Gibson

What’s going on in the UK?

For about forty years we have been living well beyond our means and the chickens are coming home to roost.

On the 29th November we’ll hear from the government about their revised cuts plan.  They’ll tell us that they’ve fallen behind and can’t meet the original 2015 target.  Let’s get some definitions straight before we move on:  a country’s deficit is the difference between expenditure and what they bring in in revenue.  The idea was to bring this down to zero by 2015.  Debt, which currently stands at £1bn, is what’s owed by the country.  Debt was always going to rise even though the deficit was to reduce.  UK debt is likely to be more than £1tn by 2015.  In the original plan economic growth was forecast at 2% however in actual fact it’s currently only at 1% with a 1% foreceast for next year.  Independent forecasters reckon it will be 2017/18 before we can spend what we bring in.

I attended a briefing by Invesco Perpetual this week and the figures were staggering.  It can be hard to put into context the billions and trillions that are bandied about but if we pretend that the UK public finances are a modern household by removing seven noughts of the government figures then the equivalent position is:

Not good is it!?

For now the government is sticking to Plan A and while there is no Plan B there may be something extra announced later this month.  Spending cuts could be ‘back loaded’ so the pain isn’t as sharp and shocking, the infrastructure programme could be accelerated and the Bank Of England are saying that we could see QE2 (the second tranche of quantitative easing).  Banks are the backbone of capitalism and when they aren’t lending the economy won’t pick up.   The first tranche of QE (£200bn) is sat on bank balance sheets and is not being leant out.  QE1 worked but not in the way intended.  In today’s climate the top guys in the banks don’t get a pat on the back for how much they’re lending, rather they get judged on the state of their bank’s balance sheet.  Bank business lending is usually zero in a recession (technically we aren’t in recession) but is currently sitting at -25%!  When this figure goes negative it usually takes about six years to come back.  And of course we know that while BOE base rate is at a historic low of 0.5% the average business lending rate is nearer 7%.  The banks are blaming the regulators for forcing them to increase their capital while the politicians are saying that it’s the banks’ unwillingness to lend.

So what’s going on in the Eurozone?

Italy is a big problem.  It is third biggest bond market in the world after the US and Japan.  International investors get exposure to the euro by buying Italian debt and once it implodes it’s a much bigger problem because it will bring in the US banks for example.  Greece is a problem.  There’s nothing in it for Greece – if they go through with the cuts their debt to GDP ratio will reduce from 140% to 120% and that’s if they endure another ten years of recession (14 in total).  But is a disorderly default an option for them?  If they go back to the drachma it will be worth about half a euro (possibly 60%) and therefore they would overnight increase their country’s debts by 100%.  Also, if we look at Argentina who defaulted in the past, we see that they can’t raise funds on the money markets – who wants to lend to a country with a track record of defaulting?  Greece is damned if it does and damned if it doesn’t. 

Germany is trying to keep the whole thing together but it can’t keep shelling out forever.  Germany doesn’t want the ECB to embark on a money printing programme because they fear inflation.  They don’t want eurobonds either where instead of having Irish debt, Spanish debt etc, you’d have one european bond underpinned by the whole of Europe i.e. Germany!  The Germans want greater fiscal and policitical union as well as monetary union so you’d common tax policies and everyone pays into a centralised pot.  That would be a struggle to get past the like of Holland and Finland because you’d basically be asking them to pay taxes to subsidise other countries.  It’s hard to see how this will play out unless the Germans capitulate and go for the idea of eurobonds and allow the ECB to become a lender of first resort and maybe print some money or we see a huge trillion euro ESF fund backed up by an IMF fund that’s backed up by Russia, China, Brazil and other economies.  This has been talked about for some time but nothing has actually happened.

What about the USA?

 It’s 60/40 whether the US will enter recession.  Certainly consumer and business confidence is low.  Large spending cuts will need to be made in 2013.  If we do the same exercise as we did before in comparing public finances to a household and we do this with the US this is what we have:

With Merkel, Sarkosy and Obama up for re-election it’s unlikely that anything major will happen before 2013 because by then it could be someone else’s problem.  The outlook is not rosy.

Summary

We’ve been chasing growth for forty years but GDP doesn’t account for debt – for example if you borrow to buy a new £50000 car that £50000 counts as GDP but once you drive it off the forecourt it’s lost £10000 so your net wealth has decreased by £10000 and your debt is £50000.  Perhaps we should be focused more on net debt with net wealth creation as the new focus rather than GDP growth?

What about investing?  Fear and a desire for capital preservation are the motivators for the large inflows into gold, Swiss Francs and US Treasuries.  Gold is particularly hard to understand as it does not do what’s supposed to do.  In fact, during the first three months of this year more gold was bought than has ever been mined.  Think about that for a minute.  People are using synthetic ETFs (that’s for another day!) to buy into the price rather than hold physical gold for which you pay a 10-15% premium.  So if everyone wanted their gold it wouldn’t be there… Are US treasuries and government debt still regarded as safe havens?  Certainly the markets believe that some corporates are a safer bet than governments.  Sir John Templeton said back in 2008 that “a diversified portfolio of stocks, with proven global earnings power, remains the most certain path to continued prosperity in these difficult times”.  The consensus view among investment houses and the likes of Warren Buffet is that global equities and global large caps is where the value is for the medium to long term investor.  Unfortunately there is no silver bullet in the short term.

By David Gibson

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With thanks to Invesco Perpetual.  Please note that nothing in this blog post should be construed as advice.  It is for information only and you should seek specific advice which would take your circumstances etc into account.