Economic Update August 2013

There is good news and bad news. First the good. GDP grew by 0.6% in Q2 in all sectors even construction showed some life ( although it is still 15% below 2008 levels). Consumption spending improved and retail sales were up 2% in volume terms. Now for the bad news this mild upturn has been financed by borrowing and reduction in debt repayments, not by growth in wages. If, and it is a big if, employers decide that the upturn in confidence is sufficient to give above inflation wage awards, then the recovery will be sustained. But if not, then it will peter out by the end of the year. The indicators of a sustainable recovery would be wages growing at 5%, retail sales volumes at 3%, and a surge in investment spending financed by the banking system.
Fig 1: Household disposable income

Bank net lending Its still falling but at least the rate of decline is now only 1.2% year on year. Net lending contracted by 1.7Bn in June. Below are the main players in order of size of lending, who have created 15.7 Bn in the past year: Barclays- +6.6Bn (but they didnt have sufficient capital to support their loan book, and need to raise 12Bn. If they fail in this, they will need to shrink their loan book by circa 88Bn by the end of next year.) Nationwide +4.7Bn (but like Barclays, they have been told that their capital base is insufficient) Coventry BS +1.5Bn Virgin +1.1Bn Tesco +1.6Bn

Here are the main destroyers of money. Over the past year they have destroyed 19.3 Bn: Santander - 8.6Bn Lloyds -6.6Bn RBS -3.9Bn
(all data from the Bank of England.)

As both Barclays and Nationwide have been told to reduce their leverage ratio we can expect them to reduce net lending over the next 12 months. It must be hoped that others in the market offset this, otherwise there is no chance of a sustained recovery. In the Eurozone almost all banks are tightening their credit requirements, particularly to smaller companies. The growth in lending was minus 1.7% in June, but my calculations suggest that net lending fell by 4%. In the USA however, banks are growing their lending at an annualised rate of 10% . And if household disposable incomes continue to grow, so will their economy.

Household disposable income is also rising, albeit gradually.

Unlike the UK and Europe, the USA has more favourable conditions for a sustainable recovery. It will gather momentum over the next 18 months. I wish I could say the same for us and the Eurozone. The UK Housing Market The Help to Buy scheme has subsidised 1.3bn worth of house purchases since April. 7000 new houses have been reserved, about a third of sales for the period. The taxpayer is committed to 260m in lending. From January all borrowers for property up to 600,000 will be able to borrow with a 5% deposit. So far the biggest take up has been in the Midlands, London lags with only 314 sales. As usual the press is calling a mini boom, Economists are told they got it wrong when they said prices would rise at best by 2% in 2013. In June prices were 0.8% higher than a year earlier. The average price is 162,621 (source: the Land Registry).. The press are probably quoting the data for London (as most economic journalists live there!). London prices are up 7% on a year earlier. The NE down 3.8%, Sw, flat, Yorkshire down 2.1% . The Midlands up 0.5%. Taylor Wimpey, the UKs largest housebuilder has announced it will create 4,000 new jobs in the next 12 months. If small independent housebuilders are financed by their bank (yet to happen) then we can talk about green shoots. UK Living Standards In 2102 real incomes fell 3%. The median income for twenty-somethings did not grow between 2002-2008. Pensioners have done best of all. 16% of the population are in relative poverty (defined as 60% or less than the median income in 2012) an increase of nearly a million. The recent increase in consumer demand has been financed by credit cards (volumes up 5%) and a reduction in the savings ratio to 4% from 6%. This has released 14Bn of spending which would have been used to pay down debt if house prices were falling. The Eurozone

The Eurozone is still in the grips of an unresolved banking crisis, with the consequential contraction of credit. This will ensure low nominal GDP growth, low inflation, and little or no debt reduction. Germany will not accept Eurozone bonds, so what can be done? The policy makers have pinned all their hopes on a Banking Union. This will consist of a central supervisor with nationally coordinated debt resolution schemes. But only the core of Europe is able to fund such schemes the periphery have no money. So debt will be merely shuffled from one sector to another. What will happen is a whole series of piecemeal steps in the hope that growth will magically appear and then debt as a proportion will start to fall ( as it is today in the USA). But the recovery is not going to happen: undercapitalised banks cannot finance it. Debt deflation will reign supreme. The Eurozone will become the Japan of 1992-2010, with falling wages, falling prices and growing indebtedness. Take a look at Italy

In time there is no doubt that lower wages will result in more competitive Exports, but it will take years. Take a look at Spain

Both Spain and Italy are now responding to the inability to devalue, by cutting wages. This deflation will create an austerity feedback loop which will last for years. And it will make it impossible for either country to reduce its national debt. By way of comparison, the UK has devalued 26%, but even with this lifeline our real incomes are falling by 3%. And the Government finds the annual deficit is stuck at 120Bn. It has gone quiet in Europe and it will remain so until September when the policy makers return from holiday. And then they will see that Greece will default to the IMF, Portugal will ask for more financing, a re-elected Merkel will reaffirm Germanys unwillingness to underwrite Eurodebt. There will a Black Swan event in Europe before the end of the year. Japan

Japan is determined to end deflation. The central bank is lending unlimited amounts to commercial banks it the hope that a massive monetary stimulus will create inflation and some real GDP growth. So far the effect has been to devalue the Yen. This should result in inflation over the next year because Japan imports almost all of its energy. However if wage inflation fails to happen then growth will be only driven by net exports. And remember that for any country who runs a surplus, there has to be another who runs a deficit. We cannot all grow through an expansion of net exports.

This is what has enabled Japan to grow under deflationary conditions, a net surplus averaging 3% of GDP.

No sign of inflation yet in Japan. And on the next page you can see that Japan has barely grown since 1992.

This is what I think we may expect from the Eurozone (excluding Germany). I hope the UK will do better, particularly as our Banks as a whole are making progress. China It appears that the new administration are beginning to implement some radical policies. They recognise that growth will come from entrepreneurial start ups, not state enterprises. Local Government is being reigned in and told to cut wasteful spending. The banking system has been warned over excessive credit expansion to real estate. It would seem that no longer is economic growth at any price a desired outcome. China is about to grow up and accept a GDP growth rate of 5% (which the demographics would support). And wasteful over-investment by state enterprises will be discouraged. This halving of growth rate rate will continue to weigh down on Australian mining output and investment. If the state could also relax its grip on the media and the internet it may well achieve a successful transition to a middle income economy. Meanwhile it continues to suffer from a growing lack of competitiveness as wages rise faster than productivity and the new generation of Chinese workers are not prepared to work under the conditions experienced by their parents. Exchange Rates Here are my (educated!) guesses. We should expect some weakening of sterling against the dollar in the Autumn. I predict $1.45 average for the final quarter of the year. The Euro: 1.15 but there could well be a few weeks at 1.20 when the black swan event takes place. The Yen should weaken by another 5% against the basket of international currencies.

The Euro will weaken 3% against the dollar by the year end. Interest Rates No change in the major economies for the rest of the year. In September the Fed may begin to reduce the monthly purchase of bills. This will probably increase long run interest rates by about 0.5%. But not by more because the US Federal deficit is slowly reducing. Inflation The UK will sit around 3%, and the Treasury and the Bank of England will be content at this level. The USA will be around 1.5%, thanks in the main to falling energy costs. Eurozone: average around 2%. Conclusion I am going off to West Wales for my holiday and will avoid reading economic stuff. I was told that Fifty Shades of Grey is a good read, but I think I will drop it in favour of Rod Stewart's autobiography. Will I notice the difference I wonder? I hope you have a good break, clear the mind, keep fit, and get ready for the challenges of the Autumn, they are likely to be considerable!

Roger Martin-Fagg August 1 2013 rmfagg@aol.com