Economic Update September 2014

I thought I would share with you how I try and make sense of the data which bombards us everyday from a wide range of media. The charts are mostly from the Bank of England.

The chart shows credit, broad money and nominal GDP. Credit is part of the assets of the banking system, money is the liabilities of the banking system. Nominal GDP is the consequence of money being spent. The crucial component is the velocity of money. This is how many times a unit of money changes hands every day. If velocity of money is stable then any change in nominal GDP must be due to more money being created by commercial banks ( or exceptionally the central bank, known as quantitative easing).

The surprising growth in Nominal GDP in the UK is mostly due to an increase in velocity. That is a unit of money is changing hands more quickly. The increase in Broad money since 2012 is clearly not caused by an increase in bank lending ( which contracted before rising a little in 2013/14). The increase in Broad money must be due to overseas investors buying sterling and holding it in their bank account ( then using it to buy UK companies, land, and property). This will increase velocity but not the amount of money overall. However a change in velocity does affect is where the money ends up.The total amount of money in the system does not change but who has it does! An increase in velocity moves money from person A to person B ( who is in the UK), it changes therefore between bank accounts and banks but total amount in the economy is unchanged. An example; 70% of all residential property sales in London were cash purchases last year. Parents helping

their child get on the property ladder move cash from their account to the vendor who puts it in his account.

Increasing confidence will increase velocity and in turn increase confidence. However the consumer cannot spend money they do not posses. For an increase in velocity to be maintained either credit and or wages must grow steadilyThe chart shows that unsecured lending is growing at 5%, credit card by 4%, mortgage lending by 2%, which is enabling consumption to grow a lot faster than income.Although good for short term nominal GDP growth it is going to be a real problem when interest rates increase. The chart on the next page shows that real post tax incomes are essentially flat and have been since 2009.

For the recovery to be sustainable, real post tax incomes have to be growing by at least 1.5% yoy which requires at least 3% on wages and salaries. At the moment the UK economy is showing signs of 2004-2007, when nominal GDP growth was maintained by credit expansion, not wage growth.

The good news is that at last Investment spending has picked up ( see chart on next page). This is being financed from retained profits, bond issues, and a little bit of net bank lending. Only the latter increases the money supply: retained profits and bond issue financing both increase velocity but not the amount of money in the economy.

The Bank of England have a real dilemma to grapple with. With low nominal wage growth any increase in interest rates will cause a sharp slowdown and possibly a recession. But 5 years of the lowest interest rates on record is clearly having an impact on the attitude of younger borrowers. I am aghast at the level of debt they seem happy to take on. The new rules on Mortgage provision hopefully will demand of them some basic risk analysis and the lender is now required to ensure the borrower can survive with unchanged incomes but a 3% hike in base rate.

UK Wages and Productivity

According to Eurostat the UK is now officially a low wage economy compared to our European neighbours. This is partly due to the weakness of sterling against the Euro, but the average hourly cost of employing someone in Spain was 21.10 Euro last year. For the UK it was 20.90 Euro. The EU average is 23.70 euro per hour. Between 2008 and 2013 the UK average labour cost was flat. In the EU it rose 10%. These figures include non-wage costs such as social taxes.The exchange rate is a significant factor in these numbers. Over the period it fell from 1.50 euro to 1.10 in 2009. Today it is 1.25.

For an international company looking for a European site, the UK is now from a labour cost point of view, cheaper than Poland and the Czech Republic.

It is clear that the UK Government’s changes to social welfare are causing individuals to seek work at almost any wage. This explains the significant fall in UK unemployment. The downside is much of new employment is in unskilled activity and overall productivity is relatively poor. Here is another dilemma: low wages drive low productivity (because it makes labour cheaper than machines or computers). But we need higher wages which are currently not justified by productivity. The only way to break this cycle is to ensure final demand is strong enough to move the bargaining power in favour of the employee. In some sectors this is already happening eg skilled construction workers and specialist personnel in the service industry.

This chart is instructive. France is 15% more productive than the UK and even more surprisingly 6% more productive than Germany. It follows that France can pay higher wages and still enjoy some competitive advantage.There is help at hand. The UK currently doesn’t measure nominal GDP in exactly the same way as our European neighbours. But this Autumn we will adopt their methodology. The consequence for international comparisons will be significant.

The chart on the next page shows that with the new methodology UK nominal GDP in 2007 was £62Bn larger. So our overall productivity is better by about 1.5% in 2007!

The revisions will change a lot of the Governments’ figures, basically showing that the boom was bigger than originally estimated, the recession not so deep. No doubt Mr Balls will use the data to argue that he and Brown were even better at managing the economy than they thought!

UK Property Prices

The chart on the next page shows the madness which is London property prices. At 8 times earnings, a London property is out of reach for the majority unless there is considerable support from family and friends. This support has been forthcoming because it helps a member of the family and it is the very best investment anyone can make. But it shows how speculative the market has become. Over the past three years prices have been rising because they have been rising. The bigger fool hypothesis at work. This can ( and should) go into reverse, prices are falling because they are falling. We need a trigger to change expectations. The opinion polls give Labour a strong chance for May next year, all we need is for Miliband to make one of his silly statements such as some form of mansion tax on property over £2m ( or whatever the average price of property held by labour MP’s in London is) and or a 30% tax on overseas based purchasers.There are signs already that the market is cooling. A 20% fall in average prices would be desirable.

For the UK as a whole, 4.6 times earnings is manageable providing interest rates do not revert to trend ( ie 5% base rate) The Northern Irish are paying the price for their exuberance in 2007!

Latest data shows 150,000 new starts, and with growing availability of bank credit for builders I would expect this to increase by more over the next 12 months( if the spec builder can source enough bricks!) I have been told that the daily rate for a brickie in the South East has risen by 50% in the last 12 months!

This increase in supply with the new mortgage rules limiting effective demand should result in prices leveling off. The government has helped the purchase of 48,393 homes. 82% to first time buyers with a 55 deposit. The average purchase price was £187,000 compared to national average price of £265,000.

The Construction sector is at last enjoying the recovery which has been experienced by the manufacturing and service sector. Add this together and we should see nominal GDP growing by 5% by the end of the year which brings us back to normal. With a 2% inflation rate or lower we will see real GDP at 3% or higher for the year. A good result.

Europe

I have been like a worn out record on the prospects for Europe ( poor) and the myopia of the ECB and the European Commission over the past three years. My view has not changed, but at last their view is showing signs of reality.

The core problem is the continuing contraction of EU Banks’ balance sheets. Latest data shows net credit continues it’s three year contraction, and consequently broad money M3 is barely growing ( 1.8%). Velocity has not risen to offset this. As a consequence France is stagnant, Italy is contracting and Germany has slowed dramatically (Germany exports less than 5% of its exports to Eastern Europe and Russia so the sanctions are material but not the main cause).

The inflation rate is now 0.3% in the Eurozone, it is on the brink of deflation.

It is clear that Draghi is getting ready to sanction Quantitative Easing. My guess is he needs to manufacture 1Bn electronic Euros over the next year. The main impact should be a weakening of the Euro against the dollar ( by up to 15% depending on by how much the Fed raise rate) and against sterling (by up to 5%). It will not increase the supply of credit to Eurozone business, but exporters will enjoy increased margins, the stock markets will go up, the banks will be able to increase their core capital more quickly via trading profits on bonds.

The action should shift expectations from deflation to mild inflation and inspire greater confidence. It should also via increases in nominal GDP make deficit reductions easier for Governments.

Exchange rates

I think a major realignment is now due. The USA will almost certainly continue tapering it’s electronic money creation and also increase interest rates by the end of the year. The ECB will almost certainly create loads of electronic money over the next 12 months. The Bank of England will certainly not create any more electronic money and will talk about the need to raise rates, without actually doing it.

The impact of this will be

A stronger dollar, a weaker Euro, a wobbly sterling ( based on yes he will raise rates, oh no he hasn’t)!

But by how much and when?

If I knew then I wouldn’t be doing this!

Guessing then and assuming the ECB acts:

Dollar up 15% against the Euro

Sterling 5% down against the dollar and 5% up against the Euro.

Stockmarkets

A good friend and first class analyst Professor Bill Weinstein has tried to make sense of what is happening to stockmarkets which are at record highs.I am grateful to him for his insight.

Consider the following:

Civil war and religious carve up in IraqIncreasing grip by Assad on SyriaRussian invasion of eastern UkraineEU sanctions unlikely to change PutinTurmoil in EgyptIsrael to annex 1200 acres of the Gaza strip China exerting muscle in the South and East China seasA coup in ThailandThe EU almost back in recession: the French Government in disarrayBrazil stagantPossibility of blackouts in the UKA yes vote in Scotland

There is a growing consensus that because yields on many asset classes are so low investors are taking riskier and riskier positions so that when an event puts the balloon up we are in real trouble.

Are the markets insensitive to the above list because the Fed still has them on life support ( albeit with reducing transfusions) and now they expect the ECB to take over the baton?

Could the trigger for the UK be blackouts this Winter due to the unexpected shortage of generating capacity?

Could a yes vote in Scotland be the trigger?

Normally there is significant market adjustment in either direction when the analysts return to their desks in September but at the time of writing the US and UK markets are at historic highs.

By the time you read this the adjustment could have already have started and you will consider the above to be of no help at all!

Personally I have not been chasing yield and so I am relaxed: markets go up, they come down, over the longer run( 5 years plus ).They are in my view driven by macroeconomic conditions, but only when the herd instinct pauses for reflection.

The USA

The graph compares the USA with the UK GDP growth rate. Please note UK is dotted line, and refers to right side axis. The USA has outperformed with an average real growth rate of 1.8% compared to the UK at an average of 0.8%.

The US has bounced back very strongly after weather conditions hit the first quarter of this year. Like the UK, unemployment is falling but wage growth is largely static. The increases

in real disposable income in the USA are largely due to tax reductions and low inflation.

The USA is doing well reducing it’s balance of payments deficit, unlike the UK. The USAis running at 0.2% of GDP deficit, the UK a massive 4.5% of GDP. UK right hand axis.

The data disproves the academics who say the current account deficit mirrors the Government deficit.

The USA is a major exporter of primary products such as corn, coal, oil, gas, timber and soya. The weak dollar has been a big advantage to them resulting is bigger export volumes. UK exports mostly price insensitive goods and services. A weaker pound does not increase volumes, just margins!

The USA is demanding that their Banks be more liquid and better captialised than Basel 3 rules require, and two years earlier.

Scotland

The single most important issue which has not been discussed in the debate is this:Oil and gas revenues are highly volatile. An independent Scotland will have to raise capital to finance a deficit which will vary between 3% and 10% of GDP depending on the price of oil and assuming no reduction in Government spending. They will not have AAA status as a new untested country. A 3% deficit will require a 4% interest rate at least to get financed.To avoid this, a new Independent Scotland will have to announce big spending cuts and or tax increases. I also fail to see how the low life expectancy of the Glaswegian male is caused by decisions taken in London.

Conclusions

The UK has enjoyed strong nominal GDP growth caused by an increase in the velocity of money, sustained through the Summer by greater debt, but now needs wage awards to rise to continue the momentum. Wage awards under 3%, no increase in base rate. Above 3%, small increments from Spring 2015. Big upward revisions to GDP data will be announced this Autumn.

Europe will see quantitative easing this Autumn and with it a devaluation of the Euro, mostly against a stronger Dollar as the Fed begins to raise rates and continues to taper it’s money creation.

The Global geopolitical scene is likely to cause stockmarkets to lose some of the massive ( mostly unjustified) gains , but exactly when and by how much, who knows?

The USA is back as the biggest and strongest economy on the earth. It will also have the the most resilient banking system by 2017.

The geopolitical scene in the world is more risky than for many years. When the markets factor this in, we will see greater volatility across and within markets. Be alert.

Prepared September 3 2014 rmfagg@aol.com