May 2010
It's not getting boring any time soon
During the fictional “Great Moderation”, which was actually the “Great Delusional Bubble”, the apparent stability of financial markets and the underlying economy made it easy to dismiss the nay-sayers against the consensus. However the world we find ourselves in a few years later continues to confound, surprise and disappoint in equal measure and after analysing a broad range of economic and market views it is a little troubling at the moment to see all the big hitters who went against the consensus and called the downturn right are, almost to a man, starting to get very concerned (from simply troubled) again. As somebody who has followed them in the days they were ridiculed Prometheus takes these people’s views very seriously but we will leave an examination of specific thoughts for another day. There is more than enough going on right now to occupy our minds.
Yesterday's inflation figures were certainly an unwelcome surprise, although the VAT changes and weak sterling were bound to have some impact. Nonetheless the size of the increase was unsettling. The common theory over the recent spike is that it has been led by “cost push”, rather than “demand pull” inflation. In short this is not an overheating economy, just one facing external pressures. Certainly as the currency stabilises, or strengthens, and if commodity prices possibly weaken in the face of slowing global demand (or less speculative demand) inflationary pressure should subside. However if it doesn't this does ask some awkward questions of BoE interest rate policies and we may see a rate hike sooner rather than later. Of particular concern was seeing car insurance rising by around a quarter, which in a competitive market should not be happening. It raises the question of semi-cartel pricing in certain industries whose products may be considered necessities as industries try to claw back profits lost in other operations.
Persistent inflation does have one benefit, however, in that it erodes the relative value of your debt. This may ultimately become a creeping fear of financial markets if UK inflation remains high; however from our point of view we are the best positioned to allow this to happen. This is because (as we have mentioned a few times before, it is important) we have the longest debt maturity timetable of all developed nations at about 13.5 years (as opposed to 4-7 years elsewhere; indeed the US has to roll over about 40% of its massive debt over the next couple of years). The reason that this is so useful is that if markets begin to believe inflation is growing in a nation then they will demand a higher yield on that nation’s debt, driving up borrowing costs ever higher, replacing a possible deflationary spiral with an inflationary one. As such the common notion that a country can simply inflate away its debt burden doesn't work as advertised as it has to refinance its debt at higher rates. However we have a window where we could get away with it for a while before it becomes crippling. This is not a policy we would advocate but it gives us some wriggle room.
The sad truth is the Western world is facing a real tightrope between deflation and inflation with massive risks on either side, and meddling ideas like the sudden German ban on short selling will not help deal with the fundamental problems. Incidentally a very sound point Mervyn King made at his conference last week was that the markets which Eurozone governments are now up in arms about are the very ones which have been funding their fiscal incontinence for years. So it is a little bit rich to complain when they suddenly start doing the maths and realise things don't add up. Indeed to Prometheus the surprise is that the markets were so generous, sorry I meant astonishingly complacent, for so long.
One bit of good(ish) news is that the Greek bail-out package has achieved its first success, supporting the roll-over of € billions of debt that had threatened to bankrupt the country. Apparently the market stayed away, meaning the EU now owns lots of debt that it will have to take a haircut on at some point (meaning billions thrown away) but at least the immediate crisis is averted, as planned.
Looking at our own problems the new coalition government continues to throw up surprises that please the optimist, the most notable being the new Chief Secretary to the Treasury, the Liberal Democrat David Laws. Looking into his past this man received a Double First in Economics from Cambridge and rapidly rose up through JP Morgan’s ranks before becoming Head of US and UK Treasuries at BZW (the forerunner to Barclays Capital) before retiring before his 30th birthday. It is this last job that is a key point because it means Mr Laws was on the very coalface of the dreaded sovereign bond markets and I doubt he took Liam Byrne's jokey letter “I'm afraid there's no money - good luck” very well. This man now understands where we are. This is good. This is very good. Not often can we say that these days.
And finally, just to prove Angela Merkel only wants markets that will accept Europe’s debt addiction unthinkingly (which they have, quietly and stupidly for years) the following quote says it all:
"The lack of rules and limits can make behaviour in financial markets driven purely by the profit motive destructive and lead to an existential threat to financial stability in Europe and even the world. The market alone won't correct these mistakes."
She doesn’t get that the mistake was to act like sheep to the rhetoric of ignorant politicians for years, not to react in panic when their plans start to crumble.
A New Dawn
No, not the new Morecambe & Wise of Politics, it’s “Behind the curve Merv” as I may have, well did, call him in the past; showing that perhaps he really isn’t so far adrift. Amazing what happens when the Governor of an independent Bank of England genuinely feels independent of political control.
In his press conference on Wednesday he raised a number of key points, which also draw the spotlight onto other events this busy week. The issue of our own fiscal deficit and growing national debt was raised: “It is the single most pressing problem facing the United Kingdom; it will take a full parliament to deal with and it is very important that measures are taken straight away to demonstrate the seriousness and the credibility of the commitment to dealing with that deficit.”
This clear statement (and I’m sure recent events in Greece) made it much easier for the new coalition government to get straight down to business on the deficit reduction, although from watching the news I am still less than convinced that some in the government get it.
Still, listening to Radio 4 on Wednesday morning comments from William Hague on the rapport struck between negotiators from the two parties started to provide a little hope that partisan rubbish might be put aside for a while. This hope was reinforced by seeing the leaders working well together in front of the press. Prometheus generally avoids discussing politics (not to avoid upsetting various sensibilities, just a general dislike of the species) but it is worthy of a paragraph this week. Anyway, back to Merv’ and the co-ordinated Greek bailout package that was announced on Monday.
“I do not want to comment on a particular measure by a particular country, but I do want to suggest that within the Euro Area it’s become very clear that there is some need for a fiscal union to make the Monetary Union work.” Well that has always been obvious to the sceptics. No sorry that’s wrong, not sceptics, those that didn’t buy into the idealistic nonsense, understood economics and had an eye for history. Still the optimism engendered by the bail-out effort (which ultimately WON’T WORK without debt restructuring/default and will throw good money after bad and result in even more debt being generated) appeared in even the most surprising corner.
On Wednesday the highly respected Martin Wolf wrote in the FT that the EU appeared to have accepted that to avoid the massive chaos of default, and the exit of a member from the Euro, that the inevitability of some central fiscal control had dawned as the alternative was too awful. Ah, the sad belief in human rationality. Gets you every time! The EU apparatchiks may happily try to enforce what would effectively be a single unelected government, but the populous at large, as they struggle under renewed recession, may have other ideas. See how the Spanish opposition is already angrily talking of Spain being a European “protectorate”. Niall Ferguson, writing in Newsweek (before the bailout announcement) headlined his article “The Death of the Euro”, which may be going too far but tough times are ahead.
The problem is that the rescue simply buys time at the expense of raising funds from other indebted countries to finance the debt of even more indebted countries. Genius. Economic restraint alone in Greece will not save it from having to restructure its debt eventually, with all the knock-on consequences and pain across the global banking system. Ireland after all is busy doing the right things and its deficit still grows because the cuts hit GDP, which lowers tax receipts, which offsets the spending cuts, so more spending has to be cut, which ....you see where this goes. There is a slim chance Ireland can work its way out of this hole, particularly if global growth picks up, but don’t place any bets.
The bigger picture across the Eurozone looks tricky and frankly adding more debt won’t help. Worse the sudden removal of planned tax cuts in Germany, that could stimulate their internal demand, that are having to be made to pay for the debts generated by the rescue package, will suppress domestic spending and add to the deflationary pressure facing the continent. And if that wasn’t enough the most positive element of the rescue package, a form of ECB QE, is likely to remain watered down under German anti-inflation pressures. Looking past the optimism of recent days (even very poor rebound EU growth figures were received with joy) it is hard to see how things won’t ultimately get a lot worse for the Eurozone, and that is bad news for us as we face years of austerity while they remain our main trading partner.
In place of an “and finally”, below is a quote from an economist for whom we have a great deal of respect and who fears German led ECB policy is likely to lead to depression: “The British tradition within which we work allows us to be quite rude about public figures, more so than is normal on the continent or in the US. But to describe accurately the conduct and mental abilities of German policy makers over the past decade would even exceed my limits. Anybody who thinks that either Europe or Germany requires fiscal deflation as a response to recent events needs a brain transplant.”
And if you need a real chortle read the deluded pro-Euro piece by Tommaso Padoa-Schioppa in today’s FT for it almost defines political LSD.
Well it's hit the fan now! Oh and some really good news.
A short note today; as you may imagine life is quite busy at the moment as markets tank, with traders de-risking their books for the weekend and the inter-bank market wobbling.
First up is the good news from the US as the benchmark non-farm payrolls showed job growth of 290K in April, well above market expectations and hopefully pointing the way to self sustaining recovery. Although before we get too excited it is worth pointing out that the headline unemployment figure is actually up to 9.9% from 9.7% in March.
Now the bad news, because being correct about unfortunate issues is rarely satisfying; however, at least we now believe that the market is starting to get it. More and more commentators are stepping forward and pointing out that Greece will have to default on or restructure its debt as the current position is unsustainable. The current rescue package (ironically just approved in the German Parliament) would leave Greece with Debt to GDP at 140/150%. The idea is that robust growth will then help them balance the books. Really, how? When Latvia tried something similar growth just dried up after all the cuts they had to make to balance the books, and as for Greece the market for olive oil is only so big.
To be fair we have just had a meeting with the chief strategist at a major international fund management group and he believes the problems are rationally solvable and will be. And while we agree with the first point we are very sceptical on the second, we just don’t have much faith in human rationality in the face of crisis.
Anyway, a recent note from New York scares us as it points out that Spanish Cajas (think building societies) has outstanding loans to property developers worth 23% of Spanish GDP, held at book value. In light of the Spanish property crash, if that was written down by 50%, that is 11.5% of GDP. As I said, scary.
Finally the UK election: a hung Parliament is the result. How this will feed through to policy is now completely open and the pound and UK government debt have been sold down as a result. This is not the outcome we needed when capital markets are facing the possibility of seizing up.
In the meantime the FTSE 100 has been oscillating between flat and about 200 points lower as the bears fight the bargain hunters. We are not sure who will win but some of those bears look mighty grizzly.