28 february 2014 schroders contributions to world gdp ......2014/02/28 · 28 february 2014 for...

28 February 2014 For professional investors only

Issued in February 2014 by Schroder Investment Management Limited.

31 Gresham Street, London EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.

Schroders

Economic and Strategy Viewpoint Keith Wade Chief Economist and Strategist Azad Zangana European Economist Craig Botham Emerging Markets Economist

Global recovery to shrug off bad weather (page 2)

Despite the recent wobble in the world economy and a further downgrade to the emerging economies, we continue to forecast a year of recovery in 2014. We attribute much of the recent weakness in US activity to adverse weather, although recognise that there is also an inventory correction weighing on activity. Growth should pick up in the second quarter and we expect the Fed to continue with the taper and actually raise rates in the third quarter of next year. Meanwhile, the ECB and BoJ are expected to ease further to support activity and inflation, whilst the Bank of England remains on hold through the forecast.

The risks to our forecasts are still tilted toward deflation although there is an increased probability of a stronger reflationary outcome if animal spirits return to the G7. On the downside, our greatest concern is a hard landing in China emanating from the financial sector. Such an outcome would hit the rest of the emerging markets, particularly the commodity producers.

Europe: Deflation fears to trigger ECB action (page 6)

Eurozone GDP growth is recovering as expected with no change to our 2014 and 2015 forecast. German growth has been downgraded due to its export exposure to emerging markets, while better results from the periphery prompt an upgrade. The inflation forecast has been lowered, and should prompt the ECB to cut rates in the near term. Meanwhile, UK inflation has also been downgraded, while growth has been upgraded, although a slowdown in activity is still forecast going forward.

BRICs: Central banks must be cruel to be kind (page 10)

We have downgraded the growth outlook for the BRICs and EM in the face of tighter monetary policy, and a range of country specific concerns. Central banks are increasingly finding they must be cruel to be kind, and tame inflation even at the cost of lower growth.

Views at a glance (page 15)

A short summary of our main macro views and where we see the risks to the world economy.

Chart: G7 set to lead global GDP recovery

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Contributions to World GDP growth (%, y/y)

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Source: Thomson Datastream, Schroders 24 February 2014 forecast. Previous forecast from November 2013. Please note the forecast warning at the back of the document.


2 Issued in February 2014 Schroder Investment Management Limited.

31 Gresham Street, London EC2V 7QA. Registered No. 1893220 England.

Authorised and regulated by the Financial Conduct Authority

1 Heating degree days are a measure of temperature, weighted by population, calculated by taking the average temperature in a day. If this number is less than 65°F (18°C), it is subtracted from 65°F to find the number of heating degree days. If it is above 65°F, a score of zero is registered for the day. The heating degree days for a given month are calculated by summing the total daily heating degree days.

Recovery forecast intact, but emerging markets are downgraded again

Weather has taken its toll on US growth, although it is not the only factor

Global recovery to shrug off bad weather

Our updated forecasts continue to paint a picture of recovery in the world economy, led by the developing world. Forecasts for the latter are little changed this month, but we have edged down our numbers for the emerging markets once again. Overall global growth is forecast to accelerate to 3% this year after 2.6% in 2013.

In the near term this is consistent with the latest Purchasing Managers Indices (PMI’s) which show the BRIC nations struggling to gain traction whilst the developed economies remain firmly in expansion territory, despite having softened recently. Looking further out, our Emerging Market downgrade is in response to the tightening of monetary policy across the region which will weigh on growth, offsetting the benefits of a lower exchange rate.

Chart 1: Developed markets PMIs leading the recovery

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Source: Markit, Schroders. 27 February 2014.

For the US we have left our growth forecast at 3% for this year and next based on the judgement that much of the recent weakness in activity has been due to the adverse weather. The number of heating days

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high (chart 2) and the cold weather has taken a toll on the economy, particularly the construction and retail sectors. Signs are that with the cold extending into February, the data releases in March will also be influenced by climatic conditions.


Issued in February 2014 Schroder Investment Management Limited.



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Now looking for the ECB to cut rates and the Fed to tighten earlier

Chart 2: Cold winter in the US

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Averages and standard deviations calculated from data from 1900. Source: National Oceanic and Atmospheric Administration. 27 February 2014.

Not all of the weaker data in the US can be attributed to the weather: we expect some payback in the first quarter as a result of a surge in inventory building and capital expenditure in the second half of 2013. As a result the quarterly profile for growth has altered with a softer first quarter than previously expected (see chart 3). Nonetheless, we continue to look for a recovery as housing improves and the fiscal drag which weighed on growth in 2013 fades.

Chart 3: US GDP forecast profile

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Elsewhere, we have pushed up our UK growth forecast to 2.6% for this year (from 2.4%) and have raised that for Japan slightly. Both changes assume that some of the momentum from 2013 spills over into 2014. However, we expect the UK to find 2015 challenging as political uncertainty weighs on activity. Japan is expected to experience a more immediate setback as the consumption tax increases. Our Eurozone forecasts are largely unchanged, but within the region we have raised the peripheral economies at the expense of the core (see next section for more detail).





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Balance of risks still in a deflationary direction led by a hard landing scenario in China

On the policy front, we are now assuming an ECB rate cut of 15 basis points to 0.1% in the second quarter as the central bank acts to reinforce the recovery and head off fears of deflation. Elsewhere we have brought forward our first US policy rate hike to the third quarter of 2015, to reflect a faster than previously forecast fall in unemployment. We still expect the Fed to end QE by October this year. By contrast, the Bank of Japan is expected to step up asset purchases in the second quarter of this year as the economy weakens in response to the consumption tax increase. Contrary to market expectations we do not expect the Bank of England to raise interest rates until 2016.

Since the US is the only of the major developed economies tightening policy over the forecast horizon, our forecasts factor in a stronger US dollar.

Risks and scenarios

The distribution of global risks is still skewed toward the downside for growth and inflation. Top of the list on the downside is a hard landing in China which then impacts the rest of the emerging markets, particularly the more vulnerable deficit economies – the China financial crisis scenario. While all but the most bullish commentators have recognised that China is going through a period of structural reform which will necessitate weaker growth, views diverge on the ability of the authorities to restructure the financial sector without a significant hit to growth.

Recent experience in the West suggests that de-leveraging an economy is fraught with systemic risks as, like a gigantic game of Jenga where players remove blocks from a tower, it is not always clear which loan default will prove to be the one which brings the whole structure tumbling down. We take comfort from arguments that the Wealth Management products which constitute the bulk of the shadow banking system are not leveraged and are more like fund management products than bank loans. Nonetheless, the reluctance of the authorities to allow a significant default suggests that there may be more risk in the system than widely perceived. Even without leverage the losses incurred by investors are likely to be a drag on activity as households try to make good their savings whilst making it more difficult to finance future projects.

If China does experience a hard landing the spill overs would be significant, but largely felt in the emerging world. For example, one recent model suggests a negative impulse of 1% in China’s GDP would reduce global growth by just under 0.5% after 4 quarters (see table 1). Of this, 12 basis points would be the direct impact on China with the remainder coming from the rest of the world. Breaking this down further the emerging markets would experience a slowdown of about 75 basis points with the greatest losses in Latin America and EMEA. The developed world would lose 20 basis points in growth, a smaller hit as part of the shock from China is mitigated by lower commodity prices, which act like a tax cut to consumers.

Table 1: Impact and spill over from a 1% GDP growth impulse by region

Source of impulse

USA EMU JPN CHN

Global 1.01 0.65 0.28 0.46

Direct 0.24 0.21 0.09 0.12

Spill over 0.77 0.44 0.19 0.35

Developed 0.86 0.32 0.20 0.21

Emerging 0.68 0.60 0.16 0.73

Asia 0.39 0.50 0.10 0.51

Latin America 0.92 0.48 0.22 0.82

EMEA 1.31 1.06 0.32 0.92

Table shows effect after 4 quarters Source: JP Morgan, Schroders. 27 February 2014.





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On the upside, animal spirits could drive a G7 boom

Our other deflationary risk scenarios include the Eurozone dropping into outright price deflation (see next section for more on Eurozone deflation) and one where Abenomics results in a significant move in the JPY to 130 against the USD (Abenomics squared). Our final downside scenario – Trade war - would take us in a stagflationary direction as the territorial island dispute between China and Japan escalates. Trade barriers increase resulting in weaker growth, whilst firms hoard commodities pushing up prices and inflation.

On the upside we see a G7 boom, an extension of our previous US boom scenario to Europe and Japan. The combination of pent up demand in the household sector combined with increased capital expenditure by the corporate sector results in a much stronger increase in activity. Such a scenario would require a significant shift in animal spirits and there is also likely to be higher inflation and tighter monetary policy (see chart 4).

Chart 4: Scenario growth-inflation grid

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Abenomics2China financial crisis + Fragile

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Source: Thomson Datastream, Schroders February 2014 forecast. Please note the forecast warning at the back of the document.

The probabilities we put on the different scenarios are shown below with the highest individual risk being the G7 boom (at 10%) and China financial crisis (at 6%).

Chart 5: Scenario probabilities

Baseline, 70%

Eurozone deflation, 5%

G7 boom, 10%

Trade war, 3%

Abenomics2, 4%

China financial crisis + Fragile

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Other, 2%

Source: Thomson Datastream, Schroders February 2014 forecast. Please note the forecast warning at the back of the document.





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Growth at the end of 2013 was largely as expected, showing a continuation of the recovery

Europe: Forecast update

Activity in Europe has been fairly robust of late, supporting our forecast of an ongoing but slow recovery. However, inflation has been lower than expected, largely as a result of external factors. While we do not forecast a protracted period of falling prices, low inflation in itself increases the risk of a self perpetuating deflationary spiral. The backdrop is unhelpful. Aggressive fiscal and banking deleveraging is placing immense pressure on households and corporates to cut back, in itself imposing deflationary pressures.

Meanwhile, the Bank of England has found reason to significantly upgrade its growth forecast, and yet, remains relaxed on when interest rates need to rise.

The Bank of England (BoE) and European Central Bank (ECB) will face increasing pressure to act on policy in the coming months, albeit in opposite directions. Whether those actions are delivered are important questions for investors.

Recovery solidifying

Eurozone aggregate growth rose to 0.3% in the three months to December - a slight acceleration compared to the 0.1% growth recorded in the third quarter (see chart 6). The results were in line with our forecast, but slightly above the Bloomberg consensus of 0.2%.

Within Europe, the UK delivered the strongest performance for the second consecutive quarter amongst the largest member states. Germany saw quarterly growth pick up from 0.3% to 0.4% in the fourth quarter, while France surprised the consensus by achieving 0.3% growth. Spain’s 0.2% was slightly lower than the earlier flash estimate, while Italy achieved 0.1% growth, the first quarterly rise in activity since the second quarter of 2011. Elsewhere, both the Netherlands and Portugal outperformed expectations by growing by 0.7% and 0.5% respectively. Austria grew by a solid 0.3%, but Finland disappointed with a 0.8% contraction, taking it back into recession.

Chart 6: European growth accelerating

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Source: Thomson Datastream, Eurostat, Schroders. 27 February 2014.

The data available on the expenditure breakdown of GDP paints a mixed picture. For example, while France saw all the major final demand indicators improving in the fourth quarter, Germany experienced a contraction in household consumption and flat government spending. Spain saw household consumption and total investment rise, however, government spending fell by a huge 3.9% on the quarter, which is a drag of approximately 0.8 percentage points in the fourth quarter. There





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Our Eurozone growth forecast is unchanged at the headline level…

…although Germany has been downgraded, while peripheral Europe upgraded.

were similarities in the external performance. Net trade was a positive contributor across the mentioned three as export growth outpaced growth in imports. Finally, France and Germany reported falls in inventories which coupled with the already low levels suggest that the turn in the inventory cycle could help support growth in the coming quarters. Indeed, this is our central case scenario for 2014. Support from the inventory cycle will be very important to pushing growth back above 1% in 2014.

Meanwhile, the breakdown of UK GDP showed a better balance of growth as household consumption more than halved, while total investment increased by 2.4% on the quarter – a long overdue pick up from very depressed levels as we have highlighted in the past. Inventories made a slightly negative contribution, but the fall was not enough to unwind the build up from the middle of last year. We continue to expect UK growth to ease in order for inventories to be run down. Finally, UK exports also grew, while imports declined, yielding a positive contribution from net trade.

Eurozone forecast update

Overall, our forecast for Eurozone aggregate GDP is unchanged at 1.1% for 2014 and 1.4% for 2015 (chart 7). However, the forecast for German growth has been lowered from 2.1% in 2014 to 1.9%, and from 2.3% in 2015 to 2.2%. This reflects the downgrade in the growth forecast for China and emerging markets, which Germany has a larger export exposure to than its European partners. Excluding Germany, the remaining Eurozone countries mostly saw upgrades, in particular Spain and France. This has been driven by a softer stance from banks on their willingness to lend this year. Our equity analysts suggest that banks in peripheral Europe, but especially in Spain, are looking to expand lending this year. We continue to expect lending to be weak due to the deleveraging pressure imposed by the European Central Bank’s asset quality review (AQR) and stress tests, however at the margin, this is a more positive signal for domestic demand. It means that the risks to the forecast are shifting to the upside. To reflect this, we have dropped the previous ‘Spanish bailout’ scenario, and incorporated a stronger Eurozone recovery in the ‘G7 boom’ scenario.

Chart 7: Eurozone GDP forecast Chart 8: Eurozone CPI forecast

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While the growth outlook is improving, the outlook for inflation is becoming more complex. We have lowered our forecast for inflation in the coming months due to increased deflationary pressures from food and energy prices, but also due to the significant depreciation of many emerging market currencies, and the likely weakness that will follow (chart 8). The latter is likely to lower import price inflation,





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Lower Eurozone inflation should prompt the ECB to cut interest rates in the near future UK growth remains strong, and has become a little more balanced

and therefore feed through to consumer prices in the Eurozone with a lag.

We have also changed our forecast for ECB interest rates. We expect the ECB to react by cutting the main refinancing rate from 0.25% to 0.1% in the coming months. There is a high chance the cut is made following the ECB’s March meeting where new internal forecasts are presented. However, with growth picking up, and credit growth improving, the ECB may opt to wait and see in March, minded that much of the drivers of recent low inflation should be temporary. We believe a rate cut will however follow by June in response to the lower inflation data as it is published.

A cut in the main refinancing rate should be accompanied by a cut in the marginal lending rate (penal rate for excess reliance on the central bank), but the deposit rate is unlikely to be cut from its current level of zero. Taking the deposit rate into negative territory would encourage the currency to depreciate, but it would impose an additional cost to banks, which will undoubtedly be passed on to households and businesses. Instead, we expect the ECB to continue to explore the possibility of purchasing asset backed securities, but is unlikely to pursue the policy until after the AQR has been completed. This would help overcome German objections to banking legacy assets being purchased or used to bail-out banks directly.

A further development worth watching is the interaction between the German Constitutional Court (GCC) and European institutions. Earlier this month, the GCC referred a decision on the legality of the ECB’s Outright Monetary Transactions (OMT) programme to the European Court of Justice (ECJ), with a strong opinion that in its current state (unlimited and targeted programme of bond buying) is illegal based on the ECB’s mandate. The referral could open up a can of worms as if the ECJ agrees with the GCC’s opinion, then it could force the Bundesbank to consider withdrawing from its partnership/subscription with the ECB – implying a German exit from the Euro. This is an extreme interpretation, and would only follow if the ECJ fully ruled against the ECB’s use of the OMT, and importantly, the ECB refused to back away from the programme. A far more likely outcome would be for the ECJ to acknowledge some of the points the GCC makes, and possibly to accept/recommend some limitations on the OMT in order to keep Germany happy.

This could risk resurrecting negative sentiment towards peripheral Europe, especially if investors start to believe that the ECB has no effective safety net at its disposal. However, given the market’s lack of response to the news, either investors are oblivious to the risks, or they continue to believe Mr Draghi’s commitment to do whatever it takes to save the Euro. In our view, the latter is more likely, and we too believe that the ECB could introduce new programmes to side-step a GCC/ECJ ruling if market conditions were to worsen. In any case, with both Spanish and Italian 10-year government bond yields falling below 3.5% this month, investors seem much more relaxed about peripheral government debt than last year.

UK forecast update

The forecast for UK real GDP growth has been revised up slightly from 2.4% to 2.6% in 2014, and from 1.9% to 2.1% for 2015 (see chart 9 on next page). This is partly driven by better than forecast results for the end of 2013, but also the pick up in business investment, which should continue in the coming quarters. We continue to forecast a slowdown from the recent peak in quarterly growth, and are very sceptical of the Bank of England’s 3.4-3.8% 2014 GDP forecast.





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Our UK growth forecast has been upgraded, while inflation forecast downgraded

The debate on when UK interest rates will rise is intensifying, with some calling for early 2015

Chart 9: UK GDP forecast Chart 10: UK CPI forecast

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Inflation on the other hand has been surprising to the downside. The annual rate of CPI inflation fell to 1.9% in January, which was the first fall below the BoE’s central 2% inflation target since November 2009. Like in the rest of Europe, lower fuel and food price inflation has pushed headline inflation lower. However, a major factor behind the lower inflation at the end of 2013 compared to our November forecast was the smaller than previously announced increases in home energy prices. Under pressure from the opposition, the government has temporarily reduced green energy levies on energy providers, which in turn have passed on the savings. Looking ahead, inflation should fall further in coming months before rebounding in the second half of the year as base effects begin to reverse.

As for interest rates, we continue to forecast no change until the start of 2016, which is predicated on GDP growth disappointing the BoE in the coming year. Our forecast assumes fiscal tightening resumes after the May 2015 general election (which has generally been absent this year), while the powerful Help-to-Buy housing scheme is also expected to expire at the same time.

The Bank backed away from its previous 7% unemployment threshold, but instead confused most with a wide array of indicators that it will now comment on. We support the holistic approach the Bank is emphasising, but the ongoing commentary is unhelpful, especially in trying to judge the degree of spare capacity in the economy. See the Schroders Quickview: BoE bamboozles with changes to forward guidance. The risk to our forecast is that the Bank hikes rates earlier rather than later. In recent press interviews, Monetary Policy Committee member Martin Weale said that “…the first rise will come perhaps in the spring of next year.” It is worth pointing out that Weale is one of the more hawkish members of the committee, but nevertheless, it highlights the risk of an earlier rise in interest rates.





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We expect lower EM growth on tighter monetary policy

China has had a troubled start this year Investment and exports are likely to be softer

BRICs: Central banks must be cruel to be kind

This forecast update sees a round of downgrades for emerging market growth, as central banks are forced to tighten more than anticipated, partly as a consequence of earlier than expected QE tapering. On top of this there are also growth negative country specific issues to be concerned with. Commodity prices offer some relief on inflation, but supply side constraints will continue to exert upward pressure on prices in many EM economies. Table 2: Summary of BRIC forecasts

% per annum

GDP Inflation

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China 7.8 7.7 7.1 ↓ 7.3 ↓ 2.6 2.6 2.7 ↑ 2.9 ↓

Brazil 0.9 2.3 1.8 ↓ 2.2 ↓ 5.4 6.2 6.3 ↑ 5.8 ↑

India* 5.1 4.7 5.0 ↓ 5.5 ↓ 9.7 10.1 7.1 ↓ 6.1 ↓

Russia 3.4 1.3 1.8 ↓ 2.4 ↓ 5.1 6.8 6.3 ↑ 5.8 ↓

*In this Viewpoint, we have switched to forecasting CPI, instead of WPI as previously for India, following a change in stance by the central bank. Source: Bloomberg, Thomson Datastream, Schroders. 24 February 2014. Previous forecast from November 2013. Please note the forecast warning at the back of the document.

China: Colic in the year of the horse

2014 has started with unpromising data for China, The HSBC manufacturing PMI slipped into contractionary territory in January, and continued its decline in February. There are also signs that the housing market, a key support of growth in recent years, is cooling, with fewer cities reporting price rises. The only positive piece of data has been stronger than expected export growth, but this figure is likely distorted by the New Year holiday, and we expected a much weaker print in February. The government has reportedly also lowered its export growth target for this year, to 7.4% from the 7.9% achieved last year.

Meanwhile, this also looks likely to be a very testing year for the authorities on the financial front. Two high profile trust product defaults have already occurred this year, and over 5000 trust products will mature at some point over 2014, far more than in previous years and at a time of tightening monetary conditions. The government faces a difficult balancing act: it wants to reduce moral hazard in the system, which means private investors must bear losses in event of default, but it does not want to spark a run on the financial system. A gradual approach seems likely; the defaults this year have seen investors forced to take small losses, compared to full reimbursement in previous years. Still, some impact on sentiment and investment is unavoidable.

With both exports and investment looking weaker, and no sign of a significant pick up in consumption, it is difficult to see where growth will come from (chart 11 on next page). Consequently, we have reduced our growth forecast for China from 7.3% to 7.1% this year, retaining our path of a small bounce in 2015 as growth friendly reforms come into effect. Though growth could temporarily dip below 7% this year, we believe this would prompt government stimulus to keep the economy above the 7% level. This need not take the form of credit stimulus, which would only worsen existing problems of excess capacity and leveraging. Lower interest rates (reducing servicing costs for embattled corporates) and a direct fiscal stimulus package comprised of tax cuts and outright expenditures seem likely to be a more effective mix.





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Monetary policy is free to focus on finance rather than inflation

Chart 11: Net exports have dragged on Chinese growth

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Inflation should remain well below the 3.5% target this year, helped by lower commodity prices, particularly oil and food, and the prevailing tighter monetary conditions in China. Recent prints have been subdued, at 2.5% (chart 12), reportedly driven in part by the effect of the anti-corruption drive on luxury foods. Producer prices remain in deflationary territory in a sign of continued overcapacity issues. In any event, monetary policy will likely remain focused on controlling the financial system this year, so even though lower inflation provides scope for easing, don’t expect it unless the economy looks set to miss its growth target, due to be announced in March. A financial crisis is the biggest risk to Chinese growth, and the authorities are determined to squeeze the shadow financing system to a more manageable size. Expect maintenance of a tight stance this year.

Chart 12: Chinese inflation pressures remain subdued

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Source: Thomson Datastream, Schroders. 25 February 2014.





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Brazil’s problems multiply, with weakness on most fronts

Fiscal and inflation issues key politically The new inflation targeting approach ensures tight policy

Brazil: Inflation gets political

Brazil’s growth number has been downgraded to 1.8% from 2.0% largely on tighter monetary policy aimed at controlling inflation, though events in Argentina and a recent drought will also have an impact. Activity data so far this year has not been encouraging. Though we have seen improvement in the manufacturing PMI, the services PMI, industrial production growth, and the central bank’s economic activity index are all showing signs of weakness (chart 13).

Chart 13: Bleakness in Brazil

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Politics continues to play a key role with elections in October. The latest poll showed a declining approval rate for Rousseff’s government, down from the 43.0% recorded in December. There are signs both that the electorate cares more about inflation and the cost of living than growth, and also that the government recognises this. Both the central bank and government officials have been taking a more hawkish stance, and inflation has been gradually pushed down, though at the cost of lower growth. Fiscal policy is now more supportive of the monetary stance, with spending cuts announced in the latest budget. Though this is as much to forestall a ratings downgrade as it is to address inflation, it reflects a welcome if belated change of stance from the government.

Inflation itself has begun to respond to tighter monetary policy, with 250 basis points of hikes now since April last year. Nonetheless, interest rate hikes can only do so much to contain inflation in an economy with supply side problems, and Brazil will need investment to resolve its inflation problem in the long run, and as we have said in past Viewpoints, there seems little prospect of an investment recovery until after October’s elections. The recent drought is also likely to cause higher food and electricity prices in the coming months. We expect monetary policy to remain tight this year, as the central bank continues attempts to anchor expectations and re-establish credibility.

India: Growth’s not in the bank

India’s economy has been picking up recently, and higher growth this year seems assured. Exports have responded well to the weaker rupee, which is now broadly stable, while imports have contracted on restrictions and demand suppression. Governor Rajan is seeing the first signs of success in his campaign against inflation, having hiked rates again in January, to 8% (chart 14). However, this tighter monetary policy seems likely to have a negative impact on economic growth. Rajan,





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Political concerns are clouding the growth outlook

who wants to focus on CPI inflation in the future instead of WPI (producer prices), believes that at present there is no negative growth-inflation trade off because inflation is so high it is reducing real incomes and confidence. While that may be true, it will still take time to hit the mooted target of 4% (+/- 2% to allow for supply side shocks), and the transition period is likely to see subdued domestic demand. Growth last year was also helped by a stronger harvest induced by better weather conditions, and there is a risk of the El Nino weather pattern having the opposite effect this year. Finally, the banking system remains strained, and India’s high corporate leverage combined with poor provisioning could see slow credit growth acting as a drag on GDP this year.

Chart 14: India’s tightening is beginning to work

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Bank rate CPI (rhs) Source: Thomson Datastream, Schroders. 27 February 2014

Opinion polls continue to point to a BJP victory in May’s elections, under Narenda Modi, and we still see this as a positive outcome given Modi’s success in Gujarat. However, we are concerned that voters remain easily swayed by populist policy and subsidies, as exemplified by the success of the AAP (Common Man Party) in New Delhi which offered free water and electricity to the poor. We had thought voters would have appetite for change after years of poor progress under this model, and must now reassess our view. The risk of a “Third Front” government (an alliance of smaller parties) can not be discounted, and if realised would likely see a less effective and more unstable government. The increased political uncertainty and challenges to domestic demand mentioned above have caused us to downgrade our growth expectations for India this year, though we still think investment will pick up after the elections.

On inflation, eagle eyed and eidetic readers may notice a considerable change in our inflation numbers. As mentioned above, this is due to Rajan’s preference for targeting the CPI and the likely formalisation of this position post-election (formation of an MPC and the creation of an official CPI target requires legislation). CPI, like WPI, has been elevated in recent years, but we think the tighter monetary policy from the RBI will remain in place this year, and succeed in gradually pushing inflation down toward the target range towards the end of 2015.





14

Still no hope of monetary easing despite stagnant growth

Russia: Reform required

Data suggests that Russia slowed coming into 2014, with industrial production falling, retail sales growth slowing, and no change in agricultural output. PMI data is similarly uncheerful. Although this slowdown has at least been accompanied by a moderation of inflation, from 6.5% in December to 6.1% in January, the ruble has depreciated around 8% against the dollar so far this year, which will provide a fresh inflation impulse to the economy. There is therefore little hope for a rate cut to support growth. If anything, the bank’s stance is becoming more hawkish; in its most recent statement it said it would tighten policy if the weaker currency impacted on inflation. It looks like more of the same low growth, high inflation scenario for Russia.

Russia’s problem, similar to Brazil’s, is a lack of investment leading to supply side constraints and poor productivity. Fixed investment fell 7% in January and has been weak in Russia for some time. Consumption, the previous driver of growth, is still relatively strong, but is now beginning to simply boost imports rather than domestic growth. Meanwhile, oil prices will likely remain soft this year, hitting Russia’s current account and exchange rate. How does this get turned around? We don’t know if it will. At least one driver for the lower investment is undeniably a host of governance issues which have been recognised for some time, but not addressed. Reforms are badly needed.

Absent reforms or investment, we see inflation persisting at elevated levels, though tightening should feed through later this year and into 2015. Lower commodity prices could help, particularly in agriculture (chart 15) but falling oil prices will likely be mitigated by a depreciating rouble.

Chart 15: Inflation remains elevated despite relief from food prices

0

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2010 2011 2012 2013 2014

y/y, %

CPI inflation CPI core inflation CPI food inflation

Source: Thomson Datastream, Schroders. 27 February 2014.





15

Schroder Economics Group: Views at a glance

Macro summary – February 2014

Key points

Baseline

World economy on track for modest recovery as monetary stimulus feeds through and fiscal headwinds fade in 2014. Inflation to remain well contained.

Recent upswing driven by lower inflation supporting real incomes and consumption, the manufacturing inventory cycle and, in the US and UK, reviving housing markets.

US economy still faces fiscal headwind, but gradually normalising as banks return to health and private sector de-leverages. Fed to complete tapering of asset purchases by October 2014, possibly earlier, with the first rate rise expected in the third quarter of 2015.

UK recovery risks skewed to upside as government stimulates housing demand, but significant economic slack should limit any tightening of monetary policy. No rate rises 2014 or 2015.

Eurozone recovery becomes more established as fiscal austerity and credit conditions ease in 2014. Low inflation likely to prompt ECB to cut rates in coming months, otherwise on hold from then on through 2015. More LTRO’s likely in 2014.

"Abenomics" achieving good results so far, but Japan faces significant challenges to eliminate deflation and repair its fiscal position. Bank of Japan to step up asset purchases to offset consumption tax hikes in 2014 and 2015. Risk of significantly weaker JPY.

US leading Japan and Europe. De-synchronised cycle implies divergence in monetary policy with the Fed eventually tightening ahead of others and a stronger USD.

Tighter monetary policy weighs on emerging economies. Region to benefit from current cyclical upswing, but China growth downshifting as past tailwinds (strong external demand, weak USD and falling global rates) go into reverse, and the authorities seek to deleverage the economy. Deflationary for world economy, especially commodity producers (e.g. Latin America).

Risks

Risks are still skewed towards deflation, but are more balanced than in the past. Principal downside risk is a China financial crisis triggered by defaults in the shadow banking system. Upside risk is a return to animal spirits and a G7 boom (see page 17 for details).

Chart: World GDP forecast

4.8

2.42.8

3.6

4.84.4

4.9 5.0

2.2

-0.9

4.1

3.1

2.02.6

3.0 3.1

-3

-2

-1

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00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Contributions to World GDP growth (%, y/y)

US Europe Japan Rest of advanced

BRICS Rest of emerging World

Forecast






16

Schroders Baseline Forecast

Real GDP

y/y% Wt (%) 2013 2014 Prev. Consensus 2015 Prev. Consensus

World 100 2.6 3.0 (3.0) 3.0 3.1 (3.1) 3.2

Advanced* 64.0 1.3 2.1 (2.1) 2.1 2.2 (2.1) 2.2

US 24.0 1.9 3.0 (3.0) 2.9 3.0 (3.0) 3.0

Eurozone 18.7 -0.4 1.1 (1.1) 1.0 1.4 (1.4) 1.4

Germany 5.2 0.5 1.9 (2.1) 1.8 2.2 (2.3) 2.0

UK 3.7 1.9 2.6 (2.4) 2.7 2.1 (1.9) 2.4

Japan 9.1 1.6 1.4 (1.3) 1.6 1.3 (0.9) 1.3

Total Emerging** 36.0 4.9 4.5 (4.7) 4.6 4.7 (4.9) 5.0

BRICs 22.2 5.5 5.3 (5.5) 5.5 5.6 (5.9) 5.7

China 12.8 7.7 7.1 (7.3) 7.5 7.3 (7.5) 7.3

Inflation CPI

y/y% Wt (%) 2013 2014 Prev. Consensus 2015 Prev. Consensus

World 100 2.7 2.8 (2.7) 3.0 2.8 (2.8) 3.0

Advanced* 64.0 1.4 1.4 (1.5) 1.6 1.5 (1.6) 1.8

US 24.0 1.5 1.5 (1.5) 1.6 1.4 (1.5) 1.9

Eurozone 18.7 1.4 0.8 (1.0) 1.0 1.2 (1.5) 1.4

Germany 5.2 1.6 1.3 (1.5) 1.5 1.7 (1.9) 1.9

UK 3.7 2.6 2.3 (2.9) 2.2 2.7 (3.0) 2.3

Japan 9.1 0.1 1.9 (1.9) 2.4 1.5 (1.4) 1.7

Total Emerging** 36.0 5.2 5.3 (4.8) 5.5 5.1 (4.9) 5.2

BRICs 22.2 4.7 4.3 (4.0) 4.7 4.1 (4.1) 4.5

China 12.8 2.6 2.7 (2.6) 3.1 2.9 (3.0) 3.2

Interest rates

% (Month of Dec) Current 2013 2014 Prev. Market 2015 Prev. Market

US 0.25 0.25 0.25 (0.25) 0.32 0.50 (0.50) 0.96

UK 0.50 0.50 0.50 (0.50) 0.74 0.50 (0.50) 1.52

Eurozone 0.25 0.25 0.10 (0.25) 0.25 0.10 (0.25) 0.45

Japan 0.10 0.10 0.10 (0.10) 0.21 0.10 (0.10) 0.23

China 6.00 6.00 6.00 (6.00) - 6.00 (6.00) -

Other monetary policy

(Over year or by Dec) Current 2013 2014 Prev. 2015 Prev.

US QE ($Bn) 2864 4033 4443 - 4443 -

UK QE (£Bn) 325 375 375 (375) 375 (375)

Eurozone LTRO NO YES YES YES YES YES

China RRR (%) 20.00 20.00 20.00 20.00 20.00 20.00

Key variables

FX Current 2013 2014 Prev. Y/Y(%) 2015 Prev. Y/Y(%)

USD/GBP 1.67 1.61 1.63 (1.58) 1.2 1.55 (1.50) 1.2

USD/EUR 1.38 1.34 1.34 (1.32) 0.0 1.27 (1.25) 0.0

JPY/USD 102.2 100.0 110.0 (110) 10.0 120.0 (120) 10.0

GBP/EUR 0.82 0.83 0.82 (0.84) -1.2 0.82 (0.83) -1.2

RMB/USD 6.08 6.10 6.00 (6.00) -1.6 5.95 (5.95) -1.6

Commodities

Brent Crude 110.9 109.0 107.6 (104) -1.3 102.7 (99) -1.3

Consensus inflation numbers for Emerging Markets is for end of period, and is not directly comparable.

Previous forecast refers to November 2013

Croatia, Latvia, Lithuania.

Source: Schroders, Thomson Datastream, Consensus Economics, February 2014

Market data as at 19/02/2014

* Advanced markets: Australia, Canada, Denmark, Euro area, Israel, Japan, New Zealand, Singapore, Sw eden, Sw itzerland,

Sw eden, Sw itzerland, United Kingdom, United States.

** Emerging markets : 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,





Schroders Forecast Scenarios

Scenario Summary Macro impact Probability* Growth Inflation

Baseline Our updated forecasts continue to paint a picture of recovery in the world

economy, led by the developed world. Forecasts for the latter are unchanged

this month, but we have edged down our forecasts for the emerging markets

once again. In the near term this is consistent with the latest Purchasing

Managers' Indices (PMI’s) which show the BRIC nations struggling to gain

traction whilst the developed remain firmly in expansion territory. Looking

further out, our EM downgrade is in response to the tightening of monetary

policy and a range of country specific issues. Inflation is expected to remain

stable and our forecasts are unchanged as a cut in the DM forecast is offset

by an increase in the EM.

Global growth is forecast to pick up to 3% in 2014 led by the US. After declerating in

2013, emerging markets are expected to stabilise, but still record a year of relatively

subdued growth by past standards. Weaker commodity prices and a reduced fiscal

headwind help support activity in the developed world which began to strengthen in the

second half of 2013. The exception is Japan where higher taxes are expected to slow

growth in 2014. Despite the pick-up in global activity, inflation is expected to remain

quiescent reflecting spare capacity in the world economy.

70% - -

1. Eurozone

deflation

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 expectations that prices will fall further.

The rise in savings rates deepens the downturn in demand and prices, thus re-

inforcing the fall in inflation expectations.

Deflationary: weaker growth and lower inflation, which persists throughout the forecast.

As a significant part of the world economy, Eurozone weakness drags on activity

elsewhere, while some of the defaltionary 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.

5% -0.3% -0.4%

2. G7 boom US 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 accelerate. Europe and Japan benefit from stronger

demand which helps boost spending further through greater capex and

confidence.

Reflationary: stronger growth and moderately higher inflation vs. baseline. Stronger US

growth increases pressure on the Fed to unwind QE and bring forward interest rate

increases. Central banks elsewhere also experience pressure to tighten resulting in

higher rates globally. 10% +0.5% +0.5%

3. Trade war The dispute between China and Japan over the 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 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. 3% -0.5% +0.4%

4. Abenomics2 After some initial success at boosting growth and inflation through the fall in

the JPY, activity in Japan moderates and then slumps as the consumption

tax is raised. In response the BoJ steps up asset purchases aggresively,

driving the JPY to 130. Competitors complain at the further devaluation of the

JPY and react by raising tarrif barriers.

Deflationary: slower growth in Japan is transmitted abroad through the devaluation of the

JPY as competitors lose market share to Japanese firms. Primarily deflationary, toward

the end of the period the subsequent increase in tariffs will push up import prices and

CPI, reducing real incomes and demand, so taking the world economy in a more

stagflationary direction.

4% -0.3% -0.3%

5. China financial

crisis + Fragile 5

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. The negative sentiment in

markets spreads to other emerging markets, causing a dominoe effect of

defaults in the Fragile 5.

Deflationary: global growth slows as China demand weakens with commodity producers

hit hardest. Pressure builds on the weaker EM countries (Fragile 5) resulting in futher

currency weakness and higer interest rates. However, the fall in commodity prices will

push down inflation to the benefit of consumers. Developed market monetary policy is

likely to ease/ stay on hold while the deflationary shock works through the world

economy.

6% -0.8% -0.5%

8. Other 2% - -*Scenario probabilities are based on mutually exclusive scenarios.

Global vs. 2014 baseline

28 February 2014 For professional investors only For professional investors only




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

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USUK

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Chart B: Inflation consensus forecasts

2014 2015

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Source: Consensus Economics (February 2014), Schroders Pacific ex. Japan: Australia, Hong Kong, New Zealand, Singapore Emerging Asia: China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan, Thailand Emerging markets: China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan, Thailand, Argentina, Brazil, Colombia, Chile, Mexico, Peru, Venezuela, South Africa, Czech Republic, Hungary, Poland, Romania, Russia, Turkey, Ukraine, Bulgaria, Croatia, Estonia, Latvia, Lithuania

This document contains forward looking forecasts which by their nature are inherently predictive, and involve risk and uncertainty. While due care has been used in the preparation of forecast information, actual results may vary considerably. Accordingly readers are cautioned not to place undue reliance on these forecasts. The views and opinions contained herein are those of Schroder Investments Management's Economics team, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document does not constitute an offer to sell or any solicitation of any offer to buy securities or any other instrument described in this document. The information and opinions contained in this document have been obtained from sources we consider to be reliable. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. For your security, communications may be taped or monitored.

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