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.

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

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

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

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

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

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

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

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

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

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

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

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

Gilts or Kilts

In recent weeks the gap in opinion polls between those in favour and those against Scottish independence has narrowed from about 10% to about 5%. With some months of campaigning still to go, the vote on 18 September looks increasingly likely to be close. What are the likely political, economic and market implications of a Yes vote?

Political implications

  • Negotiating the split. The SNP envisage 18 months of negotiations prior to becoming independent on 24 March 2016. However, they would be negotiating with the UK government and there is a general election due in May 2015 which could easily lead to a change in the governing party or coalition. The outgoing government is unlikely to deem the negotiations as an important priority, and the new government may well have more pressing policy priorities than reaching an agreement with Scotland – the power is biased towards the UK Government in the timing and pace of any negotiation.
  • Impact on Westminster parliament. Should a new government be led by Labour, then they face the risk that after March 2016, with an independent Scotland in place, the Scottish Labour MPs would have no right to vote at Westminster. This could easily deprive such a government of their majority and could lead to a general election or a change in the governing party. Such a scenario gives a very strong incentive for a Labour-led government not to reach an agreement with the SNP. A UK parliament with no Scottish members would mean a near permanent majority for the Conservative party and a clear rightward shift in the political debate in the rest of the UK.
  • EU membership. Under current EU law, Scotland would have no automatic right to become a member of the EU – in theory, it would have to negotiate terms and win a unanimous vote from all the other countries. This is by no means certain as Spain in particular is likely to vote against such a move, given its concern about setting any precedents when its own Catalan people are calling loudly for independence.
  • United Nations. If Scotland were to leave the UK, it would be likely to reduce the global political influence of the rest of the UK. Its permanent seat on the UN Security Council might well be called into question, as it would be the smallest country with that privilege. Even today, with Scotland, the UK is less than 1% of the world population.

Economic implications

  • Currency. All three major UK parties at Westminster have been clear that they would not agree to a currency union with Scotland. In practice, however, they could not stop Scotland from using the pound, though in that situation Scotland would have no influence over the UK’s monetary policy set by the Bank of England. In theory (again), if Scotland were to become a member of the EU then any new member of the EU has to adopt the Euro as its currency. Creating a brand new Scottish currency is also possible, but would create the need for foreign exchange transactions and heavy costs for Scottish businesses.

 

 

 

A negotiated agreement, which created a formal currency union, would allow Scotland to keep the pound and possibly have a Scottish member on the MPC. However, events in the Eurozone in recent years highlight the dangers and effective loss of sovereignty in being a small country in a currency union when there is no fiscal or political union.

  • Banking system. RBS is the largest Scottish bank with a balance sheet of over £ 1 trillion at the end of 2013 (and this has halved over the last 5 years) with capital of almost £60 billion; given the size of the Scottish economy, a Scottish government could not credibly act as backstop should RBS get into financial difficulties again, whereas currently RBS does benefit from being an institution of systemic importance in the UK that the government is committed to supporting in extremis. Scotland’s ratio of banking assets to GDP is 12:1, which is higher than the peak levels seen in Iceland in 2007. It is likely that RBS would choose to relocate its headquarters to London, which would lead to the loss of a significant number of jobs in Edinburgh.
  • Dividing assets and liabilities. Scotland is about 8.5% of the UK’s economy and population. The SNP is claiming just about all of the UK’s North Sea Oil, its major resource asset, since it would lie in Scottish territorial waters, but only expects to take on 8.5% of the National Debt. The UK government might argue that North Sea Oil belongs to the UK today and so be prepared only to cede 8.5% of the resource asset. The stream of revenue from taxation on North Sea Oil is a key source of money to pay for future welfare spending in Scotland, and the SNP’s economic forecasts assume much greater tax revenues in future years than the forecasts of the current UK government.
  • Credit rating. As a relatively small and new country, with a reasonably high initial level of debt, Scotland would be likely to have a lower credit rating than the rest of the UK, even if there were a strong currency union in place; this will increase borrowing costs for Scotland. There is an additional danger that by reducing the size of the UK economy, and with investors implicitly believing that in a crisis the UK would come to Scotland’s rescue, that the UK’s credit rating would in fact be lower as well. Both countries could lose out.
  • Tax revenues. A number of Scottish-headquartered companies have indicated that it may be commercially necessary or desirable to have a UK headquarters for their business outside Scotland, due to all the uncertainties regarding currency, trade, tax, EU membership and regulation. This might substantially reduce the corporate tax revenue to a new Scottish government from Scottish companies.
  • Prices. Many companies in the UK have national pricing policies, which effectively subsidise providing goods and services to less central regions such as Scotland. Tesco have already indicated that they might adopt a national Scottish pricing policy, which would mean higher prices for Scottish shoppers.

Market implications

  • Currency markets. Sterling is likely to be viewed as a less attractive currency, since it may be backed by a smaller country and tax base than it is currently, and would generally carry less weight or influence in wider world affairs. The most likely market response to a Yes vote in the referendum would be for Sterling to fall against the other major currencies, and gilt yields to rise.

 

 

 

  • Effect on business investment. For business, a vote for independence would undoubtedly create a whole range of issues, about which there would be uncertainty and risk. On pensions, for example, there are completely separate EU regulations for pension funds which cover more than one country.  This may require large extra contributions by companies to deal with current deficits.   In financial services, many providers may judge that it would be preferable to be regulated by the FCA alone rather than by both the FCA and a new Scottish regulator, paying extra regulatory fees. Firms carrying out regulated activities might seek to move employees outside Scotland. All such uncertainties would be likely to lead to delays in investment spending by businesses.
  • Scottish bonds. A new market in Scottish government debt would need to be created, and such debt would be likely to trade at higher yields than the debt of the UK. UK government debts are called gilts and any Scottish government debt has already being colloquially labelled as “kilts”.

The possibility that Scotland might vote NO, but with a very small majority should also be considered.This could be the worst possible outcome since the SNP would undoubtedly believe that a second referendum, in say two years, might enable them to get over the line. International investment into Scotland would be likely to be damaged as investors would have no clarity on Scotland’s legal status and the UK government might well believe that it would derive little benefit from supporting the Scottish economy by, for example, relocating civil servants there.

In the long term, both Scotland and the rest of the UK could be viable, solvent, independent but closely allied, political entities – if both existed today, there would be no obvious reason or need to suggest they form one larger country. However, the transition from the current version of the UK to a smaller version would create major political and economic uncertainties that would be likely negatively to affect business and the economy in the short term. The period of negotiations spanning a UK general election is particularly unhelpful in this regard, and the ramifications on Scotland’s relationship to the EU are significant, but extremely unclear.

It is striking that with less than five months until the referendum, how many major unanswered questions there are about what would happen in the event of a YES vote. In no particular order, these are (i) what currency would Scotland use and how much influence would Scotland have over its monetary policy? (ii) would a newly independent Scotland be a member of the EU and on what terms? and (iii) what happens if no satisfactory agreement can be reached in any negotiations between Scotland, the UK government and the EU? Clear answers to these questions would provide a much more satisfactory basis for Scottish voters to make an informed choice.

For now, assuming a NO vote with a reasonable majority, there are no investment implications. A narrow NO vote or a YES vote would be likely to be negative (but not hugely so) for the bond markets and for the currency, but the weaker currency would be likely to be a positive for the stock market. The impact on financial markets would depend on how constructive the UK government and the European Commission choose to be in dealing with the Scottish representatives seeking to create a new country.

ECONOMIC AND MARKETS OUTLOOK FOR 2014

Economic outlook

Five years on from interest rates being cut to almost zero in most Western economies, and the introduction of QE programmes in the US, UK and Japan, the global economy finally seems to be moving onto a more secure footing.  Risks remain though, particularly the high levels of government and consumer debt in most Western economies, which remain a constraint on future growth.  In addition, the weakness in inflation indices and continued high levels of unemployment, mean that a renewed global economic downturn, in the immediate future would be very damaging, as there would be very little policy flexibility to offset economic weakness.  Our regional views are as follows:

  • The UK economy has been recovering strongly since last spring when the Help to Buy scheme was announced.  This recovery has been led by housing and mortgage demand, rather than by the business investment that is required for a healthy and sustainable economic recovery.  However, the consumer can drive a continued recovery through 2014 and up to the 2015 election, if savings rates continue to fall.
  • The US economy has entered 2014 growing at a near 3% pace, and this is expected to continue for 2014.  As in the UK, business investment is still a problem, as companies appear far more concerned with growing dividends and buying back shares to boost their share prices than by investing for future growth.
  • The European economy is still struggling. Growth should be positive in 2014 after close to zero in 2013, but recovery will be constrained by continued austerity by most governments, negative inflation rates in many peripheral economies, and by banks still seeking to reduce their loan books ahead of the ECB’s Asset Quality Review later in 2014.
  • The Japanese economy continues to respond to Abenomics.  The increase in the National Sales Tax from 5% to 8%, which will take place in April, will mean a strong first quarter but a weak second quarter.  However, the Bank of Japan has indicated that it is ready to increase its already large QE programme to mitigate any economic weakness.
  • In Asia, Chinese growth is slowing as the  authorities there are seeking a rebalancing of growth away from the wasteful over-investment seen in recent years towards greater consumer spending.  Higher wages have been a key part of this, but this has been funnelled into property speculation rather than consumption.  The central bank is trying to deflate the housing market without deterring the consumer from spending.
  • Other emerging economies are facing problems as the improvements in growth elsewhere are impacting the flows of financial market liquidity, which have been supporting them.  Current account deficits in Brazil, Turkey and South Africa, are now causing falls in their currencies and higher interest rates in response, which will lead to weaker growth in 2014.

2014 should see the world economy move back towards a more normal pace of growth.  For central banks, the dilemma is when to move back to more normal settings for monetary policy.  We believe that official interest rates are unlikely to rise in the West during 2014, as it is likely that central banks will err on the side of risking creating inflation rather than risking creating more unemployment.

Markets outlook

Entering 2014, the consensus amongst most investors on the prospects for the global economy and for stock markets in 2014 is one of greater optimism than for several years.    However the two factors of improved economic prospects and stronger financial markets, do not necessarily occur simultaneously.  Indeed, stronger economic growth has already led to the Fed tapering its QE programme, and investors bringing forward their expectations of when interest rates will begin to rise.  Typically, the financial markets perform well in expectation of improved growth, but when that growth appears, the liquidity in the financial markets is then needed by the real economy for investment.  This tends to mean rising bond yields and falling P/E ratios, and subdued investment returns.

For the UK markets in particular, the domestic pension funds have experienced a significant improvement in their funding position from the combination of rising equity prices and rising bond yields. Many schemes are being advised by their actuaries to take advantage of this improvement and to “de-risk” their portfolios by reducing equities and buying index-linked bonds.

Within bond markets, we are not particularly hopeful of much in the way of returns in 2014, and hold UK index-linked bonds for their favourable tax treatment, and the option they provide should UK inflation expectations increase.  Emerging market government bonds issued in US dollars now offer attractive yields for the level of credit risk that they bring (such as those witnessed in the recent poor economic developments in Turkey and Argentina).

We favour UK commercial property, where we believe that the market cycled has reversed from falling rents and capital values to one where rents and capital values are rising.  The yields on commercial property are also attractive compared with those available on bonds and equities.

Within equity markets, we favour: (i) Japan, but with the yen exposure hedged, as the Bank of Japan will continue to print money until economic recovery and inflation appear well-set; (ii) UK smaller companies, which for many years have not delivered the extra performance over large and medium-sized companies normally achieved from such investments – the current strength we are witnessing in the UK domestic economy should be reflected in better performance from smaller companies;  and (iii) Asia, where valuations are historically below average in absolute terms and long term growth prospects remain strong.  We have a neutral view on the larger companies in the UK equity market, with valuations on the FTSE100 Index near their long term averages.  The market would benefit from weakness in the pound, as profits in the second half of 2013 have been hurt by the strength of Sterling against the Dollar, Euro and Yen.  We expect the Dollar to be the strongest currency in 2014, but would expect a stronger Pound against the  Euro and Yen.

We are more cautious on the US and European equity markets.  In the US, corporate earnings expectations are already very high, and the valuations on those expectations are also at historically high levels, so strong performance from US equities will be difficult to achieve.  In Europe, in addition to high expectations of earnings growth and above-average valuations, as in the US, the growth outlook also remains subdued, bringing an extra degree of risk to European share prices.

We expect equities to outperform bonds during 2014, as they did in 2013 but expect the year to be both less profitable and more volatile for investors.

 

Q to reduce bonds

In the 1970s, the British comedian, Spike Milligan devised the Q series.  This was a surreal comedy show, which when any particular sketch had come to an end without a suitable punchline, the actors would then wander around saying “What are we going to do now?”  UK economic policy seems to have reached the “What are we going to do now?” stage.

 

On fiscal policy, the coalition government has been and remains totally committed to reducing the budget deficit by a planned, slow but steady austerity approach.  This initially involves an increase in taxes, followed by spending cuts throughout the life of this parliament and now extended well into the next parliament.  Unfortunately, for the UK economy, this well-planned and thoughtful approach has not delivered the budget deficit reductions that were predicted for two main reasons as follows:

 

  • the eurozone crisis meant that the domestic economy of our nearest and largest trading partner was much weaker than expected as even more severe austerity was introduced there than in the UK.
  • all the economists’ models of how an economy performs at a time of government spending cutbacks woefully underestimated the impact of austerity on the overall economy.  The result has been considerably weaker UK economic performance, and much higher budget deficits than forecast by the government.

 

None of the Chancellor’s choices on fiscal policy are politically appealing.  Should he choose:

 

  • to cut spending faster than planned, to try and meet the deficit targets in future years, then even more public sector workers will be put out of work in the run-up to the next Election.
  • to reverse the spending cuts, then he will be accused of admitting that the austerity policy was wrong all along.
  • to do nothing, then he will be accused of having no ideas to boost the economy.  Increasingly, with a little over two years to go until the election, these accusations are likely to come as much from his own MPs as from the Opposition.

 

With regard to monetary policy, Mervyn King, the current Governor of the Bank of England, has managed to thoroughly confuse everyone. For the last twelve months he has been saying that the policy of Quantitative Easing (in place since April 2009) is becoming progressively less effective and that monetary policy cannot solve all the UK’s economic problems.  This is somewhat at variance with his confidence in the policies when they were initially unveiled.  However, the latest minutes from the Monetary Policy Committee showed him in a minority of 3 (against 6), voting for more QE to stimulate the economy at a time when inflation is expected by the Bank to be above its target throughout the next two and a quarter years.

 

Further, the Chancellor, has asked the incoming governor to lead a debate to assess what the appropriate target of monetary policy should be.  Taken all together, one gets the distinct impression that those in charge of UK economic policy have run out of ideas.

 

The investment implications of this uncertainty and indecision have already begun to be seen.   Gilt yields have been rising, and sterling has been falling, evidence that international investors have been reducing holdings of UK government bonds.  A weaker pound is however positive for the profits (in sterling terms) of many of the UK’s largest companies, and so share prices have been rising.  The rise in government bond yields is likely to be mirrored by rising sterling corporate bond yields, and exposure to this asset class should be reduced.

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.

Not so Sterling

All three of the major credit rating agencies, Standard & Poor’s, Moody’s and Fitch, have the UK rated at AAA but with a negative outlook.  A fourth, Dagong, a Chinese-owned rating agency, already has the UK at only A+, four notches below AAA.  They have each warned that a failure to reach the government’s deficit reduction targets in 2013, may lead to a decision to remove the AAA designation.  The worse than expected growth of the UK economy over the last two years has produced less tax revenue than expected and meant that reducing government spending has proved more difficult to achieve.  The government looks increasingly unlikely to meet its deficit targets, and the chances of at least one of the agencies downgrading the UK in 2013 are very high.

For Messrs. Osborne and Cameron, this will undoubtedly be politically embarrassing.  When they first came to power, they laid great store on the credibility of their austerity policy with the financial markets and the credit rating agencies.  Since then, they have often sought to justify the policy by reference to the fact that the AAA rating has been maintained to date, while most Eurozone countries undergoing austerity programmes have seen their ratings reduced.  The Labour Party will be able to score many political points, if and when a downgrade occurs.

For the financial markets, and indeed for the economy, it will, however, be of almost no significance.  Markets are rarely surprised by downgrades to credit ratings, as the agencies telegraph their thinking some months ahead.  Both the US and France have already lost their AAA status with at least one of the agencies, and it has had no obvious effect on yields on their government bonds.  Indeed, French yields have fallen sharply since being downgraded.

For countries such as the UK and US, which have Central Banks who are allowed to print their own currencies, there is in fact no doubt that these governments will always repay their debts.  They always have the power to create the money that is necessary to repay any debt denominated in their own currency.  From the perspective of a domestic investor, there is no risk of not being paid back the nominal value of any government bond, and in that sense they should remain AAA.  That is not of course the same thing as saying that these bonds have no risk, since creating a lot of money to repay government bonds is likely to prove very inflationary.  Being repaid in devalued money can seriously damage an investor’s wealth.

For countries inside the Eurozone, matters are very different.  By adopting the single currency, they have forsaken the right to be able to create the money to repay their debts and handed the right to the ECB, who hold a very strong conviction that creating money for such reasons is a very bad idea.  It is thus entirely possible for a Eurozone country to find that it does not have enough euros to pay back its lenders, and thus go into default – hence the crises in Greek, Portugese and Spanish debt markets in the last few years.

One investment implication is likely to be a reversal in the strength of sterling that was seen in 2012, when it was the strongest of the major currencies over the year.  Any downgrade itself is not likely to be the cause of sterling weakness, but both would reflect the poor growth performance of the UK economy.   Further, David Cameron’s recent call for an in/out referendum on the UK’s membership of the EU, will create much uncertainty in the minds of global businesses and investors looking to invest in the UK.  The pound looks set for a period of weakness, and investments overseas should benefit from currency gains for UK investors.

“Zombie” companies: – Why corporate bankruptcies have to increase to spur recovery

Corporate bankruptcy plays a very important role within a competitive, free-market economy. Enterprises that fail were either providing a good or service that was not in sufficient demand from the rest of the economy or were providing a good or service that was not competitive with other providers in the marketplace.  Bankruptcy provides a means for the resources that were being used by the unsuccessful company to be taken from inefficient use to a more efficient use.  If this is continually occurring throughout the economy, then the use or resources will be efficient and the level of economic activity will be greater.

The US economy has generally been very good at this.  As the fortunes of industries wax and wane, both capital and workers can be seen moving from the struggling parts of the economy to the newly growing and profitable parts.  Private sector capital will always be highly mobile, but with relatively poor welfare benefits and the advantages of a common language and laws, the US workforce is also very mobile and ready to change geography and sector of work.

The above is fine in theory.   However, for politicians, elected by voters who want secure jobs, the concept of long term resource efficiency will often play second fiddle to protecting companies from going bankrupt and making their workforce unemployed.  If too many bankruptcies (that should have occurred) are avoided, then there will be adverse economic consequences.

Japan’s long period of very slow growth since 1990 can be at least partially attributed to the reluctance of their banks to foreclose on companies and force them into bankruptcy.  The alternative was to reduce the interest rates due on the loans to very low levels, even though there was little prospect of ever repaying the principal amount – in Japan they are known as “zombie” companies.  This reluctance was for two reasons. Firstly, the banks themselves were critically short of capital, and forcing companies into bankruptcy would mean that they would have to acknowledge losses, which would reduce their capital base and weaken the perception of their capital strength in the market.  Secondly the culture of Japanese society, which like many Asian cultures, places a large emphasis of maintaining “face” and avoiding “shame”.   Going bankrupt and formally not making good on your responsibilities to creditors is seen as very shameful, and many will go to great lengths to avoid it.  In the US by contrast, having a company go bankrupt is seen as part of the learning process to becoming a successful entrepreneur.

Recent data on European bankruptcies by Creditreform Research , is very illuminating.  When ranking European countries by the number of corporate insolvencies per 10,000 businesses in 2011, the four countries with the lowest rates of insolvency are Greece (5), Spain(18), Italy (26) and Portugal (57).  These are the Eurozone peripheral countries with the poorest economic performance.  The countries with the highest rates of insolvency are Austria (152), Denmark (182) and Luxembourg (316), which have all been relatively successful European economies.   The differences in this data between countries strongly supports the idea that an insolvency process that allows bankruptcies to occur easily, works to the benefit if the economy as a whole.

After the 2008 Crash, one of the surprises in the UK economic data in the face of weak economic performance, has been the rate of corporate insolvencies.  In the 1990s, business liquidations averaged about 160 per 10,000 companies, but during and since this crisis the number has not even reached 100.  There is a general sense that, as in Japan in the 1990s, banks are not foreclosing on companies.  This is (i) to avoid even more bad publicity than they have been receiving already, (ii) to avoid selling off whatever assets there are at knock-down prices and so realise larger losses than might be warranted, and (iii) to avoid write-offs from their capital bases at a time when their regulatory capital requirements are rising sharply.  Thus, as in Japan, they are content to roll over existing debt at low interest rates, even though they know that their collateral is worth far less than the loans against it.

The UK therefore probably now has a fair share of “zombie” companies. In the longer term, this will tend to inhibit recovery and growth in the UK economy, but in the shorter term it may well explain why the UK unemployment data has been consistently better than expected.  The other conclusion is that considerable, unrecognised bad debts still exist within the UK and European banking systems.  This underpins our concern that there will not be a return to stronger growth in the UK and Europe for several years ahead, which will limit returns from financial markets.

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.

Why most economic forecasts have been so wrong in recent years

In its recent six-monthly World Economic Outlook report, the IMF included a section examining why it, and just about all other economic forecasters, had been consistently too optimistic in its forecasts of economic growth over the last three years. This has been particularly painful for those governments undergoing austerity programmes, where the shortfall in growth relative to forecasts has meant larger deficits and the need for further austerity programmes.

The very clear conclusion is that their estimates of the fiscal policy multipliers have been far too low. The fiscal policy multiplier measures the degree to which the economy is impacted by a change in fiscal policy (either a tightening of policy created by raising taxes or cutting spending, or an easing of policy created by cutting taxes or boosting spending). For the 30 years up to 2007, economists had identified this multiplier to have a value of about 0.5, so that a fiscal tightening equivalent to 1% of GDP, could be expected to reduce the growth rate of the economy as a whole by about 0.5%. However since 2008 this previously stable relationship has changed and the multipliers now appear to range between 0.9 and 1.7. Further, it was  those economies which underwent greater austerity which saw the higher multipliers on final economic demand.

For the UK, this is unfortunate news for Mr Osborne, since this is exactly what his Labour opponent, Mr Balls, has been saying for some time. It means that the steady approach to austerity at about a 1% rate of tightening per annum, that he adopted is having a greater effect on the overall economic growth than he envisaged.

The higher multipliers identified where there is greater austerity is probably due to an economic confidence effect, as the deep cuts in government spending and large increases in taxes will lead everyone to believe that recession is imminent and thus curtail their spending immediately. For Greece, Spain and Portugal this goes some way to understanding why their previous austerity plans have not worked – those who are bailing them out have demanded that they get their fiscal houses in order in a short space of time and this has resulted in even weaker economies and larger than expected budget deficits.

At the same time as the fiscal policy multipliers have risen, so the monetary policy multipliers appear to have fallen. Cutting interest rates from 6% to 5% has a far more dramatic effect on the economy than cutting the from 1% to 0% and Quantitative Easing policies are generally agreed to work best the first time they are used and have less effect with each repeated use. Keynes is often attributed with describing such policies as “pushing on a string”. Central Banks are now having to make significant monetary policy changes to have any effect on the economy.

So the world finds itself in a real policy bind. The area of policy being tightened (fiscal) is working too effectively on growth, and the area of policy being eased (monetary) is not working at all effectively on growth. This approach does help to provide an understanding of why economic growth is consistently disappointing the economic forecasters. The policy implications are at odds with conventional wisdom – governments should adopt a slow but sure approach to austerity, and a more effective form of Quantitative Easing needs to be adopted with the concept of the Modern Debt Jubilee (espoused here), appearing to be an increasingly interesting idea.