European Economic Outlook

Suffolk County Council

Azad ZanganaSchroders’ European Economist

James MontefioreClient Director

25 July 2012For professional investors only. This material is not suitable for retail clients

The Cost of Austerity

2

Key issuesEuropean Economic Outlook

• Growth vs. Austerity, can there be a winner?

• Where next for the Eurozone?

• When will the UK recession end?

3

Backlash against austerity gains legitimacyHollande victory lends credibility to growth debate

Source: Telegraphy online

4

Austerity is clearly affecting growthDivergence in recovery paths within Europe

Source: Eurostat, Thomson Datastream. Updated: 12 July 2012

Greece

Germany

Spain

Austria

France

PortugalItaly

Ireland

82

84

86

88

90

92

94

96

98

100

102

104

82

84

86

88

90

92

94

96

98

100

102

104

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18Quarters

GDP level (100=2008 peak)

5

Eurozone recession likely to be underway

Source: Thomson Datastream, Markit, BNB, Schroders. Updated 12 July 2012

Leading indicators vs. Eurozone GDP growth

-6%

-4%

-2%

0%

2%

4%

6%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012Eurozone GDP BNB survey PMI composite

GDP Growth (Y/Y)

6

More growth comes at a cost, and debt levels are already highPeripheral government bond spreads and debt to GDP levels

Source: Thomson Datastream (right); European Commission Spring 2012 Forecast (right). Updated: 22 May 2012. Please see the forecast risk warning on the important information slide.

0

5

10

15

20

25

30

35

40

45

50

Jan 09 Sep 09 May 10 Jan 11 Sep 11 May 12

10-year Govt. bond yield spreads over Bunds, %

Italy Greece Ireland Spain Portugal

Greecedebt swap completed

0

20

40

60

80

100

120

140

160

180

Ger Ire Gre Spa Fra Ita Neth Por

Government debt as % of GDP

2008 2009 2010 2011 2012 2013

7

Greece endgame in sight

8

Sovereign debt crisis reaches dangerous stageGreece could exit Eurozone in 2013

Greece finally has a new government that wants to stay in the Eurozone.

However, it also plans to test the Troika’s resolve by trying to postpone and reverse some fiscal and structural reforms.

Given the stress now present in Spain and Italy, we believe the Troika is likely to relax the conditions on Greece, in order to focus on the others.

However, Greece remains deeply uncompetitive, and we think Greece will be forced to abandon the Euro in 2013.

Source for image: Schroders

9

What to expect from a Greek exit?Greece could exit Eurozone this year

Exit would happen during a weekend/out of business hours.

Capital controls would instantly be applied including border checks.

All deposits would be switched into the new Drachma, and the Bank of Greece would start to replace. physical currency as soon as possible

The Drachma is expected to depreciate by 30-70%, causing high inflation in the first few years, along with a very deep recession.

However, local tourism and some export industries will begin to boom, which should lead to the start of the recovery.

Source for image: Reuters

10

Banks must hold on to the confidence of investors

Source: Thomson Datastream, Schroders. Updated 10 July 2012

Premium for cost of borrowing for banks vs. non-banks

-500

0

500

1000

1500

2000

2500

2007 2008 2009 2010 2011 2012

Spread between European financial & non-financial corporate credit yields, bps

AA A BBB

11

However, ECB itself will be a big loser from a Greek exitTARGET 2.0 central banks’ claims at ECB

Source: Thomson Datastream, Schroders. Updated 18 July 2012

-1000

-800

-600

-400

-200

0

200

400

600

800

2004 2005 2006 2007 2008 2009 2010 2011 2012

€bn

Germany France Core (Fr, Ger, Fin, Neth, Aust) Italy Peripheral (Por, Ire, It, Sp, Gr) Greece

12

Greek and Spanish deposits flying out of the door

Source: Thomson Datastream, Bank of Spain, Bank of Greece. Updated 10 July 2012

Household and non-bank corporate deposits in banks

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

2007 2008 2009 2010 2011 2012

Change in banking deposits, y/y

Greece Spain

13

Who will suffer if the Eurozone goes into recession?

Source: IMF Direction of Trade (DOT) database. Average between 2006-11. Updated 22 May 2012

Eurozone exports by partners

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Canada

Australia

Japan

US

China

India

Brazil

Russia

Switzerland

UK

Hungary

Poland

Norway

Czech Rep.

% of total exports % of GDP

1414

Example: UK exports to peripheral Europe underperforming Export values levels by partner (Jan’10=100)

Source: ONS, Schroders. Updated 12 July 2012.

50

60

70

80

90

100

110

120

Jan 10 Jul 10 Jan 11 Jul 11 Jan 12

Spain Italy Ireland Greece Portugal

90

95

100

105

110

115

120

125

130

135

Jan 10 Jul 10 Jan 11 Jul 11 Jan 12

China Australia Norway Germany Austria

1515

Expect another bad Q2Diamond Jubilee holiday will cause loss of output

Source: ONS, Market, Schroders. Updated 06/03/2012.

-3.0%

-5.9%

-1.8%

-4.9%

-2.0%

-1.1%-1.4%

-5.3%

-1.6% -1.6%

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

Mining & quarrying incoil & gas extraction Manufacturing

Electricity, gas, steamand air con Total Production Services

June '02 (Golden Jubilee) April '11 (Royal Wedding)

Month on month growth

1616

Austerity UK will keep growth subdued for most of this decadePublic sector net borrowing & change in cyclically adjusted budget deficit

Source: OBR, HMT, Schroders. Updated 23/03/2012.

11.1

9.38.3

5.8 5.9

4.3

2.8

1.1

0

2

4

6

8

10

12

14

09/10 10/11 11/12 12/13 13/14 14/15 15/16 16/17

PSBR, % of GDP

Structural Cyclical

0.0

0.5

1.0

1.5

2.0

2.5

3.0

10/11 11/12 12/13 13/14 14/15 15/16 16/17

% of GDP

Budget '12 Autumn Statement '11 Budget '11 PBR '10

Fiscal tightening delayed

1717

Risks to inflation outlook are on the upside at the 2-year horizonSchroders inflation forecast

Source: ONS, Schroders. Updated 18 July 2012.

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14

Y/Y

Forecast RPI RPIX CPI CPI target bands

VAT rises to 20%

VAT rises to 17.5%First BoE rate hike

1818

Fundamental step-change in pricing pressures from goodsUK goods vs. services inflation

Source: ONS, Schroders. Updated 18/07/2012.

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

00 01 02 03 04 05 06 07 08 09 10 11 12

Y/Y

Above 3% annual CPI inflation Goods Services

'00-'05 average = -0.6%

Average since '06 = +2.5%

Average since '00 = +3.7%

19

Interest rates flat as a pancakeSchroders interest rate forecast

Source: Schroders, June 2012 forecastPlease see the forecast risk warning on the important information slide

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

Jul Sep Nov Jan2012

Mar May Jul Sep Nov Jan2013

Mar May Jul Sep Nov

%

BoE ECB Fed

BoE ECB FedOct 11 0.50 1.50 0 - 0.25Nov 11 0.50 1.25 0 - 0.25Dec 11 0.50 1.00 0 - 0.25Jan 12 0.50 1.00 0 - 0.25Feb 12 0.50 1.00 0 - 0.25Mar 12 0.50 1.00 0 - 0.25Apr 12 0.50 1.00 0 - 0.25

May 12 0.50 1.00 0 - 0.25Jun 12 0.50 1.00 0 - 0.25Jul 12 0.50 0.75 0 - 0.25

Aug 12 0.50 0.75 0 - 0.25Sep 12 0.50 0.75 0 - 0.25Oct 12 0.50 0.75 0 - 0.25Nov 12 0.50 0.75 0 - 0.25Dec 12 0.50 0.75 0 - 0.25Jan 13 0.50 0.75 0 - 0.25Feb 13 0.50 0.75 0 - 0.25Mar 13 0.50 0.75 0 - 0.25Apr 13 0.50 0.75 0 - 0.25

May 13 0.50 0.75 0 - 0.25Jun 13 0.50 0.75 0 - 0.25Jul 13 0.50 0.75 0 - 0.25

Aug 13 0.50 0.75 0 - 0.25Sep 13 0.50 0.75 0 - 0.25Oct 13 0.50 0.75 0 - 0.25Nov 13 0.50 0.75 0 - 0.25Dec 13 0.50 0.75 0 - 0.25

20

For professional advisers only. This material is not suitable for retail clients. 

Schroders has expressed its own views and these may change. The data contained in this document has been sourced by Schroders and should be independently verified before further publication or use. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. 

The forecasts included in this presentation 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.

Source: Citywire ‘More ratings than anyone else’, as at 30 November 2011.

Issued in July 2012 by Schroder Investments Limited, 31 Gresham Street, London EC2V 7QA. Registered No: 2015527 England. Authorised and regulated by the Financial Services Authority. UK02291

20

Important information

21

Appendix

22

Shape of things to comeBaseline GDP forecast

Source: Schroders June 2012 forecast.

-5%-4%-3%-2%-1%0%1%2%3%

06 ii iii iv 07 ii iii iv 08 ii iii iv 09 ii iii iv 10 ii iii iv 11 ii iii iv 12 ii iii iv 13 ii iii iv

GDP growth, Q/Q

Germany France Italy Spain

-5%-4%-3%-2%-1%0%1%2%3%4%

2006 2007 2008 2009 2010 2011 2012 2013 2014

GDP growth, Y/Y

Emerging EA Wider EA EA4

Y on Y France Germany Italy Spain Eurozone2008 -0.2% 0.8% -1.2% 0.9% 0.3%2009 -3.0% -5.1% -5.5% -3.7% -4.3%2010 1.6% 3.6% 1.8% -0.1% 1.9%2011 1.7% 3.1% 0.5% 0.7% 1.5%2012 0.3% 1.1% -2.0% -1.2% -0.2%2013 0.0% 0.2% -1.5% -1.2% -0.7%2014 0.4% 1.3% -0.2% -0.8% 0.0%

Q on Q France Germany Italy Spain EurozoneQ1 0.9% 1.3% 0.1% 0.4% 0.7%Q2 0.0% 0.3% 0.3% 0.2% 0.2%Q3 0.3% 0.6% -0.2% 0.0% 0.1%Q4 0.1% -0.2% -0.7% -0.3% -0.4%Q1 0.0% 0.5% -0.8% -0.3% 0.0%Q2 -0.1% 0.2% -0.7% -0.6% -0.2%Q3 0.2% 0.3% -0.2% -0.4% 0.0%Q4 0.2% 0.3% -0.1% -0.1% 0.1%Q1 0.2% 0.3% -0.2% 0.0% 0.1%Q2 -0.5% -0.5% -0.9% -0.7% -0.7%Q3 -0.2% -0.3% -0.5% -0.4% -0.7%Q4 0.2% 0.2% -0.2% -0.2% -0.1%20

1320

1220

11

2323

Shape of things to comeBaseline UK GDP forecast

Source: ONS, Schroder. Updated 12/07/2012.

-4.0

1.80.8

-0.1

0.7

-6

-4

-2

0

2

4

6

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Year on Year % contributions to GDP

Households InvestmentGovernment Net TradeInventories Statistical DiscrepanciesGDP

Schroders forecast

24

Commodity prices set to help lower inflation in 2012Annual commodity price inflation and implied rates by forwards

Source: Thomson Datastream, Bloomberg, Schroders. Updated 22 May 2012

-75%

-50%

-25%

0%

25%

50%

75%

100%

125%

150%

175%

2007 2008 2009 2010 2011 2012

Monthly Y/Y change in price

Forward contracts Cotton Wheat Oil

2525

Leading indicators suggest weaker near term growthGDP growth vs. Schroders Activity Index

Source: ONS, Markit, Schroders. Updated 12 July 2012.

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2004 2005 2006 2007 2008 2009 2010 2011 2012

q/q

GDP growth Schroders Activity Index

James Montefiore – UK Institutional Client Director

Biographies

Joined Schroders in 2000 as UK Institutional Client Director, based in LondonResponsible for client servicing to UK pension funds and their consultantsPreviously worked at Threadneedle and Scottish Widows in a similar role. Prior to that he worked as a private client investment manager/analyst for private bankers, Adam & Company in Edinburgh from 1989. Began his career in financial services with private client stockbroker Williams de Broe from 1987Prior to the financial industry he served for 8 years as an officer in the Royal Marines from 1979. An Associate of the UK Society of Investment Professionals (UKSIP), previously known as AIIMR.Member of the CFA Institute. A Fellow of the Chartered Institute of Securities & Investment

26

Azad Zangana – European EconomistResponsible for formulating the house view on the UK and Eurozone economies. He is based in the Schroders’ Economics Group in London. Investment career commenced when he joined Schroders in 2009. Prior to joining Schroders he was an Economist at HM Treasury working on UK Macroeconomic Analysis and Eastern Europe. Azad is a regular contributor to the press including television and radio appearances.He holds an MSc in Economics, University of Southampton and BSc in Economics, Royal Holloway, University of London. He also holds the Investment Management Certificate (IMC).

27

For professional advisers only. This material is not suitable for retail clients. 

Schroders has expressed its own views and these may change. The data contained in this document has been sourced by Schroders and should be independently verified before further publication or use. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. 

The forecasts included in this presentation 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.

Source: Citywire ‘More ratings than anyone else’, as at 30 November 2011.

Issued in July 2012 by Schroder Investments Limited, 31 Gresham Street, London EC2V 7QA. Registered No: 2015527 England. Authorised and regulated by the Financial Services Authority. UK02291

27

Important information