Defend the Indefensible

I regularly tune into 'Fighting Talk' on a Saturday morning, the weekly sports quiz broadcast on BBC Radio 5 Live hosted by the highly entertaining Colin Murray. The format of the show is fairly simple, four contestants, usually sports commentators, ex sportsman or comedians, compete to accumulate points by answering topical sporting questions. "Points for punditry," as Mr Murray would say as he awards his guests arbitrary points based upon their knowledge, extreme opinion and most importantly, the wit in their answer. The week's champion is decided when the two contestants with the most points compete in a final round known as 'Defend the Indefensible.' Here each finalist is read a statement which is contrary to popular opinion and asked to vigorously defend that statement for twenty seconds no matter how much they may disagree with it. Not an easy task, it takes a particular skill to defend statements which are often blatantly wrong or untrue.

Whilst listening to the broadcast this weekend, it struck me that perhaps the BBC should consider a special edition of Fighting Talk as we find ourselves in the midst of the latest collapse in market confidence. A show where the guests are four of the world leaders. I would propose Greece's Prime Minister George Papandreou, Christine Lagarde as Head of IMF, Germany's Chancellor Angela Merkel and the US President Barack Obama. Of course, the questions would be based on current political and economic events rather than sports. There would be much talk and the contest would be tight but personally I would like to hear Chancellor Merkel and President Obama face the 'Defend the Indefensible' challenge in the final. The question is what statements would we challenge them with?

Well, starting with Angela Merkel, I would ask her to defend the following statement: "No Eurozone Government should be allowed to default on their debt and the Euro should be defended at whatever cost." This is a statement which is very unpopular with German citizens who feel frustrated at what they perceive themselves to be - the Eurozone open cheque book. The second bailout for Greece in the early summer months clearly failed to reassure bond markets and their funding costs have not improved. Furthermore, whilst the European Central Bank (ECB) have an exemplary track record to date of controlling inflation, hiking interest rates twice this year against a background of rising commodity prices has proven to be a mistake. Whilst these hikes have increased borrowing costs for all, it has been particularly painful for both Italy and Spain.

Italy, along with other Eurozone members, exchanged their currency and monetary policy for lower interest rates within a single currency. Oh how they wish now that instead of tough austerity plans they could inflate and devalue to recovery with their own currency. This option is even more tempting to the Greek population who increasingly feel persecuted by the severity of austerity demanded by other Eurozone member states as they continue to fund Greek government debt. An 'orderly' default or a major restructuring of debt perhaps coupled with a voluntary departure from the Euro may suit the Greeks in the long term. A return to the Drachma is possibly the way to break the downward spiral that Greece is suffering as more budgetary tightening leads to lower growth, a higher budgetary deficit and increasing government bond yields. But Merkel and her fellow Eurozone leaders fear the consequences of a Greek default which they believe would inevitably result in another banking crisis unless preceded by a massive recapitalisation of the Eurozone banks.

Next up would be President Obama, who I would ask to defend the following: "With a Presidential Election next year, the US should continue with unconventional measures to create employment and stimulate economic growth." Well, the latest unconventional measure announced by the Federal Reserve last week was Operation Twist, a tool last used in the 1960's, taking its name from the dance craze at the time made infamous by the Chubby Checker classic hit. The objective is to twist the yield curve by selling short term government debt held on the Fed’s balance sheet and using the proceeds to buy longer term government debt thus reducing the cost of borrowing for mortgage holders and businesses. The optimism earlier this year for stronger US economic growth waned over the summer as commodity price inflation and supply chain disruption following the natural disaster in Japan weakened the recovery. The debt ceiling debate where brinkmanship failed to prevent the ratings agency Standard & Poors' downgrading of US debt did very little to improve the confidence of investors in the US political system. Indeed, more recently this has spread to the US administration who have attacked Eurozone leaders on the speed and decisiveness of their handling of the current crisis, clearly a case of people in glasshouses!

With a weaker economy, both the US Administration and the Federal Reserve have been using much rhetoric of reassurance. However the financial markets are yet to be impressed, they are looking for bold action rather than just talk. Companies in the US are sitting with large piles of cash on their balance sheets, they no longer require cheap money if they don't have the confidence to reinvest what they already have on deposit. Households are continuing to pay down debt and consumers prefer to spend less given the uncertainty about their future. Obama is after a second term in the White House and given the campaign trail has already started, he would clearly welcome any fiscal stimulus to help.

So who would be crowned champion in this special edition of Fighting Talk? Well that’s the decision that the financial markets are awaiting. I am sure that both Chancellor Merkel and President Obama would turn in good performances. Let’s face it, they have been getting in a lot of practice of late. However, financial markets are understandably reluctant to take these words at face value as they remain sceptical that policymakers are capable of resolving the current crisis. There is criticism that policy on both sides of the Atlantic has been too incremental and not bold enough. This is a time for decisive action from our world leaders, they must be prepared to leave their concerns about popularity with voters at the door. What is needed is collaboration and co-ordinated global action. Equity markets appear good value by most measures whilst bond markets look expensive. To my mind, the catalyst for change is a reappraisal of future economic growth. This growth may come from Asia and Emerging Markets as we see global inflation begin to peak and an improvement in confidence encouraging companies in the West to reinvest, creating jobs and consumer demand. There was another G20 meeting in Washington over the weekend to discuss the ongoing crisis, I am sure there was much fighting talk, but it is action not words that is much needed now.

John Husselbee
North
27th September 2011

The week that was: What has the real impact of the US downgrade been?

Too little, too late – that was the verdict of Standard & Poor’s decision after trading finished last Friday evening to downgrade US debt from AAA status to AA+. Despite an agreement only a few days before to raise the US Debt Ceiling to avoid default, the ratings agency expressed their concerns over the handling of the World’s largest economy. These concerns were not helped by the political circus surrounding an eleventh hour compromise, although this was always to be expected with the division in political power between Congress and the White House. So after a week of more market volatility, a period of trading that resembled the turmoil following the collapse of Lehman Brothers in the autumn of 2008, how much of this can be blamed on the US downgrade?

The financial markets had already assessed that a US default was never really a risk and even expected some degree of political brinkmanship that would lead to a final hour agreement. However the public nature of the squabbling between the Democrats and the Republicans as they compromised on a package of spending cuts served as a timely reminder to all that political risk is a real threat to economic growth. The Budget Control Act, the legislation allowing the US Debt Ceiling to rise, was signed into law on 2nd August by President Obama. An Act which allows the Debt Ceiling to rise by up to $2.4 trillion, an amount adequate enough to allow the US to sustain its projected borrowing path passed next year’s Presidential Election and into 2013. It was agreed that this would be offset by spending cuts of an equal amount over the next ten years. However only $900bn of these cuts were outlined in the agreement, the remaining $1.5bn will be decided by a new committee comprising of members from each political party.

A figure of $2.4 trillion of spending cuts sounds a big deal, but in reality it does very little to address the long term underlying issues faced by the US economy. Furthermore, the $2.4 trillion comes out of the projected increase in Federal spending, so there are no real savings and it hard to see how the deficit will reduce over the next ten years. Hence you can now see why most commentators have been so underwhelmed by the plan and why Standard & Poor’s took the decision to downgrade US government debt after a few days of digestion. The agreed policy fails to scratch the surface of the US deficit as it would require trillions of spending cuts and tax hikes to make a significant reduction. With the US consumer already stretched in a weak housing and labour market, it is not surprising that there is very little appetite for drastic action, especially coming into an Election year. The general consensus is that this agreement will have only a minor impact on economic growth in the medium term.

The US authorities have been rather dismissive this week of the downgrade, from just one of three recognised rating agencies. The US equity market reacted rather differently falling sharply on Monday, the S&P 500 Index fell over 6%, which brought about a global sell off in risk assets with a flight to safe haven assets such as gold. This included Treasury bonds, the name for US government debt, whose prices rose sharply despite the lower credit quality status. The fact that US Treasury bonds rallied on the news of a downgrade may not make sense to some of you but highlights to us that investors still view this asset class as a safe haven with few defensive alternatives to US Treasuries and the US Dollar.

The timing of the US downgrade could have hardly been worse and we certainly believe that this has contributed to the overall market volatility. However this was not the only reason for the ups and downs we have witnessed this week. Investors began to hunt for the next sovereign candidate with the potential to be downgraded and turned their attention to France because of their high exposure to Greek government debt. It was only a few weeks ago that the Eurozone governments announced their latest plan to resolve the issue of sovereign debt in peripheral Europe and this week the ECB, the European Central Bank, has been purchasing both Spanish and Italian government debt in an attempt to reassure markets. These woes in Europe coupled with recent weaker economic data in Developed Market economies which increases the risk of a double dip recession and inflation in Emerging Markets have all had a significant impact on investor sentiment and confidence.

So, where does this leave us? The ability of the US to stimulate the economy through further fiscal spending is surely limited now and any further boost to growth will have to be delivered via the Federal Reserve in the form of more quantitative easing. Indeed, Ben Bernanke, the Governor of the Federal Reserve, announced earlier in the week that interest rates would remain at zero until 2013. This announcement may result in higher inflation with US unable to raise the cost of borrowing for fear of crippling their economy. We do not subscribe to the double dip recession theory despite recent events and believe that very little has actually changed. Our core scenario remains that developed economies plod along on with anaemic growth for the foreseeable future, with drivers of the global growth to be found in the emerging economies, who seem to be getting on top of their inflationary issues. We believe the pitiful coupons and as such returns on US Treasury bonds will encourage more investors to look elsewhere for returns in excess of inflation. Good quality high yielding equities to us are the obvious choice. In stark contrast to the balance sheet of the UK or US government, corporation’s finances are in great health and we believe they shall be able to continue to grow their already attractive dividends over time. The equity markets still offer the best long term returns and this week we have taken the opportunity to buy at discounted prices. Once the focus moves away from economies and back to the prospect of companies, we are confident that markets will begin to recover fairly swiftly.

11th August 2011

Get Well Soon!

Low growth and high inflation - the UK economy maybe out of the emergency room but we are still in intensive care. The huge cost of rescuing the economy from recession and bailing out the banks has left a massive hole in the nation's finances. The medicine required to reduce the deficit is austerity which means cutting government expenditure and raising taxes, helped along the way with a spoon full of sugar - low interest rates. For some time now, even with this sweetener, the economy has been finding the medicine a little too hard to swallow which has prompted critics of the Coalition's plan to question the amount as well as the fairness of the distribution of spending cuts and tax rises. However, I am yet to be convinced of any alternative medicine than will work.

Our Nation's finances are not that dissimilar to those of the Portuguese, the Irish and the Greeks, all of which have been bailed out in the past twelve months. These countries are all in the Eurozone where the responsibility for setting interest rates and as such the exchange rate via the single currency is controlled centrally by ECB (European Central Bank.). Fiscal policy on the other hand as in how much each country spends and how much they raise taxes, is left in the hands of each member state. Until the global financial crisis, all Eurozone countries enjoyed the same cost of borrowing, any past history of poor repayment was overlooked. This is not the case today and the weaker Eurozone members have seen the cost of their borrowing soar to an unsustainable level. With the benefit of hindsight the proposed bailouts were inevitable, as the alternative of sovereign default has been politically unpalatable.

However bailouts are not the solution, these are simply a temporary fix whilst something more permanent is worked out. For those countries accepting a bailout there is a hefty price to pay. Firstly, there is the loss of their fiscal autonomy - the right to manage their own finances. The government has had to persuade their people, their voters, to accept a severe austerity package and the consequential reduction in their standard of living. Secondly, there is the prospect of weaker economic growth - the ability of any country to service and repay their debt depends upon the growth of their economy, as tax revenue needs to be at least maintained to pay back their creditors. Whilst, austerity packages reassure bond holders, consumers and businesses become more cautious about spending so consequentially economic growth weakens. Squeezing more tax revenue out of a shrinking economy is a challenge. In the past, Portugal, Ireland and Greece have devalued their currencies to encourage export growth. Devaluing the Escudo, Punt and Drachma is no longer an option, they are all part of a single currency where exchange rate policy is controlled by ECB. The Euro has been a relatively strong currency and this month's hike in interest rates to hive off inflation fears will not help foster economic growth.

In the UK we have an advantage because we have more control over both our monetary and fiscal policy, although this is still limited by the wishes of our bond holders. Sterling has been devalued, in line with the plan to replace consumer spending for export growth. Whilst the competitiveness of our exporters has greatly improved, import prices have also dramatically increased with a weaker pound. The other major part of the Government's fiscal consolidation plan, is to encourage the private sector to replace government investment as the proposed spending cuts start to bite. Investors should expect to see looser regulation and more tax incentives for both new and existing private enterprise to promote this initiative.

For all the autonomy we have to manage our own public finances, there has been a cost in lower economic growth and higher inflation. Inflation remains stubbornly above the Government's 2% target and is considerably higher than most other developed economies. Whilst every part of the global economy has seen inflation rise as result of soaring commodity prices, inflation in the UK has taken on the additional price changes due to the increase in VAT and a weaker pound. The MPC (Monetary Policy Committee) at the Bank of England, which has the role of setting UK interest rate policy, has repeatedly stated that they believe the above target inflation is only temporary. It is clear from the recently published minutes of their last meeting that they are a long way from raising interest rates particularly with no signs of wage inflation given the high unemployment numbers. It seems to me that interest rates will only begin to rise either when we see a pick up in wage inflation or we experience a couple quarters of higher than higher economic growth. Until then household incomes will continue to be squeezed by low returns on cash deposits and increases in the cost of living. With the consumer representing almost two thirds of economic activity, this means weaker growth for the foreseeable future.

This weaker economic growth has clearly been reflected in lower Gilt yields in the last quarter, in recent months the yield on ten year government debt has fallen from around 3.8% to close to 3%. However these falls have exceeded my expectations and begs the question are there other factors at play here. It can be no coincidence that the fall in Gilt yields has occurred as Eurozone government bond yields in the weaker countries have soared over renewed fears of a sovereign debt default. This seems to support the fact that that bond investors still consider Gilts to be a safe haven and approve of the Government's handling of the UK economy. Or, perhaps, maybe there is a belief that we will see further quantitative easing should weak economic growth persist.

When looking at the UK economy it does seem that it has lost steam over the last year. Some commentators are saying that this is only to be expected following a major financial crisis, however there has also been a weakening in the global economy following the supply chain issues caused by the Japanese earthquake and tsunami as well as the spike in commodity prices. The resultant weaker global trade has delayed the expected boost from a lower pound. For my part, I am not in the deflation and further recession camp at this stage, I believe that Gilts are a very expensive asset to own and that equities will offer far greater value over the coming year, however I am cautious in the very short term as investors focus on the plight of sovereign debt in the Eurozone. Furthermore I believe that economic weakness also threatens the longevity of the Government's austerity plan which is not only based upon spending cuts but also on increasing tax receipts from a growing economy. I am not sure that Plan B, one which necessitates a slower pace of fiscal consolidation, will work as I believe that bond investors will not continue to lend at the current low levels of interest rates. The real fear is that a policy error may send our fragile recovery into another recession and straight back to the emergency room.

John Husselbee

20th July 2011