Prof. Trevor WilliamsUniversity of Derby & Chair of the IEA’s Shadow MonetaryPolicy Committee (SMPC)

Economic UpdatePolicy implications, risks & opportunities

WORLD FORECAST SUMMARY• Four factors dominate the outlook for 2016:

– The start to the normalisation of US – 2 interest rate hikes expected in 2016 (one as soon as this month?)– The greater-than-expected weakness of the Chinese economy, with possible policy reversals– The continued fall in commodity prices and persistence of low inflation(the last two are inter-connected)– Financial market volatility – rise in ‘high yield’ corporate bonds yields suggest a slowdown

• US recovery is robust, with consumer spending taking the lead. Eurozone outlook improving, with the Greek issue on the backburner, for now. Japan is at risk from Chinese easing. UK growing 0.4% to 0.1% a quarter?

• The growth divergence between advanced and emerging economies remains, but has narrowed.

• Decline in oil and other commodity prices is a positive for advanced economies, and some developing, but significant losers as well, like Russia, Brazil, South Africa.

• Low inflation is continuing into 2016, meaning a slow rise in global interest rates. Major central bank money creation will remain supportive of growth but could be distorting financial market behaviour and pricing.

• Potential for volatility has increased (currency, equities, bonds), threatening revival of world trade as everyone seeks export-led growth. £, Euro to fall further v $, as UK holds rates, ECB eases and US tightens.

• Debt levels amongst advanced economies in particular remain high, but China may also be a concern.

EURO HIGHLIGHTS• Accordingly, GDP growth is likely to slow in Q2. That

said, the 0.3% rise we have penciled in still suggests some underlying improvement in the pace of growth in the first half of this year.

• Looking further ahead, the ongoing labour market recovery and a modest pick-up in wage growth should ensure that household spending growth holds up reasonably well even as inflation begins to rise. Meanwhile, the ongoing strength of credit to firms, rising capacity utilisation and profit growth all suggest that the modest investment recovery will continue and perhaps build some steam.

• The upshot is that GDP forecasts for 2016 are for around 1.6% growth and there could be a modest acceleration to 1.7% in 2017. This, combined with a pick-up in CPI inflation to 1.5% next year, should be enough to ensure that the ECB unveils no further major policy support measures.

• Although Q1’s increase of 0.6% in Eurozone growth was stronger than the consensus expectation, it was in line with the estimate from our GDP indicator and only a fraction above the estimate in our April release. No breakdown is yet available, but the indications are that household spending and domestic demand remained strong.

• Not only was Q1’s quarterly rise in Eurozone GDP of 0.6% the strongest since Q1 2015, it also exceeded the US and UK growth rates over the same period.

• Admittedly, Q1’s GDP outturn is likely to have overstated the underlying pace of growth in the early stages of the year. The business surveys such as the composite PMI are consistent with the solid but unspectacular growth rates recorded in H2 last year. And the healthy rise in industrial production appears at odds with the ongoing weakness in the external sector. Meanwhile construction may have benefitted from a weather-related boost.

Probability

Greece: still cannot meet its debts and may yet need another write-down

Middle East / Ukraine: Crisis escalation?

Euro Area: Stagnation and entrenched disinflation – Europe still not met its

challenge of structural reform

China: Bumpy transition to consumption-led growth

Emerging Markets: Rising contagion from China and Fed U.S.: volatility as Fed tightens ?

Top 6 risks for the global economy

GLOBAL BACKDROP

GLOBAL GROWTH IS STRUGGLING

1

0

1

2

3

4

5

1990 1995 2000 2005 2010

Germany

Japan

United Kingdom

United States

0

1

2

3

4

5

6

7

8

9

1996–98 2002–04 2006–07 2011–12 2015–20

Emerging Market Economies

Mature Market Economies

Potential Output is falling

percent change oya, period averages

Source: IMF*, IIF.*Data from figures 3.3, 3.7, 3.9, 3.11 in April 2015 WEO

Labor productivity in mature countries is falling

percent y/y, 5-year moving average

Source: OECD, IIF.

AS EVIDENCED BY THE DATA…

0

1

2

3

4

5

6

7

World EM EM exChina

US Japan Eurozone

2000-07

2010-17F

World GDP, % increase in year

Growth is much less dynamicthan before the global financialcrisis. US growth in 2010 17 isexpected to average only around2% per year, with growth in theEurozone and Japan at around1%. With emerging marketgrowth also slower, world growthappears stuck at modest rates of2 2.5% per year. Where is the

global engine?

Source: OEF

…TRADE GROWTH IN THE DOLDRUMS…World GDP, % increase in year

International tradehas collapsed, andGDP is unlikely torecover until itdoes. Tradeopening may havea bad name atpresent but it iswhat has boostedglobal growth.

-20

-15

-10

-5

0

5

10

15

20

2000 2005 2010 2015 2020

GDP Trade% year

Forecast

Source: OEF

…WHICH SUGGEST THAT RECESSION RISK IS HIGH…World GDP, % increase in year

This weaknessheightens the risk thateconomic, financial orpolitical shocks couldpush the worldtowards recession

0

0

0

0

0

0

0

0

0

0

1

0

1

2

3

4

5

1990 1993 1995 1998 2001 2003 2006 2009 2011 2014

World recessions

Source: OEF

BUT RECOVERY IS UNDERWAY…

Source: International Monetary Fund /Haver AnalyticsInternational data sourced from Bloomberg; UK forecast sourced from LBCB

G7

Emerging & Developing Economies

Euro Area

1817161514131211100908

10.0

7.5

5.0

2.5

0.0

2.5

5.0

GDP, Constant Prices (annual % change)

Forecasts

THOUGH IT HAS TURNED OUTWEAKER EACH YEAR…

0

1

2

3

4

5

6

7

8

World Advanced economies Emerging market economies

Fall 2011 Fall 2012

Fall 2013 Fall 2014

Source: IIF

…THE GLOBAL ECONOMY HAS GOT A LOT BIGGER…Global GDP, US$ nominal 2015 prices, trillions

Since 1947,Global GDP growthhas increased1,000%, and billionslifted out of poverty.Between 1st centuryAD and 1913, globalGDP only doubled

Source: TFW research

…DRIVEN BY A HUGE INCREASE IN GLOBAL CONSUMPTION…Global consumption US$ PPP, 2010 prices, trillions

Source: TFW research

0

10

20

30

40

50

60

1980 1990 2000 2010 2015 2020 2025

GlobalUSEUEM

…AS GROWTH REFLECTS POPULATION SHARES…Global population, in billions

Source: TFW research

0

1

2

3

4

5

6

7

8

9

1980 1990 2000 2010 2015 2020 2025

GlobalUSEUEM

…GLOBAL INCOMES RISING AS POVERTY FALLS…Change in terms of share of global population the world is getting wealthier, richer

Source: Lloyds Bank

0

10

20

30

40

50

60

High income Upper middle income Middle income Low income Poor

2001

2011

…STEMMING FROM THE APPLICATION OF MARKET POLICIES

The index published in Economic Freedom of the World (157) countries measures the degree to which the policies and institutions of countries are supportive of economic freedom. The cornerstones of economic freedom are personal choice, voluntary exchange, freedom to enter markets and compete, and security of the person and privately owned property. Forty-two data points are used to construct a summary index and to measure the degree of economic freedom in five broad areas:

1. size of government: expenditures, taxes, and enterprises; 2. legal structure and security of property rights;

3. access to sound money; 4. freedom to trade internationally; and

5. regulation of credit, labour, and business.

Top-rated countries:Hong Kong and Singapore, once again, occupy the top two positions. The other nations in the top 10 are New Zealand, Switzerland, United Arab Emirates, Mauritius, Jordan, Ireland, Canada, and the United Kingdom.

Other major countries:The rankings of some other major countries are the United States (16th), Japan (26th), Germany (29th), South Korea (39th), Italy (68th), France (70th), Mexico (93st), Russia (99th), China (111th), India (114th), and Brazil (118th).

Lowest-rated countries:The 10 lowest-rated countries are: Angola, Central African Republic, Zimbabwe, Algeria, Argentina, Syria, Chad, Libya, the Republic of Congo, and, in last place, Venezuela.

Economic freedom and human progressNations that are economically free out-perform non-free nations in indicators of well-being.Nations in the top quartile of economic freedom had an average per-capita GDP of $38,601 in 2013, compared to $6,986 for bottom quartile nations (2013, PPP constant 2011 US$) (exhibit 1.6).In the top quartile, the average income of the poorest 10% was $9,881, compared to $1,629 in the bottom quartile in 2013 (2013 PPP constant 2011 US$) (exhibit 1.9). Interestingly, the average income of the poorest 10% in the most economically free nations is about 50% greater than the overall average income in the least free nations.Life expectancy is 80.1 years in the top quartile compared to 63.1 years in the bottom quartile.

….THE IMPACT OF THE 3RD Industrial revolution…

The inventions of IR2 were so far-reaching that they took 100 years to have their full effect. IR3 same?

At the moment, digital methods and cost saving activities operate alongside traditional methods. Only once they replace them, will we see the full benefits.

Full implementation of new information technology awaits effective and reliable voice recognition and translation software.

Many of the benefits influence quality, timeliness, convenience, and affect leisure.

We cannot imagine the future.

AND GLOBALISATION…

Over the last three hundred years, advances came mainly from Europe and North America. Now the whole world is involved.

The internet, and computer technology, make research easier and quicker.

Global trade linkages means that advances can be disseminated more quickly.

Information is available to all with access, so the differentiator is how you use and interpret it. Information does not equal knowledge. So invest in the latter.

Future use is limited only by imagination.

Financial market trends

FINANCIAL MARKETS CORRECT…World equity Index, rebased to 1st August 2014=100

Source: IIF

…AS VALUEWAS RESTORED IN SOMEMARKETSForward PE ratios, 12m suggests suggests further falls in some markets

Source: IIF

CURRENCY DEPRECIATONS V DOLLAR PERSISTEM currencies, by region

Source: IIF

COMMODITY PRICE FALLS PERSIST….Commodity prices continue to fall

Source: IIF

-20-15-10-505

1015

WTI

Bren

tPa

llad

ium

Nic

kel

Iron

Whe

at

Cop

per

Alu

min

um Soy

Cor

nPl

atin

um Zinc

Silv

erG

old

AgriculturePrecious metalsBase MetalEnergy

percent change since end-2015

1.8

2.0

2.2

2.4

2.6

2.8

3.0

3.2

2030405060708090

100110120

Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Jul 15 Jan 16

Brent oilU.S. breakeven inflation rate (rhs)

$ per barrel percent, 5d mavUS,5y5y breakeven inflation rate v Brent

…PUTTING PROFIT MARGINS UNDER PRESSURE…

Source: Datastream, IIF.

…AT A TIME NON FINANCIAL CORPORATE DEBT IS HIGH

Source: IIF

BIS IS WARNING ABOUT CONTINUED HIGH DEBT LEVELSMature Markets: Sectoral Indebtedness

percent of GDP

Source: BIS, Haver, IIF Emerging Market Debt Monitor.

Emerging Markets: Sectoral Indebtedness

percent of GDP

Source: BIS, IIF Emerging Market Debt Monitor.

50

60

70

80

90

100

110

120

130

140

150

1995 2000 2005 2010 2015

HouseholdsNon-fin corporatesGovernmentFinancial Corporates

0

10

20

30

40

50

60

70

80

90

1995 2000 2005 2010 2015

HouseholdsNon-fin corporatesGovernmentFinancial Corporates

PUBLIC AND PRIVATE DEBT OVERHANG PERSISTS IN EUTotal debt by segment of the economy, % GDP

Source: RBS Credit Strategy, OECD, Eurostat, ECB, Federal Reserve, Markit

0%

100%

200%

300%

400%

500%

600%

700%

800%

IE DK NL PT SE FR UK ES BE EA IT US FI AT GR DE SI

BanksCorporateHouseholdGovernment

BUT SOVEREIGN BOND YIELDS FALL FURTHER

Source: OECD, IIF.

POLICY RESPONSE

RATE EXPECTATIONS PUSHED OUT AS INFLATION SLOWS…G4 rate expectations

…THE NEGATIVE YIELD CLUB IS GROWING

Japan has joined the “club”of European countries withnegative interest rates,including the Eurozone,Denmark, Sweden andSwitzerland. All told, some $7trillion in government bonds

now have negative yields.

…fuelling concern about deflation, central banks etc.

Source: IIF

THE FASTEST GROWING ASSET CLASS IN EUROPE: NEGATIVE YIELD BONDS

Source: RBS Credit Strategy, Bloomberg

% of sovereign bonds with negative yields

0%

5%

10%

15%

20%

25%

30%

35%

40%

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar

THE NEGATIVE YIELD CLUBProportion of 2 30y bonds within the stated yield range by country

Source: RBS Credit Strategy, Bloomberg

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

FinlandGermanyHolland Austria Belg ium France Slovakia Ireland Lithuania Italy Spain Por tugal Greece

< -0.2% -0.2% to -0.1% -0.1% to 0.0% 0 to 0.1% 0.1 to 0.2% 0.2 to 1.0% 1.0%+

THE IMPACT OF NEGATIVE RATES: POSITIVE OR NEGATIVE?• In principle, cutting policy rates into negative territory should boost

growth and inflation. But central banks have not communicated these benefits clearly, raising the risk that negative rates do more harm than good.

• Although markets are rebounding, the sharp falls in equity prices and in particular bank shares since the beginning of the year have led many to claim that negative rates are damaging global economic prospects. Markets have focused on three main concerns:

• First, negative deposit rates impose a direct financial cost on banks, harming their profitability and thus their willingness to make new loans. These costs are largest in Switzerland, where the interest rate is most negative and applies to a large share of bank reserves.

• Even so, these costs do not appear to be huge. We estimate that negative policy rates in the four European economies that have applied them are costing the banking sector around €3bn a year. That is a trivial fraction of their assets and is not a game-changer for their profitability either. Moreover, central banks can reduce the share of reserves subject to negative rates – as the BoJ has promised to do – in order to alleviate these concerns.

• Instead, we suspect the larger problem for banks is the (further) decline in long term rates, which reduces their ability to generate profits from lending. However, the key point here is that the looser monetary policy is now, the sooner the economy should return to health, allowing interest rates to rise.

• The second fear is that the rush to impose negative policy rates is the latest front in a futile currency war. There is some truth to this argument as a weaker exchange rate is a key channel through which negative rates can operate. But there is little evidence that the major central banks are competing to weaken their currencies, and insofar as they are, the result will be looser global monetary policy which should be positive for global growth. Indeed, negative policy rates appear to have contributed to a reduction in borrowing costs for households and firms, as shown for the euro-zone.

• Perhaps the biggest worry though is that cuts to policy rates have added to the sense that the world economy is slowing sharply and that policymakers are running out of options. Policy loosening has fuelled, rather than soothed, market fears. Indeed it was striking that global bank stocks sold off sharply, partly in response to the decision by Sweden (share of world GDP: 0.4%) to cut policy rates to -0.5%.

• Central banks themselves are partly to blame for this response because they have repeatedly claimed that policy rates could not be lowered further, only to surprise the markets by cutting rates weeks later. Nonetheless, claims that monetary policy has reached its limits are exaggerated. After all, there is still plenty of scope for further quantitative easing.

• Overall, we still think that negative policy rates will prove effective in helping to lift growth and inflation. That said, if the latest market turmoil leads to a sustained tightening in financial conditions, the economic consequences could easily outweigh the benefits of slightly lower policy rates.

EU FOCUS

EURO AREA IS VULNERABLE BUT GROWTH LOOKING BETTER

Source: Haver.

diffusion index sa, 50+=expansion

40

42

44

46

48

50

52

54

56

58

60

2011 2012 2013 2014 2015 2016

Services

Manufacturing

Euro Area PMI: Manufacturing and ServicesEuro Area Big-4 GDP

Index, 2008-Q1=100

90

95

100

105

110

2008 2009 2010 2011 2012 2013 2014 2015

Germany

France

Italy

Spain

Source: IIF, Haver.

EURO AREA SENTIMENT SUGGESTS GROWTHWILL HOLD UP

Source: IIF, Haver.

-4

-3

-2

-1

0

1

2

2000 2003 2006 2009 2012 2015

GDP % q/q

GDP Indicator

% q/q

…AS DOES INVESTMENT AND CAPACITY TRENDS…

Source: IIF, Haver.

65

70

75

80

85

90

-15

-10

-5

0

5

10

1996 1999 2002 2005 2008 2011 2014

Investment % y/y

Capacity Ultilisation

% y/y

…SUPPORTED BY IMPROVED EMPLOYMENT TRENDS

Source: IIF, Haver.

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

-25

-20

-15

-10

-5

0

5

10

15

2004 2006 2008 2010 2012 2014 2016

Percent balance % quarter

Employment (RHS)

EC survey of employment

intentions (LHS)

2005 2007 2009 2011 2013 20156

7

8

9

10

11

12

13

-400

-200

0

200

400

600

800Thousands %Unemployment

rate (RHS)

Monthly change in the number of

unemployed (LHS)

• The recovery in employment has been an important driver of household spending since 2014and the outlook remains positive.

WHERE IS GROWTH COMING FROM?

Source: TFW

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

2013 2014 2015 2016

Net trade StockbuildingGovernment spending InvestmentHousehold spending GDP

Q1 2016 breakdown is a forecast only

A solid pace of domesticdemand in Q4 to have beenmaintained and for the dragfrom net trade to have

receded.

EURO RECOVERY NOW SURPASSES JAPAN’SQuarter 1(Jan to Mar) 2008 to Quarter 4 (Oct to Dec) 2015

Source: ONS

THE EURO DOLLAR REMAINS WEAK AS DRAGHI EXPANDS QE

Source: Datastream, IIF.

0

500

1000

1500

2000

2500

3000

3500

4000

4500

2008 2010 2012 2014 2016

Extra QE

CurrentPolicy

IIF Forecast

ECB Balance SheetUS$ versus Euro

Source: OEF

1.0

1.1

1.2

1.3

1.4

1.5

1.6

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

OE Forecast$/€

1.05 - 1.15 range

INFLATION EXPECTATIONS DROP BUT CORE RATE STABLE

Source: Bloomberg.

Euro Area Inflation Expectations%, 20d ma 5y/5y inflation swap

-1

0

1

2

3

2009 2011 2013 2015

Headline Core

Euro Area HICP Inflation% change, oya, core ex. energy, food, alcohol, tobacco

Source: Haver.

1,0

1,5

2,0

2,5

3,0

2011 2013 2015

LIMITED CONTAGION FROMGREECE?

Source: Haver, Datastream, IIF.

percent

-1

1

3

5

7

9

11

13

ago 13 feb 14 ago 14 feb 15 ago 15

Ireland

Spain

Greece

Italy

Portugal

10-Year Government Bond YieldsEconomic Sentiment Indicator

average 1990-2012=100

75

80

85

90

95

100

105

110

2010 2011 2012 2013 2014 2015

Greece

Euro Area

Source: European Commission.

ECBMONETARY TRANSMISSION ATWORK?“Draghi’s Dashboard”

1 (worst) - 5 (best)

1

2

3

4

5

2011 2012 2013 2014 2015 2016

Financial Variables

Real Economy

Inflation

Source: IIF. Last Observation: Jan. 2016.

EURO AREA BANK LOAN GROWTH CATCHES UP…Eurozone bank loan growth is positive

Source: OECD, IIF.

AND EURO AREA NON PERFORMING LOANS STABILISE

Source: OECD, IIF.

SUMMARY – EUROZONE ON SUSTAINABLE RECOVERY PATH?

Growth continues to strengthen in spite of adverse global conditions with Q1 GDP growthsurpassing the US and UK.

Exports should pick up in mid 2016 with the recovery in global demand and a weak Euro.

Further inflation weakness on oil prices, before being lifted by higher energy prices andlabour market recovery in 2017.

The consumption “sugar rush” further drives stronger activity in the services sector andemployment

Investment is on a solid recovery path with QE gaining traction, profits still rising and

improved capacity utilisation.