The stock market signals are very positive.  The Dow exceeded 15,000 recently and the FTSE is edging towards 7,000 – all time highs!  Theoretically, the stock market reflects the performance of the economy: the recorded earnings of its company constituents.  Modern technology, with instant communications and analysis, has shifted the market emphasis from real profits to expected profits, but the basic link remains.  Hence, the present stock market signal is that earnings are good and an economic recovery is coming that will make them even better.

The alternative argument is that monetary stimulus from the central bank authorities is falsely fuelling the equity upturn.  Quantitative easing (QE) and its hybrids have pumped $-trillions into the world financial system and this money has not all gone into the real economy (through increased bank loans and higher business investment) but has gone into assets (stocks an bonds).  Hence, when the money ‘tap’ is turned off, the markets will drop again.  The current market reflects a false dawn.

But, if it was just a ‘money-rush’, we’d be seeing higher inflation and higher growth already.  Actually, whilst the monetary base has exploded, M2 monetary growth has not.  Perhaps, the banks should be applauded (what!) for not indulging the authorities’ QE nonsense of potential over-stimulation.  (QE needs to be scaled back and interest rates raised.)

The market is anticipating a lower share of government in the economy and new technologies that will boost growth in the long run.  Therefore, it is seeing an undervalued corporate population whose future returns could be quite strong.  On balance, I think the rebound in share values is real and can continue.  Of course, values can easily be blown away again by further shocks from sovereign debt debacles and policy mistakes.  Negative risks are still high.  But, if these risks are not realised, the stock market recovery should be heralding a wider moderate but sustained economic recovery for the medium term – not now in 2013 but perhaps in 2014+.  For the first time in quite a while, I find myself on the positive side of the consensus.

This does not mean I am totally optimistic.  There are some big clouds out there, coming from the euro-zone, falling real incomes and inflation expectations.  Growth is still likely to track below trend for the foreseeable future.  But, I think I am feeling some winds of change.  I’ll be right if those businesses with cash, with good products and services, and with aspiration start to plan for higher investment and hirings this summer.

Alongside, you will see a link to our latest Strategic Economics Report – March 2013 (SER).

This gives our view of the global, national and local economy now and for the year or so ahead.  Importantly, whilst many business conditions remain strained, at best, this is the first time Strategic Economics ends up with a more positive assessment than our previous SER Report.  In a year’s time, we hope to be looking back and recording that now (spring 2013) is the time that the outlook started to improve.

We do think, however, that government and others need to help to underpin any forward momentum.  As well as long term investment expenditure and incentives to create the structural competitiveness the UK needs, we think an increase in the VAT threshold to £100,000 and a cut in the rate, ideally to 15% would encourage many businesses to invest and hire in the short term.  We hope something is in the Budget to engage the Laffer curve.

In addition, we want to see the Bank of England moving away from the liquidity trap and increasing interest rates to restore a yield curve that encourages risk and return decisions. Stop worrying about zombies and support the growers.

The announcement of Moody’s downgrade of the UK sovereign credit rating from AAA to AA1 caused the usual media frenzy but only modest immediate market reaction – pound down a bit, shares up a bit.  We’ll have to see next week whether deeper thought by investors and analysts produces more reaction.

According to Reuters, Moody’s said Britain’s growth was likely to be sluggish due to a mix of weaker global economic activity and a drag “from the ongoing domestic public and private-sector de-leveraging process.  This period of sluggish growth poses challenges to the government’s fiscal consolidation program, which we now assume will extend well into the next parliament”.  Oh, really – didn’t see that coming!  Talk about closing the stable door after the horse has bolted.

I would like to make two points:

1.  What took you so long?

The credit agencies should have cut the UK’s rating (and many others) in 2006/2007.  Any credit scoring system should be based on current trends and how they might move forward, i.e. based on an objective, proactive assessment of risks.  Instead, the credit rating agencies have become backward looking, reactive bodies.  Maybe, now is the rightr time to re-assess UK prospects and downgrade but, because no action was taken as things deteriorated before the 2008 credit crunch and nothing has been done in the 4+ years of downturn since, this move is well behind the curve.  Having done this sort of risk analysis for a major international bank in the past, I would judge that the UK’s rating should already be lower than it is now and we should be anticipating that the next move, though some way off, may be upwards rather than still wondering whether it’s going to come down again.

2.  What does it mean?

The main effect will be that the UK will have to pay more for it’s borrowing and this will encourage the sterling depreciation that is already underway (at least, against the dollar).  Gilt yields should rise and their prices should fall.  Some investors won’t like that, but gilts are already very over-priced and, like the rest of us, holders need to take some pain if a viable recovery is ever to get underway.  Yields are still only just above 2% (10-year) and with inflation staying above that for the foreseeable future are effectively losing money in real terms.  A recovery to a ‘normal’ yield curve would see such rates closer to 5.5%.  It may still be years before we get back to those rates but, for a sustainable, well-functioning recovery, the current situation is untenable and, again, behind the curve.  If the Moody’s downgrade starts a process of adjustment towards a better assessment of risk and return, we can all cheer that things are starting to adjust back to a better economic balance.

Finally, at the latest MPC meeting, the soon-to-leave Governor of the Bank of England voted for more gilt purchases and the soon-to-arrive Governor has indicated a willingness for further monetary stimulus.  I wonder if they are facing the wrong way.  Some of the recent business surveys suggest a bit more confidence is evident.  Without further monetary shocks, the real economy may start to move forward over the next year or so.  The monetary authorities, the markets and the credit raters should be planning for a return of growth rather than a maintenance the doldrums.  I think some indication that the next move at the short end of the yield curve will be upwards might actually help business and investor sentiment about the future.  The horse needs to get some real growth exercise outside the monetary stable.

The universe is made of matter and energy, but the boundaries between the two can seem to blur.  For example, physicists say light is made up of particles (matter) that behave like a wave (energy).  The quantum boundary between the two remains somewhat of a mystery – at least to me.

Money is similar but not exactly the same.  It appears to have economic mass and generate gravity: like matter, money attracts money and appears capable of destruction (through inflation) or expansion (through real growth).  It also appears to have economic energy, fuelling a range of supply and demand chains that suggest “what goes around comes around”.  Money can be sucked into a black hole (the event horizon of a debt-deflation induced liquidity trap) or it can be ejected out to grow new business stars with planets where new species (living standards) can evolve.  Creative destruction is a force of physics and economics.

Does monetary economics have the equivalent of the physics laws of thermodynamics concerning the conservation of energy and the process of entropy?  Yes, in the sense that the monetary system is always in balance – for every credit there is a debit, for every export there is an import,  - and yet it does seem to degrade over time (discounting the future).  Work and order are finite in the economy as well as the physical universe.  In both, some chemistry of creation and destruction seems all too natural

Bankers, whether central, investment or high street, have found ways to innovate with money over the years to influence the development of these laws of “flationarydynamics”.   Sometimes they goes too far – causing imbalances in stocks and flows that upset normal market functions and cause eruptions – supernovae that eliminate existing structures and trends.  Yet, in the death of one monetary star, the seeds of creation are soon.  New, more complex elements emerge to enrich the next cycle of growth.  Sometimes financial innovation, including in response to crises, can add real value, reallocating resources in a way that makes markets more efficient through new businesses, products, processes and markets.  New stars with complex elements that fuel recovery and development.

Right now the question is has the destructive phase of the 2008 financial supernova run its course or has it further to go before some new money-stars are born.  An optimist looks to new technologies, inventions and organisations, as well as the skills and creativity of the young, for our salvation.  The pessimist sees only the debt hangover, fiscal austerity, the low velocity of money and structural logjams.

The cycle turns but, in this period of “monetary physics”, we know not when.  As yet, it’s still long run opportunity and short term threat.  Just perhaps, however, we are getting nearer to the turn in confidence we need.

The UK economy was flat (zero growth) in 2012, as measured by the real GDP series.  That simple statement hides lots of detail.

• First, three of the quarters fell from the previous ones and the third quarter positive merely reflected special effects related to the Jubilee and the Olympics.
• Second, the output level remained below its pre-recession peak (3.2% at the end of the year).  The downturn is likely to reach 5 years at the end of this quarter.
• Third, there is little or no sign of industrial rebalancing.  The sector breakdown for 2012 is revealing: government +1.9%, business and financial services +1.3%, utilities +1.0%, distribution services (including retailing) +0.7%, transport and communications -0.1%, manufacturing -1.8%, agriculture -3.0%, construction -9.3%, and mining and quarrying -11.0%.  What happened to the Coalition assertion that government will be substituted with manufacturing?

As well as no growth, inflation and unemployment were stuck at high rates in 2012, averaging about 3% and 8% respectively.  There was some adjustment from public sector to private sector employment, but this was more rebadging than rebalancing.  In year-on-year terms, UK industrial production fell every month (in November, the level of industrial production was nearly 15% below its May 2007 peak).  The fiscal deficit grew larger (public sector net debt now over 70% of GDP) and the trade deficit remained huge (averaging close to £10bn a month for goods).  Again, there is little or no evidence of rebalancing towards a more productive, growing economy.

The cyclical drivers of so little real change in economic structures and trends is twofold: a lack of supply productivity that is dis-incentivising investment and a lack of discretionary domestic demand that is constraining household consumption.  At the same time, international conditions remain adverse, with the US ‘fiscal cliff’ and debt ceiling debates, the Euro-zone countries in depression, slower growth in the Far East, and continuing balance sheet adjustment in international banking.  Although necessary for the long term, global debt reduction continues to depress current growth.

One hopeful sign is that stock markets are making progress, reflecting positive corporate liquidity and profitability as well as uncertainty over alternative investments.  Private funds are available for corporate growth if confidence can be restored and uncertainty removed.  So, breaking these “stuck flat” barriers is key to growth in 2013 and beyond.  This probably means a different policy balance than loose money and tight fiscal stabilisation – probably, higher interest rates, lower taxes and more capital spend….