Economic and Strategy Schroder Invt Mngt

7/31/2019 Economic and Strategy Schroder Invt Mngt

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29 June 2012 For professional investors only

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.

Schroders

Economic and Strategy ViewpointKeith WadeChief Economist andStrategist(44-20)7658 6296

Azad ZanganaEuropean Economist(44-20)7658 2671

James BilsonEconomist(44-20)7658 3550

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 inventorycycle which had rebounded after last years supply chain disruptions. Thefailure to resolve the Euro crisis may also be weighing on activity as theuncertainty causes companies to delay investment plans.

Markets are now looking to central banks to ease once more and boost riskappetite. More Quantitative easing is expected, however QE is doing little togenerate a sustained recovery. The obstacle, in our opinion, is a bankingsector which is de-leveraging and prefers to put excess reserves ingovernment bonds rather than new loans. One solution would be to use QE tobuy assets off the banks thus speeding de-leveraging.

Looking at the conditions which signal that an economy has de-leveraged andcan resume growth, the US is well ahead of the UK and Eurozone. PeripheralEurope has barely started.

Europe forecast update: Greek exit postponed as Spain seeks help (page 6)

The formation of a new Greek coalition government means that Greece is likelyto remain in the Eurozone this year, though the risk of an exit has simply beenpushed out to 2013.

Spain has requested help to recapitalise its banking system. The EU hasoffered up to 100bn, though the final figure is expected to be lower. Fundingwill now come from the ESM directly to the banks, and there will be a newsuper national banking supervisor.

In shifting the Greek exit to 2013, we have upgraded our forecast for 2012growth, 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 thattheir forecast from May was too optimistic. We expect 50bn to be announcedin July, with another 25bn in November.

Meanwhile, the Chancellor was performing his own U-turns, as he reverses aseries of tax increases, and thinks of more ways to avoid admitting he hasmoved 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

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G7 Industrial Production (lhs) S&P GSCI Industrial Metals Spot (rhs) Source: Thomson Datastream, Schroders. Updated: 28th June 2012


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Global growthcontinues todecelerate

Greece livesanother day in theEuro

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 wehave 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

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

Chart 1: Emerging currencies slump

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1402007 2008 2009 2010 2011 2012

Chinese Renminbi Brazilian Real Russian Ruble Indian Rupee

Index (Jan 2007=100)

Strengthening vs. Dollar

Weakening vs. Dollar

Source: Thomson Datastream, Schroders. Updated 26

thJune 2012.

The latest slowdown is typical of the pattern seen since the financial crisis where afundamentally weak world economy is buffeted by shocks which generate fluctuationsin activity. The revival at the turn of the year was a reflection of a rebound in globalsupply chains which had been disrupted earlier by the Japanese earthquake. Anunwind of the surge in commodity prices also helped lift spending as consumersbenefited from lower inflation. The latter is still helping as commodity prices have fallenfurther; however the fading of the supply chain effect is weighing on growth through theinventory cycle.

Another factor weighing on activity is the continuing crisis in the Eurozone where, asMervyn King notes, member governments have yet to agree a solution. Suchuncertainty is likely to be weighing on business sentiment and the willingness ofcompanies to increase employment and investment. Corporates are currently sitting onsignificant cash piles, but have become too risk averse to spend. The danger is thatdeveloped economies fall into a self-fulfilling cycle of low confidence, weak spendingand weak growth.

Grexit: delayed not dodged

One Eurozone development which may turn out better than previously expected is onGreece. Our baseline forecast had assumed a Greek exit (Grexit) from the singlecurrency in the third quarter and although this still cannot be ruled out, it would seemthat the election of a pro-Euro New Democracy government should mean that thebailout terms are softened. Consequently, Greece should survive for longer and wehave adjusted our forecasts to reflect slightly better growth this year, but weakeractivity next.


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More rate cuts andQE ahead

Eurozone delay intackling bank baddebts hasweighted ongrowth

Grexit has only been delayed not dodged in our view as a lack of competitivenesscombined with an inability to implement fiscal reform means that the troika (IMF, ECBand EU) will ultimately lose patience and pull the funding from Greece. Alexis Tsiprasmay have lost the election, but his Syriza party have made significant gains in the twoelections this year and he remains well placed in Opposition as the crisis in Greececontinues. For more discussion on the Euro, see below.

Markets look to policymakers, once again

In response to the cyclical slowdown, policymakers have returned to the fray. Interestrates 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 ofQuantitative Easing (QE) in July and alongside the UK government, has announcedextra 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 JuneFOMC meeting and will switch a further $267 bn from short to longer dated securitiesby the end of the year. This can be seen as maintaining current policy, rather than anew initiative, and the US dollar strengthened on the announcement.

However, the Fed did downgrade its forecasts for growth and employment and leftopen the option of a return to full Quantitative easing. Our forecast is for a move at theAugust 1st FOMC, with an announcement of a further $400bn purchase equally splitbetween Treasuries and mortgage backed securities.

In the Eurozone, European Central bank (ECB) President Mario Draghi has held offfrom further easing measures making the point that it is now up to politicians to takethe action needed to regenerate growth. We can expect a 25 basis point cut at the Julypolicy meeting but after two unlimited 3 year liquidity auctions (LTROs), Draghi may bejustified in standing aside as liquidity does not seem to be the problem facing thebanking sector. Instead, it is a shortage of capital as banks need to be recapitalised tomake 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. Thegovernment has turned to the EU for help and the Commission will decide how muchcapital is required (see next section for more details) based on independent analysis.

Growth, de-leveraging and the banks making QE work

Such events have highlighted the symbiotic relationship between banks andgovernment. Long delays in tackling the problems of the banking sector have been oneof the weaknesses of the Eurozone approach to the crisis. By contrast, the US and UKgovernments moved swiftly to recapitalise their banks by taking significant equitystakes. 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 baddebts. There are strong similarities across Europe with the failure to acknowledge Non-performing loans in Japan. For all the benefits of the term LTROs, one of the adverseconsequences of the unlimited liquidity being provided by the ECB might be that thebanks no longer feel under pressure to sort out their balance sheets. The danger thenis that the economy becomes ossified as funds are rolled over to unprofitablebusinesses rather than going into the growth areas of the economy.

In defence of the Eurozone it might be added that despite the swift action torecapitalise elsewhere, a recovery in lending has been slow to come through in the USand has been non-existent in the UK (chart 2).


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Asia cleaned upbalance sheetsfirst then recappedthe banks

QE could helpspread de-leveraging iftargeteddifferently

Chart 2: Change in total bank leading US, UK and Eurozone

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UK Bank and Building Society Lending

US Commercial Bank Lending

Eurozone Bank Lending

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

Banks attribute weak lending to a lack of demand for funds, however it is clear that thesupply side is also important. Most banks are aiming to reduce the size of their balancesheets and focus on high margin business, effectively earning their way out of themess. The pressure to raise capital has been increased by new regulations such asBasel III. De-leveraging continues and is only likely to be slowed rather than halted bythe actions to provide cheap funding in return for increased lending. The message forthe Eurozone though is that recapitalisation is only the first step toward recovery asbanks will continue to de-leverage.

Lessons from the Asia crisis - getting the order right

Perhaps the West should have taken the approach followed in the Asian crisis of the1990s. Here the first step was to clean up the balance sheets of the banks beforerecapitalising them with government funds and some private money (through deeplydiscounted rights issues). The clean-up process involved auctioning off the bad debtsat discounted prices to a mix of vulture funds and newly created asset managementcompanies. Some banks disappeared in the process and there was a significantcontraction in economic activity and wealth. However, what emerged was a cleansedbanking system which could lend and grow in line with the economy.

By contrast, banks in the West have been recapitalised before cleaning up theirbalance sheets. Consequently they have continued to focus on balance sheet repairrather than new lending. The sharp contraction in activity experienced in Asia has beenavoided, 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 sheetsand in the UKs case have largely been lent back to the government through anacceleration in gilt purchases.

Making more of QE

One suggestion to make QE more effective has been for the central bank to buyprivate sector assets. If this was to include the bad debts of the banks it would speedde-leveraging and get us closer to the point where banks were willing to expand theirassets 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 aportfolio effect where QE drives down yields on safe assets forcing investors out alongthe risk curve into corporate debt and equity.


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The US is ahead

on our growthcheck list

Different strokesfor different folks

If QE is to have a more sustained effect though it needs to go beyond this portfolioeffect and start boosting real growth and earnings. Such an outcome is unlikely untilthe banking sector is in a better condition to lend.

Conditions for stronger growth

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 haslargely run its course focus on financial stability, bank lending, the housing market andprivate investment the areas which have been most affected by the crisis. On thefiscal front it is necessary to have a plan, but past experience finds that governmentdeficits do not improve until recovery is under way. The final condition iscompetitiveness by which we mean an economys ability to hold and grow its share ofglobal trade. As can be seen, the US is well ahead of the Eurozone and within thelatter 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 Core Periphery

Financial sector stability yes yes no yes no

Lending picking up yes no no no noHouse prices stable yes yes yes yes no

Private investment rising no no no no no

Fiscal deficit reduction plan no yes yes yes yes

Competitive economy yes yes no yes noSource: Schroders.

In our view the shift towards a faster growth phase can only be speeded up through afaster write down of debt. The US has made more progress as it has been able toadjust more rapidly, helped by factors such as non-recourse mortgages wherehomeowners can hand back the keys to their home and have no personal liability forthe 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 heldup better. The price has been a slower recovery such that the Governor of the Bank ofEngland added to his recent evidence to the select committee that he thinks we arestill only half way through the adjustment to a stronger economy.

The difference between the US and UK approach reflects social as well as economicvalues such as a willingness to allow creative destruction with its costs in terms ofunemployment. Nonetheless, neither the UK nor the US have been willing to toleratethe shock therapy applied in Asia.


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The new Greekcoalition reducesthe risk of a near-term Grexit

though thismerely pushes ourassumed exit dateto 2013.

Meanwhile, Spainhas requested abail-out for itsbanks, but wouldlike to avoidIrelands fate.

Germany hassuccumbed toSpanish demandsthat the bankingbail-out beseparate fromsovereign debt.

Greek exit postponed as Spain seeks help

The Greek elections on the 17th of June were more successful in terms of yielding acoalition government than we had anticipated. Despite the radical left wing coalitionSyriza gaining more votes in the re-run election, the previous winners New Democracyand the previous government PASOK also managed to win more votes and have nowformed a coalition that also includes the relatively small Democratic Left party.

The successful formation of a coalition is likely to satisfy the Troika (IMF, EuropeanCentral Bank and European Commission) for the time being, and should lead to someconcessions being won for Greece. This reduces the risk of Greece exiting theEurozone in the third quarter of this year as we had previously assumed in ourforecast. However, the risk of exit has merely been pushed back. There is still asignificant probability that Greece will be forced to exit the Eurozone this year, thoughwe now believe that the exit is more likely to happen in 2013. As time goes by, theTroika will expect progress from the government in implementing structural and fiscalreforms. In our view, the new government will fail to push through the painful changesthat in fact they campaigned against when in opposition.

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 beassociated with New Democracy. This makes it more likely that the coalition will atsome stage begin to disagree on reforms, especially as political opportunism returnsand as public anger rises again. At the time of writing, Microsofts headquarters inAthens 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% barrierbriefly as investors continued to question the governments ability to deal with itsbeleaguered banking system. In the wake of the Bankia nationalisation and additionalwrite-downs and provisions across its banking sector, Spain has requested funding tohelp recapitalise its banking sector. The request for aid was swiftly answered with aprovisional offer of 100bn from EU partners. However, the positive response inmarkets in reaction to the bail-out was short lived as questions started to emerge. Thescale of the bail-out is not the issue, but the source is important for existing investors.

Spain decided to seek help before attempting to fund the additional borrowing throughthe sovereign debt market as the government feared it would blow-up what is already afragile market. Markets feared that any aid from Europe was likely to be linked to thesovereign, and then lent indirectly to the banks. This would allow Europe to maintainsome control over the funds after disbursement.

Investors in Spanish government bonds feared that if the funding came from theEuropean Financial Stability Facility (EFSF), then the new debt issued would not bepari passu with existing holders of Spanish government bonds. However, if thefunding 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 usefulannouncements from the EU leaders summit in Brussels. Germany has succumbed toSpains demands that the intervention be direct with the banks, and also be done on apari passu basis through the ESM (which is likely to be launched in a matter ofweeks). However, Germany has won a highly significant concession with theagreement to move banking supervision from national regulators, to a new supernational banks regulator. This should help safeguard tax payers money with homebias removed from the regulatory framework, but also more importantly, breaks the linkbetween domestic banks and their sovereign, hopefully to avoid a downward spiral ofbank 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. TheIMF estimates that 37bn would be required to re-capitalise the banking system,though Oliver Wyman and Roland Berger, two consultancies hired to provide a top-down stress test of the banking system, estimate that losses should range between


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In addition,Hollande won the

battle for theGrowth Pact,though we doubt itwill be as effectiveas a straight taxcut.

Delaying theGrexit haschanged ourforecast profile

but we nowexpect the ECB tocut interest ratesin July, and toannounce moreLTROs.

16bn and 25bn under their base scenario, but between 51bn and 62bn under theirstressed scenario. A bottom up consultation is currently being done, and a final figureshould be decided on by the end of the summer.

In addition to the news on bank recapitalisation, French President Monsieur Hollandehas also won his battle to form a Growth Pact. 120bn (1% of GDP) of capitalinvestment will be managed by the European Investment Bank (EIB) after EUmembers agreed to increase the capital contributions to the EIB. While this is apositive move for the Eurozone in aggregate, it will not necessarily be focused in thecountries that need it the most (i.e., peripheral countries facing impending crises), norwill the disbursement be as timely as a straight tax cut, or interest rate cut. It will takethe EIB months if not years to sift through the viable projects available before investingthe full amount.

The key to stabilising financial markets in the short-term will be to find a way to bringdown Spanish and Italian interest rates. These are already at unsustainable levels, andwithout some type of credible primary of secondary market intervention, domesticinvestors will follow international investors in pulling away from Spain and Italy. In thelong-term, the Eurozone must try to complete its fiscal, political and banking union

before Germany will agree to Eurobonds.

Eurozone forecast update

Due to the change in view on the timing of the Greek exit, we have re-worked ourforecast for GDP, with a comparison of the profiles shown in chart 3 below. The impactis to raise our Eurozone GDP forecast from -0.5% to -0.2% for 2012, but lower ourforecast for 2013 from -0.5% to -0.7%.

Chart 3: Change to Eurozone GDP forecast

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Quarterly growth

Current New forecast Previous forecast

Source: Schroders. Updated 27 June 2012.

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, thebanks governing council seems less concerned about shrinking the corridor betweenthe refinancing rate (currently 1.00%) and the deposit rate (currently 0.25%). Weexpect the ECB to cut the refinance rate to 0.75% in July, but then to hold interestrates at this level.

As we have explained in the past, we do not believe the refinancing rate matters muchin the Eurozone at the moment as the flood in liquidity has kept short-term interestrates well below the reference 1% figure. Rather than cutting interest rates beyond0.75%, we expect more Long-term Refinancing Operations (LTROs) as a way to boostliquidity and confidence in the banking sector.


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Mervyn King saysthey have had torip-up theirforecast from a 6

weeks earlier

and nowappears ready torestart QE at theJuly meeting.

Meanwhile, theChancellor is alsoinvolved in manyU-turns on a rangeof taxes

UK: U-turn all round as economy weakens

What a difference a month makes. In May, the Bank of England decided to halt theBanks asset purchase scheme, or quantitative easing (QE), after some members ofthe Monetary Policy Committee cited inflation concerns as an obstacle. In the Junemeeting, 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 ofthis note, while providing evidence to the Treasury Select Committee, GovernorMervyn King presented a desperately gloomy outlook for the UK economy, especiallywith regards to the impact from the worsening crisis in Europe.

King warned that the economic situation had deteriorated so badly that they have hadto rip-up their forecast of six weeks earlier. It is almost certain now that the Bank willexpand upon its 325bn QE programme in July (chart 4). We expect the Bank toannounce an initial 50bn of purchases in the coming weeks, with another 25bnbeing announced in November. Indeed, given the risks to the economic outlook, theodds are that the Bank eventually decides to do even more QE, or may even decide itmight be appropriate to look at other assets to purchase.

Chart 4: Bank of England holdings of Gilts

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Billion

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

As we have previously discussed, the gains from QE today are questionable. Theadditional purchases of Gilts are unlikely to prompt new lending or demand forborrowing, with little scope left to push interest rates any lower on Gilts. Meanwhile,

lower interest rates are increasing pension liabilities for corporates, which in turnencourages them to put more money aside to meet deficits rather than invest in output.

The Bank of England is not the only institution making quick policy U-turns. TheTreasury has performed a number following public anger over taxes on pasties,caravans, charitable giving and church repairs. The latest, which is set to cost theexchequer approximately half a billion pounds, is the delay in the rise of petrol duty bythree pence per litre. Although the small tax break will be welcomed by motorists, thisis a U-turn that Chancellor George Osborne could have avoided. The arguments forthe scheduled tax rise were strengthened by the recent poor tax receipts, and the fallsin petrol and diesel prices thanks to the fall in the price of oil. So is the Chancellorabout to perform an even bigger U-turn on austerity altogether?

Remarkably, the press and opposition seem to have missed the fact that theChancellor effectively pushed out some of the planned fiscal tightening to latter yearsin his last budget. Though there were very few policy announcements, in order for theChancellor to have stuck to the fiscal forecast set out by the Office for Budgetary


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as he attemptsto max out Plan Awith a larger crediteasing scheme.

In addition, theBoE is alsopumping short-term liquidity intothe bankingsystem tosafeguard against

Euro crisiscontagion

Recent datashows UKhouseholds beingsqueezed evenmore

Responsibility (OBR), he would have had to tighten policy further. The budgeteffectively meant that the Chancellor had moved from plan A to plan A+, and with hisMansion House speech earlier this month, the Chancellor announced that he intendsto max out plan A with his latest proposal.

The Chancellor announced that the Government will indemnify the Bank of England toprovide 100bn of funding for lending a scheme which is set to provide belowmarket rates of funding to UK banks in exchange for lending commitments, andagainst collateral, likely to be loans. The scheme appears to be in the same vein as thecredit easing scheme announced around the time of the last budget. The onlydifference is the size - around three times larger.

While the Chancellor figures out how to max plan A (or is it really plan C?), the Bank ofEngland have also been adding new liquidity to the banking sector. Back in December,the BoE announced the extended collateral term repo (ECTR) facility to provideliquidity in times of stress. The BoE recently activated the scheme, and auctioned thefull 5bn in liquidity to banks on a 6-month loan basis, with a minimum of 5m permonth to each bank, at 25 basis points above the BoEs base rate of 0.5%. WithLIBOR 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 iscontingent 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 wasthe length of time it took for the committee to realise its mistake. The economy is inrecession, 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 forthe domestic economy. Households which are by far the biggest drivers of economicgrowth are suffering. Household disposable income adjusted for inflation has fallen by0.9% for the second consecutive quarter, despite inflation falling sharply since the startof 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 financeshas resulted in households continuing to reduce consumption (see chart 5).

Chart 5: Household disposable income vs. Consumption growth

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2007 2008 2009 2010 2011 12

Quarterly growth

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. Thehousehold savings rate has declined again, falling to 6.4% having peaked at 8.2% inQ2 2009.


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as householdsare forced to cutback on savings inorder to maintainconsumptionpatterns.

Some good news:private sector job

creation hasrebounded

While in normal times a fall in the savings rate would be seen a sign of growingconfidence, with consumer confidence so weak (GfK consumer confidence survey forJune at -29, almost two standard deviations below its long-run average), it appearsthat households are being forced to lower the amount they are saving in order tomaintain their consumption patterns. A more extreme example of such behaviouroccurred 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 (%)

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2006 2007 2008 2009 2010 2011 2012 Source: Office for National Statistics, Schroders. Updated 28 June 2012.

There has however been some good news of late. Private sector jobs growth hasrebounded 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 (chart7).

Chart 7: Public and private sector jobs growth

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Public Publically owned banks Private Total Source: Office for National Statistics, Schroders. Updated 28 June 2012.


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though thelabour market lagsactivity, whichcould mean morejob losses on theway.

Before we get excited about the prospects for falling unemployment, we have toremember that the labour market tends to lag economic activity. The recent rise inhiring could be in response to the improvement supply chains mentioned in the firstsection of this note. We certainly expect to see more job cuts in the public sector, andwe could see renewed private sector job shedding if the crisis in the Eurozone hasmore detrimental impact in the coming year.

In conclusion, our below consensus call on growth and inflation is playing out asdownside risks are materialising. While U-turns are politically difficult, policy makershave to be prepared to be flexible and react to the changing environment. So far, thegovernment does not appear to have lost much credibility with financial markets.


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Baseline ForecastBaseline

Real GDP

y/y% Wt (%) 2011 2012 Consensus 2013 Consensus

US 26.4 1.7 2.2 2.2 1.8 2.4UK 4.1 0.8 -0.1 0.3 0.7 1.8

Eurozone 23.5 1.5 -0.2 -0.4 -0.7 0.7

Japan 9.5 -0.7 2.0 2.5 1.5 1.3

OECD 63.5 1.2 1.1 1.1 0.8 1.6

BRIC 22.4 7.1 6.1 6.3 6.3 6.9

Total Emerging* 36.5 6.1 5.1 5.0 5.4 5.6

World 100.0 3.0 2.6 2.6 2.4 3.0

Inflation CPI

y/y% Wt (%) 2011 2012 Consensus 2013 Consensus

US 26.4 3.2 2.2 2.2 1.7 2.0UK 4.1 4.5 2.6 2.9 1.6 2.1

Eurozone 23.5 2.7 2.3 2.3 1.7 1.7

Japan 9.5 -0.5 -0.2 0.1 0.0 0.0

OECD 63.5 2.5 1.9 2.0 1.4 1.6

BRIC 22.4 6.2 4.2 4.6 4.3 4.7

Total Emerging* 36.5 5.9 4.5 4.9 4.6 5.1

World 100.0 3.7 2.9 3.1 2.6 2.9

Interest rates

% Wt (%) Dec-11 Dec-12 Market Dec-13 Market

US 26.4 0.25 0.25 0.49 0.25 0.60

UK 4.1 0.50 0.50 0.73 0.50 0.73

Eurozone 23.5 1.00 0.75 0.50 0.75 0.62

Japan 9.5 0.10 0.10 0.33 0.10 0.33

OECD 63.5 0.52 0.43 0.48 0.43 0.58

Key variables

FX Current Dec-11 Dec-12 y/y% Dec-13 y/y%

USD/ GBP 1.55 1.55 1.55 0.0 1.55 0.0

USD/ EUR 1.24 1.30 1.20 -7.7 1.20 0.0

JPY/ USD 79.5 75.0 76.0 1.3 83.0 9.2

GBP/ EUR 0.80 0.84 0.77 -7.7 0.77 0.0

Brent crude 92.4 112.9 107.7 -4.6 103.1 -4.3

US output gap

%GDP-4.0 76.6 -4.0 -4.0

Unemploy. % 8.2 1.8 8.5 8.6

Source: Schroders, Datastream, Consensus Economics , June 2012

* 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

Market data as at 28/06/2012


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Issued in June 2012 Schroder Investment Management Limited.

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I. Updated forecast charts - Consensus EconomicsFor the EM, EM Asia and Pacific ex Japan, growth and inflation forecasts are GDP weighted andcalculated using Consensus Economics forecasts of individual countries.

Chart A: GDP consensus forecasts2012 2013

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1

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%

EM Asia

Pac ex JP

US

UK

Eurozone

Japan

Month of forecast

EM

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EM Asia

Pac ex JP

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Japan

Month of forecast

EM

Chart B: Inflation consensus forecasts

2012 2013

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EM Asia

Pac ex JP

USUK

Eurozone

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Month of forecast

EM

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EM Asia

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Source: Consensus Economics (June 2012), SchrodersPacific ex. Japan: Australia, Hong Kong, New Zealand, SingaporeEmerging 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 necessarilyrepresent 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 thisdocument. The information and opinions contained in this document have been obtained from sources we consider to be reliable. Noresponsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to itscustomers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Relianceshould not be placed on the views and information in the document when taking individual investment and/or strategic decisions. For yoursecurity, communications may be taped or monitored.

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