What future for UK economy ?

“Sell any sterling you might have. It's finished. I hate to say it, but I would not put any money in the UK". This was investment guru Jim Rogers’s suggestion last January, which stirred up anger and poignant comments by many UK investors and commentators. Even though the unfortunately unheeded advice of the co-founder and former partner of the Quantum fund might have been exaggerated to surprise the international audience, the events of the subsequent months have confirmed that the health of the UK economy is deteriorating sharply. Since January 20 (the day of Mr Rogers statement), the pound has gained 6% against the euro and almost 18% against the US Dollar. However, Q2 GDP data released last week showed that the negative pieces of news for the UK economy are far from over. Indeed second-quarter GDP eased by 0.8% q/q, more than twice the consensus estimates, while the y/y decline was 5.6%.

But last week’s UK GDP drop is likely to be the latest of five consecutive declines since Q2 08. Some economists, including Michael Saunders of Citigroup, expect a return to growth in the current quarter. A rather widespread consensus is for UK GDP to be back in positive territory in Q4 09 at the latest. Nevertheless, the UK economy will likely remain sluggish in coming quarters, with almost no chance of a V-shaped recovery. A recent study by Deloitte has reinforced these fears, predicting GDP growth of just 0.5% in 2010 and 1.5% in 2011. Not only will a below-forecast economic improvement affect employment (Deloitte sees the number of unemployed exceeding 3m), but also the public accounts. Indeed, the Treasury relies on 3.5% growth in 2011 to restore health to the public finances. But worse than expected public accounts may surface well before 2011. For example, the Treasury’s estimate of a 175bn pound deficit in 2009 is based on the assumption of a 3.75%, contraction, which is more optimistic than the predictions of both the OECD (-4.3%) and IMF (-4.2%).

Persistent concerns on the health of the public finances are weighing on the UK bond market. The 10-year government bond yield now stands at 3.97%, well above that of the US (3.74%) and Germany (3.48%). However, expectations of a higher inflation in the UK than in the US and Euro zone should drive yields higher. Average inflation expectations over the next 10 years are at 2.36% in the UK, 1.88% in the US and 1.77% in Germany. The high public debt and the devaluation of the pound over the past two years (the Euro/Sterling exchange rate rose from 0.67 to 0.86 in August 2007 and neared 1 at the end of 2008) are the reasons why economists are predicting a more elevated inflation rate in the UK.

These expectations have led most economists to believe that the Bank of England will be the first Central Bank to raise rates and to conclude this phase of ultra-expansionary monetary policy. The outcome of the Executive Committee meeting, scheduled on August 6, will undoubtedly shed light on the issue. Whether the asset purchase program will be expanded upon having reached the threshold of 125bn pounds established at the outset will dominate the meeting’s agenda (no rate movement is expected).

But crucial indications of the inflation outlook will likely be offered by Bank of England Governor Mervin King’s quarterly press conference on August 12, on the sidelines of the presentation of the Inflation report. Any statement by Governor King (who traditionally anticipates the actions subsequently taken by other central banks) on the implementation of an exit strategy may clear the way for other international central banks in the months ahead. By contrast, lack of guidance for the inflation outlook would be a clear sign that the UK is still a very long way from getting back to normality.

Trend and interest rate push Euro higher

Over the last few weeks the Euro/Dollar exchange rate has moved in line with recent months, with the single European currency strengthening and weakening in the face of rising and declining stock markets. The current uptrend in major international equity indices has coincided with a return of the Euro/Dollar above 1.42, as clear evidence that the Euro/Dollar movement is more contingent on the trend followed by international risk premia than on the two countries’ economic fundamentals. But this trend may prove short-lived as the correlation between currency and equity market movements has often broken down in the past.
Indeed, even though a weak dollar characterised the equity market upswing in the years 2003 to 2007, of opposite sign was the US currency movement against the Euro during the 1990s bull market. Moreover, the early stages of the Euro/Dollar uptick in 2001 also coincided with an equity market slowdown. A number of academic studies have revealed that there is no medium/long-term relation between the trend followed by currency markets and that shown by other asset classes.
The correlation between Euro/Dollar and equity markets might therefore fade in coming months. The consensus of the currency strategists interviewed by Bloomberg is for an exchange rate substantially unchanged during the second half of this year to close 2009 at 1.40. Nevertheless, economists’ forecasts are not unanimous, with the Euro/Dollar exchange rate seen at between 1.16 and 1.55 by year-end.
As clear evidence of how forecasting the Euro/Dollar exchange rate fluctuations is no easy task, the same economists who have made similar forecasts for the Euro/Dollar exchange rate direction have given contrasting views on the reasons behind the emergence of this trend. On the one hand, Jim O'Neil, Goldman Sachs chief economist, sees the US Dollar strengthening over the next 12 months given a potentially better than expected economic climate in the US. On the other hand, Gareth Berry, a currency strategist for UBS, is looking for a US dollar strengthening in the weeks ahead for the opposite reason, namely the possibility that investors’ expectations of an international economic recovery are disappointed.
Nevertheless, many economists, including Jeremy Hale, Citigroup chief strategist, and Steven Englander, a chief currency strategist at Barclays Capital, predict that the Euro/Dollar will continue to move upward going forward. This negative view on the US Dollar is bolstered by institutional investors’ gloomy sentiment on the greenback and by the “uncertainty about the monetary and fiscal policy despite US assurances that the Fed and the Treasury are trying to give the market " says Englander.
Market observers believe that these diverging views on the Euro/Dollar movement might increase market volatility in the months to come.
Confronted with sharply conflicting estimates, investors are finding it hard to take a position. Therefore, analysing the factors that have provided crucial clues about past exchange rate movements may be of help.
First, the interest rate differential. In a recent study published in Vouex.com ("Can we understand the recent moves of the euro-dollar exchange rate"), the economists Brender, Gagna and Pisani have offered evidence that the Euro/Dollar exchange rate moved broadly in line with the Fed’s and ECB’s monetary policy estimates until Lehman Brothers went bust. This correlation might resume in the next few months, leading to a renewed appreciation of the Euro. Indeed, the interest rate differential is expected to continue to favour the single European currency because both a new rate cut by the ECB and a rate hike by the Fed are highly unlikely in coming months. Building a consensus for a rate cut within the ECB is challenging at current market conditions. Furthermore, the Fed is not expected to lift rates in the medium term, even in the presence of an economic recovery, to avoid repeating the mistakes made in 1937, when a suddenly restrictive monetary policy hampered the long-awaited recovery following the 1929 crisis.
Second, the current uptrend could prompt a fresh appreciation of the single currency. In recent years academic studies have shown that "trend following" strategies may lead to a currency market outperformance, as in the case of equity markets. This is confirmed by the moving average analysis, (which nevertheless should be taken with caution due to the short time horizon considered): buy the Euro/Dollar when the monthly close is above the moving average of the last 10 months and vice versa. Since January 1, 1999, this strategy has translated into a 44% increase, with 5 successful transactions and 6 failed operations, against a +25% obtained with a buy and hold strategy. Therefore, opening long positions on the US Dollar until the Euro/Dollar upward trend remains in place seems to be premature.
Although the prevailing short-term view among economists is that a new appreciation of the Euro is on the cards, medium-term projections seem instead to be in favour a US dollar appreciation, as proven by the analysis of the Purchasing Power Parity (PPP) calculated by the OECD. A 2007 report by Deutsche Bank’s economist Bilal Hafeez (“Currencies: value investing”) showed that successful investment strategies can be implemented on the basis of the PPP. Using the PPP calculation, the Euro/Dollar fair value is around 1.17, implying 17% potential for dollar appreciation. Only a sharper increase in US inflation than in the Euro zone could lead the PPP to predict lower appreciation potential for the US Dollar. It should also be noted that when the time comes to tighten monetary policy, rates will likely rise more sharply in the US than in Europe due to the latter’s stronger growth potential.

Inflation/deflation threats hanging over the US economy?

The US consumer price index for June published on Wednesday July 15 has not helped clarify one of the most controversial debates among economists over recent months: the future of inflation in coming quarters and years.

On the one hand, some economists such as John Taylor, a Stanford economics professor, and Marc Faber believe that a sharp rise in inflation could be on the cards mainly because of the expected explosion of public debt in the years ahead. Inflating the economy to ease the heavy burden of a high public debt is also a decision that the US government could take going forward, although this possibility has been dismissed by US Government officials. An increase in the inflation rate above levels that would be accepted under normal conditions is also a solution that some economists have proposed to alleviate the situation in the US. For example, Kenneth Rogoff, a professor of economics at Harvard University, pointed out that a 6% inflation rate would make the high debt burden more sustainable and help deleverage the US economy. John Makin, an economist at the American Enterprise Institute, has recommended the adoption by the Federal Reserve of a target in terms of a price level and not a growth rate of prices.
More difficult to analyse are concerns related to money supply growth. If it is a universally accepted principle that inflation is only a monetary phenomenon, in line with the thinking of Milton Friedman, the evolution of money supply has proved of little use in estimating the trend of inflation, if not for very long horizons, over the last few decades.

Deflationary fears

On the other hand, more reasonable seem to be short-term fears of a fall into deflation due to the similarities between the current economic environment, the US Great Depression in 1929 and the Japanese crisis that began in the1990s.

Some economists, including the 2008 Nobel Laureate Paul Krugman and the head of the World Bank Justin Lin, believe that the current economic weakness is creating a high level of spare capacity, which will likely lead to a further fall in prices going forward.
Under this scenario, and with the process of deleveraging of US consumers far from concluded and the decline in household wealth likely to weigh on private consumption for a long time, it is difficult to envisage that companies could lift prices significantly in coming months. The potential rise in commodity prices could hardly be passed on to end customers.

Deflation fears are being compounded by evidence of the past, which shows that the core CPI index usually continues to decline for several months after the end of a recession.

Nevertheless, the slight drop in the core CPI index in the last few months has led Justin Weidner and John Williams of the San Francisco Fed in their June report "How big is the output gap" to the conclusion that fears of deflation are exaggerated. According to the two economists the current recession could be accompanied by a reduction in the economic growth potential. Therefore, the output gap may be narrower than generally thought (and therefore unemployment will remain high in coming years) and risks of deflation lower.

In spite of the recent heated debate among economists about inflationary prospects, major financial markets have dismissed the threat of a sharp increase either in inflation or deflation. The behaviour of the US bond market bolsters this theory: inflation expectations for the next 10 years have hovered around 1.6% in recent weeks, only slightly lower than the historical average.

But it is one of the most reliable indicators for estimating the trend of inflation in the coming 12 months, gold, to send reassuring signals. Gold is well above the US$900 an ounce threshold, in line with the values recorded in July 2008.

Therefore, the market is not looking for major changes to the inflation outlook. Gold is the variable to look at more carefully to understand the future trend of inflation. After the sharp rebound staged in the period 2001/2008 up to the high of US$1030 an ounce level, which anticipated the surge in inflation to 5.6% in July 2008, gold underwent a downward correction at US700 in September/October 2008 following the Lehman Brothers bankruptcy and now remains steady above the US$900 mark. New precious metal highs will likely show that an increase in inflation in the 12 months ahead is a clear possibility, while a return to the values last seen in September 2008 will provide further evidence that fears of deflation have not been set aside.

China between excessive loan growth and consumer spending revival

Rebalancing China’s ecomomy towards sharper growth in domestic consumption: this is one of the recipes suggested by the authorities following the deepening of the crisis of many major developed economies to allow a return of the world economy to a path of sustainable growth. Indeed over the last few years the Chinese economy has focused on boosting exports and expanding investment. The share of private consumption to GDP dropped from 67% in 1981 to 48.8% in 2007, while the trade balance went from negative in 1985 (- 4%) to positive in 2007 (8.9%). Rebalancing consumption is also the number one priority for the Chinese government, which aims to make the country less vulnerable to the global recession. The 26% decrease in exports for May is clear evidence that China can no longer rely on exports to bolster its economy.

"Easier said than done": this is the recent trenchant comment made by the Central Bank Governor Zhou Xiaochuan, who highlighted the need to lower the rate of household (around 20% on average) and corporate savings (to 22.9%). With this in mind, the government has recently launched a 850bn yuan plan aimed at boosting consumption and financing a healthcare reform plan by slashing taxes on new car purchases (which soared by 48% in June compared to the same period last year) and granting incentives to farmers to buy goods for their own homes. Nevertheless, large part of the fiscal stimulus (4000bn yuan) is based on investment incentives, which are “necessary to monitor to prevent them being wasted", said Zhou.

However, a major threat that has severely damaged the leading western economies over recent years is looming on the Chinese horizon: over-indebtedness. The Bank of China’s recently published data have shown that new loans have risen to 737bn yuan, an increase of over 200% over the same period last year. New loans have thus exceeded by 47% the minimum 2009 target set by the Central Bank following the government intervention to ease lending criteria with a view to limiting the impact of export collapse. The sharp increase in new lending has led to a bounce in equity markets and to a steep rise in property prices. According to some government sources quoted by China Business News, 20% of the increase in new lending granted in the period is thought to have been invested in Shanghai stock market. "The speculation on the stock market is less than a concern" wrote Michael Pettis, professor at the University of Beijing, in an article published in China Financial News, "there is at least some possibility that some of these will be repaid. I'm not sure this is true for all other loans that have been made". Voices have already risen to warn of the dangers of a too pronounced rise in indebtedness. The Chinese banking regulatory authority has warned that such rapid growth poses risks to the financial system and the ratings agency Fitch has pointed out that future loan losses may be greater than expected and has questioned whether public authorities will be able to absorb these losses.

The central bank is understood to have already embarked on a restrictive policy. After only 8 months the bank has recently returned to place 1-year government bonds. According to estimates by Isaac Meng, a senior economist at BNP Paribas, credit should slow dramatically in the second half of this year.
China is therefore highly unlikely to act as the international driving force given that a repositioning of the country’s economy towards boosting consumption has yet to materialise. Moreover, dropping a growth model based on exports would lead the government to float the yuan at a value more in line with the country’s economic fundamentals. According to a recent study by William Cline and John Williamson (Equilibrium Exchange Rates), the yuan should appreciate by more than an unrealistic 40% against the dollar to realign itself with fundamentals. Overall, China appears unlikely to act as a long-lasting and strong growth trigger for major global economies but will likely spark short-lived rebounds.

Europe lacks scope to revive economy

Even though US economic imbalances were the main focus of interest at the start of the crisis in 2007, the state of the European economy was certainly not more favourable. Strangely enough, the countries that were held up as examples to follow proved to be the most fragile. Indeed, several of them had a macroeconomic framework similar to that of the US: robust economic growth sparked by a booming real estate sector, which triggered a large increase in household and corporate debt and a widening of the current account deficit. This was the case of Spain, Ireland and the UK, among Europe’s leading economies, and of the Baltic countries, an extreme case, whose economy has now been completely paralysed by the negative repercussions of a huge current account deficit and household debt in foreign currency (Latvia’s current account deficit peaked at 25% in Q3 2007).

It is not a surprise that Spain and Ireland are the countries that are suffering the most within the Eurozone. As an example, the Spanish unemployment rate has climbed to 18% and is highly likely to exceed 20% in coming months due to the sharp downturn in the housing sector. Therefore these countries need to correct the excesses of the past to return to grow. A positive signal came from Ireland, whose current account deficit/GDP ratio fell to 0.9% in Q4 2008 from 6% in the previous quarter, and even recorded a surplus in the first quarter of this year. The OECD’s estimate of a narrowing of the deficit during 2009 to 0.6% of GDP could be too pessimistic. By contrast, Spain’s chances of returning to more normal levels of current account deficit look slim, at least in the short term. The country’s current account deficit stood well above 7% until Q1 2009 even though the OECD’s projections are for it to weaken to 6% in 2009 and to 5.6% in 2010.

What is more, Spain and Ireland will not benefit from the currency depreciation, which would have undoubtedly occurred outside the Euro area, given that international investors have continued to reward the single currency against other major international currencies. A mild currency depreciation, as was the case with the United Kingdom, a country with similar problems to those experienced by Spain and Ireland in terms of debt rise and property market bubble, would allow both countries to gain competitiveness and profit by exports to improve economic conditions. On the contrary, not only will Spain and Ireland have to cope with a persistently strong Euro, which is 15% overvalued against the US dollar based upon the OECD’s PPPs calculation, but also with a real exchange rate calculated by Eurostat that is forecast to be 30% higher than in 1999 for Ireland and 16% for Spain. By contrast, the real exchange rate for Germany is seen decreasing by 8% in the same period. Accordingly, the OECD sounds more optimistic in its estimates than other international agencies and expects the Spanish and Irish economies to contract in 2010 as well (-0.9% and -1.5% respectively), contrary to the whole of other major European economies. The latest projections by the European Commission are even more negative, with the Irish and Spanish economies expected to shrink by 2.6% and 1% in 2010 respectively, with negative repercussions on public finances. The European Commission is looking for a double-digit deficit / GDP ratio in Ireland over the next two years (with a national debt expected to double at the end of the two years), while it should exceed 8% in 2009 and 9% in 2010 in Spain (the total debt should rise by 22%). Both countries are to meet with a total debt level that is higher than when the crisis broke out.

Nevertheless, other European countries are being hit by the global turmoil. The German growth model based on exports has turned out to be unsustainable following the steep decline in international trade. Exports, which accounted for 48% of German GDP in the first quarter of 2008, were no longer able to underpin the economy. Now that exports account for only 40% of GDP (but accounted for 32.5% of GDP in Q1 2000), the German government should implement new policies aimed at boosting private consumption, which has only edged up over the last few quarters. With a looming worsening of labour market conditions, an improvement in German consumer spending seems to be unrealistic.

Italy and France, while not presenting large macroeconomic imbalances on the private side, do not appear to be able to grow independently. The situation is slightly more negative in Italy due to the high level of public debt and the loss of competitiveness in recent years. Nevertheless, both countries should be able to weather the crisis with less accentuated imbalances.

All in all, only an international recovery may represent the real growth trigger for Europe. With US consumption likely to stay sluggish for some time, and Europe to be unable to bolster the international economy, emerging countries - China above all, will likely lead the world out of recession.

US economy still unbalanced

Rebalancing global imbalances: that is what major economists have always considered crucial for the international economy to make a lasting exit from the crisis that began in 2007 and became even more severe following the Lehman Brothers bankruptcy in September 2008. An economic growth still based exclusively on US consumption, which is driven by a booming real estate sector and buoyant credit markets, with other leading international economies (Germany, China, and emerging countries) benefiting from exports, is no longer sustainable. Several months after the outbreak of the crisis - the US officially entered into recession in December 2007 - it is essential to check whether these imbalances, over-indebtedness in the US in particular, have been healed to see if the long-awaited recovery of which we glimpse the first signs can be considered robust and lasting, or if it might be only of a temporary nature given the massive fiscal and monetary stimulus enacted at the international level. The signals coming from the United States, Europe and China are hardly encouraging. Most of the imbalances that have plunged the world economy into crisis are still far from being resolved and new sources of concern are already surfacing.

First, US consumer confidence data do not give grounds for optimism about the country’s medium-term economic growth prospects, albeit showing that US consumers are on track to correct the excesses of the past. Indeed, the recent decline in consumer spending in absolute terms (-1.7% in Q1 2009 vs. the high hit in Q2 2008) may point to a further moderation in household consumption growth going forward. However, the share of personal spending as a percentage of GDP is still well above the 70% threshold and firmly above the average for 1947 / 2001 (the year in which it broke through the 70% mark for the first time ever), when it stood at 65%, thus suggesting that a decrease in the weight of personal consumption on the US has yet to materialise and may adversely affect growth in the medium term.

Second, the drop in total household debt from 13,900bn in Q3 2008 to 13,794bn in Q1 2009 is a first promising sign for the household deleveraging process in the US, which is still far from complete due to the massive debt pile built in recent years. Household debt, in fact, is still too high as a percentage both of GDP (97%) and of personal wealth (22%), which fell by more than 16% in the face of a deteriorating housing market and bearish equity market trend. Therefore, household leverage is higher than in the months immediately preceding the ongoing financial crisis. Household net worth dropped from the peak of 645% of disposable income achieved in 2006 to 467% in the first quarter of this year. Under this scenario and given the bad health of the labour market (the unemployment rate is expected to exceed 10% in coming months) the recent increase in the savings rate has come as no surprise. The May figure showed that the savings rate jumped to 6.9%, reflecting households’ willingness to preserve the increase in disposable income stemming from higher social transfers and despite lower wages. Hence, personal spending growth is likely to remain sluggish for several quarters.
Households’ more conservative approach to personal spending has also curtailed the current account deficit, which has been another cause for concern for the US economy, the dollar in particular, in recent years. Indeed, after peaking at 5.8 of GDP in 2006, the trade deficit narrowed to 4.9% of GDP in 2008 and could fall to 2.9 of GDP in 2009 should the first-quarter trend be confirmed.

However other variables suggest that over-indebtedness in the US (based on the Federal Reserve’s latest data the total debt of the household, corporate and public sectors soared from 138% of GDP in 1974 to 243% in 2008) may continue to weigh on the US economy for many years, constraining the growth potential. First US corporates’ debt grew further in Q1 both as a percentage of GDP (79%) and as a percentage of their assets (71.7%) .As things stand, corporate investments are likely to remain very weak for some time also in the face of a slowing consumption, and only a sharp upturn in exports might give them a boost.

But it is the robust increase in public sector debt (though almost universally considered necessary to sustain economic growth in coming years) that shows that US growth will likely continue to depend on an increase in total debt in coming years. The Congressional Budget Office’s estimates see a doubling of the federal debt over the next five years, with the share of private debt due to rise from 40.8% of GDP in 2008 to 71.3% in 2013 and 81.7% in 2019. With a total debt / GDP ratio of 243% in 2008, maintaining this same ratio would require a household and corporate debt reduction of about 15% in the five years ahead. Otherwise within five years the US debt level would even be higher than that which sparked the crisis in 2008. A possible second round of fiscal stimulus, which has been hypothesised by President Obama’s economic adviser Laura Tyson during the week, is clear evidence of the risk of a further deterioration in public accounts.

Swedish Krona candidate for appreciation, despite Riksbank’s decision to cut Repo rate

The Riksbank unexpectedly decided yesterday to cut the Repo rate by 0.25% to 0.25% as “the weak development of the economy requires a somewhat more expansionary monetary policy”, in the Riksbank’s words. The Central Bank also decided to offer loans of up to SEK 100bn to commercial banks at a fixed interest rate and with 12-month maturity. The Swedish CB’s projections are for the GDP to fall by 5.4% in 2009 (vs. 4.5% contraction of previous estimates) and to edge up 1.9% in 2010. The Repo rate is expected to stay at 0.25% until the second half of 2010. In the subsequent years, the Riksbank looks for a rapid increase in the Repo rate, which is seen at around 4% in mid-2012.

The Repo rate cut is likely to have negative consequences on the Swedish Krona (the currency weakened to 10,8716 against the Euro immediately after the announcement of the rate cut) in the short term, particularly against the Euro. Indeed the interest rate differential is likely to trigger a prolonged weakening of the Krona as we do not see the ECB cutting rates (from the current 1%, which was confirmed during yesterday’s ECB meeting) in the next few months.
In the direction of a weakening of the Krona is also a level of inflation that is forecast to remain slightly more elevated than in the Eurozone. Excluding the repercussions of lower mortgage rates and energy price inflation, the annual rate of inflation should average 2% in 2009.
Financial market turbulence and concerns over the developments in the Baltic countries are another two factors that point against a Krona appreciation.

However, once the financial crisis is resolved, the Swedish Krona will likely appreciate sharply versus other international currencies. In a recent economic commentary ( The long-term development of the Krona ) the Riksbank predicted a strengthening of the Krona (+10-15%) in the years ahead. The kick-start for an upsurge in the Krona will come from signs of an economic recovery in Sweden, which will boost expectations of a quick reversal of the expansionary monetary policy.