Saturday, 19 January 2013

MPC new man does nothing to lift the gloom...

Ian McCafferty gave his first public speech as an MPC member yesterday. I found it faintly depressing, which doesn't mean it wasn't interesting. It's just that the policy prescription for the UK is wrong.

The most interesting part of Ian's speech was about the labour market. His contention is that with a shortage of skilled labour, and with more flexible wages, we have seen downward pressure on wage growth  at the same time as employment has held up far better than expected in this downturn. hence very weak productivity. Certainly, the growth of the bonus as a part of annual compensation for more workers, has provided scope for compensation to go down as well as up, and the notion that we have seen companies keep people on while cutting wages is plausible and supported by the data  - at least in the private sector.

Ian moved on to talk about exports - which have grown over the last decade, but by less than some had hoped since the financial crisis, given the pound's fall. His view is that companies used the pound's fall to boost profit margins rather than export volumes to some degree, perhaps as a way of financing labour hoarding. I have a permanent bee in my bonnet about the idea of using the pound to re-balance the economy because when I look at UK exporters, I don't see ones where a small move in the pound boosts volumes much. If BAE is the country's biggest exporter r then I am not sure the number of fighter jets they sell is affected much b the currency. Likewise Cosworth's car engines, Dyson's vacuums, or Westland's helicopters. The UK moved out of the most price-sensitive industries years ago. The notion that the weak pound improves (sterling) revenues from exports more than the volume of exports, makes lots of sense. And if we want to improve our export performance, we need to export more to big growing markets - like China  to whom we sell less than we do to the Belgians; for goodness' sake. See ONS data here:

So far, I have an image of an economy which has 'used' a weaker pound to help profits, and reacted to weaker demand by cutting worker compensation, rather than  cutting jobs. As the speech moved on to QE, the verdict was, largely, that most companies have taken advantage of the fall in funding costs to sort out their balance sheets rather than to increase investment and economic activity. This is true in the UK and in the US and in Europe, so no controversy here. Companies pay back expensive short-dated debt, and borrow for longer, and at lower rates. This works well for big companies and especially ones with access to the bond market  Less well (as in, not well at all) for small and medium-sized companies. The view is that it would be good to find a way for these smaller companies to access the capital market. Once upon a time, they could, to a greater degree  - banks lent money, and the loans were re-packaged in the form of CLOs. The death of the structured credit market, and the increased capital requirements placed on the banks, and (let's be fair) the stupidity of the senior management of  banks in abusing what could have been helpful technology,  have all put paid to that.

The funding for lending scheme is intended to help get money to borrowers other than the bond-issuing big companies. It has worked, it seems to me, better in terms of helping the mortgage market than the corporate sector. That's good, but again with a caveat. The government and the MPC want the mortgage market to recover. But there is a general hue and cry to avoid house prices rise any further (at least in the South East). But on a small, easily flooded island with a rapidly-growing population and very little room to build new homes, increased availability of funds to buy homes will inevitably push prices up. Maybe the FLS should be focused outside the South East, but more than anything, I wish there were clarity on the topic. Do the Government and MPC  think increased household indebtedness is a good idea and if so why? Are they relaxed about rising house prices, as long as house building picks up? Once you get into the business of micro-managing the economy, especially when you try and micro-manage with monetary policy (or use 'More targeted measures than QE' to drive growth, to use Ian McC's phrase), you inevitably run the risk of policy mess.

The MPC is going to fiddle around trying to find ways to help the economy. It is also going to go on worrying about inflation. The persistently high level of inflation has several causes; part of it comes down to the pound's weakness. Part, shared with other countries  is related to food prices and the weather. A really big part though comes from fiscal policy. We have required many (most) utilities to increase investment since they were privatised and allow them to raise prices irrespective of competition in order to finance it. So the price of water, electricity, gas, transport, etc. all go up faster than inflation. Government austerity then pushes up the cost of local services as cash-poor local government reacts to decreased central funding. There are no competitive pressures standing in the way of these price increases. And there absolutely nothing that monetary policy can do about except drive deflation in the rest of the economy to compensate.

Because the MPC is still worried about persistent inflation  and because the fret that if/when growth picks up there will be more inflation (my guess us that given there was inflation works in the UK  there'll be less), we will continues to see current policies left in place. That is, the pound will be talked down, rates will remain at zero, the government will raise taxes and cut spending. As the economy stagnates, the corporate sector (which pays lower taxes than the household sector) will try and maintain profit margins and revenues  Employment will hold up but wages won't and consumer spending will remain weak, as will tax revenues. This could all go on for a depressing long time before economic recovery gathers any momentum....

So thanks, Ian, I enjoyed the speech, but it left me rather gloomy.....

Thursday, 10 January 2013

Thursday Rant

A lot going on, some of it pretty silly though the net result is even more asset inflation as normally conservative investors put on lemming-onesies and leap over any handy cliff.

I'll start with a question that I was pondering for a fair bit of the day. Which would you rather put your money in - the UK 50-year index-linked gilt that will pay you (about) 0.016% above the RPI inflation rate (3% at the moment), or the US 30-year bond which yields about 3.07% at the moment? The yields are pretty much the same, so 3% is what you can earn on your savings if you want them to be 'safe'. I'm tempted to conclude that UK index-linked, even after today's rally, is the better yield. Neither exactly sets my pulse racing!

That you can lend money to your government for around 3% for as long as you like, is of course, why equity indices are back at levels we haven't seen in a while, why house prices are so high, why paintings, tuna, truffles and Bordeaux wines are all being sold for prices that blow your mind. Oh, and the price of a premiership footballer  -that too.

But the real reason I wanted to rant was about two, related topics. The first is the BOJ, who are widely touted as being on the point of adopting a 2% inflation target. I get lots and lots of emails about this. But how on earth does increasing the inflation target from 1% to 2%, when you have been seeing prices FALL for ages? Why not have a 5% inflation target on this basis? The target is not what will get the country out of deflation. Fortunately, a weaker yen will, and a weaker yen is coming.

There's a ink between the 2% inflation target and the real nonsense story in financial markets - the idea that the US should issue a trillion-dollar coin, made (it is suggested) out of platinum. the purpose of this is to get round the debt ceiling. Issuing a trillion dollar coin, boosts the country';s assets and allows it to borrow more. At one daft level, it is sensible because it gets around the really, really silly risk of a rich country defaulting because having committed to spend money, it decides bot to finance the spending, even though it could. This, in  my language is the same as agreeing to buy a house, signing on the dotted line, hiring the movers and then having a meeting with Mrs J, and agreeing that we don't want a mortgage.

If the US doesn't want to increase its debt levee, it needs a grown-up debate about that. Cut spending, or raise taxes. The coin is a gimmick that merely highlights the inability of the government to govern. But my real, deep down grouse against the coin is the same as with the 2% inflation target. It is masquerading as a sensible plan by being made out of platinum. They are not going to make a coin whose metal content itself is worth $1trn. Of course not, that would be silly.  And counter-productive. So why use expensive metal at all? Plastic would be better and a coin made up of old bottle tops would be even more sensible.

So I've had a silly decision on keeping a silly measure of inflation in the UK. A silly debate about a trillion dollar coin in the US to get around a self-imposed debt ceiling; and a silly decision to raise the inflation target in a country which can't get any inflation (yet). And we're only 10 days into the New Year.

Sunday, 6 January 2013


'Risk-on/risk-off" is nearly as annoying as the fiscal cliff, in terms of over-used expressions used by  those who work or play in financial markets. But while it would be premature to say Ro-Ro is dead, I am confident that a shake-up of the cross-makret correlations which are currently seen in market,s is on the way.  

Cross-asset correlations are nothing new and most are easily explained. Since 2006, for example, there has been a strong,and logical correlation between the level of the Japanese Nikkei index, and the Dollar/Yen exchange rate.  Logical because Japanese exporters' earnings are obviously affected by the value of the currency - a weaker yen means stronger earnings for many bellwether names.

I can play silly games with this correlation too: Dollar/Yen is also closely correlated with the level of US bond yields. Why? Because the willingness of Japanese investors to re-cycle the accumulated financial surpluses of the last few decades, is determined in no small degree by the yields they can get abroad, and US Treasuries are the driver of those. But these two correlations taken together mean that there is a strong and utterly spurious relationship between US bond yields and the Nikkei. Rising US bond yields do not imply that Japanese companies are doing better, except insofar as both reflect a healthier global economy.

There are plenty of these correlations around, but in recent years, they have all been dwarfed by 'risk-on/risk-off'. That is a world which is either 'risk on' and any higher-yielding, more volatile or generally riskier asset does well, or 'risk off', when investors are hiding under rocks, and about the only things which thrive are the dollar and US Treasuries.

For a fund manager, this is frustrating. Brought up to look for ways to build better risk-adjsuted investment portfolios, the fund manager finds instead a world where you have to accurately choose between the equivalent of red and back squares on a roulette table.

The 'risk-on/risk-off' world is a result of Federal Reserve policy, which has caused a breakdown in the relationship between US interest rates and economic activity. The Fed keeps rates at zero, and add as much money to the economy as possible through QE, irrespective of the economic data. So 'good' US economic data don't trigger a re-think about Fed policy or a rise in Treasury yields. Instead, they make investors less afraid of recession, and more desperate to earn some kind of return on their money.

The daftest consequence of all is in the currency market. "Good" economic data in the US don't make anyone think the Fed will raise rates, they just make them less gloomy about investment returns. So good news for the US is bad news for the dollar. Which would be weird were it not for the fact hat the US authorities are pretty happy with a soft dollar anyway.

Regimes come and go, of course. And so will "risk-on/risk-off". It will change when the US economy has enough traction that the normal relationship between Treasury yields and economic activity is restored. That won't only happen when the Fed talks about raising rates,  but when people in the markets dream about the notion that the Fed might contemplate the thought that they could perhaps, just perhaps raise rates, one day. When so much money is riding on the same bet  - that rates are low for ever - it won't take a solid silver economic recovery to swing market sentiment, just a series of better economic releases, a bit of a debate at the FOMC and a shift in consensus expectations of US growth to, perhaps, 2 1/2-3% or so.

And what then? Higher US yields, for sure. 2-year rates will need to build in a risk premium. 30-year yields will need to price in the likelihood that the first change will be an end to Fed buying. The dollar will then benefit from good news. As for equities, credit and volatility, frankly, who knows? Better economic news is 'good' for them but higher US rates are 'bad'. And there is a huge amount of money invested now in correlations that are a few years old, but won't last for ever.  In many ways, a stock-picker will do better than someone guessing where the overall market goes in this world. And hurray to that because what all this means is that there will be winners and losers and smart investors will be able to start building portfolios with decent risk-reward characteristics.

So when? This year but not right now. The Fed isn't about to change tack, or even hint about a possible change of tack. Ben Bernanke is still the King of easy money.
But we have had a taster in recent days of how the world is changing as economic divergence between Europe and the US becomes the single biggest macro story out there.  If US debt ceiling talks don't change the gentle thrust of US fiscal policy, and if the European recession doesn't de-rail anyone else, US growth forecasts will be revised up. And then we'll see what the second half of the year brings. Markets are forward-looking and the outlook is getting a little less bleak.