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UK net mortgage lending fell from £108 billion in 2007 to £40 billion last year and just £4 billion in the first seven months of 2009. In July alone, net lending turned negative for the first time in the history of monthly data extending back to 1986. This may, however, mark the trough, with mortgage approvals signalling a significant recovery.

Net lending is the difference between gross lending and repayments, which can be broken down into regular repayments, redemptions and other lump-sum payments. Net lending is unaffected by remortgaging activity, which boosts gross lending and redemptions by the same amount (assuming no change in the outstanding loan balance).

The chart compares gross lending minus redemptions with the sum of regular repayments and other lump-sum payments. These “other repayments” have been stable recently. The fall in net lending into negative territory in July reflected a further slump in gross lending rather than stepped-up repayments.

Gross lending minus redemptions, however, should recover significantly, judging from recent data on mortgage approvals, excluding remortgaging. Approvals have been climbing since late 2008 and their current level looks consistent with monthly lending of about £6 billion. With “other repayments” running at just below £4 billion, this suggests a revival in net lending to about £2 billion a month by late 2009.

US non-financial corporations’ financial surplus – the difference between their retained earnings and capital spending – rose to 1.1% of GDP in the second quarter, according to flow of funds accounts data released yesterday. Excluding the third and fourth quarters of 2005, which were distorted by a one-off repatriation of foreign profits to take advantage of temporary tax incentives, the surplus was the highest since the fourth quarter of 1960.

The further improvement last quarter reflected a combination of stronger profits, cuts in dividends and fixed investment and faster destocking.

On top of this surplus, corporations raised cash from equity transactions for the first time since the second quarter of 2002, i.e. new issuance exceeded share buy-backs and retirements due to cash take-overs. Meanwhile, bond issuance remained heavy, though down from the record first-quarter pace.

Strong internal cash generation combined with capital market issuance allowed firms to increase their holdings of liquid assets and pay down short-term debt. The ratio of the two therefore rose sharply to its highest level since the end of 2006, supporting hopes of a strong recovery in capital spending – see first chart.

Some commentators have interpreted the recent contraction of bank lending to companies as supply-driven and likely to curtail business expansion. The comprehensive view of corporate finances provided by the flow of funds accounts suggests that bank debt repayment has been voluntary, reflecting the financial surplus and borrowing opportunities in credit markets.

The yield spread of non-investment-grade corporate bonds over Treasuries is inversely related, with a lag, to the sum of the financial surplus and net equity issuance, expressed as a percentage of GDP. The latter last quarter reached its highest level since the second quarter of 1958, suggesting scope for further spread compression – second chart.

Posts in early and mid April suggested that G7 industrial output would recover more strongly than forecast by the IMF and consensus. This was based partly on the “Zarnowitz rule” that “deep recessions are almost always followed by steep recoveries”.

US business cycle history provides some guidance about the possible speed of a Zarnowitz-style recovery. There have been eight falls in US industrial output of 13% or more since 1890. In six of the eight cases, output regained its prior peak level within 21 months of the trough. The exceptions were the recoveries after the 1929-32 slump – when output plunged by 54% – and the 1944-46 recession, when the economy needed to restructure away from armaments production.

In the recent recession G7 industrial output fell by 19% over 13 months to a trough in March 2009. (The March trough had been signalled by monetary data in late 2008.) Based on the US evidence, discounting the post 1932 and 1946 recoveries, output could regain its peak level within 21 months, i.e. by December 2010. This would imply annualised growth of about 13% during the recovery.

The chart compares the actual rise in output since the March trough with this “Zarnowitz” forecast and an alternative 2% growth scenario. 2% is the maximum likely to be consistent with the IMF’s latest published forecast of GDP expansion in advanced economies of only 0.6% in 2010. The last data point, for August, is an estimate based on US data released yesterday and a METI survey forecast for Japanese output.

Output is tracking slightly below the Zarnowitz path but is recovering much faster than forecast by the IMF and consensus. Based on the August estimate, the growth rate in the five months since the March trough has been 10% annualised.

Leading indicators suggest an acceleraton into the autumn, possibly closing the gap with the Zarnowitz forecast. For example, the OECD’s G7 leading index, which is designed to predict industrial output, rose by 18% annualised in the three months to July.

Investors are debating whether the pick-up will be sustained into 2010. With the boost from the stocks cycle still at an early stage and financial market conditions improving, an optimistic view remains warranted but this requires confirmation over coming months from a stabilisation of labour markets and continued monetary expansion.

The three-month change in the stock of job vacancies returned to positive territory in August for the first time since March last year. Vacancies are a good coincident indicator and the 2% gain is historically consistent with quarterly GDP expansion of the order of 0.5% – see first chart.

The recovery in vacancies, as well as the prior plunge, was signalled in advance by the Markit job placements index. The Market index climbed further to a 17-month high in August, suggesting the vacancies rise will gather pace – second chart.

The MPC claims that a Bank rate of 0.5% is necessary to prevent inflation from undershooting the 2% target over the medium term. Its recent forecasting performance, however, casts doubt on its ability to predict near-term inflation movements, let alone developments two years or more ahead. If the Bank’s inflation model is broken, it is fair to ask whether the pseudo-science of the Inflation Report fan charts should be ditched in favour of an ECB-style judgemental approach, including increased emphasis on monetary analysis.

In its February Inflation Report, the MPC predicted that annual CPI inflation would fall to 0.8% and 0.7% respectively in third and fourth quarters of 2009. A post at the time argued that this was too optimistic, with the Bank underestimating the inflationary impact of sterling’s plunge during 2008.

Despite upside surprises in early 2009, the Bank actually revised down its third and fourth quarter modal projections in the May Inflation Report, to 0.7% and 0.4% respectively. Further disappointing outcomes, however, forced a significant change in the August Report, with the forecast raised to 1.3% for both quarters.

Two months of data later, this no longer looks credible. With today’s 1.6% August result following 1.8% in July, inflation would have to plunge to 0.6% in September to average 1.3% in third quarter, as projected. The overshoot is likely to carry over to the fourth quarter. Bank of England Governor Mervyn King is probably now regretting his statement at the August Inflation Report press conference that a fall below 1% was “more likely than not” later in 2009.

A puzzle for the Bank’s forecasters is that core inflation remains sticky despite a weakening of import price pressures as sterling has rebounded this year – manufactured import costs fell by 5% between March and July, following a 14% surge in the prior 12 months. The CPI excluding energy, food, tobacco and alcohol rose an annual 1.8% in August and would probably have climbed 2.4-2.5% in the absence of December’s VAT cut (based on a National Statistics estimate that the reduction lowered headline inflation by about 0.5 percentage points). This would be the highest in its 12-year history – see chart.

As well as the size and persistence of the exchange rate effect, the lack of response of core trends to rising economic slack is troubling for the MPC’s inflation optimism. This could reflect longer-than-expected lags but the Bank’s forecasts may have placed overreliance on highly-uncertain estimates of the size of the “output gap” and its influence on pricing decisions.

The 1.6% August headline rate is in line with the inflation profile forecast presented in a previous post, although the breakdown is slightly different, with core prices higher and food prices lower than assumed. Updating inputs to take account of recent information, CPI inflation is projected to fall to 1.2% in September as a result of favourable base effects before rebounding to about 3% in January as VAT is raised back to 17.5%. The implied first-quarter average of 2.75% compares with a forecast of 2.1% in the August Inflation Report.

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COMMENT:
AUTHOR: S CURRIE
EMAIL: S_CURRIE@HOTMAIL.COM
IP: 94.194.3.37
URL:
DATE: 09/16/2009 11:10:16 AM

With inflation running higher than BOE forecast by the 1st qtr 2010 and QE ending shortly ,what price/yield on UK conventional gilts ?

(Apologies for the delay in publishing this comment – Ed)

A post last week suggested that 4% UK broad money growth was sufficient to support a solid economic recovery because the velocity of circulation may be rising. Expressed differently, the demand to hold money may be declining as cash hoarding related to last year’s crisis reverses

One sign of declining money demand is a recent pick-up in mutual fund inflows. Net retail sales of unit trusts and OEICs totalled £14.0 billion in the first seven months of 2009, up from £3.9 billion in all of 2008, according to the Investment Management Association. Sales are on course to reach about £24 billion for the full year, well above the prior annual record of £17.7 billion in 2000.

If a £20 billion rise in mutual fund buying between 2008 and 2009 reflects a reduced demand for money, money supply numbers will understate the growth in cash available to finance economic recovery by £20 billion this year. This is equivalent to 1.3% of the MPC’s favoured broad money measure, M4 excluding cash holdings of “intermediate other financial corporations”.

As the earlier post noted, some monetarist economists argue that QE should be expanded further until broad money growth reaches 6% per annum or higher. With money demand likely to be rising by significantly less than 6% pa, however, this would risk creating excess liquidity, leading to new asset market bubbles and – further ahead – another pick-up in inflation.

Today’s Financial Times Lex column contains an interesting article arguing that US corporate profit margins are far above their long-run average and should “return to the mean relatively quickly”, implying significant risk to current consensus earnings estimates. The article states that corporate profits before depreciation, tax and interest amounted to about 35% of corporate output in the second quarter compared with an average since 1947 of 29%.

On closer inspection, however, the margins measure used appears somewhat odd, in that pre-depreciation profits are compared with net corporate output, i.e. after deducting depreciation. That is, there seems to be an inconsistency in the treatment of depreciation between the numerator and denominator of the ratio.

Two consistently-defined measures of profit margins are 1) profits before depreciation, tax and interest as a percentage of gross corporate output, i.e. before deducting depreciation, and 2) and profits before tax and interest as a percentage of net output. These gross and net measures are shown in the first chart. The gross measure behaves similarly to the series used in the FT article but net margins are currently much less extreme relative to history – 19.4% in the second quarter versus an average since 1950 of 18.1%.

The widening gap between the two measures reflects a trend increase in depreciation as a proportion of output, related to a rising economy-wide capital-output ratio and a shortening average life-span of capital goods. If gross margins were to mean revert, as Lex thinks likely, net margins would fall to the bottom of their historical range.

Economic theory suggests that the income share of capital-owners should be stable over the long run but this refers to their rewards after compensation for the erosion in value of assets due to depreciation. This argues for using net rather than gross margins.

The FT analysis focuses on domestic profits, ignoring the 25% share of total profits accounted for by foreign earnings. The second chart compares total profits net of taxes and adjusted for inflation with a log-linear trend. This suggests that profits were 8% below trend in the second quarter after a 10% first-quarter shortfall – similar to the 13% deviation at the bottom of the last recession.

The slope of the trend-line implies real profits growth of about 3.5% per annum. Assuming 2% inflation, nominal trend profits will be about 18% above the second-quarter actual level by the end of 2010. Consensus hopes of a significant earnings recovery next year are therefore not irrational, providing a near-term economic pick-up can be sustained.

UK broad money – as measured by M4 excluding money holdings of “intermediate other financial corporations” – probably needs to grow by 6-7% per annum over the long run to be consistent with sustainable economic growth and the 2% inflation target. This assumes a decline in the velocity of circulation of about 2% pa, in line with the trend over 1992-2004, when CPI inflation averaged close to 2%. (Trend growth of 2.5% plus 2% inflation and a 2% velocity decline implies a required 6.5% pa increase in broad money.)

In late 2008 annual broad money growth was below 4% and falling. A post in February therefore argued that the MPC needed to buy assets from the domestic non-bank private sector on a scale sufficient to deliver a five percentage point monetary boost. This was estimated to require purchases of at least £125 billion. The following month the MPC announced a purchase programme of up to £150 billion; this was expanded to £175 billion at last month’s meeting.

Broad money has accelerated as a result of this initiative but by less than expected, with a 4.9% annualised increase in the first seven months of the year. Many monetarist economists argue that, unless coming figures improve sharply, the MPC should expand asset purchases further in November and continue buying until money growth reaches at least 6%. (See, for example, the minutes of the last Sunday Times Shadow MPC meeting, available on David Smith’s blog.)

While faster growth is likely to be required over the long run, however, there are reasons for thinking that the recent modest pace of monetary expansion is consistent with a solid recovery in 2010 and does not pose a downside risk to the inflation target. On this view, the MPC should be cautious about expanding asset purchases any further, particularly given uncertainty about the lagged effects of buying to date.

The first point is that slow money growth in 2008-09 is partly just pay-back for excessive strength in earlier years. The annual increase averaged 10% over the three years 2005-07, implying a cumulative deviation from a 6.5% long-run norm of 10-11 percentage points. This has been partly absorbed by a cumulative inflation overshoot of about 3 percentage points but there remains an excess of 7-8 percentage points available to finance future economic growth. If this excess were to be eliminated by the end of 2010, broad money growth over 2008-10 would need to be about 2.5 percentage points below the 6.5% pa norm, i.e. about 4%. Recent trends are broadly consistent with this scenario.

Expressing the same point in a different way, the decline in velocity has averaged 4.5% pa since the end of 2004, much larger than the prior 2% trend. The fall last year may have reflected households and companies hoarding cash because of extreme uncertainty about financial and economic prospects. With interest rates at record lows and markets reviving, this velocity slump may now be reversing, in which case 4-5% money growth is more than sufficient to support a strong recovery and on-target inflation.

A prior post on recent US monetary trends suggested that a recovery in broad money velocity ought to be associated with a shift of funds out of savings accounts into cash and transactions deposits, implying a pick-up in narrow money relative to the broader measure. Consistent with this suggestion, notes and coin in circulation rose by 7.6% annualised over January-August, above the 4.9% growth rate of broad money up to July. Historically, “non-interest bearing M1” – comprising cash and sight deposits with no advertised interest rate – has also conveyed useful information. This measure is not officially recognised but can be calculated from published Bank of England data: annual growth was 23% in July – see first chart. (Note that this does not reflect banks cutting the interest rate on some sight deposits to zero, since the “non-interest bearing” definition covers accounts with no ability to pay interest, not those with a current zero rate.)

Monetarist arguments for a further expansion of asset purchases also cite the small scale of the recovery to date in the corporate liquidity ratio – private non-financial firms’ M4 money holdings divided by their sterling bank borrowing. A wider definition including foreign currency deposits and borrowing has shown a larger pick-up – see chart in previous post – but either version of the ratio is still well below the long-run average. However, a sectoral analysis suggests that deficient liquidity is concentrated in the real estate and construction sectors, while some industries (e.g. manufacturing) have ample cash. The aggregate ratio excluding real estate and construction is in the middle of its historical range – second chart. This supports hopes of an early recovery in business spending (outside the real estate sector) and is also easier to reconcile with national accounts data showing a record corporate sector financial surplus (i.e. undistributed income minus capital spending).

Economists expect no change in Bank rate or QE tomorrow but rumours abound of a change in arrangements for paying interest on cash reserves held at the Bank of England. Banks currently receive Bank rate on all reserves; critics claim this encourages hoarding of cash.

As explained in a prior post, a blanket abolition of interest on reserves would push overnight rates well below Bank rate. One of the objectives of the Bank of England’s money market operating procedures is to keep the two in line. Suspending this objective would undermine the anchor role of Bank rate in current monetary arrangements.

Since interest abolition and a consequent fall in overnight rates would be an effective easing of monetary policy, the decision would need to be taken by the full MPC rather than Bank staffers. If the MPC judges such an easing to be necessary, it is difficult to understand why it would not simply cut Bank rate itself, or indeed why it did not do so last month.

While interest abolition seems unlikely, at least without an accompanying cut in Bank rate, the Bank could conceivably introduce measures to penalise individual banks holding larger-than-average reserves balances, e.g. balances above a certain percentage of sterling assets could receive no interest or attract a charge. The macroeconomic implications of such a change, however, would be negligible.

The OECD’s forecast that UK GDP will contract by a further 0.25% in the third quarter looks even more suspect following today’s industrial output release for July, showing a 0.6% rise from June to a level 0.7% above the second-quarter average.

Services output for July will be published on 30 September but the June number was already slightly above the second-quarter average. Even assuming no rise in July (at odds with more upbeat recent business surveys), the monthly GDP estimate described in previous posts will be 0.2% above the second-quarter level – see chart.