Archive for March, 2011

Thrilling Budget Showdown

No, not the one between Mr Osborne and Mr Balls on Wednesday – the one between Portuguese prime minister Jose Socrates and the country’s opposition parties the same day. Portugal’s government saw its latest package of austerity measures defeated, Socrates resigned, the country is heading for an election and (so the consensus believes) a Greco-Irish bailout courtesy of the EU / IMF.

The consensus view finds support in recent bond market movements – specifically in the widening of the spread of Portuguese government debt over that of Germany. (Similar moves preceded the Irish bailout last November.) In fact, ten year Portuguese paper yields 4.3% more than Germany’s at time of writing – this remains well short of Greece and Ireland, at +9.1% and +6.4%, but well clear of Spain and Italy too (+1.9% and +1.5%).

Furthermore, Mr Socrates’ likely successor as Portugese PM, Pedro Passos Coelho, has been a bit cagey about his commitment to fiscal discipline and the avoidance of bailouts.

Before we treat the bailout as a foregone conclusion, however, let’s look at the numbers.

Portugal’s budget deficit on a Maastricht basis peaked in calendar ’09 at 9.3% – bigger than the eurozone average but much lower than equivalent figures for Greece, Ireland and Spain. The deficit for 2010 is estimated at 7%, and on the proposed measures was targeted to reach 4.6% this year. In the Greek and Irish cases, a large part of the problem was that deficits into 2010 were continuing to widen.

Taking a thoroughly non-random example to compare: the UK’s 2009 fiscal deficit on the same basis came in at 11.4%, is estimated at 9.8% for last year and forecast to come in at 7.9% in 2011.

Now Portugal has other problems. Its growth rate for the last ten years averaged a miserly 0.7% p.a., and unemployment, though stable, is rather high for comfort at some 11%. But it is clearly in a stronger fiscal position than the countries which have already been bailed out.

One view of Portugal’s vote this week is that it was about politics rather than economics. That Mr Coelho and his supporters are happy to continue on the path of deficit reduction – albeit by different means – but that they also want to overhaul a sclerotic economy viewed as increasingly corrupt. They must also understand that a bailout would come with austerity measures attached that would be harsher than those they have just voted down.

Ultimately, as one senior European politician put it, “Portugal won’t be left alone by the other Europeans.” We have already noted that such an attitude augurs well for the euro’s long term survival. But evidence that the eurozone’s less responsible borrowers are capable of getting their houses in order independently would bode even better.

25/03/2011 at 1:49 pm

Tragic Echo

Markets this week were inevitably dominated by the unfolding crisis in Japan. Though the worst of the panic seems to be over for now, with equity and commodity markets off their lows, there is still much uncertainty over the likely impact of the disaster on the Japanese and wider global economy.

One of the thoughts we shared with our clients on the situation this week was that there were parallels with the earthquake and tsunami suffered by Indonesia in 2004:

Rather uncannily, [the 2004 disaster] also occurred as the world was exiting a period of subdued growth in the wake of the TMT collapse. There were similar, terrible pictures of natural devastation. Over 200,000 people are estimated to have lost their lives – one measure by which the ’04 event was even more devastating than last Friday’s (another being the magnitude of the quake itself).

In ’04 the epicentre of the quake was just off the coast of Indonesia, which accordingly bore the brunt of the losses. Analysis of the economic impact on that country, however, throws up some surprising facts:

  • Despite the devastation of coastal communities (and related activities such as fishing), there was no interruption to Indonesian GDP growth at the aggregate level, which came in 6% in real terms for Q1 2005 and 5.9% higher for Q2.
  • The effect on unemployment was similarly muted, with the rate increasing by about 1% (to 11.2%) by October 2005 and falling back to 10.3% by the following July.
  • For local markets the biggest drama was the currency, with the rupiah off 15% against the USD at its nadir in H2 2005. This fed through to CPI – though both the currency and inflationary effects settled down in 2006.
  • While the local bond market suffered, reflecting the spike in inflation, the equity market strengthened both during Q1 ’05 and across the year as a whole, in part a response to returning strength in world markets.

This is all the more remarkable when we consider that Indonesia suffered another huge earthquake (magnitude 8.6) on 28 March 2005.

Thankfully, while the human cost of the last few days has been terrible and sobering challenges for the Japanese remain, it now seems as if their economy may indeed emerge relatively unscathed.

With events in the Arab countries to consider as well, 2011 has got off to a convulsive start. Let us hope that Japan and the rest of the world may now look forward to calmer times ahead.

18/03/2011 at 3:52 pm

Of Mortgages And King

The economic data released for the UK so far this month illustrates an important dilemma for British monetary policy. On the one hand, purchasing manager surveys for the manufacturing and construction sectors showed increasing strength, equivalent data for the service sector confirmed that it is still growing, industrial production posted its strongest annual gain since the recovery of the early 1990s and price rises at the factory gate reached new post-recessionary highs. On the other hand, the Nationwide, Halifax and Hometrack house price measures all saw declines on the twelve months to February, mortgage market data still looked relatively weak and so did growth in unsecured lending to consumers. It looks all too clear that any increase in the base rate would exert further downward pressure on an already vulnerable housing market, knocking confidence and halting the UK’s recovery in its tracks.

Appearances, however, are deceptive. Yes, mortgage approvals are running at about half the average monthly rate of the last ten years (45,000 plays 90,000), but they are well off the low of 26,000 reached in November 2008 – and does the approval of 45,000 home loans each month really indicate a mortgage market that is – in any absolute sense – broken?

More important, perhaps, is the fact that bank lending rates and the theoretical margins available on mortgage lending have returned to normal levels. Bank of England data shows average variable rates on mortgages running at about 4%, pretty much where they have been for the last couple of years or so. Reducing this by 3-month LIBOR plus the spread at which European banks can borrow (as measured by the credit default swap market) gives a figure of about 1.5% – exactly where it was in March 2007, just as the subprime crisis was beginning to break. In other words, the average mortgage lender should be able to generate similar profits to the pre-crunch market, when over 100,000 UK mortgages were being approved each month. The dislocations in the interbank and credit markets which prevented this from happening even when SVRs were much higher are now ancient history.

Leaving the technical stuff aside, are lower house prices really such a bad thing anyway? Do we want to return to the era of 125% mortgages, debt-powered buy-to-let empires and ubiquitous small-scale “property development”? Or would we rather see genuine value-added economic growth, more affordable housing for first time buyers and strengthening consumer balance sheets – while accepting a limited amount of pain in the form of negative equity for the unluckiest / most reckless borrowers as a price worth paying to stop everyone suffering the consequences of runaway inflation?

It might even turn out in an ideal world that the prospect of higher UK rates attracted investors to the pound, mitigating the worst effects of imported commodity price inflation without actually having to tighten policy all that much.

The banking system is not the basket case it was a few years ago, the mortgage market is arguably less broken than it was in the heyday of Northern Rock, and another 0.25% or 0.5% on the cost of borrowing is most unlikely to kill everything off again. The worst of the emergency is over, and prices are rising rather sharply now. It is time for Mervyn King to recognise all this and act accordingly.

11/03/2011 at 3:11 pm

Words, Words, Words

Jean-Claude Trichet, ECB President, set markets on fire yesterday. Interest rates didn’t change, but he confirmed that the use of the phrase “strong vigilance” on inflation in the ECB’s policy report indicates that a rise next month is now “possible”. Though definitely not “certain”. And it would not indicate a “series” of increases.

After a few minutes of these open mouth operations the euro rallied to a new four-month high against the dollar, the two year German government bond yield rose to a new post-recession high and bond markets in general were inspired to give up a fair chunk of their recent Gaddafi premium.

Monsieur Trichet paid particular attention to the spike in energy prices, noting that the ECB would act to counter any sign that it was filtering through into wage negotiations (so-called “second-round effects”). In some sophisticated corners this will not go down well. Doesn’t Trichet know that rising oil prices, rather than an inflationary menace, are a “tax on growth” that will reduce demand and end up containing inflation?

Now “tax on growth” is a nicely turned phrase. Let’s have a look at what it means.

First off, energy is a basic need. People and businesses need the electricity provided by oil- and gas-fired power stations; they need to keep cars and lorries on the road. They will pay for this energy no matter how much it happens to cost, so long as they can still afford it (“price inelastic demand” in the textbook jargon).

So, when energy prices go up, the amount of income consumers have to spend on other things must go down. Likewise, absorbing the shock of higher energy costs reduces business profits. Non-energy demand falls, growth falls and inflation is not an issue.

Except …

Quite a lot of businesses, and the consumers that they employ, stand to benefit from higher energy costs. Oil and gas producers comprise some 16% of UK stock market capitalization and employ about 300,000 people. So the “tax” parallel isn’t quite right. (This is especially true when you broaden the net of potential beneficiaries to include those who supply this sector, such as engineering firms.)

In addition, not all the impact of higher energy costs is absorbed by businesses – they pass some on in the form of higher prices. So the oil “tax” payable by the business sector begins to look like VAT rather than corporation tax in that it is levied ultimately on consumers.

From the consumer’s point of view, then, they end up paying more for petrol and electricity, and more for goods and services supplied by firms who also have to pay for those things. Which, to a greater or lesser extent, is all of them.

Looking at the argument from the other end again, aren’t higher food prices also a “tax on growth” by the same token? And higher metals prices?

In fact, don’t we already have a better word than “tax” for this demand-dampening mechanism that benefits certain portions of an economy while prices rise at the whole-economy level? Isn’t it spelt: I, N, F, L, A …

In other words, high oil prices are only a “tax on growth” in the sense that inflation is a tax on growth, and more expensive oil is a direct, indirect and second-round source of inflation.

Which is exactly what Trichet was on about.

04/03/2011 at 11:44 am 1 comment


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