Economic Outlook - From Goldilocks to Reflation Schroders Investment Conference 2018, Manchester

Azad Zangana, Senior European Economist and Strategist 22 May 2018

#SICM18

@Schroders_UK

From Goldilocks to reflation

Latest economic themes and questions

Global: Moving from Goldilocks to reflation – can risk assets cope?

Trade wars: A serious risk for the global economy

UK: Navigating Brexit

Source: Schroders Economics Group.

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Global overview From Goldilocks to reflation – can risk assets cope?

Thinking about the business cycle How do we define the different stages of the economic cycle

Percentages refer to share of time in each stage of the cycle since 1974. Source: Schroders Economics Group.

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Expansion Output above trend and rising, growth accelerating, inflation rising

Slowdown / Stagflation Output above trend and falling, growth decelerating, inflation rising

Recession / Disinflation Output below trend and falling, growth decelerating, inflation falling

Recovery Output below trend and rising, growth accelerating, Inflation falling

40% 24% 20% 16%

Global growth has surged since 2016

4

Leading indicators for the G7 suggest a continued acceleration in growth

Source: Thomson Datastream, Schroders Economics Group. 4 May 2018.

-20

-15

-10

-5

0

5

10

15

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018Recovery Expansion/ Reflation Slowdown/ StagflationRecession/ Disinflation G7 Industrial production, % y/y Global activity indicator, 3mMA (normalised)

%, y/y

Inflation pressures are also building

5

Producer prices in the G7 and China suggest higher CPI inflation to follow

Source: Thomson Datastream, Schroders Economics Group. 4 May 2018.

-10

-8

-6

-4

-2

0

2

4

6

8

10

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Recovery Expansion/ Reflation Slowdown/ Stagflation Recession/ Disinflation G7 CPI G7 PPI China PPI

%, y/y

US fiscal stimulus set to boost GDP growth

6

Impact of Tax Cuts & Jobs Act (2017) and the Bipartisan Budget Act (2018)

Source: Oxford Economics, Congressional Budget Office, Schroders Economics Group. 2 March 2018. Forecast risk warning: Please see the information slide at the end of this presentation.

Impact on the budget deficit Impact on GDP growth

+0.4

+0.1

+0.2

+0.4

+0.3

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2016 2017 2018 2019 2020

Real GDP growth, %

Impact of lifting secquester caps Impact of BBAImpact of Tax Cuts & Jobs Act Underlying growth

0%

1%

2%

3%

4%

5%

6%

2016 2017 2018 2019 2020 2021 2022

Budget deficit (% of GDP)

Current lawNew spending bill (BBA, 2018)New spending bill without sequester caps

Has the recovery in the eurozone peaked?

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Some loss in momentum in the eurozone, but overall growth remains strong

Source: Thomson Datastream, Markit, Belgian National Bank, Eurostat, Schroders Economics Group. 4 May 2018.

-6%

-4%

-2%

0%

2%

4%

6%

-6%

-4%

-2%

0%

2%

4%

6%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Eurozone GDP growth, Y/Y Belgian National Bank survey (standardised) Markit PMI, EZ Composite (standardised)

Higher inflation means rising interest rates

8

Schroders interest rates forecast

Source: Thomson Datastream, Bloomberg, Schroders Economics Group. March 2018 forecast. 4 May 2018. Forecast risk warning: Please see the information slide at the end of this presentation.

-1

0

1

2

3

4

5

6

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019Fed BoE ECB Schroders' forecast OIS forward curve

Main policy interest rate (%)

Trade wars A serious risk for the global economy

Trade wars: US vs. China Limited impact from proposals so far

Source: Thomson Datastream, Schroders Economics Group. 4 April 2018

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Share of Chinese exports by destination Share of US exports by destination

4%

48%

17%

2%

19%

6% 4%

Africa Asia US US (tariff) Europe LatAm Other

48%

17%

2%

19%

6% 4% 4%

19%

2%

18%

26%

34%

China China (tariff) EU NAFTA RotW

19%

2%

18%

26%

34%

Spill over effects

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A trade war between the US and China will impact third parties

Source: OECD TiVA, Thomson Datastream, Schroders Economics Group. 6 April 2018. *Estimates based on 2011 data

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Chin

a

Taiw

an

Mal

aysi

a

Sing

apor

e

Kore

a

Chile

USA

Thai

land

Phili

ppin

es

Japa

n

Sout

h Af

rica

Aust

ralia

Viet

nam

Peru

Irel

and

Cana

da

Indo

nesi

a

Russ

ia

Ger

man

y

Finl

and

Isra

el

Aust

ria

Mex

ico

Colo

mbi

a

Hun

gary

Belg

ium

Net

herla

nds

Braz

il

Ital

y

UK

Indi

a

Fran

ce

Spai

n

Pola

nd

Turk

ey

Value added from Chinese exports to the US Value added from US exports to the China

% of GDP*

A wider trade war would be a disaster for EM growth

12

Many EM countries are highly leveraged to global trade

Source: Thomson Datastream, Schroders Economics Group. 6 April 2018

-60

-40

-20

0

20

40

60

80

-40

-30

-20

-10

0

10

20

30

40

05 06 07 08 09 10 11 12 13 14 15 16 17 18

EM export values MSCI EM EPS

%, y/y

0

10

20

30

40

50

60

70

80

90

HU

F

MYR

THB

TWD

PLN

KRW

MXN CL

P

ZAR

RUB

PEN

TRY

CNY

PHP

IDR

INR

COP

BRL

Exports % GDP

Are equities under threat?

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US equity P/E ratio suggests valuations are stretched

Data based on MSCI US index. Source: Thomson Datastream, Schroders Economics Group. 4 May 2018.

0

5

10

15

20

25

30

35

50 54 58 62 66 70 74 78 82 86 90 94 98 02 06 10 14 18

MSCI-US reported price-earnings ratio

Equities overvalued

Equities undervalued

1 SD=21.9

-1 SD=10.8

Avg. 16.4

Equities appear to be well supported by growth

14

Earnings growth has been the key driver of returns, but the market is derating

Global equities calculated by Datastream (7,048 stocks). Source: Thomson Datastream, Schroders Economics Group. 4 May 2018.

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

%, Y/Y

Dividend growth Rerating (change in P/E ratio) EPS growth Total returns

UK Coping with Brexit

Brexit negotiations to move to phase II A broad agreement reached on citizens’ rights, Northern Ireland and the divorce bill

Source: Schroders Economics Group. 4 May 2018.

The 8 December agreement on citizens’ rights, Northern Ireland and the divorce bill paves the way to begin phase II of negotiations, which will include a framework for trade.

Northern Ireland is not fully resolved yet, but a commitment to maintain the 1998 peace accord could lead to a softer Brexit, possibly EEA membership.

The UK still believes it can get a bespoke deal, with a full withdrawal from the single market and separate trade deal for tariff free access.

Some restrictions on migration are politically necessary for the UK, along with repatriation of power from the ECJ.

A 21-month transition period has been agreed, but the terms have not been finalised, and is subject to the Irish border solution.

GBP: the Brexit barometer

1.1

1.12

1.14

1.16

-15

-10

-5

0

5

Oct 17 Nov 17 Dec 17 Jan 18 Feb 18 Mar 18 Apr 18 May 18Google Trends: Soft - Hard Brexit GBP/EUR, rhs

16

That sinking feeling – the Brexit effect so far

17

The UK has slipped from top of the G7 growth league to bottom

Source: Thomson Datastream, Schroders Economics Group. 20 April 2018.

House prices continue to slow

18

Range of house price indices

Source: Thomson Datastream, ONS, Halifax, Nationwide, LSL/ACAD. Schroders Economics Group. 4 May 2018.

-20%

-15%

-10%

-5%

0%

5%

10%

15%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

House prices (Y/Y)

Range of houseprices Average of surveys

House prices (Y/Y)

Strong growth to continue to support risk assets

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Key questions

Source: Schroders Economics Group.

As the global economy moves from goldilocks to expansion, higher interest rates will challenge further gains in risk assets

Strong growth can support earnings further, but as bond yields rise further, equity valuations will put prices under pressure

The fiscal stimulus package in the US could be very powerful for growth

Europe has lost some momentum recently, but temporary factors are probably to blame

Brexit details have to be finalised by the Autumn, expect more volatility

The UK economy will continue to struggle, but will this stop the BoE?

Concerns over trade wars are likely to persist, and may dampen confidence and growth

If trade wars escalate, many third parties will be impacted

Emerging markets look healthy, but a strong US dollar could hurt risk assets

Thank you

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