UK Snapshot

Today is all about the election: uncertainty, Brexit, uncertainty over Brexit, the pound, the effect of uncertainty on the pound, the effect of an uncertain Brexit on the pound, etc. ad infinitum. As we have had occasion to observe before, speculation on unknowable outcomes is pure idleness. One might as well invest on the basis of the weather.

So while others preoccupy themselves with whimsical guesses about the impact of the country’s eye-popping day out at the polls, this blog will follow up its recent drains-up summary of the global banking system with a brief, brass-tacks tour of the UK’s current and prospective economic landscape.

Economists traditionally divide indicators into one of three categories: leading, lagging, and coincident. We will take a look at all of these in chronological order to serve both logic and completeness.

The classic lagging indicators are inflation and unemployment as they represent embedded economic trends, among other things.

Readers will know that price increases have been accelerating in Britain for some time, driven by sterling weakness and commodity strength. The rate of RPI inflation has more than doubled over the last 12 months from +1.6% to +3.5%, while CPI has recovered from near zero (+0.5%) to +2.7%. This might represent a normalization of price behaviour following an unusual depression, and / or turn out to be a relatively transient phenomenon. Although we know it is consistent with a sustained upward trend in economic activity, then, it is not possible to read this from the various inflation prints alone.

The labour market is a different kettle of fish. The longstanding claimant count measure of the unemployment rate hit a more than 40-year low of just over 2% last year and has bobbled around there ever since. The more highly-favoured, internationally comparable ILO survey measure has pointed towards a steadier recent strengthening, reaching a 40-year low of 4.6% in the March release down from 5.1% a year earlier. Both measures are indicators of rude economic health and suggest that the economy is now at or around full employment.

Coincident indicators occupy a broad universe: there is a lot of data on what people have been doing just now, from consumer purchases to business activity to construction. To cover all these bases we can look at retail sales, purchasing manager surveys and broad growth in GDP.

Retail sales came under a lot of scrunity earlier this year as evidence that consumer activity was being squeezed by higher prices. Monthly figures for this series are volatile but the annual increase for the year to April came in unexpectedly high at +4.5%, bang in line with the 12-month rolling average both currently and for the pre-referendum peaks of 2015. Consumer activity, by this measure, is currently strong.

The composite PMI measure provides a snapshot of business conditions across all sectors (manufacturing, services and construction). A reading of >50 indicates expansion; of <50, shrinkage. The May print came in at 54.4, a healthy but not overly exuberant result consistent with the pace of activity observed in both of the two prior quarters.

The second estimate of broad GDP growth for Q1 came in for much attention when it was released a couple of weeks ago. Revised down all the way from +0.3% on the quarter to +0.2%, and thus equalling the level attained back in the ancient past of Q1 2016 it was taken as evidence that Brexit fears were beginning to bite. Export growth in particular came in for some scrutiny as it seemed that net trade was failing to profit from cheap sterling. Fortunately, scrutiny of ONS methodology revealed that the export fall was largely an accounting offset against increased fixed capital formation pertaining to “non-monetary gold” [further detail available on request]. Look through the noise and the top line measure of real GDP growth over the year to Q1 reached +2.0%, 0.4% more than the rate for Q1 2016.

Finally, if we are to look to the future it is the leading indicators which are of most interest. The principal leading data are confidence surveys, so we will cover the main bases and take in the GfK consumer survey, the Lloyds UK Business Barometer and the EC Economic Sentiment indicator for the UK overall.

Consumer confidence has remained steady this year at between -5 and -7, a little higher than its long run (20 and 30 year) averages. The May figure actually ticked back up to the top of this very narrow range. This stacks up pretty favourably against the low of -12 hit in the aftermath of the referendum, the -29 seen five years ago and the low of -39 plumbed in the depths of the Great Recession.

The Lloyds series is a very volatile beast indeed so I have looked only at the rolling 6-month average. This has recovered all the ground it lost in the second half of last year, though remains lower than the peaks attained in 2014-15 (+37 as against +50 to +55).

Finally, the EC’s measure has shown a steady recovery from a referendum-driven dip last year to a range of 108-111, consistent with the highest ranges reached in the 2000s.

There, then, is a broad, conventional snapshot of the UK economy as it stands today, regardless of panic (or elation?) at the various politically-led uncertainties we now undoubtedly face. Readers will be able to make their own judgements as to our economic health, sickness, or for that matter, equilibrium as these data continue to evolve.

Advertisements

09/06/2017 at 5:25 pm

A Long Time In Politics

This morning’s most widely-read headline on Bloomberg was “Pound Falls on Tighter Polls as Traders Wake Up to Election Risk”. As the article puts it:

Sterling fell against all of its 16 major peers on Friday after a poll showed the Conservative Party’s lead over the main opposition Labour Party has narrowed to five percentage points with two weeks to go until the June 8 election. That comes after weeks of surveys showing a bigger Tory lead had made the vote all but a foregone conclusion for the market . . .

If the swing to Labour were uniform across the country, May would lose seats in the House of Commons, with the Tory majority falling to two from 17, the Times said.

As Harold Wilson is supposed to have said, a week truly is a long time in politics.

When Theresa May announced the election at the end of last month her lead in the polls was so towering that the contest looked cruelly unfair to her opponents. One April survey put her party on 50% against only 25% for Labour. Predictions were being made of electoral wipeout for the latter and a landslide victory for Mrs May on a similar scale to that achieved by Tony Blair in 1997.

And then the Conservative manifesto was launched.

This contained a novel commitment to strip those of the nation’s elderly unfortunate enough to suffer dementia of their family homes after death. At the same time the existing commitment to preserve the real value of the state pension was dropped. The coup de grace was delivered a few days later, when May – slogan, “strong and stable” – U-turned abruptly on the Dementia Tax proposal by suggesting that the raid on the estates of the mentally ill would be subject to an unspecified cap. Now branded “weak and wobbly”, and having stamped all over some of her party’s core vote, Mrs May’s victory is no longer in the bag. Indeed, with a 25-point lead reduced to a slender 5-point advantage in less than a month it is arguable whether she could have done a better job of throwing the contest on purpose.

To investors today, then, falls what had seemed like a redundant exercise: we need to assess the possible consequences of a Conservative defeat.

Those traders mentioned by Bloomberg have identified sterling weakness as a product of this, either at the hands of a Labour-led coalition or a hung parliament. But the fall so far has actually been rather muted: yes, the pound is a cent and a bit weaker against the dollar but it is still well above its January low. It has fallen by less than a cent against the euro. So far, it has stabilized above its morning bottom against both currencies.

Staying with sterling, uncertainty can cut both ways. Our 8 June vote was billed as the Brexit Election. The Labour manifesto commits to remaining in the single market and customs union (i.e. no economic, nor much political change from the status quo) and ditching the “Great Repeal” of EU law. It also rejects a “no deal” / WTO rules exit and commits to a parliamentary vote on the final offer from Brussels. And the Lib Dems are calling for a second referendum. So a Tory defeat could well see the end of Brexit altogether, or at least its indefinite postponement. Would this not be taken as positive for the pound?

A Labour triumph, now no longer unthinkable, would have consequences far beyond the currency of course. The party commits itself to £250bn worth of spending on railways, energy projects and data networks. It also commits to £250bn of lending to “small businesses, co-operatives and innovative projects” via a National Investment Bank. That is comfortably more than the level of current annual lending to SMEs by the entire British banking system, and not far off the total group balance sheet value of customer lending at RBS (£352bn in 2016). Might there not be some consequences for bank profitability here?

Similar points could be made about plans for price caps on energy bills, or railway nationalization. And then there is the broader point about the national debt, and interest costs. The latter are already troubling and for 2016-17 were set to bust through the £50bn mark, only a little less than the entire education budget – and that’s with gilt yields of around 1%. Adding to the nation’s debt burden by more than a quarter would push it past 110% of GDP and see interest costs rise still further. Again, this might well have consequences for the pound, the gilt market, stocks . . .

Despite the headlines, then, it is safe to say that a Conservative defeat is not being much priced in at all. It is true that it would still be a surprise, and that there are almost two weeks of the campaign left to run. But it is now a real possibility.

This election is turning out to be much more exciting, and potentially more consequential, than anyone could have expected.

26/05/2017 at 5:37 pm

Banking On It

With equity markets reaching ever dizzier heights this year, oil stable and government bonds serene it is difficult to think back to how the financial world felt about a year ago. Back then, an eye-watering collapse in risk pricing apparently presaged a rerun of the Great Recession. The clear catalyst was to be a systemic financial crisis just like that of 2007-9, though this time originating in a China riddled with insurmountable debt problems. Bank worries persisted into the summer, with the European Banking Authority’s July “stress test” widely expected to demonstrate the insolvency of many weak banks (and especially those in Italy).

These fears – intense as they had been – eventually dissipated. Since its post-referendum nadir the UK’s FTSE All Share Banks Index has risen by 51%, comfortably outpacing the broad market ex banks by more than 30%. Yet the G7 Finance Meeting summit on in Italy right now has continued to generate headlines about bank solvency in that country. So has the problem gone away? And should risk assets head south once more, would it be a financial collapse that Mr Market, once again, was banking on?

The numbers in Italy are indeed problematic – for Italy. But they are too manageable and too well-known to foment a systemic crisis more widely. To answer the question more broadly, however – which in times of panic is invariably how it is phrased – we can take a look at various data on bank solvency and non-performing loans across the world to see where it stands today, where it stood during the crisis years and what happened to it in the supposed nightmare period of 2016.

Let’s start with non-performing loans. This is the most obvious cause for concern in the banking system: when a bank lends money to a sufficiently large number of customers who default on their loans its income falls, its balance sheet weakens and it can in extremis go under.

In the UK, the combined value of reserves for loan losses at Barclays, Lloyds and RBS (including all their current subsidiaries) peaked at £51.4bn in 2011. By the end of 2015 this had fallen to £15.0bn, and it fell further last year to £11.4bn, which is below the pre-crisis levels of 2007. In the US, where the subprime debacle saw the most severe financial bloodletting anywhere, the figures for the Big Four (Bank of America, Citi, JP Morgan and Wells Fargo) have charted a similar trajectory. The peak was reached earlier, in 2010, at $158.8bn, had fallen to $49.9bn by 2015’s close and ended last year at $48.5bn.

Taking a more global view, the IMF collects data by country on actual non-performing loans after the event, and this naturally tells the same story as individual banks’ bad debt provisions. Starting again with the UK, the banking system in aggregate saw the proportion of non-performing loans to total gross lending peak at 4.0% in 2011, falling to 1.0% in 2015 (data for last year is not available yet). The US hit a more severe peak of 5.0% in 2009, which had run down to 1.5% by 2015. It also posted that level last year.

Turning to the market’s bogey men in this department: Euro area banks didn’t see their aggregate loss ratio peak until 2013 on the back of the double-dip recession there (at 7.9%). But this has since fallen, reaching 5.8% in 2015 and continuing to fall to 5.4% over last year. And in China, while the same ratio did actually increase in 2016 this was only by 0.07% (the figure was a stable 1.7% from 2015-16 at only one decimal place). Note, too, that the Chinese peak was all the way up at 29.8% back in 2001, which ought to put this squarely into context.

As well as the incidence of loan defaults, the resilience of balance sheets is another key moving part when it comes to assessing the vulnerability of a banking system. So we can also look at bank capital ratios to see just how much sleep we might expect to lose should those not-very-concerning loan loss numbers begin to tick up again.

Regulators tend to focus on “tier 1 capital”, which can be summarized as balance sheet equity plus whatever debt can be written down without putting a bank into distress. The EBA helpfully compiles data on this for the EU in aggregate. Before the financial crisis, the tier 1 capital ratio for EU banks was 8.0% (2006). With the assistance of vast sums in emergency state support and generous debt swaps this percentage actually rose slightly during the crisis itself before really taking off in subsequent years to hit 14.9% by the end of 2015 and 15.7% last year. In other words, just as loan losses have been falling, capital buffers have been increasing – to almost twice the strength they had a decade ago.

Turning to the IMF once again we can have a look at similar data for (balance sheet equity) capital ratios across the world. This rather more traditional measure of capital is narrower than tier 1 and so the numbers are smaller and not quite so illustrative. They do, however, tell a similar story: the euro area’s “pure” bank capital ratio increased from 8.0% to 8.5% in 2016, ahead both of its 2011 nadir (5.6%) and pre-crisis level of 6.6% (2006). The Chinese ratio has risen from 5% to 8% over the last ten years, in the US it grew slightly from 10.5% to 11.7% over the same period and here in the UK the increase was from 6.1% to 6.8%.

There have been some weaknesses visible in this data – in Russia, for example, and in Brazil, which both suffered so badly at the hands of weak commodity prices in recent years. Again, though, banking issues in these countries have neither the scale nor the surprise factor to cause a genuine, systemic upset elsewhere. And in most other places, including those over which the strongest concern has traditionally been expressed, we can see that banks, as a whole, are in rather better shape now than they were in 2015 – never mind during the subprime crisis and Great Recession.

“In times of crisis”, this blog wrote back in February last year, “it behoves us to seek refuge in facts.”  The view that last year’s funk was nonsense proved correct, and provided an opportunity. But it is not just when the market is in crisis that we need to mind our fundamentals. Greed is every bit as dangerous as fear. We might not have to fear for the banking system at present (especially in places where interest rates go up) – but just because Mr Market looks unlikely to stub his toe on the banking system in the near future that doesn’t make him immune to stumbling elsewhere.

 

12/05/2017 at 3:01 pm

Alternative Ending

Counterfactual writing has been popular for many years. What if the Nazis had won the war in Europe? What if there had been no Reformation? Extending the genre to finance one might ask, what if the bond market had closed to Italy in 2011? (More of a niche market there, perhaps, but an interesting question nonetheless . . . )

Investment decision making by contrast concerns the future, of course, whose range of outcomes is practically limitless. Where the FTSE 100 index will close the year is a matter of opinion. A successful investor could be defined as someone who gets those sorts of things right more often than she gets them wrong. The only certainty she has, however, is that the future could hold almost anything.

And so to inflation, the UK, and what happens next.

The data out last week showing another uptick in the rate of price increases in Britain will have come as no surprise to readers of this blog. CPI is catching up with PPI output prices which have continued to catch up with PPI input prices, which have continued to come in at around 20% higher than the same time twelve months previously. Notably, “RPIX” – the rate of retail price inflation excluding the impact of mortgage interest payments and the rate once targeted by the Bank of England – came in at +3.5% year-on-year (to February). A full point above the old target, that would once have provoked a letter from the Governor to the Chancellor. CPI has only just got up to +2.3%, however, so under the new regime there is officially nothing to worry about.

Yet.

Bearing in mind the enormous range of possibilities encompassed by the future we ought to be surprised at the strength of the consensus about what happens next. The Bank, the City, the leading independent forecasters: all are agreed that rising inflation will eat into wage packets, dampen growth, soften the labour market a little then fall away again. This time we all know how the story will end.

Taking this as read, then, let us try to be counterfactual, if only for entertainment’s sake.

On February data, real wage growth either flatlined (using CPI) or fell by 1% (using headline RPI). Let us follow the consensus in assuming that inflation grows by another point or so into the end of this year. That would push real wage growth down to between -1% and -2%.

Now: what if the effect of this was not only, or primarily, to impact growth? What if the expectation that wage growth will muddle along at a steady +2% is wrong? What if earnings actually start to rise to compensate for higher prices?

Like any good counterfactual tale our story needs to have its roots in genuine history to come across as believable to its readers.

In this case we might look at the distance travelled by the UK economy since the unemployment rate peaked in November 2011 at 8.5%. At that time average earnings growth was coming in at +1.7-1.8%, just a little lower than its present rate, though at the time this was a noteworthy trough and a level not seen since 1967. Wage growth subsequently fell further, hitting lows of +0.7-0.8% during the 2013-14 period. During those two years, however, employment growth had taken off in earnest with joblessness falling from 7.8% to 5.7%. Average earnings growth subsequently rose too, hitting +2.8% by mid-2015.

That British pay packets began to grow as spare workers became that bit harder to get hold of might well have been a complete coincidence. Indeed if we are to believe that earnings growth will not continue to accelerate today, as unemployment is down even further at 4.7%, equalling its post-1975 low, then that must be taken as read. The consensus, after all, is convinced of it.

Let us persist with our radical, counterfactual account, however. Suppose that labour market strength might genuinely correlate with wage growth. Where might that take us?

Prior to the Great Recession the average rate of earnings growth in the UK was +4%. Using a five-year lag from earlier peaks in unemployment wage growth reached +4.9% (February 1998) and +9.3% (May 1989). The economic, market and demographic environments were very different in their own ways at each of those different times, so the absolute numbers are not perhaps that illustrative. What they have in common is that they occurred during uptrends in wage growth established in the wake of falling unemployment.

For our fictional account of the British economy, then, let us assume that 2017 were to end with average earnings growing at 3-4%. With CPI and RPI inflation settling in the same range this would not represent boom times for wage packets in real terms. But it would not mean a growth-threatening contraction either. Expectations for increased labour market slack would surely go out of the window. Inflation projections would rise. Interest rate expectations would change. We might be entering 2018 worried not so much about contraction as about an overheating economy and a monetary policy that looked to have long since fallen behind the curve.

This is hardly a gripping, mass-market narrative. But it is the kind of thing that investors might want to weigh up in their thinking from time to time.

At least it would be if it were not the most absurd counterfactual, of course. Luckily the consensus is universally settled. We all know what is going to happen. In Britain’s immediate future, there is no alternative ending.

31/03/2017 at 3:55 pm

Nothing To See?

Tomorrow’s election in the Netherlands may not be very exciting after all. Until recently it looked as though the nationalist PVV would emerge the clear winner, to the extent that keeping its leader from the Prime Ministership would be very difficult. (PVV wishes the Netherlands to leave the European Union among its other policies.) But then the party’s leader, Geert Wilders, was convicted for inciting discrimination before Christmas, and as the campaign got underway the incumbent PM, Mark Rutte, deployed much hard rhetoric and advertising on PVV’s key issue, immigration. The current polling is finely balanced. Mr Rutte has repeatedly ruled out coalition with Mr Wilders. Dutch politics may remain an earthquake-free zone; we will soon know either way.

Eurozone asset markets are priced rather sanguinely in any case. Back in 2011 it was the bond market, and specifically the Italian bond market, which threatened to ignite a wholesale global banking collapse with an internationally unaffordable sovereign default. Back then, the credit default swaps which can be bought to hedge against Italian credit risk cost almost 6% over LIBOR, as against 6bp in mid-2007. Today the rate is 192bp: higher than the pre-credit crunch levels, but then Italy has been downgraded from AA to borderline junk since then. Even the end of the country’s government last December at the hands of a referendum seen as a valve for anti-Establishment sentiment did relatively little to move the price.

Elsewhere in the euro area the story is similar. The exception, which is worth dealing with separately, is Greece. Here the debt burden, which has of course already been restructured once, has reached over 180% of GDP. The IMF – one of the “troika” of creditors dictating Greek fiscal policy – has said that it has again become unsustainable. Fraught negotiations with the Greek government have continued. But none of this is news. Furthermore the Bank of Greece’s November estimate for the country’s budget was of a “primary surplus” (budget balance before debt interest) of +4% of GDP, indicating both a sustainable underlying spending pattern and compliance with creditor demands. There are those who expect the contradiction between monetary union and fiscal autonomy to upend the single currency at some point, but then at the zone-wide level debt to GDP peaked back in 2014 and again, this is hardly news.

Another recent source of concern over Europe was the banking system – or, to be more accurate, the solvency (or otherwise) of various European banks. Deutsche Bank caused consternation for a time, but then the German government has been cutting its debt burden since 2010 and if anyone can afford a major bailout, it is surely them. In any case, no bailout was necessary; DB shares have risen by more than 70% from their lows. Where restructuring has been needed, at Banca Monte dei Paschi di Siena, it has not been anything like sufficiently material to threaten the whole Continent. And where banks are daily dependent on emergency central bank facilities (Athens), this is, once again, not news. Their shares have been available for a handful of cents for years.

There is only one moving part that has shown real signs of weakness: the euro itself. This has fallen by 23% over the last three years. Its low against the dollar of $1.0388 back in December was the weakest level it had reached since the opening sessions of 2003. However, even this is not a credible sign of structural malaise. The currency has been much lower still in the past, hitting an all-time record of $0.8272 in late 2000. And while the ECB has been loosening policy in a range of ways, the Fed has embarked on a tightening cycle. Like the Italian credit spread the euro’s weakness can be interpreted as nothing more than a rational response to changed circumstances.

In other words, there appears to be nothing to see here. Political risk remains, yet seems not to be priced in.

This blog argued at the time that the support of the stronger eurozone economies for the weaker ones in 2010 answered a key existential question for the single currency. In theory, (a) there is no debt mutualisation in Euroland and (b) its members enjoy complete fiscal autonomy. In practice, when the going got tough, there was a very EU-esque “pooling of sovereignty” over debt via the European Financial Stability Facility / European Stability Mechanism. And bailout nations have had to comply with the rules of their emergency lending regimes.

There is another factor to consider, however, and that is Brexit. Attention in the UK tends quite understandably to focus on the consequences for ourselves, but there will also be consequences for the rest of the EU.

A harsh deal, or no deal, with Britain, and some businesses and industries will suffer. It was interesting that a senior executive at global food giant Mars Incorporated spoke about this a few days ago. Agriculture has managed to remain immune to the GATT / WTO decades of compromise on tariff reduction and quota control. Look at the WTO tariff tables and food, drink and tobacco are about the last redoubts of punitive import duties. From the BBC last Friday:

Fiona Dawson . . . said the absence of a deal with EU member states would see tariffs of up to 30% for the industry.

Speaking at the American Chamber of Commerce to the EU, she warned this would “threaten [the] supply chain and the jobs that come with it.”

“The absence of hard borders (in Europe) with all their attendant tariff, customs and non-tariff barriers allows for this integrated supply chain, which helps to keep costs down,” she said. “The return of those barriers would create higher costs which would threaten that supply chain and the jobs that come with it.” Ms Dawson said those costs could not be absorbed by confectionery companies, meaning consumers would have to pay more for their products . . .

Companies in the automotive and the financial sector have been the focus since the vote, according to Ms Dawson. But with food and drink the largest manufacturing sector in the UK, accounting for 16% of turnover, she said she wanted a new focus, and called for EU leaders to look at the bigger picture when negotiating. “There can be no economic advantage either side restricting trade with a large market situated on its doorstep,” she said.

“In simple terms, if the UK and the EU fail to agree on a new preferential deal, it will be to the detriment of all. Other member states should remember this is not about ‘punishing’ Britain for her decision to withdraw, but rather about finding the best solution for European and UK workers and consumers.

The emphasis at the end there is my own. And it is not just manufacturers who could, in theory, be walloped in this sector. Pity the poor farmers, logistics firms, supermarkets, restaurauteurs who would be crippled by the reimposition of border controls. (The EU’s “Border Inspection Post” system is, to put it mildly, neither rapid nor straightforward. Our own government has helpfully printed the details here.)

A no-deal Brexit, then, would entail potentially disastrous consequences for certain sectors.

This is not priced in. Does this mean that Britain will leave with many of the customs union’s features still in place? That we will, as Ms Dawson clearly desires, not be “punished”?

That is a possibility but it could spell the end of the EU, which appears not to be priced in either . . .

Just imagine. An economically benign Brexit would mean Britain securing a free trade deal that goes way beyond current WTO rules in the key areas of agriculture and fish, while maintaining border control-free access in these and related markets. At the same time we would be regaining complete control of our immigration, lawmaking and judicial processes – and saving part, if not all, of our contributions to the Brussels budget.

A core of true believers – Luxembourg, for instance – might want to stay in the bloc and accelerate the move towards political federation. But surely, plenty of other “member states” would want to follow such an example.

This year’s electoral cycles across the Channel may not threaten the euro, then. But Brexit seemingly has to threaten either some sector-specific but nonetheless material economic damage, or the continued existence, to some extent, of the EU. If a eurozone country wanted to leave the EU, it could in theory continue to use the single currency. But might financial market pricing, by that point, not have begun to look rather different . . ?

So much of the focus has been on Article 50 and the possibility that Brexit might be somehow derailed that thinking has yet to turn to this apparently logical conclusion. The question for investors is: what are the euro assets which are so compellingly attractive that one should wait until it does so?

14/03/2017 at 6:43 pm

Fire!

It is almost four months since Donald Trump won the US presidency but the shockwaves from his victory still reverberate. Coverage of supposed scandals, protests and presidential Tweets have continued to abound. Those who were delighted by November’s result, so polling suggests, remain so; those who reverted to hysteria continue their frenzy. Amid all the drama it is perhaps an odd expression to pick, but: Amercian politics has found an equilibrium.

Assumptions about the US economy have also become entrenched. It has long been obvious that a Trump presidency would be inflationary and the bond market reacted to the result accordingly: on the day of the election the ten-year Treasury yielded 1.85%, but by the end of November had hit 2.4%. It has stayed firmly in a range of 2.3%-2.6% ever since. The dollar likewise strengthened sharply after the election and has comfortably held its range against other major currencies. Eurodollar rates moved from pricing in two Fed hikes by the end of this year to pricing in three, and have held that view right up to the present.

While American politics has become energized, however – by the ambition of the new incumbent and the vitriol of his critics – financial opinion has become complacent. While markets and observers have in many cases settled on a static view, the ground since the election has shifted. Look away from fixed income and the currency, and towards risk markets and the data and this is easily clarified.

The US stock market found a secure range after the election, but only for a time. Last month it smashed it. From meandering around the 2,250 level throughout December-January the S&P 500 broke 2,300 in early February and 2,400 less than a month later. The index has now risen by more than 6% since the beginning of the year, comfortably beating other major bourses around the world.

It is not just the stock market that is optimistic, and setting new records. Consumer confidence hit a new high this week, eclipsing the levels reached prior to the credit crunch and threatening to visit territory last occupied during the go-go boom of the later 1990s. This is of a picture with earlier data on retail sales, showing the fastest annual rate of growth (+5.6% in January) since the early stages of the recovery in 2010-11, and buoyant numbers on existing home sales, which have reached a pitch last seen before the credit crunch in 2007. (Bear in mind that mortgage costs have actually been increasing at the same time, pushed up by higher long-term interest rates.)

Industrial indicators have strengthened too. Purchasing manager activity surveys out this week for both manufacturing and service sectors continued their sharp rise. The rotary rig count released last Friday showed that US oil production has continued to recover even though the price of crude has been no better than stable since December. Again, this is consistent with earlier data such as the NFIB survey of smaller firms and the “Philly Fed” report on the national outlook for business, both of which have been rocketing up, in the latter case to a 33-year high.

If one tries very hard to find them there are more equivocal releases. Monthly variability on jobs data, for instance, has been weak in some instances; then again, the broader context is one of effectively full employment, and short-term moves from 4.6% to 4.7% in the headline jobless rate are neither here nor there.

More seriously, while vague expectations of higher inflation have been priced in since November, underlying price indicators have started to move. Import price inflation, which had been negative since mid-2014, flattened out to +0.2% in election month and has since hit +3.7% (year to January). The price components of PMI surveys have also risen. Public statements from various Fed presidents and board governors has been preparing markets for a hike this month which leaves ample scope for those three rises this year, and more.

Put all the pieces together and it seems more and more obvious that there is no longer any broad backdrop of bad economic news, whatever one’s views of American politics. The credit crunch hit housing and the banking sector – all recovered. The oil price collapse hit the shale business – recovering nicely. A strong dollar dampened activity – that effect has fallen away.

On the other hand, sentiment and output indicators are on the up. The economy is at full employment. The core rate of CPI inflation has already been running above 2% for more than a year and in January posted its fastest monthly increase since 2006.

The US economy is catching fire. This will make a novel change from the sclerotic pace of recovery we have seen there to date. The question is: are markets properly discounting the eventual need to put the fire out?

03/03/2017 at 5:24 pm

Every Cloud . . .

The gilt market has staged a modest rally over the past couple of weeks though this should not fool us: there remains a good deal of attention focused on the inflationary outlook. Data for January, out earlier this month, was entirely unsurprising on this front. Input prices were up by more than 20%, eclipsing the prior peak of +17.6% reached in 2011, CPI is almost back on target and RPI ex mortgage interest payments came in just shy of +3%. The ONS quite predictably singled out currency weakness and fuel costs as the main culprits.

But the weak currency is not all bad news as we were reminded with the publication of GDP figures for the UK this Wednesday. Export growth of over 4% on the final quarter of last year was celebrated by some of those on the Leave side of the Brexit vote; though there is considerable quarter-to-quarter volatility in this data it was, undeniably, positive.

In fact there was already evidence of this effect from industrial production numbers out for December a couple of weeks ago. The yearly IP increase of +4.3% was the highest posted since the country’s recovery from the Great Recession and smashed expectations. Looking beyond exports too there was good news from the personal consumption component of GDP, which hit a solid +0.7% for Q4 while the Q3 estimate was revised up to +0.9%, suggesting a Brexit bounce. Business investment – as highlighted by the Remain side – flattened off into the end of the year but the picture is unequivocally of an economy ticking along rather nicely and enjoying a boost from its currency-enhanced competitiveness.

Returning to the theme of inflation, there has been some coverage of the oncoming squeeze on real wages and that is a perfectly valid concern. However this cloud may not be quite as dark as all that. As of December both headline RPI and average earnings growth hit +2.6%, meaning that real wage growth was zero – not a supportive situation for the economy. But throughout the period from 2010-2014 real wage growth was negative, on several occasions falling below -3% (and hitting a nadir of -3.8% at one point). Over the same horizon annual growth in household consumption averaged 1% and broad GDP growth +2%. Today, RPI inflation would have to hit 5.6% plus to achieve the same depressive force on real wages. That is a risk and by coincidence exactly the peak reached in the autumn of 2011, but we are not there yet.

Some have turned to the second consecutive month of contracting retail sales as evidence of consumer weakness but again the short-term data here is incredibly volatile. The six month running mean for annual growth in retail sales was +4.9% as of January, a little less than double the average rate over the past 20 years. Might there be a sustained reversal in consumer behaviour? It’s possible – but the GfK consumer confidence survey actually rose for two consecutive months into January.

For investors, the big picture is therefore as follows. The UK economy is growing at a healthy rate, “despite Brexit”. This is in part due to the weak pound; a currency depreciation is a straightforward monetary expansion and this seems to have been forgotten. There is presently a risk that rising inflation will take some of the edge off the growth rate but on the basis of current data and recent history we ought not to be too anxious. Markets in some respects do appear complacent about the risk of more seriously damaging price behaviour – but that is another story.

24/02/2017 at 5:32 pm

Older Posts


Recent Posts