Author: admin@hottinger.co.uk

By Economic Strategist, Hottinger Investment Management

One of the ideas that lie at the heart of the theory of economics in a world in which capital can flow seamlessly across borders is that there is only one global price for money. The price of money is the real interest rate; it is the amount of real economic resources that have to be given up to borrow a sum of money or received for lending it. Since investors can move the capital freely, so the theory goes, any differences in real interest rates in different countries, excluding the premium that reflects country and market risk, will be traded away.

Another theory is that of ‘uncovered interest parity’ (UIP) and it describes the relationship between the difference in interest rates between two reference countries and the movement of their exchange rate pair. It is an arbitrage relationship that states that investors accommodate different nominal interest rates between states by acting in the foreign exchange market to prevent any one country offering more attractive terms than another. One country can only offer higher interest rates in their currency than another if investors expect that country’s currency to depreciate over the period of the investment. If that country continues to offer greater interest rates adjusted for expected exchange rate movements, money will pour into it until the incentive to do so disappears.

This idea is best demonstrated by way of an example. Suppose that the current (Year 1) exchange rate between the pound and the dollar is parity or $1:£1 but that the US offers a 3% interest rate in dollars and the UK offers a 1% interest rate in pounds sterling.

	Year 1 (Current)	Year 2
US (3% interest rate)	$1.00	$1.03
UK (1% interest rate)	£1.00	£1.01
Exchange rate	£1:$1	$1:£0.98 or £1:$1.0198

UIP theory says that there should be no opportunity to profit from this difference because the exchange rate adjusts from $1:£1 to $1.03:£1.01. This means that the dollar depreciates, or becomes less valuable, over the period and correspondingly the pound appreciates. The new theoretical exchange rate is $1:£0.98. Thus the gains for a sterling investor of buying in dollars in Year 1 and gaining a superior interest spread of 2% over the pound are wiped out by a completely offsetting depreciation of the dollar when the investor transfers those dollar gains back into sterling.

The conclusion is that according to the theory of UIP the strategy of investing in other countries to return a superior return in your home currency is futile. Further, the idea there is one global price of money (or real interest rate) means that the theory of UIP implies that the difference between interest rates between any two countries reflects merely differences in inflation, which are offset by subsequent movements in their currency pair. This is because the nominal interest rate in a country is approximately the sum of the real interest rate and the expected rate of inflation. In the final round, UIP simply embodies the idea that because the difference between interest rates across countries is accounted for entirely by differences in inflation, exchange rates are affected only by these differences because they must move to offset them.

It’s a neat theory but it is substantially flawed, as is the idea that real interest rates cannot vary between countries. Exchange rates are influenced by a range of factors, including economic and political uncertainty, trade flows, investment opportunities and speculative reasons. Additionally, exchange rates are influenced precisely because real interest rates can differ across territories. Countries can have high real interest rates because they offer attractive investment opportunities and not the other way round as global capital mobility theory implies. It is possible therefore for rising interest rates in one territory to correspond to its currency strengthening, either structurally or coincidentally. International money flows in keeping that country’s currency strong and yet real interest rates can remain high in regions with strong growth and good opportunities.

We see this in global markets today. Figure 1 shows how since the middle of 2016, US interest rates have divorced from UK rates, driven by the earlier rate hiking cycle of the Federal Reserve compared to the continued low rates supported by the Bank of England. With US inflation rising by less in this period, it can be said that real interest rates in the United States have risen in the last two years.

Figure 1: US and UK T-Bill yields since November 2015

Since mid-2016, sterling investor may have been attracted to US interest-bearing assets, but the currency worked against them. Between then and early 2018, the dollar weakened against sterling and something close to UIP held. However, since March 2018, this relationship has broken down as Figure 2 shows.

Figure 2: The dollar strengthens against the pound from March 2018 despite positive interest differentials.

The interest rate differential between US and UK assets continued to rise as the Federal Reserve pursued its rate-hiking policy and US real yields furthered their upward rise, yet the dollar also strengthened against the pound. Indeed, the dollar strengthened against most currencies (including the euro; see Figure 3) as global investors first responded to investment opportunities in the US at attractive interest rates and more lately on the back of rising uncertainty due to ongoing trade tensions.

Figure 3: The situation also exists for euro investors.

This means that a sterling or euro investor who took investments out of their own short-dated government bonds and placed them into US short-dated T-Bills would have made both a superior interest yield but also profited further when they transferred the gains back into their local currency. Those investments of course would have been fully exposed to exchange rate risk, but its outcome would not have been achievable had the currency risk been hedged in FX markets.

Recent experience shows we should throw out the theory of UIP*. It’s a neat, logical idea that just doesn’t hold over any reasonable time period in a complex real world. However, we should be clear; unhedged investment strategies carry significant risk and are attractive only if the investor has conviction on the direction of exchange rates.

If one believes the dollar will weaken in the next few months then an unhedged position in US fixed income is not prudent. If however one believes that the dollar will remain strong then such as position makes more sense. Indeed, it could be argued that there is a good case for this belief; with China and Europe showing signs of slowing down, there could well be a flight of capital to the US, keeping the dollar strong.

UIP therefore can break down over the short term because there is no such thing as a single global real interest rate, because global capital is not fully mobile and global investment opportunities are not fully substitutable. However, in the longer term something like UIP is more likely to hold as investment opportunities appear in different places. Today, it could be said that the US offers the attractive play. Tomorrow, it will be someplace else.

*Note: Covered Interest Parity (CIP), assuming there is no cross-currency basis, does hold by definition. Futures contracts and FX swaps that entities use to hedge currency risk are designed so that the gains from interest rate differentials are wiped out in exchange based on expectations of exchange rates at the end of the period of the contract. These expectations are governed by the basic interest parity relation described in the table. Market exchange rates can of course differ at the end of the contract meaning one party in the hedge could gain from the contract and the other could lose. If there is cross-currency basis, meaning that a premium is charged to borrow in another currency, CIP does not hold. 

By Economic Strategist, Hottinger Investment Management

Until last week, it seemed that the slowing European economy was apparent to everyone except the officials at the European Central Bank (ECB). Autumn passed and meeting after meeting of the ECB’s governing council yielded conclusions that had become almost platitudinous. Quantitative Easing (QE) was coming to an end; core inflation would continue to rise; unemployment would keep trending downwards and the slowdown in European growth was merely a reversion to a long-term, demographically determined trend rate.

With many countries having experienced weak or even negative economic growth in the third quarter and few indications that this will be short-lived, policymakers at the ECB have started to change their tune. The Bank has downgraded growth and short-term inflation forecasts in line with investor expectations (see chart below) and while QE will still end this month, the latest policy guidance from outgoing president Mario Draghi was more dovish. In his monthly press conference last week, following a meeting of the ECB’s Governing Council, Draghi highlighted a risk environment that is “moving to the downside”, with rising protectionism, emerging-market stresses and prolonged financial-market volatility bearing down on economic activity.

Analogous to the falling expectations for inflation, expectations for short-term interest rates in December 2019 have fallen throughout this year (see chart below) and now imply that the first rate rise from the ECB is now more likely to arrive in the first quarter of 2020 rather than in the second half of next year.

Draghi seemed to imply that the Bank is not dogmatically wedded to a 2019 rate hike; however, he did suggest that investors who have now put back their expectations for a rate rise into 2020 – after he will have left the Bank –  could pave the way for an earlier tightening than that. The idea is that investors – by pricing in later rate hikes – make financial conditions today easier. This, apparently, could not only offset the weakening economic environment but stimulate the economy sufficiently that official interest rate rises in 2019 do indeed become necessary. It’s a tenuous argument from a Bank that has a penchant for optimistic predictions and a President who is keen to secure his legacy.

While the controversial QE policy is ending for now, Draghi did mention that the option to restart it remains, and the Bank will extend the period over which it reinvests maturing debt from one year to three years; 200 billion euros of bonds mature next year. This betrays the broader likelihood that an extended ECB balance sheet and the policy of QE are here to stay, as is the sizeable stake that the Bank has in the public debt of Italy and France.

Enter the politics of the ECB and QE

One controversial aspect of the Eurosystem will change at the beginning of 2019 when the ECB will make changes to its capital key schedule. Capital key is a weighting schedule that assigns proportions of its bond buying programme across the various member states according to the size of their economy and population. The table below shows the schedule that has existed since January 2015 and the changes the Bank will make next month.

The table shows that the shares of ECB bond buying (or, more accurately, reinvestment of maturing bonds) allotted to countries such as Germany, France, Austria and the Netherlands have increased, while those allotted to countries such as Italy, Greece, Portugal and Spain have fallen. This is problematic for general macroeconomic reasons and specific political, market and technical reasons pertaining to this period.

In the first instance, the policy is ‘pro-cyclical’; it exacerbates the strength of economies that are doing well and the weakness of one that are doing poorly. It therefore proposes that the Bank buy more bonds from countries whose economies are growing faster (which until recently included all those countries in the first group), easing financial conditions and lowering bond yields for them. It correspondingly proposes that the Bank buy fewer bonds from countries whose economies are struggling, such as Italy and Greece, tightening financial conditions and raising interest rates and bond yields.

In other words, the policy compounds a founding problem of the euro area that it somehow has to implement a single monetary policy that is suitable for 19 different national economies. Using the capital key schedule intelligently could serve that objective, but it would mean doing precisely the opposite of what is planned next year. The ECB should be buying relatively more Italian and Greek bonds and relatively fewer German and Dutch bonds in what would amount to a counter-cyclical policy.

The new capital key assumptions could inflame existing political and market tensions within the Eurozone. Reallocating ECB investments away from Italy, especially at a time when political uncertainty has led to elevated Italian BTP yields, could push funding costs of the Italian state to an unsustainable level. Analysts think yields of 5% would make servicing Italian debts much more challenging as the state reissues maturing debt. It could also aggravate the Italian government’s sense of grievance over its treatment by Brussels and make agreement over the 2019 budget harder to achieve.

The technical issues with the new pro-cyclical capital key centre around the fact that it proposes buying more bonds from surplus-generating countries that by implication do not have net new marketable bonds to offer. This would mean the ECB owning a greater share of these countries’ public debt as redemptions are rolled over. Such a development rubs up against political economy concerns, not least from Germany, over the legitimacy not just of the ECB’s operations but also the ECB’s increasing ownership of German sovereign debt.

In summary, the ECB will need to act adroitly to exit smoothly from its QE programme. Deteriorating global economic conditions suggest moves to tighten monetary conditions by either shrinking balance sheets or raising interest rates are premature. Further, the political reluctance of some surplus countries to continue QE, particularly after the term of progressive ECB President Mario Draghi ends, will create difficulties for the Bank to restart a similar programme of monetary expansion should conditions worsen further.

At some point, both the European political establishment and the ECB will need to come to terms with the fact that the central bank’s involvement with the public debt is likely to become necessarily permanent, and that the actions of the ECB will therefore need to come under broader democratic scrutiny. As such, an agreement on how the Bank should run would have to have support from both surplus and deficit countries within the Eurozone.

In the meantime, the way the ECB handles its decision to maintain its balance sheet, especially through its policy on capital key, will in large part determine the success of the European economy in 2019. In addition, we should keep a close eye on the process by which the ECB chooses Draghi’s successor. A sharp reversal of the Bank’s philosophical outlook to the Germanic and pre-Draghi low-inflationary model may come at a bad time – economically and politically – for the region.

 

By Hottinger Investment Management

November saw global equity markets bounce back after the global correction seen in October, suggesting that in many regions the negative sentiment was felt to be overdone. Emerging markets benefitted after having registered year lows in October gaining 4.06% over the month despite a flattish US dollar but assisted by a 21% fall in the price of oil to $59 and policies to stimulate the flagging Chinese economy. From a developed market perspective the bounce largely benefitted the US S&P500 (+1.79%) and Japan’s Nikkei 225 (+1.96%) but largely missed Europe and the UK.

The Chinese have been trying to stimulate their economy by cutting reserve ratios for small and large banks after earlier efforts to tighten monetary conditions and de-lever banks’ balance sheets hit industrial companies and state-owned enterprises hard. Chinese factory growth has stalled, with the index for manufacturing purchasing managers falling to 50.0; the index for Chinese manufacturers’ import orders also shrank, from 47.6 to 47.1.

This matters for Europe because over the last few years the continent in general and manufacturing countries such as Germany, Switzerland and Italy in particular, have relied upon export growth which is largely driven by China not the US, and easy money from the ECB in order to make up for weak domestic demand. At the end of the year, that stimulus from the ECB will come to an end, with Governor Mario Draghi committing only to roll over maturing bonds. With Eurozone growth falling significantly since the summer and headline inflation heading down along with the oil price, any indication that the ECB will follow the Federal Reserve in 2019 in tightening policy could harm Europe at a time when external demand is weakening and compensatory fiscal policy action is made difficult by the EU’s intergovernmental rules. The second estimate of Q3 GDP growth was lower than expected due to a persisting slowdown in vehicle production and slowing industrial production in Germany. European PMI’s for November were also disappointing and on-going political uncertainty will no doubt dampen corporate activity.

Fed Chair Powell upset markets in October with his directness but the November meeting proved largely uneventful. There exists an 80% probability in markets for a US December rate hike but the expectation for further hikes next year has receded again after Powell’s speech at the Economic Club in New York spoke of rates being “just below” the neutral level. However, we are worried that markets may still be too sanguine; the Federal Reserve’s own models of inflationary pressures indicate that those pressures are still increasing and interestingly, the spread between US Libor 3M and Euribor 3M has approached 300 basis points. The last times US interest rates became this detached from European rates were before the Dot Com crash and the financial crisis. The effects of higher rates on the US consumer typically suppress US import demand, which by its nature has a knock-on effect on other countries.

We still believe UK markets are unloved and have been discounted since the Brexit referendum. UK economic expectations are still wholly conditional on the type of Brexit agreed by parliament. Although unemployment rose slightly to 4.1% in September wage growth is slowly picking up while headline inflation is steady at 2.4% yoy. We note that the single biggest driver of UK economic growth since the Great Recession has been population expansion driven by increases in net migration, the risks to the British economy as a result of a chaotic no deal Brexit are not just trade frictions but also negative net migration both as a result of political choice and due to the active choice of persons responding to the new economic climate. The FTSE All-share and FTSE 100 indices both fell 2.04% in November indicating that there was no real outperformance by different size companies which may be due to the fact that sterling only declined 0.36% or that the whole market is reacting to the political news flow.

We believe the more defensive approach continued during the month of November remains the right course of action as market volatility; price discovery and the uncertain economic outlook create a more uncomfortable environment for capital preservation. The relatively solid fundamentals being reported today are being undermined by fears of corporate earnings slowdown in the future and there is little doubt that the geopolitical environment that includes Brexit, China-US trade tensions, Italian budgetary issues and Middle Eastern tensions are leaving investor risk appetite subdued.

By Economic Strategist, Hottinger Investment Management  

Last week saw the release of the minutes from the Federal Reserve’s November FOMC meeting and public statements by Fed Chair Jay Powell on the future path of monetary policy. With most global financial markets except the United States experiencing a negative year to date, all eyes have been on the monetary policy of the US, the recent direction of which has been a significant cause of market instability in the last two months.

The spread between US Libor 3M and Euribor 3M, measures of three-month lending rates in the United States and Europe respectively, has approached 300 basis points (see chart). The last times US interest rates became this detached from European rates were before the Dot Com crash and the financial crisis; it’s a sign that the US economic cycle might be nearing a downturn.  The US economic cycle tends to lead those of other countries and regions – especially Europe – and this means that US rates tend to rise earlier than they do in other places and you get these US/EU Libor spread peaks, as the chart shows.

The importance of the Federal Reserve and the US dollar not just for the US economy but for the global economy too underlies the phenomenon of this ‘US-first’ economic cycle. Europe, in particular, relies heavily on dollar funding to conduct both financial activity and real trade. Other central banks tend to follow the Federal Reserve if they wish to preserve the value of their currency against the dollar and maintain adequate dollar funding for their international activities. In emerging market countries with current account deficits and external finance requirements, higher US rates and dollar strength tend to push up the cost of borrowing independently of local central bank policy.

Further, the effects of higher rates on the US consumer typically suppress US import demand, which by its nature has a knock-on effect on other countries. In recent decades, the US has occupied the position of ‘consumer of last resort’ due to its high current account deficits, with consequences for aggregate demand in other countries. This position has changed in this decade as the rise of China and the value of their imports have made other regions, especially export-oriented Europe, less dependent on the United States.

It is therefore more likely the first factor (global dependence on the Fed) rather than the second (global dependence on the American consumer) that has had the greater negative contribution on international financial markets in recent months.

Will there be a Powell put?

With global markets and economies sensitive to US rates, there has been much speculation in recent weeks about whether there would be a so-called “Powell Put”, following the tradition of Fed Governors Alan Greenspan, Ben Bernanke and Janet Yellen who have often delayed policy changes or adapted their forward guidance on policy in response to events in US and global equity and bond markets. A “put” from the US central bank is essentially a commitment to prevent financial markets going below levels that could harm the real economy. In their most extreme and well documented guise, the ‘Fed put’ has resulted in a sharp cut in interest rates (as it did under the Greenspan put) or in the policy of Quantitative Easing (as it did under Bernanke).

Greenspan puts (1999 and 2001); Bernanke Put (2007)

Figure 1 shows the three occasions during which the Federal Reserve reduced interest rates in response to fading economic strength and deteriorating market: after the LTCM crisis in 1999, during the bear market in 2000 and 2001, and after the start of the financial crisis in 2007. The Federal Reserve also injected funds after the 1987 stock market crash and the Asian financial crisis in 1997. SPX Index is the S&P 500 and FDTR is the Federal Funds Target Rate, or the basic interest rate in the United States.

Figure 1: Federal Reserve puts. Source: Bloomberg

Bernanke QE Put (2008)

In the first iteration of the Bernanke Put, interest rates reached their ‘zero-lower bound’ which limited further monetary stimulus without introducing the controversial measure of negative nominal interest rates. In response, Bernanke initiated QE1, the first round of quantitative easing that consisted of buying US Treasuries and mortgage-backed securities. This started the long-bull run in equity markets that may only now be coming to an end. The next chart, Figure 2, shows how the S&P 500 index closely matched the volume of assets that the Federal Reserve owned in the years during which the policy of QE was in effect (2008-2013).

Figure 2: Bernanke’s QE put. Source: Bloomberg 

Yellen Put (2013, 2015)

The market turbulence, known as the ‘taper tantrum’, in response to suggestions from the Federal Reserve in 2013 that it would withdraw QE led to the bank delaying that policy for 16 months. In 2015, concerns over growth in China and a bear market in emerging market equities caused the Federal Reserve to delay its first rate rise to December 2015 and to abandon three of the four rate hikes it planned in 2016.

Figure 3: Yellen’s put. Source: Bloomberg

In recent statements from the Federal Reserve and Jay Powell indeed, there was no specific indication of a Powell put; on this matter the minutes of the November FOMC meeting stated: “the turbulence in equity markets did not leave much imprint on near-term U.S. monetary policy expectations”.

However, markets have however interpreted last week’s policy guidance from the Federal Reserve as indicating that the bank is now not necessarily wedded to the three interest rate rises in 2019 that the September FOMC’s dot plot suggested; “monetary policy is not on a preset course,” the minutes state. This form of words gives the Federal Reserve the space in which to conduct what effectively amounts to a ‘put’ even if they don’t say it is one. With inflation breakevens indicating that markets think economic activity could be softening and with the slowdown in activity in China and Europe on their minds, this more dovish tone from the bank has settled some nerves.

However, markets may still be too sanguine; the Federal Reserve’s own models of inflationary pressures indicate that those pressures are still increasing (see Figure 4). Unemployment is below the level  and wages are now growing at 3.5% per annum. The bank is mandated to respond to these first before taking into account the wider situation in the global economy.

Figure 4: The Federal Reserve’s economic models predict higher rates. Source: Federal Reserve Bank of New York; Bloomberg.

Is the US economic cycle less important this time?

As indicated above, the relationship between US and European interest rates and the reliance of global economic cycle on the US cycle may be less important today because of the rise of China. Both Germany (-0.2% Q3) and Italy (-0.1% Q3, revised) announced weak third quarter economic growth figures last week. There are individual explanations for the poor performance of each of Italy and China. Emissions regulations have held up German car production and exports, while political uncertainty in addition to low inflation and, concomitantly, high real interest rates in Italy could explain that country’s problem. However, with Q3 growth figures in Switzerland (-0.2%) and Sweden (-0.2%) also surprising on the downside, something else seems to be afoot. The common denominator could be China.

The Chinese have been trying to stimulate their economy by cutting reserve ratios for small and large banks after earlier efforts to tighten monetary conditions and de-lever banks’ balance sheets hit industrial companies and state-owned enterprises Nevertheless,  Chinese factory growth continues to stall, with the index for manufacturing purchasing managers falling to 50.0 last week. The index for Chinese manufacturers’ import orders also shrank, from 47.6 to 47.1 (numbers below 50 indicate falling orders).

This matters for Europe because over the last few years the continent in general and manufacturing countries such as Germany, Switzerland and Italy in particular have solved their deficient demand problem with a combination of export growth – driven by growth in exports to China, and not to the US – and easy money from the ECB.

At the end of this year, that stimulus from the ECB will come to an end, with Governor Mario Draghi committing last week just to rolling over maturing bonds and not renewing stimulus on the grounds that the recent slowdown is due only to temporary factors and that Eurozone was merely returning to trend growth.  Sabine Lautenschlaeger, a German member of the ECB’s executive board, said she sees nothing on the horizon that could alter the decision to phase out QE and was confident that the ECB would start raising short-term interest rates, currently set at minus 0.4%, next year.

However, if Eurozone growth continues to remain soft and headline inflation comes down further along with oil prices, any indication that the ECB will follow the Federal Reserve in 2019 in tightening policy could harm Europe at a time when external demand faces negative risks from rising interest rates in the US and contraction in China, and when compensatory fiscal policy action is heavily proscribed by the EU’s intergovernmental rules.

The global economy is at a delicate moment with uncertainty, slowdown or stagnation respectively in its three largest engines – the US, China and Europe. How things develop for economies over the next few months and into 2019 will depend largely on whether central banks overshoot on rate rises, and how things for markets will go will depend on whether monetary policy pivots towards a schedule that investors think the economy can handle.

By Economic Strategist, Hottinger Investment Management  

When it comes to the importance of oil to the global economy, few have expressed it better than the Scottish novelist  James Buchan. In an article for The New Statesman in 2006, he wrote:

“A century ago, petroleum – what we call oil – was just an obscure commodity; today it is almost as vital to human existence as water. Oil transports us, powers our machines, warms us and lights us. It clothes us, wraps our food and encases our computers. It gives us medicines, cosmetics, CDs and car tyres. Even those things that are not made from oil are often made with oil, with the energy it gives. Life without oil, in fact, would be so different that it is frightening to contemplate.”

In the twelve years since, some of the technologies have changed but the triumph of oil has only advanced.  Since 2006, according to the International Energy Agency, global oil production from all sources – including shale, oil sands and natural gas liquids – has risen by over 12% from 82.5 million barrels a day to just under 93 million barrels a day. About half of that increase has come from China with other emerging economies driving the rest.

It’s no surprise, therefore, that analysts and economists still look to the oil price as a guide to the fortunes of the global system. Helen Thompson of the University of Cambridge is a specialist on the political economy of oil, and has built her thesis around an astonishing fact: All but one of the recessions in the United States have been preceded by a sharp rise in the price of oil, not just those that were specifically caused by OPEC in the 1970s and 1980s (see chart, recessionary periods in red), though that is not to say that all oil price spikes cause recessions.

In the eighteen months before the Great Recession, Brent Crude trebled in price, from around $50 per barrel at the start of 2017 to $150 per barrel in July 2008. It is not unreasonable to think that price pressures from oil caused the Federal Reserve then to tighten too quickly, seizing up credit markets at a time when banks were running amok.

This provides pause for thought for those wondering whether the global slowdown could become more severe. The current down trend in the price of oil could reflect weakened demand from emerging market economies that have been hammered by the combination of the rise in the price of crude from about $30 per barrel at the start of 2016 to $85 this May and the strengthening of the dollar.  A more sanguine view, however, would suggest that the introduction of new sources of supply has kept oil prices manageably low levels and reduced the risk of global recession in the immediate future.

While we now talk of demand for oil peaking sometime in the middle of this century due to the rise of alternative forms of energy and awareness of climate change, in the mid-2000s the fear was of peak oil supply. This was because discoveries of conventionally produced oil – that is, oil produced by drilling and pumping – had been falling (and continues to fall), and the many of the places where substantial reserves exist – such as Iran, Iraq and Venezuela – were not exactly conducive to the requirements of the global economy. That was the fundamental reason why oil prices spiked so much in the years up to the Great Recession. New sources of supply were yet to come on stream and global demand was soaring.

Oil prices have not returned to the heady heights of 2008, and indeed have broadly fallen since 2014, because the introduction of shale, tar sands and natural gas liquids onto the market has more than met the increase in demand from the emerging countries. In 1990, just over 90% of global oil was sourced from conventional processes; in 2013, that figure was just 80% and it has likely fallen further since (see chart). This increase in supply has been driven largely by the US, enabling that country to not just become energy independent but to exceed the volumes it achieved in the 1960s and 1970s when its conventional oil industry was at its peak and producing up to 10 million barrels a day.

When oil prices become too high, they put pressures on consumer spending and induce central banks to raise interest rates to keep inflation under control. This happened in 2008 and 2011, catching out the European Central Bank which responded to rising inflation by raising rates in an environment of weak demand, arguably deepening and lengthening what we call the ‘euro crisis’ of 2009-2015.

But the development of shale has, however, created a very different problem. Due to the rise of production from these high-cost alternative sources, oil prices can create problems for the economies that are dependent on these sources when prices become too low.  When prices become too low, analysts start worrying about the fortunes of highly leveraged shale producers which borrowed when QE made credit cheap, which have invested in expensive capital-intensive infrastructure at a time when oil prices were high, and which rely on high prices staying high to break even.  It is commonly thought that $40 a barrel is now the price below which shale producers start making losses, and there are concerns that the surpluses that are building up in the oil market could push the oil price down further towards those levels.

According to Thompson, the issuance of high yield bonds by US companies in the energy sector trebled between 2005 and 2015, and the value of syndicated loans to the oil and gas sector increased by 160% between 2006 and 2014. While oil prices don’t present the same direct risk to the global economy as they did in 2008 because they are relatively low, they do – precisely because they are low – to the US economy, whose central bank continues to raise interest rates at a pace that the market thinks is too fast for highly levered firms such as shale producers to handle.

Together with concerns around corporate credit more broadly in the US and the significant exposure to it of European banks, we should keep a close eye on the oil price if it continues to trend down.

By Economic Strategist, Hottinger Investment Management  

According to the Office for National Statistics, the UK grew its economy by 0.6% in the period between July and September, the fastest pace of quarterly growth for two years and a rate that would correspond to 2.5% if applied across the calendar year. This announcement came a day after the European Commission produced its forecasts for 2019 economic growth, with the UK at the bottom of its European league table tied with Italy. An annual expansion of just 1.2% is expected in both countries. Meanwhile, Ireland sits near the top of the Commission’s league table, with 4.5% growth anticipated. Political posturing aside, what is going on?

During Q1 and Q2 this year, the British economy grew by 0.2% and 0.4% respectively. If we include the Q3 figures, that means the economy has expanded by 1.2% in the first three quarters of 2018. This compares with just 1% in the Eurozone, 0.8% in France and 1.1% in Germany (based on a +0.2% Q3 estimate). Third quarter growth itself in the UK exceeded that of France and Italy – and most likely Germany too. Part of that is because of the recovery of activity lost during the first three months of the year due to the exceptionally cold weather, with construction (+2.1% QoQ) and manufacturing (+0.6% QoQ) up during the summer months, the latter on the back of strong performance in the export of cars and machinery.

The UK has been gaining momentum over the year while the rest of Europe has been losing it after its stellar performance in 2017, yet pessimism over the future for the UK is proving so hard to shift. Brexit is part of the explanation, but only part. As long as there remains uncertainty over the UK’s trading status with the countries which constitute over 40% of its exports, businesses will hold off from making long-term investments, and we see this in the data. The chart shows that the UK is an outlier among G7 nations in investment spending both over the last quarter and over the last twelve months. British businesses haven’t felt confident enough to take part in the global growth story of 2017.

Trade complexity matters, and the complacency with which some Brexit-supporting politicians treat the issue presents a risk that is now materialising to the British economy. Global supply chains get more complex each year. We realise this from time to time, whether it was how the Fukushima nuclear disaster of 2011 in Japan created delays in the supply of components for car companies and smartphone manufacturers across the region, or – closer to home and nearer in time – the situation earlier this year in which KFC, the fast-food chicken franchise, ran out of chicken. The pressure for ultra-lean inventory and fast delivery creates conditions for dramatic stories like these. But it also potentially makes Brexit Britain a less attractive place for international businesses that want to sell into Europe competing with firms that benefit from lean supply chains elsewhere. That’s what matters, not tariffs (which can be mitigated to some extent by a currency devaluation and countervailing tax measures), but regulatory frictions that cause material delays, and the EU knows it. It’s not clear, however, that the people with whom they are negotiating with do.

Business will continue to fight for a Brexit deal that keeps in place that all-important just-in-time (JIT) supply chain infrastructure. But without greater strategic awareness from the government, Brexit will look like an expensive and reckless experiment in de-globalisation.

But there is a wider problem with the British economy that means one cannot lay blame wholly at the door of Brexit. The UK has consistently lagged other G7 countries when it comes to productivity, defined as output per hour of labour, and growth in productivity (see table). An hour worked in the UK in 2017 yields 80% of an hour worked in Germany and France. We like to mock the French for their employment attitudes and general sense of joie de vivre but the fact is that if they worked as many hours each day as the British, they could afford to take Friday off and be just as well-off per capita.

The culprit is decades of underinvestment as the second chart shows; since 1979, with the exception of a brief period in the late 1980s, the UK has consistently had one of the lowest rates of investment as a share of its GDP in the G7. Business investment has remained low for decades as banks have diverted funds towards mortgage lending over productive enterprise.

The table shows that compared to its G7 peers the UK hasn’t done badly in terms of real GDP growth since the end of 2007, before the Great Recession; only the US, Canada and Germany have grown by more. The countries however are ranked according to growth in labour productivity in the first column, where the UK only marginally beats Italy in the fight to avoid the wooden spoon. If we accept that GDP is basically the sum of productivity and labour input, what this means is that the UK has relied disproportionately on labour input to deliver growth. The UK is the only country that has seen an increase in labour hours per employee since the Great Recession, and it shares a high rate of employment growth with Germany and Canada, two countries that have seen significant immigration in the last decade.

The UK has relied on three unsustainable sources for its recovery. The first is a rise in the employment rate above its pre-crisis trend, as a result of government policies that encourage work. The second is a rise in hours worked per employee, most likely in response to negative real earnings growth during much of the period of interest. The third, and most important, is immigration. The UK population has increased by almost 8% (or 4.7 millions) between 2008 and 2017; official net migration in that period was just under 2.5 million (or 53% of the total rise in population). Immigrants are significantly more likely to be of working age; EU migrants (but not non-EU migrants) are more likely to be employed than natives. But even assuming they are equally as likely in both categories means that a very substantial chunk of the 2.48m rise in employed persons between 2007 and 2017 consists of immigrants.

And this brings us back not so much to Brexit but instead to the causes of Brexit. If Brexit is about reducing immigration then the UK is going to need a new economic model and it has to revolve around raising the investment rate in order to replace the economic growth provided by recent immigrants. At some point the economic debate will have to turn to this and there are two clear models: the Conservatives favour a low tax and business-friendly approach, while the Labour Party wants to use the resources of the Bank of England and the Treasury to get things going. Without an investment strategy for after Brexit, the growth outlook for the UK is justifiably poor.

By Economic Strategist, Hottinger Investment Management  

Last week, the U.S. Labour department issued its most important figures. Job creation surprised on the upside, with 250,000 new positions filled compared to the expectation of 195,000. Additionally average earnings broke through the three-percent barrier for the first time in nine years to 3.1% in a sign that inflationary pressures are increasing. Labour force participation rose slightly from 62.7% to 62.9% as the unemployment rate held steady at 3.7%.

With the latest chapter in American democracy reaching its denouement tomorrow, it is worth considering a little trend that has wider import. Over the course of this year, the unemployment rate for Americans with less than a high school diploma actually rose. It increased from 5.2% last December to 6.0% last month. The monthly figures between those two dates are volatile but there is a clear upward movement. Meanwhile the unemployment rate for graduates has stayed flat at around 2%. It is worth noting that an unemployment rate of 2% is meaningless as it reflects mostly the proportion of people that are moving between jobs at any one time.

The high unemployment rate among those who are classed as ‘unskilled’ exists despite a record number of open vacancies (over 7 million) and firms saying it takes them over a month to fill the average role, such is the dearth of available labour.

Three features stand out from the chart below, which I have called “A Tale of Two Americas”. The first is that at no point in the last ten years has the graduate unemployment rate been higher than the lowest level that unemployment has been for those without high school diplomas. The second is that the rise in high school unemployment during the Great Recession was almost four times higher than the rise in graduate unemployment. The third point is that the chart exposes the structural inability of the US economy to produce jobs quickly for low-skilled people who want them, as there has not been a tendency for the two series to converge. This last point is underscored by the fact that the US labour force participation rate has not recovered from its high of 66% in the months before the financial crisis, meaning effectively that about 3% of the working age population have remained out of the labour force. (You could say, with some justification, that the real unemployment rate for the unskilled is as high as 9%.) It is often during recessions that firms take measures to automate and streamline their processes. And of course, lastly, these trends take no account of the rate of underemployment and precarious employment that exists to a greater extent within the lower echelons.

 

The point is that in the US if you’re a graduate you have almost no reason for economic anxiety and recessions are a mild inconvenience, although you might have the millstone of student debt around your neck. If you’re not, then you don’t. It’s a tale of two Americas because it is the people in the first camp who are likely to vote Democrat in the upcoming mid-terms and the people in the second camp who will back Donald Trump’s Republican Party; US counties that are more exposed to trade with China and Mexico, and which have more jobs at risk from automation, were significantly more likely to back Trump in 2016. There are enough people in Donald Trump’s camp to keep him from losing both chambers of Congress.

When you don’t have to worry about material matters, you can afford to build your political values around post-materialist issues such as gender, sexual and racial equality – important though they are. The Democratic Party has become a party of social-justice for post-materialist voters while developing a blind-spot towards the issues facing blue-collar workers, once a core part of their support, in the flyover states and in the Mid-West. For these, the material still matters, or as Bill Clinton eloquently put it: “It’s [still] the economy, stupid!”

It’s not that simple, however, as Republicans are still on average wealthier than Democrats, which attract a huge number of votes from poorer minorities as well as graduates. But the voters who pushed Trump over the winning line in 2016 belong to a specific, sizeable and important demographic, the white working class that once was solidly Democratic but now forms that heart of Trump’s base.

Core Trump voters, particularly male ones, can sense that the jobs that in their view gave them dignity – typically in agriculture, mining and manufacturing – are giving way to those that, again in their view, don’t. The US economy will need more care workers, nurses and office workers (jobs perceived to be feminine) in the future and fewer truck drivers, farmers and machinists (jobs perceived to be masculine), and many of Trump’s voters still think he is the one to bring them back. He’s failing.

Leaving aside whether Trump has actually done anything to advance this group’s interests in the last two years (he hasn’t), it remains the case that the US President’s targeted assault on various institutions, politicians and minorities is a sort of displacement technique that soothes the anxieties of his voters and permits blame for their plight to be shifted, not entirely unjustly, to the metropolitan and coastal view of things that has dominated since the 1980s. Sending thousands of troops to a 2000-mile US border to defend against refugees who have yet to complete the small task of walking through Mexico is the latest move to this effect.

While it is very likely that the Democrats will win the House of Representatives next week, the Republicans will probably keep control of the Senate, only a third of whose seats are being contested and most of those already held by Democrats, compared to every seat in the House of Representatives. Donald Trump’s popularity (at around the low 40s) has remained high enough for his party not to lose both chambers. But if recent presidential history is anything to go by, the return of a split Congress will make it harder for the President to push through his agenda, and that includes the tax cuts and deregulatory acts that have been helping US firms boost their earnings and increase their degree of freedom over the last 12 months.