// BLOG
The Outlook
September 6, 2010
Tomorrow’s worldly wisdom
will often have been today’s infernal heresy.
Henry David Thoreau, Journals.
Governments may come and go, fiscal and monetary policy chop and change, but the business cycle goes on forever. It marches to an internal rhythm, largely unaffected by external considerations. It accelerates and decelerates with a recurring 5½ year periodicity.
Activity troughed at the end of 2008 and has been recovering ever since. It’s due to peak in early autumn 2011. Be-tween now and then, there’s likely to be growth, but at progressively slower rates.
Is that a picture that’s consistent with published data? It certainly is. Though conditions have varied a good deal from one country to another, most have experienced (anaemic) recovery during the last eighteen months, and a slight loss of momentum recently.
If that’s the case, there’s little danger of immediate recession. But a substantial risk of renewed debility in 2012 and 2013. It’s in those years that the threat of financial default (and social bloodletting) will peak.
In public, Governments and Central Bankers disagree. They claim that the recovery is robust, that it’ll persist for several years, broadening and deepening as it does. Indeed, they fear inflation quickening again. They hint at the need for higher interest rates next year!
Wishful thinking. In 2007, they’d also reckoned the expansion to be vigorous, inflation to be likely to rise. They were hopelessly wrong, of course. The cycle had already turned. Their interest rate increases were imposed after re-trenchment had begun. They didn’t dampen the economy’s swings, but emphasised them.
It’s likely to be worse in 2012. The public sector will be cutting its spending and the personal sector scaling back its debt. It may take five years for economies to re-establish equilibrium, possibly ten.
In the meantime, there’ll be furious competition for export markets. Countries that are uncompetitive will be hard pressed. Devaluation may consequently become more frequent. Protectionism can’t be ruled out.
Europe’s problems are particularly intractable. The single currency is a disaster. It requires that Greece and Spain and Portugal be competitive with Germany. The former’s relative costs will have to be cut by 10% in the midst of a downturn, and at a time when the latter’s may also be falling! It’s true that withdrawal from the EZ would be pain-ful. But more so than staying in? Of course not!
In global terms, Europe’s financial eccentricities are of no great importance. The preservation of free trade is. How great is the danger? Significant. In recent years, the benefits have not been equitably spread. It’s been the countries of Emerging Asia, China most obviously, that have scooped the lot.
The less competitive parts of the world, those mired in persistently anaemic growth, are getting restless. They’re thinking of retaliation. Trade, they say, should be fair rather than free. The jingle goes down well with electorates.
Will protectionist sanctions therefore be imposed? It’s not impossible. In somewhat similar circumstances in the thirties, they were. And it may have been that which turned severe recession into depression!
The good news is that asset markets—bonds and equities—are likely to continue to rise. Negligible inflation, expan-sive credit and resilient corporate profits will be the driving forces.
Economics News : 3 Sept
September 4, 2010
One swallow doesn’t make a summer.
Certainly not in economics; nor, probably, in securities markets!
Economics data are sometimes seen through rose-coloured spectacles.
Last week’s economics news wasn’t good, just less bad than it had been during the summer. A fine distinction! But one that most investors were not minded to make. They’d become accustomed to downgrades and disappointments. They’d begun to think recession was imminent. Suddenly, realising it wasn’t, they reacted jubilantly. They went on a buying spree, bidding equity valuations sharply higher.
Stock market reactions depending more on investor psychology than fundamental logic.
Investors shouldn’t have been surprised by the statistics. The current business cycle wasn’t due to peak until autumn 2011. Until then, it was to be expected that activity would advance, albeit at a decelerating pace. There was nothing in last week’s numbers to necessitate a change of perspective.
Recession is still possible, probable even—but not until end 2011.
The dangerous period lay, not immediately ahead, but in 2012 and 2013. That was when recession was most likely. That was when the risk of financial default and political bloodletting was highest. By comparison, the near term was going to be almost serene. Economies would advance modestly, inflation fall sharply, interest rates stay low and asset valuations rise significantly.
Public spending austerity is about to begin.
The big change in Britain in the next twelve months concerned the social environment rather than the economics one. Spending in the public sector was going to be cut sharply and employment in it fall accordingly. It’d not be a painless process. Where it had already begun, in Europe for instance, there’d been strikes and demonstrations. Similar disturbances were likely here.
There’ll be lots of dissention.
They’d not alter the fundamentals, though. Economics logic tends usually to be on the side of the big guns: it favours creators of wealth rather than consumers of it. Accordingly, there might be twelve months or more of labour market contention, but the process would end with a more balanced economy: large numbers of public sector employees dismiss¬ed, and lower rates of pay increase for the remainder.
But, eventually, a more sustainable economy.
If the authorities were to be sensible, they’d use the endgame negotiations to bring sanity to public sector pensions. Either defined benefits would be abandoned, or the retirement age at which they started to accrue would be raised. As currently structured, public pensions were insupportable. Politicians had ignored the problem for too long. An immediate increase in the retirement age for civil servants and local authority workers was the obvious first step.
One not burdened by senseless wars.
An equally obvious second step would be the cessation of military hostilities in the Middle East. If the authorities were honest, they’d recognise that the wars in Iraq and Afghanistan had been unmitigated disasters. Their cost in lives and finance sizeable; their effectiveness in containing terrorism negative.
It’d be helpful if political leaders knew something of history.
Thankfully, the one seems almost to be over, the other beginning to wind down. The Americans are marvellous. With a fine disregard for battlefield reality, they declare victory and withdraw. It’s devoutly to be hoped that the current administration doesn’t make the same mistake with Iran and North Korea that the previous one made with Iraq and Afghanistan.
Bush and Blair didn’t, and consequently made appalling errors of judgment.
It’s even more devoutly to be hoped that Britain’s current Prime Minister should behave more sensibly than his predecessor. The latter, of course, was a wrong ’un. That he got elected in the first place is regrettable, a serious indictment of Britain’s psephological perceptiveness (excusable only by reference to the difficult aftermath of the shambles that characterised Major’s time in office). That Blair got re-elected twice subsequently is not so easily explained away. It’s a stain with which the Brits will have to learn to live!
We’re still in a bull market. The best may yet be ahead.
Where should we be putting our money? Most asset classes will appreciate during the next nine months. Bonds will be buoyed by lower inflation and governmental determination to contain public spending. Expansive credit will provide the cherry that tops the icing. Equities, though, will fret about labour disputes and the possible negative impact on profits. It’s only as these fears are seen to be groundless that investors will become positive.
Only property may be dull in the next few quarters.
Property may be the spanner in the ointment. Commercial demand seems likely to be scaled back as private companies (and public authorities) downsize. And residential demand will be restrained by job losses and smaller pay deals. Outside London and its catchment area, therefore, despite surging quantities of liquidity, the property scene may be dull.
And only if the B-of-E messes up again will valuations generally be soft.
The threat to general valuations comes from the Central Bank. It’s only if the Old Lady should take it into her head to tighten money that prices would crash. Might she do so? Sadly, yes. She’s done so before—in 2007, for instance. The misanalysis then was shocking; let’s hope it won’t be again.
Economics Views : 1 Sept
September 2, 2010
A man isn’t to be deemed clever,
just because he has lots of ideas.
Nicolas Chamfort, Maximes et Penseés, no more, of course, is a General to be reckoned competent just because he has lots of soldiers!
We all wish we’d not made so many mistakes.
It’s not uncommon for stable doors to be closed after horses have bolted. It is, though, a procedure in which politicians and bureaucrats, famously lacking foresight, specialise. It was illustrated last week by the Bank of England’s Charles Bean.
Some of us, though, try to pretend we didn’t.
Speaking in Wyoming at the Annual Conference of the Kansas City Reserve Bank, he said that mortgage finance needed tighter regulation. It was possible that “direct constraints” on lending would be required. If housing bubbles were to be avoided in the future, there was some merit in setting caps on loan-to-value ratios.
Public sector grandees, most particularly.
If he’d said these things five years ago, he’d have deserved plaudits. And it’s possible that the policies he recommended, if implemented then, would have helped stabilise mortgage finance: limiting the frenzy on the upside and containing the depression on the downside. To say them now, though, merely draws attention to past errors of judgment.
Occasionally, that compounds the original error.
As a rule, the indulgence of 20-20 hindsight does no harm. But sometimes it leads to policies that are counterproductive. If, for instance, restrictions on mortgage finance were to be imposed in the near future, they’d be more likely to exacerbate the downturn than mitigate it.
The Bank’s current thinking on housing finance is worrying.
It makes no sense to apply the brakes when the vehicle’s already going too slowly. To do so risks stalling the engine. The good driver, the one avoiding the extremes of boom and bust, waits until the pace of activity requires action. He starts to close the throttle as the vehicle’s speed approaches normality, and to brake when it becomes excessive.
It risks turning disaster into cataclysm.
Is housing finance currently excessive? Of course not! It is hopelessly inadequate. House prices are falling and negative equity is increasing. In effect, first time buyers are already excluded from the market. Has the B-of-E not noticed? Is it so concerned with preventing future problems that it can’t see current ones?
The first step should be an acknowledgement of previous mistakes.
The commercial banks need no excuse to tighten their lending criteria. They’re making so much profit from risk-free “round-tripping” (borrowing from the B-of-E’s money-creating Department at one rate and lending to the Treasury’s spending Departments at a higher one) that they have little incentive to do anything worthwhile. This is the problem to which Charles Bean might profitably have turned his attention.
The second, a reversal of earlier policies.
He didn’t because it was the B-of-E that was largely responsible for creating the mess. It was the Bank that bailed out the RBS and HBOS delinquents. And it was the Bank that sustained them by the subsequent sequestration of taxpayer funds.
It’s best not to put the lunatics in charge of the asylum!
If there’s a message here for the rest of society, it’s that commercial banks oughtn’t to be run either by second-hand car salesmen or by half-baked academics. In reality banking isn’t complicated. It needs competence rather than charisma. We didn’t get it in the past; we may not in the future.
Asset values are rising, and’ll probably continue to do so.
The good news, and there’s not much of it, is that asset valuations as a whole are rising. Currently, the emphasis is on fixed interest securities. Later on, perhaps imminently, it’ll shift to ordinary shares. A conjunction of accommodative credit and resilient corporate profits will provide the motive force.
Economics News : 27 Aug
August 27, 2010
It’s not certain that everything’s uncertain.
Blaise Pascal, Penseés—but, in economics, it is with high probability; and, in finance, with almost complete certainty.
The US is ahead of the curve: its GDP estimates are being lowered; those of others raised.
It’s rumoured that the official estimate of GDP in the US in the second quarter is shortly to be cut. Growth had previously been set at 2½% per annum. It might, it’s now being said, be lowered to just 1¾%. Some investors are worried; some, noting the exaggerated response of stock price indices to below-par economics data in recent weeks, are in panic mode.
Is that likely to undermine security valuations?
Is their anxiety justified? Probably not. Quarterly numbers are unreliable. It’s the trend that’s important, not the volatility. And the former was established several months ago. Activity in the US (indeed, in the world as a whole) is slowing. The deceleration is likely to continue for another twelve months or so. But whether it ends in recession, and whether equity and bond prices decline in consequence, are quite separate issues.
Pascal wouldn’t be sure. Nor should we be.
The relationship between asset valuations and economics activity is complicated. But it’s driven less by some factors than others. GDP is much less important than liquidity, profits or inflation. The former is relevant only if it affects the latter.
But bonds will probably extend their gains.
Will it? Yes, but often favourably rather than unfavourably! As economies subside, central bankers usually operate more accommodative monetary policies. And businesses invariably find it harder to raise prices. The conjunction of expansive credit and low inflation is unambiguously favourable for bonds. They virtually always perform well in periods in which economies are softening.
Equities might follow suit.
But equities are influenced also by corporate profits. How do they respond? It’s a two-way pull: they’re hurt by duller sales, but helped by moderating wages. Which is the more important? Often, the latter. If the economics debility should be protracted rather than ephemeral, wage negotiations take much of the strain. The employee’s bargaining position is undermined more than the employer’s. Profits hold up fairly well, and equity valuations, albeit hesitantly, rise.
Economies meanwhile will continue to soften.
Is that the prospect the world has before it now? Possibly so. The economics, it has to be admitted, aren’t looking good. The root cause of the anaemia seems to be consumer attitudes. People are choosing to save and not to spend.
Consumers seem to have lost the will to spend.
They feel insecure because their finances are stretched, and they respond by paying down debt. That causes activity to falter, unemployment to rise and insecurity to soar. It’s a vicious circle in which effect reinforces cause. And it’s one which the authorities are almost powerless to counteract.
It may be some time before they regain it.
It’s not recession that has to be feared, but depression. If a negative consumer psychology were to become ingrained in the States and Europe (as it already has in Japan), the problem would last a long time. Not until personal balance sheets had been returned to “normality” would personal spending do so as well.
Who’ll suffer more? Debtors or creditors?
It’s not only countries with sizeable consumer debt burdens that would be hurt. So also would those that had previously been exporting to them. All would suffer; the latter perhaps more than the former. In 1930, it was countries which had risen most in the prior decade that proved to be most susceptible to declines in the subsequent one.
Sometimes, ironically, the latter.
China may be particularly vulnerable, therefore. It is heavily dependent on exports. If they were to be hit for any reason (protectionism, for instance), the PRC would be devastated. Higher public spending wouldn’t square the circle, nor easier money. Japan’s experiences in somewhat similar circumstances in the last couple of decades are not encouraging.
And raw material suppliers? Are they set to climb ladders or descend snakes?
There’s also a cloud hanging over the commodity producers. The fact that the investment consensus is so positively disposed to them is a sizeable negative. They’ve enjoyed a superlative phase in the last couple of decades, but it’s resulted in strong currencies coupled with relatively high inflation. That’s no problem for them at the moment. But it would be in the context of significantly reduced demand for their exports in the future.
How vulnerable is Britain?
As a rule, countries like the UK come relatively unscathed through periods of persistent economics debility. Their economies specialise in areas in which value-added is high, but competition limited. Though real activity suffers, terms of trade don’t. They take a single whammy, not a double!
Arguably, less than most.
Perhaps significantly, sterling has been drifting up for several months. The pundits have been almost universally pessimistic, but the unit’s value nevertheless keeps edging ahead. Do traders know more than experts? Is water wet?
Global Demand Continues to Weaken
August 26, 2010
From an article published in The Daily Post, 26th August 2010
Economics data never present a completely uniform picture of developments. Even in the midst of devastating recessions, a significant proportion of published statistics (15% perhaps) will be upbeat. And, correspondingly, even in the eye of glorious booms, a similar proportion of releases will be dull.
It’s the averages that the analyst has to watch: they’re rarely misleading. And, in recent months, they’ve been saying that the world economy is losing momentum. Since late-spring, that’s been the message of almost two thirds of them; since mid-summer, almost three quarters.
The outlook for the UK is not good, therefore. Recession isn’t imminent, but it mightn’t be long delayed. At best, growth in the next couple of years can be expected to be anaemic; more likely, it’ll be negative late in 2011 and early in 2012.
Is there anything the authorities can do to restore equilibrium and reignite growth? Probably not. They’re unlikely to sanction a new surge in public spending, for instance. The one implemented in 2008 was manifestly a mistake: it made things worse, not better.
The Bank of England, on the other hand, will try to keep monetary conditions expansive: interest rates low and credit availability high. That’ll certainly help, but it’ll probably not be enough. It’s the commercial banks that are the problem.
They tend not to pass on the largesse to their customers. Though they borrow cheaply from the taxpayer, they lend expensively to the customer. Their focus is the executive’s bonus, not the economy’s vitality. They’re a drag on the economy!
The B-of-E made a huge mistake in 2008 when it acted (without Parliamentary authority) to save RBS and HBOS. The case for protecting depositors was one thing; that for bailing out incompetent managers, quite another. It would have been better to break up and sell off the failed banks. What was needed was more competition in financial services. What we got was less!
The securities markets provide the one bright spot in an otherwise gloomy scenario. At the moment, it’s bonds that are making the running. Investors have begun to appreciate that dull economics will keep inflation low and borrowing subdued. They know that the demand for fixed income paper will consequently rise, and the supply fall.
Later on, equities will take over. Corporate profits have exceeded expectations recently and will probably continue to do so. Why? Not because of higher sales, but lower costs—labour costs in particular. The process has further to go. Likewise the equity indices.