The weekly – Leveraging the future

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12/11/2019
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The UK general election is now in full swing. Unusually for a pre-election period following the dissolution of parliament, this feels like business as usual for the Brexit process, the main difference being that the arguments are taking place in mainstream media rather than across the benches of the commons. The weekend saw an attack by the Tories on Labour’s spending pledges with the media covering the consequent jousting between the Chancellor and his Shadow. You may want to buckle up and brace yourself as we have another month to go.

These debates around spending illustrate the reason why western debt mountains are the size that they are. We have had an age of austerity ever since the credit crisis when the UK’s debt to GDP ratio ballooned away from Gordon Brown’s fiscal rules, where it hovered around 45% of our national output. The logic behind this was taken from the corporate sector, where it is viewed that leveraging a balance sheet makes sound economic sense as it provides the ability to invest for the future without having to rely on operating cashflow and accumulated profits. However, as there is a connected cost depending on the prevailing level of interest rates, businesses need to be careful how far they go; a sudden increase in that cost thanks to higher interest rates could spell trouble. This is why interest cover is such an important ratio when assessing the sustainability of a company’s cashflow – not unlike mortgage interest costs as a proportion of net salary for a home-owner. Many over the age of 50 may remember the impact of 15% interest rates on household budgets and the decimation of the housing market that followed as unaffordable houses were repossessed when people lost jobs as the recession took hold.

Gordon Brown’s discipline was good for the time, but was blown away by the credit crisis which affected the UK economy particularly badly as the banking sector was such a large proportion of our GDP. The debt to GDP ratio consequently doubled to 90% as GDP shrank and the Treasury picked up the tab for the failed banks, mainly Royal Bank of Scotland and Lloyds TSB. The Right Honourable David Cameron was able to successfully convince voters the Tories would be able to repair the economy. Where the fault lies is still the subject of much debate, but it was probably most likely a global problem of corporate debt largesse which was made possible due to poor banking regulation, which failed to identify that bank balance sheets were 95% geared and the 5% retained capital was itself highly vulnerable. Banks are now far more robust, as well as heavily regulated. Lending standards are much higher, so that we shouldn’t see a repeat of this disaster ever again.

This problem of debt largesse appears now to be the norm within democratically elected governments where, taking the UK in isolation, despite ten years of austerity, our debt to GDP is still at 85% (Source: HM Treasury - March 2019), and this is before the election pledges of the various parties are implemented. So what is the ideal figure? We appear to be abandoning any desire to get back to where we were ten years ago, pre-credit crisis, and both of the main parties seem to be spending significant sums. What is the tipping point and why have we abandoned the previous rules?

A recent study by the World Bank suggests that a developed economy can sustain a debt to GDP ratio of 77% before the costs of that debt start to impact economic growth. Every percentage point of debt above this level costs the country 1.7% in economic growth over the long term. The corresponding threshold figure for an emerging economy is calculated as 64%, influenced mainly by the inevitable higher costs of borrowing due to the perceived higher risk, with each additional percentage point of debt affecting growth by 2% each year. This is higher now than ten years ago because, globally, interest rates are significantly lower. So what are the implications of breaching these thresholds? The developed country with the highest debt to GDP ratio is Japan with a figure of 238% as at December 2018 (Source: Trading Economics). This was the direct result of their own asset price bubble which burst in 1990. Debt was increased commensurately as the bubble inflated such that when asset values collapsed, the debt burden remained and now constitutes more than twice their annual GDP. We are all aware of the economic struggles they have had with anaemic economic growth ever since, using the threat of deflation and constant quantitative easing and economic experimentation to try to resolve the issue. Japan is yet to find a solution and now has a stagnating economy paired with an ageing population – this is why few investors allocate much more than 5% of their equity allocation to the region.

Next on the debt list is Greece at 176% followed by Italy at 134% and Portugal at 126%. Again, we all know why these countries remain so indebted following the credit crisis and their bail-outs from the ECB. The next highest on the list is the United States at 105% and then Spain at 98%. So, relative to these, the UK on 82% at December 2018, doesn’t look so bad, but this is still costing economic growth. Interestingly, the EU as a collective also has a figure of 82%. All these numbers are costing economic growth, but it is fair to assume that the majority of voters care more about the pounds in their pocket than those borrowed in the Treasury.

We all vote based on what is ultimately going to affect our individual standard of living alongside which ideology we agree with, whether that be a more equal distribution of wealth, tackling climate change or out and out capitalism and the survival of the fittest. The problem is that each of the parties has to spend money to achieve their ideology but doesn’t want to promote raising taxes for the masses as that is a sure-fire way to lose the election. The current solution is to increase the fiscal deficit and the debt mountain as this doesn’t immediately affect the voter’s pay packet. In the long run, however, it means that the Treasury has to issue more Gilts to pay for these promises, as the taxpayer only has so much tolerance for higher taxes. The alternative is to cut spending, which is what we have had for ten years, but again, public tolerance of this is now at an end, with spending on public services set to increase significantly after the election. Again, the two main parties are competing as to which is going to recruit more police officers or inject more money into the NHS. Transport, infrastructure and defence rarely feature as they are not vote winners.

Nowhere else is this increase in borrowing starker than in the US with the borrowing figures above revealing the impact of President Donald Trump’s policies. The forthcoming Democratic Party nominee will have to present a case to the electorate to counter President Trump’s spending spree where he has cut corporate taxes significantly, income taxes moderately, increased military spending and implemented trade tariffs, which are effectively a tax on imports for corporate America. So again, we are yet to get into the detail of the US election manifestos, but it is likely that the deficit will take the strain. As long as interest rates remain low, the public finances can take the strain, but at a cost of future economic growth.

The inevitable outcome of this is an ever-rising debt mountain within Western democratic governments who repeatedly make unaffordable promises in order to get elected. Whilst interest rates are low, the cost is manageable, but it is still billions of dollars and millions of pounds that could be spent on improving healthcare or other desperately needed infrastructure. It also means, as we have just seen in the latest cycle, that the upside for interest rates is very limited before the economy begins to struggle and rates have to be cut again. In Europe, interest rates have never been increased since the credit bubble burst and this year, they have had to re-introduce quantitative easing once more to try to stimulate economic growth as Germany and Italy enter recession. This illustrates that the economic levers of conventional monetary policy within the Eurozone are broken with money printing the only stimulating option now available.

This is all rather worrying, but probably unsurprising as populist economics has come to the fore. President Trump was elected on the basis of lots of promises which resonated with his supporters at the time. The majority are now paying lower taxes and the stock market is hitting new highs, improving the living standards of the many, with full employment. This will be a tough mantra to defeat unless the Democrats introduce a huge fiscal spending programme.

Whatever transpires over the next month, the UK’s debt is likely to get bigger as stimulation moves from interest rate cuts to fiscal spending in the form of healthcare and economic investment justified by new rules of investing over the cycle. Achieving closure on Brexit will be a huge relief to all and lift a cloud over corporate investment, whichever way it goes. The national debt, meanwhile, remains for future generations to worry about as we approach another round of economic promises, funded by yet more debt. Whilst interest rates are so low, this is probably affordable. The very fact that any increase in interest rates will cause a slowdown much faster than historically, due to the degree of leverage, will prevent rates from rising very far. The obvious flaw in this is inflation, which would historically have been the demon hiding in the background. For now, the internet seems to have killed this off as pricing power has transferred to the consumer. Even the trade tariffs from the US don’t appear to have had much affect, contrary to the harbingers of doom, but vigilance is vital as we pursue this debt fuelled tightrope model of economic prosperity.

 

Equities climb on stronger data and hopes of a trade deal

Risk assets rallied after economic indicators painted an improved picture of the global economy, and negotiators reported that the US and China had made progress toward some form of trade agreement.  The American S&P 500 index rose +0.9% during the week. The UK’s FTSE 100 closed the week up +0.8%.

Progress toward a phase one trade agreement between the US and China was reported this week, with comments coming from Chinese officials suggested some existing tariffs could be rolled back by each side.  While details have yet to be confirmed, there is speculation that an agreement could be signed by President Trump and Chinese President Xi Jinping as an aside to the NATO summit scheduled for the 3rd of December in London.  

Furthermore, market expectations are that the US Department of Commerce may refrain from placing tariffs on European vehicles next week.  In terms of economic data, German factory orders rose for the first time in three months and Eurozone retail sales rose 3.1% year-on-year, during September.  European markets rallied; Germany’s DAX 30 climbed +2.1% whilst the French CAC 40 added +2.2%.

There were additional signs from the US this week that the global slowdown that has been present over the last 12 months was abating somewhat.  On top of last Friday's strong US employment report, this week saw a rebound in the ISM non-manufacturing purchasing managers' index (PMI).  The yield on 10-year US treasuries rose 22 basis points to 1.93%.

However, UK economic data was noted to have deteriorated by the Bank of England who held their latest monetary policy meeting last week. Whilst they made no change to policy on Thursday, two members voted in favour of a 25-basis point cut to combat downside risks to the committee's projections.

Safe havens such as Gold and the Japanese yen fell.  The precious metal slipped -3.1% last week, and

in the context of a weakening Yen the Japanese equity market typically responds positively, as such the Nikkei 225 climbed +2.4%. 

 

The week ahead

It’s already been a busy start to the week for domestic data following the release of Q3’19 GDP on Monday. The preliminary figure, which is subject to revision, showed a return to growth with output having expanded by +0.3% versus Q2. On Tuesday, the latest labour market statistics were published with a 3.8% unemployment rate, 0.1% below predictions. Annualised wage growth slowed by 0.2% to +3.6%. Other UK related figures to keep an eye on include CPI inflation (Wednesday) and retail sales (Thursday).

Inflation and retail sales are also the most significant data releases in the US this week, alongside industrial production on Friday afternoon. Meanwhile, Federal Reserve Chairman Jerome Powell is testifying on the current economic conditions to the House Budget Committee in Washington on Thursday. His words will no doubt be heavily scrutinised for any indications regarding the outlook for interest rates.

On the continent, a second reading of Eurozone Q3’19 GDP is due on Thursday with no change to the previously calculated +0.2% expected. In Asia, GDP data is also the standout release in Japan whilst its particularly busy week for Chinese publications with fixed asset investment, industrial production, retail sales and unemployment all due before the close of play on Friday.

 

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Source: FE Analytics (information is correct as at 11th November 2019) 

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