Archive for December, 2014

Themes for 2015

With Christmas almost here and the New Year a little over a week away it is the traditional time for market observers to dust off their crystal balls and treat everyone to their insights on what will happen once that financially significant uptick in the Gregorian calendar has occurred. Accordingly, here are a few themes which this blog believes will be important in 2015.

Debt. Despite a return to the bond market this year, Greece has threatened to become a target of scrutiny again – but amid the wreckage of the credit crunch and Great Recession is far from the only show in town. The collapse in the price of oil this quarter is in part a reflection of the power of Saudi Arabia, with its huge balance sheet reserves, to weather it, as readers will know. On the other hand, those countries with big sovereign debt positions – most of us in the developed world – are hobbled by it.

The US for instance has $12.4trn of treasury instruments outstanding. These are already costing over $400bn in interest each year, a material amount for the budget of even the world’s largest economy. Of that $12.4trn, $4.9trn – almost 40% – matures between now and the end of 2016.

Interest rates. Emergency monetary conditions have already been pared back in many of the countries hardest hit by the events of the last seven years. In the US, the UK and elsewhere, zero or near-zero policy rates are now expected to rise again in the second half of 2015.

With interest payments already high for so many economies, rising rates are an issue, particularly for those whose debt positions are concentrated at the very short end of the yield curve. The burden of debt interest in these cases – already a hindrance to growth via austerity measures and tax increases – will get heavier.

Inflation. With huge capacity overhangs, massive labour market weakness and weak commodity prices, this has not been an issue for most major economies in recent years. However, labour markets in particular are now much healthier than they were even a year ago, and there have been tentative signs already that this has come to bear on price behaviour.

The move down in oil will once more serve to keep inflation in bed for some time, assuming that it does not reverse in the near term. But as economies continue to recover, internal rather than imported price pressures are bound to rise. Markets are not remotely concerned about inflation at the moment. Should this change there will be implications for interest rates across the yield curve and potentially for risk markets too.

Market selection. Risk on versus risk off continues to be an important general theme for markets which remain nervous. But the last couple of years have seen significant divergence between different market types and regions even within that context. In 2014 to date, the US has topped the equity charts for the developed world (+12%), while Asian markets, most notably China (+48%) and India (+31%), have leapt ahead of their emerging peers. More broadly, developed and emerging market equity indices have out- and under-performed each other at various times as the year has gone on.

There is every reason to expect this to continue over next year. As always, sentiment is unpredictable and one cannot plan for black swan events. But bearing in mind the dynamics for growth, the valuation picture and the possible importance of the themes we have already looked at, there are some interesting considerations for portfolios in this area on a fundamental view.

There are of course other questions to think about and apparent anomalies to ponder. These themes should be seen as undercurrents rather than any kind of directional forecast. Market noise aside, however, one or two of them could deliver some material surprises this coming year – pleasant or otherwise.

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22/12/2014 at 4:59 pm

Political Economy

Yesterday’s Autumn Statement by UK Chancellor of the Exchequer George Osborne was as political as expected. Impressively – and in a break with recent tradition – some of it was not leaked in advance. And beyond the Stamp Duty Mansion Tax, road building in marginal constituencies, wealth fund for hypothetical shale gas production in some long-distant future and customary crowing about how wonderfully the British economy is doing, there were a few items of actual economic interest. (There is a good summary of all the key points from the BBC here.)

It’s great that growth for this year is expected to come in at 3%, up from 2.7% in March, but as has been widely noted, the level of debt will be higher than forecast in spite of this. It is worth quoting the Office for Budget Responsibility directly (all documents here):

[W]age and productivity growth have once again disappointed, while national income and spending have outperformed most in those areas that yield least tax revenue … For these and other reasons, this year has seen a sharp fall in the amount of tax raised for every pound of measured economic activity. As a result, despite strong economic growth, the budget deficit is expected to fall by only £6.3 billion this year to £91.3 billion, around half the decline we expected in March. That would be the second smallest year-on-year reduction since its peak in 2009-10, despite this being the strongest year for GDP growth.

Hmm. Wage growth has indeed been disappointing. As regular readers will know, UK wages have been falling pretty steadily in real terms since the Great Recession. This has been due to both sluggish growth in absolute terms, and – if you have been the Bank of England over the period – completely surprisingly high inflation. In fact, adjusting for RPI, average earnings are back down where they were in the summer of 2000. Putting this another way, British pay packets have not grown in real terms so far this century.

Part of the reason for this is that inflation has been pushed up by increases in VAT, necessary because of the vast level of government borrowing. Even in nominal terms, though, wage growth has averaged a measly 1.5% per year over the last half decade. Why so? Well, public sector wage growth has been capped at 1% for some time, a necessity arising from the vast level of government borrowing. Wages in the manufacturing sector have also been squeezed, which might be connected to the pace of demographic change in the recent past (the gap between real GDP growth and real growth in GDP per capita having risen to 0.8% over the last ten years, above even the high caused by the post war baby boom). And some higher-end pay, in areas of financial services for instance, has suffered too.

In other words, the higher taxes and lower wages caused in large part by the desperate state of the public finances have themselves contributed to a disappointing outturn for the public finances.

Lest one might think that, to coin a phrase, there is an alternative, remember this: the central government debt interest burden is projected to rise to £54bn this fiscal year and to £77bn by 2018/19, the year in which the government’s books might finally balance. Even this year the payments will be more than twice the total current budget for defence. Viewed sensibly, Britain’s debt is already out of control. Worsen the debt burden from here and it could end up entailing default.

This sounds a bit gloomy, because it is. However, was there anything in the statement to give encouragement?

In the context of sovereign debt, the only real positive is economic growth. So it is unfortunate that the anti-bank and anti-wealth elements of yesterday’s announcement will do nothing to stop London’s slide down the rankings of global financial centres in future years. Only a couple of weeks ago there was a survey out showing that New York’s lead over London as a good place for financial sector business had extended (London used to come top of these lists). Bits and bobs of capital spending were announced which will have some positive effects in the relevant areas over the medium term, but growth does not generally benefit from increased regulation of and taxes on business.

The UK is clawing its way slowly towards a balanced budget, having already amassed a punitively expensive burden of debt. Budgets and Autumn Statements / Pre-Budget Reports have been overwhelmingly dominated by political gimmickry for at least the last ten years. It is difficult now to remember budget speeches in which pound note figures for spending and receipts connected to policy changes actually got a mention (standard practice until the arrival of a Mr Brown in 1997). Our Chancellors have little leeway nowadays, but yesterday’s little attacks on banking and The Rich were fiscally unnecessary and potentially damaging. (Listed banks in the UK employ about 700,000 people, over 2% of the nation’s workforce, and that is already down from almost 900,000 in 2007.) Britain’s economic policy remains primarily a vehicle for electoral showmanship, and this is not encouraging.

04/12/2014 at 6:12 pm


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