What are the prospects for UK financial markets in 2016?

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Macro Letter – No 47 – 04-12-2015

What are the prospects for UK financial markets in 2016?

  • The EU referendum may take place as early at as June next year
  • Financial markets appear to be ignoring the vote at present
  • The tightening of bank capital requirements is almost over
  • Higher tax receipts have tempered the pace of fiscal tightening

In assessing the prospects for UK financial markets next year I will focus on three areas, the EU referendum, the stability of the financial system and the state of government finances.

The EU Referedum

As we head into 2016 political and economic commentators are beginning to focus on the potential impact of a UK exit from the EU would have on the British economy. Given the size and importance of the financial services sector to the economy, I want to investigate claims that a UK exit would be damaging to growth and lead to a rise in unemployment. For a more general overview of the referendum please see my July 3rd post – Which way now – FTSE, Gilts, Sterling and the EU referendum?

In February a report by the UK Parliament – Financial Services: contribution to the UK economy opened with the following statement:-

In 2014, financial and insurance services contributed £126.9 billion in gross value added (GVA) to the UK economy, 8.0% of the UK’s total GVA. London accounted for 50.5% of the total financial and insurance sector GVA in the UK in 2012. The sector’s contribution to UK jobs is around 3.4%. Trade in financial services makes up a substantial proportion of the UK’s trade surplus in services. In 2013/14, the banking sector alone contributed £21.4 billion to UK tax receipts in corporation tax, income tax, national insurance and through the bank levy.

The GVA was down from a 2009 high of 9.3%. For London the GVA was 18.6%. In international terms the UK ranks fourth, behind Luxembourg, Australia and the Netherlands in terms of the size of its financial services sector. As at September 2014, 1.1mln people were employed in the sector. According to research by PWC financial services accounted for £65.6bln or 11.5% of total government tax receipts in 2013-14.

Last week the Evening Standard – ‘Brexit’ would lead to loss of 100,000 bank jobs, says City – cited senior banking figures warning of the potential impact of the UK leaving the EU:-

Mark Boleat, policy chairman at the City of London Corporation, said: “If as a country we were to vote to leave, then London’s position as a leading financial centre would remain but without doubt there would be an impact on our relative size and the jobs we support.”

Confidential client research from analysts at US investment bank Morgan Stanley, seen by the Standard, warned that “firms for whom the EU market is important” would need to “adjust their footprint” in London if the Eurosceptic cause was victorious.

Sir Mike Rake, deputy chair of Barclays and chairman of BT, said: “It is extremely difficult to quantify the number of jobs that would be lost and the time frame over which that might happen but leaving the EU would severely damage London’s competitiveness and our financial services sector.”

There have been growing hints from financial institutions that they are starting to plan for Britain quitting the 28 member club.

Both HSBC, which announced a review of the location of its global headquarters in April, and JP Morgan are reportedly in talks about moving sections of their businesses to Luxembourg in part because of the threat of Brexit.

Deutsche Bank, which employs 9,000 people in Britain, has set up a working group to review whether to move parts of its business from Britain in the event of a UK withdrawal. 

US asset management group Vanguard, which has a City office, has admitted that Brexit would have a “significant impact” on its operation across Europe and has already started planning for it.

Many senior bankers are concerned that they would lose the financial services “passporting” rights enjoyed by fellow EU members.

A fascinating historic assessment of the opinion of the UK electorate towards the EU is contained in this week’s Deloitte – Monday Briefing, they  anticipate a referendum date of either June or September 2016, in order to avoid coinciding with a French (March/April) or German (September) election in 2017:-

Since Ipsos MORI started polling on this issue in 1977 on average 53% of voters in a simple yes/no poll have supported membership and 47% have opposed it. The yes vote reached a low of 26% in 1980 rising, over the following decade, to a peak of 63% in 1991, shortly before the pound’s ejection from the European Exchange Rate Mechanism.

In June of this year Ipsos MORI showed UK public support for the EU, again on a straight yes/no poll, at an all-time peak of 75%. Since then it has fallen away in parallel with heightened UK public concerns about immigration. The most recent Ipsos MORI poll, from mid-October, showed the yes vote at 59%.

More recent polls suggest a further narrowing of the yes lead. Across eight polls carried out in November the yes vote averaged 52% and the no vote 48%.  

The yes vote is, by and large, younger and more affluent than the no. Opposition to the EU rises sharply among the over 40s, an important consideration given that voter turnout is higher among older voters. Conservative voters tend to be more eurosceptic than Labour voters; white voters tend to be more sceptical than non-white voters.

… “don’t knows” averaged around 15% of all voters, more than enough to tip the vote decisively.  

The last referendum on UK membership of what was then the European Economic Community (EEC) was held in 1975, just two years after the UK joined the EEC. The vote was an overwhelming victory for EEC membership, with the electorate voting by 67.2% to 32.8% to stay in.

… In an intriguing paper economists David Bowers and Richard Mylles of Absolute Strategies Research (ASR) outline how the political landscape has shifted in the last 40 years.

… in 1975 the debate was about membership of a trading bloc, the Common Market. For sure, the commitment to “ever closer union” was in the Treaty of Rome, but in 1975 few in the UK, especially in the yes campaign, paid much attention to it. Since then the EU has grown from 9 to 28 members, expanded into Central and Eastern Europe, created the Single Currency and acquired more characteristics of a federal union.

…In 1975 the UK economy was in a shambles, slipping into the role of sick man of Europe. In the previous three years the UK had endured a recession, double digit inflation, endemic industrial unrest and the imposition of a three-day working week to save scarce energy supplies. British voters in 1975 looked enviously to the prosperity and stability of Germany. Today the UK is seeing decent growth, while the euro area grapples with the migration crisis, sluggish activity and the difficulties of building a durable monetary union. On a relative basis the performance of the UK economy looks, for now at least, pretty good.

…The Maastricht Treaty of 1992 established the right of people to live and work anywhere in the EU, but… it was EU enlargement into Central and Eastern Europe in 2004 that caused immigration into the UK to rise markedly, pushing migration up the list of UK voter concerns. More recent migration from North Africa and the Middle East, and the growing problems facing the Schengen nations, have added new concerns.  

The final factor…was the enthusiasm of the majority of the press for the Common Market in 1975. The press gave the then Prime Minister, Harold Wilson, largely uncritical coverage of his negotiations for a “better deal” in Britain’s relationship with the Community. (Historians tend to the view that Wilson actually achieved little in his negotiations with the Community; but he deftly turned meagre result into a public relations triumph). The lone dissenting voice in a general mood of press enthusiasm for the EEC was the Communist Morning Star. This time round it seems likely that a number of major papers will take a euro sceptic line.

The most recent poll, published by ORB last week in the wake of the Paris attacks, found 52% in favour of exit.

Financial Stability

This week saw the release of the Bank of England – Financial Stability Report – December 2015 – it suggests that the UK economy has moved beyond the post-crisis phase, the risks are, once again, external in nature:-

The global macroeconomic environment remains challenging. Risks in relation to Greece and its financing needs have fallen from their acute level at the time of the publication of the July 2015 Report. But, as set out in July, risks arising from the global environment have rotated in origin from advanced economies to emerging market economies. Since July, there have been further downward revisions to emerging market economy growth forecasts. In global financial markets, asset prices remain vulnerable to a crystallisation of risks in emerging market economies. More broadly, asset prices are currently underpinned by the continued low level of long-term real interest rates, which may in part reflect unusually compressed term premia. As a consequence, they remain vulnerable to a sharp increase in market interest rates. The impact of such an increase could be magnified, at least temporarily, by fragile market liquidity.

Domestically, the FPC judges that the financial system has moved out of the post-crisis period. Some domestic risks remain elevated. Buy-to-let and commercial real estate activity are strengthening. The United Kingdom’s current account deficit remains high by historical and international standards, and household indebtedness is still high.

Against these elevated risks some others remain subdued, albeit less so than in the post-crisis period to date. Comparing credit indicators to the past alone cannot provide a full risk assessment of the level of risk today, but can be informative. Aggregate credit growth, though modest compared to pre-crisis growth, is rising and is close to nominal GDP growth. Spreads between mortgage lending rates and risk-free rates have fallen back from elevated levels.

They go on to note that the Tier 1 capital position of major UK banks was 13% of risk-weighted assets in September 2015, below the levels advocated by the Vicker’s Commission but above Basel requirements. The Financial Policy Committee (FPC) are expected to impose a 1% counter-cyclical capital buffer in the near future, but otherwise the fiscal tightening, which has been in train since the aftermath of the financial crisis has finally run its course.

The other risks which concern the Bank are cyber-risks of varying types and, of course, the uncertainty surrounding the EU referendum.

Autumn Statement and Spending Review

Last week saw the publication of the UK Chancellor’s Autumn Statement and Spending Review. Mr Osborne was fortunate; the OBR found an additional £27bln in tax receipts which allowed him to reverse some of the more unpopular spending cuts previously announced. He still hopes to balance the government budget by 2020/2021. Public spending will rise from £757bln this year to £857bln in 2020/21. Assuming the economy grows as forecast, public spending to GDP ratio should fall from 39.7% to 36.5%.

Writing in the Telegraph Mark Littlewood of the IEA said:-

George Osborne has today made a one-way bet. His announcements are based on two predictions: continually low interest rates and sustained strong economic growth, making our debt repayments lower than anticipated and tax revenues higher than expected. These are not unrealistic assumptions, but if either go off course, the savings announced today will not go nearly far enough.

Market Performance

Stocks

Financial markets abhor uncertainty. Concern about collapsing FDI and Scottish devolution due to Brexit, will hang over the markets until the outcome of the vote is known: meanwhile rising rhetoric will discourage investment. Regardless of economic performance UK stocks are likely to underperform.

Back in July I believed the uncertainty about the UK position on the EU would have minimal effect:-

Unless the UK joins the EZ, currency fluctuations will continue whether they stay or go. Gilt yields will continue to reflect inflation expectations and estimates of credit worthiness; being outside the EU might impose greater fiscal discipline on subsequent UK governments – in this respect the benefits of EU membership seem minimal. The UK stock market will remain diverse and the success of UK stocks will be dependent on their individual businesses and the degree to which the regulatory environment is benign.

Here’s how the markets have evolved since the summer. Firstly the FTSE100 vs EuroStox50 and S&P500 – six month chart, at first blush, I was wrong, the FTSE  has underperformed EutoStoxx and the S&P:-

FTSE vs STOX vs SPX 6month

Source: Yahoo Finance

However, the FTSE250 tells a different story:-

FTSE100 vs 250 - 6m

Source: Yahoo Finance

This divergence has been in place for several years as the five year chart below shows:-

FTSE100 vs 250 - 5 yr

Source: Yahoo Finance

Here is the FTSE250 compared to EuroStox50 and the S&P500 – over the same five year period. The mid cap Index has followed the S&P, although in US$ terms its performance has been less impressive:-

FTSE250 vs EurStox and S&P - 5yr

Source: Yahoo Finance

Gilts and Bunds

During the period since the beginning of July the spread between 10yr Gilts and Bunds has ranged between 112bp and 145bp reaching its narrowest during the fall in equity markets in August and widening amid concerns about European growth last month. UK Inflation expectations remain subdued; this is how the MPC – November Inflation Report described it:-

All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.

Sterling

The Sterling Effective Exchange Rate has traded in a relatively narrow range (please excuse the date axis, vagaries of the Bank of England’s data format – this is a one year chart):-

GiltBund JulNov

Source: Bank of England

During  stock market weakness in the summer Sterling strengthened. After weakening in October it rebounded, following the US$, in November.

Back in July I anticipated a weakening of Sterling:-

Ahead of the referendum, uncertainty will lead to weakness in Sterling, higher Gilt yields and relative underperformance of UK stocks. If the UK electorate decide to remain in the EU, there will be a relief rally before long-term trends resume. If the UK leaves the EU, Sterling will fall, inflation will rise, Gilt yields will rise in response and the FTSE will decline. GDP growth will slow somewhat, until an export led recovery kicks in as a result of the lower value of Sterling. The real cost to the UK is in policy uncertainty.

It may be that capital outflows are about to begin in earnest but I start to question my assumptions – the market seems to be caught between the uncertainty surrounding UK membership of the EU and doubts about the longevity of the “European Experiment” as a whole.

Conclusion

Gilts remain below their long run average spread over Bunds but the interest rate environment is exceptionally benign, making any pick up in yield attractive. The FTSE250 index appears to be ignoring concerns about collapsing commodities, slowing emerging markets – especially China – and the prospect of Brexit, but it may struggle to remain detached for much longer. Sterling also appears to have ignored the referendum debate so far. Or perhaps, the UK market is a relative “safe haven” offering exposure to European markets without the angst of Euro membership – either way I remain cautious until the political uncertainties dissipate.

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Which way now – FTSE, Gilts, Sterling and the EU referendum?

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Macro Letter – No 39 – 03-07-2015

Which way now – FTSE, Gilts, Sterling and the EU referendum?

  • Uncertainty is bad for business and the UK will struggle ahead of the referendum
  • Gilt yields have been around 150bps higher than Bunds over the last 25yrs
  • The DAX has substantially outperformed FTSE over the same period
  • Higher productivity is key to UK growth but, in the long run, demographics will help

Last week the UK Prime Minister began to debate EU treaty reform with his European counterparts. He has a long way to go. The deadline for a UK referendum on EU membership is the end of 2017 but an up-hill battle is likely because all EU countries must ratify treaty changes – the referendum will come before EU treaty changes have been agreed. In this letter I will review the history of UKs, uncomfortable, membership of the EU and previous renegotiations, compared with today’s proposals. I will then go on to consider the implications for Sterling, Gilts and UK Stocks should the UK decide to stay or go.

A brief history of the UK and the EU

The last time the UK voted on EU, or as it was then called, European Economic Community (EEC) membership, was in 1975. At that time the “yes” vote won by 67.5%. This took place only two years after first joining, previous attempts to join in 1961 and 1967 having been vetoed by French President de Gaulle.

British scepticism about the political ambitions of the Schuman declaration of May 1950 meant the UK failed to join the European Coal and Steel Community – established at the Treaty of Paris in 1951 – but spent much of the decade debating EEC membership. When the EEC was finally established in 1958, the UK opted out for two principal reasons: concern about its relationship with the Commonwealth and other international alliances, and its preference for free-trade over economic organisation and sectoral policies. At that time the UK was torn between two foreign policy strategies, one focused on the European Free Trade Area, the other on the General Agreement on Tariffs and Trades – the predecessor to the World Trade Organisation (WTO).

The 1974 treaty renegotiation, just a year after joining the EEC, was driven by three factors: free-trade versus political integration, the effects of the collapse of Bretton Woods and subsequent inflation on the UK economy – Sterling had been considered a quasi-reserve currency up to this point – and the size of UK contributions to the EEC budget which the UK government considered to be excessive.

The table below lists the 1974 UK government demands for renegotiation and the outcomes:-

DEMAND OUTCOME
Changes to CAP so as not to undermine free-trade None
Fairer financing of EEC budget Correcting mechanism
Withdrawal of UK from EMU Accepted
Retention of UK powers over regional, industrial and fiscal policy Creation of Regional Development fund supported by Ireland and Italy
Agreement on capital movement to protect UK jobs and balance of payments None
No harmonisation of VAT Never planned anyway
Access to Commonwealth goods Minor concessions

The next major test of the UK relationship with the EU came during Margaret Thatcher’s first Conservative government (1979-1983) although an agreement with the EEC was not reached until her second term in 1984. On this occasion the issue was simply a question of how much the UK was paying in to the EU budget given that 80% of that budget was then spent on maintaining the Common Agricultural policy (CAP). The UK “rebate” was sanctioned because at that time the UK was the second poorest of the ten member EEC.

UK demands for treaty change 2015

The current UK renegotiation of EU membership is concerned with the following issues:-

Restrictions to freedom of movement within the EU
Sovereignty of Sterling
Structural reform of the EU bureaucracy
Reclaiming of powers from Brussels to protect UK interests

On the latter point, this takes two principal forms: the ability to block EU legislation where it may be detrimental to UK interests and the ending of a commitment to “ever closer union” in respect of UK membership.

The Sovereignty of Sterling is a relatively uncontentious issue, whilst structural reform of the EU bureaucracy is an ideal to which all European governments will accede, at least in principal; the problems arise over restrictions on free-movement of people – enshrined in Article 48 of the Treaty of Rome:-

1.Freedom of movement for workers shall be secured within the Community by the end of the transitional period at the latest. 2. Such freedom of movement shall entail the abolition of any discrimination based on nationality between workers of the Member States as regards employment, remuneration and other conditions of work and employment. 3. It shall entail the right, subject to limitations justified on grounds of public policy, public security or public health: (a) to accept offers of employment actually made; (b) to move freely within the territory of Member States for this purpose; (c) to stay in a Member State for the purpose of employment in accordance with the provisions governing the employment of nationals of that State laid down by law, regulation or administrative action; (d) to remain in the territory of a Member State after having been employed in that State, subject to conditions which shall be embodied in implementing regulations to be drawn up by the Commission. 4. The provisions of this Article shall not apply to employment in the public service.

This leaves, the reclaiming of powers from Brussels. “Ever closer union” is probably negotiable since EU member states have always moved at different rates, both economically and culturally. Allowing the UK to pick and choose which aspects of EU legislation it accepts, however, is like joining an exclusive club and then ignoring the rules. Under normal circumstances you’d be asked to leave.

One of the associated problems for the EU – that of, when to stop expanding – is discussed in this essay by Tim Price – Let’s Stick Together. He reviews the work of Leopold Kohr, in particular his seminal work “The Breakdown of Nations”:-

It all comes down to scale. As Kirkpatrick Sale puts it in his foreword to ‘The Breakdown of Nations’,

“What matters in the affairs of a nation, just as in the affairs of a building, say, is the size of the unit. A building is too big when it can no longer provide its dwellers with the services they expect – running water, waste disposal, heat, electricity, elevators and the like – without these taking up so much room that there is not enough left over for living space, a phenomenon that actually begins to happen in a building over about ninety or a hundred floors. A nation becomes too big when it can no longer provide its citizens with the services they expect – defence, roads, post, health, coins, courts and the like – without amassing such complex institutions and bureaucracies that they actually end up preventing the very ends they are intending to achieve, a phenomenon that is now commonplace in the modern industrialized world. It is not the character of the building or the nation that matters, nor is it the virtue of the agents or leaders that matters, but rather the size of the unit: even saints asked to administer a building of 400 floors or a nation of 200 million people would find the job impossible.”

Kohr showed that there are unavoidable limits to the growth of societies:

“..social problems have the unfortunate tendency to grow at a geometric ratio with the growth of an organism of which they are a part, while the ability of man to cope with them, if it can be extended at all, grows only at an arithmetic ratio.”

In the real world, there are finite limits beyond which it does not make sense to grow. Kohr argued that only small states can have true democracies, because only in small states can the citizen have some direct influence over the governing authorities.

What’s in it for the UK

In the interests of levity I’ve included a link to this summation of UK foreign policy with regard to Europe from the satirical TV programme Yes, Minister – this episode was first aired in 1980.

In the intervening 35 years, trying to decipher what is best for the UK has not become any easier. I’ve chosen just two organisations to represent the views for and against EU membership: Business for New Europe and Better off Out. Here’s how Business for New Europe make the case for staying in:-

As a member of the European Union, our companies can sell, without barriers, to a market of 500 million people. The Single Market means that exporters only need to abide by one set of European regulations, instead of 28 national ones. Europe is our biggest trading partner- it buys 45% of our exports. If we left the EU, companies would face tariffs and regulatory barriers to trade.

The free movement of capital means that EU companies can invest here in Britain freely. This investment, by companies like Siemens, creates jobs and grows our economy. 46% of all the foreign investment in Britain came from EU countries.

The EU provides funding for businesses to all regions of Britain, particularly those with the greatest need. From 2014 until 2020, £8 billion of EU money will go from Brussels to the UK. The biggest winners from this process are Cornwall, Wales, the Scottish Highlands, Northern Ireland and the North of England.

EU research funding helps universities and firms innovate to create the technologies of the future. Britain will receive £7 billion from the EU’s Horizon 2020 fund, and our small businesses receive more funding for hi-tech research than those of any other EU country. EU membership is vital to rebalancing the British economy.  

Better off Out – sponsored by the Freedom Association – counter thus:-

10 Reasons to Leave

1.Freedom to make stronger trade deals with other nations. 2. Freedom to spend UK resources presently through EU membership in the UK to the advantage of our citizens. 3. Freedom to control our national borders. 4. Freedom to restore Britain’s special legal system. 5. Freedom to deregulate the EU’s costly mass of laws. 6. Freedom to make major savings for British consumers. 7. Freedom to improve the British economy and generate more jobs. 8. Freedom to regenerate Britain’s fisheries. 9. Freedom to save the NHS from EU threats to undermine it by harmonising healthcare across the EU, and to reduce welfare payments to non-UK EU citizens. 10. Freedom to restore British customs and traditions.

They go on to highlight 10 Myths about the risk of leaving – not all are economic so I’ve paraphrased their opinions below;-

Britain would lose 3mln jobs if we left the EU – Under the terms of the Lisbon Treaty the UK would enter into an FTA with the EU. The WTO obliges them to do so too. Of more importance the UK trade balance will the EU is in increasing deficit – the other member states have more to lose.

Britain will be excluded from trade with the EU by Tariff Barriers – EU has FTAs with 53 countries with a further 74 countries pending. In 2009 UK charged customs duty of just 1.76% on non-EU imports. The EU Common Market is basically redundant already.

Britain cannot survive economically outside the EU in a world of trading blocs – Japan does and it’s not a member. The EU’s share of world GDP is forecast to be 15% in 2020, down from 26% in 1980. Norway and Switzerland export more, per capita, to the EU than the UK does. Britain’s best trading relationships are with the USA and Switzerland. The largest investor in the UK is US.

The EU is moving towards the UK’s position on cutting regulation and bureaucracy – EU directives are subject to a ‘rachet’ effect – once in place they are unlikely to be reformed or repealed. 80% of the UK’s GDP is generated within the UK so should not be subject to EU laws. In 2010, Open Europe estimated EU regulation had cost Britain £124 billion since 1998.

If we leave, Britain will have to pay billions to the EU and implement all its regulations without having a say – The UK has 8.4% of votes. The Lisbon Treaty ensured the loss of Britain’s veto in many more policy areas.

Swiss Case Study: The Swiss pay the EU less than CHF600mln a year for access to the EU market. They estimate the cost of full membership would be CHF3.4bln.

Norway Case Study: In 2009 Norway’s total financial contributions to the EEA (European Economic Area) agreement was Eur340mln Britain pays £18.4bln per annum.

The EU has a positive impact on the British Economy – Fishing (115,000 jobs lost) farming, postal services and manufacturing have been devastated by EU membership. Unnecessary red tape, aid contributions, inflated consumer prices (due to CAP etc.) are indirect costs.

Britain will lose vital foreign investment as a consequence of leaving the EU – The 2010 Ernst and Young survey on UK’s attractiveness to foreign investors, found Britain still the number one Foreign Direct Investment (FDI) destination in Europe owing largely to the City of London and the UK’s close corporate relationship with the US. Key factors, in order of importance:-

Culture and values, English language, Telecommunications infrastructure, Quality of life, Stable social environment, Transport and logistics infrastructure.

Britain will lose all influence in the world by being outside the EU – Britain has a substantial ‘portfolio of power’ including membership of the G20 and G8, a permanent seat on the UN Security Council and seats on the IMF and WTO. The British Commonwealth has 54 nations which is being discriminated against by EU policy. London is the financial capital of the world and Britain has the sixth largest economy. The UK is also in the top ten manufacturing nations in the world.

Legally, Britain cannot leave the EU – A single clause Bill passed at Westminster can repeal the European Communities Act 1972 and its attendant Amendment Acts.

Having dealt with the main arguments for remaining in the EU, Better off Out do point out that creating an FTA with the EU may take time.

Greenland established a precedent when it left the EEC in 1985, this followed a referendum in 1982 and the signing of the Greenland Treaty in 1984. It had joined, as part of Denmark in 1973 but after it had achieved home rule in 1979 the importance of its fishing industry became a major economic incentive for it to leave the forerunner to the EU.

Greece may leave as early as next week and, as this March 2015 article from ECFR – The British problem and what it means for Europe makes clear, a Brexit will not be good for the EU either:-

An EU without Britain would be smaller, poorer, and less influential on the world stage. The UK makes up nearly 12.5 percent of the EU’s population, 14.8 percent of its economy, and 19.4 percent of its exports (excluding intra-EU trade). Furthermore, it runs a trade deficit of £28 billion, is home to around two million other EU citizens, and remains one of the largest net contributors to the EU budget (responsible for 12 percent of the budget in total).

Meanwhile the Confederation of British Industry claim that being a member of the EU is worth £3,000 per household whilst Business for Britain estimate that the UK would save £933 per person from cheaper food if they left. In a report last week S&P chimed in, saying 30% of foreign direct investment (FDI) into the UK – representing 17% of GDP – was directed to financial services and insurance. 50% of this FDI emanated from other EU countries – this could be at risk if the UK should leave. So the debate rumbles on.

How is the UK economy evolving?

UK manufacturing has been in decline since the start of the millennium, whilst this decline was initially a reaction to the strength of Sterling it has yet to benefit from the subsequent weakness of the currency:-

UK_Effective_Exchange_Rate_and_Manufacturing

Source: ERC, IMF, UN

Total factor productivity is near the heart of this conundrum:-

UK_TFP_vs_G7

Source: ERC, ONS

The UK is lying 6th out of the G7 in terms of output per hours worked, and since 2007, has underperformed the G7 average. The dotted line shows where productivity would have been had the recession not hit. The UK had been lagging its peers during the 1990’s so the predicted outperformance would merely have brought it back into the fold.

In a speech given last week the BoE’s Sir John Cunliffe – Pay and productivity: the next phase made a number of observations about the future:-

Between 2000 and 2007, the average worker in the UK automotive manufacturing industry produced 7.7 vehicles a year. Over the past seven years he/she averaged 9.8 vehicles a year. Productivity – output per worker – in car manufacturing has increased by 30% since the onset of the great financial crisis. Britain has become the fourth-biggest vehicle maker in the EU and is more efficient than bigger producers such as Germany and France.

Unfortunately productivity in the UK has not followed the lead of the car industry. Indeed, the opposite is true. In 2014 labour productivity in the UK was actually slightly lower than its 2007 level. In the seven years between 2000 and 2007 labour productivity grew at an average annual rate of about 2% a year. In the seven years that followed, our annual productivity growth averaged just below zero.

Or to look at it another way, the level of labour productivity – output per hour worked – in the UK economy is now 15% below where it would have been if pre-crisis trends had continued.

…It is true that the average output per hour of the rest of the G7 advanced economies is only around 5% above its pre-crisis level. But as I have noted, in the UK it has not even recovered to that level. And in 2013 output per hour in the UK was 17 percentage points below the average for the rest of the G7 – the widest gap since 1992.

In the 10 years prior to the crisis, growth in the hours worked in the UK economy, accounted for 23% of the UK’s overall economic growth. The mainstay of our economic growth, the other 77%, came from growth in productivity. Since 2013 only 9% of our annual economic growth has come from productivity improvement. The remaining 91% has come from the increase in the total hours worked.

As a result, employment in the UK is now around its highest rate since comparable records began in 1971. Over 73% of people aged 16-64 are working. There are now over 31 million people in work in the UK.   Unemployment has fallen at among its fastest rate for 40 years and is now very close to its pre-crisis level – over the past two years over 1 million jobs have been created.

Productivity growth can be divided into two sorts of change: the change in productivity inside individual firms and the changes between firms. The first, the changes within firms, happens as firms increase their efficiency. The second happens as labour and capital are reallocated between firms, from the less productive ones to the more productive.

After collapsing in the crisis, productivity began to increase again within firms two years ago. We expect that to continue. As the economy grows, spare capacity is used up. The real cost of labour increases relative to the cost of investment. Firms have a greater incentive to find efficiency gains and to switch away from more labour-intensive forms of production. This should boost productivity.

In contrast, productivity growth due to the reallocation of resources in the economy remains weak. We can see this in the divergence of rates of returns across firms which remain remarkably and unusually high and the change in capital across sectors which has been particularly low. When the reallocation mechanism is working, the transfer of capital and labour from the less productive to the more productive pulls up the level of productivity in the economy and reduces the divergence between firms. The high degree of divergence between firms at present implies that this reallocation mechanism is working significantly less powerfully now than before the crisis. This can also be seen in the proportion of loss-making firms which stands at around 20% higher than its long-run average. Company liquidations also remain low. So there is still more than a hint of ‘zombiness’ in the corporate sector.

For more on productivity issue this working paper BoE – The UK productivity puzzle 2008–13: evidence from British businesses is full of interesting insights.

The UK service sector continues to grow, although its share of exports to the EU remains smaller than that of goods – 37% vs 49%. Services exports to the rest of the world are the driver of UK export growth.

Conclusion and Investment Opportunities

Sterling

In search of a surrogate for the uncertainty surrounding the UK referendum, the chart below shows the impact on Sterling of the sudden realization that the Scottish might vote to leave the Union in 2014:-

GBP_vs_USD_and_EUR_-_Scottish_Vote_2014

Source: Oanda and ERC

Should the population of the UK vote to forsake the EU, the relative stability of the GBPEUR exchange rate is likely to become structurally more volatile, the move against the USD from 1.72 to 1.61 is but a foretaste of what we should anticipate. However, the 40% appreciation in the UK effective exchange rate between 1995 and 2000 – see the earlier chart above – and reversal between 2000 and 2009, suggests that membership of the EU has not led to the stability in exchange rates one might have expected.

Between the breakdown of Bretton Woods in March 1973 and the establishment of the European Exchange Rate Mechanism (ERM) In March 1979 (which the UK chose not to join until October 1990) was a period of intense currency volatility – exacerbated by significant interest rate differentials. During this period the GBP effective exchange rate actually moved less than it has since 2000. Nonetheless, higher daily volatility will impose a modicum of additional cost on UK businesses. This 2004 paper from the FRBSF – Measuring the Costs of Exchange Rate Volatility looks at the subject in more detail:-

The main quantitative finding is that the welfare effects of exchange rate volatility are likely to be very small for many countries. When numbers are chosen to permit the model to reproduce basic characteristics of the U.S. economy, the model indicates that the loss of utility is equal in size to only about 0.1% of annual consumption; that is, people would be willing to exchange only about 0.1% of their annual consumption level to eliminate the exchange rate volatility in the economy.

Gilts

The UK has exhibited structurally higher inflation than much of the Eurozone (EZ) since the collapse of Bretton Woods. That, combined with the relative asynchronicity of the UK and German economic cycles, made it difficult for the UK to operate inside the ERM – it lasted less than two years, from October 1990 to September 1992. The chart below shows German and UK 10yr Government bond yields during this period, Bunds, with lower yields, on the right hand scale:-

united-kingdom-and german government-bond-yield 1990 - 1992

Source: Trading Economics

Germany was struggling during this period and the Hartz labour market reforms occurred shortly thereafter.

germany-UK-government-bond-yield 1990 - 2015

Source: Trading Economics

As the chart above shows UK Gilts have traded at a higher yield than German Bunds for most of last 25 years. I think it would be reasonable to assume Gilt yields, had the UK remained in the ERM and joined the Euro, would have been between those of Germany and France during this period. In other words, the cost of UK government financing has been around 150bp higher than it might have achieved had it joined the EZ.

UK inflation over the same period has been significantly higher than Germany’s, in real-terms Bunds have offered vastly superior returns. This differential may also be due to the UK government running a substantially larger budget deficit during the period. I regret the data in the chart below only goes back to 1996. The UK balance is shown on the right hand scale:-

germany-UK government-budget 1996-2015

Source: Trading Economics

Stocks

The chart below shows the relative performance of the FTSE100 vs Germany’s DAX40 since 1990. The German market (right hand scale) has increased from 2,000 to 12,000 whilst the UK market has risen from 2,000 to 7,000. Germany has been the clear winner of this race:-

united-kingdom-German stock-market 1990-2015

Source: Trading Economics

Would the UK stock market have fared better inside the EZ and would the UK departure from the EU be detrimental or positive to stock performance going forward? Here is the 1990-2015 comparison between FTSE100 and the French CAC40 index:-

united-kingdom-france stock-market

Source: Trading Economics

Germany appears to be something of an exception, France, Italy and the Netherlands have underperformed the UK during the same period: although Spain has delivered German-like returns. It is worth mentioning that Germany has run a balance of trade surplus for the entire period 1990 – 2015 whilst, excepting a brief period between 1991 and 1997, the UK has run a continuous trade deficit.

I don’t believe UK membership of the EU has much influence over the value of UK stocks in aggregate. Certain companies benefit from access to Europe, others are disadvantaged.

Unless the UK joins the EZ, currency fluctuations will continue whether they stay or go. Gilt yields will continue to reflect inflation expectations and estimates of credit worthiness; being outside the EU might impose greater fiscal discipline on subsequent UK governments – in this respect the benefits of EU membership seem minimal. The UK stock market will remain diverse and the success of UK stocks will be dependent on their individual businesses and the degree to which the regulatory environment is benign. The chart below shows UK GDP by sector since 2008. Services stand out both in terms of their resilience to the effects of the recession and continued growth in its aftermath, it is now 8.5% higher than before the recession, all the remaining sectors languish below their 2008 levels. Improving total factor productivity is key:-

UK_GDP_by_sector_ECR_ONS

Source: ERC and ONS

Ahead of the referendum, uncertainty will lead to weakness in Sterling, higher Gilt yields and relative underperformance of UK stocks. If the UK electorate decide to remain in the EU there will be a relief rally before long-term trends resume. If the UK leaves the EU, Sterling will fall, inflation will rise, Gilt yields will rise in response and the FTSE will decline. GDP growth will slow somewhat, until an export led recovery kicks in as a result of the lower value of Sterling. The real cost to the UK is in policy uncertainty.

Longer term the demographic divergence between the UK and other countries of Europe will become evident. By 2060 the working age population of the UK is projected to increase from 37.8mln (2013) to 41.8mln whilst in Germany the same population will decline from 49.7mln to 35.4mln. The EC – Ageing Report 2015 – has more details. The UK can benefit from staying in the EU and continuously negotiating. However, it must become much more involved in the future of the EU project, including “ever closer union”. It can also benefit from “Brexit”, directly flattering the government’s bottom line. The worst of both worlds is to remain, as the UK has since 1950, sitting on the fence –decisiveness is good for financial markets and the wider economy.

The Scotian experiment and European fragmentation

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Macro Letter – No 21 – 10-10-2014

The Scotian experiment and European fragmentation

  • Scotland voted to remain part of the Union but the devolution debate doesn’t end there
  • Further European integration risks breaking the European Union
  • Economic growth in the UK and Eurozone will be damaged by long-term uncertainty

The Scottish decision to remain part of the Union, by such a slim margin – 55% to 45% on an 85% turnout – caught me by surprise. On reflection it should not have been unexpected – it was as much about the “hearts” as the “minds” of the Scottish electorate. Now that the dust has settled, I wonder what this vote means for the United Kingdom and for other regions of Europe.

In this month’s issue of The World Today, Chatham House – A result that resolves little Malcolm Chambers – Research Director at the Royal United Services Institute (RUSI) made the following observations: –

The Scottish referendum was supposed to settle the UK’s constitutional uncertainties, but the result has raised more questions than it answers. How Britain addresses the devolution issue and the question mark over its commitment to Europe will shape perceptions of its ability to wield influence and hard power abroad for years to come.

Britain’s 2010 National Security Strategy, published shortly after the coalition government took office, was entitled ‘A Strong Britain in an Age of Uncertainty’. It made no mention of the two existential challenges – the possible secession of Scotland from the United Kingdom, and the risk of a British withdrawal from the European Union. Yet either event would be a fundamental transformation in the very nature of the British state, with profound impact on its foreign and security policy.

The article goes on to discuss the promises made to Scotland by Westminster’s political elite, from all the main parties, which may now create the conditions for eventual independence: –

Devolution max could have a similar effect, making the final step from ‘devo-max’ to ‘indy-light’ appear less traumatic, even as it still allows Westminster to be blamed for any ills that remain. If a further referendum is to be avoided five or ten years from now, it will not be enough to make constitutional changes.

Prime Minister Cameron took the opportunity to raise the issue of Scottish MPs voting on English issues; whilst this was politically expedient, it sows the seeds for regional calls for devolution of power to the poorer areas of Britain: –

Yet growing awareness of the constitutional imbalances created by devolution to Scotland – and, to a lesser extent, to Wales and Northern Ireland – is creating a series of shockwaves that will not dissipate easily. The UK, as a result, could now see a long period of constitutional experimentation and controversy, with profound effects on the governance of the country as a whole.

Chambers then turns to investigate the “European Question”. Here he sees a parallel between the UKs relationship with the EU and the Scottish desire for independence: –

Britain’s relationship with the European Union is similar, in important respects, to Scotland’s position in the United Kingdom. It has a special financial arrangement, involving a rebate of most of its net contribution, that is not available to other member states. It retains its own currency and border controls, and has a permanent exemption from the common currency and passport-free travel to which other states have agreed. As in Scotland, there is strong political pressure for the UK to be allowed special treatment in further areas, such as immigration controls. In both cases, attempts to construct ‘variable geometry’ governance frameworks are made more difficult by the asymmetry in size between the opting-out nation and the political union as a whole.

From the Brussels’ perspective the issue of devolution is not just restricted to the “Sceptred Isle”: –

While the nature of the Britain’s constitutional crises is unique, they are part of a wider crisis of European politics. Over the past five years, the eurozone has faced successive crises as it has sought to find a way to reconcile vast differences in economic interest and viewpoint between its member states. Relations between Germany and the southern states have worsened as the former takes on a more openly hegemonic role.

Without further significant sharing of political sovereignty – for example through a banking union – the risk that one or more member states could leave the eurozone will remain very substantial. Yet further political integration could bring its own challenges, with powerful nationalistic parties in northern Europe already pushing against those who argue that all the answers must come from Brussels. One of the reasons that Britain’s European allies were so worried about the Scotland vote was precisely their concern as to the example that a Yes vote could have sent to separatist movements in Spain, Belgium, Italy or Bosnia. This concern will not have been entirely dissipated, both because of the precedent set by London’s willingness to hold the vote, and by the closeness of the margin.

In conclusion Chambers states: –

It is still far from likely that the United Kingdom will perish, or that it will abandon its commitment to the European Union. But the possibility of one or both of these separations taking place seems set to be a central part of British politics for a decade or more.

The impact on Sterling

Sterling is still some way below its longer-term average on a trade weighted basis as this chart of the Sterling Effective Exchange Rate (ERI) Index shows, however, it’s worth noting that the average between 1994 and 2013 is around 90: –

GBP Effective Exchange rate - BoE

Source: Bank of England

Uncertainty always undermines the stability of ones currency and the Scottish referendum was no different, although its impact proved relatively minor. In a recent speech, Bank of England – The economic impact of sterling’s recent moves: more than a midsummer night’s dream – Kristin Forbes – MPC member, downplayed what could have been a dramatic decline in the value of the GBP:-

There has been some volatility in sterling recently, especially around the time of the Scottish referendum, but sterling is currently only 1% weaker than its recent peak in July 2014.

In her conclusion she points to the appreciation of the GBP since the Great Recession and cautions those who fail to anticipate the negative inflationary consequences of a weaker exchange rate: –

Where sterling’s recent moves may have had the greatest economic impact is on prices and inflation. A “top down” analysis estimating the pass-through from exchange rate movements to prices suggests that the lagged effect of sterling’s appreciation during 2013 and early 2014 may have acted as a powerful dampening effect on inflation. Although model simulations may be overestimating the magnitude of the effect, sterling’s past moves have reduced the risk of inflation increasing sharply, despite the strong growth in employment and the overall economy.

This dampening effect of sterling’s past appreciation, however, will peak at the end of 2014 and then begin to fade. As a result, it is becoming increasingly important to monitor trends in domestically-generated inflation – and especially unit labour costs – so that monetary policy can be adjusted appropriately and also be allowed to work through the economy with its own set of lags. Unfortunately, understanding recent trends in the domestic component of inflation – especially the slow growth in wages – has been challenging. A “bottom up” analysis of inflation that focuses on current measures of domestically-generated inflation (which attempt to minimize the dampening effect of sterling’s moves) show price pressures that are well contained and little evidence of imminent inflationary risks.

These “bottom up” indicators present a very different story then the “top down” estimates of inflation after adjusting for sterling’s recent appreciation. Has sterling’s appreciation had less of a dampening effect on prices than has traditionally occurred – perhaps due to structural changes in the UK or global economy? Or are the measures of domestic inflation understating current inflationary risks – perhaps due to the long lags before timely data is available? To answer these questions, it is critically important to monitor measures of prospective inflation to determine the appropriate path for monetary policy.

If concern about political devolution of power to the regions, at the expense of the power-house of the UK’s South East, and expectation of rising Euro-scepticism, are destined to be the pre-eminent political issues for the next decade, then an appreciation in the value of Sterling is likely to be tempered. Since the UK economy is closely integrated to Europe this persistent undervaluation will be less obvious in the GBP/EUR exchange rate but hopes of the trade weighted value of GBP rising like the USD due to structurally stronger growth will be muted.

In the aftermath of the referendum RUSI – Never the Same Again – What the Referendum Means for the UK and the Worldobserved:-

Having, for the first time, looked at what a ‘yes’ vote might mean for them, private investors and businesses are now more sensitised than ever before to the risks that a further referendum could pose. If some of them were to begin to hedge their bets accordingly, there could be a risk of an extended period of underinvestment in Scotland, with serious consequences for its prosperity.

Better together?

The campaign slogan of the Westminster elite was “Better Together” but, setting aside the rhetoric of power hungry politicians, what are the pros and cons of devolution versus Union? Writing ahead of the referendum Adam Posen of the Peterson Institute – The Huge Costs of Scotland Getting Small made a valiant case for continued integration: –

When is it ever a good idea for a small nation to set up on its own? Leaving aside cases of colonization and outright oppression, there is little good reason ever to shrink on the world scene by leaving a larger unit. The internal politics of democracies always get better deals for regions within them than small sovereigns can elicit from identity-ignoring market forces. The few small nations that did gain in welfare by seceding from transnational entities are those that escaped failed autocratic systems. The Baltic countries escaping the former Soviet Union’s dominance can be seen in this light. But setting out on your own is only beneficial when the system left behind has directly constrained your nation’s human potential. Whatever else, that cannot be said of the current Scottish situation in the United Kingdom.

It is a fact of life in today’s world that a small economy on its own is always buffeted by the forces of the global economy more than a region within a larger union. Even well-run small states like Singapore and Estonia are subject to huge swings in their economy resulting from capricious capital flows in and out. These swings disrupt employment, investment, and competitiveness via real exchange rate fluctuations. More important, small economies are fundamentally undiversified because of their small scale, and they risk their specializations falling out of favor in world markets. Events beyond their control can overwhelm the small nation’s high value-added industries, no matter how good it is at those things, be they oil extraction or banking or whisky distilling. Scottish independence in form will instead mean increased vulnerability in fact, because, inherently, smaller means more exposure when the markets turn—and turn they will.

…The economic debate over independence has tended to focus on the one-time transfer costs: setting up a new government administration, apportioning the accumulated public debt, grabbing as much oil as possible. But these issues are of minimal importance, however one chooses to measure them, compared to the ongoing costs of permanently greater insecurity to households and businesses. Even if an independent Scotland were to start out with the Scottish National Party (SNP) fantasy of relatively low public debt and a relatively high share of remaining oil revenues, it would have to save more, pay higher interest rates, and keep more space in its budget for self-insurance, hampered by a narrow tax base, in order to cope with the vicissitudes of the global economy on its own.

When one looks at the economic austerity foisted on the population of Greece and at the hopeless prospects much of the unemployed youth of Europe I wonder whether there is an alternative to the “integrationist” approach.

Looking for an answer I went back to the forging of the United Kingdom. This is how John Lancaster describes the events which led to the Act of Union in 1707:-

During the 17th century, Scottish investors had noticed with envy the gigantic profits being made in trade with Asia and Africa by the English charter companies, especially the East India Company. They decided that they wanted a piece of the action and in 1694 set up the Company of Scotland, which in 1695 was granted a monopoly of Scottish trade with Africa, Asia and the Americas. The Company then bet its shirt on a new colony in Darien – that’s Panama to us – and lost. The resulting crash is estimated to have wiped out a quarter of the liquid assets in the country, and was a powerful force in impelling Scotland towards the 1707 Act of Union with its larger and better capitalised neighbour to the south. The Act of Union offered compensation to shareholders who had been cleaned out by the collapse of the Company; a body called the Equivalent Society was set up to look after their interests. It was the Equivalent Society, renamed the Equivalent Company, which a couple of decades later decided to move into banking, and was incorporated as the Royal Bank of Scotland. In other words, RBS had its origins in a failed speculation, a bail-out, and a financial crash so big it helped destroy Scotland’s status as a separate nation.”

The above passage, taken from Lancaster’s 2009 book It’s Finished, is quoted near the opening of a recent article by Tim Price – Let’s Stick Together in which he refers to Leopold Kohr – The Breakdown of Nations. The forward by Kirkpatrick Sale describes the problem of size when nation building: –

What matters in the affairs of a nation, just as in the affairs of a building, say, is the size of the unit. A building is too big when it can no longer provide its dwellers with the services they expect – running water, waste disposal, heat, electricity, elevators and the like – without these taking up so much room that there is not enough left over for living space, a phenomenon that actually begins to happen in a building over about ninety or a hundred floors. A nation becomes too big when it can no longer provide its citizens with the services they expect – defence, roads, post, health, coins, courts and the like – without amassing such complex institutions and bureaucracies that they actually end up preventing the very ends they are intending to achieve, a phenomenon that is now commonplace in the modern industrialized world. It is not the character of the building or the nation that matters, nor is it the virtue of the agents or leaders that matters, but rather the size of the unit: even saints asked to administer a building of 400 floors or a nation of 200 million people would find the job impossible.

Kohr grew up in a small village which may have helped him to recognise one of the intrinsic weaknesses of democracy: that it works best on a small scale.

Taking this theme further and applying it to an independent Scotland, John Butler – From bravery to prosperity: A six-year plan to make Scotland the wealthiest Anglosphere region of all makes the case for a smaller more flexible approach. Here is an abbreviated version of his six point plan:-

Debt Repayment

The Scots’ legendary bravery is equalled by legendary parsimony, the first essential element of success. There is no growth without investment and no sustainable investment without savings. It stands to reason that you aren’t a parsimonious society if you carry around a massive, accumulating national debt. Debt service is also a drag on future growth. Thus if the Scots want to prosper long-term, they are going to need to pay down their share of the UK national debt.

Tax Reduction

There are several policies that would quickly create an investment boom. Most important, Scotland should do better than celtic rival Ireland, with a low corporate tax rate, and abolish the corporate income tax altogether. Yes, you read that right: The effective corporate income tax in many countries now approaches zero anyway, due to all manner of creative cross-border accounting.

Human Capital

Developing human capital, at which the Scots excelled in the 19th century, is the third element. Consider which industries are most likely to relocate to Scotland: Those requiring neither natural resources nor extensive industrial infrastructure, that is, those comprised primarily of human capital. Although financial services comes to mind, there is tremendous overcapacity in this area in England and Ireland, including in unproductive yet risky activities, so that is better left to the English and Irish for now. Better would be to concentrate on health care, for example, an industry faced with soaring costs and stifling regulation in much of the world.

Scotland could, inside of six years, become the world’s premier desination for so-called ‘healthcare tourism’. Scotland lies directly under some of the world’s busiest airline routes, an ideal location.

Sound Banking

A fourth essential element to success is to implement Scottish Enlightenment principles for sound banking. This is of utmost importance due to the potential monetary and financial instability of the UK and much of the broader Anglosphere.

As a first step, Scotland should forbid any bank from conducting business in Scotland if they receive any direct financial assistance from the Bank of England or from the UK government. In turn, Scotland should make clear to Westminster that Scottish residents will not contribute to any taxpayer bail out of any UK financial institution. No ‘lender of last resort’ function will exist for financial activities in Scotland, unless such action, if formally requested by a bank, is approved by the Scots in a referendum. (Taxpayers are always on the hook for bailouts one way or the other; why not make this explicit?)

Self-Reliance

The fifth element reaches particularly deep into Scottish history: Self-Reliance. Peoples that inhabit relatively inhospitable or infertile lands tend to establish cultures with self-reliance at the core. No, this does not make them culturally backward, but it does tend to contribute to a distrust of foreign or central authority. The Scots, while brave, were frequently disunited in their opposition to English rule, something that had unfortunate consequences for many, not just William Wallace.

Scottish Presbyterianism

Finally, there is the sixth element: the collective cultural traditions of Scottish Presbyterianism. There are few religions in the world that hold not only faith, but hard work, thrift and charity in such high regard as that of traditional Presbyterianism. Yes, as with most all Europeans, the Scots have become more secular in recent decades. But the same could be said of the Germans, who nevertheless cling to their own, solid Protestant work ethic and associated legal and moral anti-corruption traditions.

To be fair to Adam Posen of the Peterson Institute, none of the arguments for a non-integrated Scotland solve the problems of vulnerability to external shocks. The crux of the issue is whether a larger, more integrated unit, is more effective than a smaller more flexible one.

The Politics of Empires

“Power tends to corrupt, and absolute power corrupts absolutely. Great men are almost always bad men.”  Lord Acton – 1834-1902.

Throughout history successful nations have grown through expansion and integration. The process is cyclical, however, and success sows the seeds of its own demise. Europe emerged from the dark ages to conquer much of the known world. Since then it has imploded during two world wars and may now be embarking on a further wave of integration. Or, perhaps, this is the last attempt to assimilate a multitude of disparate cultures before the “long withdrawing breath” into smaller, more dynamic, self-reliant units.

In the opening chapter of Edward Gibbon’s “Decline and Fall of the Roman Empire” he says:-

…but it was reserved for Augustus (who became Caesar in BC 44) to relinquish the ambitious design of subduing the whole earth and to introduce a spirit of moderation into the public councils.

However, I believe the seeds of destruction, which eventually created the conditions for the establishment of A NEW Europe, stem from Diocletian’s introduction of the Tetrarchy in AD 284. It divided the Roman Empire in four regions.

Diocletian’s son, Constantine attempted to slow this fragmentation by adopting Christianity as the official religion of the empire, however, his decision to move the seat of government from Rome to Byzantium in AD 324 set the stage for the final schism into the Eastern and Western Empires which occurred in AD395 on the demise of Theodosius.

The Western Empire sustained continuous assaults from Vandals, Alans, Suebis and Visigoths leading to the second sack of Rome in AD 410 by Alaric. The Western Empire finally collapsed in AD 476 when the Germanic Roman general Odoacer deposed the last emperor, Romulus . Europe had descended into a “dark age” of constant wars between rival tribes. The sole pan-European administrative organization after the fall of the Western Empire was the Catholic Church, which adopted the remnants of its infrastructure.

The creation of the Europe we recognise today began with the conversion to Christianity of Clovis – King of the Franks – in AD 498, but it was not until the re-uniting of the Frankish kingdoms in AD 751 under Pepin The Short and the subsequent appointment of his son Charlemagne as Holy Roman Emperor in AD 800 that the idea of a Christian “Western Europe” began to emerge. When viewed from this long historical perspective the current development of the EU is still in its infancy.

In the East, Constantinople remained the administrative center of the Byzantine Empire. Under Emperor Justinian in AD 526 the Empire expanded. Challenges from the Lombards in AD 568 saw the loss of Northern Italy, but the rise of Islam after AD 623 proved a more terminal event. Although Byzantium went into decline, due to many assailants – not least the Western Empire – it limped on until 1453 when it to finally succumbed to the Ottoman Turks.

Why the history lesson? The spark of the industrial revolution was kindled in Europe. It developed out of the chaotic collapse of the Western Roman Empire, the warring between a plethora of tribes and the rise of independent city states. It was built on the fragmented polity of petty fiefdoms and the desire to trade despite national borders and political restrictions on the movement of labour and goods. The renaissance began in Italy where the competition between small city states stimulated “animal spirits”. The flowering of art and culture that this democratisation of prosperity set in motion goes some way to support the idea that “small is beautiful”.

During the dark ages the concept of “Nationhood” was fluid, as exemplified by the Dukes of Normandy’s fealty after 1066 to the King of France, but only in respect of their French domains. As nation states began to coalesce international trade developed further. Nations waxed and waned, alliances were made and broken but no single nation succeeded in dominating the whole region. Demographic growth encouraged voyages of discovery. Colonisation followed, and finally the conditions were propitious for the birth of the industrial revolution from which we continue to benefit today.

These processes were gradual, running their course over many generations. I believe Europe is now fragmenting once more; painful for our own time but filled with promise for future generations. Calls for self-government from many regions within the EU will increase. The more Brussels attempts to make its citizens feel European the more its citizens will yearn for self-determination.

This trend will be driven by a number of factors aside from the declining effectiveness of central government. Bruegal – The Economics of big cities articulates one of these economic paradoxes, how globalisation has made the world more local: –

Local economies in the age of globalization

Enrico Moretti writes that the growing divergence between cities with a well-educated labor force and innovative employers and the rest of world points to one of the most intriguing paradoxes of our age: our global economy is becoming increasingly local. At the same time that goods and information travel at faster and faster speeds to all corners of the globe, we are witnessing an inverse gravitational pull toward certain key urban centers. We live in a world where economic success depends more than ever on location. Despite all the hype about exploding connectivity and the death of distance, economic research shows that cities are not just a collection of individuals but are complex, interrelated environments that foster the generation of new ideas and new ways of doing business.

Enrico Moretti writes that, historically, there have always been prosperous communities and struggling communities. But the difference was small until the 1980’s. The sheer size of the geographical differences within a country is now staggering, often exceeding the differences between countries. The mounting economic divide between American communities – arguably one of the most important developments in the history of the United States of the past half a century – is not an accident, but reflects a structural change in the American economy. Sixty years ago, the best predictor of a community’s economic success was physical capital. With the shift from traditional manufacturing to innovation and knowledge, the best predictor of a community’s economic success is human capital.

Human Capital may be defined as “the skills, knowledge, and experience possessed by an individual or population”. In the internet age this resource can be located almost anywhere and need not be isolated due to email, telephone or video conference technology, however, the advantages of physical proximity and social interaction favour cities.

Another, and related, issue is the increasingly disruptive effect of technology on employment. Bruegal – 54% of EU jobs at risk of computerisationhighlights one of the greatest economic challenges to the social fabric of the EU, but this is a global phenomenon: –

Based on a European application of Frey & Osborne (2013)’s data on the probability of job automation across occupations, the proportion of the EU work force predicted to be impacted significantly by advances in technology over the coming decades ranges from the mid-40% range (similar to the US) up to well over 60%.

Those authors expect that key technological advances – particular in machine learning, artificial intelligence, and mobile robotics – will impact primarily upon low-wage, low-skill sectors traditionally immune from automation. As such, based on our application it is unsurprising that wealthy, northern EU countries are projected to be less affected than their peripheral neighbours.

European governments are caught between the competing needs of an aging population and a younger generation who have little prospect of finding gainful full-time employment. Meanwhile city workers are paying for the regions where unemployment is highest. The tension between “wealth makers” and “wealth takers” are destined to increase.

Conclusion

Scotland voted to remain part of the Union. The Independence campaign was ill prepared failing to consider such issues as what currency they would use or how they would avoid a run on their banking system. The next time the Scots vote – and there will be a next time – I believe they will leave the Union because these questions will have been addressed. Other regions around the UK and Europe have taken note – the spirit of devolution is abroad. Prosperous regions, such as Catalunya and Northern Italy – Padania as it is sometimes called – crave independence from their poorer neighbours. Poorer regions resent the straight jacket of a single currency – be it the GBP for regions like the North East of England or the EUR for Greece and Portugal. To the poorer regions, the flexibility of a floating exchange rate is beguiling; as the EU stumbles through an era of debt laden low growth devolution pressures will increase.

For the GBP and EUR the Scottish “No” vote will fail to diminish the potential for social and political tension. The value of these currencies will reflect that uncertainty. Longer-term foreign direct investment will be lower. This will place an additional burden on EU budgets. A larger percentage of central government spending will be directed to regions where calls for devolution are highest rather than to economically productive projects in more prosperous areas.

European and UK equities are likely to under-perform in this environment whilst the increased indebtedness of EU governments is likely to increase their real borrowing costs.

Will this happen soon and will it be possible to measure? I think it is already happening but, given the very long-term nature of the fragmentation of nations, it will be difficult to measure except during constitutional crises. The shorter-term business cycles will still exist. Trading and investment opportunities will continue to arise. For the investor, however, it is essential to be aware of the risks and rewards which this fragmentation process will present.

Whither the UK – From Tantalus to Sisyphus?

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Macro Letter – No 4 – 31-01-2014

Whither the UK – From Tantalus to Sisyphus?

It has been a long time since I have reviewed the UK economy and the prospects for our financial markets but the recent spate of positive economic news deserves investigation.

Sterling

To begin I have enclosed a chart of GBP/USD. You will notice that despite a significant strengthening of GBP, in line with the improving economic data, we still have a distance to travel before returning to the pre-Northern Rock range. The near-term trend looks clear but a comprehensive break above 1.70 is required for confirmation.

 

GBP-USD FX 10yr - source fxtop.com

GBP/USD FX 10yr – source fxtop.com

 

To understand why GP/USD may return to its pre-crisis range one needs to consider why it has been languishing in purgatory since 2008/2009. Partly this is due to the size of the UK financial services sector, where regulatory headwinds remain fierce, and partly the direction of long-term interest rates globally. Here is a chart of 10 year Gilt yields:-

10yr Gilt yield - 10yr Monthly - source investorsintelliegence.com Stockcube Research Ltd.

10yr Gilt yield – 10yr Monthly – source investorsintelligence.com Stockcube Research Ltd

Of course short and long term interest rates have declined in most countries since the Great Recession but traditionally GBP was a “carry-currency” due to our structurally higher inflation rates. The “sea-change” in interest rate differentials has seen the “carry-trader” depart this sceptre isle. There are a number of other factors including the arrival of a coalition government in 2010, a significant decline in the UK housing market and a collapse in the UK export sector, despite the precipitous decline of sterling against its trading partners. Financial services went out of fashion and North Sea oil and gas production took an unfortunate nose-dived simultaneously.

The chart below showing the GBP Trade-Weighted Index is from Ashraf Laidi . It is a couple of years old but it’s still valid, the annotation is his:-

GBP Trade Weighted Index - 1990 - 2013 - source AshrafLaidi 

Source – AshrafLaidi.com

Gilts

Looking  at the chart of 10 year Gilt yields above, you will notice that yields bottomed in mid-2012 whilst GBP/USD took until 2013 to begin its recovery. The external factor driving Gilt yields to their nadir was the Eurozone crisis, however, since Draghi’s “whatever it takes” speech (July 26th 2012) Gilt yields have begun to normalise in a similar manner to the US. Meanwhile Eurozone rates have converged lower and German 10 year Bund rates have remained relatively low.

Looking ahead it is not unreasonable to expect Gilt yields to go higher, but, with GBP rising and inflation falling this is likely to be a gradual process; added to which the Bank of England (BoE) have been softening their tone on prospective interest rate increases.

Here’s a quote from MPC member Ben Broadbent speaking at the LSE on 17th January: –

The final and more general point is to caution against inferring too much about future growth from its current composition. Of course there’s a risk the recovery could falter. But, if it does, it will probably be because of more fundamental problems – a failure of productivity to respond to stronger demand, for example, or continuing stagnation in the euro area – not any imbalance in expenditure or income per se. These are outcomes, not determinants, of the economic cycle. As we shall see, they are poor predictors of future growth.

http://www.bankofengland.co.uk/publications/Pages/news/2014/024.aspx

On 23rd January Ian McCafferty reiterated the MPC’s position on rates: –

…the MPC sees no immediate need to increase interest rates, even if unemployment reaches 7% in the near future.

McCafferty goes on to discuss capital expenditure which, along with productivity growth, has been weak during the early stages of the recovery.

http://www.bankofengland.co.uk/publications/Pages/news/2014/027.aspx

Also on 23rd January MPC memberPaul Fisher, after explaining why the BoE allowed inflation to remain above target for so long, went on to opine: –

We are very conscious that the headwinds have not gone away: much of Europe and some other parts of the world continue to struggle for sustained growth; fiscal consolidation in the UK (and elsewhere) is likely to continue for a while to come; and the financial sector still needs some rebuilding. Indeed, the official production and construction data released earlier this month were rather disappointing, reminding us that strong growth from here on is by no means guaranteed.

http://www.bankofengland.co.uk/publications/Pages/news/2014/028.aspx

Fisher goes on to explain that unemployment, and the composition of employment, are key metrics in their thought process. The whole speech is also a fascinating insight into the MPCs approach and their ideas on forward guidance.

BoE Governor – Mark Carney addressed the CBI at Davos on 24th January: he discussed the UK economy and the need to reach “escape velocity”: –

After the Great Moderation and the Great Recession, there are several reasons why it will be years before any superlatives are attached to this recovery.

First, for all the talk of austerity and deleveraging, the aggregate debt burdens of advanced economies have actually increased; with their total non-financial sector debt rising by 25% relative to GDP since 2007. Balance sheet repair in the public and private sectors will exert a persistent drag on major economies for some time.

Second, the need to rebalance demand from deficit to surplus countries endures. Given the adjustment pressures on the former, without progress on rebalancing, robust and sustainable global growth will remain an aspiration.

Third, confidence, while improved, remains subdued. Recognising that the end isn’t nigh is far from marking the normalisation of business and consumer sentiment. Given past shocks and modest prospects, business investment in particular remains hesitant across the advanced world. On balance, corporations remain more focused on reducing operating expenditures than increasing capital expenditures.

… Nevertheless, it appears that the recovery will need to be sustained for a period before productivity gains can resume in earnest. The latest data show that more than a quarter of a million jobs were created in a three-month period – the biggest increase since records began in 1971. As a result, unemployment seems to be falling at a pace that will reach our 7% threshold materially earlier than we had expected.

Crucially, unemployment remains above the level that is likely to be consistent with maintaining inflation at the target in the medium term. It is not just that nearly three quarters of a million more people are out of work than before the crisis; another three quarters of a million more people are involuntarily working part time.

The effect of this slack in the labour market is evident in wage inflation, which is at around 1% so that, even with weak productivity, unit labour cost growth remains below 2%.

http://www.bankofengland.co.uk/publications/Pages/speeches/2014/705.aspx

All of these comments concerning lack of productivity growth, elevated levels of unemployment, growth of part-time employment, lack of capital expenditure and international headwinds from the Eurozone, suggest that interest rates will stay low and the BoE will risk above target inflation to insure the economic recovery broadens and deepens. In this environment I see Gilts remaining in a relatively narrow range, even if inflation ticks higher once more.

Politics

On 29th January, Mark Carney spoke in Edinburgh on The economics of currency unions. The full speech is here: –

http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech706.pdf

He attempted to be deliberately non-political – to judge by the press comment afterwards he failed – but it is a timely reminder that Scotland will vote on whether they remain in the Union on 18th September. The uncertainty surrounding the possible break-up of the Union and one what economic terms is another factor which will temper a broader based recovery.

Other political clouds on the horizon include the European Parliament elections (22nd to 25th May) where nationalist parties are expected to gain significant ground.

Equities

The FTSE100 has performed strongly since the beginning of 2013, in line with other developed country stock markets. The large dose of QE delivered by the BoE has underpinned this trend, but, now that the economy has regained some upward momentum, many commentators are becoming doubtful about the prospects for UK stocks – after all, lower interest rates are one of the most powerful drivers of equity market performance.

Firstly, I believe UK-centric stock momentum is increasing, but a number of external factors will be supportive of the UK equity market: –

  1. China has announced a rebalancing of their economy towards domestic consumption, even if this is at the expense of headline GDP growth. This makes inward foreign investment into China less attractive – I expect capital to flow back to UK and USA.
  2. Japan is attempting to deliver economic growth through what PM Abe has dubbed the “Three Arrows” policy, this has already seen a significant decline in the JPY and a new “quasi-carry trade” is being driven but expectation of relative government spending. The US has begun to taper (another $10bln just this week) and the UK might follow suit at some point this year, but Japan will continue with QE.
  3. Emerging markets have already started to react to the changed policy of the Federal Reserve: India, beginning last year, Argentina, South Africa and Turkey, have seen their currencies depreciate and respond with higher interest rates since the start of the year. Emerging market bonds have, needless the say, fallen sharply, prompting international investors to liquidate some of their investments. The reversal of more than a decade of Capital flows to emerging markets will support developed country currencies, especially those, like the UK, with Capital account surpluses.

Secondly, UK Exports have remained resilient despite the strengthening of sterling.

UK Exports - 10 yr - source tradingeconomics and ONS

Source – tradingeconomics.com

I have some caveats concerning UK equities however; banking and financial services firms are still under pressure due to regulatory change – a new report from United Nations Conference on Trade and Development (UNCAD) shows the UK falling to second place behind the USA; down more than 20% from its peak only seven years ago. The European Commission has just announced plans to stop all proprietary trading by Banks by 2017 – whilst this is likely to be challenged by UK, France and Germany it will lead to the postponement of any expansion plans in this area.  Another sector which is under pressure is mining or commodity firms which are still suffering from the downturn in prices in 2013 – this tallies with my short-term concerns about emerging markets.

UK House Prices

A number of commentators have suggested that the recent strength of the UK economy has been largely driven by increased debt, especially mortgages. Government schemes such as “funding for lending” actively encouraged UK banks to lend more aggressively despite their balance sheet constraints.

MPC member David Mills, in a speech to the Dallas Federal Reserve, discussed housing last November:-

That problem with using monetary policy to stabilise the housing market would be acute if housing markets were overheating when the wider economy was not and consumer price inflation was low even though house price inflation was high.

…High leverage is at the heart of problems in housing market. Monetary policy and macro prudential policy can influence leverage. But more fundamentally, use of outside equity might be a way of permanently bringing down reliance upon debt financing.

http://www.bankofengland.co.uk/publications/Pages/news/2013/132.aspx

In other words the BoE is unlikely to be concerned about house price inflation and will use macroprudential measures rather than interest rates to stem its rise should it occur in isolation. This is clearly good for property but, in anticipation of the “Macroprudential Stick” other asset classes, such as equities, may benefit by association.

The housing market is finally recovering from the bottom up as the following chart makes clear: –

First Time Buyers as percentage of home loans - source Council for Mortgage Lenders

Source – Council for Mortgage Lenders

First time buyers have returned, perhaps because banks are more amenable about loan to value ratios but also because real house prices are well off their highs: –

 Real House Prices since 1975 - source Nationwide Building Society

Real House Prices since 1975 – source Nationwide Building Society

House price momentum appears to have turned higher once more – this chart, from MarketOracle.co.uk, uses data to November 2013:-

UK house prices and annual momentumn-Dec-2013 - source Market Oracle.com and Halifax

Source – MarketOracle.co.uk and Halifax

The December 2013 report from the Land Registry, published on 29th January, shows continued improvement: –

http://www.landregistry.gov.uk/__data/assets/pdf_file/0020/71192/HPIReport20140122.pdf

Independent forecasts for UK property are strongly positive, here is a recent sampling:-

CBRE 17% Rise by 2018 Commercial property consultants

OBR 20% Rise by end of 2018

Knight Frank24% rise by end of 2018 – Retail property specialists

Savills25% rise by end of 2018 – Retail property specialists

Why so strong? Because interest rates are low and therefore housing is relatively affordable. Here is one of my favourite measures of housing affordability from Moneystepper.com:-

UK mortgage to income ratio - source moneystepper.com

UK Mortgage payment to income ratio – source Moneystepper.com

The author uses the Nationwide House Price Index, the BoE base rate plus 2% and the ONS after-tax income data.

For a more detailed investigation of the UK property market here is their post from November 2013, it’s the second of three articles:-

http://moneystepper.com/financial-planning/housing-bubble-uk-2/

Why Tantalus to Sisyphus?

Almost everything I’ve written so far has been positive for the UK economy and neutral or positive for UK markets. After unprecedented actions by the BoE, the “Tantalus Phase” appears to be over; growth that was just out of reach is now within our grasp, however, ahead of us lies the “Sisyphus Phase” where we have to pay the piper.

To begin with I want to look at money supply growth. Here is the Ratio of M4 to M0 from BoE data: –

Ratio M4 to M0 - source Bank of England

Ratio of M4 to M0 – source Bank of England – John Phelan

An excellent article by John Phelan written for the Cobden Centre analyses this development in more detail: –

http://www.cobdencentre.org/2014/01/britains-inflationary-outlook

Since March 2009 Britain’s monetary base, also known as narrow money or M0, has increased by 321%. We can see that the majority of this is in the form of increased bank reserves, up 642% since March 2009.

This is just what we’d expect to see following the Bank of England’s Quantitative Easing, where the Bank creates new money and uses it to purchase bonds from banks – that new money becomes bank reserves. Those banks have sat on that money (not using it as a basis for new credit creation and feeding into M4) which is why, while narrow (M0) money has exploded, broad (M4) money has barely budged, increasing by just 7.4% since March 2009.

This relative restraint in M4 growth explains the relative restraint in inflation. There is no great mystery as to why banks which have just seen their assets tank and ravage their balance sheets should want to hold more reserves. The key question is what happens next.

A paper published in December 2013 by European Commission – The flow of credit in the UK economy and the availability of financing to the corporate sector – looks in more detail at the problem of the transmission of credit:-

http://ec.europa.eu/economy_finance/publications/economic_paper/2013/pdf/ecp509_en.pdf

They conclude on an optimistic note: –

The flow of credit in the UK economy may be close to turning a corner in connection with recent improvements in the macroeconomic outturns and outlook, and as banks finish adapting to a new regulatory environment. Improving access to finance for firms and SMEs is set to remain a crucial element for driving the desirable rebalancing of the UK economy, fomenting investment and fostering the reallocation of resources to the most productive sectors of the economy throughout the on-going recovery.

The BoE – Corporate Credit Conditions Survey – Q4 2013 – released earlier this month, also suggests this process is starting to happen:-

Overall credit availability to the corporate sector was reported to have increased significantly in 2013 Q4; lenders have now reported an increase in availability for five consecutive quarters. Lenders cited market share objectives, competition from capital markets and an improvement in the economic outlook as factors that had contributed significantly to the increase in availability. All these factors were expected to contribute significantly to availability in 2014 Q1.

http://www.bankofengland.co.uk/publications/Documents/other/monetary/ccs/creditconditionssurvey140108.pdf

Against this back-drop of improving conditions, however, it is important to realise that the combination of UK public and private sector debt is the second largest of any developed country on the planet relative to GDP – only Japan carries a greater burden. Academic research has shown that when the ratio of debt to GDP exceeds 260% to 275% this tends to act as a drag on economic growth.

The chart below is from 2012 but the situation has not improved.

 Total Debt to GDP ratios - source DailyMail

Total Debt to GDP – source DailyMail – January 2012

UK Household debt is now at a record £1.43trln, although, it has fallen from 167% of income to 140% since 2008.

At some point in the future we will have a “reckoning” – probably when broad-based inflation begins to rise once more. Interest rates will rise dramatically to control credit growth. What the catalyst will be is difficult to say – a breakup of the Eurozone could lead to a collapse of GBP, the next major leg of a commodity super-cycle turbo-charged by the collapse of the Saudi regime – it’s best not to speculate, but, perhaps the longer term factor most likely to re-ignite the inflationary potential of the “great debasement” is demographic.

As the “Baby-boomers” finish retiring and downsizing the next leg of the demographic cycle will begin, with increased spending and consumption. When these “new-boomers” eclipse the “old-boomers” inflation will regain its power to decimate the value of money whilst at the same time asset prices will collapse under a deluge of foreclosures and debt default. The Sisyphian task will be to reduce the debt against the rising tide of servicing costs. But when will the next “Baby Boom” arrive?

Here is a fascinating chart from the ONS:-

UK Baby boom - source ONS

UK Baby boom – source Office of National Statistics

According to ONS data, UK population growth to mid-2011 was the highest in 40 years. They predict that, should this trend continue, the UK will have the largest population of any country in Europe by 2050. Recent CML data shows the average age of first time house buyers to be 29/30 years. I therefore anticipate a “mini-baby boom” effect kicking in between 2015 and 2020, followed by a 10 year decline. From 2030 this pattern will reverse; by 2040 the next significant inflation wave will be in full swing.

This weekCharles Goodhart, speaking at the LSE predicted that “The Next Crisis” – which was the title of his speech – will occur around 2025/2026. Here’s the podcast, he starts his argument around 10 minutes in and make the case for 17 year cycles. Hence 2025/26 will see the next UK crisis which, he believes, will be more severe than the recent downturn due to a greater concentration on lending to the property sector, exacerbated by the regulatory curtailment of investment banking activity in favour of more traditional bank lending: –

http://www.lse.ac.uk/newsAndMedia/videoAndAudio/channels/publicLecturesAndEvents/player.aspx?id=2219

My expectation is that during the remainder of this decade demographic forces will be somewhat supportive of inflation but attempts to deleverage UK debt after 2020 will have more deflationary consequences.

Conclusion

Sterling looks well placed to move back into its pre-crisis range. Gilts are caught between inflationary and deflationary forces and should remain range-bound. UK Equities are likely to benefit from inward capital flows and UK property looks better than ever – barring a significant change in UK planning laws, this is my preferred UK asset class for 2014, and probably beyond.