20 December 2018
Not About Brexit
by Frank O’Nomics
There are bigger issues out there.
Gather round, and settle down for a scary story of the ghost of Christmas future. As we look towards the New Year, the collective preoccupation with the various outcomes and consequences of Brexit – hard, soft or non-existent – are impossible to escape. Every social conversation, at some stage, seems to touch upon the subject, and every business and investment decision, many would argue, has to have a Brexit view at its heart. There are, however, many important factors, both domestic and global, which are likely to have a much more significant influence on whether our choices are effective, and an over emphasis on Brexit risks missing the bigger picture.
The 10-year glorious bull market, for everything from property, to bonds, to equities, has had 2 key domestic drivers. The first is the availability of vast amounts of cheap cash as a result of the low interest rates that were put in place to address the consequences of the 2008 financial crisis. This facilitated a consumer led recovery as, helped by low levels of unemployment, people were encouraged to spend and build up debt. The second key factor has been the consequences of quantitative easing; pumping cheap money into the financial system made bond yields very low and property and equities very attractive by comparison. The result of all of this was to push house prices up by 43% over the 10 years, and FTSE by 88% at its recent high.
The problem we face in 2019 is that these supportive factors are fading fast. The levels of household debt have become very onerous, to the point where consumers have to pare back their spending. Average household debt is close to £60,000, the highest level ever. Like Python’s Mr. Creosote, there is the risk that a final “wafer-thin mint” of expenditure could lead to a debt explosion and a spending implosion. The demise of the high street has long been seen as the result of the Internet, but when the likes of ASOS are putting out profit warnings, (halving their profit forecast this week), it is clear that the retrenchment has started. This will not be helped by the prospect of rate rises, albeit at a glacial pace, which will make the servicing of debt ever more difficult.
The other change is that we have now had a long period without any quantitative easing. The total cash injected has remained at £435bn for 27 months now and there is no prospect of it being added to. A reversal of QE looks a long way off, but without its impetus it becomes hard for asset prices to retain the demanding levels hit. We have already seen a 14% correction in FTSE, and property prices, at least in the Southeast, are experiencing sustained falls (to the extent that there is any turnover to record). The yields on equities and on property were pushed down to levels where the risk-return ceased to make sense when compared with the cost of money, unless (in the case of equities) the prospects for growth remained very positive.
“Aha!” I hear you say. This is where Brexit becomes important; if we can negotiate a good deal (or remain) the outlook should become more positive. To a large extent you would be right, but again there is the danger of missing the more important issue of global growth. The QE slowdown factor is a feature for many of the major economies; the ECB is about to cease bond purchases (having bought $2.6trn), while the US is raising rates and will start to reverse QE at the rate of $50bn per month. The US government bond yield curve has started to invert (a point where longer-term 5-year yields are lower than those of 3-years) suggesting that the market is already starting to discount a potential recession. The evidence may not yet be there in US data (where employment typically lags the economic cycle by 6-9 months) but the view is supported by data coming out of Europe. Growth in Germany in Q3 fell (by 0.2%) for the first time in 3½ years, and although annual growth is expected to be 1.8%, this is considerably less than the 2.3% previously expected. France is expected to grow 1.7% but this is likely to be threatened by recent disruption, and with unemployment of over 9% and a large current account deficit the outlook for 2019 does not look encouraging.
The other elephant in the room is China. The focus has for some time been on the outcome of the developing trade war with the US. Given the size of trade that could be affected by tariffs this is clearly important. However, of equal importance is the slowdown in growth in China itself. For so long the driver of global progress, China has now started to face the same issues as the West – that of excessive debt. Chinese retail sales are growing at their slowest rate for 15 years and car sales saw their first annual fall since the 1990s. The Chinese authorities may be prepared to act to stimulate their economy, but this will not be easy if discussions with the US do not result in the avoidance of tariff imposition.
Is all of this gloom and doom a case of “Christmas Humbug?” Hasn’t the recent correction in asset prices already factored in much of the risks described? I certainly hope that is the case. The US S&P has had its worst December since 1931 and the Dow is now 12% off its peak. Nevertheless, a survey this week showed that investors are now more pessimistic about the global economy than at any time since the 2008 financial crisis. A resolution to the US-China trade dispute would help. A Brexit deal, on the other hand, may prompt something of a false signal. The end of the uncertainty could lead to a wave of pent-up business investment in the UK that would be very supportive. However, the sigh of relief market rally may prove to be pyrrhic. There is no escaping the high levels of domestic debt and the lack of government stimulus for already inflated asset prices. What will be needed is renewed global growth and that may take sometime to generate.