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An understanding of economics is greatly enhanced by the study of great economists, men who formed original and ground-breaking theories regarding economic management, foreign exchange mechanisms and monetary and fiscal policy.
If Adam Smith was the founder of economic theory as we understand it today (The Wealth of Nations, 1776) then John Maynard Keynes was the father of modern monetary and fiscal policy. His brilliance, soon to be obvious, went largely unnoticed in his formative years of study and examination. “The examiners presumably knew less than I did”, he famously remarked.
Later, in the years between the two great wars, his work focused on developing theories better able to achieve full employment – in response to the deflation and poverty caused by the global depression. His work relating to interest rate controls and government led stimulus, obvious and accepted now as a cure for recessions, were at the time revolutionary, misunderstood and unproven.
Morally robust, he resigned in protest against the First World War reparations policy, a thorn in the side of Europe for 20 years and a key grievance which led to the rise of militarism across Europe, and the Second World War.
In 1943 Keynes was fundamental to the original proposal for an international monetary authority. In 1944 he led the British delegation in the Bretton Woods Agreement. Late in 1945 he was accredited with almost single-handedly negotiating the American Loan Agreement which helped rebuild Britain, bankrupt in all but name, following six years of war.
The stress and burden of the US loan negotiations contributed to the demise of his health. Americans found Keynes to be “irritatingly brilliant”. But the war, Britain’s earlier guarantee for financial help, was already over. Military cooperation had been replaced with a new economic order. Keynes secured a loan for $3.75bn agreed at a 2% rate of interest. Any other man would have returned to the UK empty-handed. The final loan repayments were made 61 years later by Tony Blair’s government.
Keynes remains famous for his theories tackling monetary deflation and trade depression. His policies embraced the economy as a whole. His understanding of the relationships between money supply, fiscal intervention, investment and job creation were unrivalled. His suggestion that increased economic activity could be best achieved via centralised intervention and sponsorship of capital projects was proved successful during the 1930’s.
During the process of financial market de-regulation from the 1980’s to 2007 the policies of John Maynard Keynes were increasingly viewed as out-dated, too interventionist. Economists cited the modern free market economy to be self-controlling, self-moderating and a capitalistic self-fulfilling prophecy of wealth creation. The past year has seen a return to centralised intervention, all-encompassing economic policies and a return to the theories that were first realised by Keynes 75 years ago.
Born on 5th June 1883, a student of Eton and Cambridge, a renowned teacher committed to helping others learn and a reputation for speed of mind that few could cope with, Keynes’ theories again form the bed-rock of solutions used to resolve recessions and stimulate economic growth.
The US looks increasingly primed to return to economic growth in 2009, before Europe. The more assertive action by the Federal Reserve via aggressive rate cuts, Fed balance sheet expansion, widespread government fiscal easing and banking sector intervention have all contributed to the consensus expectation of a Q3/Q4 recovery. Incredibly, so quickly are market-wide forecasts changing, the US futures market is now pricing in a 59% probability that interest rates will increase in Q4 2009. A month ago, such a suggestion would have been ridiculed by most analysts.
This about-turn, from deflationary to inflationary concerns, is not based on vague hope of a recovery in demand. Sharp price increases have already been seen in commodity markets. Expectations of monetary tightening, rather than additional injections of liquidity, were further supported on Friday following an unexpected improvement in non-farm payrolls data, discussed below, and confirmation Federal Reserve officials met last week to discuss potential timing of credit tightening measures to wean investors off the abnormally high levels of manufactured liquidity.
It’s worth looking at the non-farm payrolls data in more detail as it is one of the most keenly anticipated regular economic reports, with a proven ability to move markets significantly when the actual data differs greatly from the consensus, as it did this month. Interestingly, the numbers were still bad (payrolls fell by 345,000 in May), but not nearly as bad as the 500,000 to 520,000 reduction predicted by most analysts. Also released was the country-wide unemployment rate, which rose to 9.4% relative to an average forecast of 9.2%. Although, unlike the payrolls data this rate worsened more than expected, a number of market commentators interpreted this data with rose tinted glasses suggesting more long-term jobless who previously had no hope of finding work were now registering officially as job-seekers. On a corporate level both General Motors and American Express are expected to make further job cuts, whereas Wal-Mart (The owner of UK’s Asda), confirmed it was looking to recruit 22,000 more staff in line with its US store expansion plan. The US economy has now lost 6 million jobs since the start of the recession and the current unemployment rate is at a depressing 26 year high but the monthly rate of job losses looks likely to ease through the rest of 2009 relative to H1, before the US returns to employment growth sometime in 2010.
Naturally, in the face of such job uncertainty, US consumers have changed their spending habits. More Americans are saving. April saw the highest ratio of consumer saving to spending in 14 years. Consumer borrowing has also eased with April seeing the 2nd biggest fall in lending, since records began ($15.7bn lower). This return to relative prudence was and still is desperately required to fix the personal balance sheets of consumers who are burdened with too much debt and not enough savings.
The continuation of better than expected US economic data helped the dollar rally against the yen, euro and sterling, though there are domestic issues in Britain that also encouraged dollar appreciation against the pound. The Australian and New Zealand dollars also appreciated against most G7 currencies as investors chased yield, investing in currencies offering a higher return. The USD rally also reflects widening sentiment that the US will lead western economies out of the recession. Not surprisingly, the dithering European Central Bank is still paying catch-up and an ECB spokesman dropped hints on Friday that rates may have to fall further in the Euro-zone to stimulate growth.
The UK economy is slowly recovering. The green shoots of consumer demand, stabilisation in house prices, a 3 month stock market rally, the banking sector back in profit and deals being agreed in a buoyant commodity sector are collectively more than adequate evidence. There is still much work to be done, but a return to growth is highly probable in the not too distant future. Ironically, some of the credit can be allocated to the same institutions and quasi-governmental bodies that got us into this debt fuelled mess in the first place, but nevertheless, there is now clear light at the end of the recessionary tunnel. Of course there is always a chance that the fragile recovery will fade and the recession will be prolonged, particularly if business and consumer confidence in UK PLC has a reason to retreat. So what is the biggest threat to growing confidence and a successful UK economic recovery? I believe the largest single threat is further political chaos. I would suggest our politicians should be in back-to-back meetings creating an environment in which the unemployed can get back into work. They should be working with the Bank of England to ensure the £125bn stimulus package is used as quickly and efficiently as possible. Or, equally important, cutting back on red-tape in an effort to reduce the country’s growing debt burden, predicted to be £175bn in this tax year alone. Unfortunately, such crucial objectives hardly got a mention this week. The country had to suffer politicians, the names of whom were largely unknown to us a month ago, whinging over their career prospects or smirking at cameras with “rocking the boat” badges in an appalling episode of self-indulgence and self promotion. The local election results, in which Labour received its lowest ever share of the vote, will produce further unbearable months of political back-stabbing and manoeuvring, probably all the way to the next general election. Meanwhile, Barack Obama was giving a free master-class in statesmanship, touring the Middle East and receiving standing ovations from Arab audiences on his vision for the region and the world. I can’t imagine Obama has been busy submitting dubious expense claims for a non-existent mortgage either.
I empathise with readers who feel economic and stock market reviews should minimise political banter but UK politics and economics have never been more closely aligned, except during the World Wars. Further evidence of the political impact on equities and currencies was seen this past week, when both the FTSE and Sterling, fell back sharply, albeit temporarily, on unfounded rumours that Gordon Brown had resigned. Politics is markets.
Other news included a hold on interest rates. The Bank of England monetary policy committee voted to keep rates at 0.50%. The decision was in line with expectations and analysts were more focused on possible policy changes to the additional stimulus package, which so far has allocated around £125bn of the £150bn budget for boosting economic growth and lending. A number of commentators quite rightly suggested that that impact has been less than forecasted and the remaining £25bn, yet unallocated, will need to be utilised over the summer months unless lending activity accelerates from the current sloth like rate of growth.
For some weeks now this weekly review has ‘called’ Q1 or Q2 2009 as the trough of the economic cycle. Initially there was much risk in the statement as the global and US recovery was by no means certain, but as the weeks have progressed the ongoing stream of economic data has increasingly supported this view. The consensus among market commentators has also moved towards our more optimistic pro-recovery stance and now a Q3/Q4 recovery is a mainstream prediction, rather than the hopeful rhetoric of the enlightened minority. Our view did of course fully consider the unusually bitter and sharp contraction in growth primarily caused by very poor leadership in the global banking sector, ineffective regulatory risk controls and appalling credit procedures in the mortgage and commercial lending market place. But whilst we accepted this scenario as depressingly and worryingly unique in modern times, with only the depression of the 1930’s having close similarities, we also reflected on the impact of the unprecedented wall of money flooding into the global economy via government and central bank stimulus packages and its effect on demand. The global economy has never enjoyed such internationally co-ordinated monetary easing or the simultaneous hard–cash injections by governments, to shore up the balance sheets of strategically important institutions. The consequences of this combined stimulus are already being seen in the price of commodities, including oil and gold. Looking beyond the current market-wide inflation data which does not yet fully reflect improving demand outside of the resource sector, we predict that deflation will not only fade from the vocabulary of pessimistic US economists, but that concerns over inflation will return with vengeance within 18 months. The real challenge for 2010 is not achieving stronger global economic growth, a scenario which looks inevitable relative to 2009, but how to restore stable economic growth without killing the US consumer spending recovery with sharp interest rate rises, the usual primitive remedy for rising inflation. We would stress this view is not implying the deep structural problems within capitalism are being fixed. A move away from a cyclical, debt based economic system would need to be implemented for that. Nor is it an equity market prediction, which is below. But we do think the US and global economy, in terms of Gross Domestic Product, is set for a significant improvement from its Q1/Q2 trough.
Looking at the most recent US economic news in more detail, revised data now indicates the US economy weakened less than initially estimated in Q1 contracting at a 5.7% annualised rate, rather than the 6.1% fall previously announced. Investor’s, prior to the announcement, had been even more optimistic and predicted on average, the figure to be revised to a 5.5% contraction. Also, for the first time in a year, US corporate profits after tax increased, albeit only by 1.1%. The figure is a vast improvement on the 10.7% slump seen in the prior quarter and surpassed the consensus Q1 forecast of a 7% fall. Dissecting the Q1 GDP figures more closely, weakness in exports more than off-set a stabilisation in consumer spending, which accounts for around 2/3rds of US economic activity. Interestingly, some very competent market analysts are putting their neck on the block and are predicting much shallower weakness in Q2 and a return to positive US GDP growth in Q3. Unfortunately, unemployment is a lagging indicator so the US economy is likely to suffer rising jobless claims for some time yet even when the wider economy has returned to growth. The current unemployment rate is 8.9% and looks set to reach 10%, with the car manufacturing sector and Michigan, its home, likely to suffer most.
The growing expectation of H2 2009 economic recovery, and the view that equities were grossly oversold, prompted the sharp appreciation of equity prices in the period from early March to mid-May. At the end of that 10 week rally we highlighted that in the short-term prices look stretched after such a short sharp spike and a pause in upward momentum was inevitable. 2 weeks later that pause appears to be coming to a conclusion and the next move in the S&P 500, the diversified large cap index, is imminent. Based on the current trend of improving economic data and index technical factors we suggest the next significant move is up. The S&P 500 is at 907 (at the time of writing) from a March low of sub 700 and a further rise to near 1,000 would likely complete the technical recovery from the manic depressive state in investor confidence that caused the oversold trough in prices seen in March. A summer lull in trading may interfere with the timing of this view, but the next major move for US equities, we believe, is up. Time will tell.
We briefly mentioned oil. It’s worth taking a closer look at the market as the recent price action, we suggest, is a fore-taste of further inflationary pressures to come in other areas of the global economy. Reflecting for a moment, a barrel of oil fell from $147 during mid-2008, to a little over $32 by December of the same year. Since then oil has pursued a near-relentless recovery to pass $65 on Friday, twice its cyclical low. Statements from OPEC members have reinforced the view that the current rally is not a false dawn for oil bulls. The Saudi Arabia Oil Minister, Ali al-Naimi, long respected for moderate and reasonable analysis of the sector commented the market is “ready” for $75-$80 per barrel prices later in 2009. His views are based on already firming Asian, Middle Eastern and Latin American demand, not pie-in-the-sky guess work. The start of the US holiday driving season also suggests we are more likely to see $80 than $50, next. From a technical view, the price of oil has crossed its 200 day moving average and a number of oil analysts are now suggesting $60 is the new floor in prices. Politicians who side-lined their pro-green sound bites through the worst of the recession will soon be marketing their renewable energy credentials again.
Before progressing on to the UK, let’s take a brief look at the Euro-Zone economy where investment ‘professionals’ are still talking about deflation following release of May’s data which showed prices flat at 0.0% compared to the same month a year earlier. Readers will be forgiven for being confused. “Haven’t I just read oil prices have doubled and the global recession is definitely easing?” You did. But the Euro-zone is different to the US and other economies because the European Central Bank executed a monetary easing plan that was so mistimed (late) you would be forgiven for thinking they were trying to pre-empt the next recession, not cure this one. Not only were the box-tickers at the ECB too late in cutting rates, they unbelievably were still raising interest rates in July 2008 when corporate confidence had already stalled and seasoned financial sector analysts were busting blood vessels in stress as we approached the near-collapse of the global banking industry.
The Global Economy
Last week, for the first time in over 2 months, investors significantly reduced their exposure to risky assets. The flight to safety was a primarily a result of equity index technical factors with markets very overbought in the short-term. Weak corporate and economic data on a number of fronts further encouraged profit taking. Most technical analysts suggest this reversal of the recent upward momentum is likely to continue for one or two weeks further, before markets enjoy another leg up lasting several more weeks. At that point, with equity markets having gained substantially from early March lows markets will be reliant on complete Q2 and early Q3 economic data before clarifying the direction of the next multi-month trend.
Beyond the considerations of technical factors, ongoing US data is increasingly indicating the trough of the US recession is behind us. Consumer confidence in May is highest level post-Lehman. Other recent data, including the Q1 GDP contraction of 6.1% (annualised), as well as the decelerating rate in the decline of industrial output also indicates the economy is moving closer to the recovery phase. Another key measure is the industrial capacity utilisation rate which fell to 69.1% in April, the lowest figure since organised records began. This rate, and business inventory data, confirms US businesses have very aggressively reduced production to meet lower demand. Reduced production output has also helped firms to lower their marginal costs. Lower inventories can actually be good for the economy going forward, as when consumers and firms do increase spending, production has to be scaled up quickly to both build low inventory levels and meet growing demand.
The International Monetary Fund (IMF) predicts the US economy will contract by 2.8% in 2009, before stabilising at zero or marginal growth next year. This forecasted rate of growth, low as it is, may well be superior to European growth next year as the US authorities have been more aggressive in both monetary easing and the introduction of stimulus packages. This view is supported by Q1 GDP data within the Euro-zone. The single currency economic area contracted 2.5% in the first three months of the year relative to Q4 2008, according to initial Eurostat predictions.
Economic activity in Germany, long the export champion of Europe, fell at a sharper pace than the Euro-zone average, retreating 3.8% quarter on quarter (QoQ). The fall, appalling by any measure, is the worst decline since 1970 and is the 4th successive quarterly decline. French GDP also contracted, though less aggressively at 1.2% QoQ. Spanish and Italian GDP output also retreated. Similar to the US economy, European inventories are at very low levels so Q1 will probably represent the low-point in the economic cycle for the Euro-zone, but the recovery may be delayed relative to the US, and Asia, for reasons discussed above, despite tax cuts and monetary easing (rates now 1% from 3.25% in October 2008). The IMF forecast GDP to contract 4% in the Euro region this year with a marginal retreat next year of 0.1%. Unemployment usually continues to worsen deep into a recession and even if GDP stabilises and returns to positive territory earlier than anticipated the European Union jobless rate is still likely to deteriorate further to 11% (9.9% now), with Spain likely to suffer most. Euro equities fell around 3% on the week, but remain approaching 30% from the early March low.
The Global Economy Hope has turned into expectation. Through Q4 2008 and Q1 2009 commentators and analysts were steadily downgrading their economic forecasts and pushing back deeper into 2009/10 their predictions for an economic recovery. However, early in March we saw equity markets fall to new lows, then rally on bargain hunting, and since then cautious optimism has gradually returned to the banking sector and wider economy. Investors and economists increasingly feel there is light at the end of the economic tunnel and the bottom in the economic cycle occurred in Q1, or at worst in the current quarter. The unanswered question is will the global economy stabilise at current levels and provide flat to modest economic activity (an ‘L’ shaped recovery), or will the massive stimulus packages provided by G8 Central Banks spur the global economy into a ‘V’ shaped recovery accompanied by a new bout of inflationary pressures? Equity markets, particularly in the US, seem to be leaning towards to the latter scenario with further gains made this week leaving the 2-month equity rally intact with improved risk appetite spreading from speculators to more mainstream and conservative long-term equity investors.
Ironically, the foundation for improving confidence is not a new, and surprising, trend of good economic news. It’s because certain key data announcements have not been as bad as predicted. In fact it’s near impossible to find any data releases year-to-date, outside of China, that even the most cheerful economist could describe as good but when expectations and investor moral is so low, as it was at the turn of the year, quite bad economic news particularly from the US, still the world’s most influential economy, is greeted with relief and a new bout of equity buying.
A perfect example relates to US employment data, released on Friday, which indicated a further 539,000 jobs were lost during April, compared to a negative 590,000 consensus forecast. The figure, depressing by any normal measure was actually the best, or to put it more accurately, the least worst figure in 6-months encouraging commentators and even President Obama to articulate optimism that the recession was easing in its severity. However, many of the upbeat commentators omitted to mention the data was flattered by a 60,000 temporary boost to US government payrolls relating to contract workers employed for the 2010 census count. Nevertheless confidence is a crucial ingredient in any recovery and as long as the press and investors hold onto their cautious optimism we should see, later in 2009, stabilisation in US housing market which will thereafter encourage US consumers, the backbone of the US economy, to return to what they do best; shopping.
In Canada, the employment news was also better than predicted with a small increase, 35,900, in payroll numbers. Closer to home, the European Central Bank cut Euro-Zone interest rates for the 7th time since summer 2008 reducing the cost of borrowing 0.25% to 1.00%, an all-time low. The European economy is highly likely to recover later than the US due to the ECB being behind the curve on monetary easing but the latest rate cut is welcome nevertheless, though is widely viewed at best as ‘better late than never’.
UK The FTSE ended the week higher, tracking US equity gains. The recent better than expected UK banking sector updates also supported sentiment. The headline UK index has now progressed around 13% in the 5 weeks to-date during Q2. Inevitably some sectors continue to fair better then others. Resource and financial stocks continue to out-perform house builders, property and industrial related equities. This trend, many commentators suggest, is likely to continue with key analysts, Goldman Sachs and Morgan Stanley, downgrading leading property companies or advising clients to sell, whilst house builders remain vulnerable on the expectation that the sector will need further injections of capital to strengthen beaten-up balance sheets. News that house prices declined 1.7% in April (Halifax data) also encouraged equity investors to allocate cash elsewhere on the presumption that the UK property market may be the last sector to enjoy a recovery. On a more upbeat note regarding the affordability of homes, the sharp decline in prices over the past year, (17.7% lower) has improved the house prices to earnings ratio, which is now at a 6 year low of 4.26 according to Halifax. Lower interest rates have certainly helped but with rising unemployment and mortgage availability still not back to normal (pre-Lehman) levels the picture for the rest of 2009 is mixed at best.
Other UK specific news included a hold on interest rates. The Bank of England Monetary Policy Committee opted for no-change to the current rate of 0.5% but did announce an expansion of the £75 billion quantitative easing program adding a further £50bn to help the UK recover from the “deep recession”. The BoE also indicated that it did not consider inflation to be a threat hinting borrowers can expect to enjoy low interest rates for some time yet, certainly into 2010, based on current data.
Look forward, the FTSE is likely to track the S&P 500 pretty closely so the wealth of diversified UK equity investors remains at the mercy of US market sentiment. However, only the most pessimistic market analysts suggest the current rally is a false dawn, and predict a return to new fresh lows. The consensus forecast predicts flat performance or further gains through Q2, with inevitable bouts of short-term profiting taking when markets progress too-far, too quickly.
BHP Billiton PLC (BLT) 1544.00p BHP Billiton, the largest mining company in the world, enjoys balance sheet strength and financial security that most global companies, indeed most countries, would keenly like to replicate. The 2008 annual report, released before the global recession hit, is almost impossible to fault. Seven consecutive years of profit increases, an EBITDA* interest coverage of 49x and $32.1bn returned to shareholders via dividends and share buy-backs, since the BHP and Billiton merger in 2001. Clearly the company efficiently captured the growth in demand, primarily from Asia, for iron ore, copper, nickel, coal and oil, and rewarded shareholders handsomely. The headline figures point to an extremely well run company but hardly scratches the surface of the firm’s operations. BHP Billiton has an impressive portfolio of over 100 mining operations in 25 countries with (as at the end of the last tax year) a further 28 projects either in development or undergoing feasibility studies. The current operations have accumulated $60bn of net operating cash flow in the last 5 years. Commentators have typically associated the terms “China” and “BHP Billiton” in the economic articles for some years now and for very good reason. Their future prosperity and growth are aligned not just in the demand and supply of commodities but fundamentally and politically. China, committed to a unique style of capitalism within a controlled economy needs resources to maintain high economic growth rates thus allowing the spread of wealth through its enormous population. When BHP Billiton was honoured with the task of producing the 2008 Beijing Olympic medals, it confirmed the company was not just another trade partner but was fundamental to the well-being of China, its economy and was in the thoughts of the highest echelons of Chinese political circles.
So the question for investors, considering the long term fundamentals remain excellent for BHP Billiton, how has the worst global recession in 75 years hit current year demand for commodities and BLT profits? Casual observers may be surprised. The firm, in its recent production update, surprised markets with record year-to-date output of iron ore and oil. Interestingly, iron ore shipments cancelled by some customers were sold on the spot market without discomfort. Looking forward, there is further evidence, if any was needed, of the competence of management. The Q1 2009 exploration update should be renamed the “on schedule and on budget project update”. All the oil, gas and LNG projects, (Shenzi, Atlantis North, Pyrenees, Angostura, Bass Strait and North West Shelf) are on target. The Canadian potash project covering an incredible 7,000 square kilometres also highlights the firm’s determination to build on its current portfolio of products and secure new revenue streams. Even in the absence of merger and acquisition activity, BHP Billiton can look forward to growth from expanding the output of its current portfolio of long life, low cost, upstream assets and even a sharp recession seems unable to hold back the success story.
*Earnings before interest, tax, depreciation and amortisation.
On the Money 11:20 pm on June 6, 2009 Permalink |
Do we really want to go back to the sham economics of the past 10 – 30 years? Will be interesting to see what Ron Paul’s legislation bid turns up re auditing the Federal Reserve.