Archive for November, 2015

Devils In The Detail

So another Autumn Statement has been and gone. As is now traditional the Chancellor tried to lift the mood by repeating some of the more substantial announcements made in his previous set-piece appearances. But there were changes too. Most significant among these was the U-turn on tax credit reform, which would have hit the incomes of low earners hard (for those who have not yet seen the headlines the BBC’s “key points” summary is as good a place to look as any). It was widely and accurately reported that this had become affordable due to improvements in the OBR’s forecasts for the British economy, delivering £27bn of extra pie in the fiscal sky between now and the end of the current parliament.

As usual, there was a gap between spin and reality on the matter. In his speech to the Commons, Mr Osborne attributed his windfall as follows:

“This improvement in the nation’s finances is due to two things. First, the OBR expects tax receipts to be stronger. A sign that our economy is healthier than thought. Second, debt interest payments are expected to be lower – reflecting the further fall in the rates we pay to our creditors.”

Higher tax receipts can indeed signify economic growth. The OBR’s growth forecasts, however, haven’t changed much. In a rather lower-profile address given by Robert Chote, OBR Chairman, he gave the following additional information on this topic:

“[T]he underlying fiscal position looks somewhat stronger over the medium term than it did in July, before you take into account the Autumn Statement measures. This in part reflects the recent strength of income tax and corporation tax. But it also reflects better modelling of National Insurance Contributions and a correction to the modelling of VAT deductions.”


In fact, looking at the data presented at Mr Chote’s press conference, the impact of these modelling changes tots up to +£12.6bn over the five fiscal years to 2019-20.

Now let’s look at the rates demanded by those creditors. Here is how the forecasts for the UK’s central government gross debt interest have changed since the summer:

Summer Budget Autumn Statement
Fiscal Year £bn £bn
2015-16 46.7 46.5
2016-17 51.1 51.0
2017-18 55.9 54.2
2018-19 57.2 55.7
2019-20 58.5 57.3
TOTAL 269.4 264.7


£4.7bn out of such large totals is not a huge amount (less than 2% in fact), but in policy terms it is material, equivalent to the entire cost between now and 2020 of increasing the personal allowance to £11,000, the single biggest giveaway of the last Budget.

Underlying the relatively modest reduction in the projected cost of debt interest is a similarly modest reduction in projected gilt yields. The OBR data for these is scrambled between different documents for the Budget and Autumn Statement, which possibly explains why no media source appears to have covered it. But the point is that the average market interest rate assumption for the next five years has fallen all of 0.4% since July, from 2.7% to 2.3%. It is on such details that material elements of this country’s fiscal policy now have to be based.

Of course movements in gilt yields have not always been modest. And what ought to concern us is the extent to which they will impact the exchequer should they begin to rise again over coming quarters. Two short years ago – before cheap oil abolished inflation – the ten year gilt yield stood a full 1% higher at 2.8% as against 1.8% today. The Autumn Statement of 2013 put average interest rates for 2015-2019 at 3.8%. What would a forecast change of +100bp do the £4.7bn bonanza secured by a change of -40bp? A proportionate adjustment would wipe out £12bn at a stroke – exactly the amount of the extra spending on defence announced by the Prime Minister on Monday (to be spread over the next ten years.)

Look further back and the message is equally clear. The first half of 2011 was not exactly the cheeriest of times: Greece was collapsing, emergency monetary measures were in full swing and panic was pushing gold to record highs. Still the ten year gilt yielded more than 3.8% for much of the time. And in the years before the credit crunch began to bite the average was about 4.5%.

Neither is the cost of debt linked entirely to interest rates: there is inflation to consider as well. Of the UK’s £1.5trn nominal value of outstanding debt, over £300bn nominal is index-linked to RPI. Since July the OBR’s RPI inflation assumption has been cut by 0.2%; the average for the next five years is down to 2.4% from 3.1% a year ago. And talking of inflation, the CPI measure – which now governs increases to pensions and other benefits – has also seen forecast falls since the summer. The OBR’s average for the next five years is 0.5% lower now than it was last year, 1.3% versus 1.8%.

But then again, who really is talking of inflation? Not the Chancellor. Neither the word nor the concept made a single appearance in his speech on Wednesday. Still, Mr Chote had something to say:

“[W]e still expect inflation to kick up over the coming year as favourable base effects drop out. We expect it to rise slightly more quickly than in July thanks to greater pressure from unit labour costs.”

Something to think about there, possibly.

In summary the Autumn Statement carried an element of political drama but the macroeconomic substance remained hidden away – when it was not being positively spun, that is. Mr Osborne seems to have a rare knack for making political capital from fiscal policy, rather like his predecessor Mr Brown. But the evolution of the country’s debt position and the official forecasts on which policy is based have relatively little to do with him and much more to do with interest rates (and inflation).

27/11/2015 at 4:59 pm

Black Gold

Many of the headlines this week have considered weakness in equity markets. Since last month’s rally stocks have certainly come off the boil: the FTSE 100 is down by more than 3% at the time of writing, the S&P 500 by a little over 2% and the Euro Stoxx 50 by about the same. There have been glimmers of light from the Far East and a handful of emerging markets but in general sentiment is about as gloomy as the London weather.

Amid the focus on stocks it has been easy to lose track of what oil has been up to: the near Brent crude future has fallen by 12% this month and at under $44 is within a dollar of its low for the year so far. Now the collapse in the price of crude was the most important financial development of 2014 and its effects are still being felt in all sorts of ways today. (A lot of the weakness in UK equity has been attributable to the >30% fall in the All Share Oil & Gas index since September last year – and still the sector comprises about 10% of the whole market.) So what are the drivers of the oil price? What are its prospects? And what are its key influences likely to be in future?

Starting with the basics, world demand for crude oil stands at 95m barrels per day (bpd) on Energy Intelligence Group estimates. Supply is a little over 98m bpd. Overall, demand has risen by about 1m bpd per year over the last ten years, and has correlated almost perfectly (r = 0.94) with the World Bank estimate for global GDP over the last twenty. Since 1995 there has been an average excess of supply over demand of 0.2m bpd and supply too correlates near-perfectly with economic activity. The six month average excess of supply, however, now stands at 2.4m bpd: this is the highest it has been for at least 20 years (and possibly since the early 1970s – comparable data is hard to find).

It is easy to pin down what has changed. Demand over the last 12 months has risen exactly in line with the trend established since the end of the Great Recession. Supply, on the other hand, has been more volatile. Total world production flattened off in 2013 before accelerating during the second half of last year. (Since last September the average rate of growth in supply has been 53% higher than the average over the last six years.)

It is again easy to pin down the underlying production dynamics. The shale revolution in the US hit the oil market with a vengeance in 2012: total crude production in the USA has risen from about 5.8m bpd at the beginning of that year to 9.8m bpd today. Initially the shale boom effect was offset by supply constrictions elsewhere – some deliberate (Saudi Arabia), some long term (North Sea), others the result of chaos (Libya). Since last year, however, Saudi policy in particular has shifted, and it is this which has pushed the supply / demand balance to its present extreme.

So much for history. What of the future?

Starting specifically with futures, the market is currently pricing in a steady rise in Brent crude to about $50 over the next 12 months. This is a little unusual; the normal pattern over the recent past has been for the market to be “backwardated”, i.e. to be pricing in falls (the 12-month gap has averaged -$0.31 so far this century). Notable exceptions include 2005-6, when oil was treading a well-entrenched upward path; the recovery of 2009-10 which saw similar upward movement in the spot price; and today.

Turning to the outlook for supply and demand, it is clear that the latter will be driven by global activity and this is expected to continue to increase – and indeed to do so at a faster rate next year. Supply is a knottier area on which to take a view. One moving part is policy in Saudi Arabia and this is rather enigmatic. (Over the last five years it has also been worth 2m bpd of production.) The expectation that shale production in the US would fall away dramatically has not been borne out, clouding the outlook for this new source of crude as well: the States was producing about 0.5m bpd more last month than at the beginning of the year. At the same time, countries have been taking advantage of low prices to build their strategic reserves, and shipping companies have seen tanker business boom as a result of the unexpectedly robust activity.

Look forward however and supply can be expected to grow further. The prospects for Iranian oil exports in the wake of this year’s diplomacy are well established: Iranian production is about 1m bpd below where it was a few years ago and the Persians are expecting to increase exports by about that amount in 2016. Half a decade later there may be even bigger news with the development of the Great Rift Valley and the Uganda-Kenya Crude Oil Pipeline allowing the nascent east African oil industry to join the export market.

Before leaving the brass tacks of supply and demand it is worth observing that China has nothing to do with any of this. On IEA numbers Chinese demand for crude has grown very steadily over the last five years from about 8.5m to 11m bpd, and this at a time when her rate of economic growth has fallen in real terms from 10% to 7% per year. Neither current oil demand numbers nor the shape of the futures curve suggest that existing or imminent growth declines in the Chinese economy are responsible for the fall in oil prices beyond the transmission mechanism of market sentiment.

China aside: given the supply outlook it is difficult to make a short term bull case for crude. And that brings us on to the consequences of cheap oil as observed this year and as are priced in for the year to come.

Firstly the negatives: there will be casualties. If you are an oil exporter or a production company the value of your asset has gone down materially – bad news. On the other hand, oil importers have been experiencing a stimulus. In descending order by net import volume the Top Ten importers are the eurozone, the USA, China, Japan, India, South Korea, Singapore, Taiwan, Turkey and the UK. Macroeconomically, then, cheap oil has been great news for the Far East and most of the developed world.

As this blog has long observed the effects of oil on inflation will be transient unless the price continues to fall indefinitely. So when it comes to monetary policy oil has exerted an influence but this is almost certain to dissipate soon into next year.

In conclusion, the scale of the collapse in the price of oil has caused a lot of pain but has also been, and will continue to be a major benefit for key areas of the world economy. Saudi politics have been more important than Chinese economics in steering the market’s fundamentals. Cheap oil has kept inflation off the radar for a year, but this effect will fade.

The death of oil has long been exaggerated and recent events have disguised its importance. There might well be further surprises to come. But understanding what has happened already, which is all we have for sure, can often be enough – especially when it is disguised or even misunderstood.


13/11/2015 at 5:31 pm

Reading The Runes

Yesterday, just before lunch, some information was released by the Bank of England about the timing of the UK’s first rate hike. As a result, the pound posted its biggest one day fall against the dollar since August’s ghoulish gurgitations, the FTSE 100 reversed its morning losses and gilt yields fell across the curve. We know that markets are hanging on to every scripted syllable out of central banks these days – and the Old Lady had clearly delivered some big, big news.

Rather unfortunately it was not clear from the coverage exactly what this was. The headlines were all over the place. “Bank of England signals rates can remain at lows until 2017”, declared the FT, echoed by the equally authoritative voices of The Economist“The Bank of England may not raise interest rates until 2017” – and the Daily Express (“Interest rates may not rise until 2017, hints Bank of England”). On the other hand the Daily Telegraph asserted that “Global growth risks likely to keep rates at record low well into 2016, BoE suggests”, a more hawkish position putting it in the same corner as The Guardian (“Bank of England to leave interest rates at 0.5% until well into next year”).

So what had happened? Had the Bank signalled, hinted or suggested? And was the substance of whichever denotation that it would hike next year, or the year after? A year is a long time in these uncertain markets, and it would be useful to know.

The headlines were inspired of course by the release of the unmissable quarterly that is the Bank of England’s Inflation Report. But what could explain such varied interpretations of exactly the same material?

Look below the headlines and there were suggestions, or perhaps signals of the answer. The Economist piece, characteristically, brimmed with patriotic vigour, noting that Britain’s economy was now so pathetically weak that it couldn’t even produce the laughably stunted amount of inflation necessary to warrant a single miserable rate rise. The FT referred to the forecast path of inflation. The Express covered the bases on both domestic growth and inflation, while noting the impact of weaker growth abroad in passing. Both the more hawkish papers touched on this ground too, but interestingly also gave space to the impact of low commodity prices and a seemingly contrarian view that the domestic UK economy remained resilient.

This blog does its own homework and usually reads the salient parts of the Bank’s Inflation Report, together with the accompanying and much shorter but (if anything) more instructive Conditioning assumptions, MPC key judgements, and indicative projections data. And it is obvious from the latter that future assumptions about energy prices are much lower now than they were back in the summer – understandably so: as the small print tells us, they are based on futures prices and these have fallen. The Bank’s new prices for gas and oil in 2016 are respectively lower by nine and ten percent. As the s.p. further helpfully explains, these numbers “are used as conditioning assumptions for the MPC’s projections for CPI inflation, GDP growth and the unemployment rate.”

Given that these energy price effects will prove more or less transitory – even assuming they do not reverse over the Bank’s two-year forecast horizon – it is perhaps foolish to read too much into them. It is certainly a mistake to confuse them with weakness in the domestic economy. As Governor Carney himself noted in an afternoon interview with Bloomberg Television:

“My personal view is it is important that we look at [core CPI] particularly because of this imported disinflation, it shows up through core inflation,” he said. “What we want to avoid is to have cost pressures build up too much domestically to the extent that once these foreign factors ultimately pass through the economy, we’re overshooting that inflation target because of domestic strength.”

And the headline of this piece? “Mark Carney: Prudent to Expect U.K. Rate Rise in 2016”.

06/11/2015 at 11:33 am

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