28 January 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
Global: US growth pick up may be too much of a good thing (page 2)
 The US economy has strong momentum having shrugged off the government
shutdown, and leading indicators suggest that growth will remain robust in
the first quarter of 2014. Risks are still skewed to the upside of our 3% real
GDP forecast with signs that capex may also join the party as shareholders
become more positive toward companies who invest.
 Stronger growth will bring lower unemployment and our view is that the US
Federal Reserve will be surprised by the pace of tightening in the labour
market. Demographic trends suggest participation will continue to decline
even as the economy strengthens, a view at odds with Fed projections. Any
monetary policy decision would also depend on an assessment of labour
market slack, but a tightening would begin to curtail activity and the focus on
demographics is a reminder that the factors supporting strong US growth in
the past are waning.
UK: New Year’s resolutions (page 7)
 The UK should see GDP surpass its pre-crisis peak this year, but will do so
with an over-reliance on housing and consumption. Meanwhile, the Bank of
England needs to go back to basics. Forward guidance has brought nothing
but confusion, and we look forward to the unemployment threshold being
scrapped.
 Finally, the government needs to be more honest with the underlying state of
the public finances, while the proposed increase in the minimum wage looks
risky. More fiscal tightening is on the horizon.
Will emerging markets elect to grow? (page 12)
 Emerging markets have a busy election calendar this year. The Fragile Five
all have elections, adding volatility to already febrile markets. The elections
could be a catalyst for change in some, particularly India and Indonesia, but
we see little cause for optimism elsewhere.
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: US unemployment and participation rate in retreat
22
70
20
68
18
66
16
64
14
62
12
60
10
58
8
56
6
54
4
52
2
50
0
48
55
59 63 67 71 75 79 83
NBER defined US recessions
Participation rate (%), rhs
87
91
95 99 03 07 11
Unemployment rate (%), lhs
Source: Thomson Datastream, US Bureau of Economic Affairs, Schroders. 27 January 2014.
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Global: US growth pick up may be too much of a good thing
US economy has
strong momentum
Optimism about the US is gathering pace with growth now expected to have come
in at an annualised rate of 3% in the final quarter of last year as the economy
shrugged off the effects of the government shutdown. Leading indicators suggest
that growth will remain robust in the current quarter and economists’ have been
revising up their forecasts for 2014. We are among the optimists and continue to
forecast 3% growth for this year, although the consensus at 2.8% is clearly catching
up.
We discussed the prospect of US growth hitting 4% this year in our last Viewpoint
where we concluded that the risks to our forecasts were skewed in an upward
direction given the improvement in household balance sheets and potential for
better wage growth as the labour market tightens. This view has not changed, but
one downside risk which may be receding is on business capital expenditure
(capex).
Weak capex has been one of the factors holding the US back in recent years and
has been the subject of much debate with former Treasury secretary Larry
Summers suggesting that the US may be in a period where the real rate of return on
capital in the economy is negative, such that the cost of capital remains too high for
companies to find profitable opportunities1.
Such an outcome is possible and the US could be in a period of “secular stagnation”
where the economy struggles to grow without a continuation of extremely loose
monetary policy. However, recent indicators suggest “stagnation” will not happen in
2014. Orders for capex, for example, are enjoying a sharp upswing at present
across the three major developed economies (chart 1). We will return to the secular
stagnation topic later.
Chart 1: Upswing in orders for capital equipment
Capex looks set to
pick up
Y/Y %
40
30
20
10
0
-10
-20
-30
-40
-50
1996
1998
2000
Recession
2002
2004
2006
Germany
2008
Japan
2010
2012
2014
US
Source: Thomson Datastream, Schroders. 27 January 2014
One of our concerns has been that firms would simply prefer to distribute cash to
shareholders rather than spend it on capex. We saw this as one of the adverse
consequences of the low bond yields created by QE and the subsequent search for
yield which was pushing investors into high dividend paying stocks (“bond
proxies”)2. The search for yield continues, but there are a couple of reasons to
indicate that investors are looking for at a broader range of criteria.
1
2
Why stagnation might prove to be the new normal, by Lawrence Summers, Financial Times 15th December 2013.
Are shareholders stifling business investment? Schroders Economic and Strategy Viewpoint 30th October 2013.
2
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First, the Bank of America/ Merrill Lynch fund manager survey shows a clear
preference from fund managers for companies to raise capex rather than return
cash to shareholders. At nearly 60% of respondents there has been a break in
favour of capex (see chart 2).
Chart 2: Fund managers want companies to invest rather than distribute
%
Fund managers
give green light to
higher corporate
spending…
80
70
60
50
40
30
20
10
0
2009
2010
Increase in capex
2011
2012
2013
Improve balance sheets
2014
Return cash to shareholders
Source: Bank of America/Merrill Lynch Fund Manager Survey, Schroders. 24 January 2014.
Second, there is evidence that the investment community are putting their money
where their mouth. Higher yielding sectors such as utilities and REITS have been
underperforming for some time, but more recently we have seen this extend to a
wider mix of dividend paying stocks with the widely followed S&P Dividend
Aristocrats underperforming the broader S&P500 (chart 3).
Chart 3: Dividend Aristocrats begin to underperform
…and are
becoming less
keen on dividend
paying stocks
% (inverted)
0
Ratio
0.46
0.44
1
0.42
2
0.40
3
0.38
4
0.36
5
0.34
0.32
2004
6
2005
2006
2007
2008
2009
S&P Dividend aristocrats/S&P500
2010
2011
2012
2013
2014
10-year UST yield - inverted, rhs
Source: Thomson Datastream, Schroders 24 January 2014
Alongside stronger consumption, a pick up in business capex could take the US
economy to 4% growth this year. However, we would remind our readers that the
last time the US recorded such a year-on-year growth rate for a quarter was ten
years ago. Moreover, the last time a calendar year clocked above 4% was 2000
(chart 4 on next page). Clearly, it would be a strong growth rate, even by prefinancial crisis standards and remains a risk rather than the central view.
3
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Chart 4: Four percent real GDP growth has become rare (even for the US)
Four percent real
growth is quite
rare, even for the
US
Y/Y
12%
10%
8%
6%
4%
2%
0%
-2%
-4%
-6%
51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08 11 14
US real GDP growth
4%
Source: Thomson Datastream, Schroders. 24 January 2014.
The Fed and the labour market
As stronger growth in the US becomes more widely accepted the focus turns to the
Federal Reserve and monetary policy. Here the debate centres on the
unemployment rate which has now fallen to 6.7%. One factor behind the decline has
been the fall in the participation rate3 as people leave the workforce and it is whether
this is a temporary or permanent feature which will largely determine the path of
monetary policy (see chart front page). The attached table shows the rate of payroll
growth needed to hit a given level of unemployment in one year’s time dependent
on the participation rate (table 1).
Participation
rate
Stronger growth
will bring lower
unemployment,
unless the decline
in the participation
rate reverses
Table 1: Change in monthly non-farm payrolls and unemployment in 12 months
time
Unemployment rate
5.5%
6.0%
6.5%
62.0%
103k
42k
-17k
63.0%
288k
227k
165k
64.0%
474k
411k
384k
66.2%
881k
816k
751k
Note: Current unemployment rate 6.7%, participation rate: 62.8% (December 2013).
Source: Federal Reserve Bank of Atlanta, Schroders. 13 January 2014
The pace of labour
market tightening
is likely to
pressure the Fed
to become more
hawkish
3
For example with the participation rate at 63%, non-farm payroll growth of 227k per
month is needed to reach 6% unemployment by the end of the year. Should
participation decline to 62% the required rate of job growth falls to just 42k. It is our
view that we will be closer to 62% than 63% on participation by the end of the year
and if job growth remains robust the Fed will need to revise its projections.
Based on their December forecasts, the Fed does not expect the unemployment
rate to be at 6% until the end of 2015 with a central projection of 5.8 to 6.1%. This is
with a similar real GDP growth rate to our forecast of 3% this year and next. It would
seem that the FOMC is looking for a recovery to a higher participation rate in the
labour force.
The proportion of the working-age population that is employed or unemployed and seeking work.
4
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Such an outcome is possible, but recent studies suggest that there is a powerful
demographic trend pushing the economy toward lower participation as the baby
boomers move into retirement. In a recent study, economists at the Chicago Fed
concluded that just under half of the post-1999 decline in the participation rate can
be explained by demographic patterns, such as the retirement of baby boomers4.
These patterns are expected to continue, offsetting participation rate improvements
due to economic recovery and pushing the rate lower (chart 5).
Chart 5: Forecast for working age population by cohort
Proportion of total population
68%
26%
24%
66%
22%
64%
20%
18%
62%
16%
60%
14%
58%
56%
12%
10%
'90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 '20
Census Bureau Forecast
Ages 16-64, lhs
Ages 65+, rhs
Source: US Census Bureau, Schroders. 24 January 2014.
The hope for those looking for a pick up in participation is that the rate has been falling
even faster than these studies would suggest, indicating scope for a corrective
bounce-back. The most likely source of such a move would be for the trend toward
greater enrolment in higher education to reverse (another factor behind the drop in
participation), as it may do if job prospects were seen as having improved.
Long run trends point to weaker potential growth
Demographics
also mean we
have not heard the
last of “secular
stagnation”
On balance, we see the structural factors trumping the cyclical and the participation
rate falling further in 2014 and 2015. If we are correct the FOMC will be under
pressure to speed the pace of tapering and, or signal earlier rate increases than at
present.
Any monetary policy decision would also depend on an assessment of labour market
slack, but a tightening would begin to curtail activity and the focus on demographics is
a reminder that the factors supporting strong US growth in the past are waning.
Higher female participation and the arrival of the baby boomers explain much of the
increase in past labour force growth, but as the former peaks and the latter begin to
retire the growth rate will slow. Between 1960 and 1985 the US population of working
age (16-64 years old) grew 1.6% annually, today the US Census Bureau projects an
annual growth rate of only 0.2% between 2015 and 2025.
In a simple growth accounting framework the long run trend rate of growth will fall by
the same amount unless it is offset by gains in productivity and, whilst we tend to be
optimists on the ability of the US to reinvent itself, such an increase would require
some remarkable innovation. The OECD estimate that potential GDP growth in the
US has declined from 3.2% between 1989 and 1998, to 2.1% last year. One reason
why 4% real GDP growth has become so much rarer and why we have not heard
the last of the “secular stagnation” thesis.
4
Chicago Fed letter, March 2012. ‘Explaining the decline in the U.S. labour force participation rate’ by Aaronson, Davis &
Hu.
5
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Stop press: the emerging markets rout
Coming back to the present, emerging market assets have been hit hard in recent
days. In our December Viewpoint we identified some of the market implications of
higher bond yields in the US, such as a stronger USD and the increased pressure
this would put on the Emerging markets. Triggered by the recent Argentinian crisis,
it would seem that the markets are moving rapidly to discount such a situation. The
more fragile economies have been affected the most as would be expected with the
Turkish lira in steep decline, but such moves will take their toll on growth as capital
flows out of the region. The Institute for International Finance estimate that some
$3.7 billion has left emerging market equity funds so far this year, compared with
$17.3 billion for the whole of 2013.
Thus the emerging world looks set to experience the downside financial effects of a
stronger US economy, before they can reap the benefits of greater demand for their
exports. The financial channels operate more rapidly than those in the real
economy. Somewhat ironically this now seems to be pushing US yields lower as
investors seek the safe haven of the US dollar.
6
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UK: New Year’s resolutions
A new year
presents new
opportunity and
risks of the UK
The advent of the New Year usually has us thinking about progress made, along
with the opportunities and risks ahead. For the UK, there should be no exception.
Policy makers are rightfully pleased with the pick up in activity and the better than
expected fall in the unemployment rate, but the drivers for these improvements are
less than ideal. The Bank of England needs to come to terms with the failure of its
forward guidance policy, while the government has to acknowledge that little real
progress has been made with tackling the budget deficit. Some timely New Year
resolutions are required.
Almost there
The UK economy grew in real terms by 1.9% in 2013 for the year as a whole, which
is the best annual performance since 2007 and the global financial crisis. The latest
fourth quarter data showed 0.7% growth compared to the previous quarter, and
2.8% growth compared to the same quarter a year earlier – highlighting and
acceleration. As economic growth gathers momentum, the level of real GDP is
almost back to its pre-crisis peak. The latest reading puts GDP just 1.3% away,
which according to the Schroders forecast means that the previous peak will be
surpassed by the third quarter of this year (chart 6).
Strong momentum
of late means that
the level of real
GDP could soon
recover to its precrisis peak
Chart 6: UK economic recovery almost complete
Index (100 = Q1 2008)
104
102
100
98
96
94
92
2008
2009
2010
2011
Level of real GDP
2012
2013
2014
2015
Schroders forecast
Source: Thomson Datastream, ONS, Schroders November forecast. 28 January 2014.
While the return to pre-crisis peak in UK GDP will be over three years later than the
recoveries in the US and Germany, policy makers have already started to celebrate.
With a general election due in May 2015, the coalition government is making the
most of the better economic environment. However, looking at the breakdown of the
growth achieved, the recovery has not been as wholesome as hoped.
Figures for the year overall are not available until next month, however, based on
data for the first three quarters and our estimates for the fourth, it appears that
almost three quarters of the growth achieved in 2013 was driven by household
consumption. Changes in inventories appear to have made up most of the rest.
This is disappointing as given the weakness in the household sector’s fundamentals
(falling real wages and saving rates), the mix of growth suggests a lack of
sustainability.
Business investment is very likely to have contributed negatively for the year overall
along with net trade (exports minus imports), while government spending is likely to
have made little impact.
7
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The recovery has
been less than
wholesome…
For professional investors only
Even if the overall pick up in growth is being cheered, the mix will disappoint those
like the Chancellor, George Osborne, who only last month reiterated the need for
“…a more balanced recovery”.5 However, the government’s policy mix appear to be
working in the opposite direction. For example, the uncertainty over the UK’s
membership of the European Union is not helpful for business investment, while the
focus on boosting demand for housing through various schemes is exacerbating the
problem.
As we have previously highlighted, much of the improvement in household
consumption has followed the pick up in housing transactions and house prices.
There is a large cohort of would be first time buyers that have been frozen out of the
market due to tightening of lending standards following the financial crisis. While
affordability improved thanks to falls in house prices and lower Bank of England
interest rates, there was a step change in the deposit required to access credit.
Loan-to-deposit ratios were raised and much higher interest rate spreads are being
demanded for more risky borrowers.
The two main government schemes have helped to lower spreads for riskier
borrowers through increased liquidity, but also by providing equity guarantees,
bridge the funding gap. The actions appear to have unlocked the pent up demand,
helping to increase mortgage approvals, which are up by almost a third in November
compared to a year earlier.6 Given the lack of new supply of homes, especially in
the London and the South-East of England, house prices have seen steady rises.
Chart 7 shows the range of reported annual price rises from various leading
surveys, and the average rise of 6% in December. Chart 8 highlights the shrinking
supply of residential property compared to the population of London.
Chart 7: Uptrend in house prices
strengthening
Chart 8: London property supply
lagging population growth
House prices (Y/Y) Housing stock per 100 people
15% 44
…as much of the
recovery has been
driven by housing
and debt. Capex
and net trade have
been largely
absent.
10%
5%
43
0%
42
-5%
07
08
09
10
Range of
houseprices
-10%
Average of
surveys
-15%
11
12
41
-20% 40
13
'91
'95
'99
'03
'07
'11
The above range and average are taken from the following house price surveys and are based on
transactions and asking prices. DCLG/ONS, Halifax, Nationwide, Rightmove, Hometrack,
Acadametrics. Source: Thomson Datastream, Schroders, and the above mentioned sources. 24
January 2014.
Rising house prices have already prompted talk of the reflation of bubbles in the
market, all of which are premature in our view. There is plenty of evidence to
support the idea that prices should be rising on the back of an acute shortage of
housing. The pre-financial crisis behaviour of mortgage equity withdrawals and high
loan-to-value ratios are nowhere to be seen. Indeed, net mortgage lending is only
up 1.1% compared to a year earlier in December, as many existing homeowners
continue to overpay on their mortgages.
5
6
Speech on the 6th of December 2013 at the JCB headquarters in Rocester.
Bank of England data.
8
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Unemployment and the BoE
Meanwhile,
unemployment
keeps falling…
Another source of good news has been the labour market. The unemployment rate
has fallen from 7.8% at the end of 2012 (3-month average) to 7.1% in the three
months to November. 399,000 jobs were added over the same period, more so in
the private sector as the public sector shed jobs over the year. The sharp rise in
employment and fall in the unemployment rate means that the Bank of England’s
(BoE) forward guidance threshold of 7% is about to be breached. According to the
Bank’s forward guidance, this should restart discussions on when interest rates
should rise. The trouble is that the fall in the unemployment rate has come far
sooner than the BoE had forecast, causing market expectations of interest rates to
rise, which is already feeding through to higher interest rates charged for
mortgages. In addition, higher interest rate expectations have pushed up sterling on
a trade weighted basis, acting as a headwind for exporters by raising the foreign
price of goods and services being exported.
Charts 9: Sharp fall in unemployment
%
9
8
7
6
5
4
3
2
2005
2006
2007
2008
2009
2010
2011
2012
2013
Unemployment rate
Claimant count rate
2014
Source: Thomson Datastream, ONS, Schroders. 27 January 2014.
…but at a faster
pace than the BoE
had expected,
prompting a
review of forward
guidance.
Speaking from the World Economic Forum at Davos, governor of the Bank of
England, Mark Carney, hinted that the Bank is about to step back from its recent
policy of providing explicit forward guidance. This has drawn serious criticism from
the press, especially with regards to the Bank’s unemployment forecast. In our view,
criticism aimed at the Bank’s forecast of the path of the unemployment rate is unfair.
Most economists, including ourselves, came to similar conclusions last year that the
unemployment rate was unlikely to fall to 7% in 2014.7
However, we are critical of the use of forward guidance in the first place and the way
that it relies on a single indicator to provide households, businesses and financial
markets with a signal on the path of interest rates. The fall in the unemployment rate
clearly does not reflect the overall state of the economy, especially as wage growth
continues to be outstripped by inflation, and business investment is largely absent.
The Bank of England should adopt a New Year’s resolution to improve
communication. Indeed, we expect the BoE to return to the pre-Carney approach of
using the Bank’s growth and inflation forecast fan charts to signal the direction and
timing of monetary policy, and for those fan charts to signal that the Bank of
England is not ready to raise interest rates this year.
7
See Schroders Talking Point piece: “Guidance on BoE forward guidance” by Azad Zangana.
9
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Fiscal faux
The Bank of England is not the only institution in need of a New Year’s resolution.
The Chancellor along with the Treasury need to be more honest about the
underlying situation in the UK’s public finances. In his Autumn Statement, Osborne
made the most of one-off factors that have helped reduce the general government
deficit so far this fiscal year. These include the treatment of the privatisation of the
Royal Mail pension fund (counting assets as revenues, and ignoring future
liabilities), along with the transfers of proceeds from the BoE’s quantitative easing
programme. So far this fiscal year (April to December), the headline budget deficit is
£17 billion lower than the same point last year, however, when these one-off factors
are stripped out, the budget deficit has barely fallen at all (just £4.8 billion or 4.8%
reduction, see chart 10).
Chart 10: Fiscal progress, or lack of it (YTD)
The government
also needs to
come clean on the
underlying state of
the public
finances…
General government deficit, £bn
175
150
125
100
75
50
25
0
Apr
08/09
May Jun
09/10
Jul Aug
12/13
Sep Oct Nov Dec Jan Feb Mar
13/14
13/14 incl. RM and APF transfers
Source: Thomson Datastream, ONS, Schroders. 27 January 2014.
To be fair, the Chancellor kicked off the year on a cautious note with his very first
speech of the year in Coleshill. Osborne warned of “…a dangerous new
complacency…” and that “…it’s far too soon to say: job done. It’s not even half
done. That’s why 2014 is the year of hard truths. The year when Britain faces a
choice.” He goes on to outline plans for further spending cuts: “£17 billion this
coming year. £20 billion next year. And over £25 billion further across the two years
after”.
However, the Chancellor also recently announced plans to possibly increase the
minimum wage by 11%. This has been in reaction to the opposition’s arguments
that the ‘squeezed majority’ are struggling and are not benefiting from the recovery.
Instead, they are
focused on cheap
(fiscally) measures
to boost demand,
possibly at the
cost of the
nation’s
competitiveness.
In our view, raising the minimum wage in such an aggressive way is a risky strategy.
There is no doubt that living standards have been falling due to wages not keeping
up with inflation, however, the UK’s productivity figures have been appalling, and do
not justify increases in real wages. The labour market appears to have increased
employment by significantly more than warranted by GDP growth, but has only been
able to do so by replacing previously expensive workers with slightly cheaper ones.
This makes the average wage appear to fall when adjusted for inflation. However, it
misses the benefit to all those previously unemployed who are now in employment.
10
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Conclusions
Macroeconomic conditions in the UK are much healthier now than 12-months ago
when fears of a triple-dip recession were real. Growth has reaccelerated, and the
labour market is powering ahead. We hope this continues, but are also concerned
by the unbalanced nature of the recovery, and the excessive reliance on household
spending and the housing market. This has been exacerbated by the government’s
housing stimulus schemes, while the Bank of England appears to be confusing
itself, along with everyone else with its forward guidance. Now is a good time to
review policy, and to commit to New Year’s resolutions that can help maintain the
momentum built in 2013.
11
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Will emerging markets elect to grow?
2014 has a busy
EM election
calendar…
2014 sees a busy political calendar in emerging markets. In particular, large
emerging market economies exposed to higher US yields – the Fragile Five of
Brazil, India, Indonesia, South Africa and Turkey – all have important elections this
year. Polls do not suggest a change of government in all cases (table 2), but
elections could still prove a trigger for positive reform efforts. Democracy does not
lend itself to painful decisions in the run up to elections, but the immediate post
election period is often when governments feel they have the strongest mandate to
effect change.
Table 2: Major elections in 2014
Country
Election type
Election date
Change of
government
expected?
Brazil
Local, general,
presidential
October
No
India
Indonesia
South Africa
Turkey
Local, general
General, presidential
General
Local, presidential
April/May
April, July
April (expected)
March, June
Yes
Yes
No
No
Source: Barclays, Schroders. 22 January 2014
…and uncertainty
is likely to hinder
investment
Election years often engender uncertainty, and as chart 11 shows, markets have
been pricing in more risk to some of the Fragile Five in recent months. It is of course
difficult to say how much of this reflects concerns over elections, and how much
reflects other developments in those countries, or the decision by the US Federal
Reserve to initiate tapering. But the macro fundamentals of the Fragile Five have
been publicized for some time, so it seems likely that political risk has helped drive
some of the moves. Divergence between members of the Fragile Five – Turkey in
particular has seen its credit default swap (CDS, insurance against default on a
bond) spread widen dramatically – also suggests idiosyncratic factors, rather than
just a common impulse, are at work.
Chart 11: EM CDS: Market perceptions of risk have been on the rise
300
280
260
240
220
200
180
160
140
120
100
Jan
13
Feb Mar
13 13
Apr May
13
13
Brazil
Jun
13
Indonesia
Jul
13
Aug Sep
13
13
Oct
13
South Africa
Nov Dec
13
13
Jan
14
Turkey
Source: Bloomberg, Schroders. 22 January 2014. Comparable data for India is not available.
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Empirically, the uncertainty engendered by elections tends to hit investment. An
academic study8 found that corporate investment expenditures are on average 4.8%
lower in election years, with political uncertainty the main driver. This decrease is
higher when the elections are close, public expenditure accounts for a large share of
GDP, and when the current government is regarded as market friendly. There is
some overlap between these criteria and certain members of the Fragile Five, and in
general this effect is bad news for a set of countries that, for the most part, need to
increase investment. However, we do also typically see a pick up in investment
once the election is done. It is the uncertainty that presents the main hurdle.
The rest of this Viewpoint looks quickly at the elections in each of the Fragile Five
and what they might mean for the economy.
Brazil
Polls say no
change in Brazil,
but there is a long
way to go
The most recent polls, conducted in November, give incumbent Dilma Rousseff 47%
of the vote, implying a first round win. However, there is a long way to go until
October’s elections. Rousseff must successfully navigate lower growth and higher
inflation, the World Cup, and the election campaign itself, which will not really kick
off until July. The preferred outcome for the market would be a win by either of the
more market friendly opposition candidates; Aecio Neves and Eduardo Campos.
However, at 19% and 11% respectively, neither is challenging at present. One
possibility is that Campos’ more popular and well known running mate, Marina Silva,
heads the ticket in October instead.
Chart 12: Inflation remains sticky despite rate hikes
%
8
%
14
12
7
10
8
6
6
4
5
2
4
0
2010
2011
CPI, y/y
2012
Inflation expectations
2013
SELIC rate (rhs)
Source: Thomson Datastream, Schroders 24 January 2014
Whoever wins,
fiscal policy will
need to tighten
Whoever wins will need to tackle Brazil’s fiscal deficit, soft growth, and high inflation.
Clearly, the policies needed for this are something of an impossible trinity. The fiscal
deficit and high inflation can be tackled through tighter fiscal and monetary policy,
but this will crush growth already heavily dependent on credit backed consumer
spending and government largesse. Tighter fiscal policy could be paired with more
accommodative monetary policy to keep growth ticking over while getting the deficit
under control, but then inflation will likely burst out of the 4.5% +/- 2 target band. We
should also note that central bank governor Tombini believes higher rates are
needed to support the exchange rate in an era of higher US yields.
Finally, there is the option of business as usual: loose fiscal policy, tight monetary
policy, and a cap on regulated prices, but as well pumping up the deficit, this seems
to be having limited impact on inflation (chart 12). The government may not even
8
Julio, B., and Yook, Y. (2012) “Political Uncertainty and Corporate Investment Cycles”, The Journal of Finance
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For professional investors only
have much choice on fiscal policy, with ratings agencies threatening to downgrade
the sovereign’s credit rating if fiscal numbers do not pick up. The extra policy tool
needed is structural reform aimed at tackling supply bottlenecks, the root cause of
much of Brazil’s inflation. This requires investment too though, and investors seem
not to trust Rousseff. This may be connected to her tendency towards populism,
short termism and price restrictions. An opposition win might help restore investor
confidence in the government, and give Brazil the investment it badly needs.
India
Change is likely,
and needed, in
India
In comparison with Brazil, polls are pointing to a probable change of government in
India’s elections, to be held in either April or May. Narendra Modi is the current
frontrunner for Prime Minister, at the head of the opposition Bharatiya Janata Party
(BJP). The ruling, Congress Party-led “United Progressive Alliance” is taking the
blame for weak growth, high inflation, governance issues and lack of action on
reform.
While Modi’s candidacy has galvanized his party and cheered investors due to his
reputation, built as chief minister of the state of Gujarat, of an effective and probusiness administrator, there are concerns over his management of deadly
communal riots in the state in 2002. Uncertainty is also generated by the large
number of first time voters (approximately 20-30% of the electorate) and the rise of
regional parties, which could make national level reforms more difficult.
Chart 13: Rupee weakness has boosted exports
%, y/y
35
45
47
49
51
53
55
57
59
61
63
65
30
25
20
15
10
5
0
-5
Jan
12
Mar May
12
12
Jul Sep Nov Jan Mar May Jul Sep Nov
12
12
12
13
13
13
13
13
13
Exports
Rupee:dollar exchange rate (rhs)
Jan
14
Source: Thomson Datastream, Schroders. 24 January 2014.
Additional reform
momentum will
bolster the
economy
There is little doubt that reforms are needed. Much like Brazil, India suffers from
fragile public finances, high inflation, and weak growth. Unlike Brazil, some reform is
already underway and should be completed under a fresh government. One is a
much delayed Goods and Services Tax (GST) which will unite the central and state
government tax systems, broaden the tax base and raise compliance, bolstering
revenues. Another is the Dedicated Freight Corridor rail project (DFC), which will
entail $40bn investment over the next five years. Other investment projects, such as
opening the economy to FDI, will require strong leadership to overcome state
objections. Investment will help tackle both inflation and growth, providing scope for
monetary policy to ease, or at least cease tightening. Meanwhile, the weakening of
the rupee has provided a boost to export growth (chart 13) that should help reduce
the current account deficit and vulnerability to Fed tapering. 2014 has the potential
to be a good year for India.
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Indonesia
New president in
Indonesia, but the
inbox will be
crowded
Having reached his term limit, incumbent president Yudhoyono must step down this
year, ensuring a change of regime. Current opinion polls highlight Jakarta mayor
Joko Widodo (Jokowi) as the most likely replacement. However, he has yet to be
nominated as a candidate by his party. In any event, at the moment a second round
of voting seems likely, which will push the election back to September. Jokowi
appears a pragmatic and reform minded candidate, and should provide a positive
impulse to sentiment about the economy.
Indonesia faces considerable challenges in an environment of weaker commodity
prices and lower Chinese growth; non-food commodities account for over 60% of
Indonesia’s exports. There has been some recent improvement in macro
fundamentals, with the trade balance improving in response to currency
depreciation, but this is largely from import compression rather than significant
export growth (chart below). For an improvement in growth, Indonesia needs to
develop its manufacturing sector and pivot away from reliance on raw materials.
Though this may sound familiar by now, the answer is to boost investment. It has
been suggested that a new, more flexible labour law could help on this score, but in
truth it is difficult for a government to quickly reshape an economy’s structure.
Chart 14: Import compression, but little export growth in Indonesia
%, y/y
30
Index, Jan 2013 = 100
90
95
20
100
10
105
0
110
115
-10
120
-20
125
-30
130
Jan Mar May
12 12
12
Jul
12
Exports
Sep Nov Jan Mar May
12
12
13 13
13
Imports
Jul
13
Sep Nov Jan
13
13
14
Rupiah:dollar exchange rate
Source: Thomson Datastream, Schroders. 24 January 2014
Some problems
have no obvious
solution
A new government might be able to tackle the country’s twin deficits (for example by
further reducing the fuel subsidy) but there seems little hope of a quick turnaround in
the trade balance coupled with a boost to growth. A more likely scenario postelection is a boost to investment as uncertainty is reduced, continued tightness of
policy from the Indonesian central bank to address the trade balance despite the hit
to growth, and improvement on the fiscal side. Moving away from reliance on
primary goods will take time and will be difficult to rush.
South Africa
No change in
government,
minor policy
improvement
At 53% in the polls, it seems likely the ruling ANC party will retain a majority in
April’s elections. Consequently there appears little chance of a change in policy post
election. However, the 53% poll result represents a decline in support from 2009
when the ANC won 66% of the vote, and this erosion in support could, in an
optimistic scenario, spur the government to speed up reform efforts. We could, in a
best case scenario, see a fast-tracking of labour and structural reforms, along with
shale gas exploitation, all of which will help the economy and begin to close the
current account deficit, though reliance on commodities will continue to exert
headwinds.
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Consequently, more rand weakness seems likely, despite the considerable move in
the currency last year, which will exert inflationary pressure. The rand’s weakness
so far has not done much to reduce the current account deficit but the economy
should receive external supports this year as the US (8% of exports) and Europe
(21% of exports) recover, though with China slowing and account for around 12% of
exports, this effect will likely be muted.
Turkey
Political crisis and
currency crisis,
hand in hand
Of the Fragile Five, by far the most precarious political situation can be found in
Turkey, and this is reflected in its CDS spread (chart 1) and currency (chart 15). The
political crisis escalated in December when a corruption probe led to the detainment
of 52 people, some with close ties to the government. In the fallout, the government
removed the prosecutor and a number of police chiefs and has also made moves to
transfer the powers of the judiciary to the Ministry of Justice. Prime Minister
Erdogan’s Justice and Development Party (AKP) is riven by internecine strife. Trust
in Turkish institutions is eroding rapidly. From a currency perspective, it should be
particularly concerning that the central bank appears to have caved in to
government pressure not to hike rates at its latest meeting despite the obvious
need; the exchange rate has weakened and inflation jumped since concerns over
Fed tapering began last May (chart 15).
Chart 15: Turkey badly needs a rate hike
%, y/y
9.0
2.4
2.3
8.5
2.2
8.0
2.1
7.5
2.0
1.9
7.0
1.8
6.5
1.7
6.0
1.6
Jan
13
Feb Mar
13 13
Apr May Jun Jul Aug
13
13
13
13
13
Lira:dollar exchange rate
Sep Oct Nov Dec
13
13
13
13
Inflation (rhs)
Jan
14
Source: Thomson Datastream, Schroders. 24 January 2014
No change in
government
seems likely, bad
news for
institutional
strength
The latest opinion polls suggest the AKP remains firmly in the lead despite recent
developments. Municipal elections in March will influence Erdogan’s next steps. A
strong result for the AKP is likely to see Erdogan run for president and push for
executive power, as he is unable to serve another term as an MP. The most “market
friendly” scenario would probably be a swap between current President Gul and
Prime Minister Erdogan, but it is questionable whether Gul would agree to this
Putin-esque arrangement. However, while Gul may not want to be seen as
Erdogan’s pawn, he is also unlikely to confront Erdogan. Gul is a popular candidate
with the public and markets precisely because he is a conciliator. Yet this means we
could see the least market friendly scenario evolve – a junior MP becomes Prime
Minister, Erdogan becomes President, and the AKP push for constitutional changes
granting greater executive power to the President. Even if a Gul/Erdogan swap
were to occur, it is unclear that Gul would provide much of a check on Erdogan,
perhaps just providing a legitimate face for his continued exercise of power.
Continued executive power for Erdogan, unchecked by his party or the country’s
declawed institutions could be extremely negative for Turkey given his increasingly
erratic behaviour. Unfortunately, this is looking to be the most likely outcome.
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Schroder Economics Group: Views at a glance
Macro summary – January 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 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 late 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 out of recession, but banks continue to de-leverage thus preventing sustained recovery.
Asset Quality Review and stress tests will be macro headwinds in 2014. No rate rises 2014 or 2015.
More LTRO’s likely in early 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, risk of significantly weaker JPY in 2014.
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.
EM fading as a growth engine. 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. Deflationary for world economy, especially commodity producers (e.g. Latin America).
Plenum reforms in China to depress output in the near term before supporting medium term activity.








Risks

Tail risks have reduced compared to a year ago with the US avoiding the fiscal cliff and the Euro
holding together. However, some risks remain, such as "China financial crisis" and in the Eurozone, a
restructuring of Spanish sovereign debt.
Despite upside risk of stronger than expected growth in the US and UK, balance of risks are skewed
toward lower rather than higher inflation.

Chart: World GDP forecast
Contributions to World GDP growth (y/y)
6
4.8
4.8
4.4
5
5.0
Forecast
4.1
3.6
4
3
4.9
3.1
2.8
2.4
2.2
2.6
3.0
3.1
2.3
2
1
0
-1
-0.9
-2
-3
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
US
Eurozone
UK
Japan
Rest of advanced
BRICS
Rest of emerging
Source: Thomson Datastream, Schroders. November 2013 forecast
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15
World
28 January 2014
For professional investors only
Schroders Baseline Forecast
Real GDP
y/y%
World
Advanced*
US
Eurozone
Germany
UK
Japan
Total Emerging**
BRICs
China
Prev.
(2.2)
(1.0)
(1.6)
(-0.5)
(0.7)
(1.5)
(1.6)
(4.4)
(5.3)
(7.4)
Consensus 2014
2.4
3.0 
1.1
2.1 
1.7
3.0 
-0.4
1.1 
0.5
2.1 
1.4
2.4 
1.8
1.3
4.6
4.7 
5.6
5.5 
7.7
7.3 
Prev.
(2.9)
(1.9)
(2.7)
(1.0)
(2.2)
(2.1)
(1.3)
(4.9)
(5.6)
(7.6)
Consensus 2015
3.0
3.1
2.0
2.1
2.8
3.0
1.0
1.4
1.8
2.3
2.6
1.9
1.7
0.9
4.7
5.0
5.6
5.9
7.5
7.5
Prev.
(2.5)
(1.3)
(1.6)
(1.5)
(1.7)
(2.7)
(-0.1)
(4.6)
(4.2)
(2.7)
Consensus 2014
2.7
2.6
1.3
1.5 
1.5
1.5
1.4
1.0 
1.5
1.5 
2.6
2.9
0.3
1.9 
5.1
4.5 
4.5
4.0 
2.7
2.6 
Prev.
(2.6)
(1.6)
(1.5)
(1.3)
(1.8)
(2.9)
(1.7)
(4.6)
(4.3)
(3.0)
Consensus 2015
2.9
2.7
1.7
1.6
1.7
1.5
1.1
1.5
1.7
1.9
2.4
3.0
2.3
1.4
5.1
4.5
4.5
4.1
3.1
3.0
Wt (%)
100
64.0
24.0
18.7
5.2
3.7
9.1
36.0
22.2
12.8
2012
2.6
1.4
2.8
-0.6
0.9
0.1
1.9
4.8
5.7
7.8
2013
2.3
1.1
1.7
-0.4
0.6
1.4
1.8
4.5
5.6
7.6
Wt (%)
100
64.0
24.0
18.7
5.2
3.7
9.1
36.0
22.2
12.8
2012
2.9
1.8
2.1
2.5
2.1
2.8
-0.5
4.8
4.0
2.6
2013
2.6
1.3
1.6
1.4
1.6
2.6
0.1
4.8
4.3
2.7
Current
0.25
0.50
0.25
0.10
6.00
2012
0.25
0.50
0.75
0.10
6.00
Prev.
2013
0.25
(0.25)
0.50
(0.50)
0.25  (0.50)
0.10
(0.10)
6.00
(6.00)
Current
4033
325
NO
20.00
2012
2907
375
YES
20.00
2013
4033
375
YES
20.00
Current
1.66
1.37
102.4
0.83
6.05
2012
1.60
1.25
82.0
0.78
6.20
2013
1.61
1.34
100.0
0.83
6.10
107.9
112










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
-
Prev.
2014
0.25
(0.25)
0.50
(0.50)
0.25  (0.50)
0.10
(0.10)
6.00
(6.00)
Market
0.41
0.84
0.33
0.21
-
2015
0.50
0.50
0.25
0.10
6.00
Market
1.10
1.67
0.57
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




108.2 
Prev.
(375)
YES
20.00
2014
4443
375
YES
20.00
Prev.
(1.53)
(1.30)
(105.0)
(0.85)
(6.10)
Y/Y(%)
0.6
7.2
22.0
6.5
-1.6
(108)
-3.0
2014
1.58
1.32
110.0
0.84
6.00





103.8 
2015
4443
375
YES
20.00
Prev.
(1.48)
(1.25)
(115.0)
(0.84)
(5.95)
Y/Y(%)
-1.9
-1.5
10.0
0.4
-1.6
2015
1.50
1.27
110.0
0.85
6.05
Y/Y(%)
1.5
1.3
110.0
0.8
6.1
(100)
-4.1
98.8
-4.8
Source: Schroders, Thomson Datastream, Consensus Economics, January 2014
Consensus inflation numbers for Emerging Markets is for end of period, and is not directly comparable.
Market data as at 27/01/2014
Current forecast refers to November 2013. Previous forecast refers to August 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
6
EM Asia
6
EM
5
EM
5
4
4
Pac ex JP
Pac ex JP
3
3
US
UK
US
2
UK
Japan
1
2
Eurozone
Japan
1
Eurozone
0
0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan
Jan
Month of forecast
Month of forecast
Chart B: Inflation consensus forecasts
2014
2015
%
%
8
8
7
7
EM Asia
EM Asia
6
6
EM
EM
5
5
4
4
Pac ex JP
Pac ex JP
3
3
US
2
UK
US
UK
2
Japan
Eurozone
Japan
1
1
Eurozone
0
0
Jan
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan
Month of forecast
Month of forecast
Source: Consensus Economics (January 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
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necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document
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any other regulatory system. Reliance should not be placed on the views and information in the document when taking
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