29 June 2012

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Schroders

Economic and Strategy Viewpoint

Keith Wade
Forecast update: Growth fears rise, is QE the answer? (page 2) Business surveys indicate that the world economy is losing momentum again after a relatively bright start to the year. We attribute this to a fading inventory cycle which had rebounded after last years supply chain disruptions. The failure to resolve the Euro crisis may also be weighing on activity as the uncertainty causes companies to delay investment plans. Azad Zangana European Economist Markets are now looking to central banks to ease once more and boost risk appetite. More Quantitative easing is expected, however QE is doing little to (44-20)7658 2671 generate a sustained recovery. The obstacle, in our opinion, is a banking sector which is de-leveraging and prefers to put excess reserves in James Bilson government bonds rather than new loans. One solution would be to use QE to Economist buy assets off the banks thus speeding de-leveraging. (44-20)7658 3550 Looking at the conditions which signal that an economy has de-leveraged and can resume growth, the US is well ahead of the UK and Eurozone. Peripheral Europe has barely started. Chief Economist and Strategist (44-20)7658 6296 Europe forecast update: Greek exit postponed as Spain seeks help (page 6) The formation of a new Greek coalition government means that Greece is likely to remain in the Eurozone this year, though the risk of an exit has simply been pushed out to 2013. Spain has requested help to recapitalise its banking system. The EU has offered up to 100bn, though the final figure is expected to be lower. Funding will now come from the ESM directly to the banks, and there will be a new super national banking supervisor. In shifting the Greek exit to 2013, we have upgraded our forecast for 2012 growth, but downgraded 2013. We also now expect the ECB to cut interest rates to 0.75% in July, followed by more LTROs. UK: U-turns all round as economy weakens (page 8) The Bank of England appears ready to restart QE in the UK after admitting that their forecast from May was too optimistic. We expect 50bn to be announced in July, with another 25bn in November. Meanwhile, the Chancellor was performing his own U-turns, as he reverses a series of tax increases, and thinks of more ways to avoid admitting he has moved on from plan A. Credit easing is set to be expanded through the BoE, with the Bank also providing new emergency liquidity. Chart: Commodity cycle signals weaker activity
y/y, % 15 10 5 0 -5 -10 1980 y/y, % 150 100 50 0 -50 -100

1984 1988 1992 1996 2000 2004 2008 2012 G7 Industrial Production (lhs) S&P GSCI Industrial Metals Spot (rhs) Source: Thomson Datastream, Schroders. Updated: 28th June 2012
Issued in May 2012 by Schroder Investment Management Limited. 31 Gresham Street, London EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Services Authority.

29 June 2012

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Growth fears rise, is QE the answer?

'In the last six weeks I am very struck by how much has changed. I am pessimistic [about the Eurozone]. I am particularly concerned because over two years now we have seen the situation get worse and the problem pushed down the road.'
Bank of England Governor Mervyn King at the Treasury Select Committee, 26 June 2012

Global growth continues to decelerate

After a relatively bright start to the year the world economy is losing momentum again. Caution on global growth stems from surveys showing a deceleration in manufacturing activity in Europe and Asia, while in the US consumer spending has slowed and the labour market has softened. Economic data continues to surprise on the downside and cyclical commodity prices (energy and metals) remain weak. Alongside a sharp fall in the cyclically sensitive currencies of the major emerging economies, the evidence suggests that we have yet to hit a turning point in global activity (front page and chart 1).

Chart 1: Emerging currencies slump

Index (Jan 2007=100) 70 80 90 100 110 120 130 140 2007 Weakening vs. Dollar

Strengthening vs. Dollar

2008

2009 Brazilian Real

2010

2011

2012 Indian Rupee

Chinese Renminbi

Russian Ruble

th Source: Thomson Datastream, Schroders. Updated 26 June 2012.

The latest slowdown is typical of the pattern seen since the financial crisis where a fundamentally weak world economy is buffeted by shocks which generate fluctuations in activity. The revival at the turn of the year was a reflection of a rebound in global supply chains which had been disrupted earlier by the Japanese earthquake. An unwind of the surge in commodity prices also helped lift spending as consumers benefited from lower inflation. The latter is still helping as commodity prices have fallen further; however the fading of the supply chain effect is weighing on growth through the inventory cycle. Another factor weighing on activity is the continuing crisis in the Eurozone where, as Mervyn King notes, member governments have yet to agree a solution. Such uncertainty is likely to be weighing on business sentiment and the willingness of companies to increase employment and investment. Corporates are currently sitting on significant cash piles, but have become too risk averse to spend. The danger is that developed economies fall into a self-fulfilling cycle of low confidence, weak spending and weak growth. Grexit: delayed not dodged Greece lives another day in the Euro One Eurozone development which may turn out better than previously expected is on Greece. Our baseline forecast had assumed a Greek exit (Grexit) from the single currency in the third quarter and although this still cannot be ruled out, it would seem that the election of a pro-Euro New Democracy government should mean that the bailout terms are softened. Consequently, Greece should survive for longer and we have adjusted our forecasts to reflect slightly better growth this year, but weaker activity next.

29 June 2012

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Grexit has only been delayed not dodged in our view as a lack of competitiveness combined with an inability to implement fiscal reform means that the troika (IMF, ECB and EU) will ultimately lose patience and pull the funding from Greece. Alexis Tsipras may have lost the election, but his Syriza party have made significant gains in the two elections this year and he remains well placed in Opposition as the crisis in Greece continues. For more discussion on the Euro, see below. Markets look to policymakers, once again More rate cuts and QE ahead In response to the cyclical slowdown, policymakers have returned to the fray. Interest rates have already been cut in China, Brazil and other cyclically sensitive economies, such as Australia. The Bank of England now looks set to announce another 50 bn of Quantitative Easing (QE) in July and alongside the UK government, has announced extra liquidity provision and low cost funding for the banking sector. Renewed easing in monetary policy has not as yet extended to the US or Eurozone. The Federal Reserve (Fed) announced it would extend Operation Twist at its June FOMC meeting and will switch a further $267 bn from short to longer dated securities by the end of the year. This can be seen as maintaining current policy, rather than a new initiative, and the US dollar strengthened on the announcement. However, the Fed did downgrade its forecasts for growth and employment and left open the option of a return to full Quantitative easing. Our forecast is for a move at the August 1st FOMC, with an announcement of a further $400bn purchase equally split between Treasuries and mortgage backed securities. In the Eurozone, European Central bank (ECB) President Mario Draghi has held off from further easing measures making the point that it is now up to politicians to take the action needed to regenerate growth. We can expect a 25 basis point cut at the July policy meeting but after two unlimited 3 year liquidity auctions (LTROs), Draghi may be justified in standing aside as liquidity does not seem to be the problem facing the banking sector. Instead, it is a shortage of capital as banks need to be recapitalised to make up for the losses incurred during the crisis. On this note, Spain has finally admitted to the need for help in raising bank capital, having failed to persuade private investors to stump up more cash last year. The government has turned to the EU for help and the Commission will decide how much capital is required (see next section for more details) based on independent analysis.

Growth, de-leveraging and the banks making QE work

Eurozone delay in tackling bank bad debts has weighted on growth Such events have highlighted the symbiotic relationship between banks and government. Long delays in tackling the problems of the banking sector have been one of the weaknesses of the Eurozone approach to the crisis. By contrast, the US and UK governments moved swiftly to recapitalise their banks by taking significant equity stakes. This has provided financial stability and removed a key source of uncertainty. By contrast the Eurozone banking system has been following in the footsteps of Japan, where delayed action led to the creation of zombie banks which kept rolling over bad debts. There are strong similarities across Europe with the failure to acknowledge Nonperforming loans in Japan. For all the benefits of the term LTROs, one of the adverse consequences of the unlimited liquidity being provided by the ECB might be that the banks no longer feel under pressure to sort out their balance sheets. The danger then is that the economy becomes ossified as funds are rolled over to unprofitable businesses rather than going into the growth areas of the economy. In defence of the Eurozone it might be added that despite the swift action to recapitalise elsewhere, a recovery in lending has been slow to come through in the US and has been non-existent in the UK (chart 2).

29 June 2012

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Chart 2: Change in total bank leading US, UK and Eurozone y/y, % 15

10

0 UK Bank and Building Society Lending US Commercial Bank Lending Eurozone Bank Lending 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

-5

-10 1992

Source: Thomson Datastream, Schroders. Updated 28th June 2012.

Banks attribute weak lending to a lack of demand for funds, however it is clear that the supply side is also important. Most banks are aiming to reduce the size of their balance sheets and focus on high margin business, effectively earning their way out of the mess. The pressure to raise capital has been increased by new regulations such as Basel III. De-leveraging continues and is only likely to be slowed rather than halted by the actions to provide cheap funding in return for increased lending. The message for the Eurozone though is that recapitalisation is only the first step toward recovery as banks will continue to de-leverage. Lessons from the Asia crisis - getting the order right Asia cleaned up balance sheets first then recapped the banks Perhaps the West should have taken the approach followed in the Asian crisis of the 1990s. Here the first step was to clean up the balance sheets of the banks before recapitalising them with government funds and some private money (through deeply discounted rights issues). The clean-up process involved auctioning off the bad debts at discounted prices to a mix of vulture funds and newly created asset management companies. Some banks disappeared in the process and there was a significant contraction in economic activity and wealth. However, what emerged was a cleansed banking system which could lend and grow in line with the economy. By contrast, banks in the West have been recapitalised before cleaning up their balance sheets. Consequently they have continued to focus on balance sheet repair rather than new lending. The sharp contraction in activity experienced in Asia has been avoided, but the price has been a weak recovery. This helps explain the failure of QE to generate a recovery in the macro economy. Rather than lending the extra reserves created by QE, they sit on bank balance sheets and in the UKs case have largely been lent back to the government through an acceleration in gilt purchases. Making more of QE QE could help spread deleveraging if targeted differently One suggestion to make QE more effective has been for the central bank to buy private sector assets. If this was to include the bad debts of the banks it would speed de-leveraging and get us closer to the point where banks were willing to expand their assets again. Politically this may be difficult, but it would bring us closer to recovery. So, whilst markets have begun to get excited about a resumption of QE we remain sceptical about its macro benefits. The benefit to markets comes about through a portfolio effect where QE drives down yields on safe assets forcing investors out along the risk curve into corporate debt and equity.

29 June 2012

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If QE is to have a more sustained effect though it needs to go beyond this portfolio effect and start boosting real growth and earnings. Such an outcome is unlikely until the banking sector is in a better condition to lend. Conditions for stronger growth The US is ahead on our growth check list Studies of past financial crisis identify a period of de-leveraging which can last several years where growth is weak. The conditions which signal that de-leveraging has largely run its course focus on financial stability, bank lending, the housing market and private investment the areas which have been most affected by the crisis. On the fiscal front it is necessary to have a plan, but past experience finds that government deficits do not improve until recovery is under way. The final condition is competitiveness by which we mean an economys ability to hold and grow its share of global trade. As can be seen, the US is well ahead of the Eurozone and within the latter the periphery has barely started. The UK is closer to the US than the Eurozone. Table 1: Check list conditions for a revival in growth US UK Eurozone no Financial sector stability yes yes no no Lending picking up yes House prices stable yes yes yes no no no Private investment rising no Fiscal deficit reduction plan yes yes no Competitive economy yes yes
Source: Schroders.

Core yes no yes no yes yes

Periphery no no no no yes no

Different strokes for different folks

In our view the shift towards a faster growth phase can only be speeded up through a faster write down of debt. The US has made more progress as it has been able to adjust more rapidly, helped by factors such as non-recourse mortgages where homeowners can hand back the keys to their home and have no personal liability for the debt. The Mckinsey institute estimate that some two-thirds of the fall in US household debt has been achieved through such defaults. The UK has taken a more measured approach and as a result house prices have held up better. The price has been a slower recovery such that the Governor of the Bank of England added to his recent evidence to the select committee that he thinks we are still only half way through the adjustment to a stronger economy. The difference between the US and UK approach reflects social as well as economic values such as a willingness to allow creative destruction with its costs in terms of unemployment. Nonetheless, neither the UK nor the US have been willing to tolerate the shock therapy applied in Asia.

29 June 2012

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Greek exit postponed as Spain seeks help

The new Greek coalition reduces the risk of a nearterm Grexit The Greek elections on the 17th of June were more successful in terms of yielding a coalition government than we had anticipated. Despite the radical left wing coalition Syriza gaining more votes in the re-run election, the previous winners New Democracy and the previous government PASOK also managed to win more votes and have now formed a coalition that also includes the relatively small Democratic Left party. The successful formation of a coalition is likely to satisfy the Troika (IMF, European Central Bank and European Commission) for the time being, and should lead to some concessions being won for Greece. This reduces the risk of Greece exiting the Eurozone in the third quarter of this year as we had previously assumed in our forecast. However, the risk of exit has merely been pushed back. There is still a significant probability that Greece will be forced to exit the Eurozone this year, though we now believe that the exit is more likely to happen in 2013. As time goes by, the Troika will expect progress from the government in implementing structural and fiscal reforms. In our view, the new government will fail to push through the painful changes that in fact they campaigned against when in opposition. though this merely pushes our assumed exit date to 2013. The dynamics of the coalition are important too. The two junior partners have not allowed any of their MPs to join the cabinet, and so policy actions will largely be associated with New Democracy. This makes it more likely that the coalition will at some stage begin to disagree on reforms, especially as political opportunism returns and as public anger rises again. At the time of writing, Microsofts headquarters in Athens suffered a heavy arson attack, an occurrence which is becoming more common - attacks on foreign companies, banks, and politicians. Meanwhile in Spain, yields on government 10-year bonds broke through the 7% barrier briefly as investors continued to question the governments ability to deal with its beleaguered banking system. In the wake of the Bankia nationalisation and additional write-downs and provisions across its banking sector, Spain has requested funding to help recapitalise its banking sector. The request for aid was swiftly answered with a provisional offer of 100bn from EU partners. However, the positive response in markets in reaction to the bail-out was short lived as questions started to emerge. The scale of the bail-out is not the issue, but the source is important for existing investors. Meanwhile, Spain has requested a bail-out for its banks, but would like to avoid Irelands fate. Spain decided to seek help before attempting to fund the additional borrowing through the sovereign debt market as the government feared it would blow-up what is already a fragile market. Markets feared that any aid from Europe was likely to be linked to the sovereign, and then lent indirectly to the banks. This would allow Europe to maintain some control over the funds after disbursement. Investors in Spanish government bonds feared that if the funding came from the European Financial Stability Facility (EFSF), then the new debt issued would not be pari passu with existing holders of Spanish government bonds. However, if the funding came from the new and permanent European Stability Mechanism (ESM), it was likely to be senior to existing bond holders. As we put the finishing touches to this note, there have been a series of useful announcements from the EU leaders summit in Brussels. Germany has succumbed to Spains demands that the intervention be direct with the banks, and also be done on a pari passu basis through the ESM (which is likely to be launched in a matter of weeks). However, Germany has won a highly significant concession with the agreement to move banking supervision from national regulators, to a new super national banks regulator. This should help safeguard tax payers money with home bias removed from the regulatory framework, but also more importantly, breaks the link between domestic banks and their sovereign, hopefully to avoid a downward spiral of bank losses bringing down their sovereigns, as was the case with Ireland. In any case, the 100bn being made available to Spain appears to be sufficient. The IMF estimates that 37bn would be required to re-capitalise the banking system, though Oliver Wyman and Roland Berger, two consultancies hired to provide a topdown stress test of the banking system, estimate that losses should range between
6

Germany has succumbed to Spanish demands that the banking bail-out be separate from sovereign debt.

29 June 2012

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16bn and 25bn under their base scenario, but between 51bn and 62bn under their stressed scenario. A bottom up consultation is currently being done, and a final figure should be decided on by the end of the summer. In addition, Hollande won the battle for the Growth Pact, though we doubt it will be as effective as a straight tax cut. In addition to the news on bank recapitalisation, French President Monsieur Hollande has also won his battle to form a Growth Pact. 120bn (1% of GDP) of capital investment will be managed by the European Investment Bank (EIB) after EU members agreed to increase the capital contributions to the EIB. While this is a positive move for the Eurozone in aggregate, it will not necessarily be focused in the countries that need it the most (i.e., peripheral countries facing impending crises), nor will the disbursement be as timely as a straight tax cut, or interest rate cut. It will take the EIB months if not years to sift through the viable projects available before investing the full amount. The key to stabilising financial markets in the short-term will be to find a way to bring down Spanish and Italian interest rates. These are already at unsustainable levels, and without some type of credible primary of secondary market intervention, domestic investors will follow international investors in pulling away from Spain and Italy. In the long-term, the Eurozone must try to complete its fiscal, political and banking union before Germany will agree to Eurobonds. Eurozone forecast update Delaying the Grexit has changed our forecast profile Due to the change in view on the timing of the Greek exit, we have re-worked our forecast for GDP, with a comparison of the profiles shown in chart 3 below. The impact is to raise our Eurozone GDP forecast from -0.5% to -0.2% for 2012, but lower our forecast for 2013 from -0.5% to -0.7%. Chart 3: Change to Eurozone GDP forecast Quarterly growth 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% -0.2% -0.4% -0.6% -0.8% -1.0% i ii iii iv i ii iii iv i
2010 Current 2011 New forecast

ii

iii

iv

ii

iii

iv

2012

2013 Previous forecast

Source: Schroders. Updated 27 June 2012.

but we now expect the ECB to cut interest rates in July, and to announce more LTROs.

In addition, we have changed our forecast for the European Central Banks (ECB) interest rate profile. In recent comments from ECB officials and President Draghi, the banks governing council seems less concerned about shrinking the corridor between the refinancing rate (currently 1.00%) and the deposit rate (currently 0.25%). We expect the ECB to cut the refinance rate to 0.75% in July, but then to hold interest rates at this level. As we have explained in the past, we do not believe the refinancing rate matters much in the Eurozone at the moment as the flood in liquidity has kept short-term interest rates well below the reference 1% figure. Rather than cutting interest rates beyond 0.75%, we expect more Long-term Refinancing Operations (LTROs) as a way to boost liquidity and confidence in the banking sector.

29 June 2012

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UK: U-turn all round as economy weakens

Mervyn King says they have had to rip-up their forecast from a 6 weeks earlier What a difference a month makes. In May, the Bank of England decided to halt the Banks asset purchase scheme, or quantitative easing (QE), after some members of the Monetary Policy Committee cited inflation concerns as an obstacle. In the June meeting, four of the nine members voted for more QE, albeit disagreeing on the amount. This marked the start of the Banks U-turn. As mentioned in the first section of this note, while providing evidence to the Treasury Select Committee, Governor Mervyn King presented a desperately gloomy outlook for the UK economy, especially with regards to the impact from the worsening crisis in Europe. King warned that the economic situation had deteriorated so badly that they have had to rip-up their forecast of six weeks earlier. It is almost certain now that the Bank will expand upon its 325bn QE programme in July (chart 4). We expect the Bank to announce an initial 50bn of purchases in the coming weeks, with another 25bn being announced in November. Indeed, given the risks to the economic outlook, the odds are that the Bank eventually decides to do even more QE, or may even decide it might be appropriate to look at other assets to purchase. and now appears ready to restart QE at the July meeting. Chart 4: Bank of England holdings of Gilts Billion 350
300 250 200 150 100 50 0 Mar 09

Sep 09

Mar 10 Sep 10 Gilts purchased

Mar 11 Sep 11 Target purchases

Mar 12

Source: Bank of England, Schroders. Updated 28 June 2012.

As we have previously discussed, the gains from QE today are questionable. The additional purchases of Gilts are unlikely to prompt new lending or demand for borrowing, with little scope left to push interest rates any lower on Gilts. Meanwhile, lower interest rates are increasing pension liabilities for corporates, which in turn encourages them to put more money aside to meet deficits rather than invest in output. Meanwhile, the Chancellor is also involved in many U-turns on a range of taxes The Bank of England is not the only institution making quick policy U-turns. The Treasury has performed a number following public anger over taxes on pasties, caravans, charitable giving and church repairs. The latest, which is set to cost the exchequer approximately half a billion pounds, is the delay in the rise of petrol duty by three pence per litre. Although the small tax break will be welcomed by motorists, this is a U-turn that Chancellor George Osborne could have avoided. The arguments for the scheduled tax rise were strengthened by the recent poor tax receipts, and the falls in petrol and diesel prices thanks to the fall in the price of oil. So is the Chancellor about to perform an even bigger U-turn on austerity altogether? Remarkably, the press and opposition seem to have missed the fact that the Chancellor effectively pushed out some of the planned fiscal tightening to latter years in his last budget. Though there were very few policy announcements, in order for the Chancellor to have stuck to the fiscal forecast set out by the Office for Budgetary
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as he attempts to max out Plan A with a larger credit easing scheme.

Responsibility (OBR), he would have had to tighten policy further. The budget effectively meant that the Chancellor had moved from plan A to plan A+, and with his Mansion House speech earlier this month, the Chancellor announced that he intends to max out plan A with his latest proposal. The Chancellor announced that the Government will indemnify the Bank of England to provide 100bn of funding for lending a scheme which is set to provide below market rates of funding to UK banks in exchange for lending commitments, and against collateral, likely to be loans. The scheme appears to be in the same vein as the credit easing scheme announced around the time of the last budget. The only difference is the size - around three times larger.

In addition, the BoE is also pumping shortterm liquidity into the banking system to safeguard against Euro crisis contagion

While the Chancellor figures out how to max plan A (or is it really plan C?), the Bank of England have also been adding new liquidity to the banking sector. Back in December, the BoE announced the extended collateral term repo (ECTR) facility to provide liquidity in times of stress. The BoE recently activated the scheme, and auctioned the full 5bn in liquidity to banks on a 6-month loan basis, with a minimum of 5m per month to each bank, at 25 basis points above the BoEs base rate of 0.5%. With LIBOR recently trading as high as 1%, the funding will provide a useful reduction in funding costs. However, similar to the Chancellors new scheme, ECTR funding is contingent on banks increasing loans to households and businesses. Reason for concern The change in tone from the MPC was not a surprise to us. What did surprise us was the length of time it took for the committee to realise its mistake. The economy is in recession, and the UKs main export partner is at the start of a significant downturn. The latest set of the UKs National Accounts statistics also paint a gloomy picture for the domestic economy. Households which are by far the biggest drivers of economic growth are suffering. Household disposable income adjusted for inflation has fallen by 0.9% for the second consecutive quarter, despite inflation falling sharply since the start of the year. The falls in disposable income have been caused by anaemic wage growth, which is failing to keep up with inflation. The squeeze on household finances has resulted in households continuing to reduce consumption (see chart 5). Chart 5: Household disposable income vs. Consumption growth Quarterly growth 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% -6% i ii iii iv i ii iii iv i ii iii iv i ii iii iv i ii
2007 2008 2009 2010

Recent data shows UK households being squeezed even more

iii iv

i 12

2011

Real household disposable income

Real household consumption

Source: Office for National Statistics, Schroders. Updated 28 June 2012.

The fall in household consumption is not a result of precautionary savings. The household savings rate has declined again, falling to 6.4% having peaked at 8.2% in Q2 2009.

29 June 2012

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as households are forced to cut back on savings in order to maintain consumption patterns.

While in normal times a fall in the savings rate would be seen a sign of growing confidence, with consumer confidence so weak (GfK consumer confidence survey for June at -29, almost two standard deviations below its long-run average), it appears that households are being forced to lower the amount they are saving in order to maintain their consumption patterns. A more extreme example of such behaviour occurred at the start of 2008, where the household saving ratio for the nation turned negative as interest rates were rising (chart 6). Chart 6: Household saving ratio (%) 9
8 7 6 5 4 3 2 1 0 -1 2006 2007 2008 2009 2010 2011 2012

Source: Office for National Statistics, Schroders. Updated 28 June 2012.

Some good news: private sector job creation has rebounded

There has however been some good news of late. Private sector jobs growth has rebounded in the latest quarter, at the same time as a reduction in public sector job shedding. Total employment in the three months to April increased by 166,000 (chart 7). Chart 7: Public and private sector jobs growth 400
300 200 100 0 -100 -200 -300 2006 2007 Public 2008 2009 2010 Private 2011 Total 2012 Publically owned banks

Source: Office for National Statistics, Schroders. Updated 28 June 2012.

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though the labour market lags activity, which could mean more job losses on the way.

Before we get excited about the prospects for falling unemployment, we have to remember that the labour market tends to lag economic activity. The recent rise in hiring could be in response to the improvement supply chains mentioned in the first section of this note. We certainly expect to see more job cuts in the public sector, and we could see renewed private sector job shedding if the crisis in the Eurozone has more detrimental impact in the coming year. In conclusion, our below consensus call on growth and inflation is playing out as downside risks are materialising. While U-turns are politically difficult, policy makers have to be prepared to be flexible and react to the changing environment. So far, the government does not appear to have lost much credibility with financial markets.

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Baseline Forecast
Baseline Real GDP y/y% US UK Eurozone Japan OECD BRIC Total Emerging* World Inflation CPI y/y% US UK Eurozone Japan OECD BRIC Total Emerging* World Wt (%) 26.4 4.1 23.5 9.5 63.5 22.4 36.5 100.0 Wt (%) 26.4 4.1 23.5 9.5 63.5 22.4 36.5 100.0 2011 1.7 0.8 1.5 -0.7 1.2 7.1 6.1 3.0 2011 3.2 4.5 2.7 -0.5 2.5 6.2 5.9 3.7 2012 2.2 -0.1 -0.2 2.0 1.1 6.1 5.1 2.6 2012 2.2 2.6 2.3 -0.2 1.9 4.2 4.5 2.9 Consensus 2.2 0.3 -0.4 2.5 1.1 6.3 5.0 2.6 Consensus 2.2 2.9 2.3 0.1 2.0 4.6 4.9 3.1 2013 1.8 0.7 -0.7 1.5 0.8 6.3 5.4 2.4 2013 1.7 1.6 1.7 0.0 1.4 4.3 4.6 2.6 Consensus 2.4 1.8 0.7 1.3 1.6 6.9 5.6 3.0 Consensus 2.0 2.1 1.7 0.0 1.6 4.7 5.1 2.9

* Emerging markets: Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela, China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan, Thailand, South Africa, Russia, Czech Rep., Hungary, Poland, Romania, Turkey, Ukraine, Bulgaria, Croatia, Latvia, Lithuania

Interest rates % US UK Eurozone Japan OECD Market data as at Key variables FX USD/ GBP USD/ EUR JPY/ USD GBP/ EUR Brent crude
US output gap %GDP

Wt (%) 26.4 4.1 23.5 9.5 63.5

Dec-11 0.25 0.50 1.00 0.10 0.52

Dec-12 0.25 0.50 0.75 0.10 0.43 28/06/2012 Dec-12 1.55 1.20 76.0 0.77 107.7 -4.0 8.5

Market 0.49 0.73 0.50 0.33 0.48

Dec-13 0.25 0.50 0.75 0.10 0.43

Market 0.60 0.73 0.62 0.33 0.58

Current 1.55 1.24 79.5 0.80 92.4 -4.0 8.2

Dec-11 1.55 1.30 75.0 0.84 112.9 76.6 1.8

y/y% 0.0 -7.7 1.3 -7.7 -4.6

Dec-13 1.55 1.20 83.0 0.77 103.1 -4.0 8.6

y/y% 0.0 0.0 9.2 0.0 -4.3

Unemploy. %

Source: Schroders, Datastream, Consensus Economics, June 2012

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I. Updated forecast charts - Consensus Economics

For the EM, EM Asia and Pacific ex Japan, growth and inflation forecasts are GDP weighted and calculated using Consensus Economics forecasts of individual countries.

Chart A: GDP consensus forecasts 2012

%
8 7 6

2013
%
8

EM Asia

7 6

EM Asia

EM
5 4

Pac ex JP US

5 4 3 2 1

EM Pac ex JP US UK Japan Eurozone

3 2

Japan
1 0

UK Eurozone

0 -1

-1 Jan Apr Jul Oct Jan Apr Jul

Jan

Feb

Mar

Apr

May

Jun

Month of forecast

Month of forecast

Chart B: Inflation consensus forecasts 2012

%
6

2013
%
6

EM
5

EM

EM Asia
4

EM Asia
4

Pac ex JP UK US

Pac ex JP
3

UK
2

US Eurozone

Eurozone
1
1

Japan
0
0

Japan
-1 Jan Apr Jul Oct Jan Apr
-1 Jan Feb Mar Apr May Jun

Month of forecast

Month of forecast

Source: Consensus Economics (June 2012), 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
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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Issued in June 2012 Schroder Investment Management Limited. 31 Gresham Street, London EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Services Authority