For professional investors only
30 May 2014
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
Forecast update: recovery trimmed, but on track (page 2)
 Global recovery continues, but our growth forecast has been shaved as a
result of downgrades to both the advanced and emerging economies. The
latter face the more significant challenge in adjusting to the post financial
crisis world, whilst the former should bounce back with the US in the second
quarter. Divergent monetary policy remains a key theme with the Fed and
Bank of England expected to raise rates in 2015 while the ECB, BoJ and
PBoC are likely to remain on an easing tack.
 The risks to our forecasts are still tilted toward weaker growth and inflation
led by a China hard landing, the threat of Eurozone deflation and secular
stagnation. However, stagflationary risks have risen as a result of introducing
a new scenario, capacity constraints bite, whilst political event risk is present
should the Russia-Ukraine crisis deteriorate or a trade war erupt in Asia.
Europe: mixed macro & mixed election results (page 6)
 The European growth figures for the first quarter were very mixed. Some
countries such as Germany and Spain are gaining momentum in their
recoveries, while others such as Italy and France are failing to impress and
are struggling to implement structural and fiscal reforms.
 The European parliamentary election results were also mixed, with eurosceptic parties making clear gains, but not in all countries. The most
worrying results came from France and the UK, where large gains were made
by populists, and where they are most likely to influence future results. The
wider impact will be to slow EU expansion, which raises the risk of greater
Russian influence in the region in the long-term.
EM forecast update: crumbling BRICs (page 13)
 The situation has stagnated or deteriorated for the BRIC countries, with
macro disappointments in China, and political concerns in Brazil and Russia.
India alone has hinted at a brighter future, but upgrades will have to wait until
promises become actions.
Views at a glance (page 19)
 A short summary of our main macro views and where we see the risks to the
world economy.
Chart: Global growth upswing intact
Contributions to World GDP growth (y/y)
6
5
4.9
4.8
4.8
4.9
4
3.6
3.2
2.8
3
Forecast
4.6
4.4
2.6
2.4
2.1
2.8
2.9
14
15
World
2.4
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
12
13
Rest of emerging
Source: Thomson Datastream, Schroders 28 May 2014 forecast. Previous forecast from February
2014. Please note the forecast warning at the back of the document.
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30 May 2014
Forecast update: recovery trimmed, but on track
Global growth
forecasts have
been trimmed
We continue to expect global growth to strengthen, but have shaved our forecasts for
2014 and 2015 by 0.2% to 2.8% and 2.9% respectively. Downgrades to both the
advanced and emerging economies forecasts have been made, although we still see
the problems in the latter as more fundamental than in the former. In the short run this
is reflected in the continuing divergence between the Purchasing Managers' indices
(PMIs) for the developed and emerging economies, as represented by the BRICs.
Chart 1: Emerging economies lag developed market pick-up (PMI's)
Index
60
55
50
45
40
35
30
2006
2007
2008
2009
2010
Developed
2011
2012
BRICs
2013
2014
Source: Markit, Schroders. 29 May 2014.
Emerging
economies still
waiting for the
turn
Looking further out, the emerging economies need to adapt to a world of weaker
external demand through improvements in competitiveness, cutting debt and
eventually re-orientating growth toward domestic demand (see our recent Talking
Point, "Emerging markets: roadmap to recovery" for more on the adjustment process
and the characteristics of those economies most likely to succeed). Progress is being
made in economies like India where the current account deficit has narrowed, and
economies such as Korea and Taiwan are well placed to capture an upturn in US
demand, where there are signs that imports are picking up. However, we need to
become more confident on growth in the other large economies like China and Brazil
before the emerging markets can return to a stronger growth path. Our China forecast
for 2014 remains at 7.1%, but has been revised down to 6.8% in 2015 (see EM
forecast: crumbling BRICs, below).
On the advanced economy side the downgrade to growth is in large part a reaction to
the weakness of the first quarter in the US where GDP is now reported as having
fallen at an annual rate of 1%, the first contraction since 2011.
We would attribute much of this to the harsh weather during the period which hit
construction and spending on durables as well as exports. Unsurprisingly given the
impact of the weather on supply chains, inventory building fell sharply and stripping
this factor out, final sales grew and were led by a 3.1% gain in consumption. Monthly
data for April are pointing to a sharp rebound in q2 with GDP expected to rise at a
4.5% annual rate. Nonetheless, there are areas where we are more cautious, for
example, on the housing market where starts and sales have persistently
disappointed.
US rebound
expected in q2
Again this is partly a weather effect, but the slowdown was in train prior to q1. Higher
mortgage rates are one explanation following the bond market’s "taper tantrum" last
year, although mortgage borrowing does not seem to have been a driver of the
recovery in the first place. Instead there would seem to be a new dynamic at play
2
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where shifts in investor behaviour drive the market. Such buyers are sensitive to
similar factors as those buying homes to live in rather than rent, only more so, and the
rise in house prices and bond yields will have made property investment less attractive
than a year ago. In a recent study the Federal Reserve bank of San Francisco
reported evidence of a marked slowdown in regions where investment buyers had
previously been active1.
Fed and BoE to
tighten, whilst
ECB, BoJ and
PBoC ease further
Despite trimming the US growth forecast we still expect the Fed to end QE by October
and raise interest rates from q3 2015 as unemployment continues to fall and wages
accelerate. The jobless rate is forecast to fall from its current level of 6.3%, reaching
5.9% by the end of this year and 5.2% by the end of next. Our inflation forecast is
marginally higher and Fed funds is now expected to rise to 0.75% by end 2015. These
forecasts for unemployment are below the lower end of the range published by the
Federal Reserve members and presidents in March.
Divergence in monetary policy remains a key theme in the forecast. In the Eurozone
we expect another rate cut from the ECB and measures to reduce bank funding costs,
but no QE as the economy is expected to escape deflation. For the UK, we have
brought forward our first rate hike to August 2015 as a result of stronger activity, but
remain later than the consensus. In Japan we have pushed out an acceleration in
QQE until September when the Bank of Japan (BoJ) is expected to downgrade growth
expectations. We still have doubts about the sustainability of growth and fear that the
central bank has become too optimistic on the economy. The People’s Bank of China
(PBoC) is expected to trim the RRR, but refrain from easing further as it continues to
control excess liquidity.
Scenario analysis: deflation remains the greater tail risk
We have updated our scenarios and now include two new projections to capture the
risks around the baseline outlook. Both are primarily US scenarios, but they could
easily apply more widely and especially to the UK. Trade and financial links mean they
have global implications.
Secular stagnation
would add to the
deflationary risks
The first is "secular stagnation" where economic growth remains weak as a result of
slow productivity gains, an outlook recently popularised by Larry Summers. In this
scenario, capital spending remains sluggish as despite interest rates being at record
lows, the cost of capital remains above the expected rate of return. Household
expenditure is constrained by weak real income growth, a consequence of sluggish
productivity and deteriorating demographics. Other countries experience similar effects
and the net result is a deflationary outcome where growth and inflation are below the
baseline projection. Clearly, interest rates and monetary policy would be looser in this
scenario with, for example, no increase in rates from the Federal Reserve and
increased pressure for the US central bank to restart QE.
The "capacity
constraints bite"
scenario takes us
in a more
stagflationary
direction
The second we have labelled "capacity constraints bite" where the amount of spare
capacity proves to be considerably less than anticipated by policymakers. Estimating
output gaps is a hazardous business as structural shifts can make current capacity
obsolete and skills redundant. The forces of secular stagnation can also play a role by
slowing productivity and the trend rate of growth. The net result is that central banks
overestimate the ability of the economy to grow without pushing inflation higher and
keep policy too loose. Once the mistake has been realised they then have to tighten
aggressively to bring the economy back to trend. An overestimation of the amount of
slack in the economy was one of the factors which led to the great inflation of the
1970s (see chart 2). Today, it could come about through the structural changes
brought by the global financial crisis and the subsequent shift from finance and
construction – the sectors which experienced the greatest effects of the bubble.
1
3
See “The slowdown in existing home sales”, FRBSF Economic letter, May 19, 2014.
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Chart 2: The hazards of output gap analysis
US Outputgap, % of potential GDP
10
5
0
-5
-10
-15
-20
1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003
2002 retrospective output-gap estimate
Real time estimate
Source: Orphanides A., “Historical Monetary Policy Analysis and the Taylor Rule”. Federal Reserve
working paper 2003-36.
An escalation of
the Ukraine crisis
cannot be ruled
out
The other new scenario is "Russian rumble" where, following the annexation of the
Crimea, Russia takes military action in East Ukraine. In response the US and EU step
up trade sanctions and Russia cuts gas and oil supplies to Europe. So far markets
seem very relaxed about such a risk believing that neither side would wish to cause so
much damage to their economies, but if this scenario did play out it could have major
ramifications. We would expect to see a disruption to the European recovery until
alternative energy supplies are found, and for oil prices to rise significantly thus hitting
inflation and activity world wide. Amid a deterioration in international relations, market
volatility could be expected to increase and we would expect central banks to run
looser monetary policy despite the pick up in inflation.
Our other scenarios are unchanged from last quarter. On the deflationary side we still
have the "China hard landing" where the financial system unravels thus resulting in a
collapse in fixed investment and growth. As we have argued before this primarily
impacts the emerging market economies, particularly the commodity producers.
Growth in the US and Europe is also weaker, but there is some offset from the fall in
oil prices and inflation. Alongside, "secular stagnation" our third deflationary projection
is "Eurozone deflation" whereby the Eurozone experiences a Japan style slump with
prices falling persistently and the region experiencing debt deflation. Again monetary
policy would be looser than in the baseline with the ECB embarking on QE and policy
elsewhere also likely to be easier including in the US.
Of the remaining scenarios we still attach some risk to an escalation of the dispute
between China and Japan over the Diaoyu or Senkaku islands which results in the
"trade war" scenario. Alternatively this could originate from an escalation of the current
dispute between China and Vietnam. Like the "Russian rumble" this is political event
risk and would push the world economy in a more stagflationary direction through its
impact on trade and commodity prices. The latter typically rise during trade wars as
users build up their inventory and hoard commodities for fear of being unable to obtain
future supplies.
Finally, the "G7 boom" scenario is the sole reflationary outcome whereby we see a
return of animal spirits and a much stronger pick up in business spending than in the
baseline.
4
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Chart 3: Scenario risks around the baseline
2015 Inflation vs. baseline forecast
+2.0
+1.5
Stagflationary
Reflationary
Capacity limits
bite
Trade war
+1.0
+0.5
G7 boom
Russian
rumble
+0.0
Baseline
-0.5
Secular
stagnation
Eurozone
deflation
-1.0
China hard
landing
-1.5
Productivity boost
Deflationary
-2.0
-2.0
-1.5
-1.0
-0.5
+0.0
+0.5
+1.0
2015 Growth vs. baseline forecast
+1.5
+2.0
Source: Schroders 28 May 2014 forecast. Please note the forecast warning at the back of the
document.
Balance of risks
still tilts toward
deflation, but
stagflation has
risen as a result of
new scenario
In terms of probabilities there is still a skew toward deflation with a total probability of
15% attached to those scenarios which result in weaker growth and inflation,
unchanged from last quarter). However, as a result of introducing the capacity limits
bite and Russian rumble scenarios, the probability of a stagflationary outcome has
risen sharply to 12% from 3% previously. The probability on the reflationary boost has
fallen from 10% to 6% this quarter reflecting less upside risk on capex. The overall
balance of probabilities has shifted toward weaker growth and higher inflation
compared with 3 months ago.
Chart 4: Baseline and scenario probabilities
Eurozone
deflation, 4%
G7 boom, 6%
Trade war, 2%
Capacity limits
bite, 8%
Baseline, 65%
China hard
landing, 6%
Other, 2%
Russian rumble,
2%
Secular
stagnation, 5%
Source: Schroders 28 May 2014 forecast. Previous forecast from February 2014. Please note the
forecast warning at the back of the document.
5
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Europe: Mixed macro & mixed election results
The year so far has been one of consolidation for Europe. Because of the European
parliamentary elections, which took place earlier this month, very little has been
achieved with regards to the wider EU reforms required to improve stability and
resilience to future banking and sovereign debt crises. Like the Union's
macroeconomic performance, the results from the European elections have been
mixed.
European parliamentary election results
Mainstream
parties took a
beating in the
European
elections…
Nobody expected the mainstream parties to have an easy ride in this month's
European parliamentary elections. This was a chance for voters to vent their anger
and frustrations over not only the dismal macroeconomic performance of their
economies over the past five years, but also the social impact that such failings have
had. UK Independence Party leader Nigel Farage described the election as a "free hit"
for voters against the establishment, but could the results really bring about the
"earthquake" that he touted?
Chart 5: Rise in populist votes
%
70
>90%
60
50
40
30
20
10
0
Gre
UK
Ita
Den
Fra
Share of votes for populist parties
Aus Neth
Fin
Swe Ger
Spa
Voter turnout in 2014 election
Pol
Bel
Average turnout*
*Average turnout taken for 1999, 2004 and 2009 elections, except for Poland who joined after 1999.
Source: European Parliament, Schroders. 28 May 2014.
…although, it
could have been
far worse
In our view, the election results were more mixed than has been suggested by the
press. Populist parties clearly made gains compared to the previous results, but the
uniform swing towards such parties has not occurred. Voter turnout was also mixed,
but not significantly different to past elections (chart 5 above). Looking at the results,
we find a trend of rising discontent with mainstream parties where domestic economic
and social problems have been more severe, but also where those parties have not
blamed the EU for their ills, rather than a direct vote against the Europe.
Box 1: Summary of European parliamentary election results:
6

In Germany, the federal government coalition won about 63%, increasing
their share from the 2009 EU election (59%). The radical-left Die-Linke
won 7.4% of the votes, slightly down compared to the previous election,
but did manage to win a seat. In our view, a strong result for the proEuropeans, and while Die-Linke made progress, it was less than was
expected.

In France, the extreme-right wing Front National beat the mainstream
parties by winning 25% of the votes, highlighting the discontent in French
politics at the moment. The biggest loser was President Hollande's
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Socialist party, which won a pathetic 14% of the votes, finishing in third
place. The French result reflects both the anger over what is seen as
Brussels imposed austerity, but also the perceived loss in sovereignty,
and powers over national borders. Francois Hollande, who had promised
a reversal of austerity measures in his election campaign, has been
forced to backtrack and face reality. However, his (and previous
governments') refusal to be clear with the electorate has allowed the Front
National to seize the political agenda. Hollande's approval rating is now
below 20%, compared to previous president Sarkozy's rating at the end of
his second year of around 35%. The politics of France is horrible at
present, and with the main opposition being hit by bribery scandals, the
Front National has managed to capitalise on the downturn in the
popularity of leading political figures, and has emerged as a genuine
political force in France.
While Greece and
Italy saw big
support for eurosceptic parties, it
was the UK and
France that saw
the biggest swings
7

In Italy, the big winner was Matteo Renzi’s, whose party won 40.8% of the
votes in the first election since he took power as Prime Minister.
Meanwhile, the anti-establishment Beppe Grillo's party (5-star movement)
won just 21.1% of the votes, falling from 25.5% won in last year's general
election. The increased vote for Renzi's party may just be a result of the
honeymoon period new leaders tend to enjoy, however, it does reduce the
risk of the coalition breaking up in coming years.

In Spain, the governing Popular Party won the election with a slight
majority, with votes swinging towards parties that favour a referendum on
independence for certain regions.

In Portugal, the mainstream opposition Socialists Party won 32% of the
votes, while the governing coalition won about 28%. Anti-EU parties made
little impact.

In Greece, radical leftists Syriza came first with 26.5% of the votes, but
the governing coalition jointly won 30.5%. Compared to the 2012 general
election (the last contest including all parties) this was a slight fall in the
votes for Syriza. However, the extreme-right Golden Dawn party secured
9.4% of the votes - a 2.5% increase compared to the last election,
highlighting the ongoing crisis in Greece.

In the Netherlands, the anti-EU Party of Freedom (PVV) won 13% of the
votes - lower than expected and less than the 2009 election. The proEuropean parties won the largest share of the votes, suggesting low risk
from the Netherlands.

In the UK, the UK Independence Party won the largest share of the votes
(27.5%), with Labour coming in second (25.4%). The Conservative party
finished third (23.9%) with the Liberal Democrats finishing a woeful fifth
(6.9%). While the natural position of the mainstream parties is to be proEU, the surge in support for UKIP is likely to have a larger impact than
expected.
Overall, some anti-EU parties made ground in the elections, while others in some
countries actually underperformed expectations. Italy saw the biggest favourable
swing towards the current government, while Spain, the Netherlands and Portugal did
better than expected against the anti-EU parties. The results in France and the UK are
the most concerning, with a genuine message being sent to leaders that change is
needed. For France, austerity and structural reforms will continue regardless of the
result, and with both of the mainstream parties strongly in favour of the European
project, we see low risk from the European election results. The next presidential
elections are not for another three years, and even then, the first past the post system
will keep influence of the Front National low.
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The wider impact
will be to future
EU policy, in
particular on EU
expansion, which
raises the risk of
greater Russian
influence in the
region
In the UK the risks are more severe. The Conservative party harbours a significant
number of Euro-sceptics and is where UKIP originated from. The Conservatives have
promised a referendum on the UK's membership of the EU in 2017, which may
eventually be adopted by Labour as we approach the 2015 election (currently holding
on to a loose pro-European stance), especially if UKIP continues to build support. The
immediate impact has been for Prime Minister David Cameron to successfully demand
a review of EU policy, and for former Luxembourg Prime Minister Jean-Claude
Juncker’s nomination for the European Commission presidency to be challenged.
Cameron has openly been campaigning to block his candidacy as Juncker is viewed
as an old-school EU federalist. The UK's membership of the EU is looking more
precarious, which should concern other EU member states that share similar political
views.
Beyond the UK, the impact on wider EU policy could be to halt one of the Union's most
successful achievements - the expansion of the EU, and the reforms introduced in new
member states and accession candidates. If progress halts altogether, there is a
danger that candidate states in Eastern Europe could lose hope of accession, and
start to turn back to the recently resurgent Russia.
Eurozone forecast update
Like the European elections, the recent macro data has also been mixed. First quarter
Eurozone GDP is estimated to have grown by 0.2% (quarter-on-quarter), matching
quarterly growth at the end of 2013 but disappointing the City, where consensus
expectations were for an acceleration to 0.4% growth. The main drivers of the
disappointment came from France, Italy and the Netherlands – all of which continue to
struggle with ongoing austerity and structural reforms (see chart 6).
Chart 6: European growth slow but steady
Like the politics,
the growth picture
was also mixed in
Q1
Q/Q
1.5%
1.0%
0.5%
0.0%
-0.5%
-1.0%
-1.5%
Neth
Por
Fin
Ita
Fra
EZ
Aus
Q4
Q1
Spa
Bel
Ger
UK
Source: Thomson Datastream, Eurostat, Schroders. 29 May 2014.
French quarterly GDP was flat in the first quarter compared to 0.2% in the previous
three months (revised down from 0.3%) and against expectations of 0.1% growth. The
French GDP report highlighted falling domestic demand, likely to be in reaction to the
recent increases in already high taxes. The Italian economy also surprised to the
downside by contracting by 0.1% (consensus estimates of 0.2% growth). In fact, the
level of Italian GDP is now lower than the previous trough in 2013 Q3.
Elsewhere in the Union, Germany’s GDP growth was better than expected (0.8% vs.
0.7% consensus), which helped support an acceleration in growth for Poland and
Hungary (both up 1.1%). Spain is estimated to have grown by 0.4% on the quarter –
its fastest quarterly growth rate for six years - however; both Finland and the
Netherlands struggled, with the former falling into a triple-dip recession.
8
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We have revised
up the forecast for
Germany and
Spain, but
downgraded Italy
and France
In terms of our forecast, the slightly lower than expected outturn for the first quarter
coupled with downward revisions to the second half of last year's growth means that
our forecast for aggregate Eurozone growth for 2014 has been revised down from
1.1% to 1.0%. However, the aggregate figure hides some differing trends. We have
revised up our forecast for Germany for this year and next as the latest GDP figures
supported our view that the pick up in domestic demand will continue to surprise
economists to the upside (table 1). Spain has also been revised up on the back of
continued improvements in activity. We now have a higher growth forecast for Spain
than for France or Italy in 2015.
Table 1: Updated GDP growth forecasts
2014
Prev.
2015
Prev.
Germany
2.2
1.9
2.3
2.2
France
0.6
0.9
0.9
1.1
Italy
0.0
0.3
0.6
0.7
Spain
1.0
0.6
1.3
1.1
Eurozone
1.0
1.1
1.4
1.4
Source: Thomson Datastream, Schroders 28 May 2014 forecast. Previous forecast from February
2014. Please note the forecast warning at the back of the document.
We have downgraded both France and Italy on the back of the weaker start to 2014,
but also the lack of progress in implementing reforms. The fiscal slippage which is now
very likely by the pair should help avoid another round of significant recessions;
however the outlook is not particularly rosy for the pair.
The profile of our aggregate Eurozone growth profile is therefore largely unchanged
(chart 7). The forecast for HICP inflation has however been lowered slightly in the near
term, largely on the back of lower than expected energy prices, especially of natural
gas (chart 8).
Charts 7: Eurozone GDP forecast
%, Q/Q
+0.6
Charts 8: Eurozone inflation forecast
%, Y/Y
+3.0
+0.4
+2.5
+0.2
+2.0
+0.0
+1.5
HICP inflation
forecast
+1.0
-0.2
Real GDP
forecast
-0.4
+0.5
+0.0
-0.6
i ii iii iv i ii iii iv i ii iii iv i ii iii iv
2012
2013
Current forecast
2014
2015
Previous forecast
i ii iii iv i ii iii iv i ii iii iv i ii iii iv
2012
2013
Current forecast
2014
2015
Previous forecast
Source: Thomson Datastream, Schroders 28 May 2014 forecast. Previous forecast from February
2014. Please note the forecast warning at the back of the document.
Expectations are
high for ECB
action next month,
but can they
deliver?
9
With regards to monetary policy, the latest mixed growth numbers highlight the
problem the ECB faces in setting monetary policy for a diverging set of economies.
Nevertheless, the disappointment in the growth figures is likely to support the doves at
the Bank for greater stimulus. We continue to expect the European Central Bank to cut
the main refinancing rate at the June meeting (to 0.1%), but no cuts to the deposit
rate, nor the introduction of quantitative easing. However, the market is clearly pricing
in more than just a cut in the main refinancing rate, and given the recent comments
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from members of the Governing Council, the risk to our forecast is skewed towards
greater action. Whether that action can lift growth and inflation is another matter
altogether.
UK forecast update: stronger growth = earlier rate hike
The UK continues
to perform
strongly,
prompting an
upgrade to our
forecast…
The UK economy continues to perform very strongly, in particular, strong growth in
household consumption and more recently, business investment. Slight upward
revisions to growth in 2013, along with an upside surprise compared to our forecast for
the first quarter, has led us to conclude that there is stronger momentum in domestic
demand than previously forecast. Households have been reducing their savings rates
to expand consumption, despite falling real disposable income. The recent fall in
inflation is helping to moderate the squeeze, but ultimately, the household sector
seems to be happy to increase its leverage once again.
This might be explained by the recent sharp fall in the unemployment rate, which fell to
6.8% over the first quarter, compared to 7.2% in the previous quarter, and 7.8% a year
earlier. Indeed, consumer confidence has also been very strong, with the GfK survey
recording confidence in May returning to highs not seen since 2005.
Overall, it appears that in the absence of serious fiscal consolidation this year and a
willingness of households to borrow once again, domestic demand in particular is likely
to be stronger than previously forecast. We have therefore raised the 2014 growth
forecast from 2.6% to 2.9%, and from 2.1% to 2.4% for 2015 (chart 9). Supporting this
is the downgrade to the inflation forecast for the UK, partly due to a change in
assumption on GBP (smaller depreciation), but also on the back of lower near-term
pressure from food and energy price inflation (chart 10).
Charts 9: UK GDP forecast
Charts 10: UK CPI inflation forecast
%, Q/Q
+1.0
%, Y/Y
+4.0
+0.8
+3.5
+0.6
+3.0
+0.4
Real GDP
forecast
+0.2
+0.0
+2.5
+2.0
+1.5
-0.2
-0.4
CPI inflation
forecast
i ii iii iv i ii iii iv i ii iii iv i ii iii iv
2012
2013
2014
2015
Current forecast
Previous forecast
+1.0
i ii iii iv i ii iii iv i ii iii iv i ii iii iv
2012
2013
Current forecast
2014
2015
Previous forecast
Source: Thomson Datastream, Schroders 28 May 2014 forecast. Previous forecast from February
2014. Please note the forecast warning at the back of the document.
…but also
prompting
bringing forward
the first rate rise
forecast
10
Stronger growth raises the prospects that the Bank of England (BoE) may raise its
policy interest rate sooner than expected. While inflation in the near term remains
benign, the Bank is considering the profile of future interest rates. The debate seems
to be heading towards the notion that an earlier start to the hiking cycle will allow the
BoE to ease the squeeze on the household sector by hiking more slowly.
Macroeconomic theory points to the importance of the level of interest rates for longterm economic growth, but in the short-term, the change in interest rates is more
important. Therefore, the BoE should take as much time as possible in normalising
rates.
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This debate has been highlighted by recent interviews by Martin Weale, an external
member of the BoE's monetary policy committee. As the Bank forecasts the outputgap to be closed by around mid-2017, in theory, it should want to 'normalise' interest
rates by then. The first question that arises is what the new equilibrium rate actually is.
In the past, 4-4.5% seemed to be the preferred neutral rate, but the Bank has strongly
signalled that this is now too high post the financial crisis. Not only is trend GDP
growth expected to be lower, but there is an argument that prior to the crisis, banks
were not charging enough of a premium (spread) over the Bank's risk free rate implying that lending risks were being underestimated. If lenders are now charging
more appropriate premiums, then the Bank of England can achieve the same effective
interest rate (true average interest rate charged to households and corporates), but
now with a lower base rate.
In our view, the Bank is likely to remain very cautious and will look to raise interest
rates by no more than 25 basis points each quarter. Even Weale - a more hawkish
member - agrees with this pace of tightening. He may start to call for rate increases in
the near future, but we forecast the BoE to remain on hold until August 2015. This is
sooner than previously forecast (start of 2016), but is later than is priced in by money
markets (chart 11). The market is pricing in a strong chance of the first rate rise by
February 2015, and at least the first rise by May 2015. As the next general election will
be taking place at that time, in our view, it would be strange for the BoE to introduce
additional market uncertainty by raising interest rates. We think August 2015 is
therefore more likely.
Charts 11: Schroders UK interest rate forecast vs. market expectations
We expect the BoE
to remain dovish,
and to hike later
than the market
expects
Basis points (vs. current base rate)
200
175
150
125
100
75
50
25
0
Jun
'14
Sep
'14
Dec Mar Jun Sep Dec Mar Jun Sep
'14
'15
'15
'15
'15
'16
'16
'16
Short sterling contract yield minus current 3m LIBOR
Schroders forecast
Dec
'16
Source: Thomson Datastream, Schroders. 29 May 2014.
Conclusions
Overall, the quarter has highlighted the big picture in the region. The European
recovery is slow and uneven, with many countries still trying to fix their unsustainable
public finances. The politics is currently stable enough to support the recovery, but
delays to reforms and extensions of austerity are eroding the patience of voters. The
risk of Eurozone deflation is elevated as highlighted by one of our scenarios. Markets
are looking for the ECB to provide additional stimulus in response as deflation would
spell disaster for some member states’ fiscal adjustments. Investors seem happy for
the moment, but this month's wobble in peripheral equities suggests that some
investors are scaling back expectations, and maybe even losing patience with the slow
recovery, along with the poor earnings results. Even peripheral bond spreads have
widened out over the month.
11
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30 May 2014
The UK seems to be operating in a much higher gear than the rest of Europe, leading
us to revise up our forecasts for growth, and bring forward our forecast for the first rise
in interest rates. While we see no reason for activity to dramatically ease in the near
term, a return to serious fiscal austerity post the 2015 election is likely to hit growth
from there on. Meanwhile, the race for the 2015 general election is underway, and as
uncomfortable as it may be for the mainstream parties to admit, the UK Independence
Party is going to heavily influence the debate over the country's future, and may even
cause more surprises at the polls.
12
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30 May 2014
EM forecast update: crumbling BRICs
Downwards
revisions as
macro disappoints
and politics
weighs on growth
We have revised our growth and inflation numbers for the BRIC economies and have
either kept them constant or pushed them down on a mixture of macroeconomic and
political deterioration. The political situation has improved in India but we are waiting
for concrete policy signals before adjusting our growth expectations. With most
tightening cycles concluded, our inflation outlook is also relatively unchanged for now.
Table 2: Summary of BRIC forecasts
% per
GDP
annum
2013
2014f
2015f
7.7
7.1→
6.8 ↓
China
2.3
1.7 ↓
1.9 ↓
Brazil
4.6
5.0→
5.5 →
India
1.3
0.6 ↓
1.4 ↓
Russia
2013
2.6
6.2
10.9
6.8
Inflation
2014f
2.7→
6.6 ↑
7.1→
6.3→
2015f
3.1 ↑
6.3 ↑
6.1→
5.8→
Source: Bloomberg, Thomson Datastream, Schroders. 28 May 2014. Previous forecast from
February 2014. Please note the forecast warning at the back of the document.
China: property looks precarious
Chinese growth
slowed as
expected in Q1
Finance still a
concern, but risks
seem to be ebbing
The data has largely continued to deteriorate in China since our last forecast. First
quarter GDP came in at 7.4% year-on-year, down from the 7.7% recorded in the final
quarter of 2013. Other, higher frequency data has pointed to continued slowdown
since then, though the latest flash PMI showed some stabilisation. All in all though we
see little reason at this point to alter our below-consensus GDP call. The government
remains reticent on major stimulus, and continues providing minor encouragements
rather than driving in the spurs; the urbanisation plan has been accelerated, the
railway budget increased, and assorted minor tax breaks implemented. While this will
provide support to growth this year, it depletes the ammunition available later on. We
originally expected growth to rebound slightly in 2015 as growth positive measures fed
through – with these increasingly frontloaded we now think 2015 will weaken
compared to this year. Growth of 6.8% is now forecast.
The two areas generating the greatest concern at present are the financial and
property sectors. Trust product defaults seem to have tailed away for now; bank
analysts estimate that most (around 80%) issuers have successfully repaid or rolled
over the products. However, risks remain, predominantly in the mining and coal
sectors. There has been some liquidity support: interbank rates have fallen, and the
reserve ratio requirement was cut for rural banks, but the People’s Bank of China
(PBoC) has maintained a hawkish tone in statements and insisted on the need for
tighter liquidity. Credit growth, as measured by total social financing, continues to
decelerate, taking investment with it. A financial crisis seems unlikely at present,
however. As we said in the March Viewpoint, trust companies themselves are unable
to create money, and have little to no securitisation and low leverage. A trust company
failing, therefore, has limited direct impact on the financial system. The main concern
is its impact on confidence, a full default could lead to a panicked rush out of the
shadow financing system and a credit crunch.
This, though, presupposes that defaults go unchecked. It seems extremely unlikely to
us that the authorities will permit a large scale default in the near future. Though the
imposition of minor losses in recent trust default cases shows a willingness to move in
this direction, we expect a very gradual approach will be adopted to accustom Chinese
investors to the concept of moral hazard. There is also a reputational risk; 84% of trust
companies are backed by local governments and large financial institutions. Default by
such a trust risks nurturing the idea that the government or bank associated with the
product is also bankrupt, a loss of confidence of that kind would be devastating.
Continued bailouts, with partial losses, seem likely.
The property sector, meanwhile, is effectively now in recession, with sales in their
fourth month of contraction (chart 12). Price increases have slowed to just 0.1% month
on month, their lowest since October 2012, though still rising 6.7% year on year. A
13
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Property sector in
trouble…
slowdown in the sector matters because real estate accounted for 12.7% of GDP in
2013 (this compares to roughly 3% of GDP in the US). Further, land sales are a key
source of government revenues, and property sector lending accounts for
approximately 20% of bank loans. In an atmosphere of tighter credit, we think property
investment will slow compared to last year. While government investment in affordable
housing will help, it only accounts for 10-15% of real estate investment. Other
measures, such as the easing of restrictions on property purchase, will also provide
support, but not enough to reverse the slowdown.
Chart 12: The Chinese property sector is slowing
Residential floor space started and sold (sq. m, % y/y, 3mma)
120
100
80
60
40
20
0
-20
-40
2005
2006
2007
2008
2009
Starts
2010
2011
2012
Sales
2013
Source: Thomson Datastream, Schroders. 29 May 2014
… but a crisis is
unlikely
However, while we see property acting as a drag on the economy, we do not think a
Western style crisis is imminent. Mortgage loans are 14% of bank loans, and
household debt is less than 25% of GDP. Reportedly only 10% of urban households
have mortgage debt; combined with high deposit requirements (30% for the first
house, 60% for the second, and 100% for the third), this looks a lower risk area than in
the UK or US. Additionally, on a price to income basis, affordability has not markedly
worsened because incomes have also been rising rapidly in China. The wealth effect
is also much smaller; with mortgage equity withdrawal impossible in China, the impact
of falling prices on consumption will be limited largely to its impact on confidence.
Meanwhile, banks have strong buffers and, ultimately, state backing.
The broader concern about overall debt in the Chinese economy, estimated at around
230% of GDP, remains. The figure will continue to grow while total social financing
growth outstrips nominal GDP growth (7.8% in Q1), which it seems set to do for some
time yet. We do not think this will trigger a crisis but it will weigh on growth as
increasing resources are dedicated to debt servicing.
14
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30 May 2014
Chart 13: Declining food prices have kept Chinese inflation contained
%, y/y
20
15
10
5
0
-5
-10
2009
2010
2011
Headline CPI
2012
2013
CPI Food
2014
PPI
Source: Thomson Datastream, Schroders. 29 May 2014
Pork prices should
rebound and push
up inflation
Inflation so far this year has been subdued (chart 13 above), slipping to an 18 month
low of 1.8% in April as food inflation slowed dramatically. We do not expect this to
persist, however, as it appears to be linked to the pork cycle. Losses at farms have
resulted in a large contraction in capacity, which should push prices higher this year.
Still, we think inflation will remain well below the 3.5% target, providing plenty of scope
for monetary stimulus, should it be deemed necessary. We think a reserve ratio
requirement cut is likely this year, potentially around the third quarter, as the PBoC
looks to provide some support to banks, particularly in light of its stated desire to see
mortgage lending eased.
Brazil: politics and drought undermine growth outlook
First quarter GDP had not been published at the time of writing, but weaker high
frequency data reinforce our negative view of the Brazilian economy. The central
bank's GDP proxy, industrial production and to a lesser extent retail sales have been
trending down this year (chart 14). Car sales are also nearing five year lows - they fell
16% year on year in March. Consumer credit demand is also slowing, as higher
interest rates, lower consumer confidence and high inflation erode consumer demand.
Chart 14: Macro indicators point to a slowdown in Brazil
%, y/y
20
15
10
5
0
-5
-10
-15
-20
01
02
03
04
05
06
Retail sales (3mma)
07
08
09
IP (3mma)
10
11
12
13
BCB indicator
Source: Thomson Datastream, Schroders. 29 May 2014.
Political uncertainty has increased since our last forecast, with the incumbent Dilma
15
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Falling ratings for
Dilma have
cheered investors
Populist fiscal
policy is making
the central bank's
job harder
falling in approval polls, increasing the chances of a second round. Markets have been
cheering Dilma's fall, on hopes that it implies a more business friendly candidate will
triumph in October. However, she remains the clear frontrunner for now, and in any
case whoever wins will have substantial challenges; there will be no instant
turnaround. The boost to investor sentiment would be helpful but a number of
bottlenecks will take legislation and time to resolve. Until then, Dilma seems to be
resorting to populism to shore up her vote; her government has increased welfare
payments by 10% and provided additional capital injections to the development bank
to maintain credit expansion (further undermining the shaky fiscal position). All this
implies sharper cuts post-election and motivates our 2015 growth downgrade. Also
affecting our growth outlook is the impact of the recent drought, which has continued
almost unabated since we mentioned it in February's forecast. Depleted reservoirs
have seen increasing use of high cost thermoelectric plants (for which fuel must be
imported) rather than hydroelectric. This has resulted in a number of firms in the
metals and chemicals industries reducing production and selling excess power on the
spot market instead, where the price is at the government-fixed ceiling. Local media
reports a number of firms are struggling to operate with electricity costs at this level.
We suspect the central bank must be increasingly frustrated by the refusal of
government policy to truly co-operate in containing inflation, which remains close to
the upper band of the target range despite the 375 bps of rate hikes since the start of
2013 (chart 15). Inflation is, of course, a backward looking indicator, but worryingly
inflation expectations remain elevated as well, suggesting the problem is likely to
persist. Despite this, the central bank opted to keep rates on hold at 11% at its latest
policy meeting. Though the accompanying statement suggested further hikes would be
considered, it seems likely that we will have to wait until after the elections now for
rates to increase again. Despite this, inflation pressures look set to remain elevated in
2015, in part due to the ongoing need for high cost thermoelectric plants to stay online,
and in part due to the inevitable increase in regulated prices, which have been
suppressed in the run up to the election.
Chart 15: Brazilian inflation persists, despite tight monetary policy
%
8
%
20
18
7
16
14
6
12
5
10
8
4
6
4
3
2
2005
2
0
2006
2007
CPI (y/y), lhs
2008
2009
2010
Inflation expectations, lhs
Source: Thomson Datastream, Schroders. 29 May 2014
16
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2011
2012
2013
2014
Selic target rate (rhs)
For professional investors only
30 May 2014
India: election positive, but wait and see
Modi's mandate is
positive for reform
hopes
India's electorate returned Modi's BJP with 282 seats, granting them a majority and a
stronger mandate than many had expected. There had been a risk that results would
disappoint and that the optimism of recent months would sour. Instead, the count
surprised to the upside, giving investors a fresh injection of hope.
The inbox for the new government is a busy one. There is an investment bottleneck to
clear, fiscal consolidation will be important, and central bank governor Rajan is keen to
move to inflation targeting. Longer term, inefficiencies in the land and labour markets
must be addressed, and the tricky issue of foreign investment resolved. A majority for
the BJP greatly reduces the need for compromise, and could mean we see reforms
pushed through. However, the BJP-led government will still have to negotiate with
state governments and the upper house of parliament. State governments could prove
particularly obstructive. In all though, this election result is a positive one for the Indian
economy. Still, we will have to wait until July's budget for our first real taste of where
policy will go. Consequently we feel it is too soon to revise our growth outlook for India
on the back of the election results.
Higher frequency data in the first quarter was weak, with industrial production and
exports contracting, not helped by a strengthening rupee. The tighter monetary policy
used to stabilise the rupee is likely hindering growth, especially when India's banks are
seeing rising bad debt and so becoming more reluctant to lend.
On the monetary policy front, governor Rajan's crusade against inflation continues,
with policy remaining tight despite deteriorating growth indicators. Inflation has
bounced back slightly after initial successes (chart 16) This acceleration was driven
mainly by food price inflation; core CPI was unchanged at 7.8%. There are increased
upside risks to our inflation forecast as a result, particularly with the possibility of an El
Nino weather system this year. Policy will have to remain tight.
Chart 16: Indian inflation down but not out
%
9.5
%, y/y
12
9.0
11
8.5
10
8.0
9
7.5
8
7.0
6.5
Jan 12
7
Jul 12
Jan 13
Bank rate
Jul 13
CPI (rhs)
Jan 14
Source: Thomson Datastream, Schroders. 29 May 2014.
Russia: Ukraine unsettles the bear
Uncertainty and
sanctions
generating
headwinds for
Russian growth
17
Our growth forecast for Russia has seen a significant downgrade following events in
Ukraine, which were yet to transpire at the time of our last forecast update. Though
sanctions have not been broad based as yet, there is already evidence of an economic
impact; Russian GDP grew by 0.9% year on year in the first quarter. This marked a
sharp fall from the 2.0% growth recorded in the fourth quarter of 2013.
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30 May 2014
Higher frequency data suggests the slowdown has been driven by lower investment
spending. Consumer spending has slowed too, but has held up reasonably well in
comparison. Meanwhile, PMI data points to ongoing contraction in manufacturing and
services. It is not much of a stretch to argue that uncertainty arising from escalating
tensions in Ukraine contributed to reluctance to invest. If the situation in Ukraine is not
resolved, we would expect Russia’s GDP numbers to continue to worsen throughout
the year. Further sanctions are being discussed and the economic damage from
extant sanctions and general uncertainty will build over time. As it stands the second
quarter already looks likely to disappoint, and will probably put Russia into recession.
Russia is
vulnerable to
financial sanctions
Although it is not our base case, particularly as tensions seem to be easing, we should
also consider the possibility of Iranian style sanctions. The scope for economic
damage then becomes far greater. Chart 17 shows foreign bank claims on Russia in
absolute terms and as a share of Russian GDP. The withdrawal of finance equivalent
to 12.5% of GDP would be difficult to brush off.
Chart 17: Foreign bank claims on Russia
$ bn
300
12.5
250
200
9.2
150
100
2.5
1.7
50
1.4
1.1
0.9
0.9
Ge
Ned
UK Austria
0.8
0.8
0.7
0.4
Jp
Swe
Sw
0
Total Europe
Fr
US
It
Source: BIS, IMF, Schroders. 29 May 2014. Figures above columns denote bank claims as a share
of Russian GDP
The slowdown will worsen policymaker headaches – presumably already throbbing
from sanctions and political pressure – as inflation remains high. Rates have already
been hiked in response to this and currency weakness, but there will be increasing
policy conflict if the political situation does not improve. The easing of tensions though
has seen the ruble strengthen, for now, so the inflation spike could prove temporary.
18
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Schroder Economics Group: Views at a glance
Macro summary – May 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.
US to rebound in q2 after weather related dip in q1. Economy beginning to normalise as banks return
to health and private sector re-leverages. Unemployment to fall faster than Fed expects and central
bank to complete tapering of asset purchases by October 2014. First rate rise expected in q3 2015.
UK recovery to be sustained by robust housing and consumer demand whilst economic slack should
limit the pick up in inflation. Growth likely to moderate next year with general election and resumption
of austerity. Interest rates to rise in August 2015.
Eurozone recovery becomes more established as fiscal austerity and credit conditions ease in 2014.
Low inflation likely to prompt ECB to cut rates and take measures to reduce the cost of credit,
otherwise on hold through 2015. Deflation to be avoided, but possibility of QE in response to deflation
fears.
"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 as growth and
inflation fall back in 2014 and 2015.
US leading Japan and Europe (excluding UK). De-synchronised cycle implies divergence in monetary
policy with the Fed eventually tightening ahead of others and a stronger USD.
Tighter US monetary policy weighs on emerging economies. Region to benefit from advanced country
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. Some danger of
inflation if capacity proves tighter than expected whilst upside risk is a return of 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
4.9
4
3.6
3.2
2.8
3
Forecast
4.6
4.4
2.6
2.4
2.1
2.4
2.8
2.9
14
15
World
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
12
13
Rest of emerging
Source: Thomson Datastream, Schroders 28 May 2014 forecast. Previous forecast from November 2013. Please note the
forecast warning at the back of the document.
19
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30 May 2014
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)
(1.9)
(2.6)
(1.4)
(4.4)
(5.3)
(7.1)
Prev.
Consensus 2015
2.8
2.9  (3.1)
1.9
2.1  (2.2)
2.5
2.9  (3.0)
(1.4)
1.1
1.4
1.9
2.3  (2.2)
2.9
2.4  (2.1)
1.3
1.0  (1.3)
4.3
4.3  (4.6)
5.2
5.1  (5.6)
7.3
6.8  (7.3)
Consensus
3.2
2.3
3.1
1.4
2.0
2.5
1.3
4.8
5.4
7.2
Prev.
(2.8)
(1.4)
(1.5)
(0.8)
(1.3)
(2.3)
(1.9)
(5.4)
(4.3)
(2.7)
Prev.
Consensus 2015
3.0
3.1  (2.8)
1.6
1.6  (1.5)
1.8
1.9  (1.4)
(1.2)
0.8
1.2
1.3
2.0  (1.7)
1.9
2.2  (2.7)
2.6
1.6  (1.5)
5.6
5.6  (5.3)
4.3
4.4  (4.1)
2.5
3.1  (2.9)
Consensus
3.0
1.7
1.9
1.3
1.9
2.0
1.8
5.3
4.3
3.0
Wt (%)
100
64.4
24.7
18.6
5.2
3.8
9.1
35.6
21.8
12.5
2013
2.4
1.2
1.9
-0.4
0.5
1.7
1.6
4.6
5.5
7.7
2014
2.8
1.9
2.6
1.0
2.2
2.9
1.2
4.2
5.1
7.1
Wt (%)
100
64.4
24.7
18.6
5.2
3.8
9.1
35.6
21.8
12.5
2013
2.6
1.3
1.5
1.3
1.6
2.6
0.1
4.9
4.7
2.6
2014
3.0
1.5
1.8
0.9
1.3
1.9
2.0
5.7
4.4
2.7
Current
0.25
0.50
0.25
0.10
6.00
2013
0.25
0.50
0.25
0.10
6.00
2014
0.25
0.50
0.10
0.10
6.00
Prev.
(0.25)
(0.50)
(0.10)
(0.10)
(6.00)
Current
4227
375
241
20.00
2013
4033
375
224
20.00
2014
4443
375
295
19.50 
Prev.
(4443)
(375)
20.00
Current
1.68
1.37
101.5
0.81
6.23
2013
1.61
1.34
100.0
0.83
6.10
2014
1.68
1.35
105.0
0.80
6.18
Prev.
(1.63)
(1.34)
(110)
(0.82)
(6.00)
111.1
109.0
108.3  (108)









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
0.26
0.72
0.21
0.19
-
Prev.
2015
0.75  (0.50)
1.00  (0.50)
(0.10)
0.10
(0.10)
0.10
(6.00)
6.00
Market
0.92
1.58
0.30
0.19
-
Other monetary policy
(Over year or by Dec)
US QE ($Bn)
UK QE (£Bn)
JP QE (¥ Tn)
China RRR (%)
2015
4443
375
383
19.50 
Prev.
(4443)
(375)
20.00
2015
1.63
1.30
110.0
0.80
6.10
Prev.
(1.55)
(1.27)
(120)
(0.82)
(5.95)
Key variables
FX
USD/GBP
USD/EUR
JPY/USD
GBP/EUR
RMB/USD
Commodities
Brent Crude





Y/Y(%)
4.3
0.7
5.0
-3.5
1.3
-0.7





103.7  (103)
Y/Y(%)
-3.0
-3.7
4.8
-0.7
-1.3
-4.3
Source: Schroders, Thomson Datastream, Consensus Economics, May 2014
Consensus inflation numbers for Emerging Markets is for end of period, and is not directly comparable.
Please note the forecast w arning at the back of the document.
Market data as at 16/05/2014
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.
20
Issued in May 2014 Schroder Investment Management Limited.
31 Gresham Street, London EC2V 7QA. Registered No. 1893220 England.
Authorised and regulated by the Financial Conduct Authority
For professional investors only
30 May 2014
Schroders Forecast Scenarios
Global vs. 2015 baseline
Scenario
Summary
Macro impact
Baseline
We continue to expect global growth to strengthen, but have trimmed our forecasts for 2014 and 2015
by 0.2% to 2.8% and 2.9% respectively. The US should benefit from a weaker fiscal headwind in 2014
and be able to build momentum, although the economy is not expected to regain all the output lost in
the first quarter and the housing market is no longer forecast to strengthen as rapidly as before.
Europe is also improving, although growth remains skewed toward Germany with only modest signs of
improvement in the periphery. Helped by the housing market, UK growth has been revised up to 2.9%
(previously 2.6%). Stronger US demand should help global trade and the emerging markets, however
several EM economies face inflation and rebalancing pressures such that growth remains sub trend.
China forecast for 2014 remains at 7.1%, but has been revised down to 6.8% in 2015.
Despite trimming the US growth forecast we still expect the Fed to end QE by October
and raise interest rates from q3 2015 as unemployment continues to fall and wages
accelerate. Our inflation forecast is marginally higher and Fed funds is now expected
to rise to 0.75% by end 2015. In the Eurozone we expect another rate cut from the
ECB and measures to reduce bank funding costs, but no QE as the economy is
expected to escape deflation. For the UK, we have brought forward our first rate hike
to August 2015 as a result of stronger activity, but remain later than the consensus. In
Japan we have pushed out an acceleration in QQE until September when the BoJ is
expected to downgrade growth expectations. China is expected to trim the RRR, but
refrain from easing further as it continues to control excess liquidity.
Weak economic activity weighs on Eurozone prices with the region slipping into deflation. Households
and companies lower their inflation expectations and start to delay spending with the expectation that
prices will fall further. The rise in savings rates deepens the downturn in demand and prices, thus
reinforcing the fall in inflation expectations. Falling nominal GDP makes debt reduction more difficult,
further depressing activity.
Deflationary: weaker growth and lower inflation, persists throughout the scenario As a
significant part of the world economy, Eurozone weakness drags on activity elsewhere,
while some of the deflationary impact is imported by trade partners. ECB reacts by
undertaking QE, but the policy response is too small and too slow to avert the
outcome.
DM growth picks up more rapidly than in the base as the corporate sector increases capex and
consumers spend more rapidly in response to the recovery in house prices. Banks increase lending,
reducing their excess reserves and asset prices boom. The Fed begins to withdraw stimulus: rapidly
tapering bond purchases in 2014. Interest rates rise and the Fed begins to contract its balance sheet
in 2015. However, the withdrawal of stimulus is not sufficient to prevent a more rapid tightening of the
labour market and a pick-up in inflation.
Reflationary: stronger growth and inflation vs. baseline. Stronger US demand supports
activity around the world. Commodity prices and US Treasury yields rise and USD
strengthens as inflation picks up and Fed unwinds QE and raises rates.
The dispute between China and Japan over the Diaoyu/ Senkaku islands escalates to a trade war
which then spreads as nations take sides and cut their trade with each other.
Stagflationary: global growth weakens as supply chains are disrupted and a large part
of world trade shuts down. However, inflation is likely to be higher as firms hoard
commodities pushing up energy, metals and food prices.
Central banks overestimate the amount of spare capacity in the economy believing there is significant
slack in the labour market and a substantial output gap. However, weaker trend growth and the
permanent loss of some capacity in the post financial crisis environment mean that the world economy
is closer to the inflationary threshold than realised. Consequently, as demand increases, inflation starts
to accelerate prompting a re-appraisal of monetary policy and higher interest rates.
Stagflationary: tighter monetary policy slows growth, but inflation continues to rise until
the economy has returned to trend. Primarily driven by the US and to a lesser extent
the UK - who in turn impact global trade and activity.
An implosion in the wealth management products area results in a major cut in Total Social Financing
depriving Chinese industry of funds. The resulting downturn in capex spending and the adverse impact
on consumer confidence results in a sharp slowdown in Chinese growth.
1. Eurozone
deflation
2. G7 boom
3. Trade war
4. Capacity limits
bite
5. China hard
landing
6. Russian rumble Russia invades East Ukraine. The west retaliates by significantly increasing sanctions and Russia cuts
gas and oil supplies to Europe.
7. Secular
stagnation
Capital expenditure fails to revive as businesses remain cautious on the outlook believing real returns
are below the cost of capital, whilst income becomes increasingly concentrated in the hands of the rich
with low propensity to consume.
8. Other
*Scenario probabilities are based on mutually exclusive scenarios. Please note the forecast warning at the back of the document.
21
Issued in May 2014 Schroder Investment Management Limited.
31 Gresham Street, London EC2V 7QA. Registered No. 1893220 England.
Authorised and regulated by the Financial Conduct Authority
Probability* Growth
Inflation
65%
-
-
4%
-0.8%
-1.0%
6%
+1.2%
+1.1%
2%
-0.9%
+0.8%
8%
-0.4%
+0.7%
Global growth slows as China demand weakens with commodity producers hit hardest.
However, the fall in commodity prices will push down inflation to the benefit of
consumers. Monetary policy is likely to ease/ stay on hold while the deflationary shock
works through the world economy.
6%
-1.1%
-0.9%
Stagflationary. Europe is hit by the disruption to energy supply resulting in a fall in
output as alternative sources are put in place. Higher oil prices hit global inflation and
the breakdown of relations between Russia and the west creates significant volatility in
financial markets.
2%
-0.6%
+0.3%
Deflationary: weaker growth and lower inflation as demand remains sluggish. Softer
commodity prices also weigh on inflation. Fed still expected to end QE as scheduled
but does not raise rates during the forecast period. The opposite of the G7 boom
scenario.
5%
-0.4%
-0.3%
2%
-
-
For professional investors only
30 May 2014
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
EM
5
4
4
Pac ex JP
Pac ex JP
3
3
US
US
2
UK
Japan
1
Eurozone
0
2
UK
1
Japan
Eurozone
0
Jan
Mar
May
Month of forecast
Jul
Sep
Nov
Jan
Mar
May
Jan
Feb
Month of forecast
Chart B: Inflation consensus forecasts
2014
Mar
Apr
May
2015
%
%
6
6
EM
EM
5
5
EM Asia
4
Pac ex JP
3
EM Asia
4
3
UK
Pac ex JP
Japan
2
UK
US
2
Japan
US
1
Eurozone
1
0
Jan
Mar
May
Jul
Sep
Nov
Jan
Eurozone
Mar
Month of forecast
May
0
Jan
Feb
Mar
Apr
May
Month of forecast
Source: Consensus Economics (May 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.
22
Issued in May 2014 Schroder Investment Management Limited.
31 Gresham Street, London EC2V 7QA. Registered No. 1893220 England.
Authorised and regulated by the Financial Conduct Authority