The BoE’s pre-emptive strike is not without risk

The Financial Times has kindly printed my letter below, arguing that it seems the default answer to almost any economic question has now become “more stimulus” from the central bank.

After 15 years of subprime lending and then quantitative easing, last week’s warning from the Bank of England suggests there are fewer and fewer economic questions to which the default answer is not “more stimulus”.

But it is still disappointing to find the Financial Times supporting this reflex reaction when considering the risks associated with Brexit next month (“Bank of England must grapple with the risks of a no-deal Brexit”, February 6). Nobody would dispute that the bank has a critical role in terms of ensuring financial stability through the Brexit transition. As the FT says, the “potential outcomes are discrete and the impacts vary widely”.

But the bank has already fulfilled this role by publishing its November assessment of the no-deal risks for government and parliament to consider. There is therefore no justification for the bank to pre-emptively impose its views by deciding to keeping interest rates artificially low.

The political risks associated with such an intervention would be large, particularly if the bank’s assessment or its proposed solution proves wrong. And there is also the risk of unintended consequences.

The history of stimulus does, after all, suggest that the only certain outcome of lower interest rates would be a further rise in today’s already sky-high level of asset prices.

Paul Hodges
The pH Report

London house prices slip as supply/demand balances change

London house prices are “falling at the fastest rate in almost a decade” according to major property lender, Nationwide.  And almost 40% of new-build sales were to bulk buyers at discounts of up to 30%, according of researchers, Molior.  As the CEO of builders Crest Nicholson told the Financial Times:

 “We did this sale because we knew we would otherwise have unsold built stock.”

They probably made a wise decision to take their profit and sell now.  There are currently 68,000 units under construction in London, and nearly half of them are unsold.  Slower moving builders will likely find themselves having to take losses in order to find a buyer.

London is a series of villages and the issues are different across the city:

Nine Elms, SW London.  This $15bn (US$20bn) transformation has been ‘an accident waiting to happen‘ for some time.  It plans to build 20000 new homes in 39 developments at prices of up to £2200/sq ft.  Yet 2/3rds of London buyers can only afford homes costing up to $450/sq ft – thus 43% of apartments for sale have already cut their price.

West End, Central London.  This is the top end of the market, and was one of the first areas to see a decline.  As buying agent Henry Pryor notes:

“Very few people want to buy or sell property in the few months leading up to our monumental political divorce from Europe next March, which is why 50% of homes on the market in Belgravia and Mayfair have been on the market for over a year. Yet there are people who have to sell, whether it be because of divorce, debt or death, so if you have money to spend I can’t remember a time since the credit crunch in 2007 when you could get a better deal.”

NW London.  Foreign buyers flooded into this area as financial services boomed.  Rising bonuses meant many didn’t need a mortgage and could afford to pay £1m – £2.5m in cash.  But now, many banks are activating contingency plans to move some of their highly paid staff out of London ahead of Brexit.  Thus Pryor reports buying a property recently for £1.7m, which had been on the market for £2.25m just 2 years ago.

W London.  Also popular with foreign buyers, even areas such as Kew (with its world-famous Royal Botanic Gardens) have seen a dramatic sales volume decline.  In Kew itself, volume is down 40% over the past 2 years.  And, of course, volume always leads prices – up or down.  Over half of the homes now on sale have cut prices by at least 5% – 10%, and the pace of decline seems to be rising.  One home has cut its offer price by 17.5% since March.

Outer London.  This is the one area bucking the trend, due to the support provided by the government’s ‘Help to Buy’ programme.  This provides state-backed loans for up to £600k with a deposit of just 5%.  As Molior comment, this is “the only game in town” for individual purchasers, given that prices in central London are out of reach for new buyers.

The key issue is highlighted in the charts above – affordability:

  • The first chart shows how prices were very cyclical till 2000, due to interest rate changes.  They doubled between 1983 – 1989, for example, and then almost halved by 1993.  In turn, the ratio of prices to average earnings fluctuated between 4x – 6x
  • But interest rates have been relatively low over the past 20 years, and new factors instead drove home prices
  • The second chart shows the impact in terms of first-time buyer affordability and mortgage payments.  Payments were 40% of take-home pay until 1998, but then rose steadily to above 100% during the Subprime Bubble.  After a brief downturn, the Quantitative Easing (QE) bubble then took them back over 100% in 2016

The paradigm shift was driven by policy changes after the 2000 dot-com crash.  As in the USA, the Bank of England decided to support house prices via lower interest rates to avoid a downturn, and then doubled down on the policy after the financial crash – despite the Governor’s warning in 2007 that:

“We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession… That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”

  • The 2000 stock market collapse and subprime’s low interest rates led many to see property as safer than shares.  They created the buy-to-let trend and decided property would instead become their pension pot for the future
  • The 2008 financial crisis, and upheavals in the Middle East, Russia, and parts of the Eurozone led many foreign buyers to join the buying trend, seeing London property as a “safe place” in a more uncertain investment world
  • Asian buyers also flooded in to buy new property “off-plan”.  As I noted in 2015, agents were describing the Nine Elms development as: ” ‘Singapore-on-Thames’. Buying off-plan was the ultimate option play for a lot of the buyers [who are] Asian. You only need to put down 10% and then see how the market goes. A lot of buyers are effectively taking a financial position rather than buying a property”

But now all these factors are unraveling, leaving prices to be set by local supply/demand factors again.  Recent governments have taken away the tax incentives behind buy-to-let, and have raised taxes for foreign buyers.  As the top chart shows, this leave prices looking very exposed:

  • They averaged 4.8x earnings from 1971 – 2000, but have since averaged 8.7x and are currently 11.8x
  • Based on average London earnings of £39.5k, a return to the 4.8x ratio would leave prices at £190k
  • That compares with actual average prices of £468k today

And, of course, there is the issue of exchange rates.  Older house-owners will remember that the Bank of England would regularly have to raise interest rates to protect the value of the pound.  In 1992, they rose to 15% at the height of the ERM crisis.  But policy since then has been entirely in the other direction.

Nobody knows whether what will happen next to the value of the pound.  But if interest rates do become more volatile again, as in 1971-2000, cyclicality might also return to the London housing market.

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West’s household spending heads for decline as population ages and trade war looms

As promised last week, today’s post looks at the impact of the ageing of the BabyBoomers on the prospects for economic growth.

The fact that people are living up to a third longer than in 1950 should be something to celebrate.  But as I noted in my Financial Times letter, policymakers are in denial about the importance of demographic changes for the economy.

Instead, their thinking remains stuck in the past, with the focus on economists such as Franco Modigliani, who won a Nobel Prize for “The Life Cycle Hypothesis of Savings”, published in 1966.  This argued there was no real difference in spending patterns at different age groups.

Today, it is clear that his Hypothesis was wrong.  He can’t be blamed for this, as he could only work with the data that was available in the post-War period.  But policymakers should certainly have released his theories were out of date.

The chart highlights the key issue, by comparing average US and UK household spending in 2000 v 2017:

  • In 2000, there were 65m US households headed by someone in the Wealth Creator 25-54 cohort, and 12.5m in the UK.  They spent an average of $62k and £33.5k each ($2017/£2017)
  • There were 36m US households headed by someone in the 55-plus New Older cohort, and 12.4m in the UK, who spent an average of $45k and £22.8k each
  • In 2017, the number of Wealth Creator households was almost unchanged at 66m in the US and 11.9m in the UK.  Their average spend was also very similar at $64k and £31.9k each
  • But the number of New Older householders had risen by 55% in the US, and by 24% in the UK, and their average spend was still well below that of the Wealth Creators at $51k and £26.4k respectively

Amazingly, despite this data, many policymakers still only see the impact of today’s ageing Western populations in terms of  likely increases in pension and health spending.  They appear unaware of the fact that ageing populations also impact economic growth, and that they need to abandon Modigliani’s Hypothesis.

As a result, they have spent trillions of dollars on stimulus policies in the belief that Modigliani was right.  Effectively, of course, this means they have been trying to “print babies” to return to SuperCycle levels of growth.  The policy could never work, and did not work.  Sadly, therefore, for all of us, the debt they have created can never be repaid.

This will likely have major consequences for financial markets.

As the chart from Ed Yardeni shows, company earnings estimates by financial analysts have become absurdly optimistic since the US tax cut was passed.

The analysts have also completely ignored the likely impact of China’s deleveraging, discussed last month. 

And they have been blind to potential for a global trade war, once President Trump began to introduce the populist trade policies he had promised in the election.  Last week’s moves on steel and aluminium are likely only the start.

Policymakers’ misguided faith in Modigliani’s Hypothesis and stimulus has instead fed the growth of populism, as the middle classes worry their interests are being ignored. This is why the return of volatility is the key market risk for 2018.

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China’s role in market volatility – Beijing’s shifting priorities raise questions over assumptions of global growth

Commentators have confused cause with effect when analysing this month’s sudden downturn in financial markets, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog


Surprise and confusion seem to have been the main reactions to this month’s sudden downturn in western financial markets. Yet across the world in China, warning signs of a potential downturn have been building for some months, as discussed here in June.

As the chart below shows, President Xi Jinping’s decision to move away from stimulus policy will have a direct impact on the global economy, as this has been the main source of the liquidity that has boosted financial markets over the past decade.

China’s official and shadow bank lending totalled more than $20tn between 2009 and 2017. By comparison, the US Federal Reserve, Bank of Japan, European Central Bank and Bank of England added “only” $13tn between them.

The critical importance of China’s policy shift was highlighted in December by the state-owned Xinhua news service when it announced Mr Xi’s priorities for 2018 as being to fight “three tough battles” to secure China’s goal of “becoming a moderately prosperous society” by 2020.

“Financial deleveraging” was described as the first battle, and it seems the opening salvos have already been fired, given that China’s capital outflows collapsed from $640bn in 2016 to just $60bn in 2017.

The People’s Bank of China then reinforced this priority in January with a statement emphasising that “slower M2 growth than before will become the ‘new normal’, as the country’s deleveraging process deepens and the financial sector gets back to the function of serving the economy”.

Western financial markets, however, seemed to adopt the “Road Runner approach” to this major paradigm shift in economic policy. Like the cartoon character Wile E Coyote, the new year saw them continuing to hang in mid-air before finally realising they were about to plummet into the chasm.

Even more worrying, now calm has been temporarily restored, is their failure to learn from the experience. Instead, commentators have mostly gone back to their comfort zone and are again focusing on the minutiae of policy statements from the major western central banks.

This could prove a costly mistake for investors and companies. As the FT reported in December, Mr Xi has already “made controlling debt at state-owned enterprises a top policy priority”, and it seems likely he will follow the IMF’s advice by increasing budget constraints for China’s zombie companies and allowing more corporate defaults. January’s shadow bank lending was the lowest January level since 2009 at just $25bn, and it was 90 per cent lower than in January 2017.

The recent rush of asset sales by major Chinese corporates such as HNA and Dalian Wanda is another clear sign of the new discipline being imposed. Foreign investors must hope the companies realise a good return from these disposals, given that they provided $221bn in dollar-denominated loans to Chinese borrowers last year.

Deleveraging is only one of Mr Xi’s “three battles”, however. And while his second battle on poverty reduction is unlikely to impact the global economy, his third battle, the “War on Pollution”, has a number of potentially critical implications.

It has already led to thousands of company closures and forcible relocations, and has severely disrupted major parts of China’s economy — causing China’s producer price index to peak at 6.9 per cent in the fourth quarter. In turn (as we had forecast here in November), this surge has created today’s “inflation surprise” as its impact rippled round the world.

One key component of the “surprise” was the disruption caused by the unexpected loss of production in key commodity markets. Oil prices have surged, for example, as China’s move away from coal has powered a short-term increase in oil demand. And, as always, the surge has been boosted by the inventory build typically associated with such unexpected and sudden price hikes. This can be seen in the second chart, which focuses on volume changes in the chemicals market, normally an excellent leading indicator for the global economy.

It confirms that consumers put aside their initial scepticism over Opec’s ability to support the oil market, as China’s excess demand helped prices to rise 60 per cent from June’s $44 a barrel to January’s $71 peak. Purchasers scrambled to build stock ahead of likely price rises for their own raw materials.

This time round, it even led buyers to abandon their normal tactic of reducing stock at year-end to flatter working capital data. Instead, inventories rose quite sharply all down the value chains, creating the illusion that demand was suddenly increasing in a co-ordinated fashion around the world.

The world has seen many similar increases in such “apparent demand” over the years, and these can temporarily add up to an extra month’s demand to underlying levels. This increase is, of course, only a temporary effect, as it is quickly unwound again once prices start to stabilise. The chart also shows that this was already starting to happen in January, with the normal seasonal stock-build being replaced by destocking.

In turn, of course, these developments raise a major question mark over the current assumption that the world is now seeing a synchronised global recovery. We suspect that by the summer, policymakers may well find themselves repeating the famous lament of Stanley Fischer in August 2014, when the Fed’s vice-chairman sadly noted that “year after year we have had to explain from midyear on why the global growth rate has been lower than predicted as little as two quarters back”.

Paul Hodges, Daniël de Blocq van Scheltinga and Paul Satchell publish The pH Report.

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Monetary policy reaches sell-by date for managing the economy

US GDP Feb17

Monetary policy used to be the main focus for running the economy.  If demand and inflation rose too quickly, then interest rates would be raised to cool things down.  When demand and inflation slowed, interest rates would be reduced to encourage “pent-up demand” to return.

After the start of the Financial Crisis, central banks promised that lower interest rates and money-printing would have the same impact. They were sure that reducing interest rates to near-zero levels would create vast amounts of “pent-up demand”, and get the economy moving again.  But as the chart shows for US GDP, they were wrong:

□  It shows the rolling 10-year average for US GDP since 1950, to highlight longer-term trends
□  It confirms the stability seen between 1983 – 2007 during the BabyBoomer-led economic SuperCycle
□  The economy suffered just 16 months of recession in 25 years, as monetary policy balanced supply and demand
□  But the trend has been steadily downwards since 2008, despite the record levels of stimulus

The clear conclusion is that monetary policy is no longer effective for managing the economy.

Encouragingly, the UK Parliament’s Treasury Committee has now launched a formal Inquiry to investigate ‘The Effectiveness and impact of post-2008 UK monetary policy‘.  We have therefore taken the opportunity to submit our evidence, showing that demographics, not monetary policy, is now key to economic performance.  We argue that:

 It was clearly important until 2000, when the great majority of people were in the Wealth Creator 25 – 54 age group (which dominates consumption and therefore drives GDP growth). But its impact is now declining year by year as more and more BabyBoomers move into the 55+ age group – when incomes and spending begin to decline quite rapidly
 Friedman’s analysis of the effectiveness of monetary policy, when he argued that “inflation is always and everywhere a monetary phenomenon”, is therefore no longer valid. Modigliani’s “Life Cycle theory of consumption” is similarly out of date
 The issue is simply that both Friedman and Modigliani were working in an environment which assumed that people were born, educated, worked – and then died soon after reaching pension age. In these circumstance, their theories were perfectly valid and extremely useful for modelling the economy
 Today, however, the rapid increase in life expectancy, together with the collapse of Western fertility rates below replacement level, means that a paradigm shift has taken place.  People are now born, educated, work – and then continue to live for another 20 years after retirement, before dying
 The essential issue is that “you can’t print babies”. Monetary policy cannot solve the demographic challenges that now face the UK (and global) economy
 We therefore hope that the Committee will conclude that monetary policy should no longer be regarded as the major mechanism for sustaining UK growth

Please click here if you would like to read the evidence in detail.

Oil price rally disappears along with hopes of more stimulus

Burst bubbleMany people in financial markets were hoping a new QE4 stimulus programme would be announced at the recent IMF meeting in Peru.  Unsurprisingly, markets rallied in anticipation:

  • Brent oil was at $44/bbl on 24 August, and rallied to $56/bbl within a week
  • The US S&P 500 Index rallied from 1823 to 1979 over the same period as the rumour spread

We have seen such rallies before, and we will no doubt see them again. They confirm how difficult it is going to be for markets to return to valuations based on the fundamentals of supply and demand. It is so much easier to base your investment strategies on stimulus programmes. These create a looking-glass world where bad news on the economy is always good news for financial markets, as it means they will more free cash with which to push prices higher.  And the only strategy one needs to know is to “buy on the dips”.

However, there has been little follow-through on these rallies, and the hoped-for stimulus has not (yet) appeared.  As a result, investors are having some nervous moments.  In oil markets, for example, inventories have continued to increase;  China’s economic growth has slowed further; oil supply has proved resilient and Iran’s return to oil markets has come closer.  Thus Brent prices have already slipped below $49/bbl.

Importantly also, leading figures in oil markets have suggested that hopes of a substantial rally are illusional.  As Reuters reported yesterday:

“Vitol, the world’s largest oil trader, believes the crude price will struggle to trade above $60/bbl next year, as the effects of slowing global demand growth could be compounded by a return of Iranian and maybe even Libyan barrels.  

“The price of oil has halved over the last 12 months, mainly as a result of unprecedented levels of production from some major exporting countries, but also as demand from China and other commodity consumers, such as Brazil and Russia, slackened.  Ian Taylor, Vitol CEO, said his company forecast 2016 global oil demand growth at around 1.35 mbpd, slowing from this year’s strong expected growth of 1.7 mbpd”

Even this view may prove optimistic in my view.  China’s President Xi has every incentive to ‘take the pain’ of an economic slowdown by the end of 2016.  He must surely want to be able to argue that the worst is over, and better times lie ahead. when he comes up for reappointment in November 2017.

This has major implications for company Budgets next year, as I discuss in a new analysis for ICIS Chemical Business.   Xi’s New Normal policies also raise the question of whether we are now seeing a generational change in demand patterns, as I will discuss next Monday in my 2016 – 2018 Budget Outlook.

Please click here to download the ICIS article.