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Roger’s economic overview: March 2013

Animal spirits are running high. Financial markets create their own reality. Companies are refinancing at lower interest rates, Eurozone governments find it easier to finance their deficits, the US fiscal cliff is delayed until May, China has avoided a hard landing.

Greece is still in the Eurozone, Spain has not asked for a bailout, the ECB has not had to purchase outright a single sovereign bond, money is flowing from safe havens back to the Eurozone periphery. The US housing market has turned, posting 5% price increases, new housing starts are twice the 2009 low. S&P 500 companies’ earnings are flat, sales up 0.5%, and yet the index is up at its pre-slump level.

The FTSE is up 6.4% since Jan 1 and Japan’s Nikkei is up 7%. The US economy shrank in Q4 2013, Europe is shrinking, 55% of Chinese GDP is now state financed spending and a major realignment of global currencies is in prospect.

People are irrational. We make generalisations about the whole, based on the performance of one part, the so called ‘halo effect’. We are prey to our emotions when making decisions, these are easier to manipulate than we think. We all think we are above average, and our subjective confidence in our abilities and judgments usually outweighs the actual strength of either of them. Above all we are herd animals; we make decisions based on what those around us are doing. We often justify our choices like this, validating them on the basis that others were following a similar course of action.

It is tempting to view the surge in stock prices as a result of inflationary expectations, driving an exodus from bonds, but the evidence from the USA is that it is new money flowing into equity mutual funds.

So look at the data: the purchasing managers index shows contraction in the Eurozone, no growth in China (this means 7%); but expansion in the USA. People always prefer to carry on behaving as they have always done, the more we repeat particular behaviours, the more automatic they become, and over time they become default behaviour. So the reasoning must be this:

The USA is growing, interest rates will remain at current levels for years to come, the Euro is fixed, China always creates its own reality. Therefore, time to get out of cash and into equities.

Our reflexive system does not naturally check to see if rephrasing a question would produce a different answer. For example, the market analysts say that equities are cheap, based on long run P/E multiples, but what we are experiencing today is a discontinuity, thus trend is almost irrelevant. But the talk on the street is that confidence is returning, we are on a roll, Spring is in the air. The cash piles will be spent, the velocity of money will take off and we will reach the sunlit uplands. This could happen but…

The markets have ignored the second bailout of Italy’s second largest bank and the bailout of the Netherlands’ third largest bank last week. They are ignoring the fact that nominal GDP in the UK is only growing at 2.5% and net credit is still contracting at 4%.
The UK Government will not hit its debt reduction target and according to the IFS will need to borrow £180bn more than planned over the next three years. This will push the National Debt over 80% of GDP and close to France who have 86%.

I have said this many times before, but it is worth repeating. Any business with a clearly defined value proposition, based on the customers’ preferences and ability to pay, which is effectively and efficiently delivered will outperform the economy as a whole, and by a considerable margin. We can take the example of John Lewis (an outperformer) and compare it to Dixons.
The Zombie businesses will go sooner or later, leaving more market for the better players.

Exchange Rate.
For the past 3 weeks there has been a lot of market chatter about the realignment of the major currencies. As the market creates its own reality, we can expect the realignment to take place. We do not know exactly when or by how much. Here is the context.

We begin with Purchasing Power Parity (PPP). If two identical goods have the same price in two countries, each
with a different currency, then there is PPP. If you are in country B, and you exchange your currency for A’s, and
you find that the identical good is now cheaper for you in A, then using PPP, your currency is overvalued relative
to A.

Over the long run (more than 5 years) currencies do move towards their PPP unless deliberately managed by the government through direct sales and purchases in the Forex market using the central bank. China has deliberately done this for 20 years.
However, in the short run, it is financial variables plus market expectations which determine the relative exchange rate.

Relative Interest Rates
Relative Exchange Rate
Relative Inflation Rate

Each point on this triangle is determined by the other two. So what determines the relative exchange rate? It is relative interest rates and relative inflation rates. Based on these relativities for January 27 2013 the following PPP apply.
All this is relative to the US Dollar.
Norwegian Krone
Swiss Franc
Aussie Dollar
Mexican Peso 30%
Swedish Krona
Turkish Lira
Kiwi Dollar
Russian Ruble 21%
Canadian Dollar
Brazilian Real 7%

If we take Sterling it implies that $1.47 is the equilibrium price in dollars and Euro 1.08. Now we need to see what will feed market expectations. First the UK balance of payments…

For most of the last 13 years our physical trade deficit has been partially offset by investment income from our ownership of assets abroad. The remaining deficit has been financed by the sale of UK assets to overseas buyers e.g. Tata, Mittal, Sovereign Wealth Funds, and my village pub now owned by a Russian (a disaster).

We are in a spot of bother because the investment income flow has reversed. And the short term balancing from the Greek and Spanish has gone as they decide the if Euro will survive. Normally an increase in UK interest rates would solve this. But such an increase (of 2%) would kill us. So the markets now are assuming that Sterling has to fall to enable us to balance the account. A weak currency encourages speculative inflows once the market thinks the bottom has been reached.

The problem is the market always overshoots; this creates bigger swings, and more bonuses for Forex teams who call it right. The swing has already begun. But there is much which can stop the downward movement- for example Bunga Bunga. However, Berlusconi could win the Italian election and play hard ball with Merkel by threatening the break-up of the Euro. When the interest rate and inflation rate differentials are small, non financial events become more significant. The French have
suggested that the Euro should be allowed to fall against the dollar (achieved by a lowering of the ECB rate of interest to 0.5% and more QE). The Germans think not. The new governor of the Bank of England is suggesting a radical rethink of the role of the monetary policy committee, but is sketchy on detail.

On balance, Sterling is close to equilibrium, but we should expect more volatility than usual, as downward movements quickly reverse. There has been a swing of 10% for Pound/Euro from July last year to Feb 3 this year. This gives the context for those of you for whom currency values are crucial determinants of your margin. I cannot tell you what the actual rate will be on April 28th. You will have to make an informed guess like the rest of us.

And now to my School Report for the year 2012
Forecasts for 2012 (and the actuals)
Please note that numbers in parentheses have a negative value
The UK
UK inflation: RPI 3.2%, CPI 3.5%
ACTUAL RPI 3.1% CPI 2.7%
UK interest rates: 0.5%
FOOTSIE 100 at year end: 5,500
House Prices outside London: nominal (2%) real (5%)
ACTUAL (2.1%) (5%)
Commercial Property: flat
GDP for the year 0.3%, Q1 and Q2 slight contraction, Q3, Q4 some slight growth.
Q1 (0.2)
Q2 (0.4)
Q3 0.9
Q4 (0.3)
0.0% for the year

Sectors: Manufacturing will grow more slowly than the last two years: European demand will be patchy with some shocks. Asian and US demand stronger. Non-food retail will continue to be very difficult with more failures.

Financial services flat. Government sector: cuts will begin to bite.
Construction: 1% real growth
ACTUAL (11%)
Unemployment: 2.8 million at year end
Private sector wage growth 2%, public sector 0%
ACTUAL 1.6% and 0%
The World
Global growth will be 2.5%, the USA 2%, Brazil 2%, India 7.5%, China 7%, Europe (1.5%) Russia 3%
ACTUALS all correct except Europe which grew by 1%
Oil: the Saudis need $100 pb to break-even on the increased bribes to their population. They will cut output to
maintain this price in 2012 and 2013.
Non-food commodities, prices will fall.
Food commodities, harvest dependent, but steady upwards price pressure from Asian demand.
These forecasts assume Europe stumbles on. If the Greek default (likely April 2012) creates a Lehman like effect,
then all bets are off. It will be a repeat of 2008-2010.

Headmaster’s comments
“This has been a surprisingly good year for Martin-Fagg, but we sometimes think his disarming smile indicates a brain working at half power.”
(This is a direct quote from my 1964 school report!)
The Forecast for 2013
5900 at year end
CPI 2.8% RPI 3%
GDP 0.3%
World GDP
Exchange rates
£1 = Euro 1.23 average but big swings, I still think the Euro is at risk and sentiment will turn against it during this
£1 = $1.55 average until late summer, then could go to 1.45 by year end.

Roger Martin-Fagg

Breaking into the BRICS
Roger will be speaking at Vistage’s “Going International – The BRICS Opportunity” event in London on
March 22nd.

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