Monthly Archives: December 2010

Geopolitics

Clash of the titans

In today’s FT it was revealed that China now has a missile that can threaten US aircraft carriers in the near Pacific. China’s defence minister, Liang Guanglie, has stated that China is preparing for an armed conflict “in every direction”. I’m not suggesting an immediate threat of conflict, but China is ratcheting up the military tensions in Asia. An arms race usually leads to conflict. Even if it doesn’t, it is likely to lead to increasingly fractious relations between China and the US (and the rest of Asia). When will the US be pushed too far and start opposing China by economic means? The GE tie up with AIC of China must have the Pentagon worried. I don’t know how this plays out, but it doesn’t feel good.

Economics

Farewell to cheap capital?

 

Most of the time I feel pretty sceptical about management consultants. However, McKinsey do produce some very good long-term research and they give it out for free. Recently, the McKinsey Global Institute produced a fascinating paper on global savings and investment and real interest rates.

They suggest that the decline in real interest rates over the past thirty odd years has been more to do with the decline in the global investment in the aftermath of the rebuilding of Europe and Japan than a rise in global savings. The “global savings glut” has been more to do with a dearth of investment opportunities than a rise in savings.

The rising importance of emerging markets in the global economy suggests that the investment rate will rise, while the savings rate may decline. Investment will rise as infrastructure and housing is built as countries grow richer. Savings may decline as China and other Asian countries boost consumption and the baby boomer generation retire.

This has enormous implications for real interest rates. McKinsey are suggesting that these will rise by 150bp and that this move could start within five years. This will produce a profound sea change in both economic and market conditions:

  1. Heavily indebted western countries will find it more expensive to fund. Where appropriate (US, UK, Japan, N.Europe) countries should pump out as much long-dated government debt as they can.
  2. It makes it even more difficult to see how the periphery of the eurozone will grow its way out of its debt hole.
  3. Companies with high capital productivity will be advantaged, whereas those with high capital intensity could struggle.
  4. Economies and companies servicing emerging market infrastructure ought to do well (Germany!!).
  5. Consumers will find borrowing more difficult and expensive.
  6. Banks may become more profitable and perhaps safer.
  7. As an investor, long dated fixed interest securities don’t look attractive. The investment performance of all asset classes is likely to be hampered if real interest rates rise.

Those are just a few thoughts. I’ve not read through the whole report yet, but you would be mad not to look at it.

Economics, Social policy, Tax

Unintended consequences

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The problem with much government policy is that it is not vetted for unintended consequences. When Gordon Brown removed the tax credit for pension funds, I don’t believe that his primary motive was to destroy defined benefit pension funds. It was intended as a “painless” way of raising revenue. Because few understood how pension funds are valued, objections were confined to a few experts.

Warnings were ignored and now the UK has gone from having one of the best pension systems in the world to one of the worst (well in the developed world). Millions have been denied a decent pension and will have to work well past their theoretical retirement date, all because Gordon wanted a few tax revenue billions. Thanks a lot Mr Prudence.

I wondered whether the government is making another monumental blunder over university tuition fees. I can understand the view that students should pay for further education. However, there is a danger of creating a significant and growing proportion of the population who will start their working lives with a massive debt burden that they will struggle to pay off for the first decade of their careers and possibly ever.

It is almost certain that tuition fees will automatically go to the maximum of £9,000 p.a. meaning that students, after adding in living expenses, will probably have debts of around £50,000 when they leave university. I can see that many potential students won’t bother to go to university, but try to find employment after leaving school. This will leave many universities and courses under attended forcing up their unit costs unless they can entice overseas students to fill the gap.

Unintended consequence number one will be that less youngsters go through higher education, potentially degrading the skill base of the population. Already many Asian countries are achieving better educational results than the UK. The UK could become uncompetitive, particularly in technical and knowledge based industries. This could be disastrous as we are a high cost country and need to compete in high value added industries.

Arguably, we are sending too many into higher education. If higher education were downsized to provide a higher quality of education to fewer student who might benefit more from university, it might not be a bad thing. One problem we have at the moment is that too many students are qualifying with almost useless degrees and finding it difficult to find appropriate jobs. Unintended consequence number two is that there is a disappointed and possibly bitter generation who have gone through university on the promise that they needed a degree to get a good job and have ended up with poor quality jobs for which they are over-qualified.

That’s all in the past and can be blamed on Labour’s quantity over quality policies. A major iniquity of higher tuition fees is that they will only apply to English students. Scottish and Welsh students are being protected by their regional assemblies, even though English tax proceeds are subsidising these assemblies. How unfair is that? I can see that this will cause enormous resentment. As a consequence, the political union of the UK fractures further.

In the longer term, it means that many who graduate will have to pay off debts over a longer period of time before they can consider buying a home or saving for a pension. So another unintended consequence may be that the housing market is undermined with a dearth of first time buyers.

The credit crunch has compounded this with buyers needing a larger amount of equity to inject into properties. Hence there is a double whammy of having to pay off debts for longer and a (much) longer period needed to save up for a larger equity stake. There could be sustained downward pressure on house prices. Even those that do get on the housing ladder will be unable to build equity in their properties, unlike their parents.

The younger generation will also find it difficult to save adequately for their pensions. The student debt trap and higher cost of getting on the housing ladder means that it is likely that many will put off saving for their pensions until later in life. This is a terrible error as early contributions to a pension are key to building up an adequate pension pot.

Increased tuition fees heap yet another burden on what increasingly looks like an unlucky generation, who will be in debt longer, have less chance of owning their own house and who will find it more difficult to save for retirement. A disappointed and resentful generation could grow up. Who knows what the political consequences might be.

It would be sensible for politicians to recognise that there is an increasing generational inequality in wealth.David Willetts has written a book on this called “The Pinch” which is on my reading list. Flicking through it, I didn’t see any obvious answers, but I’ll reserve judgement until I’ve read it properly.

I feel extremely lucky to have graduated when I did and to have had my career at a time when I could buy a house, generate some savings and have a decent pension pot. I certainly have some sympathy for the anger that students currently feel, even if I don’t condone the violence and I don’t have any easy answers.

Economics

Getting it wrong

One reason why I am so pessimistic is that policymakers just don’t seem to understand what is going on. This is an interesting perspective from Nassim Taleb, who is not going to Davos because the great and the good are more interested in schmoozing than addressing the real problems:

  1. This is a problem of excess debt  which won’t be solved by increasing levels of debt further. Most rational economic agents are reducing debt. The debt reduction in the private sector is counterbalanced by a debt increase by the public sector. While this is OK as a temporary measure, it cannot continue forever.
  2. The skewed incentives of the financial system are still in tact, where the managers of financial institutions get most of the upside but none of the downside. A worldwide ban on bonuses until institutions are properly capitalised is the only way ahead. Investment bank leverage must be reduced even further and limits based on principle transactions. Even more radical would be a separation of capacity, a reverse big bang, to eliminate the inherent conflicts of interest in the current system. Also large financial institutions need to be broken up to reduce complexity, spill over effects and too big to fail issues.

Debt reduction is dependent on a global rebalancing of trade surplus and deficit countries, which looks unlikely to happen. Debt reduction is more likely to happen through a series of rolling debt defaults. I have no confidence that the financial system will be brought under control and de-risked. Regulators remained ensnared by the large financial groups. Hence we are going to see more crises over the next few years. Eventually the excesses will be worked through the system, but I think it will take a long time.

Economics

The debt trap

Moody’s have downgraded Irish debt by five notches. Mr Sarkozy is perplexed. Investors have recognised that the debt dynamics of Ireland are simply unsustainable and some kind of default is inevitable. The eurocrats need to do a course in basic economics and another in crisis management. At the moment they have an “F” in both. Link to Telegraph story.

Economics

US trade statistics

This is an interesting article in the Wall Street Journal, suggesting that the US trade deficit with China is massively overstated because of the way the statistics are calculated. Although I have some sympathy with this approach (GaveKal have been banging on about this for ages), the fact remains that the Chinese have amassed a huge amount of foreign exchange reserves in dollars. Now amount of fancy footwork can avoid that stark fact. If they haven’t been accrued through the trade surplus, how have they been acquired? Given capital controls, it seems very likely that the US trade deficit with China is a very real phenomenon and can’t be explained away with clever accounting tricks.

Economics

The muni time bomb

The counterpart in the US to the travails of the PIGS in the eurozone is the municipalities. Over dependent on property taxes for revenue and groaning under excessive cost bases , they are suffering from budget deficits, the need for severe retrenchment and the threat of bankruptcy. Although the Federal system can supply some offsets, the whole process of downsizing state and municipality budgets and service provision is going to be a painful business.

Nowhere is this more acute than Detroit, which is planning to effectively abandon 20% of the city. I guess this is already reflected in house prices and delinquencies in Detroit, but it does illustrate that in the US, unlike say the UK, house prices can go to zero in some cases.

Many districts in many US cities are reaching tipping points where they spiral downwards adding another twist to the mortgage crisis. Mortgage rates have been rising, with the long bond, which will start to add another layer of pressure in the housing market. The temptation for another wave of mortgagees to default is rising. Indeed, some commentators have suggested that the surprisingly strong consumption figures reflect more homeowners stopping mortgage payments to finance consumption.

Getting back to the muni time bomb, there is increasing pressure for some to declare bankruptcy. This could unleash a tidal wave. Muni bonds have been very popular with private investors, providing a tax advantaged, relatively safe high yield. This could be a nasty negative wealth shock if there are bankruptcies and a collapse in the muni market.

 

Economics

A significant ruling

Yesterday the WTO ruled that the tyre import tariff imposed by the US on Chinese was consistent with the US’s obligations under global trade rules. This is the second time that the US has won a favourable judgement on tariffs recently. In October, tariffs on steel pipes and some industrial products were upheld.

I see this as highly significant. Two positive rulings in favour of tariffs may embolden US politicians to try more protectionism. The upcoming trade talks with China has the scope for significant friction. As I’ve said before, trade protectionism is the one policy in the US that would probably garner bi-partisan support. Indeed, it is entirely possible that both houses would have the two-thirds majority required to override the Presidential veto.

The recent tax and spend “compromise” means that the US budget deficit is likely to be around 10-11% of GDP for the next two years. If private sector savings edge down through an increase in corporate investment (highly likely as corporates are cash rich and have been investing at a rate lower than depreciation), then the US trade deficit is likely to start widening again. If this happens and unemployment remains high, the voices calling for trade sanctions will become deafening.

The really depressing thing about China/Japan/Germany is that they just don’t seem to realise that their mercantilist economic policies are a significant causal factor in the recent bust. The deficit nations, one way or another, have to reverse their trade deficits and reduce borrowings. They cannot do this if the surplus countries do not adjust by reducing and reversing their trade surpluses.

If this can’t be done through the mechanisms of free trade, it will be done through protectionism. The irony is that this is likely to be worse for the surplus countries than for the deficit countries. Rationally, we know that globalisation and free trade is a win-win for everyone, but if some countries don’t play fair, then the deficit countries will lose patience. This is likely to lead to a trade war between the US and China. Even more seriously, it will lead to the almost certain demise of the eurozone and possibly the EU itself.