A Time for Optimism
The Brexit referendum has changed everything — at least politically. A new Prime Minister, a new Chancellor and a new Foreign Secretary, with fresh opportunities to set a course for foreign policy rooted in careful identification of British national interest. Economically, however, the impact has been much smaller. In the long term, there will be useful opportunities to expose UK markets to greater competition and improve upon much of the EU’s economic, environmental and financial regulation. But the immediate economic impact is more limited.
To understand why, we need a purchase on what was happening before the decision. And in passing it’s worth noting that Brexit has been no better for economists and policy advisers than the Great Recession was. The Queen famously asked at the height of the banking crisis: ‘Why did no one see it coming?’ Ahead of that crisis, bankers and economists had a myopic confidence in the efficiency of financial markets. When it came to the referendum they called it wrong again and got their trading books the wrong way round — only to reverse their judgments a few weeks later. So far (though the data is incomplete) the effects of the decision are much more muted than expected, whether in consumer spending, job vacancies or house prices.
Behind this is the fact that the UK economy has performed better than expected so far this year — as has the US economy. A year ago, policy-makers there were gearing up for a necessary tightening (that is, raising) of interest rates, but found a succession of reasons to justify their entrenched caution. Weaker US labour market data, concerns about the disappointing pace of recovery from the Great Recession and slower economic activity in China stayed the Fed’s hand. The caution was rewarded in the short term. The rate of GDP growth in America slowed in second half of last year and continued to slow in the first part of this one — but it needed to slow because it was significantly higher than the 2 per cent rate of growth that President Obama’s economists judge to be sustainable.
The British picture has also been benign. Growth slowed in the second half of last year from around 2.6 per cent to 1.9 per cent. In the first half of 2016 it picked up to 2 per cent in the first quarter and 2.2 per cent in the second quarter. After six years of expansion, unemployment is low, earnings are growing and real household disposable income has been -rising sharply. Inflation remained low at around 0.5 per cent, while a balance of payments deficit of almost 7 per cent of GDP reflects, among other things, strong growth in consumer spending: retail sales have risen by 14 per cent since 2009 and household consumption has increased by about 8.5 per cent. It also reflects weak manufacturing output, in turn reflecting a 20 per cent rise in the sterling exchange rate between 2009 and 2015.
This year, economic activity in the UK also -needed to slow down to match a realistic assessment of its trend rate of growth. UK consumers’ ability to spend abroad needed to be curbed and more resources transferred into the sectors of the economy that sell abroad, not least manufacturing. The way to do this was to bring about a change in relative prices: making foreign purchases more expensive and the things that foreigners buy from us cheaper.
The obvious relative price to change is the exchange rate. In normal circumstances this is -difficult to engineer without running other risks — of -inflation, for example — and annoying trading partners. Much of the American animus against Chinese trade is -driven by the belief that for many years the People’s Bank of China deliberately held its exchange rate down to encourage export trade.
But since the referendum, markets have given the UK the kind of exchange rate that other central banks and finance ministries pray for. The pound/
dollar exchange rate has dropped by around 10 per cent. This represents a powerful monetary stimulus directed where it is needed — lowering consumption of foreign goods and stimulating purchases of British goods and services. So far, the exchange rate fall won’t be enough to correct the trade deficit but it will probably deal with about a third of it, and there may be further falls.
The big question is whether the benefits of the lower exchange rate will be undone by higher import prices. Normally, to prevent that, a central bank has to raise interest rates. The extent to which this is -necessary depends on the pass-through of higher import costs into consumer inflation.
This year the pass-through may turn out to be weaker. The Chinese boom is over. Since 2013 the all-commodities index in sterling has fallen more than 30 per cent. Commodity prices remain weak. Good -harvests have cut the price of wheat and there is intense competition in supermarket food prices.
Meanwhile, if the Anglo-Saxon economies appear to be performing reasonably well, the same cannot be said of the eurozone. In Italy, the world’s oldest bank, Monte dei Paschi di Siena, needs to be rescued and recapitalised along with many others. There are continuing problems in Greece and Portugal. And the eurozone’s challenges are not confined to its southern periphery. The IMF and the US authorities have identified Deutsche Bank as the world largest systemic banking risk. Moreover, the negative-interest-rate policy that is emerging in Europe is a threat to the model of financial intermediation — money taken in and lent on at a net interest margin — that is at the heart of modern banking.
Since the Great Recession, the story of investment returns in American and Britain is a shared story of central banks creating huge amounts of liquidity via monetary measures. First this was done to stabilise economies experiencing a slump in confidence. Then it was to stimulate what were perceived to be disappointing rates of growth compared to the pace of recovery in previous economic cycles. The policy did well in stabilising the fall in output in 2009. It prevented the Great Recession from turning into a second Great Depression. The scale of this achievement is probably underestimated.
The second leg of the policy, as a stimulus to faster growth, has been much more disappointing. The heart of the policy has been low interest rates — so low that any marginal further reduction has little traction on decisions on spending, saving and investment. Central banks have therefore turned to other instruments to increase bank lending and economic activity.
These unorthodox policies, usually referred to as quantitative easing, involved central banks directly buying securities, mainly government bonds. A variety of accounts were given to explain the rationale of the policy, from raising asset prices to generating positive wealth effects, to simply finding different means of giving banks more money. Their distinguishing feature has been their scale. The US Federal Reserve now owns bonds worth the equivalent of about one quarter of national income.
This has inflated the price of all assets and driven down returns on them. The transmission mechanism has been plain: little or no return on cash, a move into bonds, very low yields on bonds resulting in investment in equities that have become expensive, provoking investment in property. All asset classes are very expensive. There is plainly a valuation bubble.
Low interest rates plus central bank bond -purchases have created huge distortions in credit and investment markets. Among other things, very low gilt yields have increased the liabilities of the UK’s 6,000 occupational pension funds. They are backed by £1.45 trillion of assets but their liabilities have increased to £2.16 trillion.
Today the Fed is again thinking about tightening, partly because it is concerned about a downturn in the next stage of the economic cycle. Central -bankers are coming to a view that monetary policy has run out of road and the next step will be more active -fiscal -policies.
It is difficult to know what this means for investment decisions. Probably the long bond-market boom will come to a conclusion as rates rise and debt issues increase to fund fashionable infrastructure
projects. Real assets such as equities and property should take a rising share of any portfolio, but they both look expensive.
There is one kink in current asset valuations. In international terms, all UK assets have become -cheaper. Moreover, much market commentary from the British economic establishment, such as theEconomist and Financial Times, is coloured by a pessimistic gloss that identifies a Brexit cloud darkening any chinks of silver in the sky. This prejudice is probably shared by most professional investors in big institutions. That is why they so helpfully marked the pound down. It offers astute investors interesting opportunities to arbitrage comparable risks for better returns, while a more realistic monetary policy directed at containing any inflation from the lower pound could result in better rates for savers and better returns for pension funds that are obliged to invest in bonds. So a touch of optimism is not unjustified.
This article was originally published in The Spectator.