THE GLOBAL ECONOMY: 2015 OUTLOOK AND BEYONDJANUARY 2015

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GLOBAL HEALING CONTINUES The outlook for the global economy remains positive. Although there is little risk of any economy getting a speeding ticket for going too fast, the developed world continues to heal. Progress in the US has been substantial, but many parts of Europe are recovering more slowly. The overall recovery remains supported by very loose monetary policies, and pent-up demand in some key sectors, along with moderating headwinds from weak banking systems, personal-sector deleveraging, and fiscal tightening across the developed world.

US LEADS, EUROZONE LAGSWith budget deficits now closer to becoming under control in countries such as the US, the next fiscal challenge will be to reduce the stock of government debt relative to the Gross Domestic Product. This will take many years — decades in some countries. Although this is expected to proceed in an orderly fashion, the inability of countries to loosen fiscal policies significantly is likely to remain a vulnerability in the next few years — especially while monetary policy cannot be cut, as interest rates are already at 0%. While economic growth should be decent, the level of economic activity remains subdued, following almost a decade of subpar growth. This low level of activity relative to normal (or trend) levels can be seen in the high levels of unemployment and low levels of inflation in most countries. Although the US and UK economies have made progress toward normalization, eurozone economic activity is far too weak to substantially reduce unemployment and ward off the threat of deflation.

US/UK TO TIGHTEN POLICY, EUROZONE/JAPAN TO LOOSEN ITThe different performance of the US and UK economies relative to those in the eurozone and Japan is likely to lead to an increasing divergence in monetary policy between them. This has already led to a rally in the US dollar. With the US likely to outperform for both cyclical (stronger economy) and structural reasons (an improving trade position because of shale oil and gas), US dollar strength should continue. If this appreciation

proceeds at a gentle pace, then the impact on the global economy should be positive; however, too fast an increase risks causing problems for companies that have borrowed in US dollars.

The problems arising from a sharp rise in the US dollar apply most to emerging markets — many of which are cyclically depressed, with the corporate sector struggling to improve profit margins and holding back on investments as a result. Those countries that have taken steps to reform their economies, such as India, have been rewarded with an improved economic outlook and strong equities. Overall, we expect emerging economies to benefit from stronger export growth, leading eventually to improved economic performance as the year unfolds.

On balance, the sharp fall in oil prices at the end of 2014 should provide a further source of support for global growth in 2015, although the direct impact is likely to be uneven. It is a clear positive for the developed world and the large energy importers among the emerging economies (such as China and India), but exporters (such as Russia) will suffer. We also note that oil intensity in most developed economies has fallen significantly in recent decades, resulting in a smaller boost to incomes and profitability than in the past. We also expect central banks in the developed economies to largely “look through” the direct impact on headline inflation, although at the margin the likely falls could also extend the commencement of interest rate rises in the US and the UK and boost the commitment to quantitative easing in Japan and the eurozone.

POSITIVE EQUITY OUTLOOKFrom a market perspective, we expect global equities to perform well, supported by continued earnings growth and a benign economic environment. That said, with valuations close to fair value, there is less scope for the multiple expansion that has driven equity returns over the past few years. As a result, we expect equities to generate high single-digit returns in 2015, rather than anything more substantial. With the Fed likely to

EXECUTIVE SUMMARY

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Global healing continues in 2015 supported by very loose monetary policies, less powerful headwinds from weak banking systems and personal-sector deleveraging.

raise interest rates at some point, the markets could experiences periodic bouts of weakness if investors fear a too-rapid unwind of Fed largesse. Such falls could present a good buying opportunity.

LOW BOND YIELDS LIKELY, BUT NOT THIS LOWWe expect bond yields to rise modestly from their very low levels. While we share some agreement with the view that interest rates and yields will be lower in the next decade than in the period before the crisis, we doubt that they will stay as low as they are currently priced in the markets. Non-government bonds should modestly outperform government bonds, with defaults likely to remain low for a few years. However, with spreads already tight, substantial outperformance seems unlikely.

FED, CHINA, GEOPOLITICS KEY RISKSThe key risk to the global economic and financial market outlook is whether the Fed is able to withdraw some of its accommodative monetary policy without unleashing a rise in uncertainty and risk aversion. With the Fed seeking to take its foot off the accelerator rather than put its foot on the break, it will tread carefully and should be helped by the accommodative policy in the eurozone and Japan. While a Fed rate increase would not in itself lead to economic or market weakness, a perception that the Fed was “behind the curve” could cause a problem. Key to that perception is whether wage increases remain modest and not inflationary.

The other major risk involves whether key emerging economies (in particular, China) are able to rebalance their economies away from a debt-driven investment and/or export-driven model toward a more balanced one. Although China has announced some measures that should help, it is difficult to know whether the reforms taken and proposed will be sufficient.

Our “2015 Strategic Research Themes and Opportunities” paper highlights a number of investment ideas for the current environment. Please call your consultant at Mercer.

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We believe that the developed world economy will grow at a trend or better pace for some time. The recovery is likely to be driven by the US, whose economy appears to be benefitting from a strong banking system, strong asset prices, improved balance sheets, and the end of fiscal tightening. Elsewhere, while economies in places such as the UK and Ireland should grow strongly, France, Italy, Australia, and a number of emerging economies might struggle for a few more years.

Although we expect the rate of growth to be decent, the level of economic activity will remain far from satisfactory for some time. Economic activity is only modestly higher than the levels seen in 2007, and most economies in the eurozone have yet to reach their pre-crisis peak (Figure 1). This low level of economic activity is likely to keep inflationary pressures modest, allowing central bankers to promote growth for some time. Weaker oil and commodity prices should also support global economic activity (Figure 2).

Monetary policy in aggregate will remain exceptionally loose, but the Fed and the Bank of England (BoE) may start to modestly nudge interest rates higher. Critically,

with few signs of strong wage growth, the Fed and BoE will maintain a pro-growth stance and merely aim to take their feet off the monetary policy accelerator rather than apply the break. The European Central Bank (ECB) and the Bank of Japan (BoJ), however, will both still be moving in the opposite direction (Figure 3), continuing to loosen policies to boost their economies, in part with the help of weaker currencies.

The key driver of the economic recovery is likely to remain the corporate sector. Capital expenditure (capex), which was decent in 2014, is likely to remain firm as corporates continue to shift from a defensive posture (cost control) to a more aggressive one (revenue expansion) (Figure 4). The corporate sector is likely to have to increase spending on its workforce, with wage growth at last picking up in the US and the UK. Although wage growth is likely to increase, it is unlikely to reach a level that would threaten either corporate profit growth or inflation. The recent sharp fall in the oil price should provide a significant boost to consumption, especially in the first half of the year.

FIGURE 1: ITALY AND SPAIN STILL BELOW PEAK

Source: JP Morgan

FIGURE 2: LOWER OIL PRICES SHOULD HELP

Source: Bloomberg

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FIGURE 3: RATES SET TO DIVERGE

Sources: Bloomberg, Goldman Sachs Global Investment Research

In the emerging world, the outlook remains mixed, with reformers (India, Mexico, Indonesia) outperforming nonreformers (Brazil, South Africa, Russia). China remains somewhere in the middle, in part because it remains unclear whether the reforms being undertaken will be sufficient to offset the headwind from a prolonged slowdown in credit growth and a shift from state-owned enterprises (SoEs) to the private sector. With US interest rates likely to start normalizing in 2015, the resilience of capital flows to emerging economies will again be tested. As in 2013, we are likely to see winners and losers. The sharp fall in oil prices will also create winners and losers. Energy importers (such as India and China) will benefit at the expense of countries (such as Russia) that are exporters.

UNITED STATESAfter a slow start to 2014, the US economy has strengthened and appears to be growing at about 3%. We expect the economy to maintain that rate with help from capex growth, less fiscal tightening, and stronger personal consumption. Consumption should be supported by stronger income growth on the back of more jobs and stronger wages and the boost to real incomes from lower oil prices. More jobs are likely to have been created in 2014 than in any year since 1999. With unemployment below 6% and falling, the amount of slack is diminishing rapidly and some sectors already show signs of rising wages (Figures 5 and 6).

FIGURE 4: CAPEX EXPENDITURE OUTLOOK POSITIVE

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FIGURE 6: SIGNS OF WAGE GROWTH EMERGING

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Inflation is likely to remain below the Fed’s 2% target in 2015. Despite rising modestly, wage growth is not anticipated to affect corporate profit margins enough to force companies to increase prices. In addition, the sharp fall seen in oil and other commodities in 2014, if sustained, will help keep inflation low. If, however, the economic recovery continues in 2015, then inflation risks in 2016 and beyond may become more balanced.

The Fed ended its bond-buying program under its latest quantitative easing plan in October 2014, but it continues to own a large amount of bonds (approximately $4 trillion) bought over the past few years. The Fed has signaled that it may start to raise interest rates this summer. It has also said that it will not sell any of its bonds for some time, and it is possible that it will never sell any and just slowly reduce the size of its balance sheet by allowing bonds to mature and not re-investing proceeds.

When the Fed does start to raise interest rates, it is likely to proceed cautiously. With inflation below and unemployment above their respective targets and with the global economy still fragile, the Fed will be responsive to signs, if they appear, that any rate increases are slowing the economy.

EUROZONE The eurozone economy had another poor year in 2014, with overall activity still below the pre-crisis peak. However, the “villains” in 2014 differed from those in

previous years. In 2014, France and Italy were very weak, and Germany also disappointed, albeit from a stronger starting point. Greece performed better and is now out of recession, although significant challenges remain (Figure 7). In 2015, we expect the eurozone to strengthen modestly, supported by less fiscal tightening, a weaker euro, and a stronger global economy.

While economic growth is likely to be a bit stronger in 2015, it will not nearly be enough to make a major dent in the high unemployment rate and make up the lost ground since the crisis. High unemployment, only modest growth, and the recent fall in oil prices are likely to keep inflation below target for a number of years, with a fall into deflation in 2015 possible (Figure 8).

The ECB loosened its monetary policy in 2014 but remains constrained by its mandate and by the reluctance of the Bundesbank to pursue more unconventional measures. On balance, we expect the ECB’s monetary policy to loosen further; however, with yields already at record low levels, there is only so much that monetary policy can do. Substantial improvement in the flexibility of labor and product markets in France, Italy, and some other countries is desperately needed. The new Italian prime minister, Matteo Renzi, is trying to push through change but is being opposed by unions and other parties. Whether these reform efforts and the less ambitious ones in France will be sufficient to forestall a prolonged period of very weak growth and inflation remains to be seen.

FIGURE 7: GREECE OUT OF RECESSION FIGURE 8: EUROZONE INFLATION VERY LOW

Source: JP MorganSource: Bloomberg

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One positive development in the eurozone over the past 12 months is a further sharp decline in bond yields to record low levels in almost all countries. Peripheral bond yields have fallen a long way, with Irish, Spanish, and Italian 10-year yields now below 2%. With the peripheral economies all running current account surpluses and budget deficits greatly reduced, the risk of a country leaving the eurozone because of uncontrolled bond market weakness leading to default is remote. That said, it is possible that a country, either in the periphery or a core country such as France, might decide for nationalistic reasons to leave the eurozone to escape the bloc’s political and economic constraints. The risk of this happening increases the longer that unemployment remains high. The upcoming Greek election will be the next test.

UNITED KINGDOMWe expect the UK to continue to perform more like the US than the eurozone. Although growth may moderate from the high rates seen in 2014, we expect it to remain above trend and for unemployment to fall further. Growth should be boosted by strong consumption on the back of further jobs growth (and possibly wage growth as well), while investment spending and consumption should remain strong. Net export growth is likely to remain weak on the back of the relative weakness of the UK’s main trading partners in Europe. This will keep the UK’s current account deficit wide, which will remain a source of vulnerability over the midterm.

Inflation is likely to remain well below the 2% level in 2015, although it could start to drift higher as 2016 approaches (Figure 9). Lower energy and food prices should continue to put downward pressure on inflation, while soft wage growth over the past few years should keep domestically generated inflation in check. As monetary policy acts with a lag of up to two years, the BoE needs to think about the inflation trajectory — and the outlook is more balanced. The labor market has been exceptionally strong, leading to a sharp decrease in unemployment. Wage growth has been very subdued in recent years, but some tentative signs show that it has started to pick up recently (Figure 10). With the unemployment rate likely to fall further, wage growth could pick up — supporting economic recovery but also adding some upward pressure on inflation.

On balance, we expect the BoE to raise interest rates gradually in 2015 and then again in 2016. The bank has stressed that any increases are likely to be “limited and gradual,” and, as a result, we do not expect them to hinder the economy.

FIGURE 9: INFLATION MOVING BACK TO 2% FIGURE 10: WAGES PICK UP AT LAST

Source: Office for National StatisticsSource: BoE

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JAPANWe expect the Japanese economy to perform well after a disappointing 2014, with the consumption tax increase in April having slowed economic growth more than expected. The BoJ has recently undertaken further aggressive monetary easing, and this has already weakened the yen substantially and boosted stock prices and sentiment. This could help fuel a recovery in investment and exports. The outlook for consumption has also improved, with wages finally increasing, albeit moderately.

While recent policy initiatives are welcome and should boost growth in 2015, they are not sufficient to ensure that the economy will sustain this improved performance in 2016 and beyond. Structural reforms across a range of sectors and improving the supply side of the economy by encouraging more women and elderly people into the labor force are necessary to ensure that recent progress doesn’t stall. Prime Minister Shinzō Abe was re-elected in 2014, and many view this as him being given a mandate to pursue further reform.

CHINAWe expect headline Chinese growth to slow further in 2015, with domestic activity weighted down by a deliberate policy of reining in fixed asset investment. The pickup in global growth will likely spur export demand; however, the shale energy revolution in the

US and currency depreciations in Japan and Europe will probably have eroded some of China’s manufacturing competitiveness. Nevertheless, an economic hard landing remains unlikely given China’s ability to provide both fiscal and monetary stimulus measures. The People’s Bank of China (PBoC) lowered interest rates in November, following more targeted loosening measures earlier in the year. Additional loosening measures are likely in response to slower growth and inflation (Figure 11).

Following the third Plenum in November 2013, China announced an impressive reform agenda covering areas such as capital markets, taxation, rule of law, education, and environmental protection. China’s mid- to long-term growth prospects depend on the authorities making concrete steps toward implementing these reforms, its willingness to tolerate lower growth, and its ability to manage any social and political instability from the ensuing economic slowdown. Encouraging signs have surfaced in recent months, with the Shanghai-Hong Kong exchange link being the most visible example. Nevertheless, much work remains to be done. The addiction to infrastructure investment remains difficult to cure, as between October and November 2014, the National Development and Reform Commission (NDRC) approved 21 new projects — including 16 railway lines and five airports — for a total amount of $113 billion. Credit growth remains very strong and needs to slow (Figure 12).

FIGURE 11: CHINESE INFLATION FALLS

Source: Bloomberg

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FIGURE 12: CHINESE CREDIT GROWTH STILL STRONG

Source: Trient Asset Management

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We expect global equities to generate further positive returns in 2015. Global equities should be supported by earnings growth on the back of economic growth, while the inflation and interest rate environment remains benign, even if the Fed and the BoE start to raise interest rates. Equity valuations appear to be in the ballpark of fair value. Current earnings-based measures of valuation appear reasonable, although some cyclically adjusted earnings measures look rich in the US (Figure 13). Outside the US, though, equities generally look quite cheap, while the valuation of all equities looks good relative to the low returns available on bonds and cash (Figure 14). With valuations mixed, we expect equities to return modestly above their long-run average returns, perhaps generating total returns of high single digits.

We may see a return of more substantial volatility in 2015, with the potential for periodic spikes to accompany any monetary policy changes in the US. These moves may be exacerbated in markets with low liquidity. That said, we do not expect any market weakness to be sustained for long, and any such pullbacks could be a good opportunity to increase equity exposure.

EQUITY SECTORSThe strategic benchmark for Mercer’s global growth portfolio is made up of four components: developed market equities (DME), emerging market equities (EME), small cap equities (SCE), and low volatility equities (LVE). Within these sectors, we prefer EME and DME, then SCE, followed by LVE.

We believe that DME and EME will be the top two performing sectors. EME has performed poorly over the past few years on the back of falling economic growth, flat economic growth, flat profit growth (Figure 15), and weak currencies. While emerging market economic growth is likely to remain soft in 2015, we expect it to strengthen modestly as the year progresses on the back of an increase in exports to the developed world. This stronger growth should boost corporate profits, which in turn should support EME, which are generally cheap on most measures (Figure 16).

MARKET OUTLOOK

Source: Thomson Reuters Datastream Source: Goldman Sachs

FIGURE 13: SHILLER P/E LOOKING STRETCHED

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FIGURE 14: EQUITIES CHEAP VS. BONDS

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The fall in commodity prices should boost those emerging market economies that import commodities, although this will act as a headwind to exporters. Lower interest rates across emerging markets should also help, although monetary tightening in the US is likely to be a headwind.

We expect emerging market reformers (for example, India, Indonesia, Mexico) to outperform those that fail to reform (for example, South Africa, Brazil). Much also depends on whether China is successful in rebalancing growth away from investment while reforming the corporate sector and slowing credit growth. Some progress has already been made, and both the risks and the opportunities are high.

We expect SCE to perform well, though underperform DME. While the economic environment remains supportive, valuations of SCE are looking rich on some measures. The same is true for LVE, which have been boosted over recent years by their lower risk characteristics and by investors seeking a decent yield when so little has been available in bond markets. If bond markets and the global economy stabilize, as we expect, then LVE could underperform other equity sectors.

DEVELOPED MARKET BONDSThe outlook for global bonds is poor. Although monetary policy most likely will remain exceptionally loose for some time and could be loosened further in the eurozone and Japan, this is already more than discounted in bond markets. In the US, the bond market is pricing that the Fed Funds rate will not reach 2% until 2017 and that it won’t reach 3% until the start of the of the next decade (Figure 17). An even more muted tightening cycle is expected in the UK. In the bond markets, some yields reached all-time lows in 2014. For example, 30-year gilt yields fell to 2.7% in December 2014.

The market expects interest rates in the UK and US to peak at around 3%. This is substantially lower than the level of around 5% seen before the financial crisis. We doubt that interest rates will eventually settle at such a low rate but do not expect them to rise to pre-crisis levels over the foreseeable future either.

We think the Fed and the BoE will raise interest rates in 2015. Both central banks will be taking their foot off the accelerator rather than putting their foot on the brake and will be responding to the prospect of sustained growth, leading to lower unemployment, rising wage growth, and eventually higher inflation.

FIGURE 15: EME EARNINGS FLAT FOR 3 YEARS

Source: Goldman Sachs

FIGURE 16: EME CHEAP

Source: Thomson Reuters Datastream

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The ECB and the BoJ are likely to loosen monetary policy further, and interest rate hikes remain some years away. However, with bond yields in both regions at record lows, higher bond yields seem more likely than lower ones, especially if economic growth is stronger, as we expect.

INVESTMENT GRADE (IG) AND HIGH YIELD BONDS (HY)We anticipate spreads (the difference in yield between government bonds and IG and HY bonds) to remain largely unchanged. HY and IG should be supported by lower default rates and the ongoing profitability of the corporate sector. However, with spreads already at relatively low levels and the Fed poised to start moving interest rates higher, any substantial gains may be short lived. The likelihood, however, of significant weakness remains low.

EMERGING MARKET DEBT (EMD)We believe that EMD will produce decent returns in 2015. Falling inflation across many emerging markets could lead to lower bond yields supporting EMD. However, lower inflation and interest rates could also lead to weaker emerging market currencies. The sharp fall in commodity prices will create winners (importers) and losers (exporters), while higher US bond yields

could put downward pressure on those current account deficit countries reliant on foreign inflows. Overall, while emerging market currencies could weaken, we expect overall weakness to be modest because of low government debt levels and high levels of overseas foreign exchange (FX) reserves.

FOREIGN EXCHANGE The US dollar strengthened against most countries in 2014, and we believe this will continue to be the case in 2015 and beyond (Figure 19). The US dollar is likely to be supported by cyclical and structural factors. On the cyclical side, the US economy is inclined to be one of the strongest developed world economies and also one of the first to raise interest rates. With its banking sector in generally good health, its deficit back to normal levels, and wage growth at last starting to rise, the nation’s economic health is in contrast to many of the other economies in the developed and developing world. In addition, the ongoing development of the US shale oil and gas reserves is likely to further reduce US reliance on oil imports and provide a boost to the nation’s export position for many years (Figure 20).

FIGURE 17: US RATES EXPECTED TO STAY LOW

Source: Bloomberg

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Although they have already weakened, the euro and the Japanese yen could weaken further. The BoJ and the ECB are both pursuing monetary policies that are designed to weaken their currencies and remain years away from raising interest rates. Emerging market FX rates are expected to be mixed, with some coming under pressure as the Fed moves into a monetary tightening cycle.

FIGURE 19: US$ RALLY MODEST SO FAR

Source: Bloomberg

FIGURE 20: US OIL PRODUCTION SURGES

Source: Deutsche Bank Research

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Our central view is that the global economy is continuing to heal. This should lead to trend or above-trend growth in the developed world, led by the US and the UK. In the emerging world, some countries are likely to continue to struggle, although most should be stronger. Equities are generally expected to perform well, while bonds are expected to perform poorly. There are, however, a number of risks to this relatively benign outlook. The four key risks we consider are:

1. Potentially sharp rise in bond yields — We expect bond yields to rise modestly in 2015 (and beyond), underperforming forward rates. However, yields could rise more significantly if growth or inflation is higher than expected. This could put downward pressure on emerging market equities and those markets that have benefited from low interest rates and bond yields, such as high yield debt and some emerging markets. While any such equity weakness caused by strong economic growth would likely be only temporary, much higher inflation could cause more sustained weakness.

2. Global growth rolls over — We forecast global growth to strengthen in 2015, leading to corporate profit growth and higher bond yields. However, it is possible that problems in one or more emerging markets or eurozone instability could lead to a more generalized loss of confidence and slower growth. This would remove one of the key supports to global equity markets and push bond yields even lower.

3. Goldilocks: strong growth and stable/low inflation — We anticipate reasonably strong global growth but not to the point where the global economy is firing on all cylinders. It is possible that the signs of healing in the banking sector and the eurozone, plus reform in some emerging markets, could lead to a more significant recovery in corporate confidence and growth. Corporate profit growth could also grow strongly, especially in Europe and emerging markets, and lead to very strong equity markets there.

4. Geopolitical shock — Risks are always present, and it is very difficult to predict what will happen and whether anything will have a material and long-lasting impact on global bond and stock markets. However, material risks remain in the Middle East and Ukraine, and the ongoing growth in the Chinese economy continues to threaten the delicate balance of power in the region.

FIGURE 20: US OIL PRODUCTION SURGES

Source: Deutsche Bank Research

RISKS AHEAD

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Mercer continues to view the outlook for the global economy from a “glass half full” rather than a “glass half empty” perspective. Led by the US, the developed world economy should grow by trend or a bit more over the next few years (although trend growth is likely to be a little lower than before financial crisis). Emerging market growth in 2015 is likely to remain mixed, although stronger export growth and reform in some economies could pave the way for stronger growth in 2016. The Fed and the BoE are likely to start gently raising interest rates, although the ECB and the BoJ will continue to engage in large scale asset purchase programs. Globally, central banks will retain a pro-growth bias, and this bias is likely to continue for some time.

This relatively benign outlook is positive for financial markets and in particular equities. However, with equities no longer cheap, equity returns are likely to be more muted than witnessed over the past few years. In particular, equity returns are expected to rely more on earnings growth rather than multiple expansion. The mixed performance of emerging markets is likely to continue, although valuations should continue to provide support. While many risks remain, the key risk remains whether the Fed is able to withdraw the huge amount of liquidity it has provided over recent years in an orderly fashion. As a result of this, we may witness periods of substantial volatility 2015, even if our central case is that the trend of global economic recovery remains positive.

SUMMARY AND CONCLUSIONS

We may witness periods of substantial volatility in 2015, even if our central case is that the trend of global economic recovery remains positive.

Globally, central banks will retain a pro-growth bias, and this is likely to continue for some time and continue to offer opportunities.

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