On the QT

2009 saw the world embark on a giant economic experiment – that of Quantitative Easing (QE) in which Central Banks injected large amounts of money into their financial systems. Next month, the Federal Reserve announced this week, will see a new first for monetary policy – a policy of Quantitative Tightening (QT) in which money will be withdrawn from the financial system.
They have announced that this new policy will be phased in, starting at a rate of $10bn per month from October, rising each quarter to $50bn per month by October 2018. At the same time, they expect to raise interest rate four more times to 2% by the end of 2018.
The timing of this policy shift appears less related to current economic conditions and much more to two other factors. First is that Western Central Banks appear, as a group, to have decided that the very easy monetary policies need to be pulled back. In addition to the Federal Reserve, the Bank of England has also recently indicated its desire to increase interest rates and the ECB is has laid out plans to bring to an end its QE programme. This tightening seems to be globally co-ordinated. Secondly, the Federal Reserve appears to be publicly setting out its policy for the next year, in such a way that it would be embarrassing not to carry it through. This comes at exactly the time that there are many places on the Federal Reserve Board to be filled over the next twelve months by nominees of President Trump, including the key role of Chairman currently filled by Janet Yellen.
Over the period of QE, from October 2008 to October 2014, the Federal Reserve increased its balance sheet from about $750bn to $4.5 trillion through 3 separate programmes of purchases. Its peak purchase rate was $85bn per month.
The widely accepted effects of the QE policy were:
1. It helped to offset the effects of the Global Financial Crisis in 2008/9, and prevented a 1930s style Depression from setting in.
2. It has done little to foster a rapid economic recovery, instead US GDP growth has stabilised at a muted 2% pa rate, only a little higher than the increase in population, and inflation has struggled to exceed 2%. There is little evidence that the increased money supply has found its way into the real economy through physical investment.
3. The prices of financial have moved much higher, principally through higher valuations relative to the income streams they produce. This is evident in house prices, stock prices, bond prices and the prices of prestige assets such as artwork and vintage cars. The increased money supply has thus remained within the financial economy rather than the real economy.
4. The combination of lacklustre real economic growth, rapid growth in financial asset prices, and the skewed distribution of wealth in the US economy has meant that the very wealthiest in 2008 have become even more wealthy and inequality has risen very substantially with the richest 0.1% gaining much more than the richest 1%, who gained much more than the richest 10% who gained much more than the rest of the population.
The implications of QT are thus that what has been to be a key support for financial market prices will be reversed by falling valuations as money is withdrawn from the financial system. It may also be that in fact this has a limited impact on the real economy as the decline in wealth will affect only the very wealthiest in society who demonstrate a low correlation between changes in their wealth and changes in their spending patterns.
A deeper concern is that QT will affect valuations in both equity and bond markets at the same time. Most investors have not seen an environment in which both markets fall simultaneously and this has the potential for aggressive selling of leveraged positions in markets, which could take markets down to surprisingly low levels.

Beware the decennial seasonality of Year 7 Summer

Over the last four decades equity market prices have shown a clear and remarkably consistent pattern: from lows established in Year 1 or Year 2 in each of the decades since the 1980s, have risen steady and very profitable bull markets which run into problems that begin in the summer of Year 7.
It was in August 2007 that the first cracks appeared in securities related to the US housing market – BNP Paribas froze dealing in three of their funds which contained packages of sub-prime mortgage loans called CDOs. The next month in the UK, Northern Rock which had been relying for its ongoing liquidity on demand for sales of its securities mortgages saw queues of its savers outside e very branch in a vivid replay of a nineteenth century “bank run”. The next six months saw pressure on any company which had been associated with US mortgage debt – Bear Stearns was bought by J P Morgan, the two major US mortgage providers were put back into government ownership and then Lehmans failed.
It was July 1997 that the Asian financial crisis began when Thailand was unable to ward off speculative attacks on its fixed exchange rate regime had enjoyed rapid domestic demand growth from both companies and consumers who were financed their spending by borrowing in dollars. When the exchange rate link failed, the value of their debts soared leading to a sharp recession and a banking crisis, which spread throughout East Asia. Indonesia, the Philippines, Malaysia and South Korea had similar banking and economic issues. China escaped this crisis and indeed emerged relatively unscathed since the renminbi was a non-convertible currency.
The summer of 1987 saw a major market peak in August 1987, following several years of strong market performance. There was no particular economic or political event that could be said to have been the trigger for the one day fall of 22% in the Dow Jones Index of 22%, other than an increasing realisation that markets were very highly valued. Consequently, many investors had put in place a strategy of “portfolio insurance” which meant that their market exposure was reduced and their positions were sold in response to a market decline. On October 19th this created a wall of continuous selling which pushed the market lower and lower.
The recent very hot weather is a reminder that we are now in the Summer of Year 7 for this decade. There are plenty of candidates for where a new bear market may begin – the consistent upward move from the US stock market in recent years has taken it to valuation levels only seen in 1999, the recent failure of two banks in Italy is a reminder of the weakness of many European banks, in China there has been an extraordinary build-up of domestic debt and the government id desperately trying to maintain its near-fixed link with the US dollar. Or geopolitics may play a part this time – President Trump does not appear afraid to take action against North Korea and tensions in the Middle East between Qatar and the other Gulf nations have recently risen.
History suggests that investors be careful!

 

Jeux avec frontieres

Before the UK joined the EEC in 1973, most Britons knowledge of Europe was from the BBC game show Jeux sans Frontieres (Games without Borders), which showed that Europeans were as prepared as Brits to dress up in silly costumes and attempt bizarre tasks against teams from other countries. It may even have played a part in Britain’s referendum to support EEC membership.

It is now 12 months since David Cameron permitted his government ministers to break from Cabinet responsibility ahead of the second EU referendum. The campaign and decision to leave, followed a few months later by the election of President Trump has transformed the political debate around the world. Since World War 2, the political debate was between those who thought government should seek to do less within society and those who thought government should seek to do more within society. The events of 2016 however show that the debate is now between those who would like national borders to be more difficult to cross (whether by people or goods) and those who want borders to be easier to cross.

Regarding people crossing borders, Mrs May’s immediate conclusion from the referendum was that the British people voted for regaining control of immigration, and the right to live in Britain, and that this was more important any economic benefits from EU membership. Her policy and approach to Brexit since then has clearly been dictated by that conclusion. It is however, notable, that the parts of the country most concerned by immigration are correlated to those parts of the country with the smallest immigrant populations.

For President Trump, it is the twin threats of illegal immigrants from Mexico and radical Islam from some Muslim nations that underpins his desire to establish more effective control of America’s borders. His geographical distribution of support in the election also correlated with low levels of immigrant population.

For Trump, though not for Mrs May, borders are also important for controlling the movement of goods. He argues that the free trade agreements that the US has made in recent years has meant that cheap goods have poured into the US , displacing US-made goods and thus US jobs, particularly in the areas where he drew the greatest support. He seeks to maximise American negotiating leverage by withdrawing from multilateral trade agreements such as the TPP and NAFTA and replacing them with bilateral agreements where the US will (nearly) always be the more powerful party and be more likely to reach agreements that are closer to American interests.

For the UK, voluntarily withdrawing from a trade bloc even larger than the US and seeking new trade agreements with the rest of the world, the general acceptance of free trade is paramount and much rhetoric about the UK being the beacon of free trade in the world (and goods and services crossing borders easily) can be heard from UK Conservative politicians. One early issue that UK politicians have discovered is that many of the countries (eg India and Australia) that would be keen to enter into free trade agreements with the UK, are also seeking greater freedom for their people to enter and stay in the UK.

Unusually for economists, almost all of them agree that free international trade is a good thing for the global economy (though this is not the same thing as being good for everyone in that global economy), and that the last time, the world economy saw a significant increase in protectionism, in the 1930s – this was associated with dramatic declines in trade levels and a global economic depression – ending in World War.

This desire for reinstatement of borders also flies in the face of the reality of technological progress. For people travel across the world is cheaper, more straightforward to plan and a more realistic aspiration that ever before in history. Making that more difficult implies a key loss in economic terms

For goods, bar codes, the standardisation of shipping container and the prevalence and complexity of international supply chains supported by logistical improvements has created huge efficiencies with both higher volumes of trade and lower prices for all. Re-establishing border controls (not only between the US and Mexico but also between the UK and the EU) will raise prices and reduce the global standard of living, even if tariffs remain at negligible levels.

For services, the digitisation of the world means that borders are increasingly irrelevant. More and more retailing is conducted in the ether, a large part of the world satisfies its desire to watch soccer by watching the English Premier League online, even investment bankers outsource research model-building to staff in India.

The current wave of national populism is selling the idea of greater security through control of borders and plays on traditional human tribal urges to discriminate against outsiders. It appears to be going against where technology is taking the human race and the risk must be that to deliver border control will require increasing levels of force, militarisation and regulation that will act to reduce standards of living. It also flies in the face of another great human urge – to welcome and be hospitable to visitors.

 

 

An era is ending

A year which sees Britain vote to leave the EU and the US vote Donald Trump to be their President is clearly one which could be said to be the beginning of a new era. Perhaps of equal significance is the fact that an old era is ending, which may well have played a part in enabling this new era to begin.

Jim Callaghan’s remark to the BBC in 1976 that “We used to think that you could spend our way out of a recession … I tell you in all candour that that option no longer exists” marked the end of the post-war consensus on Keynesian demand management of the economy and the primacy of fiscal policy over monetary policy in economic policy-making. Since then monetary policy has been dominant, and changes in interest rates have taken the lead in adjusting the course of the economy. Central banks have become independent given the crucial (technocratic) role they are believed to play in the modern economy.

However, recent experience shows that at very low interest rates, further monetary easing has little and arguably, counterproductive, impact on the economy and the central bankers at the Fed, Bank of England, ECB and Bank of Japan have all made it plain that they cannot deliver the faster growth that governments are depending of them. At zero or even negative interest rates and substantial Quantitative Easing, we have reached the limits of effective monetary policy. Even if the next move is “helicopter money”, this is as much a fiscal policy as a monetary policy. The era of monetary policy primacy is ending.

The era of trade policy liberalisation that started in the mid-1980s is also ending (as discussed here) – no major new multilateral  trade deals have been struck for about a decade and the recent TTP and TPP deals look like they will not survive contact with Donald Trump. In addition, NAFTA looks unlikely to survive in its current form and whatever the outcome of the Brexit negotiations, trade between the UK and the EU will be less free than it is today. 2015 marked the first year in decades that the growth in world trade was slower than the growth of world GDP – trade has acted as an accelerator for the world economy, now it is acting as a brake. The message from the successes of both Brexit and Trump is that national borders will be subject to greater controls and it will be less easy for people and goods and services to cross them. The era of greater openness is ending.

The effects of these two major eras has been most clearly seen within financial markets in the 35-year bull market in government bond markets of Western nations. The eye-wateringly high interest rates required by monetarism in the early 1980s to combat inflation have given way to the “rigged” bond markets in which central banks have become some of the largest owners of their own bond markets. It is not yet clear that this bull market is over, but a world of fiscal policy primacy over monetary policy is likely to have higher interest rates and bond yields.

This bull market has supported and inflated the markets in all other financial assets as the risk-free rate of return has declined, creating large gains both for those invested in financial assets and for those firms that aid and service them. This “financialisation” of the economy, in which the financial sector has been growing faster than the rest of the economy over this period has been a major trend.

The big winners of this trend have been the asset managers – attractive market returns have attracted strong inflows of assets and substantial economies of scale have nearly all accrued to the fund managers rather than their investors. The recent report from the FCA on the asset management industry highlighted that it was one of the industry sectors with the highest profit margins. Asset managers now top the tables of highest-paying industries, having recently overtaken investment bankers, for whom profitability has been of increasing concern since 2008. The attention of the regulators has noticeably shifted in recent years from banks to investment managers. The asset management era, which began in the early 1980s, may also be peaking.

All these trends began between 30-40 years ago, and all have showed distinct signs of ageing in recent years. The dramatic events of 2016 may represent the “coup-de-grace” for them and the conclusion must be that the future will look increasingly different from the past.

Fiscal policy will become more important than monetary policy, international trade will come under increasing pressures, bond yields will not always fall, the financial sector will fall back as a proportion of the economy and the profit margins of the asset management industry will decline.

Brexit with Trump

Just six months ago, the probability of victory for each of Brexit and Trump were 30% – and the odds on the double were thus 10-1 against. The world going into 2017 looks a very different and more uncertain place than it did a year ago.

However, Trump’s victory provides the UK with an opportunity to gain a substantially better agreement with the EU than it would have done with a Clinton victory, even though Mrs. Clinton may well have leaned on the EU countries to give the UK a sensible deal.

Trump’s victory has many European governments feeling considerably less secure. With his outspoken admiration of Vladimir Putin and his tendency to see foreign relations as a zero-sum game rather than mutual gains through international agreements, Trump’s view of NATO and European security is very different from his predecessors. For those in Eastern Europe, Putin is today a bigger threat to their borders and US military support less likely to be forthcoming.

One of the few cards that the UK holds in the Brexit negotiations is it deep and unwavering commitment to the military defence of its European allies, and despite the harsh words used against the rest of the EU from those seeking to leave the EU, their military support for the EU has not changed and they have consistently voiced this before, during and since the referendum. That support has now become much more meaningful and valuable, especially to those countries in the former Eastern Europe. 

The desire to punish the UK for its audacity to leave the EU is now (post Trump) more likely to be to seek a strong agreement with a staunch ally who is also a nuclear power. On the Maslovian hierarchy of needs, the basic security of your country is a far more powerful force than the continued existence of a financial passporting system or some controls on the uninhibited movement of people between countries.

In addition, once again, through their votes, the UK and the US have shown the similarity of their thought processes (a clear parallel being  the ascensions of Thatcher and then Reagan), which often baffle European minds.  Maintaining a close and friendly relationship with the UK is likely to be helpful to Europeans in understanding and interpreting the actions of the US. Trump has spent time in the UK (though mostly in Scotland), has openly identified his success with Brexit and did

promise to put the UK at the front of the queue for a trade agreement post-Brexit, following Obama’s threat that it would be at the back of the queue. Though of course this would be strictly on Trump’s terms, and have almost no cost to US jobs – it would enable him to show that there are some trade deals he will do if they are right for the US. The EU-US trade deal, already stymied by European doubts before Trump’s  success is now dead in the water.

Trump’s victory will change the world in many ways, but one of the more surprising ones is likely to be that the UK obtains a better exit agreement from the EU than would have occurred without Trump.

The BoJo manoeuvre

It is May 2018 and the Prime Minister is in reflective mood, relaxing in 10 Downing Street with a drink. Fortes fortuna luvat was the phrase that sprang to his mind, or “fortune favours the brave” for those not lucky enough to enjoy his classical education. He was thinking of the book he would later write describing how he had emerged not only as the man who saved both the United Kingdom and the European Union, but, more importantly, how he had succeeded where his long-time rival, Dave, had so conspicuously failed. History, he was confident, would be kind to him.

Perhaps brave was not really the best word to describe the fairly straightforward political calculation that, whatever happened in the referendum, as the most prominent Conservative to stand on the Leave side of the debate, he was the obvious choice for Conservative activists to vote for as the leader to follow Dave. The fact that he didn’t himself really believe that Britain should leave the EU had been hidden away in a distant corner of his brain for the duration of the campaign.

There had definitely been a strong element of fortune though. The 50.3% victory for Leave was clearly affected by the torrential rainstorms that hit the UK in the late afternoon of June 23, 2016. The pensioners had been able to vote to Leave in bright sunshine in the morning, but a combination of storms and England playing in the European football championships in the early evening meant a much lower turnout amongst the younger generations, who polls showed were much more inclined to vote Remain.

Though Dave had initially wanted to stay on as Prime Minister, the backbench Conservative MPs quickly made it very clear that his time was up and he announced his resignation the weekend after the referendum. He felt it inappropriate to invoke Article 50 of the Treaty of Rome and start the clock on the two year timetable that would lead to Britain’s exit from the EU, saying that was a decision that should be taken by his successor.

Boris became Conservative Party leader, and Prime Minister, in September at the Party Conference, but the British public had already begun to experience doubts about the wisdom of its referendum decision in the intervening three months. Stock markets, not only in the UK but also in Europe had fallen sharply and a surprisingly large number of businesses announced their intentions to move their European headquarters to somewhere inside the EU – investment intentions and economic confidence had been hit very hard following the vote.

Not surprisingly the global banks such as J P Morgan, Goldman Sachs and Deutsche Bank clearly had well-developed contingency plans and were quick to announce their intention to move jobs from the City to Frankfurt and Paris from 2017 onwards. However what had taken many by surprise were similar announcements from key global manufacturing companies such as Siemens, Toyota and Pfizer and the withdrawal of EdF from the Hinckley power project, on advice from the French government, had left the UK’s long term energy policy in tatters. The number of announced lost jobs directly attributable to the referendum decision was much greater than even the Remain proponents would have dared to suggest in the campaign.

With Donald Trump, the Republican candidate in the November Presidential election, telling everyone how unhappy he was over the his treatment by the Scots over his dream golf course and saying that the UK had no chance of a trade deal if he was President, the UK economy was moving rapidly into recession amid massive uncertainty.

Given this backdrop, Boris also chose not to invoke Article 50, arguing initially that it made more sense to await the outcomes first of the US elections, and then the French and German elections in 2017 – after all there was no point in beginning negotiations with the EU when the two leading nations would not want to agree anything until their domestic political situations were clarified.

The European nations were also surprised by the drop in confidence in their stock markets as investment intentions declined further. The ECB were at the very edge of what was possible in terms of negative interest rates and QE, and fiscal policy remained constrained by German orthodoxy. What Europe had not expected though was the loss of respect from both the US and China, with many very rude comments about their irrelevance in the world without the UK coming from Trump and leading Chinese politicians. The continuing refugee crisis also tested to the limit the desire to maintain the Schengen area freedoms.

The critical factor had however come from Putin, who sensing Europe’s weakness has invaded and occupied Eastern Ukraine and was openly considering its annexation as he had done with Crimea. With the US consumed by its election it was left to Europe to take the lead in responding and they realised they needed to have the active and committed support of the UK.

Both the UK and Europe thus found themselves staring into an abyss in the months following the first referendum and were very frightened by what they saw.

Europe remembered that the initial vision for the EU had been to end war within Europe, and to that end the full-hearted involvement of the UK was now key. Compared with that even the free movement of labour, so beloved by the former Eastern European nations, could be seen as secondary.

So Boris had found it fairly straightforward, once the new German government had come to power, to seize the opportunity and come to a new reform agreement with the EU, which allowed the UK to control which EU residents could stay in the country, and allowed the UK much greater freedom not to implement bureaucratic EU directives. This dealt clearly and satisfactorily with the issues of immigration and sovereignty that had led many in the UK to vote to leave in the first referendum. The second referendum saw a Remain vote of 65%.

He had achieved a rare unity – the English were pleased with him, the Scots were pleased with him and even the Europeans were pleased with him. His place in history was now assured and, best of all, future historians would be able to compare directly the two referenda and prime ministerial performances, one dismal failure under Dave, one major triumph under himself.

Reasons to be fearful … Brexit and Trump

In just eight months’ time it is possible, though currently not plausible, that the UK will be negotiating its departure from the EU and that Donald Trump will be the President-elect of the USA.

Though the current opinion polls show both being very close contests, the current bookmakers’ odds indicate that the probabilities of the UK voting to leave the EU in the June referendum and on Donald Trump winning the US presidential election in November, are each approximately 30%. Mathematically, this means the chances of both occurring are about 10%, but this combined probability is very sensitive to small changes in the opinion polls.

What would the financial and political worlds be making of such an outcome?

The first implication would be that the political establishments on both the   UK and the US would have been defeated by the votes of the populace. The political class would be shown up as having completely misunderstood or ignored the needs and desires of those they have sought to represent.

Both the Brexit and Trump campaigns appeal to those who want to feel they should have control of their own destiny, by asserting their rights ahead of those from outside their own land. The main cause of this has been the global equalising trend of labour incomes for all but those at the very top of the global income distribution. The emergence of China and India into the global economy has allowed western companies to make increasing use of their, relatively cheap but well-educated, labour pools, ahead of their more expensive Western labour forces.

The second implication is that Brexit requires the negotiation of new trade agreements with all other countries. Aside from the negotiations with the rest of the EU on our interaction post-Brexit, which is one of the largest unknowns for those arguing for Brexit, the single most important trade agreement would be with the US.

Despite the media’s fixation with Trump’s incendiary remarks with regard to Muslims, in fact the major focus of his stump speeches are the implications for the average American worker of the trade agreements that the US has signed in recent decades, and his perception that the US has been the “sucker” or the loser from these agreements. He intends to rescind many of the existing trade deals. In such a situation it is hard to see why he would put much of a high priority on doing any deal with the UK, even more so any deal where his self-proclaimed negotiating skills led to a good deal for the UK.

Thus whether or not Trump is the next President could have major impact on the UK’s economic success should the UK vote “Leave”. The problem for the UK electorate is that the Brexit vote precedes the Presidential vote by some 20 weeks.

The result of these timings is that come the end of the year, the UK could find itself negotiating an exit from the EU with very disgruntled European negotiators, keen to ensure that other countries do not become attracted to the idea of leaving the EU, and facing a US ruled by Donald Trump, who has little interest in any further free trade agreements.