Perfidious Albion

As the eighth round of post-January talks between the UK and EU gets underway this week, the newspapers are today abuzz with rumours that the British government is about to renege on the Northern Ireland protocol, signed alongside the EU Withdrawal Agreement only last year. Specifically, the FT reports that it plans to “‘eliminate the legal force of parts of the withdrawal agreement’ in areas including state aid and Northern Ireland customs.” Such a move would constitute a breach of international law and jeopardize any attempt to ensure a trade deal can be reached between the two sides before year-end. This would dramatically raise the risk of a no-deal Brexit on 31 December. Politically it is a big deal: It threatens to become a major economic issue.

Up to now I have taken the view that despite all the bluster, the UK will eventually sign a trade deal – however suboptimal compared to current arrangements – simply to allow Boris Johnson to say that the deal he promised has been achieved. However, the suggestion the government is prepared to renege on previous commitments implies that the risks to this view have taken a quantum leap higher. Recall that during the election campaign 10 months ago, Johnson promised that the deal was oven-ready. It turns out that it was merely half-baked.

What might the motivation be for taking such a stance? It could simply be a negotiating tactic: a mad dog strategy to convince the EU that the UK is crazy enough to do anything in order to force more concessions. Indeed I have learned to be wary of stories which the government plants in the press – even sources as reputable as the FT – because it has a habit of leaking stories to suit its own purposes. Or it could be that the UK really wants to avoid a hard border between Northern Ireland and the mainland, which as it currently stands would run through the Irish Sea (recall Johnson’s mid-August quote that “There will be no border down the Irish Sea – over my dead body”). The problem with this, of course, is that the alternative would be to impose a hard border between the Irish Republic and the North. Interestingly, although both the UK and EU are committed to upholding the 1998 Good Friday Agreement, the Agreement itself says very little about a physical border: The only place in which it alludes to infrastructure at the border is in the section on security (there should be a "removal of security installations").

Only this weekend Johnson sounded relaxed about the prospect of no-deal suggesting that it would be a “good outcome for the UK.” I hardly need repeat my long standing view that nothing could be further from the truth. All the economic evidence suggests otherwise (here and here for example). Nor does the electorate appear to buy into the idea with survey evidence continuing to show a lack of enthusiasm for Brexit, let alone the no-deal version that the government is edging towards (chart). This may in part be due to an erosion of trust in the government following a series of high profile missteps in the course of this year with latest polling data showing a sharp fall in the government’s approval rating.

However, this episode raises two major issues. On the domestic front, it is unclear in whose name a no-deal Brexit is being conducted. The Johnson government might believe that its whopping election victory last December gave it the green light to pursue the form of Brexit which its more hardline proponents have always advocated, involving independence at any price from the EU. That is a very risky calculation. The fact that many voters held their nose when voting for Johnson since the alternative was to vote for Jeremy Corbyn suggests that support for the government’s position may be less deep-rooted than supposed. Moreover, with the UK suffering the biggest contraction in Q2 GDP of all the world’s industrialised economies, it is evident that the economy faces significant economic headwinds. There may be some elements in government that believe they can hide the consequences of a hard Brexit behind the smokescreen of a Covid-induced recession but it would be a major political gamble to assume that the electorate will not see through the ruse.

The second issue is the international dimension of the government’s threat. Issuing threats to your main trading partner during the course of tense negotiations when they hold all the economic aces borders on lunacy. Michel Barnier has already expressed irritation that the UK has wasted time over the summer. In his words: “Too often this week it felt as if we were going backwards more than forwards … I simply do not understand why we are wasting valuable time.” The problem remains the same as ever: The UK simply does not understand (or refuses to do so) the EU’s position on the conditions for access to the single market. This is not to say the EU is blameless. The fact that it treats the UK differently to Canada in terms of access to the EU market is a genuine source of UK irritation. Nonetheless, with positions hardening in a number of EU capitals, the risk of miscalculation is mounting. If the EU simply refuses to budge – and it would have every right to do so, given that the UK is prepared to tear up agreements to which is a signatory – the prospect of a no-deal Brexit becomes more real.

In addition, as I have pointed out before, the tectonic plates of globalisation are shifting. The UK is not alone in wanting to follow a policy of economic nationalism and it does not have the clout on its own to secure the trade deals it wants with the partners of its choice. And even if it were, the latest threatened actions by the Johnson government do not paint it as a reliable partner in international agreements, which will raise the risk premium baked into sterling denominated assets.

What to make of it all? I am inclined to see the UK’s latest threat as an increasingly desperate negotiating ploy by a government which (a) does not have the experience to conduct complex trade negotiations and (b) is finding it far harder to deliver on its promises than it believed. You do not have to be a great poker player to realise that the UK has a weak hand and is bluffing. The EU knows it, but I am not sure that the UK knows that the EU knows. Whatever one’s views on Brexit, this is not the way to conduct trade negotiations and even if the UK does get some of what it wants, the Johnson government’s dwindling reserves of goodwill are almost exhausted. It does not pay to make enemies of your friends for in the words of country singer Merle Haggard, “Someday you're goin' to need your friends again.”

The pros and cons of returning to the office

Governments face one of their biggest economic dilemmas of recent times: How quickly should they withdraw the support provided to the economy during the Covid-19 crisis in order to minimise the hit to public finances, in the knowledge that this risks derailing the nascent recovery? However there are big question marks as to whether they should even be thinking on such lines in the current climate. Indeed, the French government last week launched a €100bn (4% of GDP) plan to boost investment in green energy and transport and support industrial innovation to help the economy recover from the recession. In recent days, governments in Austria, France and Germany have announced plans to extend their labour market support programmes to prevent a big rise in unemployment as activity levels prove insufficient to support pre-recession levels of employment.

It is against this backdrop that the start of the new school year in the UK has prompted a debate about how to get employees back to their workplaces after more than five months working from home (WFH) or on furlough. A month ago, a survey by Morgan Stanley suggested that UK workers were slower to return to their offices than in other European countries. According to the survey evidence, only 34% of white-collar employees had gone back to work compared to a European average of 68% (in France and Italy these figures were 83% and 76% respectively). More recent evidence suggests that British workers are now returning to the workplace, with the ONS reporting that 50% worked exclusively in the workplace in the last week of August compared with 30% in June.

Nonetheless, the data indicate that British workers lag behind their continental counterparts in this respect. Google mobility trends data (chart) bear out the view that between May and July fewer British workers had returned to their offices than in other European countries (the recent dips in Spain, Italy and France represent a holiday effect rather than a Covid-19 effect). This is sharply highlighted in the residential data where UK home footfall remains higher than elsewhere, implying a greater degree of home working.

The British government is currently advocating that workers return to their offices as it seeks to get the economy on a more solid footing. We should acknowledge that large numbers of workers were unable to work from home in the first place, with essential staff continuing to travel to their place of work throughout the pandemic. But of those who were able to work from home, the bigger question is whether they need to return to their offices. After all, many of us manage quite happily with an internet connection which allows us to do our jobs whilst remaining connected with the outside world. Whilst accepting that it is not to everyone’s taste, since a lot of people require the buzz of interaction with their colleagues, the idea that white collar workers need to be in the office to do their jobs is increasingly anachronistic. That said, there are positive externalities associated with workplace clustering so it is premature to conclude that office working is finished.

Consider the evidence

The demand by the head of the civil service that 80% of civil servants should be back at their desks at least once a week by the end of September needs a stronger economic rationalisation. According to Sir Mark Sedwill (who is technically the outgoing head, as he was effectively sacked by the government in June) “getting more people back into work in a Covid-secure way will improve the public services we deliver.” That is a bland statement which may or may not be true. But the limited evidence available on the benefits of WFH suggests that there are many upsides. 

A reputable study conducted on Chinese travel agency workers in 2014 and published in the Quarterly Journal of Economics (if Nick Bloom has his name attached to it, it’s worth taking seriously) found that “home working led to a 13% performance increase, of which 9% was from working more minutes per shift and 4% from more calls per minute. Home workers also reported improved work satisfaction, and their attrition rate halved.” The study went on to point out that: “The overall impact of WFH was striking. The firm improved total factor productivity by between 20% to 30% and saved about $2,000 a year per employee WFH. About two thirds of this improvement came from the reduction in office space and the rest from improved employee performance and reduced turnover.”

So why the rush to get people back to their offices? On the one hand, those businesses which depend on passing trade in crowded city centres are struggling. The proliferation of sandwich bars, coffee shops and pubs in our city centres rely on the lunchtime or evening crowd for their revenue and nobody wants to see our town centres becoming more hollowed out than they already are. But as Sarah O’Connor recently pointed out in the FT “Britain’s economic geography was under strain even before coronavirus. Good-quality jobs had grown ever more concentrated in London and a few other big cities like Manchester. That didn’t work for the rest of the country, and it didn’t work particularly well for the city dwellers either.” Her argument is that crowded city centres lead to spiralling accommodation costs, which is a particular problem for the low-paid, and those seeking to avoid them move further out and thus face long commutes on overcrowded (and expensive) public transport.

If we accept this view, one consequence of the pandemic will be to allow us to rethink the world of work and how we use our city centres. Assuming that at some point the social distancing measures are relaxed, businesses will need less expensive city centre real estate which will reduce costs. There will be losers, of course: property developers for one, and companies which rely on passing traffic for another. As noted above, however, this does not mean that there is no need for office working. Aside from the social aspects, office working does promote a greater delineation between work and leisure time; it allows the creation of more robust networks via face-to-face interaction; it creates a sense of belonging, which is important to company attempts to create a corporate culture, and it is a more efficient way of passing on experience as staff of different levels of seniority mix together. It is thus possible to imagine a world in which workers will be encouraged to spend some, if not all, of their working time in the office. The era of hot desking may be at hand (though not under current Covid restrictions).

Ultimately, how the world of work develops will depend on the needs of companies and their employees. It is possible to imagine a world in which the Covid crisis has accelerated a move away from the 9 to 5 drudgery although long-term predictions of working practices are fraught with uncertainty. Back in 1930, the economist John Maynard Keynes predicted that technological change and productivity improvements would eventually lead to a 15-hour workweek. Despite significant productivity gains over the past few decades, on average we work more than double (and in some cases treble) that. Nonetheless, if governments are so keen to allow market forces to operate, maybe they should let private sector companies figure out what works best for them and not impose 20^th century working practices on a 21^st century workforce.

A new monetary paradigm

Last week marked a big event in central banking history and economists will look back at Jay Powell’s speech on 27 August as the point at which the parameters of the three decade experiment with inflation targeting were changed. Central banks have tended to adopt a numerical target for inflation, usually centred around 2%, but in recent years inflation has undershot this target. A variety of reasons have been put forward for this. Many central bankers will argue that the adoption of inflation targeting was one of the factors which squeezed the high inflation of the 1970s and 1980s out of the economy. However, we can also add a number of exogenous factors such as the opening up of China as the workshop of the world, the end of the Cold War and more flexible labour markets.

Whatever the reason, there is a strong case for suggesting that the current regime which emerged in the wake of the high inflation of the 1970s and 1980s is no longer appropriate. For one thing, as currently practiced, inflation targeting contains an inbuilt asymmetry since central banks are more likely to react to inflation overshoots rather than undershoots for fear of being seen as soft on inflation, despite the fact that the target usually allows for some leeway around the central case. But we find ourselves today in an environment in which economies have taken the biggest hit in at least 90 years and inflation concerns are rapidly being put on the back burner as policy makers start to concern themselves with issues such as unemployment. Accordingly, the Fed announced last week that it will in future target maximum employment and “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” In effect, it will adopt a medium-term price level target – something many economists have devoted time to thinking about over the past decade.

This has a number of important implications for monetary policy in future. For one thing it effectively means that the Fed will be less likely to pre-emptively tighten policy in response to a perceived inflation pickup after a period of below-target inflation. At a time when real economy concerns are paramount this makes a lot of sense. But questions arise as to what the Fed means by the two parts of the phrase “inflation moderately above 2 percent” and “for some time?” Much of the early discussion about price targets tended to focus on short-term deviations of inflation from the target. Thus if an exogenous shock results in inflation averaging 1% over a year, inflation can run at 3% the following year in order that it averages 2% over the whole period. But if inflation averages 1% over a 10-year period, this would require a 3% rate over the next ten years in order to get the long-run average inflation rate back to 2% (chart). In such a case is 3% “moderately above 2%?” And does a ten year period represent “some time” or does this represent a whole different paradigm?

As I argued in this post once we start to tolerate higher inflation the concept of price stability begins to become eroded. There is thus a concern that the price level targeting regime could result in inflation expectations becoming de-anchored. We might not worry about this any time soon but it is a discussion which will doubtless be taking place within the Fed. That said, at a time when government debt levels have gone through the roof in many countries, no government is going to complain about a little bit more inflation if it helps to alleviate the debt burden.

One of the less discussed aspects of the change was that on the rules versus discretion spectrum, which has been a feature of monetary policy over recent decades, the Fed’s policy announcement is very much a step in the direction of discretion. It ascribes a greater weight to “the shortfalls of employment from its maximum level” where the Fed freely admits that “the maximum level of employment is a broad-based and inclusive goal that is not directly measurable and changes over time.” Full employment has always been a nebulous target, but it is about to become even more so and runs the risk of being whatever the Fed believes it to be in order to satisfy its current policy stance. For markets which have become used to interpreting mechanistic rules, this implies a rather more opaque central bank than we have become used to. It also suggests an enhanced role for forward guidance which is likely to become even more important as a policy tool.

Another important aspect of the new policy is that the central bank will be even less concerned in future with trying to fine tune the economy via monetary policy, since shortfalls imply a persistent deviation from the nebulous concept of maximum employment whereas deviations imply cyclical divergences. Whilst the Fed’s moves make a lot of sense from an inflation perspective, it also fits with the new realities of the post-Covid economy in which central banks will have to play their part in dealing with the resulting economic scarring. By explicitly committing to keeping rates low(er) for longer, the Fed is perhaps taking the first steps along the path towards financial repression. 

However, it is important to be aware of some of the downsides. For one thing a policy of targeting price levels implies the potential for short-term inflation volatility if economic agents are not sufficiently forward looking and base their inflation expectations on extrapolation of current rates out into the future rather than the longer term goal of ensuring that price levels will eventually return to target. In addition, the standard objection in the literature is that there is likely to be greater output volatility under a price level targeting regime as the central bank does not attempt to moderate cyclical swings as frequently.

Nonetheless, it is likely that other central banks will eventually follow in the Fed’s footsteps and adopt a version of an average price level target with a focus on the real economy. However, it is unlikely to find much favour in the euro zone where the focus on short-term price stability remains paramount. But as Martin Sandbu points out in the FT the ECB has “treated its own legal mandate far too narrowly … There is a widespread misperception that the ECB is treaty-bound to the single duty of ensuring price stability … But beyond this, the ECB has a legal obligation to ‘support the [EU’s] general economic policies’” (a point I have made repeatedly in the case of the BoE). The ECB may not be a slave to monetary policy fashions but it is not the Bundesbank and has proved itself pretty flexible in its monetary dealings in the past. It just might take a while to get there.

A highly technical rally

As the summer draws to a close the S&P500 continues to power to new highs, contrary to expectations earlier in the year when it looked like the corona effect would change the business model, if not forever then for a very long time. The benchmark US index looks set to post its best August performance since 1986. But trends in aggregate indices are not necessarily a good guide to what is happening in corporate America.

The focus of attention of late is the contribution of tech stocks to the surge in US markets. This was brought into sharp focus last week when Apple became the first company ever to post a market cap of USD 2 trillion. The company’s market cap has increased by almost 118% since the March trough, followed not far behind by Amazon whose market cap is up by 104%. At the start of the year, the FAANG sector accounted for 14.1% of the S&P500 market cap; today it stands at 19.8% and since March these five companies have contributed 25% of the increase in the index.

That is a very powerful motive force behind the surge in the aggregate index but the S&P average increase is a much lower, although still-healthy, 65% from the trough. The recovery since March has been described in some quarters as a K-shaped recovery with an increasing divergence between the top performing stocks and the worst performers. It is thus becoming increasingly obvious that this is an unbalanced US rally which is dependent on a small number of stocks. In that sense it is reminiscent of the surge in the late-1990s which proved unsustainable when the tech bubble burst.

One key difference, however, is that the FAANG stocks today have a deliverable product and a proven business model. Investors are not buying companies that offer the promise of a product at some point in the future. Amazon acts as the world’s global market place with a delivery system that can ensure that nearly anything you want can be brought to your door. That said, investors are prepared to pay a very high price to hold the stock of these digital disruptors and price metrics paint a more nuanced picture of the sector. The S&P500 as a whole is trading on a P/E multiple of 27.2x expected 2020 earnings, well above the 21x at the start of the year, but this is distorted upwards by the tech sector. Whilst Google and Facebook are trading at current year multiples of 32x, Apple is at 39x and Amazon and Netflix are running at 71x and 74x respectively (chart). Clearly the surge in FAANG is being driven by a strong earnings performance in recent months, but a lot is priced in for the future and some parts of the tech universe look more expensive than others. I can see why investors are keen to pay a premium for Amazon given the way it is shaping the face of retail, even though it looks very expensive, but Netflix?

From an investor perspective, current trends do not suggest buying an aggregate index tracker since a FAANG index contains all the stocks which are driving the market. Against that, a portfolio diversification argument would caution against putting too many eggs in one basket. Nonetheless it puts the European performance into perspective and perhaps the apparent underperformance of the FTSE100 is a better reflection of average corporate performance than the red hot S&P500.  In that light, it is notable that a recent report from Bank of America pointed out that the market cap of the US tech sector alone stands at $9.1 trillion, which is bigger than the market cap of all Europe ($8.9 trillion).

As one who has watched markets boom and bust a few times over, the surge in tech stocks should remind us of Stein’s Law, articulated by the economist Herbert Stein, that “if something cannot go on forever, it will stop." Or to paraphrase, if a trend can’t continue, it won’t. What this ignores, however, is the timing problem. You bet against a bull market like this at your peril because, as the old adage has it, “the markets can remain irrational longer than you can remain solvent.” With yesterday’s news that the Fed is effectively committing to low interest rates for a very long time to come (I will come back to this another time), debt is simply not going to act as a major constraint on company actions.

At some point, there surely has to be some form of reckoning even if monetary policy is not going to be the catalyst for a market sell-off in the coming years. But what might be the trigger? It is possible that investors will simply rotate out of tech at some point, especially if Covid becomes less of an economic threat (perhaps because a vaccine is developed). This might lead the tech sector to underperform vis-à-vis the “old economy” rather than collapse outright. Geopolitics could play a role if the US-China spat were to heat up. But perhaps the most likely catalyst is that governments start to make good on their promises to introduce a digital tax, particularly in Europe. The US also has a history of breaking up monopolies and history buffs will recall the breakup of Standard Oil which fell foul of anti-trust legislation in the early twentieth century whilst as recently as the 1980s, the Reagan administration took the axe to AT&T.

That certainly will not happen if Donald Trump is re-elected and it is even doubtful that a President Biden would want to go down that path, especially since his running mate Kamala Harris is perceived as very tech friendly. But in this crazy world, we have learned never to say never.