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….

Happy New Year to all Strategic Economics readers.

This first blog of 2013 looks at reasons why the economy will remain constrained and suggests how business and agencies should react.

The New Year started with US policy makers pulling back from the ‘fiscal cliff’.  The ‘cliff’ represented a mixture of legislated tax increases and spending cuts that would have undermined economic growth, at least in the short term.  The last minute political agreement avoided immediate market panic but merely delayed the real decisions that Washington needs to take to address its long-term fiscal imbalances.  The next decision will be about extending the debt ceiling (March).

At last, it has become clear to many more people that underlying US fiscal problems are at least as bad as those in the euro-zone.  The process and progress towards fiscal sustainability, in America and Europe, will be a recurring theme for the markets and the news media through 2013.  The question is whether this keeps the level of uncertainty high enough to suppress confidence in business investment and, thereby, to restrain real growth.

Uncertainty about fiscal austerity is not the only drag on growth.  Another factor is the historically unusual low level and change in UK productivity.  In the third quarter of 2012, for example, three measures of productivity – output per worker, output per job and output per hour, were lower than they were a year earlier.  Indeed, this data – just released – shows UK output per hour was 2.4% below its year ago level and still 3.3% below the level achieved at the peak before the downturn in the second quarter of 2008.

It is very unusual to have productivity still falling in the fifth year after the onset of a recession.  After the 1973, 1979 and 1990 recessions, productivity had recovered to well above previous peaks by now.  The failure to do so after 2008 is stark.

Productivity growth is a key indicator of the different path the economy is taking this time around.  Usually, the pattern is: 1) output drops before employment and, therefore, productivity plummets; 2) but when employment then declines, and output hits bottom, productivity starts to improve; and 3) that improvement boosts returns and encourages new corporate investment to fuel the recovery.  This time, less severe rises in unemployment and persistently flat output have meant on-going low productivity that is dissuading business investment.  Since the government is also cutting back on its investment to address fiscal deficits, the real economy is effectively stuck.  We need a return to productivity growth before any recovery in growth can be sustained.

Of course, there are other factors at work in this UK downturn, including 1) constraints on access to bank credit, 2) the liquidity trap induced by prolonged loose monetary policy, 3) falling real household incomes and 4) the global malaise in trade.  Nevertheless, as we enter 2013, my main diagnosis and prognosis of why the economy will remain sluggish is this underlying combination of fiscal austerity and low productivity.

At a local level, this economic background implies a need to raise the productivity of local businesses.  The quickest way for a firm to do that is to reduce hours and/or sack people.  Some companies will have to do this if demand remains below capacity and undermines financial viability.  However, unless ‘surplus labour’ is reallocated to growing businesses quickly – unlikely in current macro conditions, one company’s need to lay off staff risks being another company’s drop in final demand: a potential negative spiral.

Therefore, a longer term approach to growth is required.  The productivity-led growth chain requires entrepreneurial development of capacity and capability … in other words, investment with/through innovation and skills.  It also requires entrepreneurial engagement in market competitiveness – at all geographies.  Local business will outperform its peers if it can “do things better” and “do better things’, by reaching out for new methods, new outputs and new markets.  The issue is whether the confidence and incentives exist at a micro level that can boost local development despite the suppressed overall macro ‘new normal’.

Let’s hope that the business representatives running the Local Enterprise Partnerships can recognise and shape these priorities as they develop their ‘Heseltine Growth Strategies’.  Strategic Economics stands ready to help.

At the end of 2012, we look backwards and forwards: backwards to a year of recession and forwards to a year of … whisper it, a modest hope of recovery?

The last 12 months have been exciting ones for Strategic Economics Ltd, developing the analysis and advice business for public and private clients across southern England, and feeding the intelligence and explanation demands of various media.  Thank you to all who have helped us survive and provided supportive criticsm.

For the economy, however, there were more downs than ups.  The international economy continued to be buffeted by a series of ‘shocks’ and constraints: from the ongoing pain of the euro-debtors, through the remorseless strain of widespread fiscal austerity, to the runaway train of the US fiscal cliff.  There were so many reasons for investors of all types to ‘wait and see’ – to sit on their hands rather than to take risks.

The UK economy entered 2012 in recession and this continued through the first half of the year.  Then, the second half of the year was effectively flat.  Most of southern England followed this overall pattern.  With some notable exceptions in specialist, high-technology exporting, many industries and businesses, especially those dependent on consumer and government spending, have had to adjust behaviour and planning for a more competitive and smaller economy.  With household employment and real incomes still declining and state and local budgets still shrinking, there are no signs that demand is going to accelerate and stimulate strong growth soon.

Looking into 2013, then, all the forecasts are fairly negative: a bit more growth than in 2012 but not enough to address high unemployment, to remove business uncertainty, to spark exports, or to limit public deficits.

Is there anything that could suggest we may be surprised on the upside?  Perhaps, two factors will help.  First, on the supply side, many businesses remain in reasonable financial shape.  Having hunkered down for a while and still facing difficult, highly competitive trading conditions, the positive response may be finally to invest for the future in new products and services, new markets and new skills.  To survive the ‘new economy’ of less access to external finance, less government stimulus and less reliance on traditional processes and behaviours, the winners will be the entrepreneurs and innovators who grasp the opportunities of change by taking intelligent risks for high potential returns.

Second, on the demand side, we have to look abroad to what the OECD calls a “hesitant and uneven” recovery and the IMF “only a gradual strengthening”.  If the US fiscal cliff is avoided and the euro-zone does not drown in the Mediterranean sea of debt, there is some prospect that the international economy, overall, will be somewhat stronger.  The key task, then, is to find the sector segments and markets that are growing better than most and where UK suppliers can increase their market share.  Again this means, private investment of time and money to eke out opportunity.

In its widest sense, private investment is key to being pleasantly surprised by the economy in 2013.   An this requires positive incentives from the public sector – from the Treasury to the LEPs.  Meanwhile, we wish a happy and prosperous New year to all.

Monetary economics starts with the equation MV = PT where M is the money supply, V is the velocity of money, P is prices and T is transactions.  In other words, in a particular period, the amount of real activity in the economy (T) times the aggregate price level (P) gives us the total amount of economic activity in the economy in nominal (£) terms.  It is equivalent to the amount of money in the economy (M) times the number of times that money turns over (is passed from hand to hand) i.e. V.

In normal times, V is considered to be fairly predictable or, at least, is the residual from the other three.  Also, T follows a fairly well-known path around the established underlying trend rate of real growth for the economy.  Therefore, there is a strong link between the growth in the money supply (change in M) and the rate of inflation (change in P).  In recessions, when T stalls, upward pressure on P drops, V slows a bit and M a lot.

To get things going again, central banks try to accelerate M (quantitative easing etc) so that, with P constrained and V stable), it stimulates T and the economy starts to improve.  Well, that’s the theory.  This time, however, the big increase in M has not followed through to T.  With P now easing, this can only mean V has plummeted. In other words, there is plenty of money (M) around for recovery but it’s stuck – not getting through to T, as the banks and others sit on their hands.  The problem is V: getting the money to turn around more often because spending is picking up.  And, that needs confidence.

This is why the austerity debate is so fierce.  Households aren’t spending because their real incomes are dropping.  Businesses aren’t spending because of the uncertainty about demand and the low availability of credit.  Net trade is negative because EZ (and other) markets are restricted.  Meanwhile, of course, there’s no relief from governments, who are cutting back too.  It is hard for V and T to be more positive against all these headwinds.  Then, there’s the risk that if/when V does turn more positive, the sudden rise in MV goes more into P than T i.e. stagflation.

Anyway, we can use the basic equation MV = PT to explain a lot about what’s going on in the economy.  Unfortunately, it’s easy to say we need V to turn around, but it’s not easy to predict when or how.

The Fed has launched QE3.  The ECB has OMT.  The BoE has FFL.  Whatever the scheme, it name and its details, the idea is to put more money in to the economic dock to stop the economy’s boat grounding on the bottom whilst the economic tide runs out.

It assumes there is a large output gap to be filled without risking future inflation.  It assumes fiscal policy can not be used stimulate any growth.  Indeed, it is subtracting from growth to get public debts down.  It assumes banks will pass on the funds to the real economy, where private businesses and consumers will spend it and generate demand, bringing the tide back in.  It assumes the policy can be reversed later before the dock overflows into a flood of 1970s-style inflation.

The key is what is the output gap – the difference between what the economy could produce in ‘normal’ times and what it is producing today.  Better economists than I spend hours calculating these things but, in the end, no one really knows accurately because the economy is a dynamic process of resource use, investment and depreciation.  For example, we know the unemployed are a waste of potential productivity but we don’t know precisely how that potential is being eroded by prolonged inactivity – the rate of human capital depreciation.  We can and should make educated guesstimates but we never know for sure.

One important issue is where do we start from.  Do we measure the trend rate of growth from the peak (early 2008) or do we judge that 2008 was an unrealistic ‘boom’ and we need to start lower, say 2005/6.  This is vital because assuming the peak as ‘normal’ means a bigger output gap measure now which means more liquidity can be poured into the dock without risking an overflow later.  Alternatively, if we take a lower starting point, less monetary stimulus is sustainable right now.

My analysis favours the latter view.  Therefore, I fear the central banks are adding too much liquidity.  In the short run, this does help things – keeping the boat afloat, including risk assets such as stocks and shares.  In the long run, however, there will be an inflationary reckoning.  Hopefully, I’m wrong.  Moreover, I can understand that the immediate concern about grounding the economic boat on a stony bottom is more urgent than the uncertainty of inflationary floods later.  Nevertheless, I hope the monetary policy makers have a plan to reverse things before the inflationary storms come in.

The change in UK real GDP in Q2 2012 was revised to -0.5% q/q.  Despite this “upwards” revision, the recession has been harsh and, if anything, seems harsher.  In expenditure terms, consumption, investment and net trade were all deteriorating and negative in the April-June period.  In output terms, manufacturing, construction, distribution (including retail), business and financial services, and transport and communications were all declining too.  If there hadn’t been a big increase in stocks, GDP would have been down 1.7%!  There is no sign that July and August have been any better.

Special factors are blamed – extra bank holiday, Jubilee and Olympics, rainy weather and problems in the North Sea gas-fields.  Some even say, “Employment is not too bad, so the GDP fall must be exaggerated.  There will be a statistical exit from recession in the current quarter as these special factors reverse.”  But, usually, real GDP leads employment by 9-18 months not the other way around.  We must beware job losses this autumn and winter if companies start to adjust stock levels to lower world demand.  There is still some fear that we have yet seen the worst of this prolonged downturn.

The recession of 2008/9 was a precursor and a warning.  Loose monetary policy produced a ‘dead cat’ bounce in 2009-2011.  Tight fiscal policy, banking risks, euro sovereign default risks, and US election uncertainty have caused a further loss of momentum in 2011/12.  If we are to save 2012/13, potent measures to prevent further loss of confidence and activity are needed right now.  Infrastructure and other capital investment is needed for the long term.  But, to avoid depression, we need to stimulate current demand now by activating the monetary chain.  We now need anything that might get global demand moving forward again before our own caution and fear brings on the very thing we are worried about.

Yes, it could have inflationary negative side-effects and we still have to adjust debt to lower levels for government and households, but we need to save the patient from its life-threatening, acute crisis of inactivity before we can treat its chronic conditions of high monetary temperature.  Above all avoid depression.