Category: Uncategorized

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.

 

By Economic Strategist, Hottinger Investment Management  

A few years ago, the management consulting firm McKinsey produced a striking graphic. It showed how the economic centre of gravity has shifted over the millennia. In AD 1, the place to be was Asia. China and India produced about 70% of world GDP, with the rest shared by the Ancient world (Greece, Egypt, Turkey and Iran), Europe and Africa. That centre of gravity only really started to move in the 1500s, after the Black Death had transformed Europe’s social and economic institutions. By WW2 it was at its most westerly point, between Western Europe and the United States, as those two places accounted for 70% of world GDP. By 2025, McKinsey expects the world to be back to where it was in AD 1.

China and India will soon again account for the lion’s share of the world economy as the trend for countries with large, well-educated populations with strong governance systems to dominate takes hold. The French essayist Paul Valery was probably the first to notice this trend, writing in the aftermath of the first world war:

“So, the classification of the habitable regions of the world is becoming one in which gross material size, mere statistics and figures (e.g., population, area, raw materials) finally and alone determine the rating of the various sections of the globe.”

In the coming decades, it will make sense from an investment point of view to have an Asia-first focus, with the deliberations of the Central Bank of India and the People’s Bank of China carrying the weight that the decisions of the Federal Reserve and the European Central Bank have today. The International Monetary Fund predicts that in the next few years at least the continent of Asia will grow at 5.5% per year and account for two-thirds of all the world’s growth. By contrast, the U.S and Europe will struggle to grow faster than 2.5% per year.

It is in this context that we should see the rise in volatility in emerging markets in the last few months (see chart below). Over the last five years, there has been remarkable convergence between market volatility in the G7 and that in the emerging markets. Usually, emerging markets are attractive for investors who have long time horizons and a preference for growth over income in their portfolios, but in 2016 and 2017, according to the JP Morgan indices for volatility, emerging markets had as much average risk as that in G7 countries.

This year, emerging market volatility has risen sharply. Some of it is on the back of concerns over the fiscal sustainability of particular countries such as Turkey and Argentina; both of these countries have low levels of foreign reserves to support public debt in the event that tax revenues come up short. Similar to the situation in the United States, there is concern about over-leverage in corporate debt in some developing countries.

But much of the explanation lies with what developed-market central banks are doing with their monetary policies. The Federal Reserve has raised rates significantly in the last year, and have the intention to continue increasing rates until 2020. It is also selling Treasury bonds that it holds on its balance sheet at the time when the Trump Administration is planning to run $1trn annual budget deficits, funded by sales of new bonds to the public. With US interest rates still seen as a benchmark for the global economy, all these developments mean that global yields are rising on government and corporate bonds; additionally, the supply of dollars is more limited, strengthening the dollar exchange rate and making it harder for emerging markets to service their dollar debts.

This latter explanation reflects emerging markets’ vulnerability to external factors more than fundamental unsoundness with the direction of economic policy and development. It is why in the medium-run we should still expect relatively higher volatility to be the price to pay for exposure to developing countries, and why–although we should be concerned with the big uptick in EM volatility–we should place it in its proper perspective. As emerging economies grow, they will develop policy independence and less sensitivity to global events.

It has been an eventful few weeks in Europe. Markets have been actively following the unfolding situation in Italy, as the new 5 Star-Lega coalition of populist parties took office. Things have quietened down as the members of the new government have reassured investors that it has no intention of leaving the euro, or breaking EU-mandated public spending limits that might have led to the same event.

But this is not the end of the story because there are a range of possible events stemming from Italy that could unnerve markets in the coming months and test the political foundations of the eurozone.

The bold macroeconomic policies of the new Italian government are the central issue, and will create headaches in Europe. The recently agreed 5 Star-Lega populist administration has plans to sharply increase benefits to the unemployed, radically cut taxes, reduce the retirement age, and increase infrastructure spending. Independent estimates put the increase in spending at over €100bn per year, or 6% of GDP.

Italy is not a profligate country. It has run a primary budget surplus since 1992 and only has overall budget deficits due to the interest charges on its extremely large public debts – currently around 130% of GDP. Much of that debt accrued in the 1970s and 1980s as Italy raised funds to develop its welfare state and to invest in the country’s poorer and more agricultural south through the Cassa per il Mezzogiorno programme. Interest rates also rose sharply in the 1980s as the Bank of Italy clamped down on high inflation, raising the debt burden further.

There are two short-to-medium term problems with the new government’s fiscal plans, the first exists irrespective of whether one believes bigger deficits would lead to the growth and additional tax revenues that would make the new debt sustainable. But both problems potentially lead to conflict between Italy and Europe’s creditor nations such as Germany and the Netherlands.

The first issue is both legal and political. Under the EU’s Fiscal Compact, countries cannot run a budget deficit greater than 3% of GDP, and if they insist on doing so they forfeit the right to assistance from the European Stability Mechanism in times of crisis. Being told by Europe that Italy cannot implement its economic policies is unlikely to reduce populist feeling in the country. Lega’s Matteo Salvini recently said that Italy will not be “slaves of Brussels or Berlin”, while 5-Star’s leader Luigi Di Maio suggested that he will go to “European tables” to fund his spending plans. That means either ignoring or revoking the Fiscal Compact.

The second issue is practical. Running large deficits means issuing quantities of bonds into the market at a time when the central bank is not an active player on the demand side and when interest rates are rising. Italy then would become exposed to significant political risk that could sharply push up yields further and thus the cost of borrowing. That in turn makes servicing Italy’s enormous debt pile even harder and could create centrifugal forces that make the state’s position in the euro area unsustainable. It is the feared ‘debt-crisis’ scenario.

This second issue assumes that markets believe that more state spending would not boost growth, and thus cut the debt-to-GDP ratio in the long-term; that is open for debate. But it also assumes that there are no meaningful political reforms in the euro area. Meaningful reforms include either significant moves to share risk across the region, such as introducing a Eurobond or a “safe European asset” that is backed by all euro area states; or agreeing to a banking union that consists of universal deposit insurance and a fiscal backstop for failed banks. In short, it assumes that Germany and other creditor states in Northern Europe do not agree to any form of risk sharing that ranges from debt guarantees to fully-fledged fiscal transfers.

Northern Europe and particularly Germany remain resistant. Last month, over 150 ordo-liberal German economists warned in a public letter against what they called a “debt union,” which would mean German taxpayers implicitly supporting other states. Chancellor Angela Merkel wants only limited reforms, including a European Monetary Fund that restructures debt and gives loaned assistance only if there are Eurozone-wide systemic risks and recipient countries implement structural reforms. This means exposing investors in troubled states’ bonds to haircuts and lengthened maturities during times of stress.

Unfortunately the German proposals, supported by the Netherlands and Austria, as they stand serve only to crystallise all of the problems that arose from the euro crisis of 2011-15. Merkel’s debt restructuring plan would weaken private sector confidence in peripheral sovereign bonds and reopen the possibility of self-fulfilling fiscal crises. It enacts punishing and self-defeating austerity regimes on troubled debtors, and strengthens the position of German Bunds as a safe asset. Italy will want a bolder approach, and they are likely to push for that ahead of the next EU summit on June 19th. France too will expect bigger concessions after implementing domestic reforms in labour markets and public spending as a quid-pro-quo for more economic integration.

The risk of a future Italian debt crisis also assumes that the ECB will not continue to backstop Italy’s sovereign bonds. This happens by default if the bank eventually moves into a phase of shrinking its balance sheet, but if the next governor of the bank, who takes office in October 2019, takes a more hawkish point of view, as is the preference of the German government, support for Southern European sovereign bonds in a future crisis scenario may not be there. Considering that it was Mario Draghi’s commitment in 2012 to do “whatever it takes” to contain the last crisis, a reversal of that commitment would create clear dangers.

We therefore face the possibility that the political ambitions of Italy’s new government could be thwarted by other countries and the European institutions. The question then becomes whether the populist government could credibly threaten to leave the euro and throw Europe into turmoil to extract concessions from the other countries. The answer is probably ‘no’ as euro-exit would decimate the Italian middle class. However, the systemic importance of Italy in the euro area and the recent shock of Brexit should focus policymakers.

Events in Europe in the last month show that there are still significant tensions between member states that cannot be solved by a short-term burst in economic growth across the region. Yet as that growth starts to slow and the ECB tightens policy, conditions will not be more favourable than they are today to agree the necessary reforms.

What is needed is a greater sense of pan-European solidarity in which your typical German Bavarian thinks of the concerns of the Italian Neapolitan with the same empathy with which she considers the problems of her immediate compatriots. That’s a multi-generational project.  In the absence of that, Europe will continue to evolve through crisis, yet always carrying with it the tail risk of breakup. Political risk in the region has clearly not gone away.

The consensus view in markets is that the United States is in the late stage of its economy cycle, that it is very close to full employment and that inflation will accelerate this year. On the back of this, many expect that the Federal Reserve – anticipating an overheating economy – will raise interest rates multiple times this year and scale back their asset purchases.

But what if this view is wrong? While we do see signs that indicate inflationary pressures in the US–from lagged PMI trends and capacity utilisation figures – we have repeatedly pointed out that unemployment is a misleading indicator of tightness in the US labour market. This is because the measure is blind to the large volumes of people who left the labour force after the Great Recession of 2007-9 and who are now returning. Official unemployment is a measure for only those people who are in the labour force at any given point in time but do not have a job.

This is the position that Martin Sandbu at the Financial Times (£) takes yesterday, and it can best be illustrated in the chart below.

Sandbu’s basic idea is that it is possible for the US economy to continue hiring people but for wages to remain muted as more people return to the labour market. We can see in the chart above that labour force participation – the proportion in the population of 25-54 year olds which takes part in the jobs market – is still well below its 1990s-peak, while the employment rate – the proportion of the population that has a job – is below its cyclical peaks in 2001 and 2007. The message, Sandbu concludes, is that there is still spare capacity in the US economy even though unemployment is low; and wage (and price) inflation is subdued because both employment and labour force participation are rising.

How likely is this? There is reason for doubt. Unemployment among 25-54 year-olds as a proportion of the population, implied by the gap between labour force participation and the employment rate in the chart, is also near the cyclical lows of 2001 and 2007. This is not the official measure of unemployment, which measures the proportion of the labour force that is unemployed, as opposed to the proportion of the population. However, official unemployment is also at similar cyclical lows. In both 2001 and 2007 for both measures, unemployment turned upwards within twelve months of peaking. This behaviour can be seen in the chart below at the peak of almost every economic cycle in the US since 1948. The only exceptions are in the late 1950s and late 1960s, when unemployment held steady as the economy added new jobs.

The question then is: which is the better cyclical predictor for labour market tightness – employment or unemployment? While Sandbu’s argument for the employment rate is plausible, it implicitly assumes that the damage wrought by the Great Recession can be largely if not fully unwound. On that point, we are sceptical.

There is evidence that during recessions, firms are more likely not just to fire workers but replace them with technology. Technological change has made large numbers of middle-aged Blue Collar men redundant. 90% of jobs in clothing manufacturing and 40% of jobs in electronics in the US have disappeared since 1990. Indeed, the labour force participation rate itself has been trending down since 2000. These jobs are not coming back and for many of the workers who are affected it is not possible technically or mentally to reskill. The scale of the opioid crisis points to the despair that many of these people feel with regards to their situation.

We don’t know what the scale of the damage has been, but there is good reason to believe that the labour force will not reach the size it did in the late 1990s. This doesn’t mean that labour force participation cannot continue rising in the short-term, delaying inflationary pressures; or that we should not pay attention to other measures of labour market tightness such as employment. But Sandbu’s implicit suggestion that, because employment remains low compared to the last 20 years, the US is necessarily still far from full employment is too easy. It is possible that the US economy has exhausted the gains from increased labour force participation, meaning that employment cannot continue to rise without pushing down unemployment, which is at cyclical lows. And this would most likely be inflationary.

We still therefore expect wage and price inflation to pick up this year as the US labour market tightens, but we would not be surprised if the process takes a bit longer than it does under the consensus view, with signs manifesting only during H2 2018. The Trump Administration’s fiscal stimulus program will, however, act only to hasten inflation’s arrival.

Much has been made of how the recent wage data coming from the US was the cause of the correction we saw in asset markets last week. It suggested that the Phillips curve may finally be asserting itself at a time when producer and commodity prices have been rising and the temporary factors cited by the Federal Reserve as holding inflation back are easing.

However, a bigger risk is that inflationary pressures are building in the euro area. The ECB has engineered a huge export of capital from Europe to the United States with its programme of asset purchases since 2016. The ECB’s bond buying programme pushed European yields down and encouraged investors to ‘search for yield’ in relatively more mature US markets that offered higher returns.

Markets got jittery in January after the release of the minutes of the ECB’s Governing Council most recent meeting, indicating that inflation may come through sooner than expected and that the central bank was willing to change its language with regard to its future policies. Investors up until then more or less believed Mario Draghi’s commitment to easy policy for as long as necessary to support the euro area’s recovery and the convergence of inflation towards the bank’s 2.0% target. Very little activity on rates is priced in.

However, there are good reasons to believe that inflation will pick up this year in Europe. Since 2014, capacity utilisation, a measure of the degree to which firms are using their resources, has been creeping up. Part of this reflected the low level of capital expenditure in the bloc and weak bank lending. The acceleration in EZ growth in 2017 caught a lot of manufacturers by surprise, with many increasing capex spending. Imports into the euro area in the year to November 2017 grew by over 7%, with the largest increases in import volumes in machinery from capital goods exporters such as China and South Korea, as well as in energy from Russia.

Nevertheless, capacity remains constrained and inflation is currently much lower than it should be as suggested by the level of utilisation (see chart below). It certainly has the potential to break through the 2% target-level within the next 12 months.

The other indicator that points to a pick-up in inflation is the level of unemployment. It is easy to be deceived by the European jobs market. In most Anglo-Saxon countries, unemployment typically has to fall below 5% before signs of price pressures emerge.

Anglo-Saxon economies tend to have more flexible labour markets that support people who have generalist skills. This means firms tend to report shortages when most people who want a job already have one.

In continental Europe, employment is typically more exclusive. To break into many parts of the French, Italian and German labour market, workers typically need to have specialist skills that cannot be easily transferred to other occupations and require years of training to acquire. Further, the costs of employing workers are typically higher due to taxes and regulation, which encourage firms to substitute workers for machines. Higher rates of unionisation can protect insiders at the expense of outsiders. And more recently, the scale and length of the euro crisis have increased the long-term unemployment of young people. All these factors mean that firms across the EZ are reporting skill shortages despite headline figures of unemployment of around 8.5%.

As the chart below shows, there is a relatively tight relationship between trends in HICP CPI inflation, which the ECB targets through its policies, and the level of unemployment six months prior. It shows that inflation starts to accelerate when unemployment falls below 8.5%, roughly where it is today. It also suggests that based on the steady reductions in unemployment since 2013, inflation is likely to pick up later this year. It is not out of the question that it could break through the ECB’s inflation target.

Together then, both capacity utilisation and unemployment figures point to upward price pressures that are unlikely to be offset by the downward pressures of a stronger euro on import prices. Add to that the strong EZ-wide PMI data and we think there is a strong case for a change in the ECB’s stance in the second half of this year.

Last week’s correction was healthy for equity markets which looked overstretched. But it did little to change the extraordinary fact that more than 15% of bonds on global markets trade with negative interest rates, according to Deutsche Bank. As central banks move from quantitative easing to quantitative tightening in the second half of 2018, that situation will have to change, which would at the very least create a more unstable and volatile market environment as both bonds and equities adjust to their fair values.

Donald Trump put ‘America First’ front and centre of his pitch to business elites at the World Economic Forum in Davos last week. WEF is a club for business leaders, financiers and politicians who mostly share a suspicion of nationalism and a belief that globalisation is good. But Mr. Trump, surely knowing this, went to sell his country.

“America is open for business and we are competitive once again.” He praised his administration’s efforts in cutting taxes, slashing regulations and renegotiating trade agreements. The results, he boasted, were billions of dollars of announced investments in the United States.

However, competitiveness in international markets can also arise from a cheap currency. The US President didn’t mention this anywhere in his speech, but one had the impression that if his other policy proposals fall flat, the option of pushing down the dollar would be the last resort in his fight against so-called unfair trade.

At face value it seems that movements in the US trade balance have had little to do with the real effective exchange rate (REER) in recent times, as the chart below shows. To improve the fit of the two series, we would need to lag the real exchange rate by three years, but it’s implausible that it takes that long for businesses to react to changes in the real exchange rate.

There will never be a perfect relationship between REER and the trade balance, especially the US trade balance, for a number of reasons: because not all trade is price-sensitive; because the dollar is a safe-haven currency and the world’s reserve currency of choice; because many commodity contracts are priced and settled in dollars; and because speculation allows investors to take bets on the future path of national economies.

However, it remains the case that REER is the variable that ‘co-moves’ most closely with the trade balance. Sometimes the REER responds to the trade balance, driven by international capital flows and demand shocks; and other times it’s the trade balance that responds to changes in the REER. That said, the discrepancies of the 2000s – during which the dollar consistently fell but trade deficits grew – look rather large and need some explanation.

The 1990s saw the US boom relative to the rest of the world, with growth averaging close to 4% under Bill Clinton. It was these fundamentals that led to the dollar appreciating strongly during the decade as foreign capital flowed in, a process that accelerated immediately after the Asian Financial Crisis in 1999. The Clinton Administration also favoured a strong dollar because it kept inflation and interest rates low and put pressure on domestic producers to improve their competitiveness through investment. But it also caused the trade deficit to rise sharply.

While the dollar fell against most DM currencies after the US fell into recession in 2002, it continued to rise against currencies of key emerging economies which represented around half of US trade deficit in goods at the time. The dollar continued to rise against the Mexican Peso until 2007 and remained flat against the Chinese Renminbi until 2005, causing the trade deficit to keep rising. Mexico and China alone accounted for over 40% of America’s 2006 trade deficit.

It was largely China’s dollar-renminbi peg between 1995 and 2005 that distorted the relationship between REER and the US trade deficit after 2002. Large-scale capital export from China to the US also maintained a distended trade deficit until 2008.

Accusations of currency manipulation by the United States’ trading partners pre-date Trump by almost twenty years. In 1988, the US Congress passed the Omnibus Trade and Competitiveness Act, which called for more action to be taken against nations which were identified as fixing their currency to steal an advantage. It was only in 2005, ten years after China had begun holding the renminbi at 8.28 yuan to the dollar, that Congress’s threat of tariffs against China – on the grounds that the peg turbo-charged the US trade deficit by preventing the renminbi from rising – caused the country to abandon the policy.

In the immediate aftermath of the Global Financial Crisis, China halted its ‘managed appreciation’ and resumed its dollar peg at 6.83 yuan to the dollar for over two years, which led to new accusations of currency manipulation as the US trade balance started to tick up again.

Since the end of 2011, the dollar has rallied, benefitting from the combined effect of being the first major economy to recover from the GFC and, more latterly, being the main recipient of the ‘search for yield’ process that has followed loose monetary policies around the world. But as of yet, the trade deficit has yet to deteriorate further, although the most recent figures suggest it is rising.

Last year, the dollar lost close to 10% of its value on a trade-weighted basis and it is now common to hear talk of the dollar as now being ‘weak’. But this is not so. By recent standards, the dollar is still relatively strong, and on a short-term basis there is scope for capital repatriation from the Trump tax reforms to push the dollar up this year.

Fundamentals, however, suggest that unless the dollar falls over the medium run, and there is good reason to think it will (the return of Europe, the strength of EMs, normalisation in policy outside the US), the trade deficit should rise, and this creates a source of political risk from Donald Trump.

Trump cares about the trade deficit. He thinks that a large deficit means that the US is somehow losing money. It is also true that his core voters – blue collar, manufacturing workers – struggle with a strong dollar. If his tax and regulatory reforms fail to bear fruit for the people that he claims to represent – with firms using the benefits of depreciation expensing to fund stock buybacks rather than capital investment – we would not be surprised if this unpredictable President turns to more drastic action on currency and trade restrictions, including managed interventions and tariffs. And that would create all kinds of problems for businesses that use international supply chains, central banks that have independent mandates and – in extremis – whole economies that depend on the rules-based international trading system.

The global economy is in fine form. Recent figures tell us that in the last year the United States grew by 3.0%, the euro area by 2.4% and China by 7.0%. Growth in almost every significant nation has outpaced market expectations. The exception for now is India, which is still struggling with the fall out of Prime Minister Modi’s demontisation policy.

Despite favourable monetary conditions, inflation is below 2% in most developed markets and below 4% in most emerging markets. This has created a benign environment for global trade; for corporates, whose rising pricing power has fed through into earnings; and for risk assets, which have benefitted from low volatility.

We are not completely convinced that this positive moment for the world economy is sustainable and we have raised concerns about the lack of productivity growth in the G7 and the financial stability risks associated with easy money. Nevertheless, we think the outlook for both developed and emerging markets over the next 2 years looks relatively positive.

If productivity continues to disappoint, inflation will start to rise. If money stays easy for too long, financial stability tends to weaken, a particular concern of the Bank of International Settlements. A key question therefore for both economists and investors is – as ever – if, when and by how much will central banks raise interest rates. Central banks have a responsibility to manage both inflation and general financial conditions.

There are two different issues here. One relates to the nominal interest rate; the other refers to the real interest rate. Nominal interest rates remain in an exceptional place. Policy rates in Europe, Japan and the US are below 1.5%. Sukanto Chanda at Deutsche Bank has assessed the $8trn global credit market and finds that 17% of all sovereign and credit debt trades at negative interest rates. These positions depend almost entirely on central bankers’ monetary policies and are likely to reverse as soon as banks embark on a sustained course of balance sheet and policy normalisation.

But this leaves the question of how high interest rates need to go to complete the process of normalisation. To get to an answer, we need to know what the risk-free real interest rate consistent with full employment is, as this reflects the underlying balance of supply and demand in credit markets.

A study in 2014 by former Bank of England Governor Mervyn King and David Low was the first that attempts to estimate the ‘global risk-free interest rate’. They use 10-year inflation indexed government bonds across developed nations as a proxy and find that yields have fallen by about 450 basis points since 1987 and are close to 0%. What this means is that developed economies that are neutral on monetary stimulus require nominal yields to rise to around 2-3%. Since many state bonds are not far off, this suggests that the amount of further tightening required from banks is limited.

The drivers of this multi-decade shift are numerous and relate to both the global desire to save (which has gone up) and the demand for credit (which has gone down). This means that global investment as a share of GDP has remained relatively constant over the period despite a large fall in the cost of credit.

The three supply-side factors that have increased the desire to save include: (1) reductions in the dependency ratio; (2) the creation of a savings glut from emerging economies in Asia, and more recently Northern Europe; and (3) rising inequality, as wealthier people save a greater fraction of their income.

On the demand-side, pessimistic expectations for innovation and productivity growth have cooled demand for credit. The falling price of capital also means that businesses need to spend less to meet their production needs.

So if low rates are the new normal, we have to revise our outlook for expected returns for risk assets. If new innovations are not forthcoming and more global capital chases fewer investment opportunities, returns are likely to stay low.

There are risks to policy too. Low rates and volatility will encourage ‘searching for yield’ – that may lead to problems for financial stability down the road.

Additionally, if central banks are committed to low inflation targets, there is much less they can do to stimulate the economy in the event of another recession. Nominal interest rates cannot credibly be held much below 0%, so banks will either need to rely more on unconventional measures such as QE or raise their inflation targets. It also means fiscal policy will be more important in turning around depressed economies.

With real interest rates at close to 0%, the bar for fiscal expansion is effectively lower as debt interest costs become almost a non-issue. The question in the future will increasingly be: does extra spending create at least as much in GDP? And the answer will almost always be yes.

Changes in the global economy in the last thirty years have reshaped the landscape for markets and policy. Today, both markets and policy are in new, unchartered territory. This need not be a bad thing, but the uncertainty puts additional responsibility on the industry to look out for known unknowns and be ready to respond to any unknown unknowns.

It’s an interesting time to observe the UK property market. Uncertainty over the country’s economic and political future comes at the same time as an uptick in global growth, driven by Europe and Asia. With these factors pushing in opposite directions, it shouldn’t be surprising that the current outlook for the property market looks mixed.

UK commercial property

The UK investment volume for H1 2017 was £27.2 billion, which is 1% higher than the same period in 2016. London accounted for 50%. Low levels of investment stock are pushing prices higher. After a spike after the EU referendum, prime rental yields across sectors have fallen back to pre-Brexit levels. The differential between prime and average yields is close to their 180 basis-point 10-year average.

According to the latest RICS survey for Q3, demand for industrial and office use was up over the quarter, but for secondary retail demand was down significantly. Surveyors believe that UK-wide industrials look most likely to secure growth in capital value and rental income over the next 12 months. Non-prime retail looks weak across the UK. Prime office and retail are strong with the exception of London, which 67% of respondents say is overvalued. Despite concerns over London, 3-in-4 surveyors believe the UK market as a whole is fairly-valued, and up to half think the market is still in its upturn phase.

The UK student housing market has also been robust since the Brexit vote. 2016 saw the second highest ever investment volume into purpose built student housing with £4.5bn ploughed into the sector. The combined effect of the weaker pound, the UK’s strong reputation in higher education, and the government’s clarification on the fees and living status of EU applicants has eased concerns.  Investors still see student housing as a source of stable and reliable income.

However, there are concerns over data from the construction industry, which fell into recession in Q3 2017. IHS Markit says that the combination of continued uncertainty over Brexit negotiations and fears of higher interest rates has delayed or discouraged new commercial and residential projects.

While sterling has recovered as the economic effects of Brexit have proven to be weaker than expected so far, there are downside risks. Fundamentally, Brexit put a discount on the UK economy of around 10-25% in terms of currency depending on the deal that is eventually struck. This centres new sterling’s long-run value to 1.30$/£ and 1.1 €/£. In the short-term, a weakening of the British economy will push the currency down, but the main worry is the non-trivial risk that Britain leaves the EU without a deal. However, if the government succeeds in maintaining many of the economic benefits of EU membership, the post-vote effects on the currency and the wider economy can be largely reversed.

The Bank of England is likely to raise interest rates in November, with effects already priced into sterling. But if the Bank moves onto a path of further interest rate rises, downward pressure on property prices can be expected if the spread of property yields over government bonds is maintained. This pound will strengthen if interest rates rise without significantly weakening growth.

UK residential property

In the residential market, a clear division can be seen between the performance in London and the rest of the UK. Since 2014, prices for homes valued over £1m in Central London have fallen by 15.2%. The rise in stamp duty land tax by 300 basis points in 2016 to 15% for homes valued above £1.5m is cited as a major reason for the downturn. However, according to Savills, there has been little change in the number of transactions of £1m+ properties in London since the 2014 market peak. Brexit uncertainty is more likely to be a factor as is the growing attraction of other world cities such as Sydney, Toronto and Stockholm. But rental yields point to the key driver. In West London, yields are below 3%, indicating an overvalued market for ownership that cannot be supported by local incomes. Further price falls in 2018 are probable.

The rest of the UK residential property market is in better shape, with year-on-year price growth in October at 2.5% according to Nationwide. Some areas still offer attractive returns to buy-to-let investors. Towns and cities in the South East such as Luton, Colchester and Peterborough offer yields between 4-5%, double-digit capital gains, and strong rental price growth. The North-West region and Wales report strong price and yield growth, with Manchester and Salford doing particularly well. Manchester remains the UK government’s centre for its Northern Powerhouse project, while high living costs in London are pushing people to search for value in the wider commuter belt.

In summary, the UK property market looks healthy but economic and political uncertainty is keeping investors and builders cautious. Downside risks are concentrated in London, where the impacts of Brexit on commercial activity are likely to be greatest and there are concerns over affordability. The fortunes there and across the rest of the UK depend on whether the country stays open for business.

For the last 6 months, the economic narrative has turned to the idea of ‘global reflation’. Strong economic activity and rising corporate earnings have been a theme for the world economy since late last year. Consumer and investor confidence has risen in both the developed and emerging markets.

But has the recovery relied too much on loose credit? Have we learned anything from the financial crisis? It appears that we haven’t. Excess global liquidity has led to mal-investments in China. It has encouraged managers in the United States to load up on debt and buy-back stock rather than invest in their businesses.

Both the People’s Bank of China and the US Federal Reserve have raised concerns about credit and financial stability. However, the spectre of balance sheet reductions and interest rate rises at central banks in China, the euro area, Japan and the United States threatens to take liquidity out of the global system and bring reflation to a halt.

Credit has been growing at an increasing rate relative to GDP in both the US and China. The incremental benefit of additional credit has been falling. Much of that debt has been raised to fund consumption, finance existing structures (such as real estate), and refinance existing liabilities. This is also the case for the UK, where the savings rate is at an all-time low of 1.7% of GDP. With real earnings stagnant or falling for many, consumer credit is growing at a rate of 10% y/y.

In China, the ruling Communist Party has imposed lending ceilings on its banks and is taking action to restrict credit to underperforming State-Owned Enterprises (SOE) and Local Governments. While these reforms have reduced the number of units of credit to produce a unit of GDP from 5.5 to 3.9, the rate is still extremely high. According to Citigroup, credit provision in China is today half as ‘efficient’ in creating productive output than it was in just 2008. It is about 30% less efficient than it is in the United States.

That’s not to say that US financial markets have been allocating resources prudently. The country has progressively become more credit-reliant since the end of the Bretton Woods system of capital controls. The amount of credit required to drive economic growth has doubled since 1980. The Chicago Fed National Financial Conditions Index shows that a prolonged period of easy credit has existed in the US since 2012, and is similar in scale to the periods representing the dot-com bubble (1995-2001) and the housing bubble (2001-2006).

In the current cycle, according to Absolute Strategy Research, US-held debt is concentrated in companies that have high ratios of capital expenditure to sales, relatively lower levels of cash and high levels of employment. Exposed sectors include Oil & Gas, Industrial Goods and Healthcare. For the largest 500 US companies, net debt has grown faster since 2012 than before the financial crisis. As always, the risks of easy money are not confined to financial stability but extend to the real economy as a whole.

While central banks are rightly concerned with keeping credit growth under control, growing debt-to-GDP ratios have reduced tolerance for higher interest rates. A rate rise from say 1% to 2% may not sound like much, but for a company that loaded on credit at rates of 1%, such a change represents a 100% increase in financing costs. With leverage increasing, there is relatively less real activity to support higher interest expenses.

Central Banks therefore face a dilemma between maintaining financial stability and keeping the real economy strong. A further problem they face is that the performance of the global economy and the strength of demand are related not simply to the supply of credit but the acceleration of credit growth. In other words, if the rate of growth of credit growth becomes too slow, economic output and demand can suffer. The problem for the US is that despite its having easy financial conditions, credit acceleration has actually slowed and this will weigh down on demand and inflation.

The Federal Reserve is therefore caught in a bind between putting a lid on an inefficient credit market for the sake of financial stability and keeping those very lines of credit open to an increasingly addicted economy that is arguably not at full employment. Yet it is hard to believe the Fed is simply looking at what their increasingly flawed Phillips Curve models are predicting about core inflation and reacting accordingly.

That appears to be ostensibly what they are doing. Janet Yellen wants to and has started to unwind the Fed’s monetary stimulus, but she seems to be doing so under the cover that core inflation is likely to accelerate in the coming months. That might happen, but if it doesn’t, the risk going into 2018 is astonishingly that the Fed tightens conditions too prematurely. However, the relationship between interest rates and economic stability in conditions of excess liquidity is not linear, and it may be judged prudent to take some fuel out of the economy now to prevent a bigger problem — perhaps another financial crisis — later on.

Meanwhile, with China responsible for a very large part of the period of global credit acceleration since 2014, some are concerned that credit tightening in China will put strong brakes on global growth through credit markets and the inventory cycle. This certainly was the case in 2010-11 when China last squeezed the credit markets, but there is reason to believe that China is now better equipped to absorb tighter conditions. Private sector investment has replaced spending by SOEs. The labour market is tight, keeping private consumption growth high. And export growth projections are up on the back of the strong recovery in emerging markets.

Yet, similar to the US, there are risks for China in cutting credit growth too fast. Corporate debt has risen from a high 100% of GDP in 2008 to 170% last year. Clamping down too heavily on credit, in the name of making the Chinese economy healthier, could instead make things worse.

It would be too much to say that the global recovery is built on sand. Real activity is up. PMIs look good in the US and the Eurozone. Consumer confidence is growing. And while the inventory cycle has turned in Asia there is good reason to believe the correction will be small. But it is right to say that if the lesson from the Global Financial Crisis wasto reduce the role of credit in fuelling non-productive activities and of leverage in driving the business cycle, that lesson has clearly not been learned.

The mood in Europe has noticeably shifted this year as a combination of populist defeats at the ballot box and an improving economy has given rise to a feel-good factor. Unemployment, at 9.3% in May, and Q1 growth of 0.6%, suggests that the euro area, after almost seven years of stagnation, is turning the corner.

But recent developments regarding Italy’s banking system ought to give pause for thought.

The ECB is concerned about bad debt in the banking system and its concentration in Italy. And they should be. While lenders across the euro area directly supervised by the ECB are exposed to sour loans worth €915bn, or about 4 per cent of total exposure, Italian banks alone have €326bn of exposure to non-performing credit.

To attempt to address this problem the ECB recently called for banks to cover the unsecured portion of all bad debt within two years, and for all of it within seven years. This will raise the cost of holding debt for banks, as only around half of Eurozone bad debt is covered by borrowers’ collateral. The likelihood of fire-sales of NPLs risks reducing banks’ capital ratios and thus lending.  The Bank of Italy and former PM Matteo Renzi have complained that these measures threaten Italy’s fledgling recovery.

Italy’s fragmented banking system

With over 400 national and regional players, Italy’s banking sector is highly fragmented and localised. This has created a source of systemic risk in Italian banking as many of these lenders have opaque and politically-influenced lending practices, with prudence often taking a back seat.

According to ECB and IMF research, even as Italy holds a third of the eurozone’s NPLs, a much higher rate of bad debt is held in banks in the south of the country than in the north. It is alarming that the problems that have surfaced to-date – in banks such as Popolare di Vicenza, Veneto Banca and Banca Monte dei Paschi di Siena – are situated in Italy’s industrial north than in the old Bourbon states of the south, where credit allocation is more suspect. The same IMF study found that three-quarters of Italy’s NPLs are related to the corporate sector, with the construction, services and ‘less technologically intensive sectors’ most badly affected. These are typically industries that are more localised and more ‘southern’.

To understand why Italy is in such a pickle today, it is worth looking at some recent history.

After a social pact in 1993, promising to coordinate the country’s industrial, labour and financial systems, Italy had an opportunity to become a German-style economy. But these reforms were watered down and basically abandoned after Silvio Berlusconi came to power in 1994. Instead, Italy remains stuck as a state that relies heavily on the government to keep the social peace by compensating losers and strong political actors. Banks are merely one of the tools at its disposal.

Historically, Italy has had a financial system that was largely based on patient capital especially at the SME level. The country’s corporate structure is marked by ‘pyramidal ownership’ that allows families or other entities to control large parts of Italian industry with relatively small ownership stakes. Families develop long-term relationships with banks, which in theory should lead to system that is relatively stable and low-risk. However, the state has always had a great degree of influence over the allocation of capital across the financial system, and that remains despite waves of bank privatisations since 1979.

Today, politicians exert influence in Italy’s financial system through the system of ‘foundations,’ opaque, non-profit bodies that were set up in the 1990s to ensure lending remained in the ‘public interest’. Foundations own just 23% of Italian banking assets but control the boards of the country’s largest banks. In Unicredit, foundations own just 9% of stock but control 84% of seats on the Board of Directors. Almost half of foundations are elected by local authorities, and 60% of the seats on the board of Foundazione MPS and 55% at the Fondazione Cariplo (Intesa) are held by local politicians.

Italy’s banking crisis in context

But there’s a bigger problem here, and it relates to the political economy of the Eurozone. In the euro area there are two groups of economies, export-led economies in the North (such as Germany, Belgium, the Netherlands and Austria) and demand-and-credit-led economies in the South (such as Greece, Italy, Spain and Portugal).

States in the north steadily gained competitiveness vis-à-vis the South in the early 2000s by holding wages down and cutting unit labour costs through improvements in products and processes that raised productivity. Coupled with low domestic demand, particularly in Germany, this created a situation of excess savings in the euro-North (Germany) that were channelled into the euro-South (Italy) and established the trade imbalances that underpinned the first euro crisis.

Because the EU’s institutions place constraints on national economic and fiscal policy, and because member states do not have their own currency, southern states, including Italy, used their leverage on banks as a partial substitute for tools it would typically use to keep the social peace. These states were helped along by low interest rates and risk premia that were more relevant to Germany than to countries like Italy.

Credit growth, supported by capital inflows and implicit bailout guarantees, replaced fiscal management as an engine powering domestic demand growth in the euro-South. It also turbo-charged imports of the high value-added goods from the North that countries in the South did not produce itself, leading to large trade deficits. German credit was squandered on businesses and projects that were low-value and often non-tradeable, merely serving to raise inflation and sustain the competitive trade imbalances that drove the credit flows in the first place. This is the reason why Italy today has so much bad debt. It’s a combination of the design of the euro area and problems within Italy’s political economy.

Deeper levels of scrutiny that are typical within systems with more capital depth were absent, making southern European states more exposed to financial risk than other countries that had high trade deficits, such as the UK and USA. It was these self-fulfilling fears of insolvency that originated mainly in the poor state of private credit markets, and the tight link between the health of national banking systems and public sector liabilities, that led to the sovereign debt crises of the 2010s.

Necessary reform

It now appears that officials in the ECB realise that the Italian banking system needs to be reformed, not just to isolate the mountain of bad debt and to prevent another financial crisis, but also for long-term reasons. There needs to be more accountability and transparency too.

Part of that involves bank consolidation. Consolidation has worked for Spain, which has reduced the number of its savings banks (cajas) from seventy to 12 since the financial crisis, with the Spanish economy growing strongly on the back of investment and exports. Consolidation with regulation that ensures that no bank becomes too big to fail is needed to improve the Italian and wider European banking system.

With the euro-area enjoying a sustained economic recovery, the last thing its leaders want is fears of another banking or political crisis to weigh it down. The price to pay in the short-term might be a hit to the Italian economy, but this perhaps is a price worth paying, both for Italy and the wider euro area.

In the UK, the crisis in the cost of living is back, as inflation, coming in at 2.9% in the year to August, has again risen above wage growth. The Bank of England says a major factor is the fall in the value of the pound since the EU referendum result, which has increased the costs of imports – in particular energy. Wage growth, up 2.1% in the year, hasn’t kept up. Adjusted for inflation, real incomes fell by 0.4% in the three months to July 2017.

Meanwhile, unemployment at 4.3% is now at a 42-year low, continuing to confound observers about the strength of the UK recovery as wage growth remains weak.

It may not feel like it but it is now over ten years since the financial crisis began, and we are nine years into a bull-run in equity markets in most major markets. Formally, the economy is said to have recovered. Unemployment is below its long-term trend of around 5%. Growth has been positive for many years, despite severe headwinds from years of fiscal consolidation. Inflation is rising.

Yet there is one highly abnormal feature of the British economy that could explain the weak growth in real wages. For the best part of a decade, the productivity gains that have driven rising living standards in the UK since the start of the industrial revolution have stalled, at least according to official data. Much of the increase in GDP since the crisis has come from ‘labour input’ – more people in work (often supported by high levels of net migration), people working longer hours, and more people returning to the workforce.

Low growth in labour productivity has meant that ordinary people in the UK have felt next to no benefit from the recovery of the economy in the form of rising wages. The return of high inflation threatens to put any gains they did see into reverse.

But is this the full story? Our research suggests that the productivity slowdown seen in the UK has been seen to varying degrees in all other G7 countries, but the performance of the UK should be an additional cause for concern. The UK has done particularly poorly due to unique frictions within its economy that have emerged post-crisis.

Figure 1 shows how the evolution of labour productivity, measured in terms of output per head, was faster in the UK between 1970 and 2008 than in other G7 countries. Starting from a lower level in 1970, productivity in the UK grew on average by 2.3% per year and by 2.0% in the other countries (weighted by share of total GDP), which included technological leaders such as the United States and Germany.

However in 2008, productivity decoupled from its trend in all advanced economies, with the biggest deviations in the UK. One would expect this at the beginning of any recession as weak demand creates ‘spare capacity’ in labour and capital. But this phenomenon should not last. In all other recessions since 1970, productivity soon returned to trend.

The impact can be seen in Figures 2 and 3, where we see the deviation of output per hour from the level implied by trend for the UK compared to the world’s technological leader, the United States, and then compared to all other G7 countries.

The UK and other G7 countries continue to deviate from their trend rates but to vastly different degrees. The US has also experienced low productivity growth in the last 5 years causing it so far only to revert back to its long-run trend level after a decade of rapid growth. But if the US continues to underperform on official measures, as seems likely, it too will slip below its pre-2008 trend in the coming years. The UK, however, appears to have done especially badly. Productivity (and therefore real wages) in the UK is 20% below where it should be based on recent trends, compared to just 10% below-trend for rest of the G7. More on the UK’s problems later.

The productivity slowdown across the G7 suggests one or more of four things has happened. Either demand remains too low in all industrial economies; the pre-crisis trend rate has fallen across the G7 due to structural changes in the economy; the pressure to deleverage in the wake of the crisis has reduced the willingness for firms to invest in products and processes that increase productivity; or productivity gains have not been picked up by the statisticians.

The demand explanation cannot account for a decade-long trend, and apart from a short policy-induced scare in 2015-16 in the Eurozone, deflation has not been a major issue in most of G7. It is possible, however, that delivering more robust and sensibly designed fiscal action sooner would have sped up the recovery ameliorated some of the productivity problems we now face.

While we are sceptical that the long-term trend that has driven growth in the United States and its trading partners for up to 150 years should be revised fully downwards to meet the most recent trends, we think a moderate deterioration in trend growth is a possibility. Mainly this is due to a decline in secular returns from a range of general purpose technologies – such as electric power and mass production – and the growth in the share of the low-productivity services sector in all G7 economies. The financial crisis may have simply exposed these underlying changes.

It is also plausible that as a result of the financial crisis and the experience of deleveraging, firms have increased their risk aversion and are reluctant to invest in the emerging general purpose technologies in nanotechnology and biotechnology, which promise a step change in industrial activity. This would also suggest a reduction in the trend-rate of growth, at least in the short term, across the whole of the G7, meaning lower growth can be consistent with full employment.

The fourth reason – that productivity gains have been hidden – we believe explains a significant proportion of the shortfall in all G7 countries including the UK. The emergence and growth of the Information Technology sector have hidden real productivity gains that have been realised since 2008.

A smartphone today, for example, has taken the place of a number of other devices such as cameras, GPS, audio players and games machines; and to a more limited extent they have substituted for personal computers altogether. Despite this, the cost of smartphones has fallen. Product consolidation in consumable electronics and IT sectors means that the formal measure of GDP understates the true level of output, adjusted for quality, and goes some way in explaining why productivity is low relative to the level of employment.  Further, GDP statistics do not account for non-monetary transactions, such as content produced on social media or the services provided by free app technologies that underpin the ‘sharing economy’.

But for the UK economy, further underlying aspects can be highlighted, as pointed out in 2014 in a paper from Bank of England’s Monetary Analysis Directorate. They suggest that low interest rates have increased  forbearance from banks on the debts of firms that in normal conditions would have been allowed to fail. Moreover, credit frictions have prevented funds from being matched with new profitable opportunities, and a sustained fall in real wages relative to the price of capital has encouraged firms to delay investment by expanding employment.

So while a global phenomenon of depressed productivity growth exists, the problem seems particularly acute for the UK. Our research suggests that the UK has suffered a decade of lost productivity growth but that it is closer to full capacity than implied by its pre-crisis trend. This means that the country may face a period of stagflation – weak growth and high inflation – that will create a dilemma for a Bank of England that is committed to keeping inflation at 2%. As inflation rises, real interest rates fall and sterling continues to weaken, the UK economy could begin to overheat. At which point, the Bank will be encouraged to raise base rates. But this could reverse efforts to raise productivity and if markets have little tolerance for higher interest rates could create more adverse macro effects.

This is the near-term outlook, However if, as the technologists suggest, we really are on the cusp of a new industrial revolution, which promises to offer quantum leaps in productivity and living standards, the long-run prognosis for the UK and indeed the rest of the G7 need not be so bleak.

The Taylor Rule, established by economist John Taylor in 1992, tries to target a level for short term interest rates that will stabilise the economy whilst maintaining long term growth based on three factors:

Actual inflation levels

Full employment vs. actual level of employment

Short term interest rates consistent with full employment

This means the rule will recommend raising rates when inflation is high or employment exceeds the perceived level of full employment and vice versa. Like all economic models, it is only as good as the data input, in this case assumptions about the long run neutral rate and the cyclical position of inflation. Historically, however, the Taylor rule has proved a useful guide to the appropriateness of monetary policy.

The change in central bank rhetoric would indicate that we have reached an inflection point where historically accommodative monetary policy will start to be reversed through the tapering of quantitative easing measures then the raising of interest rates.

                                                                                                                                                                     Baseline Taylor Rule Estimate for United States

                                                                                                                                                               Source: Bloomberg

At the peak of the financial crisis in mid-2009 the Taylor rule suggested that US interest rates should target a rate of -2%, but the Federal Reserve unsure of the effects of negative interest rates instead embarked upon a quantitative easing project designed to reduce the overall cost of credit by employing its own balance sheet. By 2013 the rule was advocating rates be raised to approx. +1% encouraging Chairman Bernanke to embark upon the first tapering of QE that caused the summer tantrum in the US Treasury market.

Today the Taylor rule suggests that rates should be nearer 3.75% in the US which is probably the largest disconnect between the theoretical normalisation of rates and actual interest rate policy sparking debate about where the peak in this hiking cycle will ultimately prove to be. For many the current neutral rate is believed to be around 2%, much lower than the historical average of nearer 4%, but probably explains the Fed’s new commitment to tighter policy despite the absence of wage inflation in the system. In any event it seems clear that fundamental models such as the Taylor Rule are pointing towards higher rates and the phasing out of QE.

The Fed is expected to announce balance sheet reductions in September leading to another hike in rates in December; The ECB to move to a reduction in QE during Q4 17, the Bank of Japan’s balance sheet growth is reducing; and the BOE surprised many with its more hawkish rhetoric of late leading the Gilt market to adjust its rate hike expectations in the UK. The causes of the higher levels of inflation in the UK are creating a greater divergence between actual and theoretical rates which may explain the difference of opinion in the future path of interest rates.

From the bond markets perspective the adjustment to higher rates will generate capital losses as yields move higher and if handled badly by policy makers negative sentiment could spread to other areas of the economy. Expect central banks to offer high levels of forward guidance and move forward very cautiously as they remove support from the financial markets.

Just as the dust started to settle with political stability somewhat mitigated and investors focus now on corporate earnings as a means of justifying high global valuations, Italy comes to the forefront. European markets have performed strongly and valuations are becoming stretched so that even the smallest shock would likely see equity markets weaken the question is to what extent? Italy, known for its political instability, high debt and resulting drag on the European Union is in desperate need of effective leadership and structural change. The political parties of Italy recently announced that they are in the process of coming to an agreement on new electoral law that, if successful, will almost certainly lead to early elections this September. The announcement on May 16^th saw markets deteriorate slightly, primarily in Italy where the FTSE MIB fell 2.31% followed by two falls of 2% on May 26^th and 29^th as the news unfolded. The most significant decline was in Italian Mid Caps which fell 2.51% led by financials. However, the relatively sober response suggests investors believe there is a low chance of a populist party being elected and subsequently an Italexit.

The Italian and German bonds spreads widened as the yield on an Italian 10yr government bond hit 2.18% (a 6.77% increase). The change in spread represents an increase of 188 basis points. Citigroup predicts spreads to widen further to as much as 300 basis points, levels that haven’t been seen since 2013.

 

German Bund / Italian BTP 10 year Yield Spread

                Source: Bloomberg

 

With the recent win of Emmanuel Macron as French President and the likely triumph of Chancellor Angela Merkel the Euro currency has been the stronger major currency, a further reflection perhaps that most investors currently place a very low probability of a populist triumph.

Should Italy’s political parties come to accept an electoral reform it is likely to take a shape similar to that of the German model; proportional representation with a 5% threshold. Considering this, and looking closely at the most recent election polls, only four of the political parties make the 5% threshold. The PD and 5SM stand at 30% each, Forza Italia and Northern League in the low teens and no party is on course to win a majority so a coalition is almost certain. Currently, consensus seems to suggest a coalition between PD and Forza Italia (both pro-EU parties) however 5SM and Northern League should not be ignored. Both are anti EU and would call a referendum. Should this coalition become likely, we would expect to see a big sell off in markets.

In conclusion, there are a few immediate obstacles to observe. The state of the Italian economy is the first and will most definitely play a part in influencing the outcome of the election. Support for the 5SM seems to rally whenever news of Italy’s economic performance turns for the worst. Initial economic reports this year have been promising with strong results coming from boosted inventories and consumer spending. If this continues, Italians may rally behind the PD. Secondly, poll predictions will likely influence markets and be a good indicator as to the possible outcome of the elections. Looking back at the Italian referendum, polls were fairly accurate in forecasting the vote and so investors will expect this to follow through in the elections. Finally, keeping a close eye on the interaction amongst parties. If the 5SM and Northern League form a coalition, it is very likely they could win the election. The result will see devastating effects to the markets. We remain cautious in the short term upgrading risk to ‘medium’.