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.

Saudi worries

Over the last eighteen months, Saudi Arabia’s foreign policy has become extremely assertive and has created major uncertainties for the oil market and the geopolitical situation in the Middle East. Both of these are of major significance for global financial markets.

In the second half of 2014, there was a major shift in Saudi policy with regard to the oil market. Stung by rapid growth in US oil output from shale oil deposits, which led to the US no longer being a net importer of oil, the Saudis refused to continue to act as the swing producer in the oil market in order to maintain an oil price above $100. They announced that they would continue to pump oil at full capacity in order to maintain their market share. With oil demand weak due to weak global growth, particularly in China, and supply plentiful, inventories have soared and the oil price has fallen to a level at which US shale oil is uneconomic. Prices below $60 will see exploration in the US shut down and development of existing discoveries discontinued, though this process has been slow due to US investors providing a lot of capital, both debt and equity, to US shale oil companies in the first half of 2015, believing that the oil price would bounce back towards $100.

For Saudi to maintain its share of the oil market, it was necessary for them to force the most marginal oil fields out of business – these were the US shale deposits, and Saudi continues to pursue this policy which will also maintain the US as a net oil importer. As a way of treating its historic key ally and protector, this was an aggressive decision by the Saudi government.

The financial market implications have been (i) major credit problems in the US high-yield bond market which had provided a lot of capital to the shale oil companies, (ii) massive cutbacks in planned capex spending by the major oil companies – should the oil price remain in the $30s almost all of them will have no sustainable earnings or dividends and (iii) the Saudi budget, which is based on the assumption of $100 oil has moved into an enormous deficit. In order to meet the gap of 15% of GDP in 2015, the Saudi government has drawn down from its sovereign wealth fund, which in turn has liquidated investments it held global financial markets. Other oil exporters have had to act in a similar fashion and some have dubbed this “Quantitative Tightening” as liquidity is withdrawn from financial markets in contrast to the “Quantitative Easing” employed by central banks in recent years, which has acted to support financial market prices.

Cynical political observers have long noted that when a government faces difficulties in its domestic economy, its politicians often discover an external enemy that needs to be confronted that also distracts the attention of its populace. It might be argued that the New Year’s Day decision of the Saudi government to execute Nimr Al-Nimr falls into this category.

Islam is divided into two key strands, Shia Muslims for whom Iran is the acknowledged leading force and Sunni Muslims for whom Saudi Arabia is the leading force, though Iran contains a minority of Sunnis and Saudi contains minority of Shias. This divide is at the very centre of unrest in the region as a whole. Nimr Al-Nimr was the leading Shia cleric in Saudi Arabia, and his execution for terrorist offences was interpreted as an attack on the Shia minority by the Iranians, which then led to an attack on the Saudi embassy in Tehran which led to the Saudis breaking off diplomatic relations with Iran. This heightens the tensions that already exist across the region. The situation is compounded by the number of different sides that exist in the region, where your enemy’s enemy may very well prove also to be another enemy to you rather than a potential ally.

This increasingly assertive Saudi government policy follows the appointment nine months ago of a new Crown Prince and Deputy Crown Prince, representing the appointed succession plan to the 80 year old King. Their more assertive policies are a break with Saudi tradition and may well indicate a new trend. Wars which lead to attacks on the major oil fields in the region have, on fairly recent history sent the world economy into recession very quickly.

Currently, most of the world’s powers have troops attacking someone in the Middle East region – the chances of a relatively minor event drawing in military forces of many countries is very real. Once again global geopolitics is centred on the region the oddity this time is that oil prices have fallen as tensions have risen.

A much less predictable Saudi regime is the last thing financial markets need when there are so many other factors causing uncertainty. For the investor, the best response is to build exposure to gold, which would perform well in the face of both the increased geopolitical uncertainty and greater uncertainties in financial markets.

China Gold; Asia Hold

One of the themes emerging from the Chinese press in recent weeks has been their call for the world economy to become “de-Americanised”.  This was especially apposite during the debt ceiling crisis when it appeared possible that the US might default on a repayment of Treasury debt, because Congress would not extend the debt ceiling.  The knock-on effects throughout the derivative and financial markets might have been as cataclysmic for the global economy as was the failure of Lehmans five years ago.

It is the primacy of the dollar, acting as the world’s reserve currency, which gives the US such huge influence over the world economy, and the Chinese have been steadily seeking to reduce this hegemony.  They have reached agreements with Russia, Brazil and Australia, their key sources of commodity imports to transact in Renminbi, rather than US dollars, the usual currency of account for commodities.  In addition, they have been working closely with the UK to establish London as the major financial centre for offshore renminbi transactions, with the long term objective of making the Renminbi a key currency in global markets.

It is not in China’s interests however, to destabilise the US dollar.   In 2000, China owned about $600,000,000,000 (six hundred billion dollars) of US government debt, which was then about 2% of the debt owned by the general public).  By July this year, that had increased to $1,300,000,000,000 (one thousand three hundred billion dollars), about 11% of the publicly owned debt, and another $700,000,000,000 (seven hundred billion dollars) in US mortgage agency debt. This has made the Chinese quite critical of the US on occasions, with regard to the inflationary impact of the QE policies pursued by the Fed, and recently when there was the possibility of a default on Treasury debt.

In fact, the share of US dollars in the Chinese foreign exchange reserves has been falling as they have diversified into other currencies, including gold.  China’s gold reserves were disclosed at 1,054 tons in April 2009, but since then China is thought to have been producing more gold than any other country, none has been exported, and imports of gold into Shanghai and Hong Kong have been consistently strong. Gold commentators believe that China has about 3,000 tons of gold currently and may be targeting 10,000, which is in excess of the US reserves of 8,000 tons.

This month sees the Third Plenum of the Chinese Communist Party’s 18th Central Committee. Traditionally the first two Plenums for each Committee are concerned with personnel matters for the government and party leadership.  Third Plenums have historically been used to announce new structural reforms for the Chinese economy  and to reveal the major economic policies and direction that they would like to follow over the remaining 4 years in power.

For Xi Jinping, the Chinese President, the Plenum comes at a critical time in China’s economic development.  After two decades of rapid export-led growth, the 2008 crash saw China implement a massive debt-funded infrastructure spending programme, much of which has been inefficiently used by the state-owned enterprises.  Western demand for its exports remains muted, and the only long term solution to maintaining rapid Chinese growth is through Chinese domestic consumption.

However, Chinese consumers are huge savers, since there is no pension system and falling ill in China is a very expensive matter – the development of a welfare system is important in encouraging Chinese consumers to spend more and save less.  Further, there are few legitimate outlets for their savings – interest rates on bank deposits are below inflation and the stock markets have been poor performers standing well below the peak levels seen in 1993 and 2007.  Property has become the favoured investment class, which has resulted in an enormous house price boom across the whole country, even in the cities where nobody currently lives.  Alongside economic reforms, the Plenum will be closely watched for any proposed political reforms, though experience suggests these will be very limited.

We expect the Third Plenum in November to continue to emphasise that China’s growth will increasingly come from its domestic consumers, so that companies will be expected to continue increasing wages and some small steps towards a larger welfare state.  Financial market reform, aimed at extending the reach of the Renminbi is also expected.  Such moves will give consumers the confidence and ability to boost their spending and support the development of the Chinese economy and the surrounding Asian economies.  Growth in Asia should be stronger than in any other region of the global economy and led by businesses meeting the needs of the Asian consumer rather than merely seeking export markets.   This was the phase of Western economic development that had the greatest impact on asset prices and supports our long term optimism for Asian financial markets and the significant role they play in our portfolios.

2013 – Limited growth and new monetary policy regimes

As 2012 draws to a close, three things about central banks and monetary policy are becoming more apparent. Firstly, central bankers are concerned that they are being expected to fix all the ills in their economies and they believe monetary policy cannot achieve such ambitious targets.  Messrs Bernanke and King have both recently expressed concerns about the limits of what monetary policy can deliver in the face of fiscal austerity.  Secondly, successive doses of Quantitative Easing (“QE”) are generating diminishing impacts on markets and on the real economies.  This is a problem that the Bank of England has recently been highlighting about QE in the UK.  In the US, the recent, and fourth, QE announcement from the Federal Reserve, which will mean over $1 trillion of money printed every year until further notice, saw the US stock market fall on the day, in contrast to all previous QE announcements.  Thirdly, Central Banks are exploring new policy targets: in the US tying policy change to the unemployment rate; in Japan seeking to increase the inflation target; and in the UK discussing the idea of a nominal GDP target in place of an inflation target.   As 2013 begins, investors need to take into account the above developments in their investment strategy.

There are two distinct scenarios for 2013.  In the first, economic recovery and job creation continue to disappoint, in which case it appears increasingly likely that governments will tell Central Banks to concern themselves much less about inflation and more about unemployment.  If so, they would be doing this just as the Central Banks are coming to the conclusion that their current policies to boost growth, are not working very effectively.  The results would be monetary policies that are far more inflationary in intent than has so far been the case since the crisis – this would be a significant regime shift for monetary policy.

Investors therefore will need to seek greater protection from the risk of such a regime change.  This requires heavy weighting to assets that would do well in the face of a generalised increase in investor inflation expectations.  These assets would be index-linked bonds and gold.  The performance of company shares in a scenario of rising inflation expectations is mixed – over the long term company profits would be expected to rise with higher nominal growth, but in the shorter term, rising inflation tends to lead to lower valuations.  Conventional bonds would suffer very badly in an environment of higher inflation.  Commercial real estate would, in the very long term, be expected to act as a form of protection against inflation (as rents rise with inflation).  However, a combination of high unemployment and the shift towards virtual retailing is acting as a significant dampener on demand for office and retail space.  Short term prospects for returns are limited to current rental incomes alone.

In the second scenario, where the global economy does improve enough for unemployment to fall at a rate that was satisfactory to policy-makers, the response from financial markets would also be likely to be higher yields on conventional bonds, together with higher company share prices.  Given these two scenarios (of which the first, disappointing growth, is more likely ), the preferred investment strategy is to be at least neutrally invested in shares, heavily under-invested in conventional bonds and heavily-invested in the “insurance policies” of index-linked bonds and gold.

Returns on cash will remain very low in 2013 and in fact are likely to decline further if further monetary easing takes place – the aim of the Central Banks being to over-supply liquidity to the financial system.  Given the exceptionally low yields available on government bonds, it is difficult to imagine a scenario in which they deliver strong returns.  Corporate bonds, which performed very well in 2012 as credit risk perceptions declined, still offer higher yields than government bonds.  However, they no longer have the potential for significant gains from a further narrowing of the yield premium (over government bonds).  Other areas of the bond markets where the yields are still attractive relative to their risks, are emerging market local currency bonds and short duration, high yield bonds in the US.

The Eurozone economy, the UK’s largest trading partner, looks most likely to continue to disappoint next year, and so create problems for policymakers. Its key economic issue (and Mrs Merkel’s favourite trio of statistics) is that it boasts 7% of the world’s population, 25% of the world’s GDP but 50% of the world’s social spending.  This is at the same time as its demographic patterns are about to deteriorate significantly in the face of a very weak birth-rate and a rapidly expanding population of pensioners.  The sense of existential crisis about the euro may have passed for now, following the ECB’s promise to be prepared to act as purchaser of last resort for sovereign government bonds, but the danger for the euro in 2013 is more likely to come from the streets of Greece or Spain, as continued austerity bears down even harder on the public.  The Italian election is also likely to see a strong performance from anti-austerity parties.  The Eurozone enters 2013 in recession, and its financial system woefully undercapitalised.  For Eurozone markets to perform well in 2013, the ECB will need to be seen to be actually printing money – this is still an unlikely prospect, given the deeply conservative approach to monetary policy of many of the ECB members.

The Japanese economy starts 2013 with a newly-elected Prime Minister who campaigned on a promise to stimulate the economy aggressively and have a higher inflation target.  A weaker yen would be enormously helpful to Japanese industry regaining competitiveness, and after a 23 year long bear market, the stock market may finally be in a position to move higher.

The US economy, still by some distance the largest and most important to the world economy, should continue to grow modestly, but not at a rate that is likely to bring down unemployment sharply.  The short term is clouded by fears over the “fiscal cliff” negotiations, the results of which are likely to produce some modest austerity, which, if European experience is any guide, will cause some damage to growth prospects.  Expect a mediocre year for returns from US assets.

The Chinese economy, the single largest contributor to global growth, appears to be seeing a pick-up in its growth rate after the below-target 7.4% report for third quarter GDP growth.  Growth is unlikely to return to the double-digit growth rates seen in the last decade, but should be of higher quality for stock market purposes.  Instead of relying on exports of low-cost labour manufactured goods and state-sponsored investment spending, Chinese growth in the future is more likely to come from satisfying the increasingly demanding Chinese consumer.  China is also in the fortunate position of having considerable scope to ease monetary policy in conventional ways should its growth prospects deteriorate.  These more conventional methods are generally more effective in the face of weak demand, than the unconventional methods that Western Central Banks are currently forced to use.  Asian equity markets are once again expected to be the best-performing region of the world in 2013.

The UK economy remains buffeted by the trends from the European, US and, to a lesser extent, the Chinese economies. The government’s fiscal austerity programme bites a little harder in 2013 than it did in 2012, but the change in Governor at the Bank of England is likely to lead to a wider discussion about monetary policy means and objectives, which may support the UK bond and equity markets better than those of the Eurozone.  Expect a modest year for returns from UK assets and a weaker Sterling following its surprising strength in 2012.

In conclusion, global economic risks are, in our opinion, biased to the downside for 2013. If these risks are realised, the clamour for a policy response will be very great.  The shift from the 2008 conventional policy responses of lower interest rates and higher government spending to the less conventional 2009-2012 policies of QE may well then develop into a shift to very unconventional policies.  These have not to date been openly discussed, but could include such ideas as (i) using QE to buy shares rather than government or mortgage bonds, (ii) using QE to buy foreign government bonds (equivalent to deliberately pushing down the exchange rate), or (iii) pushing new money more directly into the real economy by for example printing money to pay a “citizen’s dividend” in the hope that it would be spent.  These are all theoretical ideas that would normally strike inflationary fear into the hearts of Central Bankers, but may appear next year as the logical next steps in monetary policy.


Review of financial markets performance – 2012

As 2012 comes to an end, a review of the performance of financial markets indicates that it has been (at the time of writing) a relatively good year for returns.  The major equity indices have managed very acceptable gains – the UK 6.5%, the US 12.5%, Europe 13.5%, Japan 10%, Hong Kong 22%.  Asian equity markets, except for China, once again delivered the best returns for global investors.  Government bond yields have moved lower adding some capital gains to the ever-lower income yields, while corporate and peripheral Eurozone government bonds made more substantial gains as credit risk perceptions declined and equity markets rose.

Somewhat surprisingly sterling has been the strongest of the world’s major currencies, gaining 2% against the Euro, 4% against the dollar and 13% against the yen.  With the very substantial proportion of UK stock market earnings generated overseas, this currency strength probably accounts for the slightly weaker performance of the UK market in 2012.  The best performing currency was however gold which is 7.5% higher in dollars, and 3.5% higher in sterling.

And yet, throughout the year, economic growth in Europe, Japan and China has consistently been disappointing with Europe and Japan slipping back into double-dip recessions.  Forecasts of company profits globally are about 6% lower than the levels expected at the start of the year, and European profits much worse than this.  Once again this year demonstrated that correctly forecasting economic growth or company earnings can be of little value in determining movements in asset prices.

The most significant factor in this year’s good returns is that last December there was a great deal of fear in markets that the problems in the periphery would be too much for Europe’s politicians to be able to deal with.  Stock markets thus began this year a little depressed, but rallied quickly in the first quarter after the announcement of two Long Term Repurchase Operations (“LTRO”) by Mario Draghi.  These provided about E1bn of liquidity for 3 years at 1%, which was mostly taken up by banks in the periphery, who were able to use this liquidity to buy their own governments’ bonds at much higher yields.  This generated profits for them and much-needed demand for their governments’ bonds.

After this strong first quarter, markets then gave back the gains in the second quarter as the impact of the extra LTRO liquidity faded and the global economic data started to fall short of expectations.  The Greek election (just) managed to deliver a coalition majority in favour of the bailout and austerity programme agreed with the EU and the IMF.  However the economic and fiscal situation in Spain was deteriorating rapidly over the summer, once again calling into question the survival of the euro.

In late July, Mr Draghi announced his willingness to buy up the bonds of the weaker countries in potentially unlimited amounts, and “to do whatever it takes” to ensure the survival of the euro.  This was openly opposed by the Bundesbank but once markets understood that Mrs Merkel was supporting Draghi, equity markets and the peripheral government bond markets rallied strongly to the end of the year.  Then, in September, Ben Bernanke announced a policy of monthly Quantitative Easing to be continued, initially indefinitely, or following December’s Federal Reserve meeting, until there has been sufficient recovery for the rate of unemployment to fall below 6.5%.

Since the late summer, it has been the policy actions of the ECB and the Federal Reserve that drove the markets higher, even as the economic news across Europe, the US, Japan and China continued to disappoint.

Thus the fear in financial markets, and consequent low prices, at the beginning of 2012, has given rise to the healthy returns from many investments over the year.  The transition from that fear to the more current sense of complacency, together with the poorer performance of the global economy and corporate profits, means that markets begin 2013 at more expensive levels, leaving less scope for gains next year.

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.

Changes to the UK Retail Prices Index – implications for index-linked gilts

The UK’s Office for National Statistics (“ONS”) has announced a consultation on a proposal to change the way it calculates the Retail Prices Index (“RPI”). For the last few decades, in the minds of the British public this is believed to be the best measure of inflation in the economy. This has been reinforced by the introduction in the 1980s of index-linked bonds, which are government bonds offering inflation protection by indexing both capital and income payments by the change in the RPI. In addition, many private sector pension schemes have pensions which rise in line with the RPI, and many regulated industries have their pricing models set by regulators which are linked to the RPI. The RPI is a key part of the fabric of British life.

Sadly, the ONS believe that it is, statistically, a rather poor measure of inflation (as described later). In 1996, all EU members were required to calculate their inflation measures on a consistent basis – this index is the Consumer Prices Index (“CPI”), and being of a much more modern construction, this is the measure now preferred by the government for setting its inflation objective to the Bank of England (“BoE”), and state pensions and benefits are now linked to the CPI.

The RPI and CPI use the same price inputs each month, but a different statistical formula – this formula effect meant that historically the RPI tended to be 0.5% a year higher than the CPI. Thus, when Gordon Brown switched the BoE inflation mandate from an objective of 2.5% on the RPI, it became 2.0% on the CPI.

To illustrate this formula effect, consider a prices index, calculated monthly, with just two components, say strawberries and batteries over just two months. In both months the price of batteries is unchanged but the price of strawberries doubles in the first month and then halves in the second month. Over the two months combined, the geometric-weighted CPI will show that the rate of price inflation is zero, since all prices are the same as when the index began. However the arithmetic-weighting methodology of the RPI means that it will have risen and the rate of inflation will be deemed to be positive. Thus the RPI has an inherent upward bias compared to the CPI.

Since 2010 when changes to the RPI’s measures of clothing and footwear prices were made, the size of this formula effect has grown to almost 1.0% per year, and is in danger of creating mistrust in the statistics, which is why the ONS is seeking to change the methodology. Doing so would, however, have important effects on all those areas of British life which are referenced to the RPI.

In particular the expected returns of index-linked bonds (currently worth £280bn) would be 0.5-1.0% lower each year. At a time of very low government bond yields, this is significant. Should the BoE determine that the proposal amounted to a “fundamental change” that would be “materially detrimental” to the bondholders, then investors could, under the issuing terms of index-linked bonds,  demand their money back from the government. However, they would only be entitled to the par value of their bonds uplifted by inflation, which in general is well below their current market value.

The implications for markets are that by making this proposal the ONS has introduced a new risk factor for index-linked bonds that did not exist before – the measure of the rate of inflation used for returns may be lower than before. Ordinarily that should lead to lower prices. However, this news has come out at the same time as the Federal Reserve’s decision to engage in open-ended Quantitative Easing, which represents a clear shift in policy target away from controlling inflation and towards lower unemployment. This has boosted longer term inflation expectations in markets, and pushed up prices of index-linked bonds.

Index-linked bonds still provide investment portfolios with the most direct insurance against future inflation, but the effective payout on that insurance may be about to be cut. As with any insurance policy the balance between insurance premium, insurance payout and probability of payout has to be kept under review – recent events are tilting that balance away from having too much of this insurance in a portfolio. Globally, those investors who are not in countries with index-linked bonds have historically opted for gold as their inflation insurance.


Bernanke sets the printing presses to “GO” and walks away

The recent decision of the Federal Reserve to go ahead with a policy of QE3 by which they buy $40bn of mortgage and agency securities every month until further notice was dramatic and shocking in many regards:

  • Timing – Historically the Fed has sought to avoid making major policy moves in their last meeting before an election for fear of being seen to be acting politically. In 2008, there was a global crisis which required action – this is not the case in 2012.
  • Politics – Romney and many in the Republican Party have already made clear their opposition to Bernanke personally and to the policies of Quantitative Easing already adopted. Were Romney to be elected, he might choose to ignore the fact that Bernanke has been appointed until 2014 and seek to get him replaced. The Fed’s action can be interpreted as a major political snub at a critical juncture.
  • Economic justification – Both QE1 and QE2 were introduced at a time of clear weakness in the US  economy and significant financial market concerns about the possibility of deflation. So far this year, the US economy has been growing at about a 2% rate, unemployment has been declining gently and inflation expectations have been rising.
  • Size – At $40bn per month, the policy amounts to an annualised rate of QE of  half a trillion dollars. However, the reinvestment of principals and coupons and the continued working of Operation Twist (which followed QE2) mean that for the rest of this year the Federal Reserve will in fact be purchasing securities at an annualised rate of over a trillion dollars. These are astonishing amounts of money.
  • Transmission mechanism – In the press conference following the decision, Bernanke was asked about how he expected this policy to have real world effects. He repeated his  belief that by raising equity prices, companies would find it cheaper to invest. In addition, he said that because this time the Fed was buying mortgage securities, this would reduce mortgage costs in the economy, thus boosting house prices, so helping consumers to feel wealthier, which would encourage them to spend more. This trickle-down effect of previous QE policies from injecting money into financial markets moving into the real economy is widely believed not to have worked. It appears to benefit those in financial institutions whilst having little real economic impact.
  • Duration – By making QE3 open-ended and further insisting that the Federal Reserve would not begin to tighten policy until recovery was very firmly established, even at the risk of some higher inflation in the short term, Bernanke has made it very clear that continuous easing is now the default policy setting, probably for several years. Previous QE announcements were for set amounts of money over set periods of time – this is very different – money will continue to be printed until the economy recovers.

So the unlimited money printing of the Federal Reserve now sits alongside the unlimited buying of peripheral bonds by the ECB announced the week before  and the unlimited selling of its currency by the Swiss National Bank that has been in operation for a year. Central Banks – so long famed for their moderation and control in all things relating to money have set the printing presses to “GO” and walked away.

One conclusion that could be taken from this is that the Central Banks, who we hope are a little better informed about these things than the rest of us, are terrified, and that the state of the global economy and financial system is in fact far worse than anyone is prepared to admit.

The clearest market implications of this shocking move are to expect a weaker dollar (with so many more dollars now being printed) and a higher gold price. QE1 and QE2 were positive for equity prices, but the biggest beneficiaries were precious metals (gold and silver), oil and agricultural commodities. It is by no means clear that QE3 will do anything to boost real growth in the economy, and so the boost to equities may be more short-lived and less significant than previous rounds. Most interesting has been the recent moves in government bond markets where yields have risen as long-term expected inflation worries have begun to return.

Reasons to be happy – if you own gold!

Gold is money whose supply is not decided at the whim of human leaders. Annual gold production is about 1.5% of the total amount of gold in existence, so it is the demand for gold which determines its price. In contrast the major paper monies of the world, the dollar, euro, yen, pound  and Swiss franc all have Central Banks whose job it is to determine how much of their currencies to be created. Before the crisis, the rate of increase of supply of a currency was kept roughly in line with the nominal growth rate of their economy, somewhere around the 3-6% per annum range. However in recent times, this has gone out of the window. The policies of Quantitative Easing seen in Japan, the US and the UK in the last few years have massively expanded the amount of money in their financial systems. In Switzerland, in response to the massive appreciation of the exchange rate, the Central Bank has made public on several occasions its intention to create unlimited amounts of Swiss francs in order to prevent further appreciation. The ECB (with its Germanic bias) has indicated that it would never a policy of Quantitative Easing, but within weeks of taking office as President, Mario Draghi announced 2 Long Term Repurchase Operations, which permit European banks to borrow unlimited amounts of money for 3 years at 1% and encouraged all banks to make full use of this facility – a policy which has similar short-term effects as QE. The supply of paper money across the Western world has increased sharply in recent years and the rhetoric of those in charge implies that they remain very happy to continue that policy for years to come if they feel it necessary.

Interest rates are very low. Gold brings no income return, and so tends to perform poorly when the income return on other assets is high. Today the opportunity cost of owning gold is very low since the return on other assets is so low. In addition, such low rates of interest tend to occur at times of low or tough rates of inflation and …

Gold is the best hedge against inflation. Recent analysis by Credit Suisse looking at the performance of different asset classes in times of rising inflation over the last 100 years, showed that gold delivered the best correlation to rising inflation. A relatively new asset class that might also do this is inflation-linked bonds, however were the inflation to be substantial the amount that would have to be repaid by governments would rise significantly and could cause a sovereign debt crisis. Gold is no one’s liability, unlike inflation-linked bonds, and in that sense remains the best inflation hedge.

Gold is a great hedge against political uncertainty. The Arab Spring has brought enormous political instability into the Middle East. One of gold’s huge advantages over other tangible assets is it very high value to weight ratio – and this fact has meant it is very portable. If a rapid departure from home suddenly becomes necessary, the most convenient medium for taking your wealth with you is gold.

Gold is an indicator of wealth. Through the centuries in both China and India (representing one-third of today’s global population), gold has been the first port of call for household savings. However from 1952-2002, Chinese individuals could not buy gold. Indian per capita consumption is over twice that of China, so the Chinese still have some catching up to do. At a national level, the reserves of many Asian countries have historically been held in dollars with very little held in gold (in sharp contrast to the Western Central Banks which have always maintained very high weightings in gold).

There are about 5 billion ounces of gold in the world and about 7 billion people alive today – that is about $1250 or £800 worth of gold for each person. Do you have your share?


PS Note too that Greece’s credxitors were quick to ensure that they can seize Greek gold.

Is Quantitative Easing reaching its sell-by date?

Nearly 3 years ago the Federal Reserve and the Bank of England, having taken interest rates to  just about zero but still believing that they needed to make policy even easier, announced a new policy of Quantitative Easing (QE) as their preferred route to help their economies recover. Recovery did followed, although in keeping with previous post banking crisis environments, this recovery has been weak and inconsistent. This unconventional policy was pursued because the conventional interest rate tool had reached its physical limits and with fiscal debt and deficits so high, so too had fiscal stimulus as a policy. The unconventional policy, QE, was the only thing left.

There are good grounds now for believing that the QE approach adopted to date is also approaching sensible limits. In the UK, the Bank of England will shortly own over a third of all UK government bonds outstanding – amazing as it might appear with a  trillion pound national debt which has doubled in just 4 years, there is potentially a shortage of government bonds. This is due to new, post-crisis rules on capital adequacy for both banks and insurance companies which drive these institutions towards holding many more government bonds. With many gilts also held as the underpinning of pensioner annuity payments, a continued steady reduction in the budget deficit could mean that there are simply not enough gilts available to be bought if the Bank judged that much more QE was necessary

In the US the enormous market in mortgage bonds issued by what are effectively government entities makes this less of a problem than in the UK, but it was very noticeable that the second round of QE in the US in 2010/11 resulted in a surge in commodity prices, including gold, which pushed up inflation in the US, reduced disposable income and contributed to a weakening economy, as opposed to the economic stimulus that was intended.

So if further Quantitative Easing of monetary may now be either not implementable or counterproductive, then what can the Central Banks do if they decide that their economies require further stimulus. Both the Bank of Japan and Bernanke have previously suggested that a further tool that could be deployed is for the Central Bank to buy equities in the secondary market and so push up equity prices. Terrific for shares and all those executives with share options, but it is not clear that this then leads onto companies raising new equity finance in order to invest which is the rationale for such a policy.

The problem for all monetary policy approaches post a banking crisis is that there are two economies, a financial economy which requires reliquefication, recapitalisation and write-offs of bad assets and a real economy which cannot gain finance from the financial economy and produce growth until the financial economy is cleansed and functioning again. In economic jargon, the monetary transmission mechanism from financial sector to real economy is broken and so QE although in theory a logical policy, in practice only gets adopted when things are so bad that it will not work.

The aggressive Quantitative Easing solution, which Central Banks have not yet adopted is “helicopter money”. This is where the government prints new money and drops it out of helicopters (or via tax cuts and higher welfare payments) into the real economy. This is very likely to work in boosting the economy in the short term (people have more money in their pockets and so go out and spend some of it), but it will not be long before there is an inflation problem. This is clearly an economic policy beset with risk and the reason that Central Banks prefer to work through the financial system, even though it does not function well – in Zimbabwe this policy led ultimately to the printing of Z$100 trillion notes.

Quantitative Easing is near its sell-by date – something different will be tried next, and whatever that policy is, it will mean more government interference in the economy and more (long term) inflation. Stay long of gold!