A hard Brexit please

This week the government made clear its decision regarding the sort of Brexit it will be seeking. The red lines of control of immigration and withdrawal from the European Court of Justice’s jurisdiction represent the “taking back control” that the Leave campaign promised.

The other 27 countries in the EU have made abundantly clear that the price of Britain denying freedom of movement is that it cannot continue to be inside the single market –  the working definition of a hard Brexit. Thus some sort of agreement on how trade will be conducted between Britain and the EU will be required.

There appear to be two key areas to be negotiated before Britain actually leaves – (i) a transitional trade agreement pending a more permanent agreement which might take many years to conclude and (ii) an agreement on the financial services sector and the current passporting system.

It is interesting to note that the red lines regarding “taking back control” do not include the subject of the UK’s net contributions to the EU budget and it seems that Britain may be prepared to pay (financially) for a transitional trade agreement and agreement over continued financial services passporting. Whether this would be acceptable to the EU countries is not clear – the current payment from the UK of £18bn per year (which would presumably be the maximum that Britain would be prepared to pay), does not go very far when spread around 27 countries.

Whilst now is the time of maximum pessimism about Brexit negotiations -before formal talks have even begun and with each side setting out their red lines – Britain has lost goodwill in Europe over the last week following policy ideas announced at the Conservative Party ‘s regarding foreign-born workers.

Both Merkel and Hollande have made clear that it is important for them that Britain should be not be seen as having won anything by deciding to leave the EU, and though it is quite possible neither will be around to have much influence over the negotiations, their fellow-countrymen are unlikely to have very different ideas.

With important votes and elections in Italy, Spain, France, Netherlands and Germany over the next 12 months, little progress should be expected in the Brexit talks in that time period. This will prove negative to the world’s view of Britain – the pound has continued its post-referendum decline this week, and gilt yields have risen in anticipation of the higher inflation this is likely to create in the British economy.

International investors will at best defer further investment into the country and at worst begin making adjustments to their factory and office locations to reflect a Britain outside the single market. Any good news regarding the benefits of new trade agreements with other non-EU countries will have to await the outcome of talks to agree our relationship with the EU.

By announcing when it expects Article 50 to be triggered and its red lines, Britain has now entered a period of massive vulnerability for its economy. Maintaining the goodwill of the other EU countries should now be a key objective of foreign policy.

How do you like your Brexit – hard or soft?

“Brexit means Brexit” has been Theresa May’s equivocal line since the referendum. It has become clear that this actually means that Britain will leave the EU – the manner of that departure, however, remains unclear.

The difference between a “hard” and a “soft” Brexit centres around the relationship with EU single market which allows goods to move around the EU unhindered. A soft Brexit would allow Britain to remain in the single market, whilst a hard Brexit would see it leave both the EU and the single market.

All UK politicians agree, at the very least, that Britain should aspire to “have access to the single market”. This is, however, a meaningless form of words since all countries in the world (with the exception of North Korea) are able to sell their goods to buyers in the EU if they wish – ie they have access to the single market. What is more important is to have “tariff-free access to the single market” – provided a nation is a member of the WTO (World Trade Organisation) then a maximum tariff (or a tax) of 10% can be applied to trade in goods between them. In general, this tariff will be applied to all goods imports unless there is a separate trade agreement between the importing country and the exporting country. There is also considerable bureaucracy involved in proving that the goods meet any national standards or regulations of the importing country.

Being “a member of the single market” means that there are no tariffs and no bureaucracy – if the product meets EU standards then it can be freely sold anywhere inside the EU, and in practice the slightly larger EEA which includes Norway and a few other small countries. The major disadvantage of not being inside the single market is the bureaucracy involved at border points when goods cross in to the EU, which means higher costs for business. This is a particular problem for the border between Northern Ireland and the Republic of Ireland, which is currently completely open.

Being inside the single market is a real prize for business, is the main reason that Mrs Thatcher wanted Britain to be a member of the EU, and has been the UK’s main focus of political activity while a member.

Given the referendum result, the best outcome for Britain is not to be a member of the EU, and thus able to control its own borders (by ending freedom of movement to EU citizens) and write its own laws, but to retain membership of the single market. In fact, this would probably be the best outcome for every EU member and is why the EU negotiators will not agree to it.

Since Article 50 has not yet been triggered and negotiations have not yet started, both sides are talking tough and making clear that they would not be unhappy if nothing is agreed and Britain leaves the EU with no new agreement about trading relations in place. This is assumed by both sides to be that Britain would leave the EU and become a member of the WTO in its own right, rather than as part of the EU. This would be the hardest Brexit – access to the EU but with 10% tariffs applying to all trade (though Britain could unilaterally set a zero tariff on imports if it so wished). In any negotiation, the side least able to accept the situation if the event of no agreement has the weaker hand, so both sides are saying publicly that this would not be a problem for them.

Many in the UK claim that the €90bn trade deficit in goods that Britain has with the rest of the EU, means that the EU would suffer more, in money terms, from no agreement, whilst those in the EU point out that with 47% of Britain’s goods exports going to the EU, while for the EU’s leading exporter, Germany, the UK represents just 7.5% of their exports, the effective impact of tariffs on the British economy would be much greater than on the rest of the EU.

In practice, the obvious solution for both sides is tariff-free access for goods – it is the closest solution to the current situation and any tariffs would be negative for both parties. Provide the negotiations are conducted on a friendly basis, this should be the outcome, and can be construed as a medium-hard Brexit.

In financial services, where the UK has a large trade surplus, the EU operates a “passport” system, if a firm is regulated by an EU country it can apply to have a passport to provide those services in the rest of the EU. British firms are very keen to keep these rights, but if outside the EU they are dependent on the EU agreeing to this. France and Germany are both keen to have the power and the jobs from these financial services in their own countries, and so the price for maintaining these passports will be high. It is likely that the UK would have to offer concessions on the freedom of movement of people to achieve this – this would be a difficult compromise for the British people and politicians to accept.

Britain does not hold too many cards in the negotiations and a hard Brexit looks the most likely outcome.  Provided there is rationality and goodwill on both sides, tariff-free access for trade in goods should result, but an agreement on services, which is of greater importance for Britain will be much tougher to achieve.

A badly-timed referendum

David Cameron never really envisaged losing the referendum, hence he paid no attention to the timing of it should he lose it. However, the state of national politics across many European countries is febrile and within twelve months it is quite conceivable that the four largest countries in the EU will all have different leaders and potentially these new leaders will all be from different parties than rule today. This will have a major effect on the outcome of the exit negotiations.

In Germany the next general election is set for September next year. Ahead of the 2013 election Angela Merkel indicated that she would step down before the next election – this promise has not been repeated since that election but she is yet to confirm that she will stand for re-election next year. She is one of the most experienced and highly regarded politicians globally but her stance over the migrant crisis, being happy to accept over 1 million migrants into Germany over the last year or so, has damaged the standing of her and her CDU party in Germany. Should she decide to stand down, the EU will lose its most powerful politician and Germany’s influence within Europe will decline; should she decide to stand again she might find that her CDU party garners less seats than the centre-left SPD party, her current coalition partner. Recent local and regional elections have been notable for the surge in popularity of AfD, a party that began life on an anti-euro platform but which in recent times has shifted right to become firmly anti-immigrant and anti-Muslim. The proportional voting system in Germany means they are likely to gain seats in the new Parliament and become a meaningful force in German politics

In France, there will be a Presidential election in April. The two-stage process, where the two candidates with the highest number of votes in the first round are the only ones on the ballot for the second round, combined with a large number of potential candidates make for a lot of uncertainty. Currently Marine Le Pen of the Front Nationale, whose major policy is firmly anti-euro and anti-immigration, looks set to gain the most first round votes and be in the final ballot where she would be expected to lose against most others, but it is very unclear who the other candidate might be. From the centre-right of French politics Alain Juppe, a former prime minister and Nicholas Sarkozy the previous President are the two leading candidates, whilst from the left President Hollande is very unpopular and has yet to decide if he will stand again – two members of his government, Manuel Valls and Emmanuel Macron have already announced they are candidates. The current polls indicate that should Hollande stand he would fail to reach the second round, which would be a huge political embarrassment for him.

In Italy, the current prime minister Matteo Renzi has called a referendum on some constitutional changes to reduce the powers of the Upper House and regional governments, that he feels are necessary to deliver structural reforms to the Italian economy. The referendum result is likely to be close – it will be held between November 20 and December 4. He has repeatedly said that he will resign as prime minister and leave politics if his reforms are rejected. On current polling the anti-EU and anti-establishment Five Star Movement is leading though their leader, Beppe Griilo is himself not permitted to be elected to parliament due to a previous conviction

In Spain, there was an election in December 2015 but this produced an inconclusive result and it had not proven possible for any combination of parties to agree on a forming a government with a parliamentary majority. Mariano Rajoy the prime minister before the election has continued in office without sufficient votes in parliament to pursue his policies. Nine months of inter-party talks have failed to resolve the situation and the most likely outcome is another election soon. However current polling indicates that the likely outcome would remain very unclear.

With these four large Eurozone economies facing such political uncertainty, in terms of who will lead and what their policies will be, it seems unlikely that Brexit discussions / negotiations will achieve much forward momentum for some time. For markets, European economic policy will remain dependent on ECB decisions as little progress from fiscal policy or structural reforms can be expected either.

A safe assets bubble

The financial history of the 21st century is the story of bubbles and the after-effects of bubbles in different asset markets. In March 2000, the TMT bubble burst leading to a near 80% decline in the NASDAQ Composite Index over the next few years. The response of the Federal Reserve took interest rates down to 1% and held them there until it was clear that the economy was recovering – this policy of very cheap US dollar borrowing led directly to (i) the US housing market bubble and (ii) explosive growth in the financing of a wide range of assets, the emergence of the “shadow banking” sector and a bubble in the credit markets. The Global Financial Crisis in 2008 burst those bubbles and led to a severe global recession as the world’s financial system seized up. The Chinese government decided to seek to offset the damage to its economy with an enormous surge in infrastructure spending which created bubbles in their equity market and in many commodity markets. The weakness in global growth since then has meant that the recovery expectations of central banks have been consistently disappointed and led to them pursuing Quantitative Easing (QE) in ever-increasing amounts.

To date the 21st century has suffered bubbles in developed market equities, real estate, credit, emerging market equities and commodities – all assets that are to some extent seen as risky in investors’ portfolios. However the continued and repeated application of QE has now created a bubble in government bonds – the quintessentially “safe” assets for investors.

The hallmark of a financial asset bubble is when traditional valuation concepts are ignored by investors and the bubble asset is purchased because of a belief in the greater fool theory – that is confidence that when you want to sell there will be a buyer prepared to pay an even higher price – in these situations asset prices tend to rise to far higher levels than sensible investors can imagine.

The FT last week calculated that some $13.4 trillion of global government bonds now offered negative yields – a negative yield means that investors are paying to lend money to governments. They know that buying these bonds will result in them losing money if they hold them to maturity. Their rationale for continuing to hold them must be either (i) they are forced by law or regulation to hold them, (ii) they will suffer worse negative yields if they sell them and try to deposit the cash or (iii) they believe they will be able to sell them at a higher price (and more negative yield) to another investor in the future. Most of these negative yields are in Europe and Japan but even in the UK and the US most government bonds yield less than 1% and all global index-linked government bond yields offer negative real yields.

With central bank QE programmes continuing to be forced buyers of government bonds, the marginal buyer of these bonds is not price-sensitive and so a case can be made that prices of these bonds may go even higher, but investors should be aware that these are bubble valuations in government bond markets.

The bubble is most likely to be burst by the very success of these QE programmes. They are designed to raise the rate of nominal growth in the economy, which to date has not occurred, and if that happens then investors will once again demand higher and positive yields than are available today. The scope for losing money in safe government bonds will then become manifest. As an example the UK Treasury 4% of 2060 was issued in late 2009 at a price of £96.25%, in October 2015 was trading at £136.65% and last week traded at £195.57%. Investors who bought it last week would receive an income yield of just over 2% and know that the bond would be redeemed in 2060 at a price of £100%, losing 95 points of capital value over 44 years.

As each bubble in risky assets in this century has burst, investors have flocked to their safe asset, government bonds. This is the asset class that has not disappointed since interest rates peaked under Paul Volcker in the US in 1981 – this 35 year bull market has delivered extraordinary returns for relatively little risk. The future will not, though, be the same as the past – instead government bonds will increasingly offer return-free risk. When this reversal occurs investors will need to unlearn the lessons of the last 35 years in markets and deal with a new reality – a return to inflation, rising yields and falling government bond prices.

A tide in the affairs of men

Over the last 100 years there have been two turning points in the evolution of the main economic philosophy that have supported economic policy in the UK and the US – the third such turning point appears to be now in progress.

In 1936 Keynes published his General Theory of Employment, Interest and Money in which he demonstrated that the economy could be in a state of equilibrium but with very high levels of unemployment. His policy prescription that the government make up for insufficient private sector demand by borrowing to fund public sector investment spending was the first time that an economist had argued that there was a key role for government within economic policy. This prescription was adopted in both the UK and the US (Roosevelt’s New Deal) in the next few years to deal with the Great Depression of the 1930s. The post-war economic policy conventional wisdom was that governments had a legitimate and necessary role to play by intervening in the economy in order to boost growth.

In 1976, the UK was forced by the weakness of its economy, to go and borrow money from the IMF and put in placer what would now be called policies of austerity. Most famously, the then Prime Minister, James Callaghan said “We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists …”. This was also the year that Milton Friedman received the Nobel Prize for his work on the importance of the money supply in generating inflation and marked a key change in mainstream economic orthodoxy which led to the rise of Thatcher and Reagan who looked to roll back the influence of government in the economy and re-focussed the target of central banks’ policy on containing inflation rather than supporting growth. Terms such as economic liberalism and free market capitalism also reflect the same direction of economic thought and in particular the deregulation of the financial sector that has marked economic policy in both the UK and the US from that point. Globally, free trade was a concept that dominated international policy-making as it was seen as both containing inflation and boosting growth.

In 2016, it appears that the tide of economic ideas is once again turning, and once more it is led by the UK and the US (with the UK again just a little ahead). The motto of the Brexit Leave campaign to “take back control” and of Donald Trump’s campaign to “make America great again”, are both calls to move away from the economics of free markets and the philosophy of free trade.

As in the 1930s, this follows a period in which a laissez-faire philosophy has not delivered improved living standards for the average person, but instead seen the share of wealth amongst the very richest in society rise sharply, boosting inequality. Interestingly is the right-wing of political thought that have understood and sought to exploit this. Trump’s calls to fight immigration and renege on trade deals have strong appeal to the (white) working classes who have suffered most the globalisation of the world economy. Even in the UK, the words of the incoming prime minister have pointed to the need for business to work for all sections of society, rather than the elites. Central banks around the world have for a few years now quietly been pursuing policies designed to increase inflation rather than contain it, though without success to date.

We have passed the point of “peak free markets”, and changes in the direction of the dominant economic meme tend to be long-lasting (40 years going by recent experience). We should expect governments to become increasingly involved in the affairs of men.

For investors, the key correlation to note at these tide-turning points is for interest rates and bond yields. The history of greater government action in economies is marked by rising interest rates and inflation, with real returns from government bonds the key outcome. These were disastrously poor from 1936 to 1976 but have fabulous from 1976 to 2016. A long period of very poor real returns from government bonds is now at hand.

Three into two doesn’t go

By their nature, if referenda are to be used only for matters of the greatest import, a clear answer must be forthcoming and therefore only binary outcomes can be permitted. In fact, though the Brexit referendum voting slip had just Remain or Leave printed on them, the Leave campaign was a coalition of two different perspectives. Michael Gove and Boris Johnson wanted to leave the loss of sovereignty implied by being a member of the EU with its automatic imposition of any Brussels regulations, but did not wish to lose the ability to trade freely with the EU, particularly in financial services where the UK dominates Europe. Many in wealthy parts of the UK voted Leave for this reason. For Nigel Farage on the other hand, the key issue was control of immigration – the EU’s freedom of movement for people in the single market was not acceptable and many in the poorer parts of the UK voted Leave for this reason.

The UK thus finds itself in a situation of intransitive preferences, known as Condorcet’s paradox. This occurs when a society prefers A over B and B over C and C over A. For a single individual this is obviously inconsistent, but in a society of many different points of view, this state of affairs is quite possible.

The referendum shows that the UK prefers Leaving the EU to Remaining in it. However, leaving the EU requires that we have to choose between continuing to be part of the Single Market with its economic benefits and having constraints of the freedom of movement of EU citizens. EU leaders have made it quite clear that this is the price to be paid to be part of the single market.

Thus it is entirely possible that there is majority preference to Remain rather than no longer be part of the single market but have control of immigration, ie Remainers plus many of the richer Leave voters, and a different majority preference to Remain rather than not have control of immigration and continue to have full participation in the single market, ie Remainers plus many of the poorer Leave voters.

Theory shows that for society as a whole such intransitive preferences have no good solution and this is where the UK finds itself today – wanting to Leave but with no plan and the world laughing at it.

Boris Johnson, now in campaigning mode to be the next Prime Minister, proclaims that the UK can have both, but David Cameron has already admitted that the UK must choose. The next Prime Minister will thus have to choose between the interests of business and the City and the poor. As a Conservative the obvious course may be to save the interests of business, but such a course of action will further alienate the poorer sections of the country and boost the support for UKIP and its anti-immigration stance.

There is already speculation that France would be prepared to offer the new prime minister zero tariffs on goods (where the Eurozone has a large surplus with the UK) and controls on immigration from the EU but no passporting rights for UK banks in to the EU. This would be exactly what the Farage wing of Leave would accept, but do great damage to the City and Conservative supporters.

As ever in politics there will likely be a compromise with some damage to the UK’s access to the single market in services in exchange for some flexibility on EU freedom of movement.

In or Out – the UK’s European hokey-cokey

For the last 50 years the UK has had a tortuously ambivalent political relationship with the rest of Europe – the referendum will not resolve this. This is for reasons of both geography and history. As an island with nothing but sea to the west but a huge landmass to the east, the UK is both naturally separated, and hence different, from the rest of Europe and at the same time ineluctably tied to and influenced by what happens there. The UK is both a part of Europe and not a part of Europe. This is reinforced by the sharing of a common language with the largest economy in the world, so providing the US with its key gateway to the European continent. Half of the UK’s trade is with Europe, emphasising the importance of the relationship, and of course the other half is not.

Post-war history has highlighted the indecision of the UK with regard to its relationship with Europe. In the early days of inter-government discussions between the nations to discuss political and economic co-operation and integration in the 1950s, the UK was largely absent and played no part, believing such plans were of little interest or relevance to them. By the early 1960s this indifference had turned to concern as it became clear that important economic decisions were being made in Europe that were affecting the UK’s interests. Macmillan changed course and decided the UK needed to join the European project, but was dismayed to find that the UK’s entry was vetoed by de Gaulle’s. So the 60s was a decade of the UK banging on the door of Europe but not being allowed in.

Ted Heath’s premiership in the early 70s was built around heavy diplomatic efforts aimed at negotiating the UK’s entry into the Common Market. This was finally achieved in 1973 at which point domestic politics intervened and Labour came to power with an election mandate to renegotiate the terms of entry which had only just been agreed, and then to hold a referendum. The renegotiation delivered very little and the public voted 2 to 1 to stay in.

For most of her premiership in the 80s, Margaret Thatcher was a convinced pro-European, because she saw it as good for business, and it was she who pushed hard in negotiations with the rest of Europe to deliver the European single market – the UK at this time was consistently arguing for more European integration, with opposition from much of the rest of Europe!

This reversed dramatically in the 90s as Jacques Delors led the European drive towards monetary union and the creation of the euro. In the UK this was seen as a backdoor way of seeking greater political union and sparked the rise of the Eurosceptic wing of the Conservative party, which has been the key faultline within the party ever since. Major European initiatives since then such as the Schengen free travel area and the single currency have seen the UK opt out, while letting others move forward together in greater integration.

The Blair and Brown governments in the Noughties were keen to be seen as leading Europe, with both men seeking to extend British influence by positive engagement, but increasingly the UK media railed against Brussels bureaucracy and increasing European regulation.

David Cameron was forced, for reasons of maintaining short-term party unity, to cede a second referendum, and polls, with less than a week until the vote, show a nation badly split over whether to remain in or leave the EU.

Though the shorter term consequences of the vote will be significant, on a longer term view, the UK’s essential ambivalence in its attitude to Europe will persist.

A victory for Remain will be seen as a rather grudging acceptance that the economic benefits of staying in (which have been very real for the UK economy over the last 40 years) are worth the perceived loss of sovereignty and democratic accountability, but there are few in the UK who have made an emotionally charged positive case for Europe. The UK would continue to be in but the tone will be reluctantly in – the historic ambivalence will continue.

A victory for Leave, though at first sight a clear statement that the UK does not wish to be tied to Europe, will not bring to an end the need for close understanding of European rules. The most successful UK , in services, in order to trade successfully with Europe, will be forced to comply with whatever regulations the rest of Europe decides to impose, not just with regard to those specific industries but also more generally with regard to European laws, which the UK will have no part in deciding.

The UK’s destiny with Europe is thus set to remain halfway “In” and halfway “Out” – the UK’s European hokey-cokey. The referendum will be a significant event in the UK-European relationship but will not change that fate.

Inequality – more and less

A World Bank study a few years ago concluded that the forces of globalisation prevalent in the period 1988-2008 led to the first decline in global income inequality since the Industrial Revolution. The key drivers of this were the startling economic growth in the Chinese and Indian economies, both with populations of over one billion people, relative to the growth seen in the developed economies of the world. The increase in the size of the middle classes in emerging economies has been one of the most important growth themes in global equity investing for the last decade, benefitting the share prices of many global consumer products companies.

This reduction in global income inequality has however been achieved at the expense of rising income inequality in the developed world. The same forces of globalisation that have led to the creation of many jobs in the emerging world, destroyed the jobs of many in the developed world. The much lower wages available to employers in Asia saw first unskilled manufacturing jobs move from the West, followed by semi-skilled manufacturing jobs and digitalisation has also enabled many service sector jobs also to move locations. Workers in the developed world with modest skill levels and education have discovered that the global clearing price for their labour has fallen due to the increase in supply of such labour. However, those with the skills to be in the upper management echelons of many international companies found they benefitted from their companies’ larger global markets and higher profitability. Financial market services was one industry in particular that benefitted from these trends. For the top 1% in the developed economies, globalisation has boosted incomes.

Thus income inequality in the developed world has become much more marked at the same time as global income inequality has fallen. The statistic that demonstrates this most vividly is that the real income of the median US household has barely changed from 40 years ago. All the benefits of economic growth in that period have gone to the very richest in that society and national income inequality is back at the peak levels last seen in the 1920s.


Does this matter?

In purely economic terms, with the notable exception of the US economy, Andersen and Maiborn show a positive cross-country correlation between the level of GDP per capita and the rising equality of income in developed economies, in other words wealthier countries have a more equal income distribution, implying that greater inequality is negative for a country’s standard of living.

Perhaps the greater danger though is to politics and democracy. Recent political trends on both sides of the Atlantic show the poorer parts of the population of developed economies to be increasingly unhappy with the standard political approaches and type of politician. Instead more populist political figures such as Trump, Johnson and Le Pen, are on the rise with disguised and undisguised attacks on “others” in society as the source of the lack of improvement in living standards.

In a democracy the economic system must be seen to be operating in a manner that most in society believe to be fair and reasonable. If this is not the case then politicians will have an incentive to propose policies that produce better economic results for most people.

Rising inequality does matter within a democracy, and current levels in the developed economies are back at peak levels seen in the late 1920s. It may be worth a reminder that the 1930s saw the Great Depression and the rise of fascism.


Debt without Growth

Much has been made of the fact that the last seven years have seen one of the weakest economic recoveries from recession on record. Not only has real growth been relatively low in this recovery but inflation has also remained consistently low. The two together comprise nominal (or money) GDP, which is the growth rate of the economy in actual money terms, and is what businesses and consumers experience directly. In the UK real growth of 1.5-2.0% is coinciding with inflation of near zero, so that nominal growth has been less than 2%. This compares with typical nominal growth rates of 5-6% before 2007.

This appears to be following a worryingly similar pattern to the Japanese economy which since the early 1990s has seen average real growth of about 1% and inflation of minus 1% giving zero nominal growth over the last twenty-plus years. Such stagnant nominal economic growth, if it goes on too long, affects expectations about the economy. When companies and households expect no or very little nominal growth, they lose confidence in future economic opportunities and do not seek to invest to benefit from such growth or seek to spend since there is a fair chance that purchasing anything will be cheaper in the future and they have little confidence that their revenues or pay are likely to rise in the future.

In such conditions debt becomes a huge burden as it is a fixed nominal sum. If it was taken on with expectations of nominal growth of 5% per annum, but in fact there is very little nominal growth, the cash flow to service the debt is harder to find. The rational behaviour of economic agents is thus to save and pay down debt, further constraining the level of demand in the economy and creating a negative feedback loop.

This process terrifies central bankers for while they all know how to get inflation to fall if it is too high, they do not possess safe tools to get inflation to rise when it is too low. Thus we have been in a world of first low interest rates, then zero interest rates and now negative interest rates and several rounds of QE where money has been pushed into the financial system. By and large these have failed to get inflation rising again though financial market assets have seen price inflation. Since the Global Financial Crisis, government deficits have continued to lead to more debt being issued while companies have also increased debt, not to invest productively but in order to buy back equity. Debt has continued to grow but economies have not kept up

There are only three ways to get rid of any debt burden – Deflate, Default or Devalue. “Deflate” means to spend less than your income to provide the savings to repay the debt – this is fine for individual borrowers, but troublesome for the economy when pursued by governments or many borrowers at the same time. “Default” means not repaying – a terrible solution for the lenders who will reduce their own spending to compensate and also become far less keen to lend again in the future. Since the first two are very unattractive options to policymakers, their preference is usually for “Devalue”. This means apparently repaying the debt but doing so with money that has far less value. There are two routes to achieving this, first (for governments) by letting your currency fall on the foreign exchanges and second by creating inflation so that the real value of the debt repayment is much less. A good way to achieve both routes is to create a lot more supply of your own currency.

So the global economy finds itself in a real bind – weak growth has meant that the debt burden has increased and this has ensured that weak growth will continue. Policymakers have so far been unable to break free of this cycle.

For investors, the key actions are to be prepared for continued low growth and low inflation – which means low returns from all asset classes – until such time as policymakers panic and decide to get serious about creating inflation to devalue the global debt burden. At that point bonds and cash will lose a lot of real value and gold will find itself in massive demand as the inflation hedge and the only currency that politicians cannot create at their discretion.

The returns of GARS

This was originally published as an article in Investment Week

SLI Global Absolute Return Strategies (GARS) started life as a retail fund in May 2008 (and has become the largest retail fund in the UK market) though as a strategy available to external investors, it was launched by Standard Life in the summer of 2006. Its investment objectives are to achieve a total return of cash plus 5% (gross of fees), over rolling three-year periods, roughly consistent with the long-term returns from equities, but to deliver this with only one-third to one-half of the volatility of equities.

The team has sought to generate returns from a variety of sources, using both traditional investments in equities, bonds and real estate, as well as currencies, interest rates and volatility. Additionally it uses advanced investment strategies such as relative value and directional returns. By enhancing the number of return sources, they aim to enhance diversification and provide a smoother path of returns.

In their marketing, the team at Standard Life has distinguished between four types of return: Market Beta, Security Selection, Relative Value and Directional, labelling the first two as traditional and the latter two as advanced.

Over the period from July 2006 to the end of 2015,  GARS has generated a total gross investment return (before fund fees and costs) of 71.47% from these strategies. Since 2008 the fund has been invested in between 30 and 40 individual strategies at any one time.

Using data provided by SLI, attributing performance by individual strategy on a quarterly basis since 2006, the individual strategies were classified into each of the four types of return. A fifth type, Other, was created for this analysis,which is essentially the return generated on cash holdings.

  • Within the Market Beta classification only those strategies which appeared to involve being long a sector or market in the equity, bond or property markets were included.
  • Within Security Selection, only the strategy return for security selection provided by SLI was included. Security Selection involves going overweight some securities (relative to an index) and underweight other securities. This is an alpha return.
  • Within Relative Value only those strategies which were described as one asset type versus another; for example European vs US volatility, UK vs German short-rates, German vs French equity were included. In addition, an S&P call calendar spread and various cross-asset strategies were classified as Relative Value. Relative Value trades involve going long one asset and short an equivalent value of a second asset. Returns from Relative Value are also alpha returns with no associated market risk premium.
  • Within Directional strategies in interest rate and currency markets, strategies investing in volatility and dividends and yield curve strategies were included.
  • Within Other cash, liquid instruments and a small unexplained residual, which amounts to -0.2% over the entire period were included.

Analysis of returns by strategy type

  1. Beta returns from investment in equity markets have been reasonable overall at 8.7%. Equity market exposure cost investors heavily in 2008, but fared better in 2009 when a proportion of the 2008 losses were made back. Beta from fixed income market exposure has generated positive returns in every calendar year, with 2009 and 2012 being the strongest years thus far, totalling 20.1%. The team correctly positioned the fund in anticipation of strong performance in the corporate bond market in both of these years. Returns from occasional forays into real estate investment detracted in 2008.
  2. In the original marketing of the GARS strategy, the team’s target was for security selection to contribute about 1% per annum to the fund’s returns. However, the managers have struggled to deliver even 1% of return (0.9%) over the near-10 years since launch. It is this strategy that has been the most affected by the enormous inflows into the fund in recent years.
  3. The returns from Relative Value of 7.6% since launch are less than 1% per annum, although they have been positive in eight of the ten calendar years since launch. The negative contributions from equity and cross-asset Relative Value strategies since launch are disappointing, clearly indicating that the team has struggled to find good alpha-generating ideas in these areas. They have though had some success in Relative Value strategies in rates and bond markets and in volatility across markets.
  4. The greatest generator of returns has been from Directional trades (32.0%), and within those, from trading strategies in interest rates and yield curves (21.4%). Alongside the team’s good calls in fixed interest markets generally in the beta portion of the portfolio, these markets were very fruitful for investors from 2006 until 2011. However, since then only small returns have been generated from these strategies.
  5. Over the last three years, total returns of 7.5% from Directional strategies have been generated almost exclusively from the currency markets, nearly all of which has come from trades where the US dollar was the long position.

Analysis of returns by underlying asset class

  1. FIXED INCOME Performance attribution by strategy shows that the bulk of returns (47.2% from a total gross return of 71.5%) in GARS have come from strategies, both traditional and advanced, in the money and fixed income markets. Combining Fixed Income Beta, Rates & Bonds RV and Rates and Yield Curve Directional as Fixed Income strategies, returns here amount to almost two-thirds of the total return to investors over the period. Well-timed moves into strategies that benefitted from falling interest rates and bond yields in the second half of 2008 were particularly profitable and did much to offset the losses from equity strategies at that time. However, since Q3 2014 returns from these fixed income strategies have been negative. It may be coincidental but the timing of this change in the pattern of returns occurred when Ian Pizer, a key contributor of fixed income duration ideas to GARS, left SLI to join Aviva.
  2. EQUITIES Combining Equity Beta, Equity RV, Dividends and Security Selection as Equity strategies, returns here amount to 9.2%, which since inception is less than 1% per annum. This must be viewed as disappointing given the opportunities that have prevailed for returns from both long-only and long-short strategies over this period of time.
  3. CURRENCIES From 2013 to 2015, returns from currency strategies have formed an increasingly important part of the fund’s total returns. Prior to 2013, currency strategies had generated little in the way of returns. Almost all of the returns since 2013 have come being long the US dollar.


  • Over the history of the strategy to date, GARS has broadly met its long term total return target.
  • These returns have come from both advanced investment strategies (Relative Value and Directional strategies typically used in many hedge funds) and more traditional sources of market return (the Beta and Security Selection strategies). The advanced strategies have delivered 39.6% of gross returns, while the traditional strategies have delivered only 27.6% of gross returns. This dependence on advanced strategies (alongside the large gross positioning that is required to implement some of these strategies) may be surprising to investors who have not looked deeply into the GARS investment process.
  • GARS has generated its returns principally through strategies based on investment in fixed income strategies. It generated good returns from being positioned in corporate bonds in the strong markets of 2009-10 and 2012-13 and positions aimed at benefitting from lower interest rates across the yield curve. However in recent years this source of returns have dried up.
  • Equity strategies have generated only beta-type returns, with little value added from security selection or market timing.
  • In recent years, a correct call on US dollar strength has supported returns as bond and interest rate strategies have struggled to maintain performance.