• Stuart Fowler

Spend, save or ‘sauve qui peut’?

The pre-budget report last week was pure politics and has very little bearing on the momentum of a vicious credit cycle. In this slow train crash, the back carriages have not yet left the track. Judging by the public reaction, such as the audience of Question Time and on-street interviews, it was bad politics because it made the Government look like they were taking the voters for fools. We are being asked to believe that an unprecedented crisis calls for unorthadox measures. But we are also being asked to believe this will be a short and shallow recession. When the lead carriages left the track we were told the crash was bound to be worse because of low personal savings and high borrowings. Now we are being told to spend our way out of trouble. It does not add up and on the High Street they know it.

The temporary tax stimulus in this PBR is politics – the impacts on the sources of slumping final demand in the UK economy look trivial.

The impacts may be trivial but the stimulus has a cost: it absorbs taxpayer money that is already a contingent liability backing the Prime Minister’s promise in October ‘to do whatever it takes…’ He did not say what this meant but we know what he meant to convey, which is: there will be no loss for depositors in any UK licensed deposit taker.

Incentives to households to spend are not an alternative to the cost of delivering on this vague promise as, without evidence that the banking crisis is being fixed, households would be mad not to cut discretionary spending, build liquidity or repay debt.

I think it is sensible to assume, as privately suggested by experienced bankers, that October’s £27 bn of capital injections for banks, worth about 1% of total balance sheets and 20% or so of capital, is just a start and that losses on their total loan book, not just mortgages, will absorb much more of their existing capital and trigger further calls on the Government.

Ironic, then, that the PBR coincided to the day with the US Treasury having to underwrite Citigroup to the tune of an additional $200 bn!

The UK Treasury has finally admitted that the PM’s ‘longest period of growth’ never was ‘stable’, ‘sustainable’ or ‘prudent’ but borrowed heavily from future years’ output growth. This admission, incidentally, assumes there has been no change in the sustainable trend of output growth in recent years. But many economists argue that the sustainable rate had already been shrinking (and will shrink further). This is exactly what the piling up of debts in the economy was pointing to and which the PM as Chancellor chose to ignore. The Government is fond of blaming the crisis on others but I see no ‘made in the USA’ label here.

The Treasury’s new growth forecasts rightly assume this past ‘overspending’ will not be recovered. Even so, the forecasts are implausible: we cannot be expected to believe both that this is an exceptional economic threat justifying tearing up the prudential rule book and that the recession will be briefer and shallower than all others since the 1970s.

The battle ground for the next election is clearly being prepared by each party but the actual battle ground, and outcome, will be defined by the state of the economy at the time. Timing the election on this occasion looks like a lottery.

Equity markets are now cheap (mean expected real returns without tracker costs of around 8% in the UK, Europe and the US at 10% and Japan at 12%) but capital is getting expensive – none more so than the real risk free rate. At a time of aggressive interest cuts, the immediate risk premium for building up equity or property exposure can look tempting. But this is the same illusion that led to the deterioration in the liquidity and quality of balance sheets before the crash. The equity risk premium we are interested in (the ‘Capital Allocation Line’ in any real or after-inflation version of the Capital Asset Pricing Model) has barely steepened since the equity bear market began in earnest after August because of a steep rise in index linked gilt yields – a situation mirrored in the US.

Expect to see indexed linked gilts being written about as the Cinderella of financial assets but remember what happened to Cinders. A brief interval of deflation is priced into the real risk free yield curve on both sides of the Atlantic. A short-term deflation bet may look attractive but the means of taking it without also exposing yourself to long-term inflation risks is limited to short-dated gilts paying just 2% or corporate bonds paying about 2% more (and very little short-dated paper is still rated as highly as that).

The markets are not fools and will not for long undervalue insurance against the long-term risk of inflation. They can see that piling counter-cyclical borrowing on top of misjudged pro-cyclical profligacy has raised the chance of high inflation, as a well-trodden route out of the debt trap.



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