly from 5% to 1% of GDP since the crisis according to figures
from the IMF (chart 7). It is also notable that much of the improvement in US trade
has been with the fragile 5 of Brazil, India, Turkey, Indonesia and South Africa.
These economies are now adjusting, but this analysis suggests that there will be no
return to pre-2007 export growth.
6
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Chart 7: Mirror image, the US and emerging market current accounts
Current account balance (% of GDP)
6
4
Weaker demand
and a better trade
performance
indicate that the
US will be less of a
locomotive for
global growth,
keeping pressure
on emerging
market growth and
inflation
2
0
-2
-4
-6
-8
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
IMF forecast
US
Emerging market economies
Source: Thomson Datastream, IMF, Schroders, 25 April 2014.
Clearly such a conclusion means there will be continuing pressure on emerging
economies to restructure and re-orientate their economies toward domestic rather
than external demand. However, this takes time and in the interim there will be
excess capacity and slack as the world economy moves to a new configuration.
Consequently the deflationary pressures which have been apparent in recent CPI
prints around the world are likely to persist.
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UK: Taming the housing market
Martians may be forgiven for not noticing the boom in the UK housing market over
the past year, otherwise, the nation’s favourite talking point (after the weather of
course) has returned to dominate the business news agenda. The financial press
are now filled with various indicators returning to pre-crisis levels, and of course, the
sharp rise in prices being recorded.
The UK housing
market is booming
once again
Not only has much excitement been generated in the press, but also concern over
the risk of yet another housing bubble being created. The government’s stimulus
measures announced in last year’s budget have primarily helped boost confidence
in the market, but are also helping a minority for new buyers to access higher valued
loans relative to the price of properties. Those concerns have prompted the Bank of
England to exclude mortgage financing from the Funding for Lending Scheme at the
end of last year, but may also lead its new Financial Policy Committee (FPC), which
is tasked with guarding the UK’s financial stability, to take action to tame the
housing market.
Boom times are back
According to the Halifax house price index, average UK house prices rose by 8.7%
in the first quarter of this year - their fastest pace of annual growth since the third
quarter of 2007 (see chart 8). The recent boom in house prices is far from uniform
across the UK. Unsurprisingly, London is leading the boom with prices up 15.7%
compared to a year earlier. The worst performing region is Scotland with prices
down by 1.4% compared to a year earlier. While the latter is pre-occupied with the
possibility of gaining independence from the union in a vote to be held in
September, the geographic and economic capital is firing on all cylinders, which is
being reflected by the price of property.
Chart 8: House prices boom raises questions of stability
Average prices are
up 8.7% y/y, but in
London, are up
15.7%
Quarterly Y/Y growth
25%
20%
15%
15.7%
10%
8.7%
5%
0%
-5%
-10%
-15%
-20%
-25%
2006
2007
2008
2009
UK average
2010
2011
2012
2013
2014
Greater London average
Source: Thomson Datastream, Halifax house price index (mix-adjusted), Schroders. 25 April 2014.
The London housing market has not only traditionally enjoyed huge migration from
the rest of the country as the most talented seek the most rewarding opportunities,
but its rich cultural offerings have also attracted many foreign buyers. Some of the
wealthier foreign buyers clearly take advantage of the UK’s lax foreign ownership
laws to use London property as a store of wealth – particularly when troubles flare
up at home. Indeed, according to a report by estate agent Savills, foreign investors
have bought about 70% of newly built properties across central London in 2013,
while another estate agent, Knight Frank, says that 30% of luxury London homes
worth £1 million or more were bought by foreigners.
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The market has
traditionally
attracted safe
haven flows,
prompting the
Chancellor to
tighten tax laws
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Such reports prompted Chancellor George Osborne to announce plans to introduce
a capital gains tax for non-residents from April 2015 (possibly at 28% matching the
rate residents pay). Implementation of such a tax will be difficult, but the Treasury
forecasts the measure to raise £15 billion in revenues in tax year 2016-17, rising to
£70 billion in 2018-19. The plans would bring the UK in line with other key investor
markets, such as New York and Paris, where similar taxes can reach 35-50%.
Osborne also introduced a punitive 15% rate of stamp duty on company-owned
properties worth over £2 million. The shell-company ownership was commonly used
to avoid certain taxes, but also to protect buyers’ anonymity.
By tightening these tax rules the Chancellor is seeking to close obvious loopholes,
but the strategy is also in response to fears that foreign investors could be fueling
the next property bubble. However in our view, the Chancellor should pay more
attention at the woeful lack of supply of new homes.
It’s a lack of supply stupid
Given a growing population, demand for residential property is rising. However, with
supply woefully inadequate, house prices naturally must rise in order for the market
to clear.
The lack of supply of residential property is a relatively recent phenomenon. During
most of the period between 1950 and the late 1990’s, the pace of construction kept
up with the growth in the UK’s population, and indeed, even outpaced it for long
periods (see chart on front page).
Supply was not an issue thanks to a combination of private supply, along with
government assisted ‘local authorities’ supply, and supply provided by housing
associations (privately funded non-profit organisations). The range of supply
generally satisfied the population’s income spectrum, until supply started to ease
during the 1970’s. With the government’s finances under pressure, local authorities
began to scale back new investment and to sell their stock of property to their
tenants. This was formalised with the introduction of ‘Right to Buy’ under the
Housing Act (1980) which dramatically accelerated the transfer of publically owned
property to the private sector.
The creation of new dwellings from local authorities largely ended in the mid-1990’s
and until the financial crisis, new supply had averaged a steady 193k homes per
annum, while the population grew by 240k per annum. Since the start of the
financial crisis (2008), population growth has averaged 451k per annum, while
housing supply average a mere 153k – the lowest period since official records
began in 1952.
The key problem
in the market is a
woeful lack of
supply, especially
in London…
The fall in the supply of new homes compared to the surge in the population is
particularly acute in London. Examining the number of people per residential
property (stock), we find that most regions in the UK have experienced a rise in the
density ratio (see chart 9 on next page). London has seen the number of people per
existing home rise from 2.35 in 2004 to 2.48 in 2013. In the last three years alone,
the stock of residential homes has risen by just 68k properties, while the population
has grown by a huge 381k people – 5.6 times faster than the availability of property.
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Chart 9: Housing supply adequacy by region
Population per residential property
2.55
London
2.50
W.Mid
2.45
S.East
2.40
East
2.35
E.Mid
2.30
York. &
Hum
N.West
2.25
S.West
2.20
N.East
2.15
91
93
95
97
99
01
03
05
07
09
11
13
Source: Thomson Datastream, Department for Communities and Local Government (DCLG),
ONS, Schroders. 25 April 2014.
…where supply
needs to double in
order to stabilise
the market
In order to stabilise the demand supply dynamics, we believe that the population
cannot grow by more than 2.5 times the supply of homes. Therefore, the annual
supply of London property needs to more than double just to stop the imbalance
worsening.
Will it all end in tears…again?
The sustainability of the latest boom in the housing market is closely being
examined not only by economists, but also the general public who are rightly
concerned about the risk of yet another boom and bust cycle.
Is this the next
boom before the
inevitable bust?
Judging whether the market is now in a bubble is difficult. We must consider the
demand and supply dynamics, both cyclical and structural. We have already
discussed how the chronic undersupply of property has been a key factor in recent
years. The public tends to focus on prices being very high relative to incomes; after
all, regular wages are almost 8% lower in real terms (CPI) compared to their peak at
the start of 2008, while house prices are recovering at a brisk pace.
Comparing average house prices to average earnings is a favoured measure of
affordability (Halifax index). At the peak of the market in the middle of 2007, the UK
house price-to-earnings ratio hit 5.86, well above the long-run average of 4.1. As the
financial crisis unfolded, house-price falls outpaced the fall in average earnings
pushing the ratio down and almost returning it to its long-run average. Since then,
the pickup in prices puts the house price-to-earnings ratio at 4.8, suggesting prices
are too high once again. By our calculation, prices would need to fall by 15% in
order to re-align with average earnings. However, the strength of the housing
market suggests high prices compared to earnings are not a serious barrier for
further gains. This is largely because mortgage affordability is extremely good at
present thanks to ultra-loose monetary policy set by the Bank of England.
Looking at the UK overall, we find that the current average mortgage repayment is
just 27.6% of average household disposable incomes. This is significantly lower
than the long-run average of 35.9%, and the peak of 47.7% in the third quarter of
2007, when the Bank of England’s policy interest rate was at its peak. Low interest
rates have helped borrowers afford bigger loans, therefore putting pressure on
prices to rise.
At some stage the Bank of England will raise interest rates from their record low
level of 0.5%. We should then see mortgage payments rise as a share of disposable
income, which will eventually reduce demand in the market. The danger is whether
10
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new buyers will still be able to afford their mortgages as interest rates rise, or
whether we start seeing the number of delinquent mortgages pick up.
In London, the story is similar, but more advanced in the cycle. Prices in the capital
are currently 6.36 times average earnings; close to the previous peak of 6.41 times
in the third quarter of 2007 – and well above their average of 6.18 times. However,
just as with the UK average, mortgage affordability is by historical standards good.
Average mortgage payments in London are currently 39.1% of disposable income;
well below the long-run average of 47.4%, and also below the previous peak of
55.8%. Charts 10 and 11 highlight the above mentioned affordability trends.
Chart 10 & 11: UK and London housing affordability measures
While house
prices remain high
relative to
earnings,
mortgage
affordability
remains good…
%
%
70 8.5
7.5
London
UK
6.5
60
70
6.5
5.5
50
4.5
40
5.5
3.5
30
2.5
84
80
7.5
60
50
4.5
40
3.5
30
20 2.5
20
84 88 92 96 00 04 08 12
88 92 96 00 04 08 12
House price to earnings ratio, lhs
House price to earnings ratio, lhs
Long-run average (both)
Long-run average (both)
Mortgage repayment as % of disp. inc, rhs
Mortgage repayment as % of disp. inc, rhs
Source: Thomson Datastream, Halifax, Schroders. 25 April 2014.
Caution required
…however, this
will not last
forever, as the
BoE will
eventually raise
interest rates.
Monetary policy remains ultra-loose, while the government continues to stimulate
the housing market through loan/capital guarantees. Before the market becomes
dangerously overheated, it may soon be time to take precautionary action. The
obvious action would be for the government to halt its stimulus measures, or for the
Bank to raise interest rates. However, there is little chance of the former given the
general election next year, while the Bank is still concerned by the fragility of the
economy, along with their estimates of the amount of deflationary spare capacity in
the economy.
A more likely course of action is likely to come from the Financial Conduct Authority
(FCA) in partnership with the Bank of England’s Prudential Regulation Authority
(PRA). At the time of writing, the FCA has introduced new tougher mortgage lending
rules to “…put common sense at the heart of the mortgage market and prevent
borrowers ending up with a mortgage they cannot afford.” The Mortgage Market
Review essentially attempts to reduce ‘execution only’ mortgages, which have been
the norm for most borrowers. Lenders are now obliged to give advice on the
suitability of a mortgage product, both in terms of meeting the needs of the borrower
and the affordability of the product at present and in the future. Of course, lenders
cannot predict interest rates (economist have a hard enough time), but they will now
use sensible illustrative scenarios to test affordability. If a new applicant for example
can easily afford mortgage payments today, but cannot afford them when they are
set using 3% higher interest rates (market expectations in 5-years time), then that
applicant will have to make alternative arrangements.
The PRA and FCA
are now taking
steps to improve
loan quality
Not only are lenders directly responsible for checking suitability, but they are now
also responsible for checking suitability even if the product is arranged through an
agent (for example, an independent financial advisor). In addition, the new rules
also ban ‘self-certified’ mortgages, where borrowers who were typically selfemployed, did not have to prove their incomes.
11
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We expect some disruption to the market in the short-term, but we believe that the
introduction of these rules make a lot of sense. Lenders should be more careful in
whom they lend to, and hopefully these rules will not only raise standards across the
industry, but also the knowledge of consumers. Incidentally, we expect the
compulsory provision of ‘advice’ to borrowers to open up lenders to scrutiny from the
Financial Ombudsman Service should accusations of mis-selling arise.
The Mortgage Market Review is the first step in the use of macro-prudential policy.
Eventually, we could see limits to loan-to-value (LTV) ratios, introduction to limits to
loan-to-income multiples, and possibly even more micro measures such as time
limits on mortgages etc. The Bank of England’s Financial Policy Committee (FPC)
announced last month that it expects to be ready in June to set the interest rates
that should be used for the affordability tests in the MMR.
Before we become too concerned by the standards of lending, it is worth
highlighting the latest data on the types of mortgages being issued. The first point to
make is that the return of first time buyers to the market is a welcomed
development. First time buyers now make up just over 20% of the market – over
twice the proportion in 2008. Meanwhile, more risky mortgages such as those with
LTVs of over 90%; those with LTVs of over 90% and high income multiples; those
for borrowers with impaired credit; and those where the borrower is increasing the
size of their loan all fell considerably since the financial crisis, and have not returned
in a meaningful way (chart 12).
Chart 12: First time buyers returning, but not the risky behaviour
The good news is
that risky lending
remains largely
absent
% of all new mortgages
25
20
15
10
5
0
2007
2008
2009
Over 90% LTV
Impaired credit
First time buyers
2010
2011
2012
2013
Over 90% LTV & high multiple
Further advances
Source: Thomson Datastream, Bank of England, Schroders. 25 April 2014.
The government
must consider
intervening in the
supply of new
homes to stave off
a bigger crisis in
the future
The absence of the previous risky lending is good news and suggests there is less
urgency for immediate policy tightening. Good affordability and a severe lack of
supply in some areas are driving prices higher. Affordability will eventually
deteriorate, which will put pressure on the government to provide more help.
However, the only real policy that has any chance of working in the long-term is the
provision of additional supply. As discussed earlier, construction of new homes
needs to double just to stabilise supply relative to population growth. However, the
private sector has historically never been able to produce the number of homes that
are now required, regardless of market conditions. The government must consider
entering the construction market, and if necessary, to compete with home
developers that continue to horde land. If they fail to do so and house prices
continue to rise aggressively, the UK could find that the average household will no
longer be able to get on to the housing ladder, which will ultimately raise demand for
social housing, and therefore costs for the exchequer in the long-run. It’s time to
build again.
12
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South Africa: Zuma zooms on
Despite South Africa’s anti-corruption watchdog publishing a damning report on
“security” upgrades to President Zuma’s home, opinion polls continue to point to
victory for the ruling African National Congress (ANC) party in elections on May 7th.
The state paid $21 million to equip Zuma’s home with, amongst other things, a
chicken run, amphitheatre and swimming pool, but voters seem unfazed; a poll on
April 4th said the ANC was likely to win 65.5% of the vote. This is close to the two
thirds majority needed to alter the constitution and is down only slightly from the
65.9% share of the vote they received in the 2009 elections (chart 13).
Chart 13: The ANC has maintained its vote share
% of vote
An election victory
for the ANC seems
certain despite
corruption
allegations
70
60
50
40
30
20
10
0
ANC
DA
COPE
2009 election
IFP
EFF
Latest poll
Source: IEC, Sunday Times (South Africa), Ipsos, Schroders. 23 April 2014
The race for
second place
could sway the
direction of future
policy
The main opposition party, the reformist and more market friendly Democratic
Alliance (DA) has run a fairly negative campaign, focusing on Zuma. Though they
have gained in the polls it appears not to be at the expense of the ANC. The only
other party to have made gains is the new Economic Freedom Fighters (EFF) party,
a left wing populist group under ANC breakaway Julius Malema – though they have
plateaued in recent months. Again, this gain appears to be the loss of other
opposition parties rather than the ANC.
The election seems set to deliver a strong majority for the ANC if polls are to be
believed. If the ANC were to see its share of the vote eroded, it would likely alter its
policies, though the direction would depend on who was responsible. Should the DA
take votes away the ANC could be driven to pursue labour reforms, and more rapid
implementation of the National Development Plan. A more negative outcome would
be one where the ANC loses vote share to the EFF, which has been pushing for
nationalisation of the mines and uncompensated land seizures. At present though,
the polls suggest no particular political push is likely; so the base case is for more of
the same. The only positive we can offer on this front is that we should see more
movement on reform post-elections, when there is more political capital to spend.
Still Fragile
South Africa has
been slow to
adjust
Can the country survive another round of “business as usual”? The “Fragile Five”
concept is increasingly redundant as India and Indonesia continue to make
macroeconomic adjustments, while Brazil and now even Turkey have moved in the
right policy direction. South Africa, though, remains firmly ensconced in the realms
of fragility. Yet if we look at measures like credit growth, wage growth and real
effective exchange rate (REER) adjustment, South Africa actually fares very well in
a comparison with the other Fragile Five countries (chart 14), and versus most other
current account deficit EM economies too.
13
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Chart 14: Domestic adjustment in the Fragile Five
%
40
30
20
10
0
-10
-20
Credit growth (y/y, 3mma,
Jan 2014)
Turkey
Wage growth (3mma,
latest available)
Brazil
India
Change in REER since
May 2013 (%)
Indonesia
South Africa
Source: Thomson Datastream, Bloomberg, IMF, Schroders. 14 April 2014.
Export
performance has
been woeful
South Africa’s fragility stems instead almost entirely from its poor export
performance. Exports have fallen sharply in dollar terms in recent years (chart 15),
unlike any other EM economy. Driving this is a fall in local production and global
prices for the country’s commodity exports. Weaker growth in China, discussed
briefly at the end of this Viewpoint, is one factor behind this fall in prices, and looks
set to continue.
There has been a recent improvement in the merchandise trade and current
account data, but it may only be temporary. Two monthly surpluses were posted in
the last quarter of 2013 which reduced the current account deficit for the quarter to
5.1% from 6.4% the previous quarter. While this is a positive development, the
recent platinum strike will show up in the data from March onwards, and has also
accelerated (if not triggered) the closure of platinum mines which will structurally
reduce export volumes. Recovery in the current account looks likely to be
increasingly reliant on import compression.
Chart 15: South Africa’s exports have underperformed EM
Index of exports (2009/10 = 100); 3m MA
160
140
120
100
80
60
40
20
0
03
04
05
06
07
08
09
South Africa
10
11
12
13
14
EM Average
Source: Thomson Datastream, Schroders. 24 April 2014
Now, we can see from chart 14 that there is little needed in the way of domestic
adjustment. Recent PMI, GDP and other activity data has all been unimpressive –
domestic demand is crawling along. Negative from a growth and earnings
14
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Labour protests
need to be
resolved and root
causes addressed
For professional investors only
perspective, of course, but it does mean there’s little adjustment needed on this
score. Instead, the main adjustment is to be made in the external sector, and the
best channel is probably the currency. A large scale depreciation would make
imports more expensive and exports cheaper, rebalancing trade without constricting
growth further. The currency has in fact already depreciated 18% from a year ago,
and while export performance has improved marginally there is clearly much further
to go given the deterioration in the terms of trade. Weakness in commodity prices
means the country must ship out even more of the stuff it digs out of the ground for
a given trade balance improvement Further, though depreciation helps, it also
causes inflation. If this inflation feeds through into wages and ultimately export
prices, it will undermine competiveness. There would appear to be relatively little the
government can do, whatever the election outcome, to resolve this.
However, while South Africa is powerless to affect global commodity prices, it could
at least do something to address its local production problems. Labour disputes are
frequent and costly; the platinum miners’ strike has been running for three months
now, reportedly costing $1.4bn in lost revenue. Reforms to labour institutions and
the market as a whole would help address this issue, and encourage new
investment in industries capable of generating export revenues. The government
recognises this as an issue, but whether it will feel capable of tackling it will depend
on whether voter sentiment tends towards populism or pragmatism in May.
Domestic picture still weak
Growth is, and
looks likely to
remain, anaemic
Growth since 2009 has been dependent upon public consumption and public
infrastructure investment, which between them have accounted for nearly 40% of
growth in that period. Households enjoyed income growth and rising unsecured credit,
boosting private consumption. Private investment, though, has been weak. Now
consumption is faltering in the face of tighter credit conditions and high inflation.
Inflation is currently just below its 6% target, at 5.9%, but further pass-through from
currency weakness seems likely. The central bank typically assumes a 20% passthrough coefficient, though this can be lower at times of very weak demand.
Barclays estimates that the rate of pass-through has dropped to 13% since 2007.
Still, inflation looks set to face upward pressure from this channel and also domestic
food price pressures, and further policy tightening is warranted. Obviously, further
hikes will act as additional hurdles to consumption.
Charts 16 & 17: Consumption faces headwinds
% %, y/y
14 30
13
25
12
%, y/y
14
12
10
8
11 20
10
9 15
6
8
7
4
6
2
5
0
4
00
02 04 06
Inflation
08 10 12 14
Policy rate (rhs)
%, y/y
10
8
6
4
2
10
0
5
-2
-4
0
00
02
04 06 08 10 12
Lending to households
Consumption (rhs)
14
Source: Thomson Datastream, Schroders. 25 April 2014
On the public expenditure side, the National Treasury has committed to keep
expenditure growth to just 2% per annum in real terms (excluding interest payments).
Though this is to be welcomed given that the country’s credit rating is on negative
outlook with two of the three ratings agencies, it will limit fiscal support for growth. All
in all this looks set to be a tough year for South Africa, whatever happens in May.
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China: The dragon begins its descent
Chinese GDP growth slowed in the first quarter of 2014, from 7.7% at the end of last
year to 7.4%, year on year. Though this was better than expected – City
expectations had been for a rate of 7.3% - the economy is still slowing and we think
hopes for greater stimulus will be dashed. Meanwhile, higher frequency data for
March, combined to give a leading indicator, generally points to continued softness
in the second quarter (chart 18).
Further slowing
and little stimulus
likely in China
Chart 18: GDP growth decelerates and there’s more to come
y/y, %
14
y/y, %
14
13
13
12
12
11
11
10
10
9
9
8
8
7
7
6
6
5
2008
5
2009
2010
GDP
2011
2012
2013
Schroders Activity Model
2014
The Schroders Activity Model looks at a mix of leading indicators for GDP growth, including
investment, exports, car sales, new orders and industrial production. Source: Thomson
Datastream, Schroders. 25 April 2014
Industrial production did pick up slightly in March, climbing to 8.8% year on year
from 8.6% in the first two months, but the number is flattered somewhat due to a
positive base effect. Meanwhile, investment continued to slow; fixed asset
investment rose 17.4% year on year from 17.9% in the previous two months, with
the weakness led by real estate (down to 14.2% year on year growth from 19.3%).
In line with this, property sales and new starts contracted notably. Combined with
the weaker PMI seen at the month’s start and softer money supply numbers, it is
difficult to feel positive about Chinese growth, despite the better than expected GDP
number. What is more, the record low in M2 growth seems set to feed through to
further weakness in growth in the months ahead. The latest flash PMI number,
coming in at 48.3, confirms this.
Still we do not expect a significant stimulus response. We have seen some fine
tuning. Reserve requirement cuts for rural banks have been announced, but are
likely to have a marginal impact at the macro level, as they allow for at most
additional lending equal to 0.75% of GDP. With the credit multiplier low and falling,
the stimulus effect will be limited The move will provide some support to the county
level economy, which represents around 30% of GDP, and to rural banks, which are
less resilient than their larger counterparts. Meanwhile, policymakers remain relaxed
in public comments. We have already heard that growth of 7.2% would apparently
be in keeping with the growth target of “about 7.5%”, and that growth is currently at
acceptable levels. Meanwhile the central bank has said that the easing of reserve
requirements for rural banks does not reflect a change in stance on liquidity
conditions overall in the economy; i.e. there’s not going to be any serious loosening.
Growth will have to weaken much further before significant stimulus is enacted.
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Schroder Economics Group: Views at a glance
Macro summary – April 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
5
4.9
4.8
4.8
5.0
3.6
4
Forecast
4.6
4.4
3.2
2.8
3
2.4
3.0
2.6
2.4
12
13
2.2
3.1
2
1
0
-1
-1.4
-2
-3
00
01
US
02
03
Europe
04
05
Japan
06
07
08
Rest of advanced
09
10
BRICS
11
Rest of emerging
14
15
World
Source: Thomson Datastream, Schroders 24 February 2014 forecast. Previous forecast from November 2013. Please note
the forecast warning at the back of the document.
17
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Schroders Baseline Forecast
Real GDP
y/y%
World
Advanced*
US
Eurozone
Germany
UK
Japan
Total Emerging**
BRICs
China
Prev.
(3.0)
(2.1)
(3.0)
(1.1)
(2.1)
(2.4)
(1.3)
(4.7)
(5.5)
(7.3)
Prev.
Consensus 2015
2.9
3.1
(3.1)
2.0
2.2  (2.1)
2.7
3.0
(3.0)
1.2
1.4
(1.4)
1.9
2.2  (2.3)
2.8
2.1  (1.9)
1.3
1.3  (0.9)
4.4
4.7  (4.9)
5.3
5.6  (5.9)
7.3
7.3  (7.5)
Consensus
3.2
2.2
3.0
1.5
2.0
2.4
1.3
4.8
5.5
7.2
Prev.
(2.7)
(1.5)
(1.5)
(1.0)
(1.5)
(2.9)
(1.9)
(4.8)
(4.0)
(2.6)
Prev.
Consensus 2015
3.0
2.8
(2.8)
1.6
1.5  (1.6)
1.7
1.4  (1.5)
0.9
1.2  (1.5)
1.4
1.7  (1.9)
1.9
2.7  (3.0)
2.6
1.5  (1.4)
5.4
5.1  (4.9)
4.3
4.1
(4.1)
2.6
2.9  (3.0)
Consensus
3.0
1.7
1.9
1.3
1.8
2.1
1.7
5.1
4.3
3.0
Wt (%)
100
64.0
24.0
18.7
5.2
3.7
9.1
36.0
22.2
12.8
2013
2.4
1.2
1.9
-0.4
0.5
1.9
1.6
4.6
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
2.6
1.3
1.5
1.4
1.6
2.6
0.1
4.9
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
Prev.
2014
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
Prev.
2014
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






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
-
Prev.
2015
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
Prev.
2015
1.55  (1.50)
1.27  (1.25)
120.0
(120)
0.82  (0.83)
5.95
(5.95)
102.7 
(99)
Y/Y(%)
-4.9
-5.2
9.1
-0.3
-0.8
-4.6
Source: Schroders, Thomson Datastream, Consensus Economics, April 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.
18
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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
EM Asia
6
6
EM
5
5
4
EM
4
Pac ex JP
Pac ex JP
3
3
US
US
2
UK
Japan
1
2
UK
1
Japan
Eurozone
Eurozone
0
0
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
Jan
Feb
Mar
Apr
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
UK
2
2
US
Japan
US
1
Eurozone
1
Eurozone
0
0
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
Month of forecast
Jan
Feb
Mar
Apr
Month of forecast
Source: Consensus Economics (April 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 information
in the document when taking individual investment and/or strategic decisions. For your security, communications may be taped or
monitored.
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