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The US economy suffered continued economic contraction during the 2nd quarter, (April to June), though the gap to growth narrowed, relative to Q1. The fall in output of -1% annualised compared to a consensus forecast of -1.5%. Q1 GDP was revised downwards from -5.5% to -6.4%. 2008 growth was also revised to a weaker 0.4% from 1.1%.
The world’s largest economy has now shrunk for four consecutive quarters, the longest losing sequence since records were formalised in 1947.
A key contributor to the latest decline was the erosion of business inventories which slumped by a record $140bn in the quarter as firms cut production in an effort to reduce stockpiles. The production cut-backs contributed about 80% of the Q2 contraction in economic activity.
Exports, residential and business investment all fell though the rate of decline in each sector slowed compared to the 1st quarter.
The GDP report came at the end of another week of appreciating equity prices, though as predicted in this column last week Monday and Tuesday saw equity markets stutter giving short sellers a small window of opportunity mid-session to prosper before equities resumed their bullish run later in the week.
For four decades the Japanese economy secured more than its fair share of coverage in the financial press. Dominating the economic headlines were the manufacturing and export expansion of the 60’s and 70’s and the phenomenal market rally that took the Nikkei to almost 40,000 during the 80’s. Thereafter commentators focused on the lost decade of the 90’s caused by the property market crash, bank balance sheet shrinkage and the death of Japanese equity wealth by a thousand cuts.
This decade has seen the rise of China’s economic profile, with the PRC now destined to replace Japan as the world’s second largest economy. Such is the dominance of Chinese related articles it’s easy to forget Japan is still an economic goliath, albeit in relative decline. And the cause of that decline can be summed up in one word; deflation.
There’s something deeply embedded in the Japanese economy and psyche of Japanese businesses and consumers that has caused deflation to be a secular and persistent challenge for the Bank of Japan for the past 20 years. The problem with deflation is that it maintains the real value and burden of debt, whereas a healthy rate of inflation, 2-3%, over the years gently erodes the real economic cost of borrowed capital. It is inflation that has given the western economies the luxury of consuming more in the present, with debt in nominal terms eroded by the passage of time. Deflation throws another spanner in the works of economic growth. Why buy a new car, or new machinery, in fact why buy anything today that will be cheaper in a few months? The result is structurally weak demand, an interest rate so low it’s barely visible to the naked eye and a flight of capital to higher yielding currencies (the New Zealand and Australian dollars have been a favoured destination for retail and institutional investors for years). Deflation is a nasty poke in the eye for demand, capital investment and growth.
In fact Japanese interest rates have been so low for so long, the Yen has been systematically sold (shorted) not just by Japanese investors but by a legion of hedge fund managers for years with the proceeds placed just about anywhere that offered a higher return. Admittedly that carry-trade, along with most risk embracing investment strategies, grew to bubble proportions and burst in 2008 but with investors embracing risk again, greed replacing fear, that transaction (short Yen, long anything else that moves) is likely to re-surface.
Investors unsure about the viability of continued Japanese deflation, preferring to focus on the unprecedented global stimulus measures, that should be inflationary, should look closely at the latest Japanese consumer prices data. Prices fell 1.7% in the year to June, prolonging the sequence of deflationary months (year-on-year) to four in row. The main contributor to the decline in prices is energy, with oil settling into $60-$70 channel compared to last years roller-coaster ride to $147.
Investors could suggest that the global economic recovery could re-inflate energy and commodity prices, prompting inflation and thus curing the Japanese “I’ll buy it later when it’s cheaper” philosophy. Unfortunately, higher energy costs are paramount to poking the Japanese economy in the other eye. Japanese energy imports can peak to 97% of its oil and 96% of its gas needs. Japan is similarly deficient in other key energy and mineral related commodities. Higher energy and commodity prices just leave Japanese consumers with less to spend on domestic goods, further hurting demand.
Democracy is the system of one person one vote. Business is one dollar one vote. It would take a vivid imagination to think that the perfect scenario for a business; securing abnormal profits or a monopoly, is appropriate in a fair and democratic society. Likewise, the managers and shareholders of corporations need to be offered a reward for their time, skills and investment otherwise there would be no motivation to take risks or to employ workers. A fair equilibrium is the logical aim.
But the two, democracy and business, co-exist uncomfortably as there is a finite amount of wealth in the economy and that wealth needs to be shared equitably between two of the three participants in any economy: individuals, (workers, consumers and taxpayers) and businesses. The third participant is the government which should not pursue wealth or power for its own benefit but should act as the moderator and facilitator creating a scenario which allows the two other parties to prosper fairly, in correct proportion and in line with the law. To achieve this fair scenario key governmental decision makers should not have personal interests more aligned with one group, business, than the other, society.
In periods of economic growth when both the individual and corporations as a whole prosper the division of wealth between the two is naturally a concern. But those concerns are magnified significantly when the economic pool of wealth is contracting. In a recession tensions between the individual (the ‘man on the street’) and companies increase as corporations lay off staff to protect the interests of the firm’s owners. Tensions rise further when certain companies or industries receiving preferential treatment at the expense of industries with less political influence or the collective society.
The onus is on the government to ensure fair allocation of stimulus and support so that both individuals and companies exit the recession together, as far as that is possible. But if the country is still struggling to recover, unemployment is rising and the average individual is still suffering whilst certain corporations are already, again, enjoying abnormal profits then the division of wealth and the legislation that created that scenario is flawed. Also, corporate earnings can only grow quicker than GDP growth if the finite wealth of society is being re-allocated from the individual to corporations.
The past 25 years has seen the economic balance of power shift too far from the fair equilibrium. The few are benefiting at the expense of the many. Goldman Sachs is a beneficiary. Wall Street as a whole is another beneficiary. Main St has suffered. But the individual, the workers, the micro-engines of the economy have suffered most. Unfortunately, one dollar one vote is more popular than ever in Washington.
GS to 29th July 2009
Wolseley, the plumbing and building products supplier, has provided investors with a comprehensive update ahead of its 31st July year end. Of all the companies reviewed in this column over the past 6 months, Wolseley, at first glance is uniquely vulnerable with extensive debt on the balance sheet and a perceived collapse in demand for its merchandise. The firm indeed has faced a mountain of challenges but entered the recession strong and adaptable and will therefore survive, albeit beaten-up and smaller. Many other building product suppliers have collapsed under the financial stress and fall in demand.
A brief look at the financials sums up Wolseley’s predicament. Revenue from continuing operations is thought to be 16% lower, year on year. Trading profit is likely to be 56% weaker than the prior year. Profit before tax, amortisation and impairment charges is to slide a painful 60% (continuing operations).
In response the firm has cut costs vigorously, £200m in the current year and £392 in annualised savings. Further efforts to de-leverage the balance sheet has also seen net debt fall £108m to £1,426m since April 30th and from £2,711m a year ago.
Strategically Wolseley has also cut a swathe through its non-core markets. Its interests in Belgium, the Czech Republic and Slovakia are to be sold. The firm has lost market share in France whilst management, distracted, grappled with onerous local employment law in an effort to cut the cost base. The Irish business is to be down-sized, possibly permanently, with the firm viewing the market as “unlikely to return to the levels of activity experienced in the past decade”.
Key markets remain grim also. The UK offers promise but a return to strong growth is unlikely before 2011. Their US operations remain strained suffering from weak demand and intense competition.
The management are committed to cutting costs further and focusing on improving their competitive advantage by “enhancing customer service”. Watching Wolseley fight the competition in an attempt to secure a larger share of a shrinking market sometimes feels like observing bald men fight over a comb, but 2009 isn’t about winning, it’s about surviving and Wolseley look set to achieve that objective through its effective and ongoing strategic review, debt reduction and cost controls.
Wolseley will probably never experience such challenging markets again.
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.
Some weeks ago, the NIESR (National Institute of Economic and Social Research), released a relatively upbeat review of Q2 economic activity. Their thoughts, that Q2 Gross Domestic Product could be flat or marginally positive, were broadly in line with the growing number of cautiously optimistic predictions. March was to be the trough, the bottom, of the British economic cycle and April through June was to see expanding output and the start of the recovery after a year of contraction. The prediction was not a shoot from the hip exercise. Data across the economy had been improving for some months encompassing retail sales, the housing market, risk appetite, merger and acquisition activity, corporate profits and the back bone of every recovery, confidence.
Friday’s first official estimate of UK GDP is therefore a kick in the teeth for optimists. The Office for National Statistics reported a -0.8% decline in Q2 GDP quarter on quarter, against consensus forecasts of a -0.3% contraction. It’s highly unlikely ongoing revisions to the data will retrospectively propel the economy from contraction to growth, the gap is too big. The UK economy has therefore contracted for 5 consecutive quarters and has fallen over the period by -5.7%, resulting in the worst 12-month decline in economic output since 1955.
Predictably, analysts rushed to speculate. The Bank of England would have to re-think its stimulus policy. The £125bn quantitative easing program, recently put on hold, would have to be expanded. Interest rates would have to stay low, for longer.
In currency and bond markets guess-work was not required. Sterling fell against the dollar and government bonds rose as investors exposed to the UK economy de-risked their portfolio. Trading rooms across London were consistent in their analysis of the GDP data with “awful” being the singular opinion.
Government debt always increases sharply in recessions. Falling tax revenues, a function of lower corporate profitability and weaker receipts from a shrinking workforce are combined with the fiscal burden of higher benefit payments to the growing numbers of unemployed. No one expects government debt to fall in such a scenario but today’s news that June’s government borrowing, at £13bn, was the largest 3rd fiscal month increase ever has reinforced the concerns that UK PLC is sinking into a unsustainable debt spiral that the government has to tackle urgently.
National debt as a percentage of annual GDP is now at 57%. Even optimistic forecasts suggest this burden will increase to 77% by 2013. Pessimistic predictions quote government debt will rise to 100% of annual output. That figure would put the UK in an awful mess and it’s not debt burden that can be re-paid in one year, or even in one economic cycle. It’s a level of debt that could take decades to clear. Add into the equation the next inevitable recession; length, cost and depth yet unknown, and the picture could get very grim indeed.
So tax rises are inevitable, even if the current government are doing their best to avoid the subject. Value Added Tax will be a likely tool. Reduced funding for councils, forcing local authorities to help relieve pressure on central government expenditure is also a certainty. They may as well just call the next extortionate council tax increase a “local income tax”. It will feel like it and that’s what it is. Petrol, alcohol and tobacco will also suffer tax rises ahead of inflation, motives hidden behind health and environmental arguments.
Income tax thresholds will be tweaked to squeeze marginal tax payers into the neighbouring unfavourable band and no-doubt the tax-system as a whole will be complicated further so that the average consumer has no idea whatsoever of their total direct and indirect tax burden. These measures are near certain.
But in all probability the government will just give up the façade and increase the basic rate of income tax as well. Such a move is political suicide before an election so expect it to be introduced just after the 2010 election and reduced back to the status quo just in time for the following 2014/15 vote. Also, sure as night follows day, expect an announcement increasing the retirement age from 65, by-passing 67, straight to 70. I can hear the longevity and anti-age discrimination sound bites already.
In the very short term rating agencies will dissect the new borrowing data. Sterling will come under renewed pressure as a growing consensus realises the current government is putting off unpopular but obviously necessary decisions, preferring to persist with the current ostrich-head-in-sand fiscal policy in an effort to stem the collapse in their popularity this side of next year’s election. The country is still going to recover from the current global recession, that is evident, but the next two decades will be grim indeed relative to the boom years of 1997 to 2007.
Whilst the UK economy cautiously continues to improve following significant fiscal and monetary stimulus elsewhere in Europe, the German economy, the long-serving export king of Europe, continues to struggle. The ZEW Centre for European Economic Research has reported deterioration in its forward looking confidence measure. The index declined from 44.8 in June to 39.5. German economists predict GDP for the year will contract by -6.0%, more or less in line with last week’s IMF prediction of a -6.2% fall. The Euro currency weakened on the news. Euro rates are currently 1.0% compared to 0.50% in the UK and a narrow range of zero to 0.25% in the US.
The German Chancellor Angela Merkel is under pressure to increase stimulus above the current pledge of 85 billion Euros to prevent Europe’s largest economy, already suffering the worst recession in 65 years, from contracting further deep into 2010.
EWG Germany iShares to 14th July
The International Monetary Fund (IMF) has released a World Economic Outlook update with revised 2009/10 output predictions. The July 10th publication is a timely follow-up to the comprehensive and excellent April 2009 report, which in great detail highlighted the failings within the banking sector (which prompted a global recession) and offered readers a number of common sense, and academically robust solutions to prevent a re-occurrence.
The latest IMF outlook is cautiously optimistic. Of significant interest is the revised output forecasts for 2009 relating to developed and emerging nations. Recovery expectations have been uniformly lowered for developed countries, and predominately raised for emerging nations (Mexico a notable exception).
On cursory examination with world output predicted to fall by -1.4% in the current year pessimists can legitimately cite a global recession, but closer inspection provides some surprises and indeed reinforces hopes that 2010 will most definitely close the door on the most serious economic challenge since the Great Depression.
Revised output expectations, by country or region for 2009, are below with strongest output detailed first:
China 7.5%
Emerging Asia 5.5%
India 5.4%
Middle East 2.0%
Africa 1.8%
Brazil -1.3%
World -1.4%
US -2.6%
Euro-Zone -4.8%
Japan -6.0%
Russia -6.5%
Mexico -7.3%
The revised world forecast for 2010 offers 2.5% output growth, year-on-year, with only the Euro-Zone predicted to stay in recession, albeit it by a modest -0.3%.
The IMF cites recent massive fiscal and monetary government stimulus as the primary reason for the 2010 growth prediction. Keen eyed observers would be forgiven for interpreting the IMF message as an implication the European Central Bank and Euro-Zone authorities have acted with insufficient haste and action in tackling the recession. A review of ECB monetary action over the past 18 months supports that implication.
Clearly emerging countries have generally faired better than developed nations, except for Mexico and Russia for country specific reasons. Mexico has suffered disproportionately following the swine flu pandemic whilst Russia entered the global recession as the “least favored” trading partner following a number of commercial, energy and geo-political disputes with key commerce partners. Russia’s inability to diversify its economy away from oil and gas also created a slump in the face of fast falling energy prices.
Overall the IMF report does imply a very high probability of a widespread return to economic growth late in 2009 or early 2010. Bearish equity investors, who have convinced themselves that risky assets are poised to return to March lows on the back of doomsday economic predictions, may have revisit their price targets.
