Now, right now, is the winter of our discontent

The failure of the political class 

After a relaxing Brexit-free fortnight, UK parliament resumed on Monday and was plunged into a series of constitutional crises related to the apparently never-ending Brexit shenanigans. As one who has followed the twists and turns in this debate from the very start, it is highly frustrating at this point of the proceedings to see that politicians are still treating the most serious economic and political event in British modern history as if it were the subject of an undergraduate debating society.

Just before Christmas The Economist’s Bagehot column published a particularly scathing critique of the UK’s political class. In The Economist’s words “the country’s model of leadership is disintegrating. Britain is governed by a self-involved clique that rewards group membership above competence and self-confidence above expertise.” The article points out that David Cameron “rewarded … pals for losing an unlosable referendum, with peerages [and] knighthoods” whilst the system is “introverted and self-regarding, sending its members straight from university to jobs in the Westminster village.” It goes on to criticise the “new political class [for being ] devoid of self-restraint, precisely because it thinks it owes its position to personal merit rather than the luck of birth.” In another article in the same edition, The Economist calls Theresa May “politically unembarrassable” for remaining in office “despite losing her majority in an election that was considered unlosable.” Jeremy Corbyn, Labour’s leader, “is perhaps more shameless still: in 2016 he refused to budge even after losing a confidence vote among his MPs, on the basis that under Labour’s rules the members pick the leader.” 

Not all politicians deserve to be tarred with the same brush, of course, but when it comes to Brexit too many of them fail to adhere to Mark Twain’s maxim that it is best to keep quiet and be thought a fool than open one’s mouth and remove all doubt.  Take for example the view expressed by the prime minister in December that another referendum “would do irreparable damage to the integrity of our politics.” It will not require another referendum to damage the integrity of the political system: In the minds of many people, MPs are doing a good enough job of that on their own. 

Parliament to the rescue? 

I am not altogether sure whether the Brexit-related events of this week show parliament in a good light or not - only time will tell. To recap, a House of Commons motion was amended by backbench MP (and former Attorney General) Dominic Grieve which will force the government to put forward its Plan B within three days of the Withdrawal Bill being defeated in the parliamentary vote – something which is seen as inevitable next week. Controversy arose because the motion was believed to be unamendable and was only altered thanks to the intervention of the House of Commons Speaker – a move which was deemed unconstitutional by Brexit supporting MPs. But as Grieve pointed out, the previous requirement for the government to present its Plan B 21 days after parliamentary defeat was no longer credible after it wasted four valuable weeks by postponing the vote which should have taken place in December.

There is a huge irony in the complaints of those MPs who deem the actions of the Speaker unconstitutional for he has effectively enhanced parliament’s power over the Brexit process. Those who are serious about taking back control surely have to recognise that parliament is the only sovereign body. Looking back over the past two years, the government’s original plan that only it would manage the Brexit process has been gradually stripped  away piece by piece – recall that in 2016 the government envisaged little role for parliament in the Brexit process which was only reversed following an intervention by the courts.  Of course the full consequences of the Speaker’s decision will only be manifest in the course of time: If a precedent has been set that allows parliamentary motions to be amended in this way, it will reduce the government’s control over the parliamentary process which could have major adverse consequences in future. 

Dealing with the vote 

But that is not a consideration for today. All attention is fixed on next week’s vote on the Withdrawal Agreement which is likely to be rejected – by a substantial margin if current rumours are true. Although the government has not so far countenanced the prospect of defeat, there are signs it is beginning to realise that the game is up. We are thus back to the position of asking what happens next? If Theresa May were not so “politically unembarrassable” she might consider resigning given the extent to which her credibility is bound up in the deal her government has reached with the EU. Somehow I can’t see that happening: The prime minister believes she has a duty to see Brexit through and is too dogged to resign. But a three day window gives the UK too little time to go back to Brussels to try and get some concessions from the EU which will not be granted in any case.

My default position remains that the UK will be forced to extend the Article 50 period. Whilst the EU is likely to grant such a request in order to prevent the chaos that would result from a hard Brexit, it might yet call upon the UK to justify such an action by asking whether it plans a general election or even a second referendum. As abhorrent to the government as the latter option might be, the former is even less palatable since there is a real possibility that the Conservatives’ position would be weakened still further.

To say that the government is between a rock and a hard place is an understatement. I recently came across an article in the Daily Telegraph suggesting that the situation facing Britain 40 years ago during the Winter of Discontent was far worse than the position we find ourselves in today. It isn’t! Like the Conservative government today, the then-Labour government was a prisoner of factions within its own party. But unlike 40 years ago when the Labour Party was fraying at the edges in the same way that the Tories are now, the government was still coherent. It also faced credible political opposition in the form of Margaret Thatcher who took office soon after. The scars of 1978-79 thus healed relatively quickly and although this period gets regurgitated from time to time, most people dismiss it fairly quickly. I fear this will not be the case with Brexit. To quote Shakespeare, “NOW is the winter of our discontent.”

Some thoughts on the 2019 outlook

It is with some trepidation that we look ahead to 2019. There are indications that economic activity is slowing and markets are selling off as they adjust to changed circumstances, which is reason enough to be concerned. But the overriding concern is politics with Donald Trump applying his policy of unfiltered Tweeting rather than rational engagement, on issues ranging from China and North Korea to veiled threats about the position of Fed Chair Powell. Brexit continues to demonstrate why political decisions are too important to be left to politicians and the European elections in May will give voters another chance to demonstrate their support for populists who continue to undermine the rules-based system on which we depend.

Starting first with the economics, it is unlikely that we will see recessions in any of the world’s major economies this year (hard-Brexit considerations in the UK notwithstanding). Both the US and euro zone are projected to lose some momentum this year, with growth rates around 2.5% and 1.4% respectively roughly around 0.5 percentage points lower than in 2018. That is far from a bad outcome if realised, although some of the data around the turn of the year suggest that the slowdown may be a bit more abrupt than we thought a few weeks ago.

But the US cycle in particular looks long in the tooth: So long as the US does not fall into recession before July, it will surpass the 120 month upswing between March 1991 and March 2001 as the longest on record. But the strength of each successive upswing is weaker than the previous one and policy makers continue to fret about the weakness of productivity growth, which is the key driver of living standards, compared to previous cycles. Another puzzle for policymakers is the absence of inflation, and I doubt that inflationary concerns will justify monetary tightening in 2019. But I maintain my view that interest rates that were set in order to deal with economic conditions a decade ago are not appropriate for today’s environment. The Fed was right to raise rates since late-2015 which at least gives it some monetary ammunition to deploy in the event that the economy turns down – room for manoeuvre that neither the ECB nor BoE have.

Against this backdrop, why are markets so jittery? I have long maintained that a large part of the correction reflects a repricing after investors pushed asset valuations too far on the back of loose monetary policy and recovering growth prospects. In the course of the first nine months of last year, investors continued to force US equities higher despite the fact that the Fed was clearly engaged in monetary tightening, buoyed by the fact that cuts in corporate tax cuts were giving earnings a one-off boost. Reality finally began to take hold during the autumn but what surprised me was that many market commentators were surprised.

Regular readers may know that I track Robert Shiller’s 10-year trailing P/E for the S&P500 as a measure of the extent to which markets are out of line. Last month it dipped below 30 for the first time since summer 2017 (the post-1950 average is 19.4). On the basis of current data, the S&P500 would have to fall by another 10% just to return the P/E index to 25. This would put the S&P500 around 2270, representing a 23% decline from the September 2018 peak and only around 3% below the pre-Christmas flash crash low. Making stock market predictions tends to make fools of us all, but I would not be surprised to see US equities making a 10% downward correction during the course of this year. Whether we go lower depends very much on the outlook for 2020. I am not hopeful.

Politics remains the big concern for markets. Dealing with the easy one first, I do not believe that the UK will be allowed to crash out of the EU without a safety net in place so my prediction Is that there will be no no-deal Brexit (probability 80%). Note that the probability is not 100% – such has been the lack of economic rationality during the whole Brexit process that there are major tail risks and the events of December 2018 give little confidence that the UK knows precisely what it wants and, more worryingly, how to achieve it.

A more difficult question is what will happen in the US-China trade dispute. As a (usually) rational individual, I find it difficult to understand why the US would want to ratchet up the pressure. Admittedly, the trade dispute is hurting China but this week’s announcement by Apple that slowing Chinese revenues will hurt profits is an indication that the process is also beginning to impact on the US. My guess is that some of the tension will ease in 2019 once Trump is satisfied that China has taken some pain. But as one who has habitually underestimated Trump’s unwillingness to play by normal rules, I may be accused of being too sanguine. However, one prediction I will make is that impeachment proceedings will not be initiated against Trump as Democrats realise that the process will be politically counterproductive.

Europe will likely to continue grinding along in low gear. The economy has lost momentum and EMU members increasingly have to deal with domestic political issues. I would not like to offer odds on Angela Merkel remaining as German Chancellor, given that she has already announced her departure. But September will mark the halfway point of her final term in office and it might be deemed a good time to hand over the reins.

One change we know is happening for sure is that Mario Draghi will end his eight-year term as ECB President. The smart money suggests that he will be succeeded by former Bank of Finland governor, Erkki Liikanen. I have no strong opinions on the matter but I suspect whoever it is, it won’t be Bundesbank President Jens Weidmann whose stock with southern European nations is not high. Also this year, we can look forward to the announcement of who will succeed Mark Carney as BoE Governor, as he is scheduled to depart in January 2020. Whenever anyone asks me, I say the BoE need look no further than FCA Chief Executive Andrew Bailey. But given that Carney has already twice extended his tenure, who knows whether he might do so again?

We all know that there are no certainties in life. But I hope I am right about my Brexit call above all others. Because if I am wrong, my blog posts around early April might become less frequent as I am forced to forage for the food that we used to import.

2018 in review

As we look back at 2018, many of the bigger trends which I anticipated a year ago did indeed pan out. There were a few unanticipated surprises, of course: It would not be quite the same if there were not. To summarise the year as succinctly as possible, global growth held up although fears of a slowdown began to materialise late in the year; markets had a rocky year and politics dominated the agenda. 

As I noted in early January, markets at the start of the year were entering late-cycle territory with many investors describing themselves as “reluctant bulls.” My recommendation at the start of the year was to reduce the degree of risk exposure, primarily because I expected volatility to pick up, but I still expected equity markets to end the year up 5-10%. I was right about the volatility but wrong about the trend in equities, although I was right to believe that equities could not continue to rally as they had done in previous years. The equity option volatility trend reflects a change in investor attitude towards risk and there was a sharp spike in February and a less elevated but still strong upward movement towards the end of the year. I have long believed that markets were under-pricing risk and 2018 was the year that a reassessment took place. Many of those who were reluctant bulls a year ago are now outright bears, and with hindsight I should have had the courage of my convictions to call for the market correction that I feared might happen.

The reasons for the investor reassessment are many and varied. My main concern a year ago was I believed equities to be overvalued: Based on the Shiller ten-year trailing P/E metric I still believe they are. Cracks in the tech universe were another factor: Tech stocks continued to fly high until late in the year but I did warn that “a market which is so dependent on tech stocks is clearly vulnerable to a shift in sentiment.” And so it proved when the FAANG stocks started to give up their gains around October. This is partly the result of product dependency fears, with concerns that demand for Apple products is slowing, and cyclical factors as growth concerns mount. I also noted that the Fed’s quantitative tightening policy, whereby it continued to reduce its balance sheet, at a time when interest rates were rising indicated that “more air is being taken out of the monetary balloon than at any time in the past decade.” There is no doubt that US monetary support for equity markets has been steadily withdrawn over the past 12 months.

But undoubtedly the biggest factor influencing markets was the outbreak of a trade war between the US and China – something which happened more suddenly than I anticipated because I thought that President Trump’s bark was worse than his bite. Although the G20 summit in December appeared to take some heat out of the US-China trade dispute, many of the issues which prompted the dispute in the first place remain unresolved. In what appears to have been a truce in trade hostilities, China made some trade concessions that prompted the US to hold off from raising tariffs on a wider range of goods. But China continues to skirt around the fact that the expropriation of copyright technology as a precondition for foreign firms to do business in the domestic Chinese market remains a live issue. To the extent that the trade ceasefire is conditional on eliminating this problem, we cannot say that trade concerns will not resurface in 2019.

Perhaps one of the biggest issues exposed by the trade war is that the rules-based architecture on which global prosperity has been based is threatened in a way we have not seen in many decades. The WTO exists as part of the institutional framework to prevent trade frictions from escalating, with 38 disputes brought before it this year alone. Unfortunately, the Trump administration is sceptical that the WTO will act in favour of the US and it continues to block appointments to the WTO’s Appellate Body which has been reduced from seven members to three. With the terms of two members set to expire in December 2019, this would reduce the Appellate Body below its necessary quorum unless new members are appointed and would mean that the WTO is no longer able to arbitrate in trade disputes. For the record, an analysis of WTO cases brought against China[1] indicate that “there are no cases where China has simply ignored rulings against it” – in contrast to the US which “has not complied with the WTO ruling in the cotton subsidies complaint brought by Brazil.” Bias? What bias?

But it is not only trade issues that have rattled markets. There is a growing trend towards economic nationalism evident throughout global politics which is leading to concerns that we have passed the high water mark of globalisation. Trump’s America First policy is a clear manifestation of this, as is Brexit. Indeed, perhaps one of the key trends to emerge in 2018 was the sense of drift in political leadership. I have talked at length about the political failures of Brexit, and I have serious reservations that politicians will see the light in the next three months which will avoid a hard Brexit having spent the past 30 months behaving irrationally. But French and German politicians are also facing increased pressure from an electorate which does not like what is on offer, whilst Italy’s populist policies have drawn the ire of the European Commission. This lack of leadership and inability to rise above local concerns to see the bigger picture is one of the biggest threats to the economy and markets as we look ahead to 2019.

In terms of some of my other 2018 predictions, I didn’t do altogether badly. Bitcoin prices collapsed, as I suspected they would; there was no war on the Korean peninsula and Donald Trump was not impeached. I was also right that Italy would not win the World Cup (though that was more to do with the fact they did not qualify for the finals). But when I did do the analysis in mid-year and tipped Germany to win, I did so only on the basis that the 18% probability assigned to their victory chances implied an 82% they would fail to win. Those are the sort of predictions I like – ones which can be both right and wrong at the same time. Happy New Year.

[1] Bacchus et al (2018) ‘Disciplining China’s Trade Practices at the WTO’, Policy Analysis 856, Cato Institute

Forecasting the UK: How did we do?

At this time of year journalists like to look back at how forecasters did over the past twelve months. One of the comparisons I follow most keenly is that compiled by David Smith in the Sunday Times, even though I have some reservations about the methodology (here for the full article if you can get past the paywall). Smith makes the point that those making UK forecasts in 2018 did pretty well. But what has struck me most in recent weeks is not so much that many forecasters did well in their assessment of UK growth in 2018, but how consistent the consensus has been for the past two years regarding the impact of Brexit on the economy.

Each month the Treasury invites contributors to make projections for a wide variety of indicators for the current and following years, with the forecast horizon rolled over in February of each year. The first projections for 2017 were thus published in February 2016. Prior to the EU referendum the consensus was that GDP growth last year would come in at 2.1%. After a brief wobble in the summer and autumn of 2016, when the consensus dipped to 0.7%, forecasters quickly adjusted their forecasts upwards when it became clear that the economy was not falling off a cliff. Nonetheless, growth last year came in at 1.7% - a good 0.4 percentage points below pre-referendum estimates.

The first projections for 2018 were published in February 2017. What is remarkable is that over the last 22 months the projection for 2018 growth has barely changed, and although we only have data for the first 10 months of the year we have enough to be confident that it will come out close to 1.3% for 2018 as a whole. As a rough guide to assess the extent to which forecasts have changed, I used the Treasury’s database of consensus forecasts to measure the consensus projection for growth in December of each year versus the initial estimate for the year in question, made in February of the previous year. For example, in February 2017 the consensus forecast for 2018 UK GDP growth was 1.4%, implying a 0.1 percentage point deviation from (expected) outturn.

We can run this analysis all the way back to 1988. The evidence indicates that the 22-month accuracy of UK forecast projections for 2018 was the second lowest in 31 years, beaten only by 2015 which turned out to be spot on. Of course, forecasts can bounce around throughout the forecast horizon as short-term indicators give additional information. Indeed, the consensus forecasts for 2015 rose during 2014 and early 2015, only to fall back again to where they first started. One measure of forecast stability is the standard deviation of monthly forecasts, and on this basis projections for 2018 have shown the lowest degree of variation in the 31 years of available data (chart).

 

If nothing else, this rather refutes the claim by Steve Baker MP, who noted earlier this year  that he was unable “to name an accurate forecast, and I think they are always wrong.” Where forecasts do tend to go look shaky is when the economy is subjected to an unanticipated shock. A good example of this is the recession of 2008-09 which was entirely unforeseen when the first 2009 forecasts were published in February 2008, with the result that the consensus was forced to downgrade sharply. A similar, although less sharp, correction was evident during the recession of 1990-91. Whilst the economy was not subject to a shock in 2018, the forecasts have to be seen against a backdrop of high post-referendum uncertainty – it has not been a “normal” year.

One of the great ironies of the 2018 comparisons, which are based on projections submitted to the Treasury in January 2018, is that Patrick Minford’s Liverpool Macroeconomic Research (LMR) outfit[1] finished at the bottom of Smith’s rankings. You may recall that Minford is one of the leading lights in the pro-Brexit group Economists for Free Trade which produced its Alternative Brexit Analysis earlier this year which suggested: “All those who attempt to forecast the UK’s long-term future must bear the burden of having their endeavours frequently proved wrong … This isn’t a matter of misforecasting the GDP or inflation figures by the odd percentage point or two. We all do that all the time. Rather, the record is making some serious errors of judgement about some of the key issues before the country.” There is a delicious irony in this statement: Most economists believe that pro-Brexit groups are making serious errors of judgement about the economic impact of Brexit and as a consequence their forecasts are way off target.

The level of uncertainty surrounding next year’s forecasts is even greater and I will deal with that another time. Suffice to say, however, if there is a hard Brexit the consensus forecast for growth of 1.5% is likely to prove an over-estimate. For the record, LMR is forecasting growth of 1.9% next year. It is not impossible, but only if the cliff edge Brexit is avoided.

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[1] Mrs Rosemary Irene Minford has more than 75% of the company’s voting rights which of itself is not an issue. But Mrs Minford’s date of birth is given as May 1943 which happens to be Patrick’s d-o-b. Elsewhere in the filings Mrs Minford’s d-o-b is given as January 1946. I am not sure whether this reflects laxity on the part of Companies House or is another example of Minford playing fast and loose with facts. See this link for more detail https://beta.companieshouse.gov.uk/company/01645294