THE US ECONOMY
In my January update I said I would wait for more data before forecasting the USA. We now have the data and it’s good news. The flow of credit has increased and this is driving retail spend, replacement investment (ie. the truck market and Caterpillar products) and combined with growing exports to the rest of the world, the USA has sprung into life.
We in Europe should be grateful because it will offset to some extent the Eurozone recession and make it less severe, but as Europe is the biggest single market on the planet, its recession this year will impact on the USA next year.
In the past six months US Commercial Banks have created nearly $600Bn of new money. In sharp contrast to UK Banks who continue to destroy money.
The US Banking System is quite different from the UK. About half of US banking is profit hungry, too big to fail and with global reach. The other half behaves more like a utility, serving narrow geographic areas. There are 2500 banks in the US with balance sheets under $100m, and 2400 with over $100m. Many are community banks concentrating on niche local markets.
They supply half the funding to SMEs, none are too big to fail, so they do a very good job of assessing risk and they have a strong capital base, typically in excess of 12% of total assets. The Americans define an SME as having 500 employees or fewer. They employ 50% of the workforce; create 60% of non-farm added value. There are 25.8 million of them and 10% fail each year. The only bank in the UK which is similar in culture and behaviour is Handlesbanken.
Retail sales volumes in the USA are growing but are still only at the 2005 level.
Ed Balls seems to think that the US recovery is due to Federal Deficit spending, and the UK stagnation is because of the cuts. He couldn’t be more wrong. What matters is credit expansion (or contraction).
The £130bn borrowing requirement of the government is being financed by the Bank of England. It is creating money (called QE) to offset the destruction by commercial banks. As the net increase in money supply in only 2.3% this is not inflationary. For reference, inflationary money supply growth is 10% plus.
In February a key component of the Finance Bill was passed by Westminster. This gives the Bank of England the power to vary the rules for the provision of mortgages by Banks; if a property boom is beginning, the Bank can impose higher deposits, lower income multiples, and even demand more capital be allocated to a mortgage book. The banks, of course, do not like this at all, but they deserve to be controlled given their past behaviour.
THE UK BUDGET
The Chancellor should produce a very boring budget. He may decide to give away up to £5bn for political reasons. If so, he should do it by increasing personal allowances. He will keep the 50% tax rate as a political gesture despite the fact that it yields very little income. He should leave fuel duty and VAT alone and commit to a vision of the future where tax law is simplified and grants and subsidies removed. I personally support the creation of a UK Business Bank to undercut the existing banks, so they are forced to innovate. They will whinge like hell.
The Business Bank would work on smaller margins, larger volume and have all its depositors insured by the taxpayer. There would be no shortage of funding. This would be much more effective in stimulating growth than the government trying to pick winners or handing out tax incentives for innovation.
THE EUROZONE
The ECB has created 1 trillion Euros in the last three months. European Banks are using this new credit (which costs them 1%) to buy Club Med sovereign bonds which yield 5% plus. So a nice little earner which doesn’t lock up any scarce core tier 1 capital, moves the banks further along the Basel Three compliance rules, and is actually liquid, as Super Mario is clearly prepared to accept these bonds as collateral. It would seem that the ECB is underwriting Sovereign Debt, albeit through the back door. Simply put, the German Bundesbank is underwriting about 600bn of debt. I suspect the German Constitutional Court will have a lot to say about this, particularly when defaults will pile on the losses.
The ECB has solved the liquidity crisis but the problem is solvency and that is not yet sorted, so the supply of credit to Eurozone SMEs continues to shrink because it requires capital to support it, effort to lend it, and the margin will be less than can be obtained on Sovereign Bonds. The forecast of a 1.5% contraction in Eurozone countries will turn out
to be correct because of this credit squeeze.
So you might ask why are the Europeans lifting their optimism? It has been clear to me for some time that they do not understand what is going on. The Commission forecasting model doesn’t have the behaviour of banks within it; because of this it will always be too optimistic.
GREECE
Greece has effectively defaulted as private bond holders have agreed (under pressure) to a 73% haircut on their holdings. This will trigger Credit Default Swap payments. It would appear that the market had always expected this.
The next big event will be departure from the Euro, again as expected, probably followed by Portugal next year. What then happens depends to some extent on who wins the French presidency.
OIL
The price of oil will again reduce the global growth rate if it stays at the current level of $125 or above. The tipping point is $135 a barrel for the USA, and around $115 for the UK (this is because the weak pound requires us to spend more of our money per barrel).
We know the global price will stay above $100 because the Saudis need that to
balance their budget. The Russians need $110. The impact is via discretionary incomes, the cost of transportation and on a wide range of food and non-food products. A sharp increase in the price of oil is both inflationary: average prices rise, and deflationary as real non-oil consumer spending falls. It was the quadrupling of oil price in 1973 which
introduced a new macro-economic phenomena we now call ‘slumpflation’.
BRAZIL, INDIA and CHINA
They are all slowing down, Brazil to 2.7%. Brazil has the classic problem of an overvalued currency; this is squeezing domestic firms but fuelling a credit boom. India is down to 6% and China to 7.5%. There is more slowdown to come over the next 12 months.
THE PSYCHOLOGY OF THE PRESENT
It’s springtime and the warmer weather is lifting our spirits. There have been a range of business surveys suggesting a growing sense of optimism. This is important for economic outcomes. We know that credit will be in short supply in Europe and the UK. We also know that UK companies are sitting on £750bn of cash. It would transform the economic outlook if they pressed the spend button. In Europe, 77% of corporate liquidity is invested overnight.
Recent research shows that corporate profit margins are improbably high, net income has risen sixfold since early 2010, but the corporate tax payments by only 17%. Indeed, in Europe the effective corporate tax rate has dropped from 33% to 28%.
I would suggest this is where the optimism is coming from, not the hard cash balances, which continue to fall.
Roger Martin-Fagg
rmfagg@aol.com
Prepared March 2012
