John Greenwood, Chief Economist, Invesco Ltd

Quarterly Economic Outlook - Second Quarter 2011

This document is for Professional Clients only in Continental Europe, Dubai, Ireland, Malta,
Isle of Man, Jersey, Guernsey and the UK. This document is not for consumer use.

INTRODUCTION: TWO DIFFERENT TYPES OF INFLATION emerging economies are experiencing a much more rapid rate of
Between September 2010 and the Japanese earthquake on 11 growth of money and credit which has already triggered property
March 2011, equity and commodity markets have enjoyed an price increases, and could threaten a more prolonged bout of
extended rally, driven principally by the prospect of sustainable generalised inflation if not brought under control.
economic recovery in the leading economies, particularly in the
United States. Two major factors in the upturn in US markets Meanwhile the sovereign debt crisis in the euro economies has
since September were the announcement in August followed by spread to Portugal. This is merely the latest example of
the implementation from November of QE2, together with the sovereign balance sheet vulnerability in the euro-area that has
fiscal stimulus agreed between the Obama administration and become common to many developed economies. The recurrent
the Congress in December. QE2 will terminate in June and is not euro-zone crisis has resulted from a decade of over-expansion
expected to be renewed, while the fiscal stimulus will fade either of the banking systems or of government spending
gradually during the second half of 2011. Markets will therefore commitments to their populations. Since governments nowadays
face significant challenges in the period ahead. feel obliged to step in and prevent massive failures in the
banking system (as they did in Iceland and Ireland), the
In addition, inflation concerns have been rising, not only in the liabilities of banks have ended up as obligations of governments.
US and most developed economies, but also in the emerging Consequently, no matter whether the source of the problem was
economies of Asia and Latin America as commodity prices – private or public debt, government balance sheets have become
especially energy and food prices – have continued to rise. The dangerously extended. In my view the debt crisis in the euro-
immediate trigger for commodity price rises was a series of zone will continue for several more quarters, and more
environmental problems such as floods and droughts affecting economies will be tested since market participants are highly
agricultural commodities, exacerbated by political tensions in the sceptical of the interim solutions offered so far, either on the
Middle East and North Africa affecting energy prices, together fiscal side or on the monetary and banking side.
with continuing anxieties about the stability of the financial
systems in the developed economies affecting precious metal 2010 2011 Consensus Forecast
prices. However, there has been one main, underlying driver: the Real GDP CPI Inflation Real GDP CPI Inflation
strong economic recovery in emerging economies. US 2.8% 1.6% 3.1% 3.0% 2.3% 1.8%
EU-16 1.7% 1.6% 1.7% 1.8% 2.3% 2.2%
The key question for markets over the next few months is the UK 1.3% 3.3% 1.9% 1.5% 3.9% 3.9%
sustainability of economic recovery and the extent of the Japan 3.9% -0.7% 1.4% 1.1% 0.2% 0.2%
inflationary threat. In my view the answer is different for the Australia 2.7% 2.8% 2.9% 3.2% 3.1% 2.8%
developed and emerging economies. Canada 3.1% 1.8% 2.9% 2.8% 2.4% 2.1%
China 10.3% 3.3% 9.4% 9.3% 4.6% 4.1%
In the developed economies money and credit growth have been India* 8.6% 10.3% 8.2% 8.6% 7.2% 7.7%
very weak over the past year and more, and fiscal retrenchment Source: Consensus Economics, 14 March, Invesco Forecast in blue
is widespread, meaning there will continue to be excess capacity * Fiscal year data (ie. FY10 = Apr 10 to March 11)
available to meet any upswing in demand. For these economies,
therefore, the upturn in inflation does not represent a threat of In financial markets the divergence between the easy monetary
sustained inflation, but is best understood as a shift in relative stance in the developed economies and the tightening monetary
prices or in the terms of trade, with the rise in imported stance in emerging economies has already caused a wide
commodity prices leading to a temporary rise in headline prices divergence of performance between equities in the two arenas.
and a lesser rise in core price indices (which generally exclude Since these two contrasting policy stances are likely to remain in
food and energy). The rise in such prices will erode consumer force during the remainder of 2011, the performance divergence
incomes and spending power in the commodity-importing may be expected to continue. However, the longer term
economies in the short term, and encourage a shift of resources prospects for both areas are promising provided that the EM
away from consumption and housing towards investment and policy-makers are successful in bringing inflation under control.
production in the deficit economies in the longer term. This is The current hiatus in EM performance should therefore be
part of the needed macro-economic rebalancing of economies in regarded as merely a mid-course correction with the possibility
the aftermath of the global economic crisis of 2008-09. of several years of business cycle expansion still ahead for both
developed and emerging markets.
In the emerging economies where economic recovery has been
strong, notably in Asia and Latin America, money and credit UNITED STATES
growth has been much faster, thanks to healthy balance sheets US real GDP growth maintained its moderate momentum in 2010
in the banking, corporate and household sectors. The problem is Q4, growing at 3.1% on an annualised basis, and 2.8% over the
that easier credit, exacerbated by investment and carry-trade year as a whole. The improvement in consumer spending that
inflows from the developed economies, has already generated had become evident in late 2010 has continued with retail sales
sharp property price increases across much of Asia, and as growing at a robust 1.0% month-on-month in February,
domestic spending continues to strengthen it is now threatening following upward revisions to data for December and January.
a more deeply embedded inflation at the consumer price level. Consumer confidence has also maintained its improvement since
Unless monetary conditions are tightened through higher interest the trough of 2008-09, with the Michigan index reaching a three-
rates, increased reserve requirements or currency appreciation, year high of 77.5 in February, although it has fallen back to 67.5
there is a significant risk that central banks in these emerging in March. Business equipment investment has weakened,
economies may be compelled to curtail money and credit growth however, slowing to 7.7% in the GDP statistics for Q4 following
more forcefully, putting an end to the economic upswing. its recent peak of 24.8% in 2010 Q2. This trend has continued in
Emerging markets therefore face a year of further policy- early 2011 with orders for non-defence durable goods excluding
tightening measures which are likely to undermine equity and aircraft falling in both January (-6.0%) and February (-1.3%),
bond market performance in these regions. though adverse winter weather may have played a part in these
declines. However, other forward-looking indicators such as the
To summarise: developed economies mostly face a shift in the PMI for manufacturing have been upbeat, increasing to a 7-year
composition of inflation with higher commodity and goods prices high of 61.4 in February, while the PMI for non-manufacturing
but relatively lower service prices and an erosion of real incomes industries hit a 5 year high of 59.7 in February.
against a background of weak money and credit growth, whereas
 John Greenwood, Chief Economist, Invesco Ltd
Quarterly Economic Outlook - Second Quarter 2011
This document is for Professional Clients only in Continental Europe, Dubai, Ireland, Malta,
Isle of Man, Jersey, Guernsey and the UK. This document is not for consumer use.

Three areas of the economy have shown consistent weakness For the year as a whole I expect real GDP growth of 3.0% with
during this recovery: housing, non-residential construction and headline CPI inflation of 1.8%. Provided that corporate profits
the labour market. Although housing has remained depressed, can continue increasing at a healthy rate, this combination
and non-residential construction is still falling, there are at last should be positive from an investment perspective. However, the
some signs that the prospects for employment are improving. withdrawal of QE2 and the prospect of gradual tightening of fiscal
policy could prove challenging for risk asset markets in the
On the housing front, starts, completions, permits, new home second half of 2011.
sales and existing home sales have all remained weak, troubled
by excess supply, continuing mortgage loan delinquencies and THE EUROZONE
record high foreclosures. Meanwhile house prices as measured The contrast between the strongly recovering north eastern part
by the Case-Shiller 20-city composite have been falling since of the eurozone (France, Germany and the Benelux, and
July, and in January fell back almost to their lows of April 2009. stretching into Switzerland and parts of Scandinavia that are
The failure of the housing and commercial real estate sectors to outside the common currency area), and the anaemic or still
recover so far are acting as a continuing drag on growth, recessionary southern and western periphery persists. The
adversely affecting both the investment and consumer spending recovery in the north and east has been driven by strong exports
components of GDP. and a rise in consumption and investment, highlighted by
Germany’s 4.0% real GDP growth (year-to-year) in 2010 Q4, led
Non-residential construction is roughly the same size as the by a 17.9% increase in plant and equipment investment, and
housing sector, but started to decline in 2008 rather than 2006 15.7% growth in exports of goods and services. Business
for the housing sector. The problem here is that US regional confidence has rebounded with the IFO index reaching a new
banks are heavily exposed to commercial property, and the high in February, and export orders for plant and machinery
sector appears to have a considerable decline still ahead of it, growing at 47% in the three months November-January.
with expenditures likely to fall to the $400bn mark before any
revival can be expected (see chart below). Growth in exports of goods and services drives
strong growth in Germany
US Expenditure on non-residential construction 25 115
expected to continue falling Export growth of goods & services % (lhs)
$bn's IFO Index (rhs)
110
800 15
Residential C ontruction
Non-Residential C onstruction 105
700
5
100
600

95
500 -5

90
400
-15
300
85

200 -25 80
Apr-01 Oct-02 Apr-04 Oct-05 Apr-07 Oct-08 Apr-10
100
Source: Datastream, 31 March 2011

0
Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 However, elsewhere in the eurozone, especially in the southern
and western periphery the rolling sovereign debt-cum-banking
Source: Datastream, 28 February 2011
crisis means that economic weakness and recession will persist
well into 2012. The underlying problems – the slump in money
The job market, in contrast, has started to brighten up.
and credit growth, the on-going private sector balance sheet
Household employment data show monthly increases averaging
repair, necessary fiscal consolidation, and prolonged internal
219,000 for the three months January-March, while the non-farm
deflation to restore external competitiveness and overcome large
payroll data show an average increase of 159,000 per month
external imbalances – would all have been much more easily
over the same period. Due to the relatively rapid increase in the
treated if currency devaluation and an independent monetary
size of the labour force the unemployment rate had not fallen
policy had been possible. As members of the currency union,
much until the start of 2011, since when it has declined from an
such a strategy is ruled out. Having benefited during the boom
average of 9.6% in Q4 to 8.8% in March.
from inflows of money and labour, the peripheral economies are
seeing money flows reverse, with outflows of capital and labour
The Federal Reserve will complete its current program of $600bn
to areas where employment prospects are better.
of US Treasury purchases at the end of June, setting the scene
for the next stage of monetary policy. In the next phase it is
Consequently Portugal, following Greece and Ireland, is
likely to change the language in its regular FOMC statement,
experiencing a drastic loss of credibility in the ability of its
ending its commitment to maintain low interest rates for “an
government to refinance its obligations as they mature, and will
extended period,” and to indicate the need for a gradual
be forced to apply to the EFSF for a substantial loan to tide it
withdrawal of monetary accommodation. Given that banks are
over. After Portugal, there is a significant probability that either
still not increasing their total loans (adjusted for changes in
Spain or possibly Belgium will suffer the same loss of financial
coverage in the Fed’s H8 release) and therefore Fed ease is not
market confidence. The Euro-zone crisis will therefore continue
being transmitted to the markets and the economy in full
to trouble financial markets until the fiscal control and
measure, I do not expect rate hikes to begin until 2012 when the
supervision issues as well as the underlying monetary and
unemployment rate has fallen further. On the fiscal side the
banking issues have both been adequately addressed.
100% capital depreciation allowance will end in December, and
unless there are any new stimulus measures, the overall stance
of fiscal policy will become less expansionary towards yearend.
 John Greenwood, Chief Economist, Invesco Ltd
Quarterly Economic Outlook - Second Quarter 2011
This document is for Professional Clients only in Continental Europe, Dubai, Ireland, Malta,
Isle of Man, Jersey, Guernsey and the UK. This document is not for consumer use.

As elsewhere in the developed world commodity price increases first of these explanations, offering four main reasons for the
have raised reported inflation rates, pushing the overall euro- series of inflation shocks: the weakness of sterling, externally-
zone CPI increase to 2.4% in February, and a flash estimate of driven commodity price increases, a high degree of pass-through
2.6% in March. Even in the crisis economies of Greece and by firms, and government-mandated VAT and fuel duty
Ireland the deflation that had gripped each economy has increases. All of these do indeed provide a measure of comfort to
temporarily been reversed by increased commodity prices (and policy-makers. But given that inflation rates in the US and the
additional taxes) to CPI inflation rates of 2.2% in Ireland and Euro-zone are far lower than in the UK, this defence misses some
4.2% in Greece. However, disinflationary or deflationary trends key, quantitative issues.
are likely to re-assert themselves over the next year or so.
The reality is that the UK has a far larger financial sector than
We expect overall real GDP growth in the eurozone to be 1.8% in other similar-sized economies, and the growth of bank balance
2011, concealing a wide divergence of performance between the sheets, bank credit and money had all been allowed to run
core and the periphery. The combination of very low overall rates rampant. The rapid growth in broad measures of money and
of growth of money and credit together with considerable slack in credit continued until the second half of 2009, and the economy
employment and capital equipment will restrict inflation to 2.2% is therefore still in the two-year period during which monetary
on average in 2011. growth can be expected to impact goods and service prices.
Against a backdrop of falling real incomes, real GDP growth is
UNITED KINGDOM likely to be disappointingly low this year and very dependent on
Real GDP growth had been somewhat better than expected in exports and business investment while inflation, reflecting the
2010 Q2 and Q3 (at 1.1% and 0.7% quarter on quarter overhang of easy money from the past, will exceed the 2%
respectively), but declined abruptly by 0.5% in 2010 Q4, largely target for the entire year. I am forecasting 1.5% real GDP
due to a bout of extreme cold and snow in December. In the growth and 3.9% inflation in 2011.
absence of adverse weather conditions, growth would have been
roughly zero or flat according to the National Statistics office. JAPAN
With inflation rising to 4.4% on the CPI measure in February and Japan has responded with dignity and discipline to the twin
wage earnings for the whole economy only growing at 2.3% in disasters of the Tohoku earthquake and tsunami of March 11, but
January, most households are seeing real income declines that the radiation problems at the nuclear power plant at Fukushima
are likely to continue through the entire year. This means that are proving much more intractable. Early private sector
personal consumption, by far the largest component of GDP will estimates of the scale of the reconstruction needs (excluding
at best be very weak, and may even decline over the year as a dealing with the nuclear plant) were in the range Yen 12-15
whole. trillion (about 3% of GDP), but the government has put out a
UK Inflation remains elevated much higher estimate of the damage at Yen 25 trillion (5.2% of
GDP) which includes an allowance for repair or de-commissioning
% 6
UK CPI UK RPI of the nuclear facilities. It should be noted that the GDP (current
value of output) losses will be significantly less than the overall
losses of people, capital equipment, houses and infrastructure.
4

According to a METI survey over 11,000 manufacturing sites

were operating in the three affected prefectures, with annual
2
shipment values of Yen 110 trillion p.a., or 3.7% of national
industrial output (not value added as in the GDP), but as much
as 9.5% of IT and communications equipment, 7.7% of
0 electronic components , and 7.6% of wood products. Much of the
reconstruction costs will be privately financed by earthquake
insurance as well as other private sector sources, so not all of
-2 the cost will become a government obligation. Thanks to Japan’s
Feb-04 Feb-05 Feb-06 Feb-07 Feb-08 Feb-09 Feb-10 Feb-11
large stock of savings both at home and abroad there should be
Source: Bloomberg, 31 March 2011. no difficulty in raising the funding needed to overcome the
effects of the triple disasters.
In these circumstances the Coalition’s fiscal strategy has been
designed to reduce the structural budget deficit and hence the Nevertheless, the Japanese economy will undoubtedly experience
amount of official borrowing as quickly as reasonably feasible. a further short-term downturn following two negative quarters of
The Budget of March 23rd reaffirmed this broad strategy, without GDP in 2010 Q2 and Q4. This will probably translate into another
significant changes in target or timing, despite the downgrading negative GDP figure in the April-June quarter due to earthquake-
of economic growth forecasts by the OBR. The Budget also related disruptions such as the rolling black-outs in Tokyo and
offered a few inducements for growth but countered them with eight other prefectures, declines in output in the three affected
additional taxes on North Sea oil producers and an increased levy prefectures of Iwate, Miyagi and Fukushima, and disruptions to
on banks, effectively denying them the benefit of the lower supply chains in the electronics and auto industries. Conversely,
corporate income tax rate. substantial reconstruction efforts will be spread over many
quarters, boosting GDP in subsequent quarters. Consequently
Against this sombre background, the MPC at the Bank of England with the economy already recovering from the 2008-09
has so far kept Base Rate at 0.5%, although there are now three recession, corporate earnings improving, and strong gains from
votes out of nine for a hike in rates. If the underlying sub-par overseas investments, it is unlikely that the triple disasters will
rate of GDP growth was the only problem, the answer would be cause Japan to be derailed from its existing macro-trajectory of
fairly simple – namely to keep monetary policy on an gradual economic upswing.
expansionary or accommodative course until inflation was
forecast to approach its target. But with CPI inflation now at In response to the crisis the Bank of Japan began injecting funds
4.4% year-on-year and more than double the 2% target, the into the money markets from Monday, March 14. By March 29
question is whether there has been a series of external shocks the BOJ’s balance sheet had expanded from Yen 129 trillion to
that cannot adequately be handled by tighter monetary policy, or 149 trillion, while commercial banks’ reserve deposits at the
whether there has been some inherent failure of monetary central bank had been boosted from Yen 21 trillion to 33 trillion.
policy. The mainstream line from the MPC has centred on the
 John Greenwood, Chief Economist, Invesco Ltd
Quarterly Economic Outlook - Second Quarter 2011
This document is for Professional Clients only in Continental Europe, Dubai, Ireland, Malta,
Isle of Man, Jersey, Guernsey and the UK. This document is not for consumer use.

In addition, to deal with the rapid appreciation of the currency, a outside the formal banking channels appears to be undermining
G7 intervention operation was arranged to lower the yen from 78 the authorities’ attempt to tighten credit with minimal rate hikes.
yen per US dollar initially to 81, and more recently to around 84-
85. Credit growth still rising in Asia
20 NICS lending growth %
The fastest growing segment of the economy is Japan’s exports Malaysia & Thailand lending growth %
which have recovered just over half of their 2007-08 peak levels. 18
Monthly exports were running at Yen 5,550 bn in March 16
compared with a peak of Yen 7,024 bn in July 2008 and a trough 14
of Yen 3,484 bn in February 2009. Strong growth in China and 12
other parts of East Asia, in addition to Latin America will continue 10
to power Japan’s formidable export sector. Elsewhere domestic
8
demand has remained subdued, and is unlikely to be affected in
any major way by the post-earthquake reconstruction projects. 6
Unemployment has fallen to 4.6% in February from its recession 4
peak of 5.6% in July 2009, but still well above its pre-crisis level 2
of about 4%. 0
-2
On the price front, the recent surge in food and energy prices Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11
has eased Japan’s deflation, despite the strength of the yen,
raising the year-on-year rate of CPI inflation to zero in February Source: Datastream, 31 March 2011. NICS = Korea, Taiwan, Hong Kong & Singapore
from a low of -2.5% in October 2009. Even so, the core CPI
which excludes food and energy prices was still -0.6% in As a result, inflation rates across the region are rising, triggered
February, a testament to the tenacity of deflation trends that as elsewhere by soaring food and energy prices, but driven in a
have persisted since 1998. My forecast is for real GDP growth of more fundamental sense by relaxed money and credit conditions.
1.1% in 2011, with a miniscule rise of headline consumer prices Average inflation for the region increased to 4.3% in January, up
of 0.2%. from 3.8% in December. In financial markets most regional
currencies strengthened against the US dollar in February and
NON-JAPAN ASIA March, but benchmark equity indices declined on concerns about
Across the region the economic recovery from the global further policy tightening and increased risk aversion amid
recession has continued to gain momentum. Strong balance growing political tensions in the Middle East and North Africa. I
sheets and very low interest rates have fostered easy credit expect strong growth with rising inflation to continue for most of
conditions. Exports have once again led the recovery in the 2011.
aftermath of the abrupt and severe global downturn in trade in
2008-09, but there is increasing evidence of domestic demand COMMODITIES
taking over the lead role as easy monetary conditions translate The surge in commodity prices has been driven by one key
into faster spending on property, commodities and consumer underlying factor, but exacerbated by numerous smaller, more
goods and services. temporary events or disruptions. The primary factor underlying
the strength of commodities has been the vigorous upswing in
In China, industrial production accelerated to 14.9% in February, emerging economies, many of which are at a particularly
supported by strong growth in chemicals and machinery commodity intensive phase of their development as they build
production. Fixed asset investment also picked up in January and the necessary infrastructure for a more advanced standard of
February, underpinned by the construction of affordable housing. living. In addition there has been a seemingly endless series of
Growth in retail sales, however, slowed in February, perhaps floods, droughts, crop failures, earthquakes and other natural
affected by weaker consumer confidence in the face of higher disasters that have impacted individual commodity suppliers. On
inflation. Export growth has moderated slightly in recent months, top of that, political uprisings in the Middle East and North
while import growth has been strong, in part due to the surge in African (MENA) region have disrupted the flow of oil and
commodity prices. Due to the varying timing of the Chinese threatened the closure of critical pipelines and shipping routes.
Lunar New Year holiday it is always difficult to be sure about
underlying trends in exports and imports over the first three Commodity prices continue to surge
months of the year, but it appears that the strength of domestic
600 160
demand is being reflected in a slight narrowing of the trade Reuters C RB US Raw Industrial
balance. The GDP target for 2011 remains at 8.0%, but in the C ommodity Index (lhs)
550
recently adopted 12th Five Year Plan for 2011-15 the long term Brent C rude Oil $per barrel (rhs) 140
target has been lowered from 7.5% to 7%.
500
120
In the NIE-3 economies (Korea, Taiwan and Hong Kong) and
ASEAN-4 (Indonesia, Malaysia, the Philippines and Thailand) 450
growth was a strong 5.2% (quarter-on-quarter annualised) in Q4 100
compared with 1% in Q3. Indonesia and the Philippines showed 400
exceptionally strong growth, but in 2011 all have benefited from
80
double digit growth of exports and rising levels of domestic 350
consumption spending.
300
60
Central banks across the region have responded to the upturn by
raising interest rates, hiking reserve requirements, and
250 40
tightening credit conditions by means of stricter loan-to-value Feb-08 Nov-08 Aug-09 May-10 Feb-11
ratios for mortgage loans or other explicit controls. However, it
Source: Bloomberg, 31 March 2011.
would seem that in most cases the tightening measures are so
far insufficient. Money and credit growth rates are generally still
All this is happening at a time when interest rates in the west are
rising, with the exception of China, but even here credit growth
still very low and therefore investors are earning desperately low
 John Greenwood, Chief Economist, Invesco Ltd
Quarterly Economic Outlook - Second Quarter 2011
This document is for Professional Clients only in Continental Europe, Dubai, Ireland, Malta,
Isle of Man, Jersey, Guernsey and the UK. This document is not for consumer use.

returns on deposits and other safe assets such as government Authority.

bonds. In addition, many investors have not yet overcome their
risk aversion from the recession, and consequently are under- Issued in France by Invesco Asset Management S.A. 18, rue de
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the rise in commodity import prices is triggering an upturn in
headline and -- in some cases – core inflation. However, despite
QE and very low interest rates, this episode of commodity-based
inflation does not mark the start of a sustained inflationary
upswing, as money and credit growth rates are negligible across
the developed world. Consequently most developed economy
central banks will not respond with rate hikes.

By contrast, in the emerging world strong recoveries and rapid

rates of growth of money and credit are fuelling a more
fundamentally-based inflation. These recoveries should continue
at a healthy pace in 2011, but policy-makers are already being
confronted with rising inflation, requiring central banks to tighten
further. In the past emerging economies tended to judge their
interest rates in relation to levels in the developed world, but
with the developed world struggling with the aftermath of
banking crises and a balance sheet recession, those guideposts
are no longer appropriate. Most emerging economies will
therefore spend the balance of this year attempting to normalise
rates, but will often find that they are behind the curve.

John Greenwood
Chief Economist, Invesco Ltd
31 March 2011.

Important information
Where John Greenwood has expressed views and opinions, they
are based on current market conditions and are subject to
change without notice. These opinions may differ from those of
other Invesco investment professionals.

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