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By Ewen Stewart, on 6 August 10
Tim Congdon’s recent article, for the excellent Critical Reaction website, illustrates only too clearly the MPC’s complacent disregard for its remit to target inflation at 2%.
Congdon wrote
Even if (Andrew) Sentance is right, a relaxed monetary stance serves the useful purpose at present of making it easier for the UK government to press on with necessary fiscal consolidation. Admittedly, the Bank of England’s job is to keep inflation in line with the official target, not to support the government’s programme to restore fiscal sustainability. Even so, there may be a tacit understanding of some sort between the Bank and the government, that the Bank will take a relatively permissive view of the inflation target while the deficit is being curbed. And in my opinion, quite right, too.
This comes close to admitting what many of us have suspected that the Bank and HMG, while paying lip service to inflation targeting, actually, post the credit crunch, are only concerned with promoting growth and ensuring there is not a double dip. Without debating the legitimacy of the formal Bank of England remit (this author believes that the remit is far too narrow) this policy risks disaster.
It is clear that the Bank of England has, to date, consistently underestimated the persistence of inflation. The charts below show RPI and CPI since early 2007. Despite the worst recession in 50 years CPI (which underestimates inflation) has remained well above the official target while RPI has now reached 5%. The Bank persists with the notion that the ‘output gap’ will mute inflation and so called one off factors, like the increase in VAT. Given the official remit of the Bank this complacency is staggering. Indeed despite recent strong GDP numbers, and persistent inflation, the MPC still whisper that they may even need to extend QE as well as maintain rates at near zero for the foreseeable future. Only Andrew Sentance sees sense.
However Tim Congdon’s article is important because he implies that the Bank is in cahoots with HMG in believing a little bit of inflation might be a tad useful ‘to help the government press ahead with the necessary fiscal consolidation.’
If true, this is a highly dangerous strategy indeed. Inflation, once embedded, can be very difficult to eradicate and I would argue that the current policy, started by the previous Government, and broadly continued by this administration risks a loss of monetary confidence. Certainly the Keynesian aspect of the last regime is in the process of being ditched, as, thankfully, public sector austerity seems to be taken seriously. This is important and will be a genuine achievement of the Coalition, if implemented, but the monetary policy remains highly dangerous. ‘Near free’ money coupled with £200bn of newly minted QE, with the threat of possibly yet more, has expanded the monetary base of the banks and arguably distorted, downwards, the yield curve. Propensity to lend today may be low, but it is from highly elevated aggregate levels, and monetary velocity, as Congdon accepts, is a notoriously difficult animal to predict. To assume it will remain subdued, with the greatly expanded monetary base, is dangerous.
The ‘helicopter monetarists’ like Congdon believe, like the central planners of the old Soviet Block, that they can omnipotently manage the money supply — print a bit here when it contracts, magically withdraw a bit there when it over heats, and take our economy to the high plateau of stability. The reality is that this arrogance could well spell disaster. It is in any case a million miles from a market solution.
Despite strong evidence of the embedded nature of inflation, the MPC persists in talking about the mythical output gap, which in a modern, global, service based economy, is in my view increasingly irrelevant. Lending growth may be subdued, but let’s not forget that consumers and HMG remain very heavily in hock. Sterling, despite its recent modest recovery, is still in the doldrums making imports somewhat more expensive. Asset prices are through the roof. Without the inappropriate monetary policy real estate values would be 25-40% lower than the highs now achieved. This may sound good for property owners, like this author, but it is a major distortion and leaves individuals impotent to make decisions as they try and second guess the machinations of the central monentary policy makers.
It creates moral hazard. It rewards the imprudent over the prudent, the elderly and those of fixed income. A poor example indeed.
Congdon’s article in Critical Reaction does us all a favour. It is honest and explains very clearly that the MPC and HMG are quite happy with a bit of inflation — it suits their purpose. For the rest of us, don’t be a bond holder, don’t hold cash, don’t be old and don’t be prudent.
By Ewen Stewart, on 31 March 10
We are indebted to Ewen Stewart of Arden Partners for permission to publish his report: A Game of Two Halves – Equities to Win. Please see that report for full detail.
Summary
2009 was a remarkable year for the global economy and a remarkable year for equities. In this note we try to explain why 2009 turned out as it did and examine the prospects for 2010 and beyond.
We have called this note ‘A Game of Two Halves – Equities to Win’ because we believe that although the short-term trends for the UK economy are improving the longer-term forecast looks troubled indeed. Despite this, we believe the outlook for UK equities remains positive.
The first few months of 2010 may well surprise on the upside in terms of employment, house prices, consumer-spend and even, ultimately, GDP. But this is no ‘V’ shaped recovery.
We argue that trend growth, longer term, is likely to significantly disappoint. We argue that the UK’s superior growth, relative to many other developed nations, in the noughties was largely an illusion and we struggle to find the dynamo for growth over the next few years. We believe that the unwinding of the extraordinary fiscal and monetary stimulus, is a necessity, but will also be very difficult to achieve painlessly.
We believe the markets are still underestimating the structural problems with the public sector deficit and that politicians of all colours will be forced to deal with it. The consequences of not doing so would result in rising interest rates and a collapse in international confidence. The deficit remains the key issue for the UK and it may well bring substantial political challenges in itself. Indeed perhaps we should not have called this ‘A Game of Two Halves’ but a ‘Back to the Future – Welcome Mr Heath and the 1970s’?
Despite this, we are not bears of equities. It is true that current valuations are not particularly cheap by historic standards but the UK stock market is fairly defensive and internationally diverse. We believe equities look attractive against cash, bonds and, ultimately, real estate. We are concerned about a potential rise in inflation and again equities are a good hedge.
We have set a year end target of 5750 for the FTSE 100. Sector valuations do not follow a clear pattern and we believe this offers a number of anomalies. We have outlined our suggested sector weights below. As a generalisation, we seek overseas earnings – especially the US$, moderate leverage and strong cash flow as the place to be in 2010 with a return to M&A being more pronounced than perhaps expected.
Policy reaction
The extreme cannot become the norm?
It may be a blessing that Ben Bernanke made the study of the 1930s great depression his speciality. We say may because, while the unprecedented global response undoubtedly has alleviated economic implosion, it does remain to be seen if the ‘nationalisation’ of deficits, the eclipse of moral hazard and the unique policy of both near-zero global interest rates and, in many parts of the globe, with quantitative easing (QE), has succeeded in sending growth back on an inflation-free growth projectory or whether the underlying malaise has been merely kicked into the medium grass. These issues are global, with substantial government deficits, trade and growth imbalances impacting upon different regions.
 Source: Bank of England Stability Report, December 2009.
The economic policy reaction in the UK has been greater and more prolonged than any G20 nation, which is partially demonstrated by the chart above. The Bank of England cut interest rates to 0.5% (the lowest since the foundation of the Bank in 1694); 2009 saw a programme of QE to the tune of £200bn (equivalent to 25% of all outstanding gilt stock) and government spending was accelerated, despite plummeting tax receipts. The fiscal deficit is forecast by the Treasury to peak at 12.6% of GDP – a figure roughly twice as large as the UK’s 1975-1977 IMF crisis, and on a par with Greece.
Read on: A Game of Two Halves – Equities to Win
By Ewen Stewart, on 25 March 10
Ewen Stewart of Arden Partners has kindly supplied his note The Budget – Much ado about nothing for publication.
The backdrop to this budget could not be more fascinating: tightening polls and an apparent improving economic position but still within the confines of a fiscal deficit and monetary policy that is literally unprecedented since the Second World War. Darling’s performance yesterday was of a reassuring bank manager but in reality little new was established. The Budget was clever politics but the real economic meat – in terms of a credible plan for tackling the deficit – will need to wait until after the Election.
Today’s Highlights
The Budget was more focused on politics than economics. The tone, at times, was close to a triumphal justification of policy aided by apparent recovery. Growth forecasts were broadly maintained, save for a 0.25% cut to 3.25% growth for 2011. The deficit forecasts were also reduced slightly to £167bn (from £178bn) in 2010/11 and £163bn (from £174bn in 2011/12). HMG sees a rapid reduction in debt thereafter – a point we take issue with.
Read more…
By Ewen Stewart, on 16 October 09
 UK Household Savings Ratio (click to enlarge) Equity Strategist Ewen Stewart makes the case that the national debt will within 5 years be over £150,000 per family of 4 with debt repayments of twice the present defence budget, up from £31 billion in 2008/9 to £70 billion in 2013/14. He explains the root causes of our difficulties and indicates a route to recovery.
It’s all over. What a fuss about nothing. The economy will soon be growing again and, look, the FTSE100 is up almost 50% since the March low. Even house prices, according to the Halifax, have risen 6 months in a row. The doom mongers were wrong. Central Banks and Keynesian public spending programmes, together with QE, have worked. Brown indeed has saved the world!
Well that would be one interpretation and a very short sighted one too, for this recovery shows all the hallmarks of a drug addict who claims to be going straight injecting a further mighty dose of the substance that has caused such decay in the first place to prolong the party.
The problem is that the underlying fault lines in the UK economy remain and, thanks to the Government’s response, are even more pronounced.
The underlying problem is, in my view, an addiction to debt, a banking system which is over-leveraged, and now government finances that are out of control. This country that has been living considerably beyond its means for a very long time. Artificial efforts to prop this up, through printing money or inappropriately low interest rates, at best are a short term delaying tactic and at worst risk stoking a loss of confidence and ultimately inflation.
It is my central conjecture that much of the economic growth over the last decade was less the result of genuine private wealth creation but more the result of a number of unique factors which were both unsustainable in their nature and damaging to long term growth. If this view is correct the scale of the over-leverage and the action required to alleviate the problem become even more pronounced.
Continue reading “Happy days are here again? Another view from the City”
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