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Economic and Strategy Viewpoint July 2017

Economic and Strategy Viewpoint July 2017 2

3 Mid-year markets review

– The "Trump reflation trade" appears to be over as doubts over the president's ability to deliver on promises made have grown. The initial sell-off in long-dated government bonds has now almost fully been reversed. Meanwhile, oil prices are back in bear market territory, despite OPEC's decision to keep its production quotas in place.

– In reviewing the performance of markets so far this year, we find that equities have been the best performing asset class, with the Spanish IBEX 35 index leading the way. Gold and corporate bonds have also done well, but commodities were the worst performers.

8 Are investors complacent?

– Rising equity markets and low volatility raise the question as to whether investors are becoming complacent, especially against a backdrop of falling bond yields and elevated political uncertainty. We look at the macro factors driving risk through the lens of the VIX index.

– A sharp drop in oil prices, or greater than expected Fed tightening threaten the risk rally. The latter is the greater threat, but will probably not materialise until later in 2018. Meanwhile, investors may find it hard to resist being "complacent" as liquidity will continue to drive markets with the risk being that they move into bubble territory.

12 Global liquidity and EM: where are the danger points?

– With the Fed signalling tighter policy, the ECB tapering and China tightening, global liquidity conditions are getting less easy than they used to be. Emerging markets have benefitted from an extremely accommodative environment, and we look at where the vulnerabilities may lie.

16 Views at a glance

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

Chart: Global equity market and G7 government bond yields

Source: Thomson Datastream, Schroders Economics Group, 26 June 2017.

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Keith Wade Chief Economist and Strategist (44-20)7658 6296

Azad Zangana Senior European Economist and Strategist (44-20)7658 2671

Craig Botham Emerging Markets Economist (44-20)7658 2882


Mid-year markets review “I would say have some stocks in your portfolio. It could go up 50% from here. That's what it did around 2000, after it reached this level, it went up another 50%. So I'm not against investing in the stock market when you consider alternatives. But I think if one wants to diversify, US is high in its CAPE1 ratio. You can go practically anywhere else in the world and it’s lower.”

Nobel Prize-winning economist Robert Shiller, CNBC, 23 May 2017

2017 has been an interesting year for investors so far. Buoyed by a rally in risk assets at the end of 2016 sparked by President Trump's election victory, investors started the year confident that the "Trump reflation rally" could continue. As the first half of the year ends, we look back at recent trends and examine which were the best broad asset classes and markets to be invested in.

What happened to the Trump reflation rally?

The Trump reflation rally initially continued at the start of 2017, but has faded away slowly over the course of recent months. His promise to cut tax, increase infrastructure spending and deregulate industry and banking were music to the ears of investors in US companies. Investors piled in to sectors that were set to benefit from Trump's agenda, like energy, banks and some tech stocks. From a macroeconomic perspective, extra fiscal spending and deregulation could spur faster growth, and with unemployment already at cyclical lows, concerns over inflation had returned.

Expectations of higher inflation were reflected by inflation-linked bonds, but also the performance of long-dated US Treasuries bonds. Chart 1 shows the yields-to-maturity of 30-year Treasury bonds, along with the shaded section highlighting the period of the presidential election.

Chart 1: The Trump reflation trade unwinds

Source: Thomson Datastream, Schroders Economics Group. 26 June 2017.

The immediate reaction to Trump's victory last November was for investors to sell long-dated Treasury bonds, causing prices to fall and yields to rise. This makes

1CAPE – Cyclically adjusted price-to-earnings ratio. A measure of long-run valuations developed by Robert Shiller.

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sense if higher inflation is a concern as these fixed income assets do not protect investors from rising inflation.

However, as time has passed, investors have lost some faith in the president's ability to deliver on his promises. The clumsy and combative nature of the administration has seen delays to the reforms promised to the Affordable Care Act, which in turn has delayed progress on budget reforms in the House.

To make matters worse, questions over both Trump and members of his team's conduct before and since the election have raised the possibility of impeachment. While this is unlikely given both the House and Senate are controlled by Republicans, investors' confidence in Trump has taken a blow. As a result, the "Trump reflation trade" has been unwinding as shown in chart 1 above, although this has not stopped equities from performing well, as we will discuss later in this note.

Oil prices slip despite OPEC cuts in output

After almost two years of battling with other energy producers for market share, the Organisation of the Petroleum Exporting Countries (OPEC) came together towards the end of 2016 and agreed to cut oil production by a million barrels per day. OPEC had suspended its quota system over the previous year in an attempt to drive less competitive producers out of the market. US shale gas producers were key targets and as they suffered over 2015, the price of oil started to rebound last year. However, as momentum faded, OPEC decided to cut production to help prices higher.

In May 2017, OPEC members decided to extend the new quotas through March 2018, as they felt that the cuts had been working. However, some analysts had expected a further cut in production, especially as US shale producers had appeared to have adapted their businesses to lower oil prices. Combined with some concerns over global growth and inflation, oil prices have once again come under pressure of late. Chart 2 shows the fall in both the spot and futures markets since the start of the year. With a 20% fall since the last peak in March, oil has re-entered bear market territory.

Chart 2: Oil enters a bear-market


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…however, as he has disappointed, the reflation trade has unwound.

OPEC decided to extend its previously agreed quotas, but it did not stop oil returning to a bear market


The ramifications of the decline in oil prices do not appear to have been fully considered by markets. First, oil producers will be negatively impacted, although oil consumers will eventually enjoy the savings made. Meanwhile, inflation is likely to be lower everywhere, which is likely to lead to more dovish sentiment from central banks. While the Federal Reserve (Fed) is the only major central bank actually raising interest rates, the Bank of England (BoE) came close in its June meeting. At the same time, pressure for the European Central Bank (ECB) to scale back stimulus has also risen. Undoubtedly, fears of secular stagnation will return (as it did in our scenario analysis), but investors should consider whether oil prices are really signalling a slump in demand or, more likely, whether they are reflecting improvements in productivity.

Cross-asset performance comparison

Over the first half of the year, equities have been the best performing asset class as measured by total-returns in US dollars (+11.5% year-to-date). Gold has actually led the way over the first quarter, but the Fed's March rate rise caused real yields to rise, hurting the precious metal. Nevertheless, gold has had a good year so far, returning 8.5%. Global high yield (+5.8%) and global investment grade (+5.4%) corporate bonds follow.

Chart 3: 2017 to date, cross-asset performance (USD)


Government bonds as represented by US Treasuries were underwater over the first quarter, but the unwind of the Trump reflation trade has helped improve performance since (+3.1%). Finally, the Dow Jones/UBS commodity price index was by far the worst performer, down 8.7% so far, with the performance of energy a big contributing factor.

Comparing equity market performance

Within equity markets, high-beta markets have generally performed well against a backdrop of positive risk sentiment. The best performing market was the Spanish IBEX 35, returning 21.8% (USD) and helped by a stronger local economy and a pick up in world trade. The absence of a major European crisis also helped, although the huge liquidity provided by the ECB also played a role.

The second-best performer was the MSCI Emerging Markets index (+18.4%). Despite fears over the impact of Trump on trade, the improving macro environment has helped these markets regain the momentum they had in 2015 (pre-November).

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So far this year, equities have been the best asset class to be invested in. Commodities have been the worst.


Chart 4: Equity markets performance


Next is a group of European markets again, with the CAC 40 (+17.4%), the FTSE MIB (+17.2%) and the DAX 30 (17.1%). The MSCI World (11.5%), Japanese NIKKEI 225 (+10.7%) and the UK FTSE All Share (+10.2%) indices follow, with the US S&P 500 (+10%) in last position. Although, given the concerns over the Trump rally unwinding, the positive performance from US equities is a solid achievement.

Comparing currency market performance

Part of the reason for the European and emerging markets outperformance in equities was the weaker US dollar. On a trade-weighted basis, the greenback has depreciated 4.9% so far this year (chart 5). Meanwhile, the euro has been stronger, helped by stronger growth and a less dovish outlook from the ECB. Also, the current account surplus remains substantial, with the monetary union benefiting from the pick-up in world trade. Sandwiched between the two is the British pound, which is down just 1% – not a bad performance considering the Brexit and election uncertainty over the past year.

Chart 5 and 6: Currency performance in developed markets

Source: Bank of England, Schroders Economics Group. 26 June 2017.

Elsewhere, the Japanese yen has been volatile this year, but up overall (+3%), while the Australian dollar, Canadian dollar and Swiss franc area all near to where they started the year.

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Within equity markets, the Spanish IBEX 35 has been the best performer, followed by MSCI Emerging Markets

The euro and yen have strengthen this year, while the dollar has been one of the weakest currencies


Comparing debt market performance

In the fixed income world, the best performance within government bond markets came from UK gilts (+3.3%). Gilts led the way as a slowing economy and Brexit uncertainty made the safe haven asset more attractive. US Treasuries also performed well (+3%), although most of this performance came in the second quarter, as the Trump trade was unwinding.

French OATs (+1.75%) and Italian BTPs (+1.7%) both had a terrible start to the year. Concerns over the French presidential election caused yields to spike and prices to fall, with Italy seen as a candidate for contagion given the political situation there. However, once the election result was largely secured, investors poured back in, helping to lift performance back into positive territory. Lastly, though more volatile than Japanese government bonds, German bunds returned a similar amount.

Chart 7: Government debt returns Chart 8: Corporate credit returns


As for credit markets, US markets outperformed their European peers comfortably as yields came down (prices up) sharply last year in the latter as the ECB added corporate debt to its QE portfolio. Therefore, there was greater scope for US credit to outperform, which it did against a backdrop of falling bond yields but rising equity markets.

Are current trends sustainable?

The fall in government bond yields alongside the ongoing rally in equities suggests investors are split on the current outlook. Volatility remains very low despite the Fed tightening policy. While liquidity is ample and has in the past been a major factor in causing these markets to move in the same direction and suppressing volatility, history suggests that this trend is unsustainable.

The fall in oil prices is a possible factor for the current state of markets. Although lower oil prices will hit the energy sector, with lower inflation ahead, some central banks like the Fed and BoE may become less ambitious in tightening monetary policy, while some, such as the ECB, may be forced to step up stimulus again. This suggests risk assets can continue to do well, especially as growth continues unabated, while inflation remains low. The next section considers the outlook for markets in greater detail and explores these questions further.

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Total returns, 100=31/12/2016In government bond markets, UK gilts were the best performing, closely followed by US Treasuries.

Looking ahead, can equities continue to outperform while bonds see yields falling?


Are investors complacent? “Keeping interest rates too low for long could raise financial stability and macroeconomic risks further down the road, as debt continues to pile up and risk-taking in financial markets gathers steam”

Bank for International Settlements, Annual Report 2017

The rally in equity markets continues with the MSCI World index reaching new highs in June (see chart front page). However, the strength of equities against a backdrop of falling bond yields and elevated political uncertainty has raised the question as to whether investors are becoming complacent.

Evidence of such can be found in the behaviour of the VIX index, often referred to as the "fear gauge", which has recently touched new lows. The move is particularly surprising given that the US Federal Reserve (the Fed) has just hiked rates for the second time this year and is signalling another move in September as well as balance sheet reduction (chart 9).

Chart 9: Fed tightens, but volatility falls

Source: Thomson Datastream, Schroder Economics Group, 24 June 2017.

We examine the factors driving volatility in more detail below, but first we would note that although the VIX is low, markets are not entirely ignoring the risks as is often claimed. Gold, which is often seen as the ultimate safe haven asset, has performed well this year (see above). In equity markets there has been a rotation away from the cyclicals, which benefitted from the Trump reflation trade, and back toward the high quality dividend payers. These moves are consistent with lower rates and the bull flattening of the yield curve. The surge in technology stocks also reflects strong liquidity and a preference for stocks which can increase earnings when top line growth is scarce.

Until recently Fed tightening has been associated with increased, rather than decreased volatility. For example, the VIX index spiked after the first move in Fed funds in December 2015 and again during the taper tantrum of 2013, when the Fed signalled an end to quantitative easing (QE).

Other factors have also played a role in driving volatility. Prior to the Fed tightening in 2015, concerns that China would significantly devalue the RMB sent the VIX higher in August of that year. Along with worries over Fed tightening, those concerns resurfaced in January 2016.

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Another key factor has been the oil price. Sharp falls in the oil price in 2014, 2015 and again in 2016 caused volatility to soar as investors feared an increase in defaults in the energy sector.

From this perspective it could be argued that volatility is low because investors are now comfortable with the Fed's tightening policy, China has clarified its position on the RMB and the oil price is more stable. We would add that the current low level of volatility today also owes something to favourable political outcomes in Europe where there has been no swing toward populism. We still have to negotiate the German and Italian elections, but so far voters on the continent have chosen not to join the UK in leaving the European Union (EU).

What could possibly go wrong? Threats to low volatility

Of course this is hardly an exclusive list of the causes of market volatility, but to focus on the three areas – China, oil and the Fed – mentioned above.

China does seem to be less of a concern as the authorities have regained control over the RMB by reining in capital outflows. Foreign exchange reserves have stabilised and recently the RMB has appreciated. The cost though has been a significant increase in capital controls.

There are still worries about oil with the crude price falling recently, although the decline has been modest compared to the past. Nonetheless, the risk of a sharper fall remains and we do have a weaker oil price as one of our key risk scenarios where the OPEC deal breaks down and Brent crude prices drop back to $30 p/b2. Despite a significantly lower rig count, US production of crude oil is now close to peak levels thus putting pressure on the ageing cartel. Saudi Arabia's efforts to drive US shale out of business have been for naught.

Chart 10: The rig count and oil production in the US

Source: Thomson Datastream, Schroder Economics Group, 26 June 2017.

From a volatility perspective, the greater concern is on US interest rates as we see some complacency in market expectations about the degree of tightening by the Fed. At present the market is only discounting one, or possibly two more rate hikes to the end of 2018. Meanwhile, the Fed's FOMC members projections (know as the "dots"), put rates at just over 2% at the end of 2018 (see chart 11).

2See Economic and Strategy Viewpoint, June 2017.

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…and markets are vulnerable to further tightening in US monetary policy


Chart 11: Fed rate setters expectations (the "dots") well ahead of the market

Source: Thomson Datastream, US Federal Reserve, 24 June 2017.

Despite expecting inflation to remain relatively subdued we also see further rate hikes as the Fed continues to normalise interest rates. Such a view is consistent with models such as the Taylor rule which say rates should be higher given the position of the US in its cycle.

Support for higher interest rates has also come from the Bank for International Settlements (BIS) who recently commented that central banks should be prepared to tighten policy "when demand is strong, even if inflation is weak, so as not to fall behind the curve with respect to the financial cycle"3.

Arguably an excessive focus on inflation allowed central banks to ignore the build up of debt and excessive risk taking in financial markets which preceded the global financial crisis. While we are some way from that position today, demand is healthy, risk assets are performing strongly and there is talk of bubbles in some markets. The Fed appears to recognise this with chair Janet Yellen playing down low US inflation at her last press conference following the decision to raise rates on 15th June.

Meanwhile, financial markets are discounting a benign outcome for interest rates. This could reflect expectations of a weaker economy, or the appointment of a new Fed chair who is reluctant to tighten (perhaps under political pressure from the president). Janet Yellen's term expires next February.

On balance though these are risks rather than the central view. We would certainly put more weight on a fiscal stimulus next year than the market given the political pressures for the Republicans to deliver ahead of the mid-term elections. Consequently, alongside a fall in the oil price, tighter policy from the Fed has the potential to trigger an increase in financial market volatility.

This suggests a note of caution for financial markets, but we would make two points.

First, global inflation remains low, a trend which is likely to be reinforced by the recent fall in oil prices. Notwithstanding the BIS analysis, central banks are mandated to target inflation and will be reluctant to tighten in a world where there are fears of secular stagnation. If the choice is between having a financial market bubble or deflation, the bubble wins every time.

Second, global liquidity will remain supportive. Policy rates in Japan and the eurozone are set to remain in negative territory throughout 2018 and probably beyond. Meanwhile, central bank asset purchases will continue in the eurozone 3See BIS 2017 Annual report.

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throughout 2018 and in Japan for longer. The latter is some way from hitting its inflation target of 2% or more.

Moreover, on our calculations total central bank asset purchases can be expected to continue to rise over the next 18 months thus maintaining a high level of liquidity in global markets. This largely reflects a view on the Bank of Japan (BoJ). We expect it will gradually raise asset purchases in response to the need to boost inflation and pressure to maintain 10 year government bond yields at close to zero through its Yield Curve Control policy. Rising BoJ purchases offset tapering by the European Central bank (ECB) and the reduction in the balance sheet at the Fed.

Chart 12: Global liquidity to continue to rise

Source: Thomson Datastream, Schroders Economics Group, 26 June 2017.

Are investors complacent?

The next shock to markets may not be driven by the Fed, oil or China. It could be geopolitical in origin, for while political risks may have eased in Europe they are building in Asia where tensions between the US and China will rise if North Korea does not ease back on its nuclear weapons programme.

Notwithstanding such an outcome, more conventional economic risks are not insignificant. In particular the market appears to be underestimating the potential for US interest rates to rise. The desire to normalise remains high and rates are still well below where most models would have them given where the US is in its cycle.

However, such pressures will not become apparent until further out. Low inflation will keep the Fed cautious and the start of balance sheet reduction will probably see the US central bank pause rate rises to monitor any more general tightening of financial conditions. Unless the Fed signals otherwise, the difference of opinion between the market and the "dots" will probably not be resolved until spring next year. Meanwhile, central bank asset purchases are likely to continue to expand. In this environment investors may find it hard to resist being "complacent" as liquidity will continue to drive markets with the risk that they move into bubble territory.

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Global liquidity and EM: where are the danger spots?

"…we anticipate reducing reserve balances and our overall balance sheet to levels appreciably below those seen in recent years but larger than before the financial crisis"

Janet Yellen, Federal Reserve Chair

Emerging market (EM) balance sheets have not been a serious determinant of market moves for some time. Arguably the last time that they were truly in focus was in 2013, at the time of the Federal Reserve (Fed) induced "taper tantrum" when Fed Chair Bernanke spoke of the possibility that the central bank would begin tapering its quantitative easing programme, and emerging market assets sold off sharply in response. Particularly hard hit were economies with large external exposures, and so a high reliance on dollar liquidity. A group of these economies: Brazil, India, Indonesia, South Africa and Turkey, were notable outliers and became known as the "Fragile Five".

As discussed above, central banks are now reviewing their unconventional measures. The ECB is having its own tapering discussion, and we expect the process to be complete by the end of 2018. The Fed, meanwhile, is now looking at actually reducing the size of its balance sheet, rather than reinvesting maturing assets. This would seem to be a more substantial change of policy than tapering and yet emerging market assets have seen little response. Policy is also turning tighter in China, with market rates rising even if policy rates are unchanged, as macroprudential and other measures take hold. However, though the Fed balance sheet is set to shrink, we still expect central bank balance sheets to expand in aggregate (chart 12 above).

This suggests the potential for asset markets to remain supported, but the withdrawal of dollar liquidity specifically could cause stress for certain emerging economies with high levels of dollar dependence, which we will examine later in this piece. Beyond pure balance sheet effects, it should be noted that we also expect to see more hikes from the Fed than currently anticipated by the market. More of a 2018 story, this would also place risk assets, including EM, under strain.

Chart 13 shows the reliance on short term external financing for a range of EM economies, depicting the total as a share of GDP. For comparison we show the most recent data compared to the position immediately following the Taper Tantrum. The improvement in most economies is marked, suggesting a degree of market calm regarding the prospect of liquidity withdrawal is warranted. However, levels remain elevated, and for a small group of economies have actually risen. We would still regard South Africa, Turkey, Peru, Chile, Colombia and Malaysia as at risk, based on this metric.

Tighter global monetary conditions typically put pressure on EM

The withdrawal of dollar liquidity could cause stress for certain emerging markets

Most EMEs look stronger than in 2013, but some are weaker


Chart 13: EM resilience to external shocks has generally improved


However, while reliance on foreign finance is important, strong domestic credit growth can also be a risk if global liquidity tightens. Central banks in EM economies could be forced to tighten policy to defend against the inflationary impacts of exchange rate moves, and to prevent large capital outflows. Since the crisis, Latin America and EM Asia (even excluding China) have seen relatively rapid re-leveraging by the private sector (chart 14), with EMEA far more restrained. However, even within regions there are considerable differences. In Asia, for example, India has seen only a 5 percentage point increase in private sector debt as a share of GDP. This compares to 25–30 percentage point increases in Malaysia and Thailand. Rapid increases in leverage raise the likelihood of credit quality issues surfacing, particularly if interest rates move higher.

Chart 14: EM leveraged up in the wake of the crisis

Source: Thomson Datastream, Schroders Economics Group. 21 June 2017. All figures are unweighted regional averages.

The question then becomes whether a given country's central bank would be forced to hike rates in response to tighter policies from major global central banks. Historically, EM central banks have been forced to follow the Fed to defend against capital outflows and currency moves, which can have large inflationary consequences. We must however see this against a backdrop where EM currencies have already fallen significantly since the taper tantrum, an important reason for their stability today.

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Capital outflows are more likely for economies with large portfolio capital inflows; FDI flows tend to be stickier and less sensitive to changes in short term interest rates. Chart 15 shows significant disparities within EM on this score, with India and China least exposed to the whims of international investors, assisted by capital controls. At the other end, the liquid capital markets of South Africa, Mexico and Korea are equivalent to significant shares of GDP. If capital flows back to the US as rates normalise, the impact on the rand, peso and won is likely to be much larger than on the renminbi, rupee or rouble. Still, China has its own problems, as its tightening of capital controls suggests; there may not be much foreign money, but domestic money could still look to leave if yields elsewhere look more attractive.

In addition to the total stock of portfolio liabilities, we also look at the change since 2014 (the closest we could get to the taper tantrum, given data limitations). In most cases, the stock has decreased, suggesting a reduced vulnerability. However, we do see increases in South Africa and Latin America, particularly Mexico and Colombia.

Chart 15: Capital is less sticky in some parts of EM


In terms of inflationary effects from currency moves, these will generally be larger for more open economies, where imported goods account for a larger share of GDP. In addition, whether a central bank would need to hike would also depend on the other factors influencing inflation. Notably, price growth in previously high inflation economies like India, Brazil and Russia has been much weaker than the norm. EM in general is better positioned to absorb an inflationary shock than in the past. This is not to say that monetary policy will be unaffected, but it has the potential to limit rate increases.

Chart 16 shows some EM economies have more to worry about than others as a consequence. A high trade share of GDP (a measure of openness) coupled with inflation at or above target (so a positive number on the chart) can imply a larger inflationary response to currency moves and less space to accommodate it. Although complicated by energy exports, economies like Malaysia and Mexico might then be more likely to hike in response to tighter global liquidity than Brazil, India or China. Turkey looks like it should be hiking rates regardless of global conditions at this point, while EM Europe is very open, but also experiencing low inflation. More generally though, note that all but three of our sample of EM economies are running inflation below target, providing a cushion from the adverse effects of possible devaluation.

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Chart 16: Openness and inflation


Overall, considering the range of metrics above, it is hard not to think that South Africa and Turkey are almost as vulnerable today as in 2013. We think also that Peru, Colombia, and Chile have a strong case to be included alongside them given a build up in liabilities both abroad and at home, and for Colombia and Peru limited space to absorb an inflationary shock. Mexico also looks vulnerable but has arguably begun the adjustment process – although this perhaps suggests more caution is needed before simply buying Mexico as an unwind of the earlier "Trump Trade".

On balance, given that we expect central bank balance sheet expansion to continue in aggregate this year, and that even Fed balance sheet reduction is not expected until September or later, global liquidity conditions seem unlikely to threaten EM as a whole this year. However, given also that we expect the Fed to surprise the market with a more aggressive hiking profile, we do see risks on the horizon in 2018, particularly for the more exposed EMEs. South Africa, Turkey, and certain Latin American economies seem vulnerable. By contrast, EM Europe and much of EM Asia look insulated by their lower levels of debt and inflation, and higher real interest rates.

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Schroder Economics Group: Views at a glance Macro summary – July 2017 Key points

Baseline

– Global growth is expected to come in at 2.9% in 2017 (after 2.6% in 2016) led by the advanced economies whilst inflation rises to 2.4% (from 2% in 2016) largely due to higher oil prices. This checks activity in 2017H2, but global growth of 3% is still expected in 2018 boosted by fiscal loosening in the US, and as inflation falls back helping to support consumer demand globally.

– The US Fed is expected to raise rates three times in 2017 taking fed funds to 1.5% by end year. We expect the central bank to begin to trim its balance sheet towards year end resulting in a pause in tightening as we enter 2018. Firm growth and a modest rise in core inflation allow the Fed to raise rates to 2% by end 2018.

– UK to slow in 2017 to 1.6%. Inflation is set to rise sharply due to the fall in the pound, which will reduce disposable income of households and encourage cuts in spending. Investment is already weak, and has started to impact employment. The BoE is expected to remain on hold, constrained by higher inflation. Growth remains below trend in 2018 causing unemployment to rise.

– Eurozone growth to pick up in 2017 to 1.8% following robust surveys and an easing in political uncertainty. The ECB should keep interest rates on hold, but will quicken tapering of QE in 2018.

– Japanese growth forecast at 1.6% in 2017 and inflation at 0.7% supported by looser fiscal policy and a weaker yen. No further rate cuts from the BoJ, but more QQE is expected as the central bank targets zero yield for the 10 year government bond.

– Emerging economies benefit from modest advanced economy demand growth and firmer commodity prices, but tighter US monetary policy weighs on activity. Concerns over China’s growth to persist, further fiscal support and easing from the PBoC is expected.

Risks

– Risks skewed towards deflation on fears of secular stagnation, China credit crisis (hard landing) or a spike in bond yields. Reflationary risks stem from more aggressive Trump policy on fiscal expansion.

Chart: World GDP forecast

Source: Thomson Datastream, Schroders Economics Group, May 2017 forecast. Please note the forecast warning at the back of the document.

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

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Forecast


Schroders Baseline Forecast

Real GDPy/y% Wt (%) 2016 2017 Prev. Consensus 2018 Prev. ConsensusWorld 100 2.6 2.9 (2.9) 3.0 3.0 (3.0) 3.0

Advanced* 62.6 1.7 1.9 (1.9) 2.0 2.0 (2.0) 1.9US 27.0 1.6 2.0 (2.3) 2.2 2.2 (2.4) 2.4Eurozone 17.4 1.7 1.8 (1.5) 1.8 1.8 (1.8) 1.6

Germany 5.1 1.8 1.8 (1.6) 1.6 1.9 (2.0) 1.7UK 4.3 1.8 1.6 (1.7) 1.6 1.6 (1.7) 1.4J apan 6.2 1.0 1.6 (1.6) 1.4 1.3 (1.0) 1.1

Total Emerging** 37.4 4.1 4.6 (4.6) 4.7 4.6 (4.6) 4.7BRICs 24.2 5.1 5.5 (5.6) 5.6 5.5 (5.6) 5.6

China 16.4 6.7 6.6 (6.6) 6.6 6.2 (6.2) 6.3

Inflation CPI y/y% Wt (%) 2016 2017 Prev. Consensus 2018 Prev. ConsensusWorld 100 2.0 2.4 (2.7) 2.5 2.3 (2.4) 2.4

Advanced* 62.6 0.7 1.8 (2.0) 1.9 1.4 (1.5) 1.8US 27.0 1.3 2.0 (2.6) 2.3 1.9 (2.3) 2.2Eurozone 17.4 0.2 1.6 (1.6) 1.6 1.1 (0.9) 1.4

Germany 5.1 0.4 1.9 (2.0) 1.7 1.3 (1.3) 1.6UK 4.3 0.7 2.8 (2.9) 2.7 2.2 (2.2) 2.7J apan 6.2 -0.1 0.7 (1.1) 0.6 1.1 (1.1) 0.8

Total Emerging** 37.4 4.1 3.5 (3.8) 3.5 3.8 (3.8) 3.3BRICs 24.2 3.5 2.7 (3.3) 2.6 3.1 (3.3) 2.8

China 16.4 2.0 2.0 (2.5) 1.9 2.3 (2.3) 2.0

Interest rates % (Month of Dec) Current 2016 2017 Prev. Market 2018 Prev. Market

US 1.25 0.75 1.50 (1.50) 1.46 2.00 (2.00) 1.75UK 0.25 0.25 0.25 (0.25) 0.45 0.25 (0.25) 0.64Eurozone (Refi) 0.00 0.00 0.00 (0.00) 0.00 (0.00)Eurozone (Depo) -0.40 -0.40 -0.40 (-0.40) -0.40 (-0.40)J apan -0.10 -0.10 -0.10 (-0.10) 0.03 -0.10 (-0.10) 0.04China 4.35 4.35 4.35 (4.00) - 3.50 (3.50) -

Other monetary policy(Over year or by Dec) Current 2016 2017 Prev. 2018 Prev.

US QE ($Bn) 4470 4451 4440 (4450) 4020 (4050)EZ QE (€Bn) 1696 1481 2236 (2261) 2566 (2591)UK QE (£Bn) 435 423 444 (444) 445 (445)J P QE (¥Tn) 490 476 553 (556) 653 (676)China RRR (%) 17.00 17.00 16.50 16.50 16.00 16.00

Key variablesFX (Month of Dec) Current 2016 2017 Prev. Y/Y(%) 2018 Prev. Y/Y(%)

US D/GBP 1.28 1.24 1.32 (1.22) 6.8 1.30 (1.20) -1.5US D/EUR 1.13 1.05 1.15 (1.04) 9.0 1.12 (1.01) -2.6J PY/US D 112.2 116.6 108 (114) -7.4 110 (116) 1.9GBP/EUR 0.88 0.85 0.87 (0.85) 2.1 0.86 (0.84) -1.1RMB/US D 6.81 6.95 7.05 (7.10) 1.4 7.40 (7.40) 5.0

Commodities (over year)Brent Crude 46.9 45.9 52.1 (56.5) 13.6 51.8 (56.2) -0.7

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

Previous forecast refers to February 2017

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

-0.30 -0.14

Source: Schroders, Thomson Datastream, Consensus Economics, J une 2017

Market data as at 27/06/2017

* Advanced markets : Australia, Canada, Denmark, Euro area, Israel, J apan, New Zealand, Singapore, Sweden, Switzerland,United Kingdom, United States.


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

2017 2018

Chart B: Inflation consensus forecasts

2017 2018

Source: Consensus Economics (June 2017), 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 forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. We accept no responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors. 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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Schroder Investment Management Limited

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