There is a great divide today: between the narkets, the economy and politics. As far as investors are concerned, it would seem things couldn’t be better; stockmarkets are at record highs, bond yields are close to record lows. Volatility in the market is also very low. People are willing to lend to the British government for ten years at 1.2% (when inflation is 3%); they will lend to the French government at 0.7% over the same period and they are willing to take a loss by lending to the Swiss government, where yields are negative. People who lend to the corporate sector are also willing to take very low spreads in comparison with history.
Look at the politics, however, and you would be surprised at how calm the markets are. The American President has threatened to cancel trade deals, withdraw from the US’s international commitments and to destroy North Korea with “fire and fury”. Russia has invaded two neighbourts in the last decade and likes to interfere in the west’s elections. China, under a new authoritarian emperor under Xi Jinping, is flexing its muscles in Asia. Saudi Arabia is undergoing internal turmoil while bombing Yemen and stepping up the rhetoric in Iran. Turkey, Poland and Hungary have nationalist, authoritarian governments. The UK, in the middle of the uncertainty of the Brexit negotiations, has a government in chaos and an opposition whose leaders may be the most left-wing ever to take office.
There might seem a simple answer to this question: politics doesn’t matter. The markets have seen Republican and Democratic Presidents come and go; Labour and Tory governments; they have seen acts of mass terrorism and wars in the Middle East; and after the odd wobble, they have kept going up.
They may have a similar feeling now. Bank of America Merrill Lynch polls fund managers every month and its most recent finding was that Goldilocks was back; investors think economic growth will not be so hot as to cause inflation, nor too cold as to cause recession, but be just right.
The tide semed to turn in early 2016, before either Brexit or Trump. As the time, as you may recall, there was much talk of secular stagnation — of a Japan-like combination of sluggish growth and deflationary pressure. The growth of global trade has been very sluggish since the financial crisis of 2008. The big fear was that China would slow; the weak oil price of the time was seen as a sign of sluggish demand. But then Chinese indicators picked up, commodity prices rallied and equity markets took the hint.
Economic growth forecasts have been revised higher; the IMF reckons global growth was 3.2% in 2016, will be 3.6% this year and should be 3.7% in 2018.
Discussions of the impact of Trump and Brexit need to be seen in this light. Yes, there was a “Trump bump” as investors hoped that taxes would be cut, infrastructure spending would be increased and regulations reduced. Regulations have been trimmed but the fiscal package has yet to be passed. On the plus side, all the negative stuff that Trump might have done; starting a trade war with China, exiting Nafta, hasn’t happened either. Even his threatening tweets about individual companies are having less effect than they did.
As for Brexit, the UK economy has not slumped into recession as some forecast it would. But there has been an impact.
Until the middle of 2015, the UK economy was growing faster than the average rich economy (those in the OECD); now it is growing more slowly.
The main impact of the referendum vote has been on sterling. The big drop in the pound against the euro and the dollar has helped exports a bit, but nothing like as much as it did after Black Wednesday or Harold Wilson’s “pound in your pocket” devaluation of 1967. We still have a sizeable trade deficit.
In part this is down to the way trade is conducted these days. Most people have a model in their heads in which we make “our” cars (or planes or machinery) which compete against German or Japanese cars and planes. Instead, the modern manufacturing process has a global supply chain; parts may go in and out of several countries before they are assembled into a single car or plane. These supply chains are not adjusted overnight. Similarly service provision may be done on cost, but also on factors like reliability and effectiveness; you don’t switch a fund management contract from New York to London because the pound is cheaper.
The bigger impact of the pound’s fall has come from the rising cost of imports that has squeezed real wages. Consumers kept spending in the immediate aftermath of the referendum but that impact is dying down.
In this context, the recent rate rise from the Bank of England was a bit of a risk. I think the Bank’s reasoning was fourfold. First, the increase was only reversing last year’s cut in the immediate aftermath of the referendum. Second, other central banks, notably the Fed, are now tightening policy; this gives the Bank cover to do so, without pushing the pound up too far. Third, having hinted at raising rates, the Bank would have lost credibility by not acting.
But this was a dovish rate rise; the pound and bond yields fell when it happened. That is because the Bank could only see two more rate rises in the near future, pushing rates to the giddy heights of 1%.
The much more disturbing side of the Bank’s actions was the long-term picture. Along with the Office of Budgetary Responsibility, it is lowering its forecast for the trend rate of UK economic growth. That makes a huge difference and it ought to make financial markets more worried than they are.
The Bank now thinks trend growth will be 1.5% a year; that is down from 2.5% before 2007. They are not the most pessimistic; J P Morgan thinks UK trend growth is 1.25%, That is lower than their assumption of EU growth of 1.5%; so Brexit will actually push up average EU growth. Brussels, you’re welcome.
What economists mean by trend growth is the rate the economy can continue to grow without overheating. If an economy is operating at full capacity and grows above trend; inflationary pressures will emerge. There will be shortages of goods or labour; prices and wages will be bid up. If the economy is operating below capacity, it can still grow above the trend rate without a problem until it catches up.
When you lower the trend rate, that means the moment of catch-up comes sooner; the fourth reason why the Bank felt it had to push up rates.
What determines the trend rate of growth? In essence, there are two things; the number of workers employed and how efficiently they work, ie productivity gains. The UK’s demographic position is not as bad as that of Japan or Germany. But the proportion of the population made up of people of working age (16–64) peaked in 2006 at 65%; it is now 63% and it’s projected to be 58% by 2046. Those aged over 65 are now 18% and will hit 25%. We could ease this problem with immigration but the politics are against it.
What about making workers more productive? As is well known, the UK productivity record has been dismal in recent years. This may be a good news/bad news situation; low wages have meant businesses have taken on workers rather than investing in machinery. Better perhaps to have low unemployment and low productivity than France which has high unemployment and high productivity. But unless technology spreads in a way that dramatically boosts output, it is hard to see where our growth will come from.
And then there is the politics. Growth could come of course from foreign investment; this is often the way that new techniques are introduced. Britain is a more successful car producer today thanks to Nissan and Toyota than it was under British Leyland. But global business may be thinking twice at the moment about whether to invest in the UK until they see what kind of Brexit deal we do.
If you talk to most business leaders, they will tell you what kind of EU deal they want. It is pretty simple; it is access on exactly the same terms as today — membership of both the single market and the customs union.
The problem is that the government has pretty much rules out such a deal. It wants free trade etc but it doesn’t want to sign up to the rules — the four freedoms (goods, capital, services and labour) or adjudication by the European Court of Justice. A two-year transition deal in which the UK maintains all the rules would please business but only postpone the awkward choice. On top of all this is the awkward fact that the UK needs to pay for its existing EU commitments which may be 40–50 billion or so. This will play terribly with the Tory backbenchers, The Mail and the Telegraph.
There are lots of practical issues to deal with. The problem is that, any time someone raises a practical problem, they are dismissed as a Remoaner. Take the border between Ireland and Northern Ireland. You can have the UK stay in the customs union and keep the border free. You can have customs checks and border posts strung across the border. Or you can keep Northern Ireland within the customs union and have the border in the Irish sea, as the EU has suggested. The UK government has ruled out all three.
Theresa May, who as we have seen this week is on very shaky ground, could fall before the EU deal or after it. Indeed, if she opts for the EU’s Irish solution that might prompt the DUP to bring her down. And that might bring in Jeremy Corbyn. He, as you recall, plans to raise taxes on companies, raise taxes on executives, nationalise utilities and take back PFI contracts for less than market value and make the labour market less flexible. Oh yes and to take a more anti-American stance.
So think of how that will look to international investors. Five years ago, Britain was the freemarket hub within the EU; the place where English-speaking executives were happy to settle. In two years time, the UK could be out of the EU and ruled by the most left-wing government in history with a hostile attitude to multinationals. The shock would be enormous.
That is one reason why I think UK investors are a bit too complacent about the outlook. Politics haven’t mattered that much since the early 1990s because, broadly speaking, voters were choosing between who best could manage the economy; there was no great ideological divide between Tony Blair and John Major. But with Brexit and the rise of Corbyn, the UK is heading off into new areas; here be dragons, as they say on the map.
The same could be said internationally. Populism can be defined as two things; a revolt against the elite and against globalisation. It is driven by an economic component (the failure for real wages to grow) and a cultural one (immigration and other social changes that disturb some white voters).
But business and investors have prospered from those changes. Squeezed wages have kept profits high; globalisation has helped businesses move to the most tax-friendly profitable locations. Trump is a very odd tribune of the populist cause, a real-estate developer who packs his cabinet with billionaires and generals and plans to cut taxes for people like him. But he talks the talk in some areas; trying to force companies to bring jobs and cash back to the US; trying to eliminate bilateral trade deficits with other countries; using the US’s political power to try to bully other countries into changing their economic policies. Many of these ideas are batty. What matters is the overall trade deficit not the deficit with one country; I have a big surplus with The Economist but a big deficit with Sainsbury’s. I don’t demand that Sainsbury’s orders some articles from me in return for the weekly shop.
Again the market is generally assuming that profits will stay high. But if populism has any practical results that please the people who vote for it, it will be in the form of higher wages, lower margins and more barriers to trade.
And populists have a point. Take two issue; profits and house prices. Both are high. What should happen under capitalism is that high profits attract a flood of new investment that drives down profit margins but drives up economic growth so that everyone ends up better off. What should happen when demand for houses is high is that more homes get built until the supply/demand imbalance is redressed. But neither has occurred.
The best way out of this disconnect between politics, economics and finance is for capitalism to start working properly again. Until it does, the danger is that, at some point, politics will interrupt the market’s celebrations.