This document discusses challenges facing the global and UK economies, including high unemployment, weak wage growth, fiscal tightening, and debt sustainability issues. Inflation is expected to remain low across developed economies due to slack in labor markets and weak wage demands. The UK faces particular challenges, such as a weak industrial production recovery despite currency depreciation, mixed retail sales, and high inflation expectations according to options markets. Deleveraging of private sector and bank balance sheets will constrain credit growth for years.

1. Fixed-income strategy
A tour of inflation . . .
. . .and why the world (& the UK) is not rosy
March 2011
Andrew Roberts
“The rise and fall of civilizations are linked to demographic trends” (Source: CIA)

2. CLIENT
LOGO
RBS00000
2
Risky assets doing fine… on. Well, they were up to last week
55
60
65
70
75
80
85
90
Feb-09 Jul-09 Dec-09 May-10 Oct-10 Mar-11
AUD/JPY
-2000
-1500
-1000
-500
0
500
'91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11
RBS Risk appetite indicator
Risk-off
Risk-on
10
60
110
160
210
Feb-09 Aug-09 Feb-10 Aug-10 Feb-11
0
10
20
30
40
50
60
Treasury Option Volatility Estimate
VIX Index (rhs)
0
20
40
60
80
100
120
140
Jun-08 Jan-09 Aug-09 Mar-10 Oct-10
EUR FRA/OIS SPRD 3M,
4th future
GBP FRA/OIS SPRD 3M,
4th future
USD FRA/OIS SPRD 3M,
4th future
20
30
40
50
60
Feb-07 Nov-07 Aug-08May-09Feb-10 Nov-10
World Equity
0
200
400
600
800
1000
1200
1400
Feb-07 Dec-07 Oct-08 Aug-09 Jun-10
US Industrial 10-yr
Benchmark - US
Treasury 10-yr
B rated industrials

3. RBS00000
3
Data surprises are already at all time highs. Worrying for equity bulls
Surprise
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Mar-02 Mar-04 Mar-06 Mar-08 Mar-10
RBS data surprise index, sample of USA & Germany front line data.
Normalised surprise indices, monthly data to end-Feb 2011

4. RBS00000
4
What about the oil effect? About to hit
6
8
10
12
14
16
18
20
'67 '69 '71 '73 '75 '77 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11
USCPI UrbanConsumersGasoline/ UShourlywage
900
1000
1100
1200
1300
1400
1500
Feb-
06
Aug-
06
Feb-
07
Aug-
07
Feb-
08
Aug-
08
Feb-
09
Aug-
09
Feb-
10
Aug-
10
Feb-
11
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
EU27gasoil
pumpprice
index
German2-yr
yield
Demand driven
Demand
driven: up to
now

5. RBS00000
5
The rate of change can count . . . beware sharp rises
-75%
-55%
-35%
-15%
5%
25%
45%
65%
85%
105%
125%
Dec-
1961
May-
1967
Nov-
1972
May-
1978
Oct-1983 Apr-
1989
Oct-1994 Mar-
2000
Sep-
2005
-2
-1
0
1
2
3
4
5
6
7
Oil PriceYoY%change WorldGDPgrowthYoY%change(rhs)
-75.00%
-25.00%
25.00%
75.00%
125.00%
175.00%
225.00%
275.00%
325.00%
375.00%
Dec-
1961
May-
1967
Nov-
1972
May-
1978
Oct-1983 Apr-1989 Oct-1994 Mar-
2000
Sep-
2005
Mar-
2011
-3
-2
-1
0
1
2
3
4
5
6
7
8
Oil Price2yr change WorldGDPgrowthYoY%change(rhs)

6. RBS00000
6
Real wages the key in H2. Already plunging, falling further in zones with
spare labour
-3
-2
-1
0
1
2
3
4
5
6
7
Mar-71
Mar-74
Mar-77
Mar-80
Mar-83
Mar-86
Mar-89
Mar-92
Mar-95
Mar-98
Mar-01
Mar-04
Mar-07
Mar-10
Germany, Real
compensation rate,
total economy, yoy
United States, Real
compensation rate,
total economy, yoy
-6
-4
-2
0
2
4
6
8
10
Mar-71
Mar-74
Mar-77
Mar-80
Mar-83
Mar-86
Mar-89
Mar-92
Mar-95
Mar-98
Mar-01
Mar-04
Mar-07
Mar-10
United Kingdom, Real compensation rate,
total economy, yoy
Sweden, Real compensation rate, total
economy, yoy
The big theme (even though no-one is discussing it). Spare labour capacity = no wage bargaining

7. RBS00000
7
Eg US unemployment is high. Extraordinarily high in some measures
Source: Courtesy of ShadowStats.com
The augmented U-6 rate includes long-term discouraged workers (defined out of
existence in 1994). U-6 only includes short-term discouraged workers
Unemployment Rate
0
2
4
6
8
10
12
Jan-50 Jan-58 Jan-66 Jan-74 Jan-82 Jan-90 Jan-98 Jan-06
% Unemployed for >6m
0
10
20
30
40
50
Jan-48 Jan-57 Jan-66 Jan-75 Jan-84 Jan-93 Jan-02 Jan-11

8. RBS00000
8
EMU: where is inflation going to come from? Wages low, demands high
– Negotiated wages outlook weak. Was at weakest ever last month
– Parts of EMU approaching deflation already
– Just popped up to due to fiscal tightening = higher VAT/taxes (notwithstanding oil)
Source: RBS Euro economics
0
0.5
1
1.5
2
2.5
3
3.5
4
97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
EMU Negotiated Wages, % yoy EMU Core inflation, % yoy
97-10 avg
97-10 avg
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Ger, Fra, Ita, Neth, Bel, Aut, Fin, Lux
Spa, Gre, Por, Ire, Cyp, Mal, Svn, Svk
Taxes
7
7.5
8
8.5
9
9.5
10
10.5
11
Jan-91 Mar-95 Apr-99 May-03 Jul-07 Aug-11
0
1
2
3
4
5
Eurozone Unemployment
Eurostat Harmonised Index of Consumer Prices
German wage claims in 2011
Sector demand
Construction industry 5.9%
Chemicals 6-7%
Deutsche Telekom 6.5%
Food and Catering 5-6%
Public services €50 + 3%
Coal industry Real wage rise
Textiles 5%
Insurance 6%
Volkswagan 6%

9. RBS00000
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What about the UK? In poor shape, according to balance sheet
-14.0
-12.0
-10.0
-8.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
Mar-88 Nov-90 Aug-93 May-96 Feb-99 Nov-01 Aug-04 May-07 Jan-10
Government Households
Privatenon-financial corporations UnitedKingdomtorestoftheworld
Household
financial balance
is negative
35
40
45
50
55
60
65
Ma
r-
06
J
ul-
06
No
v-
06
Ma
r-
07
J
ul-
07
No
v-
07
Ma
r-
08
J
ul-
08
No
v-
08
Ma
r-
09
J
ul-
09
No
v-
09
Ma
r-
10
J
ul-
10
No
v-
10
USISMNon-Manufacturing UKServicesPMI
EMUServicesPMI

10. RBS00000
10
Risk assets are recovering, but UK production is not
UK production hardly bounced whatsoever, despite -26% sterling trade-weighted fall
Q307 to Q408
60
70
80
90
100
110
Mar-78 Mar-82 Mar-86 Mar-90 Mar-94 Mar-98 Mar-02 Mar-06 Mar-10
-15
-10
-5
0
5
10
15Industrial Production Change (YoY)

11. RBS00000
11
What about the UK? Retail sales news mixed
Retail sales(ex. auto) - ChangeYoY
-8
-6
-4
-2
0
2
4
6
8
Feb-
05
Jul-
05
Dec-
05
May-
06
Oct-
06
Mar-
07
Aug-
07
Jan-
08
Jun-
08
Nov-
08
Apr-
09
Sep-
09
Feb-
10
Jul-
10
Dec-
10
UK EMU US
Better? No, with BRC retail sales at -0.4%yoy

12. RBS00000
12
UK fiscal tightening set to bite
Government balances(%of GDP)
-12.0
-10.0
-8.0
-6.0
-4.0
-2.0
0.0
2.0
Australia
Canada
France
Germany
Greece
Italy
Netherlands
Portugal
Spain
Sweden
SwitzerlandUnitedKingdom
Euroarea
TotalOECD
2010 2011 2012

13. RBS00000
13
Sticky UK inflation, yes … taxes & external influences
-1
0
1
2
3
4
5
6
2004 2005 2006 2007 2008 2009 2010 2011
UK
EMU
HICP constant tax, % y/y
85
90
95
100
105
110
Feb-06 Jun-06 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct-10
US Composite Leading Ind.
Total Leading
UK Composite Leading Ind.
Total Leading
EMU Composite Leading Ind.
Total Leading
Japan Composite Leading Ind.
Total Leading
Spot the odd man out: before the turmoil, UK was showing weaker momentum (data up to end-2010)
Source: OECD

14. RBS00000
14
UK CPI forecasts
-2.00
-1.00
0.00
1.00
2.00
3.00
4.00
5.00
6.00
Jan-02
Jul-02
Jan-03
Jul-03
Jan-04
Jul-04
Jan-05
Jul-05
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
RPI
RPI forecast
CPI
CPI forecast
il13s

15. RBS00000
15
What are inflation options telling you? That the UK is seen to have an
inflation problem
EMU
15
20
25
30
35
40
45
50
Feb-10
M
ar-10
Apr-10
M
ay-10
Jun-10
Jul-10
Aug-10
Sep-10
Oct-10
Nov-10
Dec-10
Jan-11
Feb-11
M
ar-11
<1%
Between1%and2%
>3%
Probability of yoy inflation at various levels
in 10 years
UK
0
10
20
30
40
50
60
70
80
90
Feb-10
M
ar-10
Apr-10
M
ay-10
Jun-10
Jul-10
Aug-10
Sep-10
Oct-10
Nov-10
Dec-10
Jan-11
Feb-11
M
ar-11
<1%
Between
1%and2%
>3%
US
10
20
30
40
50
60
70
Feb-10
Mar-10
Apr-10
May-10
Jun-10
Jul-10
Aug-10
Sep-10
Oct-10
Nov-10
Dec-10
Jan-11
Feb-11
Mar-11
<1%
Between
1%and2%
>3%

16. RBS00000
16
Bank balance sheets not fixed. Credit to tighten for years
The knock-out punch that deleveraging delivers. 6 years of deleveraging?
Bank credit to the private sector (% of nominal GDP)

17. RBS00000
17
No-one wants any credit when you are deleveraging . . .
UK: more credit available UK: that nobody wants

18. RBS00000
18
UK rates already discounted a lot higher
UK rates already seen to rise significantly
0
1
2
3
4
5
6
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
GBP USD EUR
1yr swap rates, starting at various forwards

19. RBS00000
19
EMU debt sustainability
1.7
2.7 2.8 2.8 2.9
3.2
3.4 3.5
3.7 3.7
4.3
5.1
4.2
0
1
2
3
4
5
6
Greece
Portugal
Holland
Germany
Spain
Italy
Finland
Belgium
France
Austria
Ireland
USA
UK
%
-5.9
-4.7 -4.7
-1.8
-1.5
-1.1
-0.8 -0.6 -0.6
-0.2 -0.1
0.5
-0.2
-7
-6
-5
-4
-3
-2
-1
0
1
Greece
Spain
Ireland
Netherlands
Portugal
Finland
UnitedStates
Belgium
Italy
France
Austria
UK
Germany
%
Difference versus 2000-07IMF estimates of mean nominal GDP growth 2011-15
Growth is pivotal
Spain, Portugal & Ireland all suffer massive drops in nominal growth compared to the years 2000-2007

20. RBS00000
20
Nominal growth minus long-term interest rates
-8
-6
-4
-2
0
2
4
6
G
reece
Ireland
Portugal
Spain
Italy
Finland
N
etherlands
Belgium
France
G
erm
any
U
K
U
nited
States
2000-2007 2008-2015

21. RBS00000
21
A Fiscal Risk Index
Source: Maplecroft, February 2011
“…identify countries that will come under increasing economic pressure in
future years due to low birth rates, high life expectancy and state
commitments to look after ageing populations.
The index is calculated using eight indicators: child and old-age
dependency ratios between 2010 and 2050; labour rates of the over-65s;
GDP; debt; and public spending on pensions, health and education.”

22. RBS00000
22
Uncomfortable bedfellows
Changes in public debt, 2008-2011, & 2008-2015
Source: IMF Fiscal Monitor, November 2010
Easy to differentiate between:
a) Countries that have gone beyond (?) or almost
reached the point of no return
b) Countries that have terrible metrics but are
doing what is necessary (UK)
c) Countries that are in the „bubbling under‟, next
countries to be hit category (Spain, Portugal,
France)
d) Countries that have done less easing and
should be less punished (Italy, Australia, EM)
Source: IMF World economic outlook, October 2010. Note: net debt for Japan

23. RBS00000
23
UK funding needs coming down. From a high level, but falling
0
50
100
150
200
250
2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16
Gilt issuance/grossfinancingrequirement
Gross Gilt sales
As of March Budget 2010: £187.3bn
As of April 2010 revision: £185.2bn
As of June 2010 emergency budget: £165.0bn
Current: £165.2 Gilt sales
Cumulative fall in gross financing requirement
announced in June 2010 emergency Budget:
-£106bn

24. RBS00000
24
UK: logically, doing what it says on the tin
Gilts have just been on one big round trip (10-yr spread to bunds)
-80
-60
-40
-20
0
20
40
60
80
100
120
Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11
(bps)
UK10yvs.
France
UK10yvs.
Germany
The 7 Dec 2009
Budget give-
away, & capital
flight
The great Gilt reappraisal

25. RBS00000
25
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