Thoughts through the cycle: W1 December ’20

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The UK economy – taking stock after Rishi’s fire-side chat

  • If one were to create an all-time list of examples of economic self-immolation, then Easter Island would definitely be a contender for top spot. The islanders cut down all the trees to transport stone monoliths to prominent positions on the coastline. As a result of deforestation, the top soil blew away and the population starved. Because there were no trees, they couldn’t make boats so they were stuck there. When Easter Island as it became known was ‘discovered’ in the early eighteenth century, the population had dwindled from the thousands to mere hundreds.
  • In terms of economic adventurism, Scotland’s Darien scheme (an attempt in the late 1690s to establish a ‘New Caledonia’ colony in the Americas) gets an honourable mention. It is estimated that as much as a quarter of the national wealth was invested in the project. Unluckily for the Scots, the malarial swamps of the Isthmus of Panama proved a disastrous location for a trading post, and the investment soured. These losses, along with the poor harvests and a dearth resulting from a cold period known as the ‘mini ice-age’ led to near economic collapse, and eventually a forced union with England in 1707. Should have built a canal, mate.
  • To listen to Bank of England Governor Andrew Bailey in his speech before the Parliamentary Treasury Select Committee on the 23rd November, one would think Brexit is a shoo-in for a podium place in the economic-catastrophe hall of fame to rank with the examples mentioned above. Apparently, the risks of a no-deal are much worse than the fall-out from the pandemic. That is really saying something. What Mr Bailey in fact said is as follows:

“I think the long-term effect would be larger than the long-term effect of Covid. The models would suggest that the effects of a WTO no-deal trade agreement are longer term. The reason for that is that it takes a lot longer period of time for the real economy to adjust.”

  • Mr Bailey did add though that, “Covid obviously has a much bigger impact at the moment, in the short run.” His colleague on the Monetary Policy Committee (MPC) Silvana Tenreyro chipped in with a mixed metaphor for the ages, “The scarring effects are not written in stone, and we should avoid them as far as we can,”. Not only is this gibberish, but if one can extract any sense at all from this statement, it appears to be a rather bland claim that we’ll definitely avoid the worst of the things we can’t control even though we don’t know what the future holds.
  • Private Eye nailed the ‘elite’ view of Brexit way back in 2016 as can be seen from its front cover from February 2016 – a horror so diabolical that only the crazed mind of medieval painter Hieronymus Bosch could do it justice.
  • Idle speculation about the relative awfulness of the pandemic and Brexit can fortunately be set aside for a moment as Chancellor of the Exchequer Rishi Sunak’s spending review on the 23rd November provided some actual facts for us to assess. Even in the age of the magic money tree, the UK Treasury still seems to be able to conjure up some residual air of fiscal prudence, and the media loves portraying Rishi as struggling to keep a reign on the nation’s finances despite Boris’s buffoonery and spendthrift inclinations. Rishi bought us all lunch in the summer and that goes a long way too.
  • Looking at the figures from the Office of Budget Responsibility (OBR), it’s a little difficult to contemplate how bad no-deal Brexit will be if it’s going to be worse for the public finances than the events experienced so far in 2020. GDP for the year will fall by 11.3%, a partial recovery from the 20% collapse in Q2 which took GDP back to the level of 2000. The deficit will be around £394bn, or 20% of GDP, and includes extra borrowing of £280bn as well as fall in tax receipts of £55bn. As a result, the national debt will rise to 105% of GDP.
  • GDP growth for 2021 will be 5.5%, and 6.6% for 2022 with the economy back to its pre-Covid-19 size in Q4 of that year. Unemployment is supposed to peak at 7.5%, although most of the furlough figures are excluded from this number. It is unclear how the national debt will be reduced, but that is not a consideration either for politicians or for the Bank of England, as they are concerned only with affordability, and that means suppressing interest rates to zero or lower so the cost of servicing the debt remains low.
  • The problem with this approach (ignoring the stock effect of debt and focusing only on the flow effect) is that any putative rise in interest rates, say from a recovery driving real rates higher or inflation driving nominal rates higher, would cause a funding crisis to emerge almost immediately. This is a situation where the greatest risk would now actually result from a robust recovery. Success creates failure due to the massive stock of debt. This is not a problem for Britain alone – the essence of ‘Japanification’ is that high levels of debt stifle the recovery due to this affordability issue, so the economy experiences sub-par growth and can never really take off, like an overburdened aeroplane on a very short runway.
  • We learned too from the Chancellor that the much lauded ‘eat-out-to-help-out’ scheme went significantly over budget, with the £894m figure quoted being some 70% more than expected. This may have been a lifeline to the hospitality industry in the summer, but with the UK emerging on the 2nd December to almost-pervasive Tier 2 and Tier 3 lockdowns, the risk that many pubs and restaurants go under has to be rising incrementally. This shows that much of the emergency spending has been solely on consumption, and that leaves very little to show aside from a slightly larger waist-band. When one is considering the public finances, not only does the stock of debt matter in this context, but one has to assume that there may well be higher structural unemployment and lower productivity as a result. This is before the ‘build back better’ and green revolution is accounted for.
  • Mr Sunak said in his speech that the economic crisis is only just starting, and this seems a fair assessment given the data mentioned above. The market has been amazingly sanguine about all of this so far. The pound is basically flat against the dollar on the year, and the gilt curve below (the green line is the current curve, last year’s equivalent is in yellow) shows the Bank of England quantitative easing (QE) suppressing nominal rates around or just above zero all the way out to the 10yr point. With QE unlikely ever to end, the market just shrugs at deficits and allows the stock of debt to tick up.

Source: Bloomberg, 27th November 2020

  • Modern Monetary Theory holds that a country which has monetary sovereignty (i.e. prints its own money) should never default, and this allows any amount of government spending when it is deemed necessary. Money can simply be printed or created to pay the bills. This is fine for the public sector, but for the private sector, the rules are a little different. One of the things which is going on in the background during 2020 is the payment holiday phenomenon. This is not a case of debt being written off but debt servicing merely being postponed and therefore accruing larger, future obligations.
  • The OBR GDP forecasts of returning to a pre-Covid-19 level in late 2022 bely a feeble recovery entirely disconnected with the summer chat of V-shapes and the like. The massive increase in the stock of debt and the ensuing servicing burden almost makes a slow recovery a certainty. While the living wage has been increased by the Chancellor to £8.91, there has also been a freeze on public sector pay outside the National Health Service. With food-price inflation appearing, bills and debts stacking up and wages not necessarily bouncing back, the vigour of the demand-side of the economy has to be called into question, especially with the government’s ongoing willingness to plunge the country back into lockdowns.
  • Ground zero for debt in the household sector is of course the sub-prime sector. Amigo lends to those with low credit ratings but who can secure a guarantor for their loan. Looking at Amigo’s recent half-year results, the severity of the stress in the poorer parts of the economy becomes abundantly clear. The company reported a half-year loss of £58.1m (vs. £35.8m profit in the prior year), with revenues down a third as new lending has largely been suspended apart from loans for key workers. Of the company’s 176,000 borrowers, 55,000 took advantage of the payment-holiday scheme earlier in the year, and 22,000 are still ‘on holiday’. The company warned of ‘material uncertainty’ over its future.
  • One cannot and should not infer from a company like Amigo any broader conclusions about the issue of credit and bad debt in the broader economy. Quarterly earnings reports from blue-chip banks like Lloyds and Barclays have shown a far healthier picture in terms of loan servicing and bad-debt provisions. It is however a good reminder of the choices faced when dealing with ‘paying for’ debt. Default is one option. Tax is another, and the Chancellor had very little to say here, despite fears of an impending rise in capital gains tax and lower pension allowances. The £4bn fund for ‘levelling-up’ suggests austerity is not on the cards any time soon. That leaves just one further way for the elimination of debt, at least in nominal terms – inflating it away.
  • The graph below shows the UK 5y5y inflation swap curve (5yr inflation in 5yrs time). The pop higher on the 23rd November which can be seen in the graph was purely technical, relating to actuarial changes in the retail-price index (RPI) calculation which will become effective for linkers and other inflation-adjusted instruments in 2030. UK CPI-inflation numbers are higher than their US counterparts due to the inclusion of housing in the calculation.

Source: Bloomberg, 27th November 2020.

  • The 10-basis point jump in inflation expectations following Rishi’s speech was the only discernible indication in the market that Chancellor had even done a spending review. Nothing else flickered. With Brexit pending though, and with the UK’s twin deficits (current account and primary deficit) at levels which would make many emerging market countries blush, monitoring forward inflation expectations and with it the prognosis for the pound is going to be a key exercise for UK investors. This is especially true in the context of the big jump in debt (and bad debt) resulting from the 2020 pandemic, a situation which portends a weak recovery and therefore low real interest rates for some time to come.

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