“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way.” Charles Dickens in 1859 “A Tale of Two Cities”
“Will the last person to leave Britain please turn out the lights.“ The Sun Newspaper, 1992 Election
“Britain’s economy is a must avoid….Gilts are resting on a bed of nitroglycerine” Bill Gross – “Mr Bond Market”
“Much has been written about panics and manias… but one thing is certain that at particular times a great deal of stupid people have a great deal of stupid money.” Walter Bagehot, ‘Essay on Edward Gibbon’
In this post I am going to venture into deep waters, discussing several of the macroeconomic headwinds facing the UK and ultimately why I think this is a very large negative for two assets I am trying desperately to limit my exposure to; the Pound Sterling and UK Housing. I will be testing the bounds of my limited circle of competence here as I am not a trained economist but hopefully for everyone’s sake I’ll be able to keep it simple and thankfully many of my sources have already done the hard work!
The UK Economy
The 2000s were a decade of growth for the UK, but that growth was an illusion. It was not borne out of productivity gains or of diligent savings but instead out of rising debt levels. Our seeming prosperity was, and remains, false.
From 1996 to 2010 exports and investments as a share of GDP declined whilst government consumption grew. The UK economy stopped selling things abroad, stymied private sector investment and instead focused on the expansion of its own government sector. As you can see below Public Spending as a percentage of GDP moved up from a trough in 1999 of 37% to today’s level of 46%.
From 1999 to 2009 public spending grew by 53% and public debt rose 73% (before including exceptional costs like the bank bailouts), despite all this spending, an effective stimulus or boost to growth, Real GDP grew only 16%. A painful example of the inefficiency inherent in government directed spending.
The growth that the UK has had over the last 10-15 years has been heavily reliant upon the extension of credit at every level of the economy; household, corporate, financial and government.
If you combine public and private borrowing, the UK has since 2003 borrowed an annual average of 11.2% of GDP, a clearly unsustainable amount. When the government deficit jumped from 2.4% to 11.2% between 2008 and 2009 all the government was doing was filling the void by replacing the private demand for borrowing which had been crushed by the global financial crisis.
Swimming in Debt
The chart below put together by Morgan Stanley serves to highlight the scale of the problem. The entire developed world is mired in debt but we really seem to be leading the pack, partly as a result of our banks failed attempts to take-over the world in the middle of the last decade. As a percentage of GDP our financial sector exposure is vast compared to other nations, even the apparently banking centric Swiss.
“Households took on rising levels of mortgage debt to buy increasingly expensive housing, while by 2008 the debt of nonfinancial companies reached 110 per cent of GDP. Within the financial sector, the accumulation of debt was even greater. By 2007, the UK financial system had become the most highly leveraged of any major economy…” (UK Budget Report, 2011)
Reliance On Ex-Growth Industries or the Public Sector
“Three of the eight largest sectors of the economy – real estate, construction and financial services – have enjoyed huge growth fuelled overwhelmingly by private borrowings. These three sectors alone account for 39% of economic output.
Another three of the ‘big eight’ sectors (accounting for a further 19%) are health, education, and public administration and defence, each of which has grown as public spending has ballooned.” Dr Tim Morgan
In my opinion there are still way too many financial sector jobs. The financial sector not only employs around 1.1m UK workers but they are often some of the best paid and the sector contributes massively to the UK tax take at around 12% of total tax revenue (PWC 2010 report) relative to their being around 5% of the workforce. The sector is shrinking inexorably but at a very slow pace, I see substantial downside risks to property and employment prospects in finance hubs like Edinburgh and London. However, the UK economy as a whole is highly geared to FIRE (Finance, Insurance and Real Estate) jobs so this shrinkage does not bode well.
The chart below shows the extent of the rebalancing on the UK economy that has taken place over the last 20 years with the “FIRE” sectors stealing share from the traditional industries.
Austerity is going to be a struggle given the current backdrop, the economy is already in recession whilst Europe implodes and the US slows dramatically. There is a comparison with Spain which also made commitments to harsh fiscal tightening to maintain the confidence of the bond market. The markets have not responded favourably, punishing the Spanish sovereign yield because they realise that the banks are heavily burdened with housing market losses which will eventually have to be socialised onto the sovereign balance sheet.
How does Financial Repression impact the UK?
“Financial repression includes directed lending to the government by captive domestic audiences (such as pension funds or domestic banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks, either explicitly through public ownership of some banks or through heavy ‘moral suasion’.
Financial repression is also sometimes associated with relatively high reserve requirements (or liquidity requirements), securities transaction taxes, prohibition of gold purchases (as in the United States from 1933 to 1974), or the placement of significant amounts of government debt that is non-marketable. A large presence of state-owned or state intervened banks is also common in financially repressed economies. In the current policy discussion, financial repression issues come under the broad umbrella of “macroprudential regulation”, which refers to government efforts to ensure the health of an entire financial system.” Carmen Reinhart
Regulatory changes like Basel require increased capital for non sovereign assets. The effect seems to be that in these times of extremely scarce capital banks are forced to own UK gilts as these are afforded a zero-risk weighting and therefore improve capital adequacy. The interlinkages between banks and sovereigns increase whilst the return on