The British economy has rallied – but, based as it is on debt, low interest rates and printed money, the good times can’t last, says John Stepek.
Last week was a good one for Chancellor George Osborne. He used his Autumn Statement as an extended opportunity to rub the opposition’s face in Britain’s economic recovery.
There were no big headline-grabbing changes, just a general sense that things were going as he’d planned (and after all, why splash out on any big giveaways when there are still 18 months to go until the election?).
His shadow, Ed Balls, was left red in the face and with his position looking increasingly untenable.
The reality, of course, is a little different. Yes, the British economy has rallied sharply in the past year – if you drop almost anything from a great enough height, it’ll bounce.
Even the Office for Budget Responsibility (OBR) – the independent body charged with trying to give voters the unvarnished truth about a chancellor’s budget shenanigans – points this out. “The improvements are cyclical rather than structural.” The recovery is not “indicating stronger underlying growth potential”.
You can see this in the GDP figures if you look closely. As Richard Jeffrey of Cazenove Capital Management points out, most of the 0.8% growth seen in the third quarter came from inventory rebuilding (companies replenishing stocks, which cannot sustain growth in the long run) and household spending. Business investment contributed very little, and exports actually fell. And it doesn’t help that GDP may be overstated in any case.
The Office for National Statistics has started using a very forgiving ‘GDP deflator’ to measure real (after inflation) GDP. They don’t tell anyone precisely how this is calculated, but while it used to correspond closely to the retail prices index (RPI) measure, since 2010 the deflator has been far lower – meaning that GDP has been higher than if you’d adjusted it using RPI. (For more on this, see Merryn’s Somerset Webb’s blog.)
In short, the recovery is “extremely fragile and may not be sustained”, as Liam Halligan notes in The Sunday Telegraph. Meanwhile, “our country remains deep in the fiscal mire”.
Britain’s deficit – the gap between what the government takes in and what it spends – is set to come in at £111bn in this fiscal year. That’s better than the £120bn predicted in March. But back in 2010, it was meant to be down to £60bn. And at 6.8% of GDP, the deficit “remains massive by historic standards”.
By 2018, we’ll have added more than £350bn to our national debt pile, and it’s only then that we’re expected to have a surplus – in other words, to start paying some of this off. The reality is that “for all the ‘austerity’ talk, we’re halfway through a process that will see our national debt more than double over eight years”.
It’s not just government debt that remains a problem – far from it. You might be wondering how household spending is contributing to the recovery at a time when real wages have been falling. Well, here’s a clue: personal debt in Britain has just hit a record of £1,400bn – 90% of GDP.
That, as Halligan says, “goes a long way… towards explaining our recent growth surge”. With the government ramping up the housing market via the Help to Buy scheme, boosting property owners’ sense of financial wellbeing, it’s no surprise that consumption is picking up again. Car sales are rocketing too – but a record 74.5% of those sales is funded by borrowing, says the FT.
So this is a cyclical recovery based on debt. That means it depends on interest rates staying low. Which is why, of course, Bank of England Governor Mark Carney has no intention of raising them this side of the 2015 election, regardless of how ‘good’ things get.
Carney to the rescue?
On the evidence so far, Carney is a consummate politician. It’s easy to forget, but the strength of this recovery has clearly surprised him. Within months of taking the reins at the Bank, Carney’s key policy – ‘forward guidance’ – was out of date.
He told markets he had no intention of raising interest rates until unemployment had fallen to at least 7%, which he didn’t forsee happening until mid-2016. But he’s rapidly been forced to revise that to late 2014.
Yet, he is still smoothly juggling expectations. Carney’s problem is this. The economy looks like it’s recovering. That leads markets to expect higher interest rates. But if rates rise during a recovery that’s based on nothing more than a cyclical, debt-fuelled bounce, the cost of debt will surge and the economy will plunge right back into recession.
So he can’t raise rates. But he has to justify that in some way, so as to maintain the Bank’s credibility. And so, even as he insists that rates won’t rise anytime soon, he is equally insistent that he can prevent a property bubble from inflating via other means.
“There is a history of things shifting in the UK and the housing market of moving from stall speed to warp speed and underwriting standards slipping. So we want to avoid that,” Carney said in a recent speech to the Economic Club of New York.
He has already dropped the Funding for Lending Scheme (FLS) for mortgages, which was a clever piece of theatre. On the one hand, FLS will make little difference to mortgage demand, given the existence of Help to Buy. On the other, it frees up a little more money to lend to small businesses.
But for all that Carney is trying to reassure us that he’ll pop any housing bubble if necessary, it’s hard to believe him. Because like it or not, rising house prices are a key part of the recovery plan. Even the Office for Budget Responsibility expects house prices in Britain to rise by 5% in 2014, then 7% in 2015.
That’s punchy in a world where inflation is meant to stay quiescent and commentators talk of a ‘new normal’ where we can only expect annual real returns in the region of 2% from equities.
Meanwhile, as Matthew Lynn points out, our tax base is becoming ever more dependent on takings from stamp duty, which are expected nearly to triple between now and 2018-2019.
A boom and bust economy, dependent on consumer spending and rising house prices, is precisely what got us into trouble in the first place. But for all the talk of rebalancing, it seems to be what we’re stuck with.
The investment puzzle
Surely this is all too gloomy? Former BBC economics editor, Stephanie Flanders, now at JP Morgan Asset Management, thinks so.
In the Financial Times she writes that the OBR is too gloomy on growth. “Investment – public and private – now accounts for a smaller share of the UK economy than at any time in the past 30 years, and is five percentage points of GDP lower than in the US.”
The OBR doesn’t expect that to budge much between now and 2018. But to rectify this, “we just need businesses to have confidence that the UK is on the road to recovery”. In other words, we all need to cheer up and look to a brighter future.
Investment is certainly the key to a more sustainable recovery. As Cazenove’s Richard Jeffrey points out, more investment should lead to higher productivity, higher profits, and rising wages for those with jobs (although it would probably hit employment growth, as rising productivity means more can be done with the same level of staffing).
Unfortunately, boosting investment is not a simple matter of everyone clicking into ‘glass-half-full’ mode. Regardless of what people like to believe, economies don’t just nosedive or rocket on the basis of mood swings or media reports.
If businesses aren’t investing, there’s a reason for that. And at least part of the blame can be laid at the feet of the low-interest-rate, money-printing policies that we’ve chosen to get us out of this mess.
For one thing, quantitative easing (QE) has arrested the process of ‘creative destruction’. So lots of businesses that should have gone bust, leaving more innovative competitors to make better use of their resources, are still around today.
Meanwhile, as Jeremy Warner points out in The Daily Telegraph, small businesses in particular are being starved of cash. With investors desperately hunting for yield, any business that can borrow straight from the markets via corporate bonds has been able to secure rock-bottom rates.
But smaller companies, which rely on banks, have found life much harder. When you stifle competition like this, it removes much of the impetus for companies to invest.
If competition isn’t as fierce, there’s no need to invest and take risks to stay ahead of the competition. “Thus does unconventional monetary policy stifle the new in support of the big and weak.”
Other problems include terribly skewed boardroom pay incentives, which, as economist Andrew Smithers keeps pointing out, encourage executives to take short-term measures to boost metrics such as earnings per share, which dictate their bonuses, rather than focusing on a firm’s long-term welfare.
There’s also the very concrete problem of corporate pension deficits. As Merryn points out on her blog this week, more than two-thirds of top executives surveyed by the Confederation for British Industry and Standard Chartered said that fears over pension scheme liabilities were having an “impact on business investment”.
The problem is that, as interest rates have plunged, pension-scheme liabilities have surged (the lower the return you can expect on your money, the more you need to save).
These deficits need to be plugged – so companies are saving money to pay their future pensioners, rather than investing in growth for today. It’s another example of how low rates have damaged, rather than helped, investment.
It’s not as if Britain needs to be entirely dependent on consumer spending to drive our economy forward. We still have a significant, respected manufacturing sector.
Our efforts to build a more significant tech sector are bearing fruit (if slowly) – the ‘Silicon Roundabout’ area of London is home to more than 1,500 digital companies, from less than 200 three years ago, according to the Techworld blog.
And if fracking takes off – as the government seems keen to make happen – our energy woes would be far less pressing if we could access cheap shale gas, as America has done.
But if it’s truly the case that low interest rates and QE are a big part of what’s holding back investment, then arguably what Britain really needs for a sustainable recovery is for rates to rise.
But the problem is walking that tightrope – higher rates will make life very difficult for an awful lot of people before they shows any sign of making things better.
The government itself is hardly in any position to cope with higher rates – as Liam Halligan points out in The Sunday Telegraph, if gilt rates rose “above a still relatively low 4%, the government would then have to allocate more to interest payment than it spends on education”.
This is yet another reason why Carney is likely to do everything in his power to keep rates where they are until after the 2015 election.
But given the poor record that central bankers have of both popping bubbles and defending against inflation, it’s hard to have any faith in his ability to get the timing of any rise just right.
M&G’s Ben Lord reckons “there could be significant inflationary impact when banks do begin to increase their lending activities”. And with Carney determined to stay ‘behind the curve’, the risk is that if and when inflation does make a come back, he won’t be able to get ahead of it without driving rates up more rapidly than the economy can handle.
If that’s what happens, it’s only a matter of time before our cyclical run hits a wall, and our huge debt burden drags the economy back down. We look at how to profit in the short term and protect yourself in the longer run below.
The coming London house price crash
London house prices are still booming. According to figures from Nationwide, they are up 4% in the last quarter alone, and 10% on this time last year.
However, just as the recovery in the housing market is showing signs of spreading to the rest of the UK – driven mainly by the government’s Help to Buy scheme – there are signs that the London market might be peaking, especially at the higher end, reports The Sunday Times.
According to property agents Knight Frank, annual growth in the price of prime central London property slowed to 6.9% in November – that’s still high, but it’s down from nearly 13% the year before.
Knight Frank thinks the slowdown simply means sellers “have to be increasingly realistic, particularly in the £10m and above super-prime bracket, where prices were flat in November”.
But a recent report from Fathom Consulting, commissioned by the boss of listed property group Development Securities, suggests that prices could fall hard. Compared to the rest of the country, valuations in London have become “stretched, relative to their fundamental drivers”.
For central London – driven largely by foreign buyers – these fundamentals include how cheap sterling is compared to the euro and the dollar, and how much appetite there is for ‘safe haven’ assets.
Based on this model, Fathom reckons prices are already 13% overvalued. One trigger for a correction would be rising interest rates, which would hit property hard, or a drop off in foreign demand caused by confidence being rattled by more aggressive than expected ‘tapering’ of quantitative easing in America.
Other analysts think higher taxes could be an important factor. Trevor Abrahmsohn of Glentree International believes higher stamp duty and the threat of more taxes is already hurting top-end transactions – “the market for houses over £2m is flatlining”.
Finally, good old supply and demand might help bring down prices too – as Savills recently put it, “the pipeline for prime schemes across London is entering uncharted territory”.
The investments to buy into now
With Help to Buy continuing to prop up the housing market, construction and consumption-related stocks may continue to do well – in the short-term at least.
In the longer run, one side effect of UK interest rates being held down for longer than markets expect is that the pound is likely to weaken, particularly against currencies where monetary policy is going in the opposite direction.
The US dollar in particular may well strengthen if the Federal Reserve starts tapering earlier than expected. As well as spurring inflation, this is a good reason to have your portfolio diversified beyond Britain – we like both Japanese and eurozone stocks, which still look good value.
Also, as Ben Lord of M&G notes, in the name of securing a recovery, central bankers “might be prepared to tolerate a period of higher inflation”. Yet index-linked gilts price in “only moderate levels of UK inflation” – roughly 2.7% over the next five years, based on the retail price index (RPI) measure.
However, “RPI has averaged around 3.7% over the past three years”. That leaves index-linked gilts looking cheap, he reckons. One way to buy in is via the Vanguard UK Inflation Linked Gilt Index fund, which charges 0.15% a year.
On the ‘glass half-full’ side, if fracking takes off in the UK, one beneficiary could be UK gas explorer iGas Energy (LSE: IGAS), a favourite of Fleet Street Letter editor David Stevenson. It’s high-risk, but it’s one of the purest plays on UK fracking out there.