Is GDP set to contract?

January 24, 2008 | posted by Michael Baxter in UK economy, US economy, inflation | comments (0) | Print This Post

In the US, it seems we are seeing the full gamut of views, ranging from those who say the US could hit depression, to those who see a gentle slow-down.

Encouragingly, Capital Economics, which even as far back as 2006 was predicting major problems in the US, thinks the economy will avoid recession. The economic think tank predicts zero growth in the second and third quarters, followed by a sharp 1.6 per cent jump in the fourth quarter, and further rises in 2009.

But others believe the US is already in recession.

CNN Money quoted David Wyss, chief economist with Standard Poor’s as saying, “Americans could just get scared by a barrage of bad news. The stock market could continue going down because of foreigners pulling money out, and between that and home values going through the floor, it could lead to a real pullback of spending, particularly by Baby Boomers who are getting close to retirement.”

As for the UK, earlier this week, the ITEM club from Ernst and Young predicted 1.8 per cent growth this year, down from 3.1 per cent last year, and then pick up slightly in 2009, with growth of 2.4 per cent, before it fires along on all cylinders in 2010.

So really, if the ITEM club is right, and if Capital Economics is right about the US, then all this doom and gloom we are seeing is being overplayed.

Perhaps it all depends on inflation, and whether central banks can get away with cutting interest rates.

This has become a tricky call, because there are a number of contradictory forces at work.

First of all, the combination of advances in technology and globalisation has created dramatic improvements in global capacity. Maybe we should throw into the mix here, the end of the cold war too. It is easy to forget, what with the war on terror, that we live in a time of peace – at least a time of peace for most of us in the developed world. The end of the cold war and the end of the arms race has freed-up global resources.

Yet strangely, war can be a good economic fillip. The economic depression in the US only really came to an end with World War II.

Maybe 60 years of peace are helping create the conditions that lead to deflation.

Fears about deflation were doing the rounds earlier this decade, that’s the reason given by the Fed for slashing interest rates to 1 per cent. But the dangers of deflation remain. History tells us that periods of rapid advances in productivity have often been followed by a period of deflation – and economic depression.

When you think about it, if we are suddenly all able to produce more, there has to be a rise in demand too, or we won’t sell all these extra products we produce. So maybe we need to borrow against future earnings.

Rapid advances in productivity have to be financed. It has been theorized that the Industrial Revolution was funded by the discovery of gold in the New World.

But while we worry about deflation, throw into the pot the rising price of oil and food. Are the recent rises we have seen one-offs, in which case it could be quite dangerous to set interest rates taking into account the rise in inflation caused by more-expensive food and oil. Or are the jumps symptoms of a growing population, and the growing size of the global economy, in which case we can expect more price rises to follow, which in turn will lead to inflation.

Then there’s asset prices. In measuring inflation, should we take into account asset prices? The Economist, for example, has argued that when central banks set interest rates in the future they should take into account house prices.

You will see there are a myriad of conflicting considerations. It seems that whatever a central bank does, you can construct an argument to support the bank, or an argument to slam it for economic incompetence.

We see this conflict of views reflected in the words and actions of the Fed and Bank of England.

In the US the Fed is slashing interest rates at an almost-breathless pace. Meanwhile, the Bank of England still seems hung on fears over inflation. Yesterday, the minutes from the last meeting revealed that only one member of the interest rate setting committee voted to lower rates. This has left markets wondering whether the Bank is going to slash rates as fast and as far as was previously expected.

The European Central Bank also seems to be still be caught up in hawk mode – still fretting about inflation.

Who is right and who is wrong? Well, they are all right and they are all wrong. It depends on your view of inflation.

But it does seem to us that sometimes we overplay the inflation card.

Surely, inflation is just a symptom of demand rising above supply. On a global scale, it seems that, actually, inflation is well-anchored; if anything, global supply exceeds demand.

But here is another symptom of demand rising too far – debt. On a global scale debt is not too high – it balances out. The likes of China and the petro-dollar economies have plenty of savings.

But in the US and UK, and indeed in other countries such as Australia, it seems debt may have risen to a level that could crush the economies.

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Fed bails out stock market

January 23, 2008 | posted by Michael Baxter in US economy, credit crunch | comments (0) | Print This Post

In his book, Age of Turbulence, Alan Greenspan repeatedly stated that it’s not the Fed’s job to worry about the stock market. Rather, the Fed is charged with the task of striking the right balance between inflation and growth in GDP. (This differs, by the way, from the Bank of England and European Central Bank, which are supposed to focus solely on inflation.)

Yesterday, the Fed did the opposite of what Greenspan suggested it should do, and quite clearly put the interest of traders and investors above all else.

The announcement of a 0.75 per cent cut in rates, the biggest one-day cut since 1982, was relevant to US inflation and US growth in one respect only.

The move carried massive psychological impact. If the chairman of the Fed was a PR man, he would have recommended yesterday’s move. Bernanke certainly won the headlines – and in so doing sent a message to banks, borrowers and consumers: “Don’t panic,” he said, “Uncle Ben is here to help.”

But that was it. The economy is not like a Formula 1 racing car, which reacts almost instantly to a press on the brakes, or pushing down the gas. Rather it is like a cruise liner. Perhaps one of the most memorable moments in James Cameron’s film ‘Titanic’ was when the iceberg was spotted, and despite the efforts of the crew the ship just couldn’t turn around fast enough.

The relationship between changes in the rate of interest, and inflation and growth, has a time lag built into it. It can take as much as two years before a change in rates has its full effect.

If the Fed had chosen to lower interest rates at the end of the month, when it was due to meet, the economy’s performance would not have been affected – at all.

If the Fed had made its announcement yesterday afternoon, it would have made no difference. Instead it went for maximum impact, revealing its latest cards first thing in the morning – so that the markets had all day to ruminate on the move. So the markets had no reason to start the day off with a panic sale.

And in that one respect the Fed’s move was an unqualified success. Sure, the Dow was down 128 points, but some analysts believe that if the Fed had not made its announcement, the index could have plunged by 600 points, or more.

Many economists believe the US could be in recession – right now – even as you read this. Yesterday’s move will have no impact on this.

But, the rate cut will give borrowers a huge lift. Both indebted businesses and individuals paying interest at a rate that changes with the official US discount rate, will soon be much better off.

Couple this with George W’s move earlier in the week to give out a $150 billion tax boost, combine this with the money flooding into the US from sovereign funds, shoring up bank balance sheets, then throw into the pot the various occasions in recent weeks in which the Fed has pumped money into the system. Right now the US is fighting back.

Was Bernanke right to take such drastic action yesterday? In an interview on Radio 4’s Today programme, George Soros said he was right. “I think you do have to rescue markets, otherwise you go into depression like you did in 1930,” he said.

There are serous risks with the move, however.

If in cutting interest rates the Fed makes things easier for debtors, and enables people to avoid bankruptcy, or house possession, then the move was a good thing. If on the other hand, it encourages a new borrowing frenzy, if people just go out and borrow some more, perhaps they borrow to pay off existing borrowings; then that is a bad thing.

If the cut in rates leads to further falls in the dollar, and if the price of oil starts to go up again, then inflation will pick up.

Ben Bernanke once said, famously, that the solution to a credit crisis was to get into a helicopter and spray money across the land. This earned him the nickname of helicopter Ben. Well, he has done that. In this week’s Economist, the front cover showed a fleet of helicopters, this time depositing money from the sovereign funds. The last few weeks have seen the economic equivalent of shock and awe, a full-frontal aerial strike – helicopters carrying money from the Fed, helicopters from the People’s Republic of China, and Arab states, carrying economic aid; F15 jets firing $150bn-worth of tax boost, and now a missile loaded with a 0.75 per cent cut in rates.

But, supposing it is not enough?

George Soros said this morning, that he believed the US will hit recession, and the UK may well follow in its wake.

Maybe the battle we are now seeing being fought is not to try and avoid recession, it is not to try and kick-start the economy. Rather, we are seeing an attempt to avoid the US following Japan, and hit depression. The fear has to be that the price for avoiding this depression is even more debt – increasing the dangers of an even-more severe economic shock in the years to come.

What we really need is not for an air strike carpet-bombing the economy with capital – what we really need is the foot soldiers of China and India – the consumers, to go out and spend more of their county’s new wealth.

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Hope is revealed at bottom of box of economic woes

January 21, 2008 | posted by Michael Baxter in US economy | comments (0) | Print This Post

The last 12 months have been like the opening of Pandora’s box. It seems as if all the economic ills of the world have been released – and yet lurking at the bottom of the box, we find hope.

In the US, while the world watches in morbid fascination as the mighty economy pays for its years of excess, maybe we have at last spotted the seed of the next boom.

2007, the year of subprime woe, of massive bank losses, of clear evidence the housing market was on the brink of crashing, saw the highest level of spending by venture capital in six years.

Venture capital surely provides the lubrication for entrepreneurial activity. And entrepreneurs are surely tomorrow’s wealth creators.

In all, 3,813 deals enjoyed $29.4bn worth of funding – not since 2001, which saw $40.6bn piling into 45,000 start-ups, has the US seen better than that.

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Uncle Sam rings the panic alarm

January 18, 2008 | posted by Michael Baxter in UK economy, US economy, credit crunch | comments (1) | Print This Post

One piece of good news stood above all the rest yesterday, like a beacon. The big question ruminating around Wall Street is this: will things get worse? Yesterday, after revealing quite appalling write-downs – Merrill Lynch’s boss, John Thain said “I don’t think you should anticipate any further problems of this magnitude.” He added, “There would have to be something incredibly bad out there to have this happen again, and our whole goal is to get 2007 behind us.”

That’s what markets wanted to hear. Sure, 2007 was bad, but let’s move forward now, let’s get all the bad news out of the way, and start 2008 with a clean sleet.

But instead of that, yesterday was another day of blood-letting on Wall Street. The Dow Jones fell 307 points; once upon a time that would have been disastrous, but actually it merely amounted to the worst day in two months. As for the FTSE 100, actually yesterday wasn’t too bad – the index was down 40 points, but then most of the bad news out of America broke after London markets were closed, and this morning, the news from the Far East was pretty grim, with markets tumbling like a contestant on celebrity ice skating.

More to the point, the Dow is now 884 points (6.7 per cent) down this year, and 2004 (14 per cent) lower than the all-time high set on October 9 last year. The FTSE 100 is down 514 points (8 per cent) this year and 818 points (12 per cent) off its six-year high set on 31 October.

dow 2008

ftse 2008

So why are markets so far down, when actually the news coming out of corporate America is about what you would have expected?

Okay, let’s be honest, all the write-downs out there are not good. Yesterday, Merrill Lynch pulled off a record no one wanted to hold, by announcing the biggest write-downs from any bank since the subprime crisis first broke. In the 12 months to the end of December, net losses came in at $7.8bn, and total write-down for the year tallied $22.1bn.

By contrast, Citigroup’s $18bn worth of write-downs seem positively frugal.

But really, if there’s anything strange in yesterday’s events, then it’s surprise that markets were surprised. The Fed, the IMF, and that legendary trio of economists, Tom, Dick and Harry have all warned that total subprime-related losses will run to the multiples of 100s of $bn. There is nothing in yesterday’s news which wasn’t as well broadcast in advance as an attack on a goal by an England football team.

Then again, yesterday’s bad news was not restricted to bank losses. More woe relating to the US housing market hit the news desk. Housing starts fell to 1,006,000. That’s the lowest level in 16 years. Then again, there were mitigating factors. The month the data related to, December, was beset by awful weather – and the region where the data was particularly bad was the midwest, where the storms were at their worst. Even so, you can’t just blame the weather for the worst monthly results in 16 years.

Clearly the US housing market is still in crisis – but then, who is surprised to hear that?

Then there’s the investments from the sovereign funds – okay, you don’t need to be full of sagacity to know that there are important long-term implications of the recent investment in banks from sovereign funds from the Middle and Far East, but surely, right now, markets should be celebrating the fact that banks have managed to strengthen their balance sheets. Writing in The Times, Anatole Kaletsky, made this point well when he said, “Instead of heaving a sigh of relief that the two largest and most-troubled institutions at the heart of last year’s credit crunch had replaced their managements and raised enough capital to survive and get back to business, investors and analysts redoubled their panic.“

Why is that?

It seems there was one piece of bad news that also emerged yesterday that wasn’t expected. But maybe to truly answer the question of why the markets have fallen so far this year, we need to rewind the clock back to the irrational exuberance shown in 2007. But maybe there is an even deeper problem, which, right now, markets have failed to grasp.

Amongst all the bad stuff yesterday, Merrill Lynch announced a $3.1 billion write-down related to insurance taken out on some of its mortgage securities. And all of a sudden a new fear has grown. How stable is the business for some forms of financial insurance?

And if the insurance write-down from Merrill wasn’t bad enough, yesterday, Moody’s Investors’ Service raised the spectre of removing the triple-A credit ratings on Ambac Financial and MBIA, the world’s two largest bond insurers. On that news, the FT said this morning, “Shares fell 52 per cent and 31 per cent respectively.”

That’s the trouble with economic crises. One set of bad news often begets another set. It has always been thus.

So that’s a new worry to come on top of all the rest.

But maybe there is a far deeper reason to fret. First we need to ask this: why did markets jump so high last year? At the time, we regularly scratched our head, and said things like markets seem to be interpreting everything as good news, no matter how bad it is. We also drew analogies with a Cheshire cat, saying, “But it sometimes feels as if the smile on Uncle Sam’s face is all there is. It’s like Lewis Carroll’s Cheshire Cat which ‘vanished quite slowly, beginning with the tail, and ending with the grin, which remained some time after the rest of it had gone’.”

Last year, markets were smiling when traders should have been drinking hemlock en masse. Now they are paying the price for that irrational exhilaration.

But maybe there is another deeper problem. Markets remain far too short-termist in their outlook. The banks are the worst culprits of the lot. As Anatole Kaletsky pointed out this morning, much of the money being raised by the US banks is being spent on bonuses and dividends. Shareholders and managers are being rewarded for failure.

Banking crisis must be avoided at all costs. A true banking crisis could send the global economy into depression. So if banks know that governments and central bankers won’t allow full scale failure, they can carry on taking too many risks.

There is no easy solution. But that’s why Mervyn King made the stand he did with Northern Rock, and was slow to pump money into the system last year. That’s why calls for his head, often expressed by banks who have got away with so much recklessness, precisely because there have not been enough central bankers like Mervyn King, are too rich for words

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US sees good news on inflation front at last

January 18, 2008 | posted by Michael Baxter in US economy, inflation | comments (0) | Print This Post

The timing couldn’t have been better. At last, good news is emerging on US inflation.

The latest statistics reveal that headline prices in the US were up by just 0.3 per cent in December, but, more to the point, inflation with food and energy taken out was up by 0.2 per cent.

Us inflation

Okay, the annual rate is still high – 4.1 per cent year-on-year for the annual headline rate, but the point is, with the monthly rises seen in December, the annual rate is due to fall quite rapidly.

It wasn’t all good news, with clothing and housing rental costs, for example, up. But even so, Capital Economics confidently predicts that US inflation will be down to 2 per cent or so by the end of the year, so that the Fed can get away with slashing interest rates, as is widely expected.

But the good news on inflation comes with a cloud hanging over it. Because, while one set of official data revealed good news on inflation, another set revealed worrying news on US manufacturing.

As you know, right now, the problem in the US is with the consumer. The area you would expect to be strong is industrial production. But alas, no. Latest data out yesterday revealed that the US industrial sector was flat in December. So that’s bad news indeed. No wonder the markets are in so much of a tizz at the moment.

But, there is a ray of hope. The worst-affected area was in construction – down 0.9 per cent on the month, and that is down to the US housing market crisis.

Even so, with the dollar all at sea, one would have expected a lot better.

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2007: A look back

December 21, 2007 | posted by Michael Baxter in UK economy, US economy | comments (0) | Print This Post

What a year. Who would have thought it? 2007 began with such promise and ended with such trepidation. This is the last issue of Investment and Business News from Defaqto this year, so we thought we would leave you with a reminder of how the economic prospects turned, and look at what 2008 may have in store.

In yesterday’s Independent, it was stated that no one had predicted the crisis of 2007. Well, that depends on what you think the crisis is. If you think the credit crunch is all a big misunderstanding, and it’s down to trust leaving the market, then they are right: it was not predicted. But if you think the problem is deeper than that, and that the fundamental cause of today’s economic crisis is the level of debt we have built up, the writing was on the wall, or at least it was in your email newsletter from us.

In our first issue of this year, we wrote, “We have noticed an abundance of books being published that predict doom for the economy in a few years’ time, from the Great Debt Crisis, Boom and Bust, to even the esteemed Roger Bootle (top honcho at Capital Economics and a man often quoted here) with his book Money for Nothing. If the number of books out there on the subject is any guide, then there’s trouble ahead.”

We then added, “The truth is, consumers and governments across the developed world are spending. The Anglo Saxons in particular seem to spare no thought for the present as spending becomes the fashion.”

We went on: “In the past, overspending and borrowing led to inflation. This time around, it has stayed relatively in check. But does that mean that thanks to the Internet and China we can have our cake and eat it? Spending without inflation taking hold, creating prosperity for all. It may do, but on the other hand… ”

But perhaps the headline that proved the best sign of things to come was this one. “Stuck between rock and hard place.” (4 January) Weren’t we clever? Surely we were the first to run the most popular business news headline of the year. Mind you, in getting there first we were a tad lucky. Our story had nothing to do with Northern Rock. Rather it referred to the dilemma faced by the Fed of facing inflationary pressure at a time of declining economic sentiment. Yet in a way this story did relate to Northern Rock. It was the first sign of the problem that was just beginning to hit the economy.

For 2007 was the year when inflation reared its ugly head. And when the economy turned, when it became obvious that economic growth both in the US and then in the UK was set to slow, what did inflation do? Did it obligingly go away? No, instead it appeared to make itself comfortable and prepared to stay. Then on April 16 it happened. The official Consumer Price Index hit 3.1 per cent, more than a whole percentage point above target, and Mervyn King got his pen out and wrote his infamous letter to Gordon Brown, then chancellor, explaining what had happened.

And turning to today, it really does seem that there are two schools of thought. Last night, Capital Economics released a press release in which it said, “The pick-up in headline inflation has been driven largely by temporary supply-side pressures on food and energy prices. It is hard to see underlying inflation picking up in 2008, given the prospect of weaker economic growth.” In any case, it added, “There is still relatively little evidence of “second-round” effects whereby a jump in inflation (whatever the cause) might become embedded in the economy via higher inflation expectations and in wage and price-setting behaviour.”

Capital Economists may well be right, but we want to make you aware of an alternative point of view that many economists seem to be oblivious to.

Those who say inflationary pressures are temporary, point to historical trends. They say oil always goes up, and then goes down. They point to the high price of food, and say it is just down to one-offs. In his book, the Age of Turbulence, Alan Greenspan ridiculed the idea of peak of oil as a short term problem; when demand rises, supply rises to meet it, he said.

The problem with this is that economists, when they map out their trends, look at an incredibly short period of time. They look at oil, and think that just by tracking its pattern over the last 100 years, they can predict the future. They look at economic cycles, and think it will always be like that. We found some of Mr Greenspan’s views articulated towards the end of his book on future productivity, almost naive.

The fact is that change is occurring at an accelerating rate; not only that, the rate of acceleration is accelerating. We really are entering a new era, we really are stepping into new territory.

Whether we run out of oil is almost irrelevant. The fact is that the planet needs us to find an alternative. If producers had to bear the true cost of environmental damage in their production, prices would be soaring.

And yet, new technology is coming fast. There are many reasons to be hopeful, and no reason to believe economic growth has to be dramatically curtailed in order to avoid ecological crisis.

But it does seem inevitable that soaring demand from China and India will exact a toll on the earth’s resources. The world has never seen anything like it. Literally billions of people are about to join the consumer society. Can you really say with certainty that inflation will stay down?

At the beginning of this year it was thought oil had peaked, and inevitable that 2007 would see the black stuff decline in price. Instead it soared, from around $52 in mid-January to almost $100 a few weeks ago.

Economic theory says high consumer and government spending leads to inflation. But, of late, it hasn’t been like that. Inflation stayed down despite high spending because of other factors: the end of the Cold War, central banks becoming more savvy, rises in productivity caused by technological advances, the Internet promoting competition, and China.

But this year, that fortuitous combination seemed to shrink. The word stagflation crept back into the lexicon. Whether inflation will ease next year or not, we are yet to see, but if you really want to know the story of 2007, it is not subprime, or credit crunch, it is rising inflation at a time of falling economic prospects. And whether we see a repeat of this story next year, or whether Capital Economics is right, and inflation falls, will determine whether the US and UK can avoid recession.

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Uncle Sam gives hope as exports rise

December 19, 2007 | posted by Michael Baxter in US economy | comments (0) | Print This Post

Decoupling is one of those words that has being doing the rounds of late. It describes how these days the global economy can carry on growing, even if the US gets laid up in bed. Thanks to China and the ilk, the world can do perfectly well without Uncle Sam, thank you very much, or so goes the idea.

As for the US itself, the hope is that as its consumers take the foot off the pedal, its exporters can take up the slack and, benefiting from the falling dollar, and then sell, sell and sell.

We have been a tad cynical about this decoupling idea. The US still remains central to the global economy, and China exports rather a lot of its goods into the US. So a slowing US will mean Chinese growth will slow, leading to a knock-on effect elsewhere. The US deficit on its current account is simply huge, and to believe this can start shrinking, without there being serious repercussions for the rest us, seems a tad naive.

And yet, maybe the naivety is paying off. The deficit on the US current account fell to a two-year low in the third quarter. It dropped from $188.9bn in Q2, or 5.5 per cent of US GDP, to $178.5bn in Q3. That’s 5.1 per cent of GDP.

The really good news, however, lies in how the shrinking deficit came about. Exports were up; the rest of the world, it appears, want to buy goods made in the US after all.

Now, one swallow does not make a summer, and the deficit is still massive: even so, it is a promising sign.

There is another interesting aspect to the latest figures on the US balance of payments. It appears the flow of money to and from the US for the purchase of assets dropped like a stone. According to Capital Economics, “Net foreign purchases of US assets dropped to $249bn, from $619bn, while net purchases of foreign assets by US residents dropped to $155.7bn, from $465.5bn.”

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