The
reputation of macroeconomics took a battering in the wake of the global
financial crisis after failing to predict the
great recession. Although much of the criticism by outsiders is misplaced,
there are some grains of truth and many academic economists would agree that
there are many areas where economics needs to improve.
This collection of papers from
the Oxford Review of Economic Policy looks at the state of macroeconomics today
and provides a range of opinions from leading macroeconomists. More
importantly, it shines the spotlight on those areas where economics can be seen
to have failed and offers some suggestions about how to take us forward (the
papers are not particularly technical and as such are relatively accessible.
Credit should also go to the publishers, Oxford University Press, for taking
this volume from out behind the paywall).
David Vines and Samuel Wills make
the point that macroeconomics has been here before – in the early 1930s and
again in the 1970s, and both times the discipline evolved to try and make sense
of changed circumstances. But in order to identify what has to change, we need
to know where we are and what is wrong. At the centre of the debate stand New
Keynesian Dynamic Stochastic General Equilibrium (DSGE) models, which form the
workhorse model for policy analysis.
The general consensus is that they are not
fit for purpose – a point I have made before (here and
here).
Such models are based on microfounded representative-agents – a theoretical
approach which postulates that there is a typical household or firm whose
behaviour is representative of the economy as a whole. I have always rather
struggled with this approach because it assumes that all agents respond in the
same way – something we know is not true in the case of households given
differing time preferences, depending on age and educational attainment. An
additional assumption that underpins such models is that expectations are
formed rationally – something we know is not always true.
Thus
the consensus appears to be that these two assumptions need to be relaxed if
macroeconomics is going to be more relevant for future policy work. You might
say that it is about time. Indeed it is a sad indictment that it took the
failure of DSGE models during the financial crisis to convince proponents that
their models were flawed when it was so obvious to many people all along.
In
order to understand this failure, Simon Wren-Lewis offers an explanation as to why this form of thinking became so predominant to
the exclusion of other types of model. He argues that the adoption of rational
expectations was “a natural extension of the idea of rationality that was
ubiquitous in microeconomic theory” and that “a new generation of
economists found the idea of microfounding macroeconomics very attractive. As
macroeconomists, they would prefer not to be seen by their microeconomic
colleagues as pursuing a discipline with seemingly little connection to their
own … Whatever the precise reasons, microfounded macroeconomic models
became the norm in the better academic journals.” Indeed, Wren-Lewis has
long argued that since academics could only get their work published in top
journals if they went down this route, this promoted an “academic capture”
process which led to the propagation of a flawed methodology.
Wren-Lewis
also makes the point that much of so-called cutting edge analysis is no longer
constrained to be as consistent with the data as was once the case. He notes
that in the 1970s, when he began working on macro models “consistency with
the data was the key criteria for equations to be admissible as part of a
model. If the model didn’t match past data, we had no business using it to give
policy advice.” There is, of course, a well-recognised trade-off between
data coherency and theoretical consistency, and I have always believed that the
trick is to find the optimal point between the two in the form of a structural
economic model. It does not mean that the models I use are particularly great –
they certainly would not make it into the academic journals – but they do allow
me to provide a simplified theoretical justification for the structure of the
model, in the knowledge that it is reasonably consistent with the data.
Ultimately
one of the questions macroeconomists have to answer more clearly – particularly
to outsiders – is what are we trying to achieve? Although much of the external
criticism zooms in on the failure of economists to forecast the future, what we
are really trying to do is better understand how the economy currently works
and how it might be expected to respond to shocks (such as the financial
crisis). Olivier Blanchard
believes that “we need different types of macroeconomic models for different
purposes” which allows a continued role for structural models, particularly
for forecasting purposes. Whilst I agree with this, I have still not shaken off
the conviction, best expressed by Ray Fair back in 1994 (here
p28), that the structural model approach “is the best way of trying to
learn how the macroeconomy works.” Structural models are far from perfect,
but in my experience they are the least worst option at our disposal.
Monday, 15 January 2018
Thursday, 11 January 2018
Double or quits?
We are less than two weeks into the new year but a number of
very odd things have already taken place. Arch-protectionist Donald Trump is
prepared to rub shoulders with the global elite in Davos whilst Steve Bannon,
who promised to “go nuclear” on those opposed to Trump’s populist nationalist
agenda following his White House departure, has been fired by Breitbart News.
Perhaps most surprisingly of all, Nigel Farage has suggested that a second
referendum on the UK’s EU membership might be necessary to resolve the Brexit
question once and for all.
This comes against the backdrop of a renewed campaign against Brexit. As Farage put it, “My mind is actually changing on all this. What is for certain is that the Cleggs, the Blairs, the Adonises will never, ever, ever give up. They will go on whinging and whining and moaning all the way through this process. So maybe, just maybe, I’m reaching the point of thinking that we should have a second referendum on EU membership … I think that if we had a second referendum on EU membership we would kill it off for a generation.”
This follows the comments by Andrew Adonis, former chair of the National Infrastructure Commission, who resigned at the end of December, arguing that “good government has essentially broken down in the face of Brexit” and will now devote more time to the issue of a second referendum. Former prime minister Tony Blair took a slightly different tack with his Institute for Global Change highlighting the economic costs that are so far visible. He also made the valid point that 2017 was too early to rethink the Brexit strategy but by 2019 it will be too late. “Realistically, 2018 will be the last chance to secure a say on whether the new relationship proposed with Europe is better than the existing one.” Whatever people might think of Blair – and he is widely reviled for his role in involving the UK in unpopular conflicts in the Middle East – he remains a formidable centrist politician and it is hard to disagree with much of the IGC’s analysis (if only Blair had applied a similar level of rigour to the weapons of mass destruction question in 2003 he would have a claim as one of the greatest peacetime prime ministers).
On the question of a second referendum, my guess is that it is most unlikely. Despite calls for a second vote to give a verdict on the terms of the final EU deal, it is unlikely to happen because: (i) neither the Conservative nor Labour parties support the idea and (ii) it is too soon to reopen the divisions created by the 2016 referendum. Add to this the fact that Theresa May and her government have invested so much time and credibility in delivering Brexit, it becomes inconceivable to think that it will be open to calling a second plebiscite.
Nonetheless, it is astonishing to hear Farage make his suggestion. In his view “the percentage that would vote to leave next time would be very much bigger than it was last time round. And we may just finish the whole thing off.” That is a very bold statement and like many of Farage’s predictions, probably not true. Although the economy has held up better than anticipated, consumers are being squeezed by the Brexit-induced decline in real wages. Moreover, with the question of NHS funding and staff shortages currently so prominent, Blair points out that “applications from EU nurses to work in the UK have fallen by 89% since the referendum” and “nearly 1 in 5 NHS doctors from the European Economic Area have made concrete plans to leave the UK.” I have also pointed to survey evidence that suggests a rising trend in people believing that voting for Brexit may have been the wrong decision (here). Any attempt to re-run the referendum would likely result in a very tight race and it is far from clear how it would pan out.
But let us suppose that in order to clear the air the government does accede to this suggestion. What should it do? First and foremost, it should introduce a minimum participation threshold. A simple in-out referendum which results in a narrow win for one side is not sufficient. In order for change to come into effect, it would have to be ratified by at least 40% of all eligible voters in the same way as the Scottish devolution referendum of 1979. Assuming the electorate is the same size as in June 2016, the Leavers would have to gain 6.8% more votes (almost 1.9 million). But even if this were to happen, the Remain voters would still argue that the 40% threshold represents a minority of the eligible electorate. Thus, an additional constraint might be that in the event Leave gains less than 50% of all eligible votes, it must secure a victory margin of at least 10 percentage points. If you want a really funky solution, perhaps we could weight votes according to age. Although this undermines the principle of one person-one vote, on the basis that younger voters have more to lose there is an argument that their votes should count for more[1].
I stress that this is all hypothetical. But if the government were to take up Farage’s suggestion it would be easy enough to put in place a system which makes it very difficult for the leavers to win. There would be howls of protest from Brexiteers that the rules of the game have changed. But if the decision is to be binding (and let us recall that the 2016 referendum was purely advisory) we would have to be damn sure that the case is watertight. Only then will we Remainers shut up.
This comes against the backdrop of a renewed campaign against Brexit. As Farage put it, “My mind is actually changing on all this. What is for certain is that the Cleggs, the Blairs, the Adonises will never, ever, ever give up. They will go on whinging and whining and moaning all the way through this process. So maybe, just maybe, I’m reaching the point of thinking that we should have a second referendum on EU membership … I think that if we had a second referendum on EU membership we would kill it off for a generation.”
This follows the comments by Andrew Adonis, former chair of the National Infrastructure Commission, who resigned at the end of December, arguing that “good government has essentially broken down in the face of Brexit” and will now devote more time to the issue of a second referendum. Former prime minister Tony Blair took a slightly different tack with his Institute for Global Change highlighting the economic costs that are so far visible. He also made the valid point that 2017 was too early to rethink the Brexit strategy but by 2019 it will be too late. “Realistically, 2018 will be the last chance to secure a say on whether the new relationship proposed with Europe is better than the existing one.” Whatever people might think of Blair – and he is widely reviled for his role in involving the UK in unpopular conflicts in the Middle East – he remains a formidable centrist politician and it is hard to disagree with much of the IGC’s analysis (if only Blair had applied a similar level of rigour to the weapons of mass destruction question in 2003 he would have a claim as one of the greatest peacetime prime ministers).
On the question of a second referendum, my guess is that it is most unlikely. Despite calls for a second vote to give a verdict on the terms of the final EU deal, it is unlikely to happen because: (i) neither the Conservative nor Labour parties support the idea and (ii) it is too soon to reopen the divisions created by the 2016 referendum. Add to this the fact that Theresa May and her government have invested so much time and credibility in delivering Brexit, it becomes inconceivable to think that it will be open to calling a second plebiscite.
Nonetheless, it is astonishing to hear Farage make his suggestion. In his view “the percentage that would vote to leave next time would be very much bigger than it was last time round. And we may just finish the whole thing off.” That is a very bold statement and like many of Farage’s predictions, probably not true. Although the economy has held up better than anticipated, consumers are being squeezed by the Brexit-induced decline in real wages. Moreover, with the question of NHS funding and staff shortages currently so prominent, Blair points out that “applications from EU nurses to work in the UK have fallen by 89% since the referendum” and “nearly 1 in 5 NHS doctors from the European Economic Area have made concrete plans to leave the UK.” I have also pointed to survey evidence that suggests a rising trend in people believing that voting for Brexit may have been the wrong decision (here). Any attempt to re-run the referendum would likely result in a very tight race and it is far from clear how it would pan out.
But let us suppose that in order to clear the air the government does accede to this suggestion. What should it do? First and foremost, it should introduce a minimum participation threshold. A simple in-out referendum which results in a narrow win for one side is not sufficient. In order for change to come into effect, it would have to be ratified by at least 40% of all eligible voters in the same way as the Scottish devolution referendum of 1979. Assuming the electorate is the same size as in June 2016, the Leavers would have to gain 6.8% more votes (almost 1.9 million). But even if this were to happen, the Remain voters would still argue that the 40% threshold represents a minority of the eligible electorate. Thus, an additional constraint might be that in the event Leave gains less than 50% of all eligible votes, it must secure a victory margin of at least 10 percentage points. If you want a really funky solution, perhaps we could weight votes according to age. Although this undermines the principle of one person-one vote, on the basis that younger voters have more to lose there is an argument that their votes should count for more[1].
I stress that this is all hypothetical. But if the government were to take up Farage’s suggestion it would be easy enough to put in place a system which makes it very difficult for the leavers to win. There would be howls of protest from Brexiteers that the rules of the game have changed. But if the decision is to be binding (and let us recall that the 2016 referendum was purely advisory) we would have to be damn sure that the case is watertight. Only then will we Remainers shut up.
[1] On
the basis of a voting system which raises the voting weight the further below
the age of 90 you are, a back-of-the-envelope calculation suggests that Remain
would have won the June 2016 referendum by a margin of 52.8% to 47.2%.
Monday, 8 January 2018
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.
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.
[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.
Wednesday, 3 January 2018
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.
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.
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.
Sunday, 31 December 2017
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.
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.
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.
Friday, 29 December 2017
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.
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.
Saturday, 23 December 2017
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.
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).
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.
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