MiFID II: End of the road or just a bend?

For those working in European financial services the MiFID II (Markets in Financial Instruments Directive) legislation, which came into effect on 3 January, potentially marks one of the biggest shifts in the business since Big Bang in 1986. The latter marked the liberalisation of financial services by deregulating many of the practices which had previously characterised the City of London (notably the abolition of fixed commission charges and the demarcation between market makers and the brokers selling stocks). For a time in the late-1980s, the City felt a bit like the wild west as companies with deep pockets rushed to expand into new business areas against a backdrop of relatively lax regulation. More than three decades later, if MiFID does not represent a 180 degree turn it is certainly a long way around the dial.

The objective of MiFID II is to strengthen the degree of investor protection by improving the functioning of financial markets. This in turn implies increasing the degree of market transparency and resilience. The law puts a much greater onus on counterparties to accurately report trades and the prices at which they take place (the transparency part). Enhanced reporting structures are also required to ensure that the products which are sold by financial institutions are appropriate for the client, thus reducing the likelihood of a bust (the resiliency aspect). It is thus far harder these days to flog inappropriate products to unsuspecting clients in order to make a fast buck. About time, of course. We have heard too many stories of misselling over recent decades to avoid the conclusion that some parts of the industry cannot be trusted to regulate themselves and that they will have to be forced into it by the power of the law.

The scope of the products to which all these regulations apply is also being expanded as MiFIR (Markets in Financial Instruments Regulation) comes into force. Not surprisingly, the costs of implementing the procedures required to comply with the new regulations are enormous. And nobody knows how the regime will work in practice. The whole process is based upon the application of “best execution” – the duty to get the best price in the shortest possible time. But this is open to a great deal of interpretation. There is also a risk of regulatory arbitrage across the EU if the MiFID II rules are implemented differently across legislative regimes. Moreover, whilst it is impossible for business conducted in the EU on behalf of EU-based clients to avoid the scope of the law, there is no reason why business conducted in the EU on behalf of extra-EU clients need be subject to the same rules. Accordingly, this could drive some activity out of the EU towards more light-touch regulatory areas.

From a research perspective, the biggest issue is that the costs of research now have to be unbundled and can no longer be hidden within trading commissions. The law now says that financial institutions managing money on behalf of clients are no longer allowed to receive unsolicited research from those providing investment advice. Thus, asset managers now have to enter into a contract with a sell-side institution to ensure that they are compliant with the law, in order that those whose funds they are managing can see how much they are being charged for research advice. We have known for some time that this issue would hit us eventually and many firms have been thinking about its implications for at least two years. What is particularly interesting is the process of price discovery that has since taken place.

Initially, firms providing financial research aimed high but as asset managers baulked at the charges, so they have been dramatically reduced. Much of the anecdotal evidence suggests that research costs will not be covered by the fees paid by the buy side which is going to change the face of financial sector research. An article in the FT last week asked us to “spare a thought, friends, for Julian Bonusworthy. North of 40, he works for a respectable if second-tier global bank with towering offices in London. He is an equity analyst, advising fund manager clients what to buy and sell. His base salary is £350,000 and in a good year he takes a big performance award at year-end. His twins are in private school, the Land Rover is paid for and his £4m house is not.” He may be an imaginary character but research analysts earning that kind of money are about to become a much rarer breed[1].

The largest company by market cap in the FTSE100 is HSBC. According to Bloomberg, it is covered by 33 analysts of which 12 have a buy recommendation; 5 a sell and 16 a hold. One thing is for sure: the buy side of the industry simply does not have the budget to pay 33 analysts to cover this single stock, and they certainly do not need to shell out huge amounts to be told to hold. Therefore a lot of winnowing is about to take place. Firms which can offer a wide range of client services will continue to find a market for single stock research and offer it at competitive prices. Those continuing to offer good investment ideas should also be able to continue making a living. But for many people in financial services life is about to get a lot harder. Big Bang may have heralded the start of the financial research industry; MiFID II might sound its death knell.

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[1] As for economists who, I can assure you, earn much less the MiFID legislation defines investment research as “financial analysis or other forms of general recommendation relating to transactions in financial instruments.” Technically, that means we are largely exempt since much of our analysis does not relate to transactions in financial instruments.

Some thoughts on the 2018 outlook

One of the anniversaries you may have missed was the bicentenary of the first publication of the novel Frankenstein, which first saw the light of day on January 1 1818 when the author, Mary Shelley, was just 20 years old. As you are no doubt aware, the eponymous title referred to the scientist who created the monster which in popular culture now bears his name. A couple more economically relevant anniversaries will also fall in 2018. Assuming that the US economy does not go into reverse, May 2018 will mark the second longest US economic expansion on record, exceeding the 106 month upswing between February 1961 and December 1969. Perhaps of greater symbolic significance, September will mark the tenth anniversary of the Lehman’s bankruptcy – an event which proved to be a Frankenstein moment for the global economy.

From an economic perspective, global GDP growth this year is predicted to post its strongest rate since 2011 with the IMF forecasting a rate of 3.7%. Indeed, there are increasing signs that the global economy is beginning to match the optimism which has long been a feature of financial markets, with Europe likely to be one of the brighter spots after years of underperformance. But markets appear to be in the late stages of a cycle which will soon enter its tenth year, with concerns about the overvaluation of equities whilst in the credit world spreads remain narrow and covenant-lite issuance is on the rise.

As I noted in my previous post, it was possible to rationalise market movements in 2017 on the basis of accelerating global growth, low inflation and a lax monetary stance on the part of global central banks. But one of the features of the current market cycle is that many investors describe themselves as “reluctant bulls.” This suggests that they may decide to jump off the bandwagon in the event of an event which triggers a change in sentiment. This is not to say that I believe markets will necessarily crash, but it might pay to reduce the degree of risk exposure – perhaps by switching the top 10% of risky assets in the portfolio for something less risky. One curiosity of market moves of late is that the surge in US equities is increasingly reliant on a narrow base of stocks. Indeed, the so-called ‘FANG’ stocks (Facebook, Amazon, Netflix and Alphabet) accounted for roughly 17% of the rise in the S&P500 in 2017: If we add Apple, this figure rises to 25%. A market which is so dependent on tech stocks is clearly vulnerable to a shift in sentiment.

Monetary policy is likely to play a more important role in market thinking in 2018. Whilst the market shrugged off US rate hikes during 2017, it will probably have to contend with another 50-75 bps of monetary tightening this year. In addition, the Fed will continue to run down its balance sheet. Admittedly, an expected reduction of $300 million relative to an overall balance sheet of $4.5 trillion does not represent a huge amount of liquidity withdrawal, but to the extent that more air is being taken out of the monetary balloon than at any time in the past decade, it might point to a market which rallies at a slower pace than we witnessed in 2017. I expect that global stock markets will end the year higher than they began and I’ll stick my neck out by predicting a rise of 5-10% in the major US and European indices.

One of the interesting developments to watch in 2018 will be the course of bitcoin prices. There are numerous unknowns regarding the nature of the first digital currency to capture public imagination, notably who holds it. Despite the establishment of a bitcoin futures contract last month, this is unlikely to increase the depth and liquidity of the market so long as institutional investors remain on the sidelines. I still believe bitcoin is a bubble waiting to burst – it is after all currently trading 23% below its mid-December high (chart) – but predicting the future course of events is a mug’s game, as anyone who tried predicting its course last year discovered. I will, however, be that willing mug and predict that the price will end the year lower than where it started.

Politics in the Anglo Saxon world will continue to feel the aftershocks of the great 2016 populist revolt. US mid-term elections will be held in November where attention will focus on whether the Democrats can win back control of the House. Last month’s Alabama Senate election, in which Democrat Doug Jones pulled off a stunning win over his Republican opponent, Roy Moore, is an indication that there are limits to the electorate‘s tolerance of the nastier elements of Republican politics. Moreover, the parties of first-term presidents have in recent years tended to lose seats in the mid-terms, suggesting that there is a chance that the Democrats can mount a political comeback. Whilst I would not put money on it, it does raise a risk that 2018 might be the year in which political gridlock returns to Washington.

On this side of the Atlantic, the Brexit soap opera will continue to play out. In twelve months’ time the UK will be staring Brexit in the face, so it is imperative that progress is made with regard to setting out the terms of the subsequent relationship between the UK and EU. Nothing that we saw in 2017 gives me much hope that the UK government is up to the task. Such progress as we have seen has been dependent on the goodwill of the EU, such as accepting the Irish border fudge as a sign of genuine progress (it isn’t). There is also evidence to suggest that questions are being raised amongst voters regarding the Brexit process and whilst this will not mean that the UK government changes its position, it may be forced to soften it. Undoubtedly, this is a theme to which I will return.

Other things I have been asked about of late include whether I believe the Italian elections due in March are a big deal (no); whether there will be a war on the Korean peninsula (doubtful) and whether Donald Trump will be impeached (no). Unfortunately my clairvoyant abilities do not extend to giving definitive answers to these questions, so let us just say that I would assign a probability of less than 50% to any of them. Of course, the big question of 2018 is who will win the World Cup? I can respond with much more certainty than to any of the issues above: Not Italy.

2017 in review

After an unpredictable 2016, 2017 was unable to live up to that level of excitement – and I for one am extremely thankful for that. From a macroeconomic perspective there were certainly no fireworks: GDP growth in most parts of the world was steady, and in Europe it outperformed expectations – even in the UK, where recent data revisions suggest a growth rate closer to 1.8% in 2017 rather than the long-predicted 1.5%. Central banks did not have a lot to do, other than the Fed which raised rates in three steps of 25 bps, although the Bank of England surprisingly stepped into the ring with a 25 bps rise in November. The lack of both wage and price inflation is becoming an increasing cause for concern in many parts of the industrialised world, although policymakers hope that ongoing recovery in 2018 will eventually prompt a pickup.

In this benign environment markets continued to make hay, with equity indices on both sides of the Atlantic setting new highs. This confounded one of my predictions for 2017 which was that the ongoing equity rally would peter out in the spring. Many measures of equity valuation certainly appear elevated: Robert Shiller’s long-term trailing P/E measure for the S&P500 is currently at the level seen at the time of the 1929 Wall Street crash and is only exceeded by the levels of the late-1990s tech boom (chart). A measure of the S&P market cap relative to US GDP is also running at levels which in the past have preceded a bust. Add in the fact that measures of market risk, as proxied by option volatility, have touched record lows in the course of 2017, suggest that this is a market which looks too frothy.

That said, solid growth and low inflation add up to a goldilocks scenario for most investors, particularly with central banks continuing to offer cheap money. But if we think about equity P/E ratios, the denominator (earnings) is currently not being driven by rapid price inflation: Corporate profits generally reflect the solid growth picture. Investors are thus prepared to pay a sizeable premium for equities, which is normal in a low inflation environment. Thus, a focus on elevated P/E ratios may paint an overly pessimistic market view. This does not mean we can afford to be complacent and I will look at the 2018 outlook in my next post, but given the macro and monetary policy backdrop, we can at least rationalise market movements in 2017.

Indeed, markets have shrugged off the biggest risk identified 12 months ago: politics. In that sense, one of my 2017 predictions was borne out when I wrote in early January that “I would be surprised if Donald Trump can do much damage to the US economy in 2017.” To my surprise, the administration did manage to force through its planned tax reform before year-end, with the proposed cuts in corporate taxes giving equity markets a boost. Refinements to the package suggest that the longer-term economic impacts may not be quite as bad as initially expected, with analysis by the Tax Policy Center pointing to a short-term GDP boost and a smaller rise in the deficit over the longer-term compared to the analysis it produced in June.

On this side of the Atlantic, fears that the populist surge unfolding elsewhere would find renewed expression in the Dutch and French elections proved unfounded. Indeed, the emergence of Emmanuel Macron was one of the biggest political surprises, and a positive one at that, with Europe at last finding a charismatic centrist politician committed to the liberal democratic ideas which have underpinned the peace and prosperity of the last 70 years. But the German election did provide an upset as voters deserted the two main parties in favour of smaller groups, with the AfD emerging as a relative winner. The fact that Germany has not yet managed to form a coalition government more than three months after the election is an indication that Europe’s largest economy is not without its own political problems, and the general consensus is that Angela Merkel has entered the twilight of her political career. The fact that the twin motors of the EU project continue to run out of synch suggests that the EU reform process may not make much headway in the near term.

Which brings us to Brexit, a subject that has taken up so much of my time in recent years. I assigned a 45% probability to the likelihood that the UK government would trigger Article 50 in March without making any contingency plans in the event that discussions with the EU proved more difficult than expected. But in effect, that is precisely what happened. The UK remains a divided and polarised country characterised by an absence of effective government. On Friday, Andrew Adonis, a Labour politician who chaired the national infrastructure commission, resigned citing the dysfunction at the heart of government and accused the prime minister of being “the voice of UKIP”. 

To quote Adonis, “I do not think there has ever been a period when the civil service has been more disaffected with the government it serves. I do not know a single senior civil servant who thinks that Brexit is the right policy, and those that are responsible for negotiating it are in a desperate and constant argument with the government over the need to minimise the damage done by the prime minister’s hard-Brexit stance. It is an open secret that no one will go and work in David Davis’s department, and Liam Fox is regarded as a semi-lunatic.”

Whatever one’s views on Brexit, Adonis’ comments highlight what many of us have suspected for a long time: The government does not have a plan, without which Brexit will be an utter car crash. And to think, the Conservatives remain the largest party in parliament (despite losing their majority following a spectacularly incompetent election campaign). What does that say about the opposition? Or indeed us? We deserve better in 2018.

Generating economic policy buy-in

Just before Christmas, the FT commentator Gideon Rachman penned a column which argued very strongly that “Economics is – or should be – part of moral philosophy  …  ‘the economy’ is not just about growth. It is also about justice.” This is a very important point and one that tends to be overlooked, or at least downplayed, by large parts of the economics profession. Rachman argues – as indeed as I have done on this blog – that many voters do not buy into the economic vision offered by politicians because they do not see how it benefits them. What is even worse, they often believe they are being discriminated against in favour of other interest groups.

Making America great again speaks to the millions of voters who believe somehow that the US’s status of top dog is being eroded by emerging economies that do not play by the economic rules and that the US is being penalised for abiding by them. In a similar vein, taking back control speaks to those British voters who see the UK as being held back by a monolithic EU. As an economist, I find such statements absurd. After all, the US is still the pre-eminent economic and military superpower whilst EU membership gives the UK access to the largest and richest single market on the planet. But there is no reason why this should cut any ice with the average voter who is struggling to make ends meet at a time of low wage inflation and against a perceived backdrop of mounting job insecurity (which incidentally is not backed up by the UK evidence).

The predominant economic model in the Anglo Saxon world over the last 35 years has been a market-oriented policy in which government has tried to reduce its role in the belief that the market will provide the most efficient allocation of resources, thus boosting welfare. Prior to 2008 the evidence appeared to suggest that whilst voters were aware of the downsides of this model, the economic tide was rising sufficiently quickly to float all boats. But political and economic circumstances have changed over the past decade. Society’s sense of natural justice was offended by government actions to bail out banks whilst simultaneously imposing a policy of fiscal austerity, which sowed the seeds of a belief that the system is rigged in favour of big business at the expense of the little guy.

This has resulted in many aspects of our current model being put under the microscope and raises questions whether economic policy is going in the direction which voters are prepared to buy into. As Rachman points out, intra-generational issues are uppermost in the minds of many voters. There are concerns across the western economies that those in born after 1980 will not be as wealthy as their parents. Evidence from the UK, for example, suggests that younger adults have much less wealth to their name than previous generations did at a similar age. Over the past decade, as younger voters have gone through university and entered the labour force, many of them are beginning to question whether they will be able to reap the economic rewards they were promised. UK students no longer get the benefit of a free university education and finish their university studies with much higher levels of debt than their parents. Indeed, UK students now carry a staggering £13bn of debt – an increase of almost 190 times what they owed in 1990.

At the same time, the younger generation must pay the taxes to cover the rising costs of providing for the welfare needs of the ageing baby boomers, whilst struggling to find the high-paying jobs which previous generations were able to secure. They will also have to deal with the fallout from the populist reactions triggered by the Brexit vote and the election of Trump – both of which were propelled by the votes of the older generation. Millennials in the industrialised world can be forgiven for questioning the legacy bequeathed to them by older generations.

Policies which offer a trade-off between more market solutions and lower taxes are increasingly unlikely to find electoral favour. Nobody wants to pay more taxes, of course, but there are limits on how far countries such as the UK can continue to reduce them and still maintain the reasonable standard of public services that the public has come to expect. Scarcely a week goes by without a newspaper story decrying cuts to the armed forces or the strains imposed on a health system which struggles to cope with the strains placed upon it. It is perhaps for this reason that we are seeing renewed voter interest in “radical left” parties across Europe which promise a greater role for the state in a bid to improve the lot of those left behind (chart).

Indeed, as the IMF pointed out last week in its regular assessment of the UK economy “greater reliance on revenue measures for [fiscal] consolidation than in recent years may be warranted.” Amongst the potential measures put forward were a reduction in “the tax code’s bias toward debt” which benefits corporations, and rebalancing property taxation away from transactions and toward property values. Ironically, the US appears to have gone in the other direction with the recently unveiled changes to the tax system primarily benefiting corporates and better off individuals.

If we really are in it together (to use George Osborne’s phrase) some changes to the incidence of taxation would be a good place to start to help win over voters that the system is not biased against them. Whilst many in the policy establishment draw on the laissez-faire teachings of Adam Smith, we should not forget that “The Theory of Moral Sentiments” extensively explored ideas such as morality and human sympathy. He never advocated the devil-take-the-hindmost policy which many of his adherents claim. It is a lesson the economic and policy establishment perhaps needs to relearn.

The costs (and benefits) of Christmas

According to a survey conducted by the National Retail Federation, the average American plans to spend $967.13 on gifts during the 2017 holiday season (defined as spending over November and December), which represents an increase of 3.4% on 2016. Cheapskates! According to the Christmas Price Index calculated by PNC Financial Services Group, the basket of goods which one’s true love can be expected to send over the twelve days of Christmas (a partridge in a pear tree, two turtle doves etc.) costs a whopping $34,559. If you follow the sequential purchasing of the presents (12 partridges in pear trees, 11 times two turtle doves etc.), the total cost amounts to almost $160,000.

Over the last 33 years, the average cost of Christmas on the basis of this index has risen by 2.9% per year. But significant volatility is introduced by the price of swans. PNC thus suggest that a core Christmas index can be constructed excluding this item, although this does rather change the nature of the index as it is by far the most expensive item, accounting for 50% of total outlays (down from 78% in 1984). If your true love is not particularly partial to swans a-swimming, this reduces the total cost of the basket to just below $80,000. Quite the bargain! In terms of inflation, however, the core index has increased at a rate of 4% per year since 1984. For the purposes of comparison, US headline consumer price inflation since 1984 has averaged 2.6% per year (core: 2.7%).

Assuming that the UK imports all of these goods from the US (I know, but we are not being entirely serious here), the total cost of Christmas in the UK has increased at an average rate of 2.5% per year. However, it probably makes more sense to focus on the core index since the Queen owns all the swans in the UK (technically, she owns any unclaimed mute swan in open water in England and Wales but let’s not split too many hairs). This measure of the UK core Christmas index has posted an average inflation rate of 3.6% per year since 1984. Last year was a particularly painful one given the collapse in sterling which raised the UK Christmas index by 20%. It has since fallen back a bit on the basis of a slight rally in sterling but clearly even Christmas is not immune to the costs of Brexit (so thanks for that Nigel and co). 

Of course you can avoid the whole rigmarole by refusing to play along. Back in 2001,the economist Joel Waldfogel argued that there is a significant deadweight loss associated with Christmas primarily because the consumption choice is made by the giver of gifts rather than the final consumer. As he put it “it is more likely that the gift will leave the recipient worse off than if she had made her own consumption choice with an equal amount of cash.” This deadweight loss is estimated at between 10% and 33% of the value of gifts. So if you are thinking about buying someone a book for Christmas, you should probably follow Waldfogel’s advice and not buy them a copy of his book Scroogenomics.

Indeed, Waldfogel is guilty of making the classic error of focusing purely on those quantities that can be assigned a monetary value. The whole point of giving a gift is a sign of appreciation that we value the recipient, and it should be seen as a signal that the giver is prepared to invest time and effort to demonstrate individual recognition that is absent at most other times of the year. It is thus probably going overboard to purchase the 364 gifts required in the old Christmas carol (assuming a partridge in a pear tree is one gift). Indeed, if someone were prepared to spend the $157,558 that PNC calculates that the basket of goods cost, I think I would rather have the cash if it’s all the same to you.

But even if Santa Claus somehow forgets to bring you an envelope stuffed with that amount of cash, I wish you and yours a Merry and Peaceful Christmas.

You say you want a revolution

It has been a tumultuous year for those of us who spend a lot of time looking at the British economic and political scene. Recall that former prime minister David Cameron hoped a referendum would lay to rest once and for all the civil war within the Conservative Party that was being fought on the battleground of EU membership. As it turned out, Cameron’s decision proved to be the most spectacular political own goal in at least 60 years (rivalled only by the failure triggered by the Suez invasion of 1956). Consequently, this has been a year characterised by social division and political anger, with no signs that the divisions stoked by the Brexit decision show any sign of healing. It has also been a year strewn with political mistakes which have compounded Cameron’s original error, notably the government’s failure to clarify what it wanted prior to triggering Article 50 and the shocking error of judgement in calling an unnecessary general election.

Despite all this, the economy has trundled along and looks set to post a growth rate around 1.5% this year whilst the unemployment rate has fallen from 4.8% a year ago to 4.3% today. But the pace of growth is considerably slower than we might have expected in the absence of the referendum. In June 2016, my forecast called for real GDP growth of 2.2% in 2017. A direct monetary comparison of what this means in terms of lost output is distorted by data revisions and methodological changes, which have raised the current vintage of nominal GDP by an average of 1.1% since 2010 compared to the June 2016 vintage. But assuming away such matters and focusing purely on the growth trajectory, latest data suggest that real GDP Is currently almost 1% below the level expected in the pre-referendum forecast.

This is roughly what was predicted in spring 2016 in the event of a leave vote and would appear to reinforce the views of the economics profession which argued forcefully that there would be a cost to leaving the EU (bear in mind we have not left yet), whilst giving the lie to claims by Brexit supporters that such warnings were overly gloomy.  You can argue about whether pre-referendum forecasts were too optimistic, but given the pickup in the rest of the EU this year I would suggest this is not the case. And as Chris Giles pointed out in the Financial Times this week, such a shortfall amounts to lost output equivalent to £350 million per week – the amount which the Leave campaign (falsely) claimed the UK would save by leaving the EU. Given that the net savings in direct EU contributions are only half that amount, the inaugural Dixon Award for Dodgy Analysis (DADA) goes to the Leave Campaign whose referendum victory imposed a cost on the UK economy double the amount which it was claimed could be saved.

Brexit supporters will always claim that there is a short-term price to be paid but it will be worth it in order to reclaim sovereignty over UK laws. Indeed, so committed is the government to taking back control that it planned simply to enact the result of a legally non-binding referendum without any form of parliamentary debate. It took the brave efforts of Gina Miller last year to force a parliamentary vote before implementing Article 50.  Not that it mattered much in the end: the decision to trigger it was passed by a majority of 498 to 114 with 38 abstentions – or, in terms of the arithmetic applied to the EU vote, by a majority of 81.4% to 18.6% which is a rather larger margin than the actual referendum. It is also ironic that each time the degree of parliamentary unanimity on a Brexit vote is less than total, the Daily Mail takes it upon itself to denounce the dissidents as traitors (the most recent example being only last week).

Looking ahead, 2018 promises more of the same both politically and economically. The consensus view is that the UK will again grow at a rate around 1.5%, though I suspect there may be some upside risks on the basis that the inflation-induced constraint on real incomes is likely to ease. But politics will remain as fractious as ever. In my view – and one which I have been espousing for the last five years – opening a partisan debate on EU membership means that many politicians are taking positions which run contrary to the UK’s economic interests. This has met with huge pushback and continues to distort the political debate to the extent that many other pressing economic issues - such as welfare reform and overhauling the social care system - continue to be pushed down the agenda.

I would like nothing better than to write less about the politics of Brexit in 2018 but it is the dominant theme of our time which will have profound economic consequences. Brexit represents a political revolution, with many politicians apparently forced to take positions which they may not personally agree with because they are afraid of acting against “the will of the people.” In some ways I am reminded of the Iranian popular revolution, which unfolded on our nightly TV news bulletins almost 40 years ago. Years of dissatisfaction with the status quo in Iran prompted a revolution, based in this case around religion. Years of dissatisfaction with the UK political status quo has resulted in a revolution based around the cause of the EU. The Iranian case led to years of hardship and international isolation. Quite what Brexit will do to the UK will become apparent only in the years ahead.