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Illusion never turned into something real

26th Oct 2017
Well, what a couple of months it’s been. So much to talk about and so little time.... Let’s start with Brexit, which will have almost no impact whatsoever on the UK’s economic performance over the coming 20 years whatever happens in the political shenanigans over the next two or more years. So that’s that.

Next, we really should talk about the move from QE to QT. We know you know all about this stuff, but just in case you don’t find it as fascinating as we do, in QE, or quantitative easing, central banks buy assets, most usually government or sovereign bonds, which is paid for by money created by the central bank specifically for that purpose. Think of Mr Corbyn’s Magic Money Tree and then multiply it by about 100 times. In this way the money supply is increased. QE does not lower interest rates, which are already at about zero, but instead eases through the quantity of money available to be spent.

The practical impact of QE is that the previous owner of the government bonds now has cash, having sold the asset to the central bank. Cash yields zero and inflation is well above zero.

Therefore, in order to maintain the purchasing power of their money, the investor with cash is effectively forced to buy something else. After years and years of QE the result is an additional $12 trillion ($12,000,000,000,000!) of global money seeking a return. Such a huge amount of additional return-seeking-investment has produced some bizarre results in the past few years:

  • Iraq (war torn, still fighting against Daesh and with the FCO recommending no travel to the majority of the country) issued a sovereign bond running until 2023 yielding interest of only 6.75%. In other words, investors fully expect to get their money back in 2023 – good luck with that chaps.
  • Ireland, yes the same Ireland that was forced into an international bailout just seven years ago, recently issued a five year bond at 0% interest which was priced slightly above par, meaning that investors receive no interest and are guaranteed to make a small loss at maturity.
  • Mexico (bankrupt in 1982) issued a 100 year euro denominated bond at 4.2% per annum.
  • Swiss 10 year government bonds trade at a negative yield, so you pay for the privilege of holding them.

The impact from QE has not been limited to just the bond markets. Share valuations have been pushed up to historically high levels as investors move further up the risk scale in the hunt for returns. It is clear from the data that the rise in equity markets in the recent past has been driven primarily by a change in the multiple investors are willing to pay rather than by an increase in the earnings power of the companies. This is testament to the power of policymakers and miniscule interest rates. Zero interest rates for almost a decade have created huge imbalances which will prove extremely difficult to unwind.

Central bankers have finally started discussing raising interest rates, together with the possibility of reducing the excess assets that they now hold on their balance sheets (the additional $12 trillion). The situation they find themselves in is an unenviable one; they recognise interest rates need to rise and that over time they need to unwind the asset purchases they have made but they have no idea how to do this safely. Furthermore they would like interest rates back towards a more ‘normal’ level (3% – 5%) before the next recession in order to give them some scope to cut rates at that time. With the current expansion already the third longest on record, the time pressure to normalise interest rates is clearly rising.

The US central bank, the Federal Reserve, has recently taken the historic decision to start unwinding its $4.2 trillion of bonds built up through its stimulus efforts following the financial crisis. After buying up US treasuries as part of QE, the Fed’s balance sheet increased from $900 billion in 2009 to $4.5 trillion in 2015. Now the Federal Reserve will start to reduce those holdings by gradually reinvesting $10 billion each month less into bonds, increasing this amount by $10 billion every three months until it reaches $50 billion. The significance of this should not be under appreciated; this is a once-in-a-generation change. Over the past decade we have been used to central banks buying bonds each and every day. That has now changed and when the programme gets up to speed the Fed will be reducing its balance sheet by $600 billion a year. This is QT, or quantitative tapering and nobody really knows what the effects will be. Scary stuff.

On the plus side, there are plenty of examples around the world of good economic practices taking place at the moment. None from the UK, EU or US of course, but in countries such as India infrastructure, business and commercial development are continuing to advance and evolve at a pace. The Indian Prime Minister Narendra Modi and Japanese Prime Minister Shinzo Abe recently announced the building of India’s first high-speed rail line. This new HSR line will extend for 320 miles between Mumbai and Ahmedabad, the largest city of Modi’s home province, cutting the travel time down from eight hours to two or three hours. While the specs of this rail line are nothing to be impressed by in China or Japan, in India they are the cutting edge of overland transportation technology. The new train will run at more than 200 miles per hour, make 70 trips per day and go through a 17 mile long tunnel, of which five miles will be under the sea. This is a proud moment that is symbolically meant to usher in a new age for India. The scheduled completion date has been strategically moved up one year to August 2022, so it can be unveiled as part of the ceremonies commemorating the 75th anniversary of India's Independence. The total cost of this rail line is estimated to be around $17 billion, with over 80% of it coming from Japan in the form of an extremely friendly loan. There are plans in place to construct a further five high-speed rail lines on top of Mumbai-Ahmedabad. India remains a relatively impoverished place, recently ranking as the 64th poorest country in the world and coming in 60 out 79 countries on the World Economic Forum’s Index, significantly lower than even neighboring Pakistan and Bangladesh. But they are headed in the right direction at ever-increasing speed.

Overall, global growth is strong and widespread, financial conditions remain supportive and equity valuations outside the United States remain pretty reasonable. For now, we remain neutral; we know what we don’t know, but we don’t always know everything, if you know what we mean. It’s geopolitical and political risks that are at the forefront today, most notably tensions in North Korea and Newcastle with the proposed takeover of the club by a Turkish billionaire. Evolution in the global balance of power and resolution of political, economic and social risks can take decades to play out, not years. Prospects for military conflict on the Korean peninsula and St James’ Park are very low, but the consequences would obviously be dramatic. Some clients have asked us what might happen if there’s real trouble between North Korea and America. Well, with respect to capital markets, the impact of geopolitical events on equities historically has been sharp sell-offs followed by rapid recoveries. Most share sell-offs have been relatively modest and short lived, with the decline in the immediate aftermath of an event averaging roughly 7.5% and recoveries beginning less than a month after the sell-off started. So, steady as she goes Corporal Jones. Successful investing means shunning middling ideas. Movements in foreign exchange rates notwithstanding, we remain optimistic that our clients’ funds will continue to deliver attractive returns in what remains a low interest rate environment in the UK.

In our regular discussions with fund managers and economists about the prospects for your hard earned money, some of them are very good at telling you in great complicated detail why their previous predictions did not come to pass. That’s why we always give more weight to the views of those fund managers who can manage to keep things simple. It’s funny isn’t it, how ‘experts’ will tell you that something is “incredibly complicated” when it’s not. The mass unplanned migration from Africa to Europe could have been stopped in its tracks right at the outset by a few carefully positioned gunboats about 50 miles off the African coast to arrest the people smugglers, destroy their boats and, after giving food and medical help to the victims, returning them safely. This problem would have taken around a month to solve, according to a retired British Admiral of the Fleet heard on Radio 4 one morning. Similarly, the squeeze on capacity in the NHS is often felt most acutely in the number of operations that can’t be carried out because of a shortage of theatre time. It’s apparently an incredibly complex problem to solve. Well, again on Radio 4 a few months ago, they interviewed a young German eye surgeon currently working in Glasgow who told us that operating theatres were only being utilised part of the day due to outdated cleaning practices that would never be tolerated in Germany. By setting up specialist cleaning teams just dealing with the special needs of operating theatres rather than cleaners also being responsible for general wards it would apparently be possible to keep theatres functioning for much longer each day, so cutting waiting times dramatically at little or no cost. On the same programme a health consultant explained how hospitals in China are able to see 33% more patients per day than their UK equivalents. Greater efficiency also leads to more positive outcomes for patients of course, meaning that less time off work is needed. Maybe we could export some of our experts to the EU when we leave?

Penultimately, our headline, ‘Illusion never turned into something real’ refers to the almost complete lack of progress that has been made in the past 10 years to improve the lives of ordinary citizens. When Jeremy Corbyn was elected leader of the Labour party in September 2015 we said in the very next bulletin that this country was just one financial crisis away from him becoming Prime Minister in 2020. The howls of derision you emailed back were deafening. “He’ll not last 6/12/18 months”, He’ll be gone by Christmas”, “Have you taken leave of your senses?” were some of the polite replies we received. Well, we are happy to admit that we got it wrong. It doesn’t have to be a financial crisis that impels Jezza to the steps of Number 10, it could be any old crisis. Would you bet your pension fund on Mrs May winning another General Election today (or in 2022)? Unless the Government starts to take some action that is going to be both popular and raise living standards without breaking the bank, starting with the Budget on 22 November, then you better start swimmin’ or you’ll sink like a stone.

Finally, I think we can agree that we are now living in a period of liminality. But what exactly is liminality?

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