First, the good news. It has long been recognised that the UK economy is over-dependent on financial services, and that its housing market – particularly in London – is wildly over-priced in relation to earnings. The Brexit vote should ensure that both these problems are solved:
- Many banks and financial institutions are already planning to move out of the UK to other locations within the EU, so they can continue to operate inside the Single Market
- There is no reason for those which are foreign-owned to stay in the country, now the UK is leaving the EU
- This will also undermine the London housing market by removing the support provided by these high-earners
- In addition, thousands of Asians, Arabs, Russians and others will now start selling the homes they bought when the UK was seen as a “safe haven”
This is probably not the result that most Leave voters expected when they voted on Thursday. These voters will also soon find out that Thursday was not the Independence Day they were promised. It is already obvious that Leave campaigners have no clear idea of what to do next. They are even divided about whether to immediately trigger the 2-year departure period under Article 50 of the Lisbon Treaty.
Leave voters have more shocks ahead of them, of course:
- Most believed that the UK would immediately be able to “take control of its borders” and dramatically reduce immigration. But as I noted during the campaign, the majority of immigration has always been from outside the EU – and could already have been stopped, had the current or previous governments chosen to do this
- Nor will the National Health Service suddenly benefit from the promised £350m/week ($475m) by stopping UK contributions to the EU. For a start, more than half of this money already came back to the UK from the EU, and so can’t be spent a second time
- Even more importantly, nothing is going to happen for at least 2 years whilst the Leave negotiations take place
This, of course, is where the bad news starts. What will be the reaction of Leave voters as they discover they have been fed half-truths on these and other critical issues? And what will happen as house prices begin to fall, and jobs in financial services – as well as manufacturing – begin to disappear as companies relocate elsewhere within the EU?
BREXIT VOTE WILL HIT EUROPE AND THE GLOBAL ECONOMY
The bad news is, unfortunately, not restricted to the UK. Already, alarm has begun to spread across the rest of the EU. There are strong calls for referendums to take place in 3 of the EU’s 6 founding members – France, Italy and The Netherlands. It is hard to see how the EU could survive if even one of these votes resulted in a Leave decision.
In turn, of course, this is bound to draw attention once more to the unsolved Eurozone debt crisis. Can anyone now really continue to believe the European Central Bank’s 2012 promise to do “whatever it takes” to preserve the euro, as set out by its President, Mario Draghi?
The simple fact is that the Brexit vote is the canary in the coalmine. It is the equivalent of the “Bear Stearns collapse” in March 2008, ahead of the financial crisis. And as I have argued for some time, the global economy is in far worse shape today than in 2008, due to the debt created by the world’s major central banks.
THE BREXIT VOTE, LIKE THE 2008 CRISIS, WAS NOT A ‘BLACK SWAN’ EVENT
I am used, by now, to my forecasts being ignored by conventional wisdom. The Brexit vote saw a repeat of the complacency that greeted my warnings in the Financial Times and here before the 2008 financial crisis. Thus my March warning was again mostly ignored, namely that:
“A UK vote to leave the European Union is becoming more likely”.
Instead, like the 2008 crisis, the Brexit vote is already being described as a ‘black swan’ event – impossible to forecast. This attitude merely supports the status quo, as it means consensus wisdom does not have to challenge its core assumptions. Instead, it takes comfort in the view that “nobody could have foreseen this happening”.
Critically, this means that the failure of the post-2008 stimulus programmes is still widely ignored. Yet these have caused global debt levels to climb to more than 3x total GDP, according to McKinsey. As the map above shows, they have created a debt-fuelled ‘ring of fire’, which now threatens to collapse the entire global economy:
- China’s reversal of stimulus policies has led to major downturns in the economies of all its commodity suppliers
- Latin America, Africa, Russia and the Middle East can no longer rely on exports to China to support their growth
- Japan’s unwise efforts at stimulus via Abenomics have also proved a complete failure
- Now Brexit will almost inevitably cause a major collapse in London house prices
- And it will focus attention on the vast debts created by the Eurozone debt crisis
- It will also unsettle US investors, who have taken margin debt to record levels in the belief that the US Federal Reserve will never let stock market prices fall
TIME FOR STRAIGHT TALKING ON THE IMPACT OF AGEING POPULATIONS ON ECONOMIC GROWTH
It is therefore vital that policymakers now make a new start, whilst there is still time to avoid total financial collapse. Once people begin to realise that all this debt can never be repaid, then interest rates will soar and many currencies collapse. This is not being alarmist – this is just stating obvious facts.
The critical need is to recognise that demographics, not monetary policy, drive economies. A world with lots of young BabyBoomers in the Wealth Creating 25-54 age group will inevitably see strong growth. And if more and more women return to the workforce after childbirth, this will turbo-charge an economic SuperCycle.
This is what happened between 1983 – 2007, when the world saw almost constant growth. The US recorded just 16 months of recession in 25 years. But last year saw global GDP decline by a record amount in current dollars, more than in 2009 – a clear warning sign of major trouble ahead.
The issue is very simple. Common sense tells us that the combination of a 50% increase in global life expectancy since 1950, and a 50% fall in fertility rates, means that the world has now reached the “demographic cliff“:
- 1bn ageing Boomers are joining the low-spending, low-earning New Old 55+ generation for the first time in history
- They will be more than 1 in 5 of the global population by 2030, twice the percentage in 1950
This is good news, not bad. Who amongst us, after all, would not choose to have 20 years of life expectancy at age 65 instead of dying? That is today’s position in the Western world. And people in the emerging economies are catching up fast. They can already now expect to live another 15 years at age 65.
The trade-off is lower, or negative growth. People in this New Old 55+ age group already own most of what they need, and their incomes decline dramatically as they approach retirement.
But this simple fact of life has never been explained to voters. Instead they have been told since 2008 that policymakers are confident of returning the economy to SuperCycle levels of growth. No wonder they are growing restless, and starting to mistrust everything they are being told by the supposed experts.
CONCLUSION – TIME TO RESTORE TRUST WITH PLAIN SPEAKING
Policymakers and the media now have a grave responsibility, as do do all of us.
It is critically important that policymakers now recognise they must immediately reverse course on stimulus policies, and come clean with voters about the real economic situation.
Of course this will result in very painful conversations. But the alternative, of ignoring the warning provided by the Brexit vote, is simply too awful to contemplate.
Nobody can guess the outcome of the UK’s general election on 7 May. This is astonishing, as it is only 4 months away.
Currently, it seems most unlikely that either of the main parties, Conservative or Labour, will be able to form a government on their own. Indeed, 7 different outcomes have been identified as possible by the civil servants preparing for a new government to take power.
Equally astonishing, given the 2-party history of British politics, is that the combined vote of the minor parties is now more than either the Conservative or Labour vote, as the Financial Times chart shows.
Opinion polls are not elections, of course. But so far they suggest that it will take a 3-party coalition to form a government – normally something only seen in wartime. In turn, this means it is quite possible that key policies could be dictated by minority parties as their price for votes.
The position of the Liberal Democrats position highlights the uncertainty. They are currently the minority party in the Coalition government, but are likely to lose at least half of their seats – and could lose many more. And so they would be most unlikely to support the Conservatives again, and would probably support Labour.
Instead, the Conservatives might well have to look for support from the UK Independence Party. Their main policy, as the name suggests, is for the UK to leave the European Union. They would drive a hard bargain for their votes, and a referendum on the subject would become almost inevitable.
Another remarkable development is underway in Scotland, long a Labour heartland. Polls suggest the Scottish National Party will win a majority of seats, despite having lost the independence referendum. They are unlikely to support the Conservatives, and might well demand a second referendum as their price for supporting Labour.
Other minority parties may also be critical to forming a government. The Democratic Unionists from N Ireland might support the Conservatives, whilst the Greens might support Labour if it accepted their key policies.
The problem is simple to explain. Voters no longer believe that the major parties are listening to their concerns, and are instead merely exchanging meaningless sound-bites. Thus Labour’s leader, Ed Milliband, famously forgot to talk about the UK’s problems with the budget deficit and immigration in his keynote Party Conference speech last year.
Unsurprisingly, therefore, alienation is rising amongst the electorate. As a result, populist rhetoric and narrow single-interest policies start to appear more attractive. And instead of returning to the centre ground, the major parties are increasingly focusing on these minority concerns, fearing the loss of votes, and so losing even more credibility.
Thus nobody knows how the voting will go in May or what policies might be pursued by a new government. Horse-trading for coalition votes could easily lead to outcomes that today seem most unlikely. And some seasoned observers even suggest it may prove impossible to form a stable government, leading to new elections later in the year.
Interest rate risk is rising in the developed economies as the Great Unwinding of policymaker stimulus continues. Since the blog first highlighted this Unwinding last month:
- Oil prices have continued to tumble, with Brent now down over $15/bbl from its late-June peak
- The US$ has continued to rise from multi-year lows versus the yen, euro and pound
And of course, these developments are self-reinforcing. Pension funds are now losing money on their oil market positions. They also have no reason to own oil as a ‘store of value’ if the US$ is strengthening.
In turn, these developments also impact interest rates and equity markets. The blog looks at interest rates today, and will then complete its mini-series next week by focusing on equities. As the chart shows:
- The US 10-year bond fell last year, as US investors believed economic recovery had become certain
- In turn, this caused interest rates to rise, as bond prices are the inverse of interest rates
- But more recently, the downward trend has halted, much to the surprise of the ‘experts‘
- The 10-year Treasury bond has thus been trading in a narrow band this year (blue lines)
This confirms it has been China’s reversal of economic policy that has changed financial market direction. US Federal Reserve cutbacks have been relatively minor by comparison. As the blog warned in February, when publishing its major Research Note (China bank lending: From $1tn to $10tn and back again).
“Why did nobody notice that China was the ‘elephant in the room’, in terms of being the main cause of today’s downturn in global demand and financial markets?” Answer: “Because we were all wearing rose-tinted glasses”.”
The question today is what happens if China’s housing bubble continues to burst?
- 49 million homes in China’s urban areas have been sold to speculators and sit empty today – more than 1 in 5 of the total – and $674bn of mortgage loans are secured on them
- Financing for the bubble has mainly come from Asian investors and the shadow banking system, so lenders to both these sectors will face big losses
- It will also undermine the ‘collateral trade’, so large quantities of iron ore, copper and even polymers will flood global markets in a disorderly fashion
- Most likely therefore, this will put further pressure on oil prices and strengthen the US$, reinforcing current trends
- But it will also focus attention on the key issue of debt repayment (as well as the outlook for company earnings)
We cannot know how markets will react:
- They might decide to see US markets as a ‘safe haven’ and dump debt in weaker currencies, such as the yen, euro and pound. If this happened, US interest rates could fall sharply
- Alternatively, investors might be forced to raise cash quickly to meet margin calls*, if commodity markets start to dive. This could force them to sell low-risk assets such as US Treasuries, causing interest rates to rise
This is one of the reasons why the blog fears we may see scary moments as markets slowly recover their prime function of price discovery. The collapse of the Chinese housing bubble will not just impact China – in fact, its biggest impact may well be felt outside China.
The reason is that, as the blog suggested back in June, China’s earthquake will open fault-lines in today’s debt-fuelled global ‘ring of fire’
*Margin debt is at record levels in New York markets, so this might be the only way to meet ‘margin calls’ (these are brokers’ demands to make immediate payment if prices have fallen during the day).
Back in April, the blog suggested that capital controls might remain for rather longer in Cyprus than the “few days or weeks” suggested by the central bank. And a month later, the bank was still unrealistically claiming they would be lifted “as soon as possible”.
Today, the blog’s own view that they could be in place “for a decade or more” is looking more and more likely.
As the chart from the Wall Street Journal shows, the decline in GDP is accelerating, contrary to all the official forecasts. GDP fell 4.8% in Q1 and 5.4% in Q2. As the Journal notes:
“Christopher Pissarides, a Nobel laureate and head of the government’s council of economic advisers, acknowledges that the economy is sinking faster than expected.”
Credit has basically stopped on the island, with most transactions now in cash. And the economy’s downward spiral is likely to intensify. Unemployment was 17.3% in June, well above the forecast of 15.5%.
Basic industries are suffering badly. Cement sales are only 25% of those in 2008. And as Mr Pissarides added in an unguarded moment ”disaster is still some way off. But times are getting tougher.”
Clearly this is very bad news for Cypriots. But it is equally ominous for the Eurozone for 3 key reasons:
- Cyprus is in the Eurozone. Its use of capital controls means they could happen in other member countries
- Its bailout was the first one where depositors suffered major losses, also setting a precedent for the future
- The policy prescription has now had 6 months to work, and has clearly failed
This would not matter if the rest of the Eurozone was healthy. But it isn’t. Germany’s finance minister has said Greece may another bailout of perhaps €10bn.
Click here to view the embedded video.
And then there is Portugal, whose economy is also getting worse, not better, as this Financial Times video shows.
So what will happen with Greece and Portugal? Will the German taxpayer be asked to pay the bill all on their own? Or will investors instead be forced to take another ‘haircut’ – to use the phrase popularised with Cyprus?
Neither option looks good. As the blog noted in its 4 Butterflies post last month, we all know that these issues cannot be discussed before the German election on 22 September, for fear of frightening voters. Markets clearly expect Germany to then pick up the bill on 23 September. But the blog is not so sure.
Investors are complacent today, but they are not stupid. If Germany forces them to take a haircut or suffer capital controls in Portugal or Greece, they will immediately worry about what might happen next in Spain and Italy? Both will likely need outside help before too long. Spain is not a small island like Cyprus, but the 13th largest economy in the world. And Italy is not a minor country like Greece, but the world’s 9th largest economy. Combined, their economies are the same size as Germany’s.
Most large companies have some exposure to both Spain and Italy either directly or indirectly. Any CFO who hasn’t already developed a contingency plan for the period after 22 September, clearly has a few sleepless nights ahead.
Newton’s 3rd Law of Motion states, “To every action there is always an equal and opposite reaction“. Thus the forces of two bodies on each other are always equal and are directed in opposite directions.
Policymakers forgot this Law in their response to the 2008 financial Crisis. Instead they believed that cutting short-term interest rates in the major economies to zero, and thereby reducing 10-year rates, would force investors to make riskier investments and so stimulate economic growth.
5 years later, of course, it is clear there has been no recovery to SuperCycle levels of economic growth, despite their $33tn of global stimulus. Instead, as Mexico’s central bank governor admitted at the weekend, the policy simply led to “large short-term speculative capital inflows” – exactly the ‘equal and opposite reaction’ that Newton’s 3rd Law would have predicted.
The chart shows what has happened to interest rates for 10-year bonds over the period. It shows them in August 2008 (red column) when the Crisis burst, and then on 1 May 2013 (blue), just before policymakers finally began to reverse course. It also updates the position to last Friday (green). Its focus is on the weaker European economies (the PIIGS – Portugal, Ireland, Italy, Greece, Spain) and the stronger global economies (the JUUGS – Japan, UK, USA, Germany, Switzerland):
- August 2008 rates were very similar across most countries at around 4%
- Only Japan was much lower at 1.5%, as its ageing population had led to deflation
- But interest rates then diverged quite strongly until May 2013
- In the PIIGS, Portugal, Ireland and Greece went through messy defaults
- In the JUUGS, by contrast, rates fell to all-time lows over the period
The decline in the JUUGS’ interest rates thus created the basis for the speculative capital outflows that Mexico’s governor identified..
Since May, however, rates in the JUUGS have begun to rise quite steeply. They have jumped by 60%-75% in Germany, the UK and US; and nearly doubled in Switzerland. Even Japan’s rates have risen.
Thus it is clear that the Crisis is now entering a new and even more dangerous phase. The $33tn spent on stimulus is equal to around half of global GDP. It is hard to see how this debt can ever be repaid, given that it financed a speculative credit boom, rather than the production of useful goods and services.
Policymakers should not have ignored Newton’s Law. Nor should they have refused to accept the critical learning from Japan, that ageing populations create economies which have low or even negative growth. These economies also have deflation rather than inflation, for the simple reason that older people no longer buy many new things, as the kids have left home and they already own most of what they need.
As we show in Boom, Gloom and the New Normal, the West is now going through Japan’s experience. The 1983-2007 SuperCycle saw large numbers of BabyBoomers in the Wealth Creating 25 – 54 age group. Now the average Boomer is 55 years old, and so the world is entering a New Normal of low or negative economic growth.
Thus as Newton would have predicted, the short-term speculative capital flows are now disappearing:
- The first casualties are countries such as India, Brazil, Indonesia and South Africa who never reformed their economies, and instead allowed imports to rise uncontrollably. They have large deficits on their current accounts, which cannot be financed now the speculative inflows have become outflows
- The next casualty will be the supposed ‘recovery’ in Western housing markets. This has been driven by rental market investors, not homeowners. As Goldman Sachs report, “more than half of all US homes sold last year and so far in 2013 have been financed without a mortgage“, versus less than a quarter before the subprime crash.
What happens next is difficult to forecast. The worst case is that interest rates will continue to rise, as investors head for the exits. This would likely cause stock and commodity markets to fall, as many investors have borrowed heavily to finance their positions . Margin debt (their total borrowing) is currently at a near-record $377bn level in New York. In turn, deflation would be almost inevitable under this Scenario.
Newton, however, would probably not be surprised at seeing his Law confirmed once more.
‘When I use a word,’ Humpty Dumpty said, in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’
This quotation from Lewis Carroll’s great novel ‘Through the Looking-Glass‘ rather seems to sum up policymakers’ current approach to financial markets. Two recent examples highlight the issue:
• Cyprus. Last month, we were assured that the capital controls introduced in Cyprus were only ‘temporary’ and would be lifted within days, or maybe a few weeks. But last week, the Governor of the central bank changed his mind. Instead, they will be lifted “as soon as possible“. And the criteria for lifting is he needs to “make sure that trust in the banks has recovered sufficiently“. That rather sounds, to the blog at least, as though it could be a decade or more before people are allowed to move their euros around freely again. As Reuters notes, the ‘temporary’ controls imposed by Argentina and Iceland are still in place years later.
• Japan. Also last month, the G20 Finance ministers issued a statement noting that “Japan’s recent policy actions are intended to stop deflation and support domestic demand“. Nothing about devaluation in order to boost exports. But after pausing in its downward spiral whilst the meeting took place, the currency has resumed its fall and has now passed the $1: ¥100 level. This is already a 27% devaluation since the Abe government arrived.
The blog will continue to keep a close eye on developments, particularly with regard to the Japanese yen. Its link to a potential bursting of the oil price bubble is too important to ignore.