Roger Martin-Fagg

_______________________ Economic Update - Dec 2012

I will keep it short. As I have hinted in previous updates, the global economy is slowing down rapidly due in the main to Europe’s recession and the failure of oil prices to respond to falling demand. Governments will be accused of causing the malaise, but in the main it is due to the deleveraging of balance sheets by banks, companies and to a lesser extent; households. This sort of adjustment is a once in a generation event. Governments and Central Banks have grown their balance sheets to mitigate the impact on growth and employment. They have been largely successful, things could have been a whole lot worse. But the actions they have taken are on top of the impact of ageing populations in the West which were already straining national budgets. The deficits currently racked up by Governments will persist for years, but remember absolute size is not the problem although the cost of financing can be. What Mark Carney, the new Governor of the Bank of England, will find and what he leaves behind in June 2013. Some of the UK media have presented the new Governor of the Bank of England as a unique saviour who will ensure the UK returns to stable non-inflationary growth. Really? Carney got the job in Canada after the Government had created tight rules for Canadian Banks in 1998. A restrictive structure was already in place which is why Canada did not experience asset price bubbles, until now that is:

As you can see from the chart, Canada is in a house price bubble, household income leverage is now greater than the UK or USA. It must be said that total Mortgage debt at 68% of GDP is still well below the UK‘s 100%. Mark Carney should be raising interest rates. They are currently 1%. My guess is 5% will be needed to dissuade would be borrowers. It will be a big test for Carney and his committee. The basic rule for the correct rate of interest

is to take real growth in GDP and add 2.5%. But will they do it? No- especially as demand for Canadian exports is weakening with the global slowdown. Watch this space.

Canadian house prices are close to a peak, interest rates will rise and the bubble will burst. The outlook for property in the UK The yield on commercial property is expressed as a %. The rental income is expressed as a % of the market price (not the original purchase price). At a time of falling rents, yield can only increase if market prices fall.

The chart shows that prime property prices have picked up in the last year (yield has fallen by 1%) but the opposite is true for secondary property. As any surveyor will tell you there will always be a market for prime especially in London. The Bank of England in their latest financial stability report state that UK Banks have £38Bn of commercial property loans where the value of the property is less than the loan amount outstanding, and a further £95Bn where the loan to value is greater than 70%. When one considers that their core equity is £210Bn we can see why they are keeping Zombie property companies alive in the hope that prices will recover (they cannot afford the hit to their core capital). The next chart shows what has happened in Japan. Of course it will not be exactly the same in the UK, but we have to consider the possibility of 20 years of low growth. When credit conditions are normal the price of residential property is determined by demographics i.e. the number, age profile and growth rate of the resident population (not central London) plus the growth in their nominal incomes. The demographic profile of the UK and Europe suggests that over the next 40 years real property prices will not rise at the rate established since 1970. This was 2.9% per annum on average. At a guess this will drop to 1.2% per annum when credit conditions return to normal. This translates into nominal price increases of 3-4% per annum. This is a much more positive outlook than the Japanese experience. So the forecast for UK residential prices is for no growth in real terms, but prices moving upwards at 1-2% depending on location.

Japanese asset price movements are the result of a toxic combination of undercapitalised banks and demography. The next chart shows how long it took banks to behave normally after a financial crisis in a number of countries. Assuming we follow the Swedish pattern, then there will be no recovery in bank lending until 2016. But I fear we will be more like the Japanese because of the impact of property prices on the banking systems’ solvency. Please note that despite what they say, UK Banks are destroying money at a rate of 3% a year. This is why the Government is failing to meet its financial targets. And until banks begin to increase credit supply, the Government will not be able to reduce it’s current deficit. We are in another perfect storm as the aging population combines with declining credit growth. The aging population increases Government spending on health, care homes and pensions. As it is the elderly who vote, Government will not reduce these items of expenditure. But the labour supply slows or contracts (depending on the attitude to retirement). This reduces the rate of growth in economic potential (unless technological advance can offset this). This all combines to cause asset prices to grow more slowly or fall. We all become wealthy at a much slower rate that hitherto.

If we look at the above chart, Sweden had the benefit of a growing Eurozone from 1997, Norway had growing oil revenues. Today we face a shrinking Eurozone, we have declining oil revenues, and a slowing world economy. Our trajectory will be more like Japan which means at least another 5 years of slow or no growth. A look at Europe The outlook is poor to awful. Take a look at the on the next page. You will see that Eurozone credit supply is contracting (as I forecast it would a year ago). The time lag between credit contraction and GDP contraction is around 9 months. Europe will be in a deeper recession than 2008-10. Government deficits will balloon (Germany too). The divergence between loan growth and money is because the ECB has manufactured over a Trillion Euros, which sit on the liabilities side of the European Banking system.

They are using this money to finance their holdings of Sovereign Bonds. You can see from the second chart that if the Clubmed left the Euro, it would bring down German, French and British Banks. UK Banks hold Euro assets which are 400% larger than their core capital. The European Commission is now fast tracking its blueprint for a Federal Europe, it is planning that the Council of Ministers sign it off for implementation from 2014. They somehow believe that this will be the solution to the problem. The plan includes bank deposit insurance, joint and several sharing of sovereign debt, and a fiscal union with tax raising powers. It is highly unlikely Germany will agree to this because they have written into their constitution that the Federal Government must always balance its budget from 2016. Greece is now defaulting on its debt; the default is managed by asking the bond holders to accept increasing haircuts, and then the debt being bought back by Stability Fund at 20% of its face value. So it would seem Germany has calculated that this approach will cost them less than the shock, unmanaged default. As ever, German efficiency rules Europe. The UK and its rebalancing We are not making any progress here at all. The current account of the balance of payments is worsening as our investment income from the trading activities of banks has shrunk.

The stability in the price of sterling tells us that the deficit of nearly 6% of GDP is being financed by long and short term investment inflows. The government has to be careful not to damage these; they are preventing a collapse in sterling. The investment spending picture is not encouraging either. But, the increase in the investment allowance from £25,000 to £250,000 has to welcomed. As is the creation of a business bank with £1Bn of capital, which should allow the creation of £8Bn of new credit for business.

Now some good news! The Funding for Lending scheme has changed. Participating banks no longer have to put any scarce capital behind a loan. This significant change means that any lending under the scheme can be undertaken at lower margin (lower interest rate) and still enhance shareholder value. Yes the bank has to do the normal credit risk assessment, but this change in the rules should encourage a significant increase in SME lending. A bank can no longer claim Basel 3 compliance as a reason not to lend. However so far they have taken £3.5Bn from the Bank of England but only lent on £0.5Bn. This will take some explaining.

And although the level of employment is holding up which is good from a social point of view, labour productivity is falling. As a consequence unit labour costs are rising at over 4% whilst wages grow at 1.8%.

This suggests corporate profit margins are under pressure. And it also will result in inflation running at around 3-4% ( the Treasury are assuming 2%). Some commentators will be suggesting that interest rates will rise as a result. I think not. Interest rates will be at the current level for another three years. The Autumn statement provides for a net stimulus of nearly £5Bn which is the equivalent of 1p off the basic rate of tax. Every little helps. But the growth assumptions are still too optimistic. In 2013 they think 1.2%, I think 0.3% In 2014 they think 2%, I think 1% In 2015 they think 2.3% I think 1.3% In 2016 they think 2.7% I think 1.5% In 2017 they think 2.8% I think 1.7% Their numbers have been produced to make the deficit reduce as a % of GDP. My numbers suggest there will be a slight reduction in the deficit but most will not even notice. If the current account on the Balance of Payments continues to deteriorate, we will be revising the forecast for sterling against the dollar in a year from now, to around $1.40 We end the year with the real economy smaller than a year ago. We are now 15% below trend for nominal GDP. It is mild stagflation. The majority are working as hard as ever, but are actually worse off. What can we expect in 2013? No change in interest rates, an EU recession, slower growth in the USA and the world economy. Italy will be back in the news as Monti stands down, and Bunga Bunga Man stands for office again. Social tensions in Southern Europe will increase. The Germans will begin to question the austerity model. Sterling $1.60 and 1.23 to the Euro. Oil at $100 or above. Stockmarkets will be volatile but basically stand still. Bond prices will remain at record highs. Quantitative easing will be increased in the middle of 2013. The Government will not get its deficit down as planned. What should we do about it? Keep calm and carry on doing more of the things we know work, and less of the things we know don’t work so well. Nurture business and social relationships. Think positively and believe in the power of the human spirit to make good things happen.

I will publish my 2012 school report when we have the data for 2012 as a whole, it will be end of February 2013. I wish you all a very Happy Christmas and an energetic and fulfilling 2013!

Roger Martin-Fagg Rmfagg@aol.com