Economic Update September 2014

I thought I would share with you how I try and make sense of the data which bombards us
everyday from a wide range of media. The charts are mostly from the Bank of England.
The chart shows credit, broad money and nominal GDP. Credit is part of the assets of the
banking system, money is the liabilities of the banking system. Nominal GDP is the
consequence of money being spent. The crucial component is the velocity of money. This
is how many times a unit of money changes hands every day. If velocity of money is stable
then any change in nominal GDP must be due to more money being created by
commercial banks ( or exceptionally the central bank, known as quantitative easing).
The surprising growth in Nominal GDP in the UK is mostly due to an increase in velocity.
That is a unit of money is changing hands more quickly. The increase in Broad money
since 2012 is clearly not caused by an increase in bank lending ( which contracted before
rising a little in 2013/14). The increase in Broad money must be due to overseas investors
buying sterling and holding it in their bank account ( then using it to buy UK companies,
land, and property). This will increase velocity but not the amount of money overall.
However a change in velocity does afect is where the money ends up.The total amount of
money in the system does not change but who has it does! An increase in velocity moves
money from person A to person B ( who is in the UK), it changes therefore between bank
accounts and banks but total amount in the economy is unchanged. An example; 70% of
all residential property sales in London were cash purchases last year. Parents helping
their child get on the property ladder move cash from their account to the vendor who puts
it in his account.
Increasing confdence will increase velocity and in turn increase confdence. However the
consumer cannot spend money they do not posses. For an increase in velocity to be
maintained either credit and or wages must grow steadily
The chart shows that unsecured lending is growing at 5%, credit card by 4%, mortgage
lending by 2%, which is enabling consumption to grow a lot faster than income.
Although good for short term nominal GDP growth it is going to be a real problem when
interest rates increase. The chart on the next page shows that real post tax incomes are
essentially fat and have been since 2009.
For the recovery to be sustainable, real post tax incomes have to be growing by at least
1.5% yoy which requires at least 3% on wages and salaries. At the moment the UK
economy is showing signs of 2004-2007, when nominal GDP growth was maintained by
credit expansion, not wage growth.
The good news is that at last Investment spending has picked up ( see chart on next
page). This is being fnanced from retained profts, bond issues, and a little bit of net bank
lending. Only the latter increases the money supply: retained profts and bond issue
fnancing both increase velocity but not the amount of money in the economy.
The Bank of England have a real dilemma to grapple with. With low nominal wage growth
any increase in interest rates will cause a sharp slowdown and possibly a recession. But 5
years of the lowest interest rates on record is clearly having an impact on the attitude of
younger borrowers. I am aghast at the level of debt they seem happy to take on. The new
rules on Mortgage provision hopefully will demand of them some basic risk analysis and
the lender is now required to ensure the borrower can survive with unchanged incomes but
a 3% hike in base rate.
UK Wages and Productivity
According to Eurostat the UK is now ofcially a low wage economy compared to our
European neighbours. This is partly due to the weakness of sterling against the Euro, but
the average hourly cost of employing someone in Spain was 21.10 Euro last year. For the
UK it was 20.90 Euro. The EU average is 23.70 euro per hour. Between 2008 and 2013
the UK average labour cost was fat. In the EU it rose 10%. These fgures include non-
wage costs such as social taxes.
The exchange rate is a signifcant factor in these numbers. Over the period it fell from 1.50
euro to 1.10 in 2009. Today it is 1.25.
For an international company looking for a European site, the UK is now from a labour cost
point of view, cheaper than Poland and the Czech Republic.
It is clear that the UK Governments changes to social welfare are causing individuals to
seek work at almost any wage. This explains the signifcant fall in UK unemployment. The
downside is much of new employment is in unskilled activity and overall productivity is
relatively poor. Here is another dilemma: low wages drive low productivity (because it
makes labour cheaper than machines or computers). But we need higher wages which are
currently not justifed by productivity. The only way to break this cycle is to ensure fnal
demand is strong enough to move the bargaining power in favour of the employee. In
some sectors this is already happening eg skilled construction workers and specialist
personnel in the service industry.
This chart is instructive. France is 15% more productive than the UK and even more
surprisingly 6% more productive than Germany. It follows that France can pay higher
wages and still enjoy some competitive advantage.
There is help at hand. The UK currently doesnt measure nominal GDP in exactly the same
way as our European neighbours. But this Autumn we will adopt their methodology. The
consequence for international comparisons will be signifcant.
The chart on the next page shows that with the new methodology UK nominal GDP in
2007 was 62Bn larger. So our overall productivity is better by about 1.5% in 2007!
The revisions will change a lot of the Governments fgures, basically showing that the
boom was bigger than originally estimated, the recession not so deep. No doubt Mr Balls
will use the data to argue that he and Brown were even better at managing the economy
than they thought!
UK Property Prices
The chart on the next page shows the madness which is London property prices. At 8
times earnings, a London property is out of reach for the majority unless there is
considerable support from family and friends. This support has been forthcoming because
it helps a member of the family and it is the very best investment anyone can make. But it
shows how speculative the market has become. Over the past three years prices have
been rising because they have been rising. The bigger fool hypothesis at work. This can
( and should) go into reverse, prices are falling because they are falling. We need a trigger
to change expectations. The opinion polls give Labour a strong chance for May next year,
all we need is for Miliband to make one of his silly statements such as some form of
mansion tax on property over 2m ( or whatever the average price of property held by
labour MPs in London is) and or a 30% tax on overseas based purchasers.
There are signs already that the market is cooling. A 20% fall in average prices would be
desirable.
For the UK as a whole, 4.6 times earnings is manageable providing interest rates do not
revert to trend ( ie 5% base rate) The Northern Irish are paying the price for their
exuberance in 2007!
Latest data shows 150,000 new starts, and with growing availability of bank credit for
builders I would expect this to increase by more over the next 12 months( if the spec
builder can source enough bricks!) I have been told that the daily rate for a brickie in the
South East has risen by 50% in the last 12 months!
This increase in supply with the new mortgage rules limiting efective demand should
result in prices leveling of. The government has helped the purchase of 48,393 homes.
82% to frst time buyers with a 55 deposit. The average purchase price was 187,000
compared to national average price of 265,000.
The Construction sector is at last enjoying the recovery which has been experienced by
the manufacturing and service sector. Add this together and we should see nominal GDP
growing by 5% by the end of the year which brings us back to normal. With a 2% infation
rate or lower we will see real GDP at 3% or higher for the year. A good result.
Europe
I have been like a worn out record on the prospects for Europe ( poor) and the myopia of
the ECB and the European Commission over the past three years. My view has not
changed, but at last their view is showing signs of reality.
The core problem is the continuing contraction of EU Banks balance sheets. Latest data
shows net credit continues its three year contraction, and consequently broad money M3
is barely growing ( 1.8%). Velocity has not risen to ofset this. As a consequence France is
stagnant, Italy is contracting and Germany has slowed dramatically (Germany exports less
than 5% of its exports to Eastern Europe and Russia so the sanctions are material but not
the main cause).
The infation rate is now 0.3% in the Eurozone, it is on the brink of defation.
It is clear that Draghi is getting ready to sanction Quantitative Easing. My guess is he
needs to manufacture 1Bn electronic Euros over the next year. The main impact should be
a weakening of the Euro against the dollar ( by up to 15% depending on by how much the
Fed raise rate) and against sterling (by up to 5%). It will not increase the supply of credit to
Eurozone business, but exporters will enjoy increased margins, the stock markets will go
up, the banks will be able to increase their core capital more quickly via trading profts on
bonds.
The action should shift expectations from defation to mild infation and inspire greater
confdence. It should also via increases in nominal GDP make defcit reductions easier for
Governments.
Exchange rates
I think a major realignment is now due. The USA will almost certainly continue tapering its
electronic money creation and also increase interest rates by the end of the year. The ECB
will almost certainly create loads of electronic money over the next 12 months. The Bank of
England will certainly not create any more electronic money and will talk about the need to
raise rates, without actually doing it.
The impact of this will be
A stronger dollar, a weaker Euro, a wobbly sterling ( based on yes he will raise rates,
oh no he hasnt)!
But by how much and when?
If I knew then I wouldnt be doing this!
Guessing then and assuming the ECB acts:
Dollar up 15% against the Euro
Sterling 5% down against the dollar and 5% up against the Euro.
Stockmarkets
A good friend and frst class analyst Professor Bill Weinstein has tried to make sense of
what is happening to stockmarkets which are at record highs.I am grateful to him for his
insight.
Consider the following:
Civil war and religious carve up in Iraq
Increasing grip by Assad on Syria
Russian invasion of eastern Ukraine
EU sanctions unlikely to change Putin
Turmoil in Egypt
Israel to annex 1200 acres of the Gaza strip
China exerting muscle in the South and East China seas
A coup in Thailand
The EU almost back in recession: the French Government in disarray
Brazil stagant
Possibility of blackouts in the UK
A yes vote in Scotland

There is a growing consensus that because yields on many asset classes are so low
investors are taking riskier and riskier positions so that when an event puts the balloon up
we are in real trouble.
Are the markets insensitive to the above list because the Fed still has them on life support (
albeit with reducing transfusions) and now they expect the ECB to take over the baton?
Could the trigger for the UK be blackouts this Winter due to the unexpected shortage of
generating capacity?
Could a yes vote in Scotland be the trigger?
Normally there is signifcant market adjustment in either direction when the analysts return
to their desks in September but at the time of writing the US and UK markets are at historic
highs.
By the time you read this the adjustment could have already have started and you will
consider the above to be of no help at all!
Personally I have not been chasing yield and so I am relaxed: markets go up, they come
down, over the longer run( 5 years plus ).They are in my view driven by macroeconomic
conditions, but only when the herd instinct pauses for refection.
The USA
The graph compares the USA with the UK GDP growth rate. Please note UK is dotted line,
and refers to right side axis. The USA has outperformed with an average real growth rate
of 1.8% compared to the UK at an average of 0.8%.
The US has bounced back very strongly after weather conditions hit the frst quarter of this
year. Like the UK, unemployment is falling but wage growth is largely static. The increases
in real disposable income in the USA are largely due to tax reductions and low infation.
The USA is doing well reducing its balance of payments defcit, unlike the UK. The USA
is running at 0.2% of GDP defcit, the UK a massive 4.5% of GDP. UK right hand axis.
The data disproves the academics who say the current account defcit mirrors the
Government defcit.
The USA is a major exporter of primary products such as corn, coal, oil, gas, timber and
soya. The weak dollar has been a big advantage to them resulting is bigger export
volumes. UK exports mostly price insensitive goods and services. A weaker pound does
not increase volumes, just margins!
The USA is demanding that their Banks be more liquid and better captialised than Basel 3
rules require, and two years earlier.
Scotland
The single most important issue which has not been discussed in the debate is this:
Oil and gas revenues are highly volatile. An independent Scotland will have to raise capital
to fnance a defcit which will vary between 3% and 10% of GDP depending on the price of
oil and assuming no reduction in Government spending. They will not have AAA status as
a new untested country. A 3% defcit will require a 4% interest rate at least to get fnanced.
To avoid this, a new Independent Scotland will have to announce big spending cuts and or
tax increases.
I also fail to see how the low life expectancy of the Glaswegian male is caused by
decisions taken in London.
Conclusions
The UK has enjoyed strong nominal GDP growth caused by an increase in the velocity of
money, sustained through the Summer by greater debt, but now needs wage awards to
rise to continue the momentum. Wage awards under 3%, no increase in base rate. Above
3%, small increments from Spring 2015. Big upward revisions to GDP data will be
announced this Autumn.
Europe will see quantitative easing this Autumn and with it a devaluation of the Euro,
mostly against a stronger Dollar as the Fed begins to raise rates and continues to taper its
money creation.
The Global geopolitical scene is likely to cause stockmarkets to lose some of the massive (
mostly unjustifed) gains , but exactly when and by how much, who knows?
The USA is back as the biggest and strongest economy on the earth. It will also have the
the most resilient banking system by 2017.
The geopolitical scene in the world is more risky than for many years. When the markets
factor this in, we will see greater volatility across and within markets. Be alert.
Prepared September 3 2014 rmfagg@aol.com