Economic Update February 2014 The Outlook for the UK A year ago I wrote about animal spirits and

optimism, hoping that they would translate into growth, but I was pessimistic for the UK given the outlook for Europe. I was wrong. I am tempted to be really optimistic but that would be a mistake. Let s firsts consider what has already happened in the UK !irstly, people are believing the misleading data on house prices which are not rising as fast as they think. "his has caused said people to e#perience the perceived wealth effect and subse$uently increase their spending. %et mortgage lending has only increased very slightly to date. &hen the cash buyers stop entering the market there will be nothing to sustain prices. 'urrently average prices are (.)# median incomes. "he figure was *.)# in +,,). -econdly the growth in the UK car market at +./ is actually driven by people putting off the evil payment day0 about half the new cars are sold on a 1ersonal 'ontract 1lan. "his encourages the purchaser to enlarge the debt they already have on the vehicle, even though the monthly payment is reduced. 1eople are delaying payment because they are strapped for cash. "hey are hoping that in three years time, they will be able to afford the final 2balloon payment . -econd hand prices should plummet in 34+(. I guess that is when I will replace my +4 year old car5 6ritish 6anks are 6asel * compliant 7 with the possible e#ception of 86-9. "he rules have been rela#ed as a result of intense lobbying from !rance and :ermany, which improves the outlook for the Euro;one because the rule change means less contraction of their loan book 7latest data shows contraction has continued for the last two years9. <opefully this will give some relief to smaller businesses in the Euro;one periphery who are being starved of credit. 6ase rates will not rise this year, but will probably return to normal in the middle of 34+= > I guess 3.3=/ by the end of 34+(. "he I?! has raised its forecast for UK growth to 3../. All growth forecasts will be higher if the e#pected inflation rate is lower, it is purely arithmetic. !or e#ample0 if nominal spending growth is forecast at @/, the inflation forecast is 3.=/, and the real :A1 forecast becomes +.=/. If the inflation forecast drops to +.=/, then real growth forecast increases to 3.=/ Easy5

"he latest data which suggests a :A1 growth rate for 34+* at +.,/ is based on only @=/ of sample data. -ince +,,) there have been (* $uarters. In all but . there have been revisions which take place over three years after the $uarter. "he revisions tell us the recession was deeper than first estimated, but also the doubleBdip never happened. 'urrently economists are suggesting that the retail sales data for Aecember at =.*/ up on a year earlier is inconsistent with the reports from maCor retailers. It e#pected to be revised downwards, as will the fourth $uarter :A1 figure. ?y guess :A1 growth is 3.3=/ for 34+@. A vie on the !lobal price of oil over the ne"t 10 year# "he rate of global growth is inversely related to the price of oil. "he graph below shows this $uite clearly. "he price of oil since 344, has been around D+44 per barrel, and yet demand has fallen due to recession in most &estern economies. "his is because supply has also fallen due to the Libyan uprising, the U- sanctions on Iran, and E1E' $uotas. The !lobal oil demand and #upply e$uation i# about to chan!e%

!irstly the U-A domestic production will e#ceed its imports this year. It will become a net e#porter for the first time thanks to +6n barrels per day from shale deposits, and is on track to overtake -audi Arabia as the top producer. -audi Arabia will have to cut its production by 3=/ to stop a global price collapse. "he $uelling of the Arab -pring is costing them a fortune in welfare paymentsF they have little money to spare. -econdly the lifting of sanctions on Iran could bring an e#tra +6n barrels a day onto the global market. Libya may add another +6n by the end of this year, and -audi Arabia pumped ,.)m barrels a day in Aecember 34+*. Iran has announced a consortium with Ira$ to share e#pertise. 'ombined they have more oil reserves than -audi Arabia and with the help of international investment would be able to match the -audis with a potential output of +3.=m barrels per day within +4 years. "hese changes will encourage E1E' members to pump more to maintain market share 7and essential e#port earnings9. "he result of this mu#t be a significant drop in price. I am pretty sure we will see the price of oil falling towards D(4 a barrel over the ne#t = years. "his will give a significant boost to global growth. "hirdly, 'hina has the biggest reserves of shale gas on the planet, roughly * times that of the U-A. &hen they begin to e#ploit this, their demand for oil will drop. 7%6 U- households have enCoyed a fall in utility bills of *4/ thanks to fracking9.

A D(4 barrel price would boost global growth by +.=/ over two years. It also would result in interest rates averaging at a lower rate because energy prices are a significant component of the price inde# 7*/ instead of =/9. Gim E %eil has coined the ?I%"- 7 ?e#ico, Indonesia, %igeria, "urkey and -udan9 as the ne#t big growth economies. If the oil price drops to D(4 per barrel he will be proved wrong regarding Indonesia, %igeria and the -udan . Eil production and refining is +4/ of Indonesia s :A1 and +@/ of %igerian :A1 7also ,4/ of its e#port earnings and )4/ of government ta# receipts9. !or -outh -udan, where .=/ of the oil is, the figures are )=/ of :A1 and ,)/ of e#port earnings. %igeria needs D+34 per barrel to break even on its national budget, Algeria needs the same, 8ussia needs D++., Hene;uela D++4 and the -audis D+44. E1E' therefore will try and manage the price to the highest level possible, but (4/ of oil is produced by non E1E' members. 8ussia, the U-A, Indonesia, and the -udan are not members, and %igeria and Hene;uela always play their own game. If we combine this with the now agreed rela#ation of the European targets for carbon emissions then we can suggest that transition from traditional sources

of energy, to renewables is likely. !or UK electricity this may come Cust in time to stop the lights going out. It will e#tend the economic life of mi#ed fuel power stations. "he geopolitics are also of great interest. &ould an energy selfBsufficient America lose interest in the ?iddle EastI If so, who would fill the gap, 'hinaI Er nobodyI The &orld Economy In order to prop up the U-A , the !ed since the start of 344, has created D* trillion. D+ trillion in 34+*5 "his new supply of money has enabled emerging economies to finance their current account deficits with 2hot money. <ot money is that which changes location at the touch of a button and is driven by e#pectations on how relative interest and e#change rates will change in the near future. 'ountries like "urkey with a ..=/ of :A1 current account deficit are forced to raise interest rates to prevent an outflow 7which if it occurs has to be funded from "urkish central bank reserves9. "he hedge funds know how many weeks of reserves are available B low reserves suggest either massive devaluation or considerable hikes in interest rates, or some combination of the two. Jesterday the base rate in "urkey went from ./ to +3/. If it stays up, it will choke off growth. "his argument also applies to India who similarly have a large current account deficit financed by hot money. India has Cust announced that they welcome inward investment to finance motorway building and high speed railway development. "his type of investment is primarily political risk sensitive, and not financed with hot money. It can therefore be viewed as a stable, long term investment flow. "he UK is very good at financing its current account deficit 7*/ of :A19 in this way. "he tapering by the !ed will continue throughout this year and it will cause a good deal of instability in emerging economies. "he first thing we can be sure of is higher average base rates, and lower consumption spending in credit driven 7middle classes only9 6ra;il, "urkey, India, Argentina, 'hile, -outh Africa and Indonesia. 'hina remains a conundrum. "hey continue to have the 2build it and they will come mindset. "his ma#im, financed by a massive e#pansion of new money, is making some 'hinese people very rich indeed, and lifting everyone into higher average incomes. 6ut now 'hina needs D@ of credit to create D+ of added value. And D+.=4 of this is for debt repayment. <istory tells us that no country on this planet has got away with this, without a maCor crisis or significant slowdown. <istory repeats itself, and it will in 'hina.

&hen it happens though, it will not follow the typical pattern > a balance of payments crisis, followed by a currency devaluation and political crisis 7Argentina and "urkey today9 > because 'hina controls capital flows. Instead it will be a full blown domestic crisis, with social media fanning the flames. "he worst outcome would be if 'hina chooses to e#ert military strength in certain regions to counter the internal strife. I personally would never underestimate the general 'hinese view which is, they believe they have never enCoyed the respect they deserve from the rest of the world. And they have not forgiven the Gapanese for invading them.

It is worth noting that Gapan collapsed in +,), due to e#cess capital investment financed by the banks. A year earlier :oldman -achs had published a report confidently saying that by the year 3444, Gapan would dominate the world. Aoes this sound familiarI 'chool (eport "he forecasts made in !eb 34+* are below0 Footsie 5900 at year end ACTUAL 6749 UK UK CPI 2.8% GDP 0.3% RPI 3% ACTUAL CPI 2% RPI 2.7% ACTUAL 1.9% ACTUAL, see chart

Eurozone (1.5%)

USA 2.3% Brazil 1%

ACTUAL 2.6% ACTUAL 2.2%

China 7.6% Correct , but easy to get right, because the authorities say it has to be at least 7% so it will be! Russia 3% ACTUAL 1.4%

The World GDP 2.9% ACTUAL 2.4% 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 year. ACTUAL 1.18 1 = $ 1.55 average until late summer, then could go to 1.45 by year end. ACTUAL AVERAGE $1.55 spot on, 1.45 not! MARKS 4/10 HEADMASTERS comments For most boys a musical ability is associated with mathematical capability, alas not so in this case. (Actual quote 1962!) I received 100% for music and 9% for maths! And the maths was being taught by the music master (who was brilliant at music but hopeless at maths I sense a pattern here!) Roger Martin-Fagg 31 January 2014