Greatest hits

For most of the last 40 years I have listened to politicians misrepresenting fiscal issues. In the 1980s the Thatcher government in the UK talked about “living within our means”, treating the government budget constraint as if it were a household. This never made any sense because whilst households have a finite lifespan, governments – in theory – do not which raises their borrowing capacity because they can repay debt on a multi-generational basis. A decade ago, George Osborne adopted a similar approach, arguing that if the UK government did not rein in its budget deficit it would suffer similar fiscal consequences to Greece. Never mind the fact that UK debt levels were lower, or the fact the UK had an independent monetary policy or indeed that it issued debt in a currency which it controlled.

For the present we appear to have put the need for wearing a fiscal hair shirt behind us. Instead politicians like to boast of their fiscal largesse, even though a large segment of the public is increasingly asking who will pay for it. Ultimately, it is the tax payer although not necessarily the current generation. But just as politicians have overdone the fiscal rectitude in the past, so they may be guilty of exaggerating their largesse today. At the end of June, Boris Johnson announced a plan to spend £5bn on infrastructure which was portrayed as a “new deal” along the lines of Franklin D Roosevelt’s 1930s plan. It was, of course, nothing of the sort. FDR’s plan amounted to a splurge equivalent to around 40% of US GDP at the time whereas Johnson’s equates to around 0.2% of UK GDP. The BBC Fact Check team looked at the details of Johnson’s speech and concluded that large parts of the plan merely involved allocating funds that had previously been announced.

Chancellor Rishi Sunak, who has performed creditably during the crisis, did come up with a more substantive plan in his Summer Statement last week. His plan to provide additional support of £30bn (1.4% of GDP) included a Job Retention Bonus which promised a subsidy to employers for each furloughed employee they retain until end-January 2021; a package of measures to help the hospitality sector and a housing Stamp Duty holiday. There are many reasons why the package is badly targeted: A subsidy of £1000 per employee will not do much to dissuade employers from making job cuts and it also runs the risk that taxpayers will foot the bill for workers who would otherwise have been re-employed anyway. A Stamp Duty holiday will be of most benefit to those in the south east of England where house prices are highest, which is not exactly consistent with the government’s plan to level up the economy by helping those regions which have fallen behind. Yet for all that, we do have to give the Chancellor credit for pulling out all the stops after a decade in which fiscal policy has been relegated to the back burner.

The plan came too late to be fully incorporated into this week’s Fiscal Sustainability Report (FSR) from the OBR. Nonetheless, it dutifully ploughed through the fine details and found that the Chancellor has been even more generous than he admitted. The OBR pointed out that the Treasury “’has so far approved £48.5 billion of additional expenditure on public services’, of which £32.9 billion had not previously been announced.” On my maths, this implies a fiscal boost equivalent to almost 3% of GDP.

For those with the time to browse it, the FSR was an excellent, sober overview of the current problems facing the UK economy and how it might perform in future (chart 1). The scenario set out in April always felt a little rushed – understandably – but having had time to reflect on events, the OBR set out three possible long-term scenarios. The central case looks for output to get back to pre-recession levels by end-2022, which is achievable although I fear it could take a bit longer. In this scenario, the deficit balloons out to 16% of GDP this year before falling back to 4.6% by fiscal 2024-25 with the debt-to-GDP ratio remaining above 100%.

Indeed it is the long-term implications of the economic crisis which are particularly interesting.  A debt ratio in 2025 of around 100% is far lower than in the late-1940s when it went above 250%. A combination of favourable demographics, rapid growth and low interest rates allowed the ratio to halve between 1947 and 1957 and it halved again within the next 15 years. We are unlikely to see such a rapid reduction this time around unless there is a miraculous transformation in the potential growth rate. Indeed, the OBR’s central case scenario suggests that based on assumptions for demographics, pensions and health care spending, the debt ratio will rise to 320% on a 50 year horizon (chart 2). Whilst we should not take the figures at face value, they do highlight that in the absence of counteracting measures the debt ratio is not going to decline anytime soon and the OBR’s illustrative calculations suggest that fiscal tightening of around 2.9% per decade will be required to get the debt ratio back to 75% over a 50-year span.

All of this is, of course, subject to a huge degree of uncertainty and it is purely an illustrative scenario. But the point is made that even in the absence of COVID-19, the UK (and indeed all industrialised countries) face major fiscal challenges. Governments will have to make major decisions about what kind of debt levels they are prepared to tolerate and what level of services they can realistically provide. Societies as a whole will have to make decisions about how much tax they are prepared to pay. Whilst I have been an advocate for greater use of fiscal policy over the past decade, like most people I never expected to see the kind of hit to public finances which we have seen in just the last four months. In the coming years we will need a proper debate about the role of the state in the economy. Political blustering on fiscal issues will no longer suffice.

Don't give up on the tried and trusted

There is a considerable degree of trepidation as we head into the Q2 company earnings reporting season. It is obvious that earnings will have taken a huge hit as consumer demand collapsed across the board. However, the main focus will be on guidance as investors treat the last three months as bygones. Dow Jones reported at the start of July that 157 S&P500 companies had reduced their outlook as of end-June with just 23 providing upgrades, whilst 180 have pulled them altogether which suggests that markets will be flying blind for a while to come.

Current consensus estimates point to a fall of around 30% in S&P500 Q2 earnings relative to Q1, which follows a 15% decline in Q1. If realised, this will put Q2 earnings around 45% below year-ago levels. Even assuming a rebound in the second half, the consensus suggests we are set for a 25% decline in 2020, which would be close to the 28% decline registered in 2008. It would not take a huge miss on the numbers to record the worst year for US corporate earnings since the 1930s (chart 1).  Moreover the concern is that the consensus is overstating expectations for an earnings rebound. In the wake of the 2008 crash it took more than three years for earnings to get within 10% of the previous cyclical high. This time around, the consensus view is that it can be achieved within 18 months.

 

Valuation metrics also look elevated as markets are priced for perfection. The one-year forward P/E ratio on the S&P500 is trading above a multiple of 25 and the price-to-book ratio is at 3.65 versus a long-term average of 2.65. Under normal circumstances such indicators would set the alarm bells ringing but as we are all too well aware, times are not normal. Discounted future cash flows have been boosted by central bank actions to cut rates to zero, and on the expectation they will not rise anytime soon it is logical that equity prices should rise. The lack of returns in other asset classes further raises the attractiveness of equities. Even sectors which have performed strongly over the past decade, such as property, are struggling. Whilst stocks may look over-bought and there are clearly risks associated with both the earnings and economic outlook, investors cannot bring themselves to bet against a strategy which has worked so well in the post-2008 world.

This impact of low interest rates and their effects on equity markets has once again raised questions of whether the traditional 60/40 portfolio rule is fit for purpose. This famous investment rule of thumb suggests investors should hold 60% of their portfolio in stocks and 40% in lower risk securities such as bonds. In theory this should produce long-term average returns which match equities but by allocating a sizeable chunk to bonds it smooths out the extreme highs and lows associated with an equity-only portfolio. The evidence suggests that this strategy has outperformed over the past 20 years. Using a portfolio in which the available assets are global equities, US Treasuries, the GSCI commodity returns index and an estimate of cash returns in the industrialised world, the 60/40 portfolio generated an average annual return of 4.9% between September 2000 and June 2020.

It has not always been the optimal portfolio. Immediately prior to the Lehman’s crash, the 60/40 portfolio was one of the poorer performers largely because it took no account of the commodity boom that was building at the time. Indeed, I well remember being told in 2006-07 that no self-respecting portfolio manager could afford to ignore commodities because returns were uncorrelated with other financial assets and consequently they enhanced portfolio risk diversification. How times change: Commodities are down 84% from their peak achieved in summer 2008 and they have proven poisonous to investor returns. The 60/40 portfolio has outperformed both safe and risky structures which assign varying non-zero weights to commodities and cash. Moreover, as the Credit Suisse hedge fund returns index shows, this simple strategy has matched hedge fund strategies in recent years which – given what investors pay hedge funds to manage their money – is a poor show on their part (chart 2). All told, on a 20 year horizon the 60/40 strategy has generated higher returns once hedge fund fees are taken into account.

This is not the first time the 60/40 strategy has been called into question – it seems to arise every time one or other of the markets appears out of whack. On this occasion low interest rates mean that the returns from bonds are likely to look very poor for years to come. But investors tempted to overweight equities, which are likely to benefit as a consequence, run the risk of getting caught out by volatility as markets continue to question whether current price valuations are justified (we can expect quite a lot of that in the months ahead). Since the intention of 60/40 is to offset the extreme highs and lows of equities, it may be worthwhile sticking with it for a bit longer. It is after all, a tried and trusted method and that is not a bad thing in our new, uncertain investment world.

Looking at lockdowns

The reopening of pubs in the UK this weekend marks an important milestone in the easing of lockdown conditions (though the Scots will have to wait until 15 July). It is 103 days since English residents have been able to take advantage of their inalienable right to drink alcohol in their local pub. This is historically unprecedented: As far back as anyone knows, pubs have always remained open. The last time there was an assault on people’s right to buy alcohol on licensed premises was during World War I when the government reckoned that drunkenness was undermining the war effort (a highly questionable assertion). This led to the imposition of limits on opening times, which lasted until the 1980s, but the pubs nonetheless remained open.

There is little doubt that the lockdown has been the most stringent imposition on individual freedoms in living memory and it has been repeated across the world, with news bulletins showing pictures of empty shopping malls and motorways that would normally otherwise be packed. In an attempt to compare the extent of the lockdowns across different countries, I am indebted to the work of academics at the Blavatnik School of Government at Oxford University who have constructed lockdown indices across more than 160 countries. The index is composed of a series of individual policy response indicators based on a range of indicators (interested readers are referred to the working paper for more detail, which can be found here).

The data are collated over the period since 1 January 2020 and chart 1 shows the maximum value of the index over the course of this year-to-date. Based on the random sample of 16 countries used here, the UK ranks fairly low down in terms of lockdown stringency. It is notable, however, that it is slightly ahead of Germany yet Germany had a very low death rate from Covid-19 infections[1] (10.8 per 100,000 of population versus 65.6 in the UK). Italy introduced the most stringent set of measures and recorded a high number of deaths (57.6 per 100,000). As has been well documented elsewhere, Sweden’s lockdown was relatively relaxed and although the death rate is still relatively high it is still below that of the UK and Italy at 52.1 per 100,000. Clearly, the maximum extent of the lockdown is not very meaningful as an indicator of the severity of the Covid-19 outbreak.

 

A more useful indicator might be the average measure of the index which also takes duration into account. But here, too, there is no ordinal ranking from lockdown severity to Covid-19 mortality rates. Chart 2 indicates that Italy’s average lockdown is significantly higher than that of Germany but mortality rates are too. To make the point more clearly, the scatter plots in chart 3 clearly indicate only a limited negative relationship between the extent of the lockdown and Covid mortality or infection rates.

This obviously raises the question of how useful have the lockdowns been as a defence mechanism against Covid-19. The trick is not to think in terms of levels but rates of change. Or to put it another way, how much worse would infection rates have been in the absence of lockdowns? Here we seem to be on safer ground for there is a very strong relationship between the extent and duration of the lockdown and the rate of infections (chart 4). In the three European examples chosen here, it is notable that Italy introduced the lockdown long before infections peaked whereas the UK clamped down quite some time after infections started to pick up, thus supporting the view that the UK was late in acting which contributed to the surge in mortality.

Lockdowns do, of course, have a significant economic cost. The lockdown indices on their own are not particularly useful and have to be augmented with other indicators such as mobility trends and specific country characteristics to render useful information. The Bank of England has done some sophisticated modelling work using the lockdown index as one input and concluded that the data across a range of countries is consistent with a decline in world GDP of around 15% over the first half of 2020 (chart 5).

Prior to this weekend the UK lockdown index was still fairly high in comparison to a number of other countries. That is appropriate given that Covid-related deaths are still high in a European comparison. However, they are well down from their previous highs and given the improvements in recent weeks, it is probably appropriate to begin a limited form of easing. But striking the right balance is virtually impossible. Some think that the infection rates are too high to justify any form of lockdown whilst others believe it should have been lifted long ago. We will only know whether the current policy stance is the right one when we can assess the trends in Covid infections.

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[1] I use mortality rates rather than the number of reported infections because this is dependent on the breadth of the testing programme which differs across countries.

Stay positive or turn negative?

In recent weeks the Bank of England has given the impression that it may be prepared to take interest rates into negative territory. Although the debate has gone a bit quiet of late, it has not gone away, perhaps because the BoE believes the economic collapse in April was not quite as bad as previously expected or, and this is my preferred take, it was only ever a device to jawbone market interest rates as low as possible.

The economist Silvio Gesell was one of the first proponents of negative interest rates in the nineteenth century when he proposed a tax to dissuade people from hoarding cash. But it was never seriously tried in a policy context until the Swiss introduced a policy of negative rates in the 1970s in a bid to prevent foreign investment flows from driving the franc higher. However the policy was deemed a failure and the idea was eventually abandoned in 1978 after an experiment lasting six years. In the wake of the 2008 financial crisis the idea came back onto the agenda with Denmark being the first mover, again as a means to hold the currency stable. This time, other countries followed suit with the likes of Switzerland (again), the euro zone, Sweden and Japan all driving rates into negative territory. Both the US and UK have resisted the charms of negative rates, largely because there is a presumption in the Anglo Saxon world that the monetary transmission mechanism ceases to operate properly with interest rates below the lower bound.

There are many good arguments against negative rates

In the current policy framework, the banking sector is charged a negative interest rate on its cash deposits at the central bank. Banks have an incentive to run down their cash holdings and either lend more into the wider economy or pass on the negative cost to their customers who run down their money holdings, and in the process stimulate the economy as they spend their cash. However, low interest rates and flat yield curves distort time preferences for households and companies, which results in sub-optimal resource allocation (e.g. they allow zombie companies to operate which would otherwise cease trading). Central bankers who have observed the experience of Japan over the last two decades cannot be blamed for calling into question the usefulness of ultra-lax monetary policy. Ironically, in the late-1990s I remember half-jokingly suggesting to a Japanese economist that the BoJ should consider negative rates. It was probably not my greatest idea in retrospect.

Furthermore, ultra-loose monetary policy distorts markets. By reducing the returns to cash holdings, investors have an incentive to seek higher returns by loading up on risky assets, which in turn results in widening disparities between market prices and fundamentally justified levels. No investor would question the view that low rates have helped markets to blow out.

For all that, there is no good reason in theory why interest rates should not go negative.  After all ancient mathematicians regarded negative numbers as “false” and it was not until the late seventeenth century that respectable mathematicians such as Leibniz began to take them seriously in Europe. Today, however, we are all familiar with the concept and we might wonder why they were ever regarded with such suspicion.  Moreover to the extent that real economic quantities respond to real interest rates, we have long become used to the notion of negative real rates with nominal interest rates lower than inflation.

Yet there is something of the taboo about a negative nominal interest rate. Perhaps one reason is that the interest rate represents the cost of time: it represents the return derived from waiting; from saving rather than consuming. Perhaps it offends the Puritan streak in the western psyche. Or maybe because the arrow of time only runs in one direction, a negative interest rate somehow inverts the cost of time and is therefore perceived as unnatural. Whatever the reason, many people have difficulties with the concept of negative central bank rates.

For all the evidence amassed by the likes of the ECB suggesting that negative rates have helped to stimulate the economy, we should treat the arguments with a pinch of salt. Without any doubt, negative interest rates penalise savers. Unless we are forced to work long past our planned retirement date, we all need to make provision for old age and this is made all the harder by low or negative interest rates. There may be an argument in favour of temporarily trying to boost the economy by cutting rates into negative territory but the ECB has held the depo rate below zero for six years. I fear that a prolonged period of negative rates will ultimately prove counterproductive as individuals attempt to raise their precautionary saving.

But consider this …

One of the key features of all the countries that have experimented with negative rates so far is that they run a current account surplus i.e. there is a surplus of domestic saving with respect to investment (chart). Both the UK and US run current account deficits – they suffer from deficient domestic saving. At first glance, you may ask whether negative rates in these economies are such a good idea if they encourage further dissaving. In a static framework, they are not. But let’s try to think through the dynamics. Encouraging households to bring forward spending should widen the current account deficit in the near-term and ought, in theory, to result in currency depreciation. This in turn should generate higher imported inflation, which after all is how central banks have justified their actions, and allow them to respond by returning interest rates towards positive territory.

In this framework the key transmission mechanism is the exchange rate. If the cut in interest rates is not sufficient to produce concern in the FX market, the negative interest rate policy will not have the desired effect. This might be because the pickup in consumption is insufficient to generate a current account deficit so the currency market remains unconcerned. Or it might be due to the fact that the currency in question (the likes of the Swiss franc, yen and euro) acts as a safe haven, particularly since rates elsewhere are also extremely low. In either of these cases, perhaps interest rates will have to be pushed so far into negative territory to have the desired effect that the side effects would be unacceptable. But this begs the question whether they would work better in an economy which already runs a current account deficit, and where the FX market is perhaps more sensitive to external deficit concerns. The pound would certainly be such a candidate.

I would be hesitant to advocate the BoE cutting interest rates into negative territory because the experience elsewhere shows that once they go below the zero line, it proves difficult to get them back up again. But if I were a maverick on the MPC I would at least try to ensure that this argument gets a hearing and make the case for a short, sharp dip into negative territory with the unspoken assumption that they will be raised after (say) two years. There is nothing to be gained by holding rates below zero for long. But there also seems little to be gained from a prolonged period of holding them so close to zero they might as well be negative.