The end of the beginning

An investor’s view of the eurozone crisis

We need more Europe. We don’t only need monetary union, we also need a so-called fiscal union. And most of all we need a political union – which means we need to gradually cede powers to Europe and give Europe control.

Chancellor Merkel’s quote at a press conference with David Cameron, 7th June 2012. She added for good measure “We cannot just stop [the process] because one or other doesn’t want to join in yet.”

Now is the moment of truth. Well at least over the next few weeks! Forget the Greek elections on June 17th. While doubtless the Commission would prefer Greece to knuckle down and accept austerity, rather than take the gamble and from an EU perspective, set an unfortunate precedent of a Greek withdrawal, markets would do well to remember Merkel’s words.

However suboptimal the Eurozone, regardless of the economic divergence caused by this currency union, and the subsequent loss of competitiveness of the periphery, ‘more Europe not less’ is the answer from the people who matter, the European Commission and the German hierarchy. Bamboozled, bankrupt and broken, the weak Southern neighbours will accept this milk as a short term palliative to their considerable woes. Long term may be a very different story.

The elite, who no doubt for honourable reasons in the 1950’s, wanted to banish war from the continent for ever, through this ‘ever closer union’ have met their moment of truth. They say there will be no U turn. They say let’s finish the job. We would not bet against that attempt, ill-conceived, or not.

While the fat lady has not yet sung, and their plans may still be derailed, we have argued that their political will towards a Federal Europe, remains undiminished. While ‘the project’ has very little active support, outside the elites, it is also fair to say, outside the UK and a few other northern European countries, the populations have been somewhat supine in their acquiescence. They have trusted their political betters to lead them. Although ‘the peasants’ have revolted, a bit in France, and elsewhere, in truth these revolts remain well below boiling point. Further, we would somewhat controversially suggest deep rooted psychological scars are liable to result in this European process accelerating, short term.

While the forthcoming European football championships will doubtless underline that national loyalties remain supreme, it is possible to construct a thesis where many of the people of European nations actually see European Government as an enhancement to their nationhood.

Our brief analysis is that Germany arguably still sees a burden of guilt and perhaps a lack of trust in itself, hence its willingness to support a perception of the greater good. Many Southern European states were either military or fascist dictatorships in our lifetimes and could be considered to have weak governance. Perhaps they too don’t trust themselves? East European nations remain wary of Russia and perhaps look for a shield too?

The principal exceptions are certainly Britain which is not in the Eurozone, Scandinavia which has shown some concern at the process, and France. France remains the enigma. A proud, ancient nation with a very strong culture, its elite has arguably seen Europe as a method of enhancing ‘la Gloire de France.’ Coupled with concern at a more powerful neighbour who has flexed its muscle three times in the French direction in a hundred years, their elite concluded, in our view, that it is better to have Germany in the tent than outside.

France does however have a robust political tradition, with the far left and right consistently polling strongly (they scored around one third of the popular vote in the recent 1st round of the French Presidential elections). France short term looks wedded to the project. Longer term, we must wait and see.

While the above comments are clearly a massive simplification of reality, we do believe they possess more than a grain of truth. The problem is that if populations convince themselves that more Europe is their national salvation and if, in time, ‘Europe’ is manifestly in charge and it does not work as expected, then we have a problem. To date, more Europe, certainly in the terms of the divergence of the Single Currency, cannot have been considered a triumph.

This creates a major problem for investors. Short term ‘a resolution’ will clearly be positive, but longer term we have our doubts. That said, bad systems can and do survive for very long periods of time. Ask the peasant farmers of Maoist China or, closer to home, the proletariat in the good old USSR. Predicting timelines of disaster is an imprecise art and while it is hard to believe Europe can return to any real, meaningful growth any time soon, unusual and distorting monetary practices can impact markets for long periods.

The primary reason we have been equity market bulls since January 2009 (indeed the only reason) and we accept that that positivity has, of late, been tested to the limit, has been our belief that, when push comes to shove, Western Governments would effectively print money.

As a Strategy team we are sceptical that such a policy creates real wealth, rather than merely distorting asset prices and delaying the inevitable adjustments. It surely has not helped real growth. Like it, or not, monetary policy in the UK and US has been extraordinarily loose. Germany has, to a degree, held out, correctly in our judgement, against Eurobonds and a pooling of liabilities. It has promoted southern austerity. Ultimately, we remain of the view, Greece or no Greece, that Germany supported by the EU institutions, US, China and even the UK, will indeed commit to some kind of fiscal union. Certainly we believe it unwise to ignore Ms Merkel’s stated comments. If correct, this should, in the short term, be highly supportive for markets which are, in our view, discounting very negative news. Markets have discounted European recession, in our opinion, hence the maintenance of even temporary monetary order in Europe would surely be positive?

There may not be direct Eurobonds issued, but doubtless a political and legal sleight-of-hand will be found. While we believe such a Union will continue to be very far from optimal, given the divergent nature of the European economies, differing political and cultural traditions and differing stages in competitiveness and economic development, if the political will exists, in the medium term, at least, it can hold. Such a move can only succeed with a very significant creation of money. This remains our primary call and while we reiterate our view that this does not provide real growth, real assets, like equities, are likely to be the best protectors of wealth in these unprecedented times.

The implications of a move to effectively a Federal Europe are profound indeed. The outcome in the long term is very hard to predict as it is dependent on some many new and untested variables. Short term markets have been ruled by fear; fear of collapse, banking contagion, confidence and very poor growth. If the EU can cobble together a sufficient monetary creation firewall, markets will rally. We believe the EU will move down this route, but this is essentially a political call, not an economic one. The LTRO deal in late 2011 is a prime example of how markets may respond to further stimulus.

Remember that the FTSE100 trades at a discount in excess of 40% of its long term average and trading on a consensus based PER of 9.7x for 2012 is less than 10% above the post Lehman low. Further, a 4.3% yield is reasonable compensation when the 10 year UK benchmark gilt yield a mere 1.7%. Further, balance sheets remain strong and corporate profitability, despite a highly uncertain macro-economic backdrop, elevated. Very bad news is priced in, in our judgement.

However such a monetary creation, in whatever legal form they felt is most expedient does not solve the fundamental problems that the Eurozone has created. Unemployment, fiscal deficits and economic contraction in ‘the South,’ are at dangerous levels. The Euro has created these imbalances, removing the safety valve of devaluation. There was a reason that when one used to visit Rome that there was over one thousand lira to the pound, that reason was to stay competitive as these nations constantly devalued. That option is no longer available so long as they remain in this currency union.

There are however two ways they can regain that competitiveness. One is to cut wages (and living standards) so far that they become attractive again and can grow from a much lower base, or they can culturally change, toss away a thousand years of tradition and adopt a Teutonic efficiency.

Looking at the first method, to some degree it is happening now with unprecedented Southern unemployment, depopulation and a rebasing of new private sector wages. Unfortunately such enforced deflation further undermines tax receipts, widens deficits and risks social cohesion. Outside massive transfer payments across the Union, it is hard to see this ending happily on a medium term view.

Further, at a time when resentment is rising in a country as stable as the UK with transfer payments, or alleged payments, between north and south, Scotland and England, what hope is there for long term meaningful transfers amongst linguistically and culturally distinct nations? The transfers involved would need to be huge and near permanent. Will that be acceptable to the good people of Rhine Westphalia?

Our second suggestion of adopting Teutonic efficiency can be dismissed. Culture is not so easily malleable in our view.

These are fascinating and unprecedented times. What the Eurozone attempts to do have implications far beyond it’s borders. If Europe federalises, what will be the British response? Will the UK seek to realign towards its historic partners in American and the fast growing commonwealth countries or will it be drawn further into the EU? What are the implications for migration flows of European policy choices and London’s position as de facto global financial capital? How will the Euro’s travails impact UK monetary policy? These are essentially political questions, but the implications will reach far and wide, with long and uncertain timelines.

Our conclusion is stark. Too much political blood has been spilt building this European home for the elite to abandon the estate. Germany will accept substantial short term transfers and monetary creation in exchange for a much tighter political control at the European level. The democratic deficit will become ever more apparent as voters still remain attached to national politicians who will be increasingly impotent. Longer term, this is a toxic mix indeed. Short term, markets will sigh with relief, rally hard and worry about the sand this European house has been built on tomorrow.


As Safe as Houses?

This report from Arden Partners was originally published on the 24th of September.

Why have house prices rebounded?

In 1776 Adam Smith described Britain as ‘a nation of shopkeepers’. Today, judging by the number of home makeover TV programmes, we are a ‘nation obsessed by property values’. This note seeks to examine the prospects for house prices in the medium and longer term.

Given our view of the likely prospects perhaps we should find a new TV pastime, for we argue that the best case scenario, which is our central case, is that house prices drift downwards, settling in three years time some 10% lower with continuing very low transaction volumes. We also see a tail scenario (25% probability) of a crisis-induced interest rate shock that could hit house values by up to 25%.

Notwithstanding signs of a recent slowdown in UK house prices, property values have confounded forecasts by rebounding sharply. According to Nationwide Survey data, average house prices have increased by 12.7% since the low in Q109. Average prices are now just 8.3% off the Q307 high and, in parts of London and the south east, are actually trading well above the pre-credit crunch high.

This note examines the survey evidence along with the macroeconomic environment and highlights our view of the likely trend in house prices. The chart above, however, in our opinion, neatly emphasises why this recovery has taken place and the dangers surrounding this recovery. In two words: interest rates.

Economics & Strategy

Although housing is credibly valued on the mortgage strain measure, this is only the case due to abnormally low interest rates. The chart on the front page demonstrates  that, on more normalised interest rate assumptions, real estate is far from cheap. Further, all other major housing measures from simple house prices to average earnings, credit availability, first-time buyer affordability and, also, in our view, from a macroeconomic perspective, show significant risks exist. Our best case scenario, which is our central case, is for house prices, nationally, to subside by an average of 10% over the next three years. There is a tail possibility that it could be significantly worse. We see little prospect of further increases in property values.

Interest rates: Can they hold the line?

It is well understood that interest rates are currently at their lowest level since the foundation of the Bank of England in 1694. What should happen, in our humble opinion, and what will happen are perhaps two different things.

In our view, what should happen is that interest rates rise at a relatively gradual pace. We believe this because, despite the steepest contraction in GDP since the Second World War, inflation has remained embedded. This has been the case for a variety of reasons: some technical, like VAT rises and some embedded like the depreciation of Sterling, rising food prices and some debatable and perhaps yet to be seen like QE.  Needless to say, we see this current inflation as embedded; hence, our concern over current interest rate policy.

Nevertheless, our thoughts and prejudices matter little compared with the view of HMG and the Bank of England which argue that this recent bout of inflation is a little local difficulty that will subside as the mythical, in our view, output gap exerts a downward pressure on longer-term inflation. More QE is the probable response of the Bank of England to mitigate the risk of a slowdown resulting from required spending cuts. Although the Bank of England denies this, we suspect that it has quietly dropped its official remit, to maintain inflation around 2% with an emphasis on stimulating growth.

As it is the Bank of England that sets interest rates, and not Arden Partners, we believe every attempt will be made to keep rates very low for as long as possible. Our central case is that a rise in rates is not likely in 2011. Rates will only be forced upwards should the economy be hit by further sustained increasing inflation levels, renewed concern over the Coalition’s seriousness (which, incidentally, we do not materially doubt) in tackling the deficit, or some external shock. We ascribe a 25% probability to the rise in interest rates scenario, which clearly would have serious implications for asset values.

There are other tail risks as well. While the Coalition is unlikely to shift materially the tax burden towards property, elements of the Liberal and Labour parties are examining forms of property taxes. It is hard to ascribe a probability to political expediency, but any substantial change in the way property is taxed could have a very material, negative impact on valuations. This is a long term, not short-term risk and would almost certainly be directed at more expensive property.

The current abnormal interest rate policy, coupled with QE, has had the impact of pumping up real asset values well beyond where they would have been under more normalised interest rate conditions. Prospective house purchasers now need not only to consider current affordability, but also need to build in a risk premium for the unpredictability of the government’s and the Bank of England’s policy. Will they maintain QE or won’t they? Will they keep interest rates artificially low, ignore their inflation remit, or won’t they? What will the tax treatment of property be- will there be a mansion tax in a few years or not? Will there be two spoons of sugar in the tea or will it be bitter? Investment decisions are tough enough without having to second-guess policy.

The impact of this interest rate policy can be seen from the chart above. As all are aware, the cost of borrowing has crashed. This has doubtless been the primary factor in stabilising the housing market, in particular, and, also, consumer expenditure in general.

Many other factors are connected and interplay with real estate values. Unemployment and fear of unemployment is clearly a key variable. Again, UK unemployment has surprised many commentators in being relatively subdued. The relative resilience of the labour market has also been a prime beneficiary of the sugar rush of macroeconomic policy.

We remain concerned, however, that unemployment remains embedded. There are three primary reasons for this concern. First, we have argued that the UK economic performance, prior to the credit crunch, was not as splendid as often believed. Much of the growth was a public sector and debt-fuelled binge (see our note ‘A Game of Two Halves,’ February 2010). Secondly, public sector employment (formal and private sector dependent upon public sector) is set to fall sharply – some commentators have suggested by around 600,000 employees (which is still less than the one million increase in public sector employment over the last decade). Thirdly, we are growth sceptics: our 2011 and 2012 growth forecasts remain at 0.75%, which is well below consensus. If we are correct this is not a clement environment for the private sector to pick up the slack.

Unemployment may not spike up to 10% of the working population but it will, in our view, remain embedded and is likely to remain well above 8% until 2012. This is not helpful to housing market sentiment.

A measure of confidence is the savings ratio. In times of collective confidence the perceived need to save is minimal. In times of despair the reverse is true. Later in this note we argue that the UK is addicted to debt and we have failed to save as a nation. However, the above chart demonstrates that UK consumers, despite lamentable savings rates, have started to save again. This is, in our view, positive and part of the ‘healing process’ although the savings ratio needs to remain elevated for years to have any appreciable impact on depleted personal balance sheets.

Another manifestation of the pre-2008 boom and the UK’s propensity for low savings is equity withdrawal. Despite the current rebound in real asset values we see a return to equity withdrawal as highly improbable. Banks are likely to remain cautious on lending for equity withdrawal and we believe consumers, too, will be unlikely to use this as a significant form of funds in the medium term.

HMG has been chastising the banks for not lending. There are three primary aspects to lending: availability of funds; desirability of making the loan in the lenders view, and at what price; and the demand for loans.

In our view, HMG can bang the drum on this as much as it likes – and hang a couple of bankers in the process – but we believe this approach fundamentally misunderstands a) where we start (i.e. with too much leverage) and b) the attitude of consumers.

We see the problem (if it is a problem, which we doubt) as more a lack of demand. If you have a hangover you can either keep on drinking (might be pleasant in the short term but not very wise beyond tomorrow) or you can dry out. We believe consumers are drying out. The two charts above, coupled with the two below, provide some evidence of this, in our opinion.

The UK in an international context

The following chart below shows the Anglo Saxon countries addiction to debt. While one needs to be careful with international comparisons – for reasons of culture, politics and history – the Anglo Saxons do rather stand out with very high levels of personal debt relative to GDP. Not only are the absolute levels high but the direction of increasing leverage is also salutary.

This increasing level of indebtedness seen internationally is bucked by only one nation, from those selected below: Germany. The Germans, for a variety of reasons (perhaps low growth over the decade and the absence of a housing bubble), remain a cautious bunch. Although this is outside the scope of this note this, in our view, leaves them in good stead for the future.

It is also worth noting the low levels of consumer debt of the southern European nations. The Greek interest rate shock has certainly impacted the Greek economy and its public sector, but the impact on its private sector will perhaps be less pronounced than a similar shock would be to the UK.

The chart below also highlights the direction of house prices in a number of selected markets. There is a small prize for the first reader who spots the odd one out.

While the level of Spanish house prices also looks anomalous, given chronic oversupply, the UK does stand out with its sharp recovery. This contrasts with falls in house prices in France, the US and Ireland of around 35%. Can the UK really buck the trend?

UK house prices: the tea leaf

The chart above looks at the Nationwide House Price index changes year-on-year and the real price of the average property: prices have rebounded. However, remembering the very first chart in this note, house prices have been pumped up by the extraordinary interest rate policy. Mortgage strain may be affordable at current interest rates, but on more normalised interest rate assumptions mortgage strain would be highly stretched.

House prices on other measures are currently trading well ahead of their normal valuation ranges. The table above, according to Halifax data, highlights, for example, that the simple house price to average earnings ratio lies close to the 1987-crash high.

First-time buyers

According to research by the National Housing Federation (NHF), the average age of first-time buyers joining the property ladder without parental support is escalating. Research suggests that while the average age of unassisted first-time buyers has already risen from 34-years old to 37-years old over the past few years, it is expected to rise even further, potentially to a high of 43-years old for the next wave of first-time buyers. Worse news still for those looking to buy property in London, with the National Housing Federation forecasting that those wanting to live in the capital could expect to save up until the age of 52-years old to be able to afford their own property, unassisted. Recent research from the Council for Mortgage Lenders claims that eight out of 10 current homeowners under the age of 30, receive financial help from their parents in purchasing their first property.

Another recent survey by the property website warned that the proportion of first-time buyers was currently sitting at around half the level needed for a healthy housing market, with mortgage availability and deposit sizes being the top concerns of the demographic. With the days of 100% mortgages well and truly a thing of the past, the average size of deposit that first-time buyers are required to pay down has jumped from 10 per cent to up to 25 per cent of the property value in the last few years.

Even those who are able and or lucky enough to afford the steep deposit amounts are likely to experience further hurdles, with mortgage lenders being increasingly more selective with whom they lend to, tending to focus on those holding existing mortgages, or those holding mortgages with competing lenders, thus taking less risks.

Despite interest rates being at their all-time low since 1694, the market for first-time buyers remains particularly expensive with many deals for a first-time buyer at around ten times the Bank of England base rate: ie. 4.99%. With interest rates at such historically low levels and first-time buyers still unable to get on the ladder, when will they be able to afford a place of their own?

Taking account of the steep mortgage rates, coupled with the aforementioned deposit barriers, this equates to an almost impossible situation for those eager to own their first home. This is complicated further by the surge of newly-graduated twenty-somethings who are continuing to struggle to gain entry to the graduate job market – thus, pushing the expected age of home ownership even higher as the majority live at home with parents for an extended period.

The chart below illustrates that the elevated house price to earnings ratio is highest for London. Excluding London (Outer Met), the cheapest region is Scotland – calculated using the ratio to the nationwide FTB house price to mean gross earnings per region.

In terms of first-time buyer affordability, the chart below illustrates initial mortgage payments as a percentage of take-home pay for each region, based upon a 90% mortgage loan of the typical house price. Affordability is measured against the long-term average of 1985. The chart reveals that the least financially-affordable area for first-time buyers is somewhat surprisingly in the West Midlands, compared with the more affordable north of England. Towards the end of 2007 the UK average stood at 136.2 – suggesting it was 36.2% harder to access the market for the first time than when it was when the index started back in 1985. While the affordability index started to recover towards the beginning of 2009, with the UK average index value of 91.8 the index began steadily increasing again over the next year, with the most recent reading at the 92.5 level.

Further, while credit markets have improved, the demand for credit remains low. Transactions have picked up slightly but remain around 50% of the long-term average and close to 35% of the peak. The ‘recovery’ in house prices has been based on very thin volumes, few repossessions (as a result of interest rates, average unemployment and benevolent banking policy directed, in principal, by HMG).

Further, the supply of new houses remains at critically low levels as is demonstrated by the chart below. UK house prices have remained elevated partially as a result of the limited supply of housing and a planning policy that bumps up the value of land well above a true free market price. The most recent measure of around 75,000 UK housing starts in 2010, compared with the high of 1999 of around 220,000, represents a decline of 65% and given demographic trends stands well below the long term required equilibrium.

While there may well be positive reasons for controlling the supply of land (environmental and NIMBY etc.) for house building, the impact is clear.


In this note we try to explain why the UK housing market has rebounded so strongly. We also argue that on virtually every measure other than mortgage strain, UK property valuations are highly extended.

Our view is that the Bank of England will maintain interest rates at abnormally low levels in 2011, and possibly into 2012. Under this scenario, we believe house prices will subside by around 10% over the next three years. Transaction levels will remain very subdued and the first-time buyer will remain largely excluded.

We believe the problems faced by the first-time buyer, in particular, are likely to move ‘up the political agenda’. We are in danger of heading towards a real social predicament if the housing market continues in the worrying current trends. The Liberal and Labour parties appear to remain hostile to property-related wealth, and longer term some form of property tax is possible. This would most likely impact higher-end properties. This risk is very hard to quantify, and beyond the short-term investment time horizon as it is unlikely the current leadership of the Coalition would sanction such a change. But investors need to keep this at the back of their minds.

We ascribe a 25% probability to a shock that would force the Bank of England to have to raise rates substantially. Such a shock could come from renewed euro difficulties, concern on UK deficit reduction (unlikely in the short term, more likely on two to three-year view) or persistent and continuing domestic inflation. We estimate that if base rates had to rise to 5%, property values, in aggregate, would correct by at least 25% to reach any semblance of credible valuation. On balance we believe and hope that the authorities will be able to avoid such a scenario.

We find it hard to perceive any scenario where property prices can rise further, given that rates cannot go any lower than current rates, transaction volumes are liable to remain highly depressed and valuations on most measures are well ahead of the long-term average.


The Cat is out of the Bag

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.


Arden Partners – Equities to Win

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.


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


Arden Partners: Much ado about nothing

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…


Happy days are here again? Another view from the City

UK Household Savings Ratio (click to enlarge)

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.

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