Category: Money Moves Markets

The 1.9% fall in GDP in the first quarter represents the largest quarterly drop since a strike-related 2.4% plunge in the third quarter of 1979. GDP has now declined 4.1% from its peak in the first quarter of 2008, which compares with peak-to-trough falls of 2.5% in the 1990-91 recession, 3.3% over 1973-75 and 5.9% in the 1979-81 slump.

The chart shows the current fall in GDP together with Treasury and Bank of England forecasts and the 1979-81 decline, rebased to the peak in the first quarter of last year. The first-quarter result was 0.8% lower than implied by the central projection in the Bank’s February Inflation Report. The MPC judged that the latest indicators were broadly consistent with this forecast at its April meeting so today’s number could boost the chances of an expansion of QE.

The Treasury’s Budget forecast implied that GDP would fall by 2.2% between the fourth quarter of 2008 and the second half of 2009. This looked hopeful even before today’s news of a 1.9% first-quarter loss. A monthly GDP estimate derived from data on industrial and services output was 0.4% below its first-quarter average in March, suggesting a further fall of at least this amount in the second quarter.

The Treasury projects a recovery in GDP of 2.9% per annum between the second halves of 2009 and 2011. While widely derided, this is lower than the 3.3% pa increase over the same period forecast in the Bank of England’s February Inflation Report. A key issue is whether the Bank will retain this steep recovery profile, albeit from a lower base, in its next Report, released on 13 May.

The 1.9% first-quarter decline is difficult to reconcile with available expenditure data. With retail sales rising by 1.0% in the first quarter, overall consumer spending seems unlikely to show a decline larger than the 1.0% recorded in the fourth quarter. Trade figures for January and February signal little impact from net exports. Meanwhile, output of “government and other services” rose in the first quarter, suggesting higher general government consumption. The implication is that GDP weakness was driven by investment and stocks.

Destocking already amounted to 1.3% of GDP in the fourth quarter, based on current data. This offers a glimmer of hope – a faster cut-back in the first quarter would imply a correspondingly larger future boost to GDP when stock levels stabilise.

The Budget “Red Book” paints a dire picture of the state of the public finances. It is tempting to suggest the Chancellor has exaggerated the gloom to create room for favourable “surprises” ahead of the election but the assumptions underlying the projections look, if anything, too optimistic.

• In the five months since the Pre-Budget Report, forecast net borrowing in 2010-11 has ballooned from £105 billion to £173 billion. Collapsing receipts account for £48 billion of this increase, with the remaining £20 billion due to higher expenditure.

• Receipts could yet undershoot even this revised forecast. The ratio of taxes to GDP is projected to bottom at 33.0% in 2009-10 before recovering but reached a low of 31.8% after the less-severe recession of the early 1990s.

• The Augustinian approach to spending discipline is maintained. Longer-term projections benefit from cuts to previous plans but the expenditure-GDP ratio surges to 48.1% in 2010-11 – the highest since 1982-83 and up from 41.0% as recently as 2007-08.

• After a 3.5% drop this year, GDP is forecast to grow by 1.25% in 2010, 3.5% in 2011 and 3.25% per annum in later years. While not unreasonable, this is clearly at the optimistic end of the range of possible scenarios.

• The Budget changes were modest in terms of sums dispensed. A net “injection” of £5.2 billion in 2009-10 is reversed in 2010-11 as the tax hike on higher-earners kicks in. The key measures this year are a temporary boost to capital allowances (costing £1.6 billion), phasing-in of the uprating of business rates (£700 million), employment initiatives (£890 million) and winter payments to pensioners (£600 million).

• The planned hike in the income tax rate on high-earners to 50% will tie the UK with Japan at the top of the G7 league table. This will create significant negative economic incentive effects and is unlikely to raise the amounts projected, especially if capital gains tax is kept at the current 18%.

• With the rise in net borrowing fully reflected in the “central government net cash requirement”, the Debt Management Office projects net gilt sales of £220 billion in 2009-10, up from £146.5 billion in 2008-09. The Bank of England, however, will absorb at least £55 billion – the gilt market’s day of reckoning may be delayed until 2010-11, when a similar level of funding will need to be raised without Bank support

The macroeconomic judgement underlying the Chancellor’s strategy is that higher borrowing will deliver an economic stimulus even though households and companies anticipate a significantly higher tax burden in years to come. This would be questionable in normal times but is even less likely given the unprecedented scale of necessary future fiscal adjustment bequeathed by Mr. Darling to his successor.

The plunge in sterling has pushed the gap between UK and Eurozone consumer price inflation to its highest level since 1992 – despite the UK number being artificially depressed by December’s VAT cut.

Slower food and energy price gains caused UK annual CPI inflation to ease from 3.2% in February to 2.9% in March but the equivalent Eurozone measure slumped from 1.2% to just 0.6%. The difference of 2.3 percentage points between the UK and Eurozone increases is the largest since a 2.8 point divergence in March 1992 – see chart.

The gap would be significantly larger but for the VAT cut. The CPI at constant tax rates (CPI-CT), which assumes that the reduction was passed on in full, rose by an annual 3.9% in March – one percentage point more than the headline measure. Some retailers have used the cut to boost margins: a conservative assumption that only half of the reduction has been transmitted to consumers would imply “true” CPI inflation of 3.4%, 2.8 percentage points above the Eurozone level.

The gap can be attributed roughly equally to differences in food and energy price trends and “core” inflation – both have been affected by the fall in sterling. The UK CPI excluding unprocessed food and energy – a measure of core prices – rose by an annual 2.3% in March, or 2.9% assuming 50% pass-through of the VAT cut, versus an increase of just 1.5% in the equivalent Eurozone index.

The IMF’s latest World Economic Outlook is downbeat on recovery prospects, based partly on an analysis of business cycles in 21 economies since 1960, showing that recessions associated with financial crises or with a strong global element tend to be longer and followed by weaker upswings.

The IMF’s findings, however, are at odds with longer-term historical evidence that “deep recessions are almost always followed by steep recoveries” – a regularity known as the “Zarnowitz rule” after the distinguished US business cycle analyst Victor Zarnowitz (quoted by former IMF Chief Economist Michael Mussa in a recent paper).

The table below, documenting the six largest declines in US industrial output between 1880 and 1960, illustrates Zarnowitz’s observation. The 1929-32 slump clearly stands out in terms of severity and duration. The other five recessions / recoveries show considerable similarity – contractions were deep but lasted no more than 14 months, while subsequent recoveries were strong, with peak output regained within 19 months.

These five recessions include downturns associated with a severe financial crisis (e.g. 1907-08) and / or globally-synchronised weakness (e.g. 1920-21).

The 18% fall in Group of Seven (G7) industrial output since its peak in February 2008 is in the middle of the range of these five severe US recessions (excluding the 1929-32 slump). The US historical experience suggests that the output fall – 12 months in duration as of February, the latest data point – should be approaching an end. If the recovery were also to follow the US historical pattern, output would regain its February 2008 level by late 2010 at the latest. This would imply a growth rate of output during the recovery phase of about 11% per annum – far higher than suggested by the IMF’s gloomy forecasts.

Indicators supporting a V-shaped recovery include surging G7 real money growth and a widening gap between retail sales and production, suggesting a potential big boost from the stocks cycle. Credit conditions, however, remain restrictive, though have started to ease, a process that could gather pace if investor risk appetite returns.

How is the Bank of England’s “quantitative easing” initiative progressing?

The Bank is on course to achieve its target of buying £75 billion of assets by early June. As of yesterday (16 April), cumulative purchases had reached £34.3 billion, comprising £31.5 billion of gilts, £0.5 billion of corporate bonds and £2.4 billion of commercial paper – see first chart.

The dominance of gilt-buying has led to criticisms that the Bank is failing to achieve its objective of improving the flow of finance to companies. This is simplistic, ignoring the indirect benefit of institutions that have received cash from the Bank in return for gilts reinvesting the proceeds in corporate securities.

Another criticism is that corporate yields are little changed from their level when the asset purchase facility was first announced in late January. However, stability in the investment-grade index conceals a material fall in yields on securities issued by non-financial companies offset by a rise in financial yields – second chart.

In any case, the impact of the scheme on credit conditions cannot be measured simply by yields – improving companies’ ability to raise funds is a more important goal. Encouragingly, underwritten sterling bond issues have totalled £54 billion so far in 2009 versus £94 billion in all of 2008, according to Bloomberg.

The success of QE will ultimately hinge on its impact on monetary growth – particularly broad money. As expected, unsterilised asset purchases have boosted banks’ reserves at the Bank of England, which – together with currency in circulation – comprise the monetary base. Annual growth in monetary base has soared to 66%, well above levels in the Eurozone and Japan though lower than in the US – third chart.

March broad money figures will be published next Wednesday but – as previously discussed – headline M4 has been distorted by the activities of “intermediate other financial corporations”. The Bank of England is unwilling to publish monthly estimates of its adjusted M4 measure, excluding money holdings of these entities. The last quarterly number, for December, showed annual growth of just 3.8%; the next Inflation Report, due on 13 May, should include a chart incorporating a March figure.

Annual growth in adjusted M4 probably needs to rise to 10% to lay the foundations for an economic recovery. The Bank’s asset-buying plans appear to be on the right scale – £75 billion is equivalent to 4.5% of adjusted M4 so a one-for-one impact, assuming a stable underlying trend, would imply a rise in annual growth to 8-9%.

There are two risks. First, to the extent that the Bank buys securities from banks and overseas investors, rather than domestic non-banks, there is no direct positive impact on M4. The Bank will publish March data on gilt transactions by non-banks, banks and overseas investors on 1 May. These are, however, net figures, including purchases of new issues from the Debt Management Office.

Secondly, the boost to M4 from QE could be offset by a further slowdown in private sector lending growth, reflecting weak credit demand and / or continuing efforts by banks – particularly foreign-owned institutions – to shrink balance sheets. Continued sluggish M4 growth would indicate not that QE has failed but rather that plans need to be expanded to utilise more of the £150 billion authority granted by the Treasury.

Recent evidence of a liquidity thaw and easing credit conditions suggests that the probability of a V-shaped global economic recovery is rising.

Consistent with a normalisation of money flows, the spread between UK interbank and government interest rates has narrowed to its lowest level since Lehman’s bankruptcy last September – first chart.

An equivalent US measure, inverted, is shown in the second chart along with the annual growth rate of US industrial output. Historically, recessions have been signalled by the spread moving above 100 basis points. It reached a peak of 360 bp (monthly average basis) in October but is now back below 100 bp, supporting recovery hopes.

Business surveys are recovering, with yesterday’s New York Fed survey notably stronger. This improvement was foreshadowed by a slowdown in earnings downgrades by equity analysts – third chart. Assuming that the recovery in the “revisions ratio” survives the current earnings reporting season, purchasing managers’ manufacturing indices look set to revert to the breakeven 50 level, implying a stabilisation of industrial activity.

A previous post suggested a more promising outlook for corporate high-yield bonds, based on an easing of credit conditions reported in the latest UK loan officer survey and the likelihood of a similar improvement in the next US survey, due for release in early May.

Another hopeful sign for credit conditions and high-yield bonds is a recent fall in the borrowing requirement of US non-financial corporations, defined here as their “financing gap” – capital spending minus domestic retained profits – plus share purchases net of issuance. As the chart shows, this measure leads the yield spread of high-yield bonds over Treasuries.

The borrowing requirement has fallen steeply from 9.5% of GDP in the fourth quarter of 2007 to 3.6% by last year’s fourth quarter. A further decline is likely, since companies’ net share-buying was still running at 3.2% of GDP in the fourth quarter but should slow in 2009.

A sharp fall in the borrowing requirement preceded a narrowing of high-yield spreads by two years in both the late 1980s and early 2000s. Assuming a similar lag in the current cycle, high-yield spreads could decline significantly from late 2009.

The MPC-ometer predicts that Bank rate will be held at 0.5% at tomorrow’s Monetary Policy Committee meeting. A split decision is indicated, however, with one or more members – probably including arch-dove David Blanchflower – voting to lower the target for official rates to between zero and 0.25%, the currently-prevailing US level.

The MPC-ometer forecasts the outcome of each month’s MPC meeting based on the latest economic and financial indicators. The no-change prediction reflects slightly less grim news over the last month: business surveys indicate a slower decline in new orders, consumers are a bit less pessimistic, share prices have rallied and money market conditions have eased.

As well as cutting rates to 0.5%, the MPC last month announced plans to boost the money supply by buying £75 billion of gilts and other securities by early June. It is much too early to judge the success of this policy but the Bank of England had purchased £21 billion by last week, suggesting it is on course to reach the target.

The broad money supply M4, adjusted for distortions due to the financial crisis, needs to grow by 6-7% a year to support economic expansion but rose by just 3.8% during 2008, contributing to the slide into recession. The MPC should calibrate asset purchases to boost annual growth in adjusted M4 to 10% to compensate for last year’s shortfall and lay the foundations for an economic recovery.

The initial plans look sensible – £75 billion is the equivalent of 4.5% of the adjusted money supply – but the MPC will need to fine-tune its operations in the light of incoming monetary data. The Bank of England is making it more difficult for outside observers to make a judgement on this issue by refusing to publish its monthly estimates of the adjusted M4 money supply.

The Bank gave the following response to a freedom-of-information request for access to the data:

Thank you for your email dated 5 March in which you request access under the Freedom of Information Act 2000 (‘FoI Act’) to:

‘…the adjusted M4 and M4L data prepared monthly within the Bank (ie the monthly versions of the series that have been published quarterly in chart form – with underlying data available in a spreadsheet – in recent Inflation Reports)’

But in any case, the data is held by the Bank for the purposes of its monetary policy functions and is not, therefore, subject to the requirements of the FoI Act. Parts I to V of the FoI Act (including the general right of access under section 1) do not apply to information which the Bank holds for the purposes of its functions with respect to monetary policy (see section 7(1) and the Bank of England entry in Schedule 1, Part VI FoI Act).

US companies included in the S&P 500 index recorded a large aggregate loss in the fourth quarter, reflecting financial write-downs, a fall in the value of inventories due to plunging commodity prices and other recession-related charges – see first chart.

By contrast, the national accounts measure of “economic” profits was still firmly in the black in the fourth quarter. This covers all companies, excludes valuation effects and other charges, and adjusts for under- or over-depreciation in reported accounts. It is a better guide to underlying profitability.

Fourth-quarter economic profits were down by 18% from their peak in the third quarter of 2006 but 94% above the trough reached in the last recession, in the third quarter of 2001. Companies have limited damage to profitability by acting fast to shed labour and slash other costs.

The second chart shows inflation-adjusted economic profits together with a log-linear trend. At the 2006 peak, profits were 41% above the trend-line – the largest deviation since 1966. The subsequent plunge has closed the gap and profits should move below trend in early 2009.

Market valuations already discount earnings gloom. As the third chart shows, a price / earnings ratio based on trend economic profits stood at 12.6 at the end of 2008 versus a long-run average of 13.8. The P / E, however, reached much lower levels in the 1970s and 1980s.

From a liquidity perspective, market falls since late 2007 were caused by a fear-induced rise in the precautionary demand for money coupled with a withdrawal of credit from leveraged investors, resulting in forced selling of assets. Contrary to fears, the global supply of money has continued to expand but not sufficiently to offset these negatives.

As the second quarter begins, money supply trends are improving, risk aversion and precautionary cash demand appear to be moderating and investor leverage is at its lowest level for several years. This suggests support for equity markets but any rally faces hurdles from ongoing poor earnings news, a likely rise in issuance and a possible rebound in commodity prices.

A key policy development last quarter was the $1.15 trillion expansion of the Fed’s securities purchase programme, which promises to give a major boost to US and global monetary growth. Including the unutilised portion of earlier plans, the Fed could buy $1.4 trillion of assets over the remainder of 2009, equivalent to 11% of US M2+ and about 5% of our G7 broad money measure.

The demand for money is unobservable but cash hoarding is likely to diminish as fears of financial collapse abate and the economic cycle approaches a trough. Consistent with this view, measures of risk aversion have moderated recently – see chart – while narrow monetary aggregates have been rising relative to broader measures, which often precedes a pick-up in velocity.

Meanwhile, investor deleveraging appears to be well-advanced. US margin debt is back at 2003 levels while hedge fund returns have recently shown little correlation with equities, suggesting minimal market exposure. Hedge funds suffered investor withdrawals of $260 billion between November and January but outflows slowed to $17 billion in February, according to Trim Tabs.

While the liquidity backdrop for equities is improving, several factors could delay a significant recovery in markets. First, corporate newsflow may remain negative – another large fall in global GDP in the first quarter suggests the potential for downside surprises in coming earnings reports, even relative to recently-lowered expectations.

Secondly, any rally is likely to call forth an avalanche of issuance as companies seek to reduce gearing against the backdrop of high corporate borrowing costs. Balance sheet adjustment also implies that cash take-over activity and share buy-backs will remain weak for the foreseeable future.

Thirdly, “excess” liquidity resulting from a fall in money demand relative to supply could flow into commodity markets, particularly given investor concerns that unprecedented monetary and fiscal stimulus will lead to higher inflation over the longer term. A renewed commodity price surge would damage prospects for a recovery in economic activity and earnings recovery later in 2009.