Last week I met the Iveagh fund manager who touched on the shape of the recovery and it got me thinking about it in more detail. He says we are probably experiencing a v-shaped recovery and that he doesn’t see a double dip coming for economies or markets (although he has only become confident about this during the past 3 months). It made me think about what people would actually be seeing and feeling even if a double dip scenario was ‘in progress.’
The double dip scenario looks like a large W.
We have been down the first part of the w and are now climbing up the second part, so it could still be a V-shaped recovery. However, in order for markets to start this climb up the central part of the W there has to be something driving it. Therefore, one would need to see positive economic indicators and positive stock market sentiment to drive the rise, which is exactly where we are today.
If we were seeing predominantly negative indicators for the economy and stock market then it is unlikely that we would be climbing out of the trough and we would be experiencing something that more closely resembles an ‘L’.
In short, the optimism that we are seeing now, that is built on the belief that the worst is behind us and we are on a sustainable up-trend, is an essential part of a W-shaped recovery which means it is too early to discount the possibility of one occurring.
For the next stage of the W to pan out there would need to be something on the horizon that could derail an economic recovery and knock stock market sentiment. With interest rates at close to zero and government debt levels at record levels a combination of rising rates, higher taxation and government spending cuts is a foregone conclusion and could be the catalyst.
For the V-shape recovery to pan out we need to see growing consumer spending in the West, falling unemployment and stronger corporate investment. This will need to occur against the headwinds mentioned above.
I can see why an optimistic investor could argue that we are enjoying a V-shaped recovery but I also think that it is still too early to say that we are out of the woods as the current economic environment is as much a prerequisite for a W-shaped recovery as it is for a V-shaped recovery.
Wednesday, April 21, 2010
Monday, March 22, 2010
Is the commercial property sector facing a long-term decline in demand for shops and offices?
The government has announced it is going to put as many services as possible online in the next few years. Ministers and their advisers are currently drawing up plans to move the delivery of services relating to passports, job centres, benefit offices and town halls onto the internet. Tens of thousands of public sector jobs could be ‘streamlined’ as a result. This highlights a growing trend in society and suggests that we might already have enough shops and offices for our future needs. Modern life is evolving because technology is forcing rapid changes to the way we work and the way we live and this announcement to cut jobs in public services by automating processes and putting services online is only the tip of the iceberg. The internet is to 21st century industrialisation what the production line was to 20th century manufacturing.
Ever since dotcom euphoria started to take hold and online business began to look like it would change the world people have been claiming that the end of bricks and mortar business is in sight. We got slightly ahead of ourselves by a decade or two but things are changing rapidly now, driven by the need to cut costs, better technology, widespread wireless communication and a need to adapt to a new generation of adults that are completely at home in the virtual world of instant messaging, social networking, text messages and online commerce. These changes, at the very least, raise the question: how many more shops and offices do we really need?
According to a recent report commissioned by the British Council of Shopping Centres, one in five shopping centres in the UK are at risk of defaulting on loans, which suggests that demand for new retail space is weak whilst supply is still growing. There has been a huge amount of new retail space built during the consumer boom and this has continued to some extent during the past two years as lead time from planning to completion is quite long and shopping centres such as Newcastle’s new £170m mall that was opened in February this year will have been conceived before the UK went into recession. By mid-2008, just as the downturn hit home, the rate of retail space development was at its highest for 40 years. Some developments have been postponed since then and some projects have been cancelled altogether due to a lack of financing but there is also a drop in demand from retailers who are experiencing a downturn in consumer spending. It is possible that the nationwide volume of retail space when combined with the potentially long-term effects of the financial crisis could mean that we have sufficient supply for decades to come.
The huge expansion in personal loans, leasing, equity release, credit cards and mortgages in the years leading up to the start of the financial crisis has created what could turn out to be unnaturally high levels of consumer spending, especially in the UK. We are now seeing an increase in the savings rate as households attempt to unwind their high debt levels and this will have a negative impact on retail spending overall whilst it continues. This level of spending might fluctuate in the short term but for the next few years it could actually decline in real terms as consumers come to grips with weak pay increases, persistently high unemployment, reduced government spending, higher interest rates, higher inflation and higher taxes. A decline in spending power hits retailers directly and they may be forced to continue cutting costs and streamlining their operations. Past experience suggests that they will close underperforming stores and focus on improving sales from better-performing locations whilst trying to boost online sales as much as possible. The net effect could well be less need for new shops.
Technology is also having a significant impact on consumer shopping habits. According to Retail Decisions, a card payment business, online sales in the UK increased by 21% between 2008 and 2009 and up to 33 million people made a purchase online. There is a growing tendency for shoppers to spend their time in shops at weekends and then to make their purchases online during the week, with Monday traditionally being the busiest day for online sales. The role of shops is changing and they are often used by consumers simply as a means to physically view items before searching online for them at a better price. The rise of smart phones, such as the iPhone, and netbooks is also making this easier as shoppers are now able to obtain an online price comparison of an item whilst standing in a store looking at it. Portable widespread access to the internet is making it easier and quicker to shop around without moving and online retailers often have a price advantage because they don’t pay high rents for prime retail sites. The extrapolation of this trend, as 24hr online access and the prevalence of browser-enabled portable devices make accessing the internet much easier, suggests that online competition will continue to intensify for bricks and mortar-only businesses.
Demand for office space is another sector under threat on a long-term basis. Outside of London rents are expected to fall during 2010 due to oversupply and the public sector cutting back on workspace requirements. The need to be physically close to other people is diminishing rapidly as communication via the phone and the internet is improving and becoming more widespread. The ability to speak to people and to see them via a webcam is becoming more mobile, less expensive and of much higher quality. The idea of a face-to-face meeting between 2 people in separate cities is now entirely possible and the use of video-conferencing is expanding as it saves time and money whilst still enabling participants to read expressions and body language. Only the physical handshake is missing from the meeting.
The concept of working at a distance has been around for some time but there are certain catalysts that might cause a significant step-up in the evolution of the process. The financial crisis could be one such catalyst, especially if we see the economy drop back into recession, another could be a change in government policy such as tax breaks for those who are prepared to change their habits, but change will probably come more gradually. Advances in technology are making remote working easier and cheaper as mentioned and as companies have sought to cut costs during the recession they have reduced spending on business travel (high and rising fuel prices haven’t helped) and have looked at ways to reduce fixed overhead costs such as office space. The financial crisis has made ‘streamlining’ a priority for businesses that only needed to focus on managing expansion during the boom years and a drawn out period of weak growth could see this continuing for longer than usual.
One particular theme that is rapidly gaining prominence is the misery of commuting and congestion for workers travelling to and from their workplace on a daily basis. The sheer numbers of people moving around the country, especially at rush hours, makes the idea of working from home increasingly more appealing. The roads are already clogged up so imagine what they will be like in 10 or 20 years time if society continues on its current course. The threat of transport strikes as unions fight with employers and the government about pay rises only highlights how pointless so much commuting really is. Home working saves wasted time (some people spend 3 hours a day or more going to and from work), whereas commuting costs money, can be stressful and adds greatly to pollution. Whilst there will always be a need for certain jobs to be located in one single office, I believe it is unlikely that we will need a growing number of centralised workplaces over the longer-term when the alternative is becoming more feasible and more attractive.
I’m not suggesting that the construction industry will disappear, there will always be a need for new buildings, even as technology brings changes to requirements. For example, the adoption of the desktop computer helped automate offices but businesses also required new building designs to accommodate all the cabling under floors and through ceilings. In turn it is likely that changes in technology and their effects on our lives will create new ‘machines’ for living and working (as Le Corbusier described them). Online businesses require warehouses to store goods and an expansion in distance working could see more residential development being adapted to suit the requirement for work space in the home, but the net overall effect is that the migration of services into the online world could change the physical landscape of the country and this would have massive repercussions for the commercial property sector as it stands today.
Ever since dotcom euphoria started to take hold and online business began to look like it would change the world people have been claiming that the end of bricks and mortar business is in sight. We got slightly ahead of ourselves by a decade or two but things are changing rapidly now, driven by the need to cut costs, better technology, widespread wireless communication and a need to adapt to a new generation of adults that are completely at home in the virtual world of instant messaging, social networking, text messages and online commerce. These changes, at the very least, raise the question: how many more shops and offices do we really need?
According to a recent report commissioned by the British Council of Shopping Centres, one in five shopping centres in the UK are at risk of defaulting on loans, which suggests that demand for new retail space is weak whilst supply is still growing. There has been a huge amount of new retail space built during the consumer boom and this has continued to some extent during the past two years as lead time from planning to completion is quite long and shopping centres such as Newcastle’s new £170m mall that was opened in February this year will have been conceived before the UK went into recession. By mid-2008, just as the downturn hit home, the rate of retail space development was at its highest for 40 years. Some developments have been postponed since then and some projects have been cancelled altogether due to a lack of financing but there is also a drop in demand from retailers who are experiencing a downturn in consumer spending. It is possible that the nationwide volume of retail space when combined with the potentially long-term effects of the financial crisis could mean that we have sufficient supply for decades to come.
The huge expansion in personal loans, leasing, equity release, credit cards and mortgages in the years leading up to the start of the financial crisis has created what could turn out to be unnaturally high levels of consumer spending, especially in the UK. We are now seeing an increase in the savings rate as households attempt to unwind their high debt levels and this will have a negative impact on retail spending overall whilst it continues. This level of spending might fluctuate in the short term but for the next few years it could actually decline in real terms as consumers come to grips with weak pay increases, persistently high unemployment, reduced government spending, higher interest rates, higher inflation and higher taxes. A decline in spending power hits retailers directly and they may be forced to continue cutting costs and streamlining their operations. Past experience suggests that they will close underperforming stores and focus on improving sales from better-performing locations whilst trying to boost online sales as much as possible. The net effect could well be less need for new shops.
Technology is also having a significant impact on consumer shopping habits. According to Retail Decisions, a card payment business, online sales in the UK increased by 21% between 2008 and 2009 and up to 33 million people made a purchase online. There is a growing tendency for shoppers to spend their time in shops at weekends and then to make their purchases online during the week, with Monday traditionally being the busiest day for online sales. The role of shops is changing and they are often used by consumers simply as a means to physically view items before searching online for them at a better price. The rise of smart phones, such as the iPhone, and netbooks is also making this easier as shoppers are now able to obtain an online price comparison of an item whilst standing in a store looking at it. Portable widespread access to the internet is making it easier and quicker to shop around without moving and online retailers often have a price advantage because they don’t pay high rents for prime retail sites. The extrapolation of this trend, as 24hr online access and the prevalence of browser-enabled portable devices make accessing the internet much easier, suggests that online competition will continue to intensify for bricks and mortar-only businesses.
Demand for office space is another sector under threat on a long-term basis. Outside of London rents are expected to fall during 2010 due to oversupply and the public sector cutting back on workspace requirements. The need to be physically close to other people is diminishing rapidly as communication via the phone and the internet is improving and becoming more widespread. The ability to speak to people and to see them via a webcam is becoming more mobile, less expensive and of much higher quality. The idea of a face-to-face meeting between 2 people in separate cities is now entirely possible and the use of video-conferencing is expanding as it saves time and money whilst still enabling participants to read expressions and body language. Only the physical handshake is missing from the meeting.
The concept of working at a distance has been around for some time but there are certain catalysts that might cause a significant step-up in the evolution of the process. The financial crisis could be one such catalyst, especially if we see the economy drop back into recession, another could be a change in government policy such as tax breaks for those who are prepared to change their habits, but change will probably come more gradually. Advances in technology are making remote working easier and cheaper as mentioned and as companies have sought to cut costs during the recession they have reduced spending on business travel (high and rising fuel prices haven’t helped) and have looked at ways to reduce fixed overhead costs such as office space. The financial crisis has made ‘streamlining’ a priority for businesses that only needed to focus on managing expansion during the boom years and a drawn out period of weak growth could see this continuing for longer than usual.
One particular theme that is rapidly gaining prominence is the misery of commuting and congestion for workers travelling to and from their workplace on a daily basis. The sheer numbers of people moving around the country, especially at rush hours, makes the idea of working from home increasingly more appealing. The roads are already clogged up so imagine what they will be like in 10 or 20 years time if society continues on its current course. The threat of transport strikes as unions fight with employers and the government about pay rises only highlights how pointless so much commuting really is. Home working saves wasted time (some people spend 3 hours a day or more going to and from work), whereas commuting costs money, can be stressful and adds greatly to pollution. Whilst there will always be a need for certain jobs to be located in one single office, I believe it is unlikely that we will need a growing number of centralised workplaces over the longer-term when the alternative is becoming more feasible and more attractive.
I’m not suggesting that the construction industry will disappear, there will always be a need for new buildings, even as technology brings changes to requirements. For example, the adoption of the desktop computer helped automate offices but businesses also required new building designs to accommodate all the cabling under floors and through ceilings. In turn it is likely that changes in technology and their effects on our lives will create new ‘machines’ for living and working (as Le Corbusier described them). Online businesses require warehouses to store goods and an expansion in distance working could see more residential development being adapted to suit the requirement for work space in the home, but the net overall effect is that the migration of services into the online world could change the physical landscape of the country and this would have massive repercussions for the commercial property sector as it stands today.
Wednesday, March 3, 2010
The Nightmare Scenario for Britain’s Property Market.
The nations favourite conversational subject for many years has been that of house prices and the state of the property market. In spite of a significant downturn in the market since the credit crunch began, we have recently seen evidence of a revival in prices and renewed enthusiasm for the sector as we hear reports of auction houses crowded with property developers looking for a bargain. Buy-to-let investors seemed to have scraped though the crisis and property-related programmes show no signs of disappearing from our tv screens. It was a downturn but not the major crash so many people expected. But what if this was just a taste of what is still to come?
It looks like the huge drop in base rates to 0.5% has staved off a lot of potential pain for the nation’s homeowners but things could be very different if interest rates were forced to rise substantially. By current standards the 1970s and 1980s were characterised by persistently high Bank of England base rates, until they started to come down in the early 90s. These lower rates then laid the foundations for the rise in house prices that started in the mid-1990s and continued their seemingly-unstoppable ascension until the peak in 2007. However, the Bank of England has no more room for manoeuvre, base rates only have one possible course from here: up.
Under the current arrangement between the government and the Bank of England it is the Bank that is responsible for inflation targeting and it is inflation that is the most likely reason for interest rates to go higher. Whilst the Governor of the Bank of England was recently forced to write a letter of explanation to the Chancellor, as inflation reached 3.5% year-on-year in January, the Bank still expects inflation to fall back below this level later in 2010. However, there are growing signs that inflation may yet become a force to be reckoned with.
The Pound has dropped nearly 5% against the Euro in just over two weeks. Europe is the UK’s largest trading partner and the falling Pound means that imports from the Eurozone have suddenly become significantly more expensive. Sterling has also recently weakened against most other currencies, many of which have their own problems to face, which indicates the low esteem in which it is held today. The UK’s dire financial situation and the threat of a hung parliament have led investors to reassess our ability to pay down debt and this is weighing on the Pound, to the extent where some commentators are talking of the Pound/Euro exchange rate falling below parity and with the possibility that the Pound will keep on falling beyond that level.
Whilst UK exports would undoubtedly benefit from a weak Pound the reality is that life in the UK today relies heavily on imports and a severe drop in the Pound pushes up prices for everyone. If the government decides that Sterling has weakened too much, to the point where it seriously undermines the fiscal credibility of the currency, then the government may be forced to defend it, as it did in 1992 when Sterling was forced out of the ERM. Even though the currency is now free-floating and events would not exactly mirror those of Black Wednesday, the question remains: what action would the UK government take if a beaten down Pound meant that import prices were forced up sharply? This could soon feed through into inflation figures and everyone knows that strong inflation is very hard to tame once it becomes imbedded.
If UK interest rates were forced up suddenly to relatively high levels, in order to stifle inflation and to make the Pound more attractive, the effect on the UK property market could be devastating. House prices are still about 40% above their peak in the 1980s housing boom, even adjusted for inflation, and much of that rise has been fuelled by an expansion in mortgage lending. Household debt levels are still high, there are still plenty of examples of high levels of corporate debt (especially in the commercial property sector) and now government debt levels are also very high. In the event that the interest rate on a large proportion of this borrowing was raised significantly then we can expect to see extremely severe stress in all sectors exposed to high debt levels and in particular the property market.
If the Pound continues to weaken substantially from here then it won’t be long before something needs to be done to support it. If rate rises aren’t forthcoming then Sterling could remain weak for some time and that means import prices will stay high. Either way, it’s not good news for the UK economy. Relatively few distressed assets have come onto the market during this recession because the banks have largely been able to service debt at historically low interest rates and they have therefore been able to avoid putting them up for sale but this could all change if interest rates are forced up. Rising yields on Greek sovereign debt have already highlighted how worries about debt servicing can push up interest rates on borrowing and the threat of a downgrade to the UK’s triple-A credit rating have been a reminder of concerns about the UK’s own fiscal situation.
Some hard choices will have to be made about how to deal with the UK’s debt burden at some point but it wouldn’t surprise anyone if it turned out that the political will to deal with the problem was lacking. Unless the economic situation improves without the requirement for ongoing government fiscal stimulus then investors will choose to avoid Sterling or they will demand a premium for holding it, both of which suggest that interest rates will need to rise. If this rise is badly managed by the Bank of England then the bond market will probably force a change. If interest rates shoot up then investors that managed to preserve their capital during the downturn, and who are not heavily leveraged today, could find that the investment opportunities of a lifetime might finally start to appear.
It looks like the huge drop in base rates to 0.5% has staved off a lot of potential pain for the nation’s homeowners but things could be very different if interest rates were forced to rise substantially. By current standards the 1970s and 1980s were characterised by persistently high Bank of England base rates, until they started to come down in the early 90s. These lower rates then laid the foundations for the rise in house prices that started in the mid-1990s and continued their seemingly-unstoppable ascension until the peak in 2007. However, the Bank of England has no more room for manoeuvre, base rates only have one possible course from here: up.
Under the current arrangement between the government and the Bank of England it is the Bank that is responsible for inflation targeting and it is inflation that is the most likely reason for interest rates to go higher. Whilst the Governor of the Bank of England was recently forced to write a letter of explanation to the Chancellor, as inflation reached 3.5% year-on-year in January, the Bank still expects inflation to fall back below this level later in 2010. However, there are growing signs that inflation may yet become a force to be reckoned with.
The Pound has dropped nearly 5% against the Euro in just over two weeks. Europe is the UK’s largest trading partner and the falling Pound means that imports from the Eurozone have suddenly become significantly more expensive. Sterling has also recently weakened against most other currencies, many of which have their own problems to face, which indicates the low esteem in which it is held today. The UK’s dire financial situation and the threat of a hung parliament have led investors to reassess our ability to pay down debt and this is weighing on the Pound, to the extent where some commentators are talking of the Pound/Euro exchange rate falling below parity and with the possibility that the Pound will keep on falling beyond that level.
Whilst UK exports would undoubtedly benefit from a weak Pound the reality is that life in the UK today relies heavily on imports and a severe drop in the Pound pushes up prices for everyone. If the government decides that Sterling has weakened too much, to the point where it seriously undermines the fiscal credibility of the currency, then the government may be forced to defend it, as it did in 1992 when Sterling was forced out of the ERM. Even though the currency is now free-floating and events would not exactly mirror those of Black Wednesday, the question remains: what action would the UK government take if a beaten down Pound meant that import prices were forced up sharply? This could soon feed through into inflation figures and everyone knows that strong inflation is very hard to tame once it becomes imbedded.
If UK interest rates were forced up suddenly to relatively high levels, in order to stifle inflation and to make the Pound more attractive, the effect on the UK property market could be devastating. House prices are still about 40% above their peak in the 1980s housing boom, even adjusted for inflation, and much of that rise has been fuelled by an expansion in mortgage lending. Household debt levels are still high, there are still plenty of examples of high levels of corporate debt (especially in the commercial property sector) and now government debt levels are also very high. In the event that the interest rate on a large proportion of this borrowing was raised significantly then we can expect to see extremely severe stress in all sectors exposed to high debt levels and in particular the property market.
If the Pound continues to weaken substantially from here then it won’t be long before something needs to be done to support it. If rate rises aren’t forthcoming then Sterling could remain weak for some time and that means import prices will stay high. Either way, it’s not good news for the UK economy. Relatively few distressed assets have come onto the market during this recession because the banks have largely been able to service debt at historically low interest rates and they have therefore been able to avoid putting them up for sale but this could all change if interest rates are forced up. Rising yields on Greek sovereign debt have already highlighted how worries about debt servicing can push up interest rates on borrowing and the threat of a downgrade to the UK’s triple-A credit rating have been a reminder of concerns about the UK’s own fiscal situation.
Some hard choices will have to be made about how to deal with the UK’s debt burden at some point but it wouldn’t surprise anyone if it turned out that the political will to deal with the problem was lacking. Unless the economic situation improves without the requirement for ongoing government fiscal stimulus then investors will choose to avoid Sterling or they will demand a premium for holding it, both of which suggest that interest rates will need to rise. If this rise is badly managed by the Bank of England then the bond market will probably force a change. If interest rates shoot up then investors that managed to preserve their capital during the downturn, and who are not heavily leveraged today, could find that the investment opportunities of a lifetime might finally start to appear.
Friday, November 6, 2009
Why 2009 is not 2003
This article was written at the start of September 2009.
There are many parallels one can draw with the stock market rally we have seen since mid-March (earlier in emerging markets) and that of the start of the last major stock market rally that started in 2003 and ended in 2007. Many investors appear to believe that, just like then, this is the start of a much longer bull market that could go on to reach the heights of the previous two bull markets. However, there are a number of reasons why this rally is very different from that of 2003 and many of the others throughout history with which it is being compared.
A good reason for comparing this rally with that in 2003 is that it began in the trough between the peak market levels of 2000 and 2007, both of which shared certain similarities in some important markets. For example, if you look at 15 year charts for the S&P500, the Nikkei 225, the FTSE All Share, the FTSE 100 and the CAC 40 you will see that they all shared double top formations with markets peaking at similar levels in 2000 and 2007. None of them have exactly the same pattern but there are clear similarities in the index levels which all peaked only a few percentage points apart.
The second interesting similarity is that each of these markets also bottomed out at around the same level in 2003 and 2009. Therefore, having peaked in 2007 at the same level as in 2000 and then rebounded from low points in 2003 and 2009 there now appears to be an assumption that we will see a second repeat of the climb back up to the highs of 2000 and 2007.
The bull market in stocks that peaked in 2000 was a big one. By the time the dotcom bubble had burst and investors realised that they may have overestimated the way the internet would change the world, individual stock valuations had reached new heights. The S&P500 had a PE of 46 by the end of 2001, a year in which the September 11th attacks in the US also contributed to negative investor sentiment and were blamed for a large number of companies issuing profit warnings. The market fell until the first half of 2003 before bottoming out.
The story behind the 2000-2003 market decline was very much about valuations. Stock prices had become far too inflated relative to earnings but that wasn’t the case when markets peaked in 2007. At the end of December 2007 the PE for the S&P 500 was 19.84, which is not cheap but is lower than in 2000 when it stood at 26 and especially compared to the 2001 valuation of 46. Instead of a simple overvaluation of stocks, the boom that led up to 2007’s peak was fuelled by increased earnings that had been inflated by a massive expansion in credit at the customer and corporate level.
A stock valuation which is inflated by exuberant investors is easily corrected by a stock market fall but the when the problem is of a more fundamental nature then a simple stock market correction does not solve the underlying problem. I would argue that we are seeing a long-term correction to corporate profits as a result of a global contraction in credit and the spending power that it afforded us, and this reflects a long-term change in the way the global economy works.
The 2000 bull market was fuelled by a bubble in stock valuations and when interest rates were lowered it was followed by a bubble in the accessibility of credit that fed into many elements of the wider economy, leading to a global property boom amongst other things. High market peaks leave investors with high expectations for future market peaks. If we are to see stock markets ‘recover’ to former levels within the next decade then it would appear that we need either a major positive fundamental change to the way the economy works or we need another bubble.
In my view it appears that there are more negative fundamental differences at play today than positive and there are several important differences between the economic environment of today and that of 2003 which suggest that this market rally will not be sustainable.
a) From 2002, US GDP was never technically in recession and in the period from 2000 to 2007 it never contracted for more than one quarter at a time, having shown negative growth on just two occasions. Conversely, from Q2 2008, US GDP contracted for 4 quarters in a row which suggests that the economy is in considerably worse shape today than it was during the last stock market crash. Many countries have experienced negative GDP growth whereas they didn’t during the last downturn.
b) The 2003 rebound was fuelled by pent up consumer demand that had been dampened after the 2000 stock market crash and also by the negative effect of 9/11. The US consumer had been able to continue his spending in spite of the supposed economic downturn and household consumption rose in every year from 2000 to 2007 . In 2003 consumers had the ability to spend whereas today they are far more indebted and they have more restricted access to credit, both of which will severely curtail their spending.
c) Today they are also more likely to be out of work. From 2000 to 2003 the US unemployment rate rose from 4% to 6%, which was a significant increase but was nothing compared to the change since mid-2007, when the US unemployment rate rose from 4.7% to 9.4% by July 2009 .
d) This year we have seen total US household debt shrinking whereas in 2002 and 2003 it was still growing as consumers were able to leverage the value of their properties and use money released from equity for other spending.
e) US house prices rose every year through 2000 to 2006 . This was a major boost to spending power and consumer confidence which is completely missing today. US house prices have fallen substantially since their peak thereby removing the ability and the desire to release equity for spending.
The flipside of the negative factors above is that government intervention directly into the economy during the last downturn was nowhere near as significant as today. Whilst quantative easing and the purchase of government bonds are an attempt to restore ‘normality’ to lending costs, the wider economy should today also feel the positive effects of the subsidies for new cars, tax cuts such as the UK cut in VAT and the US income tax rebates which put money directly into circulation. However, these schemes have had limited success because they encourage a short term spending spree, they bring forward spending that would have occurred later or they have diverted spending away from other areas of the economy. Some of this money has also been used to pay down debt or to rebuild savings. We also know that such methods of stimulation have a finite life, they can’t be sustained indefinitely, and they also have to be paid for at some point in the future.
Another example of ‘distortion’ in the market is that many companies have been kept alive by a combination of support from the government and financiers. In Italy only one publicly traded company has filed for bankruptcy this year even though many more are unable to pay their loans. In a normally operating free market many companies would have gone out of business and this would likely have had a more damaging effect on investor confidence and stock markets in general. It is another example of the difficult and unusual investing environment we have to contend with today.
The evidence shows us that much of the global economy is in a worse state today than it was in 2003 and that many of the problems that led to the credit crunch have not yet been solved. GDP growth in developed economies is forecast to be extremely weak for the foreseeable future, company directors who are selling their own stock outweigh those buying by a record amount, there are a record number of homeowners in negative equity (8m in the US) and 9% of US mortgage holders have defaulted, having missed at least one monthly mortgage payment. We are still at risk from banking collapses where banks have high exposure to commercial property lending, credit card debt or Eastern European investments. Unemployment is still rising in many countries.
It would appear that the global economy, and the environment for corporate profits, is considerably worse today than it was in 2003, yet the major stock markets have rallied significantly since their credit crunch lows. The factors I’ve highlighted above would tend to suggest that a recovery in corporate profits is far less certain than stock markets would have us believe and the higher markets go without a solution for the fundamental problems then the greater the likelihood of a major correction.
Several major stock markets have fallen no further than they did in the last bear market and this is supposed to be telling us that the worst recession since the 1930s actually has a relatively limited negative impact on corporate profits. With the exception of the financial sector, the valuations of most stocks have not fallen to the kind of low levels seen in previous bear markets. This does not make sense to me and it makes me doubt the validity of the forecast upturn. A v-shaped recovery was always seen as the least likely course of events but that is what markets appear to be pricing in. The points I’ve highlighted here suggest that a return to an economy similar to that experienced in 2003 looks like a rather distant possibility and investors could well be disappointed when economic reality fails to catch up with the stock market rally. The question is whether this results in a new downward leg of the bear market to new lows, or whether government intervention ensures that we only suffer a relatively minor correction and the markets remain on life support.
The Japanese were criticised for supporting ‘zombie’ banks during the lost decade of the 1990s, having failed to deal with the problem of non-performing loans in the banking sector, and it was this approach that was blamed for prolonging the severity of the downturn after their own stock and property market bubbles popped. I would argue that the leaders of the US and Europe are equally guilty of avoiding the need to take painful decisions and they are failing to address the underlying problems of the economy. Debt is being shifted from the private sector onto the shoulders of the taxpayer, companies that should fail are being saved from bankruptcy and over-indebted consumers are being incentivised to spend their way out of an economic crisis that was brought about by over-spending. These are short term solutions to long term problems and I fail to see what will provide the power to drive a sustainable stock market recovery from here. The factors that enabled the 2003-2007 bull market are not in place and there are no obvious alternatives in sight.
There are many parallels one can draw with the stock market rally we have seen since mid-March (earlier in emerging markets) and that of the start of the last major stock market rally that started in 2003 and ended in 2007. Many investors appear to believe that, just like then, this is the start of a much longer bull market that could go on to reach the heights of the previous two bull markets. However, there are a number of reasons why this rally is very different from that of 2003 and many of the others throughout history with which it is being compared.
A good reason for comparing this rally with that in 2003 is that it began in the trough between the peak market levels of 2000 and 2007, both of which shared certain similarities in some important markets. For example, if you look at 15 year charts for the S&P500, the Nikkei 225, the FTSE All Share, the FTSE 100 and the CAC 40 you will see that they all shared double top formations with markets peaking at similar levels in 2000 and 2007. None of them have exactly the same pattern but there are clear similarities in the index levels which all peaked only a few percentage points apart.
The second interesting similarity is that each of these markets also bottomed out at around the same level in 2003 and 2009. Therefore, having peaked in 2007 at the same level as in 2000 and then rebounded from low points in 2003 and 2009 there now appears to be an assumption that we will see a second repeat of the climb back up to the highs of 2000 and 2007.
The bull market in stocks that peaked in 2000 was a big one. By the time the dotcom bubble had burst and investors realised that they may have overestimated the way the internet would change the world, individual stock valuations had reached new heights. The S&P500 had a PE of 46 by the end of 2001, a year in which the September 11th attacks in the US also contributed to negative investor sentiment and were blamed for a large number of companies issuing profit warnings. The market fell until the first half of 2003 before bottoming out.
The story behind the 2000-2003 market decline was very much about valuations. Stock prices had become far too inflated relative to earnings but that wasn’t the case when markets peaked in 2007. At the end of December 2007 the PE for the S&P 500 was 19.84, which is not cheap but is lower than in 2000 when it stood at 26 and especially compared to the 2001 valuation of 46. Instead of a simple overvaluation of stocks, the boom that led up to 2007’s peak was fuelled by increased earnings that had been inflated by a massive expansion in credit at the customer and corporate level.
A stock valuation which is inflated by exuberant investors is easily corrected by a stock market fall but the when the problem is of a more fundamental nature then a simple stock market correction does not solve the underlying problem. I would argue that we are seeing a long-term correction to corporate profits as a result of a global contraction in credit and the spending power that it afforded us, and this reflects a long-term change in the way the global economy works.
The 2000 bull market was fuelled by a bubble in stock valuations and when interest rates were lowered it was followed by a bubble in the accessibility of credit that fed into many elements of the wider economy, leading to a global property boom amongst other things. High market peaks leave investors with high expectations for future market peaks. If we are to see stock markets ‘recover’ to former levels within the next decade then it would appear that we need either a major positive fundamental change to the way the economy works or we need another bubble.
In my view it appears that there are more negative fundamental differences at play today than positive and there are several important differences between the economic environment of today and that of 2003 which suggest that this market rally will not be sustainable.
a) From 2002, US GDP was never technically in recession and in the period from 2000 to 2007 it never contracted for more than one quarter at a time, having shown negative growth on just two occasions. Conversely, from Q2 2008, US GDP contracted for 4 quarters in a row which suggests that the economy is in considerably worse shape today than it was during the last stock market crash. Many countries have experienced negative GDP growth whereas they didn’t during the last downturn.
b) The 2003 rebound was fuelled by pent up consumer demand that had been dampened after the 2000 stock market crash and also by the negative effect of 9/11. The US consumer had been able to continue his spending in spite of the supposed economic downturn and household consumption rose in every year from 2000 to 2007 . In 2003 consumers had the ability to spend whereas today they are far more indebted and they have more restricted access to credit, both of which will severely curtail their spending.
c) Today they are also more likely to be out of work. From 2000 to 2003 the US unemployment rate rose from 4% to 6%, which was a significant increase but was nothing compared to the change since mid-2007, when the US unemployment rate rose from 4.7% to 9.4% by July 2009 .
d) This year we have seen total US household debt shrinking whereas in 2002 and 2003 it was still growing as consumers were able to leverage the value of their properties and use money released from equity for other spending.
e) US house prices rose every year through 2000 to 2006 . This was a major boost to spending power and consumer confidence which is completely missing today. US house prices have fallen substantially since their peak thereby removing the ability and the desire to release equity for spending.
The flipside of the negative factors above is that government intervention directly into the economy during the last downturn was nowhere near as significant as today. Whilst quantative easing and the purchase of government bonds are an attempt to restore ‘normality’ to lending costs, the wider economy should today also feel the positive effects of the subsidies for new cars, tax cuts such as the UK cut in VAT and the US income tax rebates which put money directly into circulation. However, these schemes have had limited success because they encourage a short term spending spree, they bring forward spending that would have occurred later or they have diverted spending away from other areas of the economy. Some of this money has also been used to pay down debt or to rebuild savings. We also know that such methods of stimulation have a finite life, they can’t be sustained indefinitely, and they also have to be paid for at some point in the future.
Another example of ‘distortion’ in the market is that many companies have been kept alive by a combination of support from the government and financiers. In Italy only one publicly traded company has filed for bankruptcy this year even though many more are unable to pay their loans. In a normally operating free market many companies would have gone out of business and this would likely have had a more damaging effect on investor confidence and stock markets in general. It is another example of the difficult and unusual investing environment we have to contend with today.
The evidence shows us that much of the global economy is in a worse state today than it was in 2003 and that many of the problems that led to the credit crunch have not yet been solved. GDP growth in developed economies is forecast to be extremely weak for the foreseeable future, company directors who are selling their own stock outweigh those buying by a record amount, there are a record number of homeowners in negative equity (8m in the US) and 9% of US mortgage holders have defaulted, having missed at least one monthly mortgage payment. We are still at risk from banking collapses where banks have high exposure to commercial property lending, credit card debt or Eastern European investments. Unemployment is still rising in many countries.
It would appear that the global economy, and the environment for corporate profits, is considerably worse today than it was in 2003, yet the major stock markets have rallied significantly since their credit crunch lows. The factors I’ve highlighted above would tend to suggest that a recovery in corporate profits is far less certain than stock markets would have us believe and the higher markets go without a solution for the fundamental problems then the greater the likelihood of a major correction.
Several major stock markets have fallen no further than they did in the last bear market and this is supposed to be telling us that the worst recession since the 1930s actually has a relatively limited negative impact on corporate profits. With the exception of the financial sector, the valuations of most stocks have not fallen to the kind of low levels seen in previous bear markets. This does not make sense to me and it makes me doubt the validity of the forecast upturn. A v-shaped recovery was always seen as the least likely course of events but that is what markets appear to be pricing in. The points I’ve highlighted here suggest that a return to an economy similar to that experienced in 2003 looks like a rather distant possibility and investors could well be disappointed when economic reality fails to catch up with the stock market rally. The question is whether this results in a new downward leg of the bear market to new lows, or whether government intervention ensures that we only suffer a relatively minor correction and the markets remain on life support.
The Japanese were criticised for supporting ‘zombie’ banks during the lost decade of the 1990s, having failed to deal with the problem of non-performing loans in the banking sector, and it was this approach that was blamed for prolonging the severity of the downturn after their own stock and property market bubbles popped. I would argue that the leaders of the US and Europe are equally guilty of avoiding the need to take painful decisions and they are failing to address the underlying problems of the economy. Debt is being shifted from the private sector onto the shoulders of the taxpayer, companies that should fail are being saved from bankruptcy and over-indebted consumers are being incentivised to spend their way out of an economic crisis that was brought about by over-spending. These are short term solutions to long term problems and I fail to see what will provide the power to drive a sustainable stock market recovery from here. The factors that enabled the 2003-2007 bull market are not in place and there are no obvious alternatives in sight.
Friday, March 20, 2009
Some of my views on the Fed move to buy treasuries.
The Fed announced this week that it will spend $300 billion buying US treasuries, presumably to bring down interest rates and to increase market liquidity (weren’t treasuries already liquid?). In the same week we have seen a drop in the Dollar and a significant rise in the oil price, the gold price and other commodity prices. OPEC probably can’t believe their luck, having only just announced that they would not be cutting production quotas further in light of the severity of the economic downturn.
Whilst it is early days, the rise in commodity prices raises some significant questions about the targeting and validity of the Fed policy. As well as bringing down interest rates the buying of treasuries is also another way of putting money back into the financial system, with the aim of feeding through to the wider economy and keeping inflation alive (specifically to avoid deflation).
Real world inflation is generally driven by two factors (ignoring specific supply bottlenecks) that cause prices to rise: wage growth and credit expansion. The 10 year US treasury yield is currently 2.6% which would suggest that it is not high interest rates that are stopping credit expansion. Extra liquidity in the system could help but what is really needed would be widespread take up of new credit by companies and consumers (not just a rolling over of existing debt, which wouldn’t be expansion). I would argue that most companies and consumers are still in deleveraging mode and will be for some time. I think credit expansion on a meaningful scale is unlikely to happen yet, maybe not for a long time.
Will the new Fed spending encourage wage growth? Not unless companies start experiencing increased demand (which won’t happen without greater disposable income for consumers, which itself would be a result of higher wages or lower outgoings). Wage demands that are satisfied by employers, are driven by rising prices in an economy but only where they arise from increased demand for goods and services. In the current environment workers will want higher wages because the cost of basic materials such as food and energy are rising but will employers be inclined to give them without a commensurate rise in demand for the goods they produce? Long gone are the days when an employer such as Henry Ford believed that paying higher wages to his employees would enable more of them to buy his cars.
So what if the Fed’s policy actually turns out to be damaging to the economy? In the period of a few short days the net result of the Feds treasury-buying policy is that it has pushed up oil, metal and various other food and energy commodities. The costs of production just got higher. So far, investor demand for inflation-hedging commodities has been sufficient to move their prices in anticipation of the higher inflation rates that could follow. However, if the net result of the Fed’s policy is to push up commodity prices initially, but it doesn’t feed into wages or credit expansion for the reasons mentioned above, then it is likely to put a brake on any hint of economic recovery that might have been occurring.
We are in unprecedented times and it is entirely feasible, in my humble opinion (!), that the Fed may be on the wrong path and it may actually prolong the pain of a recession. Higher prices are only desirable in the current situation if they lead to wage growth and reasonable credit expansion but if they only succeed in pushing up producer input prices before economic demand recovers then they are unlikely to get a warm welcome from either consumers or companies.
Whilst it is early days, the rise in commodity prices raises some significant questions about the targeting and validity of the Fed policy. As well as bringing down interest rates the buying of treasuries is also another way of putting money back into the financial system, with the aim of feeding through to the wider economy and keeping inflation alive (specifically to avoid deflation).
Real world inflation is generally driven by two factors (ignoring specific supply bottlenecks) that cause prices to rise: wage growth and credit expansion. The 10 year US treasury yield is currently 2.6% which would suggest that it is not high interest rates that are stopping credit expansion. Extra liquidity in the system could help but what is really needed would be widespread take up of new credit by companies and consumers (not just a rolling over of existing debt, which wouldn’t be expansion). I would argue that most companies and consumers are still in deleveraging mode and will be for some time. I think credit expansion on a meaningful scale is unlikely to happen yet, maybe not for a long time.
Will the new Fed spending encourage wage growth? Not unless companies start experiencing increased demand (which won’t happen without greater disposable income for consumers, which itself would be a result of higher wages or lower outgoings). Wage demands that are satisfied by employers, are driven by rising prices in an economy but only where they arise from increased demand for goods and services. In the current environment workers will want higher wages because the cost of basic materials such as food and energy are rising but will employers be inclined to give them without a commensurate rise in demand for the goods they produce? Long gone are the days when an employer such as Henry Ford believed that paying higher wages to his employees would enable more of them to buy his cars.
So what if the Fed’s policy actually turns out to be damaging to the economy? In the period of a few short days the net result of the Feds treasury-buying policy is that it has pushed up oil, metal and various other food and energy commodities. The costs of production just got higher. So far, investor demand for inflation-hedging commodities has been sufficient to move their prices in anticipation of the higher inflation rates that could follow. However, if the net result of the Fed’s policy is to push up commodity prices initially, but it doesn’t feed into wages or credit expansion for the reasons mentioned above, then it is likely to put a brake on any hint of economic recovery that might have been occurring.
We are in unprecedented times and it is entirely feasible, in my humble opinion (!), that the Fed may be on the wrong path and it may actually prolong the pain of a recession. Higher prices are only desirable in the current situation if they lead to wage growth and reasonable credit expansion but if they only succeed in pushing up producer input prices before economic demand recovers then they are unlikely to get a warm welcome from either consumers or companies.
Monday, September 8, 2008
Is the luxury car market facing long-term decline?
When you were little and you wanted to buy something your parents gave you the money, if you were lucky. Life was so much simpler when you didn’t have to worry about where the money came from, you just had to ask nicely for it (and do your homework). For many adults the first few years of the 21st century have seen this easy approach to shopping return and if you wanted to buy a car, the manufacturer or the dealer would offer you the money to buy it. If you look in detail at the car industry you see how cheap and easily available credit oils the wheels of this particular brand of commerce at so many levels and it has been especially successful at elevating the luxury end of the market into the mainstream.
The premium car market has boomed during the last decade, to the extent that in the UK the BMW 3 Series now outsells the Ford Mondeo, the Vauxhall Vectra and the Renault Clio. Throughout Europe BMW only sold 5000 less 3 Series than Ford sold Fiestas. The cars in the premium sector, even though they are considerably more expensive than their rivals, have enjoyed huge sales increases at the expense of the more mundane brands as people have been able to upgrade due to easily available finance. Some of the main beneficiaries of this step change in spending habits has been BMW, Mercedes (owned by Daimler) and Audi, all of whom have seen their luxury car ranges move into the mainstream. BMW and Mercedes in particular have benefited from the increase in demand for SUVs with their popular X5 and ML models, with Audi coming late to the game. According to the Society of Motor Manufacturers and Traders either Mercedes or BMW take the top place for sales in the Upper Medium, Luxury Saloon and Executive sectors of the UK car market. 4 out of the top 5 Sports cars on sales in the UK are German. In fact, German-owned marques dominate the top of all these sectors despite the fact that they tend to be more expensive than the equivalent models from other marques.
The expansion of the German car manufacturer’s sales in the last decade has come about as a direct consequence of rising aspirations and the ability to achieve them. Whilst ownership of a BMW or Mercedes used to signify a certain level of success, today these marques are accessible to a far more wide ranging section of society and they are a lot less exclusive than they used to be. In addition, new car ownership has increased in the UK so that we now have the youngest fleet of cars on the roads in Europe. This is probably best explained by the fact that the UK has the highest proportion of cars purchased with loans and it is this reason that explains why the premium car sector has been able to increase its market share.
Globally, one in three Daimler Group vehicles is bought on finance that is provided by the company itself. As well as being a major car manufacturer the Daimler Group is also the world’s largest manufacturer of trucks, and as economic activity around the world has increased, so has demand for their trucks. At BMW, nearly one in two vehicles is purchased using BMW-supplied finance and they also offer their own credit cards, home insurance and savings accounts in certain markets. To drive expansion of the distribution network they lend money to dealers to enable them to make property purchases and to buy stock and equipment. Last year nearly 20% of BMW Group profits came directly from their own financial services division. It’s clear that the ability to lend and borrow money is a crucial part of the business model for the major car companies.
However, the credit crunch has changed the dynamics of car retailing. Buyers are finding it more difficult to get credit, the credit is more expensive when they do get it and there are less people who can afford the monthly payments for a luxury car. Buyers are trading down or postponing their purchase. In the US, used car prices have plummeted, especially for large luxury cars and SUVs that tend to consume more fuel than smaller cars. This means that when clients who leased their cars trade them in, the residual values are much lower than had been forecast at the outset of the lease period. This is bad news for the car companies as it means they sell each leased car at a lower price and they have been forced to write down the value of their leasing books. Leased assets at BMW totalled $20 billion in 2007 and this year they have already increased their risk provisions for residual value risks and bad debts to €695 million.
BMW lent €8 billion to dealers last year and this money must also be at risk as car dealers fight weaker demand and higher operating costs. Pendragon, the UK’s largest car dealership group, recently announced that trading conditions were deteriorating and they have been cutting staff and other overheads to reduce costs. National car sales were down 18.6% in August compared to a year ago. Potentially more worrying, according to their 6 month statement of results Pendragon has in recent years made significant profits from the sale of its properties but the credit crunch has cut a swathe through the UK commercial property sector and this source of revenue is likely to be very weak, if not non-existent, for at least the next couple of years. The dealer’s best business hope is that revenue from parts and servicing continues to be strong but even this is likely to decline as people use their cars less frequently and more people take public transport rather than pay high petrol prices.
The modern day car business is one that is completely reliant on the availability of cheap and easily available credit. It drives almost every part of the business model, either directly or indirectly, and without this finance the industry could go into serious decline if the credit market fails to return to its former glory. The huge growth in the market for the luxury brands is going to reverse as people trade down and the major luxury manufacturers, especially the German marques, are going to see their business model come under severe pressure. It is possible to envisage a luxury car industry that experiences declining demand for years to come as UK consumers pay down debt, face rising unemployment and as a weak Pound pushes up import prices. A ‘luxury’ may once again become just that, rather than something that everyone can afford
The premium car market has boomed during the last decade, to the extent that in the UK the BMW 3 Series now outsells the Ford Mondeo, the Vauxhall Vectra and the Renault Clio. Throughout Europe BMW only sold 5000 less 3 Series than Ford sold Fiestas. The cars in the premium sector, even though they are considerably more expensive than their rivals, have enjoyed huge sales increases at the expense of the more mundane brands as people have been able to upgrade due to easily available finance. Some of the main beneficiaries of this step change in spending habits has been BMW, Mercedes (owned by Daimler) and Audi, all of whom have seen their luxury car ranges move into the mainstream. BMW and Mercedes in particular have benefited from the increase in demand for SUVs with their popular X5 and ML models, with Audi coming late to the game. According to the Society of Motor Manufacturers and Traders either Mercedes or BMW take the top place for sales in the Upper Medium, Luxury Saloon and Executive sectors of the UK car market. 4 out of the top 5 Sports cars on sales in the UK are German. In fact, German-owned marques dominate the top of all these sectors despite the fact that they tend to be more expensive than the equivalent models from other marques.
The expansion of the German car manufacturer’s sales in the last decade has come about as a direct consequence of rising aspirations and the ability to achieve them. Whilst ownership of a BMW or Mercedes used to signify a certain level of success, today these marques are accessible to a far more wide ranging section of society and they are a lot less exclusive than they used to be. In addition, new car ownership has increased in the UK so that we now have the youngest fleet of cars on the roads in Europe. This is probably best explained by the fact that the UK has the highest proportion of cars purchased with loans and it is this reason that explains why the premium car sector has been able to increase its market share.
Globally, one in three Daimler Group vehicles is bought on finance that is provided by the company itself. As well as being a major car manufacturer the Daimler Group is also the world’s largest manufacturer of trucks, and as economic activity around the world has increased, so has demand for their trucks. At BMW, nearly one in two vehicles is purchased using BMW-supplied finance and they also offer their own credit cards, home insurance and savings accounts in certain markets. To drive expansion of the distribution network they lend money to dealers to enable them to make property purchases and to buy stock and equipment. Last year nearly 20% of BMW Group profits came directly from their own financial services division. It’s clear that the ability to lend and borrow money is a crucial part of the business model for the major car companies.
However, the credit crunch has changed the dynamics of car retailing. Buyers are finding it more difficult to get credit, the credit is more expensive when they do get it and there are less people who can afford the monthly payments for a luxury car. Buyers are trading down or postponing their purchase. In the US, used car prices have plummeted, especially for large luxury cars and SUVs that tend to consume more fuel than smaller cars. This means that when clients who leased their cars trade them in, the residual values are much lower than had been forecast at the outset of the lease period. This is bad news for the car companies as it means they sell each leased car at a lower price and they have been forced to write down the value of their leasing books. Leased assets at BMW totalled $20 billion in 2007 and this year they have already increased their risk provisions for residual value risks and bad debts to €695 million.
BMW lent €8 billion to dealers last year and this money must also be at risk as car dealers fight weaker demand and higher operating costs. Pendragon, the UK’s largest car dealership group, recently announced that trading conditions were deteriorating and they have been cutting staff and other overheads to reduce costs. National car sales were down 18.6% in August compared to a year ago. Potentially more worrying, according to their 6 month statement of results Pendragon has in recent years made significant profits from the sale of its properties but the credit crunch has cut a swathe through the UK commercial property sector and this source of revenue is likely to be very weak, if not non-existent, for at least the next couple of years. The dealer’s best business hope is that revenue from parts and servicing continues to be strong but even this is likely to decline as people use their cars less frequently and more people take public transport rather than pay high petrol prices.
The modern day car business is one that is completely reliant on the availability of cheap and easily available credit. It drives almost every part of the business model, either directly or indirectly, and without this finance the industry could go into serious decline if the credit market fails to return to its former glory. The huge growth in the market for the luxury brands is going to reverse as people trade down and the major luxury manufacturers, especially the German marques, are going to see their business model come under severe pressure. It is possible to envisage a luxury car industry that experiences declining demand for years to come as UK consumers pay down debt, face rising unemployment and as a weak Pound pushes up import prices. A ‘luxury’ may once again become just that, rather than something that everyone can afford
Thursday, July 24, 2008
Why US debt makes the country vulnerable.
The US government now has $2061billion of Treasury Bills in circulation. This is effectively the size of the loan it has taken from the rest of the world in order to finance its economy and is one of the reasons that the US Dollar has depreciated so significantly against many other currencies over the last few years. Since 2001 the US Dollar has depreciated 43% against the Swiss Franc and 47% against the Euro. This depreciation has been fairly orderly but there are increasingly important reasons why a disorderly depreciation, or even a run on the currency, could occur.
The largest holder of T-bills is Japan with $592 billion, closely followed by China with $502 billion and the OPEC members who between them officially have $154 billion. However, a lot of OPEC members also own T-bills via proxy that are held in the UK. The high oil price has seen the foreign exchange reserves of these countries swelled with Dollars as oil is primarily priced in US Dollars. China has accumulated their holdings due to the huge levels of trade that are carried on with the rest of the world using Dollars. Japan has long been a keen buyer of T-bills but has recently started to reduce its holdings (by 3.6% in the last year). Asian central banks don’t publicise the allocation of their currency reserves but they hold about $4.35 trillion in total foreign exchange reserves and about 70% of these are thought to be Dollar-denominated. US Dollars and Dollar-denominated assets are held in a wide range of foreign countries, some of whom have strained political relations with the US due to the aggressive foreign policy of the Bush administration and one has to wonder how far they will bend to the will of a financially weak and economically exposed America.
There are several reasons why the US Dollar is exposed to geopolitical and investment risk in a way that hasn’t been seen before:
1) Several countries are now pursuing a policy of diversification away from the US Dollar in their foreign exchange reserves as they are still worried about further depreciation due to the declining economic environment in the US. The Euro is a potential beneficiary or a basket of currencies could be adopted. If everyone starts diversifying at the same time there is the risk of flight from Dollar assets that begins to become obvious to markets and which could cause other investors to panic. Whilst sovereign wealth funds are usually slow to act, they have indicated greater interest in investments in Europe and emerging markets as a way of diversifying their currency allocation as well as their asset allocations.
2) There is talk of the US losing its top investment grade rating and if this were to happen there could be a crisis of confidence in the Dollar. A downgrade would require the US to offer higher interest rates, which in turn is not good for the economy and could cause further Dollar weakness. The US has held a triple-A rating since 1917 but healthcare and social security costs are rising with no sign of a solution to their spiralling costs. The cost of financing military excursions in Afghanistan and Iraq also adds to the problem. America has been spending beyond its means for some time (hence the huge volume of T-bills in circulation) but there is a strong possibility that this strategy may have serious repercussions one day.
3) Several middle-eastern and Asian countries have pegged their currencies to the US Dollar and have had to lower their base rates in line with US rates, in spite of the fact that they are experiencing very high levels of inflation. Qatar is struggling with 14% inflation, Egypt 19%, Dubai 20%, Saudi 10%, UAE 11%. They are not suffering from the same economic woes as the US so interest rates of 2% are totally inappropriate. Middle-eastern countries have been forced to lower rates just as their economies are booming on the back of oil receipts and domestic investment is running at record levels. This divergence in economic fortunes has placed great strains on the Dollar peg and there is a chance that some countries might have to break it at some point, which could be extremely Dollar-negative.
4) The size of its outstanding debt to the rest of the world makes the US vulnerable to pressure in global political matters. If, for example, China wanted to have its way on an important political issue, it could infer that it was going to reduce its Dollar holdings due to lack of confidence in the currency. This kind of declaration would have hugely negative ramifications for the Dollar and the US economy and is something the US would be keen to avoid.
It is this fourth point that I wish to expand on. China is often seen as seen as the main threat to US domination in global politics due to its size, its economy and its military might. It now has a major bargaining advantage in its creditor status. Since China’s rise to prominence as a global economic power, its partial embrace of capitalist culture and its accession to the World Trade Organisation there hasn’t really been a significant dispute with the US. But what if this was to change one day? In the same way that Russia has become more confident and more belligerent as its economic wealth has grown, China could also adopt a more aggressive stance towards the US.
In some ways the economic strength of the US and its influence on the world stage has been sold out from underneath it by the sale of so many Treasury bills. A country such as China, which holds 19% of all the T-bills in circulation, might be able to dictate terms to the US or else it could threaten to sell off its holdings under the auspices of diversification or lack of confidence. Whilst this would mean that the value of all China’s Dollar-denominated foreign reserves were pummelled, it would ultimately survive. However, there would be a run on the US Dollar and it would decimate the US economic system. In one single bound China could overtake the US as the world’s most important economy and as the world’s premier superpower.
If China was to sell its US Dollar holdings at an accelerated rate then the value of the Dollar would collapse and interest rates would be forced up in order to support the currency. High interest rates would almost certainly send the US into a severe recession. It would also likely lose its triple-A credit rating which would exacerbate the problem. A stable currency is essential for any country to attract foreign investment and the Dollar has been propped up for a long time by the continued purchases of T-bills by overseas investors, particularly China due to the size of its holdings. It currently requires $2billion a day to finance the current account and if sovereign wealth funds stopped buying Dollars the deficit could balloon to unmanageable proportions. America’s role as the greatest economic power in the world would be at an end.
Other holders of Dollar-denominated assets such as Japan and the OPEC members would also suffer and they would certainly condemn China for taking such action but are their concerns enough for China to pass up the chance of moving up the rankings in the global economy? Wars have been started for less.
Whilst the chance of an economic attack on the US by China as described above might be considered fantasy, the fact remains that the US has put itself in a position where it is theoretically possible that such a strategy could be carried out and where the very hint of a threat by the Chinese could be extremely damaging. Sino-US relations have never been particularly friendly and the two countries have traditionally been seen as opponents, if not enemies. Maybe the struggle between Communism and Capitalism hasn’t completely disappeared after all and the Chinese have been merely biding their time.
The US has been quite vocal about the way it thinks China should manage its currency but it is not really in a position to dish out advice on a subject in which it is clearly not an expert. The current Bush administration continues to officially support a strong Dollar policy but the reality is somewhat different and they are kidding no-one. Either the US has no control over its own currency or the huge depreciation in the value of the Dollar was what they wanted all along. However, today the US has clearly lost a large degree of control over its currency, and by association its economy, because it has put itself in the position of debtor to China (and to other countries) and this makes the US a riskier place to invest than is widely perceived, regardless of its current credit rating. A rapid sale of US treasuries by China might seem like a black swan event but it is one that is theoretically possible and which can be foreseen. If it ever occurs then you don’t want to be holding US Dollars. Even without any action on the part of foreign holders of US Treasuries, the balance of power has certainly changed and the US has placed itself in a vulnerable position.
The largest holder of T-bills is Japan with $592 billion, closely followed by China with $502 billion and the OPEC members who between them officially have $154 billion. However, a lot of OPEC members also own T-bills via proxy that are held in the UK. The high oil price has seen the foreign exchange reserves of these countries swelled with Dollars as oil is primarily priced in US Dollars. China has accumulated their holdings due to the huge levels of trade that are carried on with the rest of the world using Dollars. Japan has long been a keen buyer of T-bills but has recently started to reduce its holdings (by 3.6% in the last year). Asian central banks don’t publicise the allocation of their currency reserves but they hold about $4.35 trillion in total foreign exchange reserves and about 70% of these are thought to be Dollar-denominated. US Dollars and Dollar-denominated assets are held in a wide range of foreign countries, some of whom have strained political relations with the US due to the aggressive foreign policy of the Bush administration and one has to wonder how far they will bend to the will of a financially weak and economically exposed America.
There are several reasons why the US Dollar is exposed to geopolitical and investment risk in a way that hasn’t been seen before:
1) Several countries are now pursuing a policy of diversification away from the US Dollar in their foreign exchange reserves as they are still worried about further depreciation due to the declining economic environment in the US. The Euro is a potential beneficiary or a basket of currencies could be adopted. If everyone starts diversifying at the same time there is the risk of flight from Dollar assets that begins to become obvious to markets and which could cause other investors to panic. Whilst sovereign wealth funds are usually slow to act, they have indicated greater interest in investments in Europe and emerging markets as a way of diversifying their currency allocation as well as their asset allocations.
2) There is talk of the US losing its top investment grade rating and if this were to happen there could be a crisis of confidence in the Dollar. A downgrade would require the US to offer higher interest rates, which in turn is not good for the economy and could cause further Dollar weakness. The US has held a triple-A rating since 1917 but healthcare and social security costs are rising with no sign of a solution to their spiralling costs. The cost of financing military excursions in Afghanistan and Iraq also adds to the problem. America has been spending beyond its means for some time (hence the huge volume of T-bills in circulation) but there is a strong possibility that this strategy may have serious repercussions one day.
3) Several middle-eastern and Asian countries have pegged their currencies to the US Dollar and have had to lower their base rates in line with US rates, in spite of the fact that they are experiencing very high levels of inflation. Qatar is struggling with 14% inflation, Egypt 19%, Dubai 20%, Saudi 10%, UAE 11%. They are not suffering from the same economic woes as the US so interest rates of 2% are totally inappropriate. Middle-eastern countries have been forced to lower rates just as their economies are booming on the back of oil receipts and domestic investment is running at record levels. This divergence in economic fortunes has placed great strains on the Dollar peg and there is a chance that some countries might have to break it at some point, which could be extremely Dollar-negative.
4) The size of its outstanding debt to the rest of the world makes the US vulnerable to pressure in global political matters. If, for example, China wanted to have its way on an important political issue, it could infer that it was going to reduce its Dollar holdings due to lack of confidence in the currency. This kind of declaration would have hugely negative ramifications for the Dollar and the US economy and is something the US would be keen to avoid.
It is this fourth point that I wish to expand on. China is often seen as seen as the main threat to US domination in global politics due to its size, its economy and its military might. It now has a major bargaining advantage in its creditor status. Since China’s rise to prominence as a global economic power, its partial embrace of capitalist culture and its accession to the World Trade Organisation there hasn’t really been a significant dispute with the US. But what if this was to change one day? In the same way that Russia has become more confident and more belligerent as its economic wealth has grown, China could also adopt a more aggressive stance towards the US.
In some ways the economic strength of the US and its influence on the world stage has been sold out from underneath it by the sale of so many Treasury bills. A country such as China, which holds 19% of all the T-bills in circulation, might be able to dictate terms to the US or else it could threaten to sell off its holdings under the auspices of diversification or lack of confidence. Whilst this would mean that the value of all China’s Dollar-denominated foreign reserves were pummelled, it would ultimately survive. However, there would be a run on the US Dollar and it would decimate the US economic system. In one single bound China could overtake the US as the world’s most important economy and as the world’s premier superpower.
If China was to sell its US Dollar holdings at an accelerated rate then the value of the Dollar would collapse and interest rates would be forced up in order to support the currency. High interest rates would almost certainly send the US into a severe recession. It would also likely lose its triple-A credit rating which would exacerbate the problem. A stable currency is essential for any country to attract foreign investment and the Dollar has been propped up for a long time by the continued purchases of T-bills by overseas investors, particularly China due to the size of its holdings. It currently requires $2billion a day to finance the current account and if sovereign wealth funds stopped buying Dollars the deficit could balloon to unmanageable proportions. America’s role as the greatest economic power in the world would be at an end.
Other holders of Dollar-denominated assets such as Japan and the OPEC members would also suffer and they would certainly condemn China for taking such action but are their concerns enough for China to pass up the chance of moving up the rankings in the global economy? Wars have been started for less.
Whilst the chance of an economic attack on the US by China as described above might be considered fantasy, the fact remains that the US has put itself in a position where it is theoretically possible that such a strategy could be carried out and where the very hint of a threat by the Chinese could be extremely damaging. Sino-US relations have never been particularly friendly and the two countries have traditionally been seen as opponents, if not enemies. Maybe the struggle between Communism and Capitalism hasn’t completely disappeared after all and the Chinese have been merely biding their time.
The US has been quite vocal about the way it thinks China should manage its currency but it is not really in a position to dish out advice on a subject in which it is clearly not an expert. The current Bush administration continues to officially support a strong Dollar policy but the reality is somewhat different and they are kidding no-one. Either the US has no control over its own currency or the huge depreciation in the value of the Dollar was what they wanted all along. However, today the US has clearly lost a large degree of control over its currency, and by association its economy, because it has put itself in the position of debtor to China (and to other countries) and this makes the US a riskier place to invest than is widely perceived, regardless of its current credit rating. A rapid sale of US treasuries by China might seem like a black swan event but it is one that is theoretically possible and which can be foreseen. If it ever occurs then you don’t want to be holding US Dollars. Even without any action on the part of foreign holders of US Treasuries, the balance of power has certainly changed and the US has placed itself in a vulnerable position.
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