The UK‘s choice – Perseverance or Printing

The UK economy grew by 1.0% in the third quarter, the fastest quarterly growth rate for five years.  After several quarters of negative data and a slump into double-dip recession, this would appear, at first sight, to be very good news.  Though the news is welcome, it cannot yet be described as good. First there are two, significant one-off items that should be stripped out; the Diamond Jubilee holiday last June is estimated to have reduced the economy by 0.5% in the second quarter.  Absent anything else happening, there would have been a statistical rebound in growth of that amount in the third quarter.  Additionally, in August the sales of Olympic tickets were estimated to have contributed 0.2% to economic growth.  This leaves 0.3% as the underlying figure for economic growth once these have been taken into account.  Rather surprisingly, in an age of government austerity, the increase in output of government services accounted for 0.36% in the third quarter, which leaves the non-government sector still in decline!

A clearer view would appear from looking at the data over the last twelve months as a whole.  Over this period, growth in the economy has been essentially zero, as it has been since the third quarter of 2008 when Lehman Brothers collapsed.  Four years of zero growth is a far better description of what has occurred than the sequence of recessions and recoveries that media headlines would imply.

The number of people employed in the UK recently reached an all-time high, beating the previous record set in 2007. However, the UK economy is actually 3% smaller than at the time of that peak in employment – this implies that productivity (the amount of output produced for each worker) in the economy has actually been falling, which is very unusual, and has been causing much head-scratching amongst economists.  The explanation comes from two sectors.  First, North Sea oil production has peaked and is becoming progressively more difficult and expensive to produce, so productivity is in decline.  The second area is financial services;  over the last five years there has been a 16% fall in measured output from banks and insurance companies with no significant decline in employment.

In a recent speech in Cardiff, Mervyn King, the Governor of the Bank of England, made it very clear that he believes that this period of zero or very low growth is likely to continue for some years.  He stated that Western banking systems had still not recognised the full extent of bad assets remaining on the books of the banks. Until the banks do this and recapitalise themselves, monetary policy alone (including QE) was not going to be able to solve the economies’ problems.  The effectiveness of QE is really limited to offsetting some of the weakness in demand that this consolidation of the banking sector would generate, rather than generating economic recovery.

Lord King’s perspective is that the policy choice for the UK (and indeed the other indebted Western countries) is between Perseverance and Printing.  As befits a Central Banker, he believes that Perseverance is the best path back towards economic growth.  This requires enduring more (un-quantified) years of near zero growth (as the banking system corrects itself and consumers and governments cut back their spending so that they can reduce their debts), while the Central Bank supports the economy through QE.  The alternative of Printing, which he would not endorse, but has been hinted at by Lord Turner, a potential successor to Lord King next year, is one of “helicopter money”, in which newly created money is handed out to the public.  This is clearly the inflationary solution to the debt problems facing Western economies.  However, it is not a solution that is yet being promoted, but the concern must be that the longer the period of low or zero growth, the more that politicians will seize on such ideas as a means of creating employment and growth, and hence votes.

It is for this reason that gold should have a key part of everyone’s portfolios, as the insurance policy that Printing overcomes Perseverance through a long period without growth.

Whilst the world watches Europe, it is missing the Chinese slowdown

The official Chinese GDP data show economic growth of 8.1% in the year to end March, as always a little above the recently-reduced official target of 7.5%. There is though a considerable degree of scepticism over this number (in 2007, the GDP data series were described as “for reference only” by Li Keqiang, who becomes Prime Minister in November) as other data series are much weaker. Power output (a data series likely to be accurately measured and very significant in a manufacturing-based economy) rose by only 0.7% over the same period, car retailers are reporting a huge build-up in inventories indicating a fall in consumer confidence, and sales of bulldozers are down by 51% compared with a year ago which indicates weakness in construction. These are worrying figures.

In the very worst of the global economic crisis in 2008/09, China embarked on a staggeringly large investment and infrastructure spending programme in a bid to maintain demand in the economy in 2009 and 2010 whilst they hoped that the rest of the world would sort out their banking crises and associated problems. They were hoping that by the time their own stimulus programme had run its course, the rest of the global economy would have regained its poise and would once again provide the strong consumer demand for Chinese exports. With the US also spending heavily, the world did come out of recession in 2009, and 2010 was also a reasonable year. However Western consumer confidence has not recovered and consumer spending has not returned to make the recovery self-sustaining – and the eurozone’s problems have only made things worse. So the hoped-for recovery in Western demand for Chinese exports has not occurred.

Worse still for the Chinese, the enormous stimulus they delivered has had two serious negative consequences. First was a house price boom in the major cities of China, as the extra spending engendered confidence that Chinese growth would continue to be strong, interest rates were held at low levels and banks were strongly encouraged to lend. In 2011 the authorities became concerned about this and sought ways to reduce the flow of credit for speculative house purchases. Secondly, the infrastructure projects that were built were brought forward from plans for several years hence, and so there are now many entire “ghost” towns built with roads, houses, and shops where nobody lives or works – the infrastructure of China is now years ahead of its current stage of economic development and the demand for that infrastructure. In economic terms the returns from much of the investment boom China undertook have been very low or possibly zero.

China’s economy is now hugely imbalanced with consumer spending just 35% of the economy. Contrast this with the UK and US where consumer spending represents nearly 70% of the economy. If China’s growth story is to be sustained it will need to produce its own consumer demand rather than rely on the Western consumer, and a major rebalancing between investment spending and consumer spending is required. Wages have been growing very quickly, but the Chinese love to save and encouraging them to spend has so far proved difficult. Ironically, whilst the West’s problems are an unaffordable welfare state system and a crumbling infrastructure, China currently has too much infrastructure and not enough of a welfare state. The cost of healthcare in China is very high and pension provision is poor – a stronger safety net might encourage Chinese workers to hold lower savings and go on a mini-consumption boom.

China’s economy is slowing more dramatically than the official data show; commentators have been assuming that in this situation, further economic stimulus would be the policy response. Such a stimulus should not however be a repeat of the government-directed investment spending. Instead to be effective, more subtle policies aimed at boosting consumption are required. Until then, whilst the world watches the Eurozone fall apart they may be missing the problems that are emerging in China. Chinese and Asian equities are the preferred asset class over the next decade, and long term investors should be seeking a heavy exposure in their portfolios. Over the next few months however, there remains scope for investors to be disappointed with Chinese economic developments, and a better buying opportunity is likely to emerge.