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.

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.

UK economy – green shoots

Over the last ten quarters to March 2013, the UK economy has produced essentially zero growth due to a combination of (i) the UK government’s austerity plans encompassing both spending cuts and tax increases, (ii) severe economic weakness in the Eurozone, the UK’s largest trading partner, (iii) weakness in North Sea oil production due to essential maintenance work,  (iv) a large banking sector engulfed in a series of scandals, which have damaged their profitability, and (v) declining consumer real incomes

During this period the UK economy has consistently disappointed the expectations of the Bank of England, the Office of Budget Responsibility and the IMF, as well as many private sector forecasters.  In recent weeks however, this trend of disappointing expectations has come to an end, and the Bank of England, in Mervyn King’s last presentation of the state of the UK economy, upgraded its growth forecast for the UK in 2013 from 1.0% to 1.2%.

Beneath the headline figure of zero growth, there have however been two important improvements in the UK economy, which give encouragement to longer term recovery prospects as follows:

  1.  The structural budget deficit (that is after allowing for the extra government spending and lower tax revenues that arise from a weaker economy) has been reduced by over 4% of GDP in just 3 years (or 1.3% per annum) .Given that state spending is about 40% of the economy, it has required the other 60% (the private sector) to grow at about 1% per annum over this period, merely to offset the public sector weakness and achieve zero growth for the economy as a whole.  This 1% growth from the private sector is quite an achievement in the face of so many headwinds for consumer and government spending.  Though the structural budget deficit remains too high, there has been good progress in reducing it.
  2. The flexibility of the UK labour market has surprised many.   Despite the economic weakness, unemployment has stabilised at around 2.5m rather than the 3m that many commentators expected to see when the crisis first hit.  The major reason for this has been workers preparedness to take pay cuts or not demand pay rises to preserve their jobs – UK wages are only growing at about 1% currently, and have been well below the rate of inflation for four years. By contrast, French unemployment (France has essentially the same population and size of economy as the UK) has gone through 3m and is still rising.

The weather has played a surprisingly key role in the UK economy over the last twelve months – last summer was extremely wet (excepting the period of the Olympics) and both of the last two winters have been very cold and wet.  This has had a very serious effect on the construction industry, which had already been extremely weak over the life of this government, first from a cutback in government investment programmes, and secondly from weakness in UK housebuilding.  Just a return to normal weather over the summer and next winter should see a sharp improvement in construction spending, and with it the demand for construction workers, and the prospects for an improvement in overall economic growth.

There are other reasons though for being more confident. The electoral clock is now audibly ticking, and though the government will not reverse course on their austerity programme, they will be more sympathetic to ideas, which boost economic growth in the shorter term, particularly if they can be labelled as “investment”.  Importantly too, the new Governor of the Bank of England has been selected because he is an activist who believes that monetary policy can make a difference to the real economy. He has already been granted a more flexible mandate than just the control of inflation. Growth is now almost as important, and more emphasis on getting funds into the hands of industrial borrowers can be expected.

In the run-up to the 2015 election, there will be a more marked policy bias to boosting growth, and with the underlying improvements that can already be seen in the UK economy, it is likely that growth will exceed the (very low) expectations that currently exist. Note though that this is a forecast of modest improvement rather than of a boom.

The investment implications of beating the low expectations that exist for the UK economy are that, after two decades of performing much worse than either large or mid-sized companies, smaller companies in the UK, who are most exposed to the strength of the UK domestic economy, may be about to benefit most from the improving economic trends.  Where client portfolios do not have specific smaller companies exposure, we will be seeking to include it in any recommendations, as appropriate.

 

Low growth; more jobs?

Over the ten complete quarters that the current UK government has been in power, economic growth has been minus 3%, but total employment has risen by 1%.  For the last calendar year, the data show the size of the economy as unchanged but total employment up by over 550,000 or about 1.6%.  In contrast to the jobless recoveries seen in many Western countries after the 2001 downturn, the UK is experiencing a job-creating recession that is the cause of great head-scratching amongst economists.

Productivity is defined as total output divided by the amount of labour used to produce that output.  It is increasing productivity that produces the increases in the standard of living within an economy.  Historically, productivity growth in the UK economy has averaged about 1.5% per annum, but over the last ten quarters, the UK’s productivity has been averaging minus 1.5% per annum – indicating that the overall standard of living in the UK is declining.

Two sectors in particular account for much of the fall in productivity.  First, North Sea oil output has been in decline for some time now, and requires more effort and resource to produce that declining output.  Secondly, the banking sector (which delivered dramatic productivity growth before 2008) has seen a dramatic fall in output, with little change in total employment.  Many highly-paid bankers have lost their jobs, but the banks have had to hire just as many people in the compliance, risk and legal areas to deal with the aftermath of the banking crisis.

It is also undeniably true that the UK labour market has become very flexible with many businesses making much more use of variable pay structures through bonus systems, meaning that labour costs can be initially lowered by reducing the variable element of compensation, rather than immediately reducing the size of the workforce.  There are also many examples of businesses where workers have agreed to lower wages and benefits, to maintain their jobs.  Average wage growth in the UK has been below inflation for the last four years, so real wages have been falling steadily.

The statistics of the numbers of people employed also show a steep increase in the numbers of self-employed.  However, many of these are actually working very few hours, and so the official data show them as employed but in fact with very little economic output.

Elsewhere, surveys indicate that there is a degree of labour hoarding going on within companies, who fear that by reducing their workforce, they may lose key skills that they might not be able to replace in an upturn.  This however becomes progressively more difficult to maintain as time passes.  It also acts as a potential overhang to the unemployment rate and restrains business and consumer confidence.

The paradox of a job-creating recession reinforces the views and sentiments that were set out in our 2013 investment outlook: 2013 – Limited Growth and New Monetary Policy Regimes .  The UK economy is likely to continue to struggle in 2013.  However, the combination of (i) a governing coalition in the second half of its life and needing some positive economic news, and (ii) the summer arrival of a newly-imported Governor of the Bank of England, who is generally regarded as being much softer on inflation than Lord King, could well lead to a new direction in economic policy, which would bring long-term inflationary consequences.  We continue to recommend positions in index-linked gilts and gold for most investors, to act as a portfolio insurance policy against these inflationary possibilities.

Weak Yen weakens Germany

Germany, the powerhouse economy of the Eurozone, recently announced 2012 GDP growth of only 0.5%, and that it expected 2013 to deliver only 0.4% growth.  At a time when most of rest of the Eurozone is undergoing policies of austerity and reductions in private sector wage costs, they are looking to Germany to be the source of demand for their goods and services, which their own economies are currently unable to provide.

With a balanced budget, near full employment, and a trade surplus of 7% of GDP, Germany is ideally placed to pursue policies designed to boost German consumer incomes and spending, which the rest of the Eurozone could supply.  Yet, aside from some very modest pre-election tax cuts, which have already been announced, there is no indication that German politicians wish to go down such a road.

This is for two reasons.  Firstly, they take the view that the reason for their economic success is precisely because they have not, historically, pursued such short-term stimulatory policies, but have instead concentrated on ensuring they have globally competitive private-sector industries and a structurally balanced public-sector budget.  Secondly, the German Finance Ministry has realised that in the next few years they will need to provide funds to meet their obligations to the EFSF and the ESM, which have been set up to provide the bail-out monies for the weaker countries. They are thus already planning for offsetting public sector spending cuts in 2014 and beyond – in sharp contrast to all other countries, who are hoping further bail-outs won’t be needed, or will seek to borrow the funds from the markets if they are.

So, domestic spending is unlikely to be driving the German economy in the near future.  As usual, Germany will be hoping to benefit from global demand for its exports. Here though, the actions of the ECB and Japan may thwart those hopes.

Despite the Eurozone sliding back into recession, at its last two monthly meetings, the ECB has not cut interest rates when many commentators thought that it could and should have done.  Indeed after the last meeting, Mr Draghi made clear that the ECB had done as much as it could to promote growth, and it was now the role of governments to produce pro-growth policies.  The markets interpreted this as saying that no more rate cuts or easing of monetary policy would be forthcoming, in contrast to the $85bn each month of QE from the Federal Reserve.  Since then the euro has been the strongest of the major currencies, making German exports less competitive.

In Japan, the focus of the new government to stimulate the economy by all possible means including weakening the currency has seen the yen fall sharply in recent weeks.  Against the euro the yen is 20% weaker over two months and 26% weaker over six months.  These are dramatic moves for any major exchange rate, but the euro-yen exchange rate is particularly important for Japan and Germany.  This is because their strengths are in very similar industries, and competition is hard-fought in sectors such as automobiles, power plants and high-technology capital goods.

In early 2009, the exchange rate was 140 yen to the euro, and over the next 3 years the yen strengthened to 95 yen to the euro, making Japanese companies very uncompetitive against European (but most importantly, German) companies. German exports performed very well in 2010 and 2011, particularly to China.  This was also helped by a diplomatic row between Japan and China about sovereignty rights over some small islands lying between their two countries, sparking popular anti-Japanese sentiments inside China, and consumer boycotts of Japanese goods.

Japan is now deliberately weakening the yen further to stimulate their economy – the recent 20+% fall in the exchange rate will be a particular problem for German competitiveness, and will hold back export demand this year.

The investment implications of this are to remain wary of the European economy and light in European shares, to expect the euro to strengthen , and to be heavy in Japanese shares, but to avoid the yen exposure by, for example, owning currency-hedged share classes of Japanese funds.

Eurocalm before the Eurostorm

That the Eurozone ends 2012 in an apparently stable condition is mainly down to the work of two people. The first is Mario Draghi with his promise of potentially unlimited intervention in sovereign bond markets.  The second is Angela Merkel’s with her summer policy decision that forcing Greece from the Eurozone would be more damaging than keeping it in.

Mrs Merkel over-ruled the Bundesbank on both of these issues, and her steady approach to crisis management leaves her as one of the most popular European leaders within her own party and country.  She has now clearly grasped that, for the Eurozone to survive in the long term, it is necessary to have a much deeper integration of Eurozone countries, which extends ultimately to national government finances, common banking supervision and control, and joint liability for debt. In short banking, fiscal and political union is required to complete the economic and monetary union.  These are not particularly popular positions to adopt, either with the German people or with the other European nations, but they are the logical steps required to ensure the long term existence of the single currency.

She understands that for this to happen, Germany will have to dip into its pockets and provide substantial assistance to the poorer countries in the transition. However, she has not been as explicit with the German people that the financial costs of such policies to them will be very great.  The German people are not in favour of lending more money in bailouts to their Southern neighbours, and they are not in favour of accepting losses on previous bailout monies already granted.  Next autumn there is a Federal election in Germany in which Mrs Merkel would like to be re-elected as Chancellor.  So ideally, from her perspective, there would not be any more Eurozone bailouts before the German elections.

The recent agreement on the next tranche of Greek aid was farcical.  Everyone (Greece, the IMF, the EU and the ECB) is pretending that Greece is not insolvent, merely illiquid and that (based on optimistic assumptions) all will be well a decade from now.  Significantly, Germany has agreed that should Greece be doing well by 2015 in delivering on its budget deficit targets, then they would be prepared to forgive some of their debt.  The truth is that if Greece does not achieve its targets the Germans will be forced to forgive the debt because it cannot be repaid.  The point though is that any debt forgiveness happens after the German elections, when European priorities may once again be more important than domestic German ones..

Southern Europe is now very close to the limits of its tolerance for austerity. The Greek, Spanish and Portugese governments have all told their people that they are on the last round of austerity measures.  With youth unemployment close to 50% in these countries, anti-euro, anti-austerity political ideas are beginning to gain ground.  German leaders still consistently state that austerity in these economies will be necessary if further bailout funds are to be provided, and this rhetoric will not be watered down ahead of the elections.

The other major Eurozone election due by April 2013 is in Italy.  Mr Berlusconi’s withdrawal of support for the technocratic Monti government and his announcement that he will fight the elections on an anti-austerity, anti-German platform are not helpful for the euro. However, it is the honest debate to be having.

The Eurozone begins 2013 in recession, and fiscal policy is being tightened further, except in Germany.  A weak European economy will mean larger budget deficits than planned, and more pressure from the southern economies for bailouts.  This will produce more demands for austerity from the northern economies, with the rapidly fading ability to deliver either.

The stability of current financial markets in the Eurozone will not survive very long into 2013 without a dramatic improvement in economic growth, which is very hard to envisage.  Ultimately, the only solution for the weaker economies is inflation. This can come about either through leaving the single currency or through overturning the Germanic culture, which controls Eurozone economic policy. The former is the more likely solution, and the investment conclusion is to remain very wary of all euro-denominated investments until a more sustainable monetary system is in place in Europe.

 

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.