Global Market Insights | A Fisher Investments Blog

Don’t Fret the Current Account Deficit

Since ONS revealed the UK’s current account deficit spiked in 2012, I’ve seen a few jitters about the report: 

UK Trade Gap Just Gets Worse

Wider Trade Gap Highlights Continued Problems for Troubled UK Economy

Britain’s Current Account Deficit at Worst Level Since 1989

March of the Makers? Balance of Payment Figures Make Dismal Reading

The current account aggregates net trade of goods and services, foreigners’ earnings on investments in the UK, earnings on UK investments abroad, and cross-border transfers of money, goods and services. Here’s the equation:

 

In 2012, the current account deficit rose to £55 billion, or about 3.7% of GDP—the biggest it’s been since 1989. Some posit that’s a bad sign—that since foreign investment isn’t high enough to offset the current account shortfall, capital’s draining out of the UK, and crisis thus looms.

Here’s the problem with that logic: It assumes the UK economy is a fixed pie—that there’s only a limited amount of capital, and if more leaves than comes in, then the entire country will be worse off. But that’s not quite true.

Imagine I’m a country—the Sovereign Nation of Elisabeth. I have trade relationships with three nearby countries, Landlordia, Malldonia and Supermarketland, and I have a huge deficit with each. I buy lots of goods and services from them, but I don’t sell them a darned thing—and yet my country isn’t bankrupt. Why? Because I have other sources of income, like my job, which more than offsets my outflows. In essence, I create personal wealth (at least what little I can considering California’s high taxes and cost of living).  

And that’s how it is for the UK and other advanced economies with current account deficits. The UK may send more money out than it gets from abroad, but it also creates quite a bit of wealth domestically. Inventors get ideas, create products and start companies that grow into huge businesses—that creates wealth. People invest, and asset values grow—that creates wealth. The private sector’s net return on investment has ranged from 11% to 15% for over 15 years. Through year-end 2012, the FTSE 100 had returned 959% since 1981 (7.65% annualized). Private non-financials firms have accumulated about £750 billion in cash. Household wealth has steadily grown over time and is nearly £4 trillion today. All of this domestic growth is more than enough to offset the amount of capital flowing out.

Simply put: The UK has its share of risks these days, but the current account deficit likely isn’t one of them.

 

 

The UK Downgrade in Three Charts

Nearly two weeks after Moody’s downgraded the UK’s credit rating, markets still seem to be taking the news in stride: The FTSE All-Share Index is up, and 10-year gilt yields were back below 2% on Tuesday (per Bloomberg).

Why don’t markets much care about the downgrade?

Well, for one, Moody’s and the other ratings agencies (Fitch and Standard & Poor’s) don’t have a great track record for accurate, forward-looking forecasts of credit risk. Instead, their opinions often seem based on backward-looking information or political, rather than economic, factors. For example, S&P downgraded the US due to heated political debate over the US’s arbitrary debt limit—which has no bearing on the US’s solvency.

True to form, Moody’s decision cited the UK’s likely delay in reaching some deficit targets—it’s self-imposed, politically driven, economically arbitrary deficit targets. But a one-year delay in reaching austerity targets doesn’t really alter the UK’s credit risk—the deficit’s still expected to fall over the next few years. Credit markets care more about overall progress than whether the deficit is 1.2% of GDP in 2017 (as projected in 2011) or 2.6% (latest projection). Granted, the delay’s not ideal—an extra year of deficit reduction won’t be easy on those people impacted by tax hikes, public sector job cuts and real (i.e., inflation-adjusted) cuts to pension benefits, but this is ancillary from the UK’s credit risk. Markets understand this.

Markets also understand the UK is, in fact, one of the most stable, solvent nations on the planet, and its default risk is exceedingly low. We can see this in three charts.

First, Exhibit 1 shows net public debt (total debt excluding intra-governmental holdings, which effectively cancel) as a percentage of GDP.

 

Exhibit 1: Net Public Debt as a Percentage of GDP, 1692 – 2012 (Estimated)

 

Source: HM Treasury, as of 02/21/2013. Includes official 2012 estimate. All others are actual outturn.

 

Though net debt has increased relative to the size of the economy in recent years, it still remains well under points seen during much of the past three centuries.

And this debt is plenty affordable. Exhibit 2 shows UK interest costs as a percentage of GDP.

 

Exhibit 2: Debt Interest Costs as a Percentage of GDP, 1946 – 2012

 

Source: Office for National Statistics, as of 02/27/2013.

The ratio has increased since 2008, but it remains near 20^th-century cyclical lows. In fact, interest payments were much higher during the 1990s, which featured robust economic gains.

Interest costs as a percentage of tax revenue, shown in Exhibit 5, tell a similar story.

 

Exhibit 5: Debt Interest Costs as a Percentage of Tax Revenue, 1946 – 2012

Source: Office for National Statistics, as of 02/27/2013.

Here, too, UK debt appears very affordable by historical standards. And, as even Moody’s admitted, debt service can likely withstand even higher yields. According to Treasury forecasts, if 10-year gilt yields were to rise to 5% and stay there for years—a seemingly unlikely scenario given the UK’s fiscal strength and cumulative deficit reduction progress—the ratio of interest costs to expected tax revenue would rise just north of 10% of GDP over the next three years. That’s still plenty manageable.

Simply put, with very affordable debt and some of the world’s deepest, most liquid and most stable credit markets, the UK doesn’t appear to have heightened credit risk.

For All Would-Be Gold Buyers

The following sentence leads off a recent Bloomberg story on gold prices:

“Gold futures slumped below $1,600 an ounce for the first time since August as signals on the US economy spurred optimism, eroding demand for the precious metal as a store of value.”

Public service announcement: If something can “slump,” it is not a “store of value.”

That’s true of gold. Because of its historical role as a currency backer, many investors see gold as an inflation hedge or stable investment when stocks are falling. In reality though, it’s neither—it’s just a commodity, and like all commodities, it’s volatile. It doesn’t always rise or hold value when inflation’s high, and there’s no historical correlation between gold and equity price movement—sometimes they rise at the same time, sometimes they fall at the same time, sometimes they move in opposite directions.

So if you’re thinking about gold, don’t be fooled by those common tropes. 

In Pictures: Quantitative Easing

As expected, the Bank of England (BOE) announced it is increasing its asset purchase program, otherwise known as quantitative easing (QE) by £50 billion. To put that in non-industry terms, the bank will purchase €50 billion in gilts from commercial banks, giving banks more money to lend, which ideally helps the British economy grow faster.

Why did the BOE think this necessary? British GDP growth was rather sluggish in 2011, as shown in Exhibit 1.

Exhibit 1: UK GDP Growth, Q4 2007 – Q4 2011

Source: Thomson Reuters, as of 1/25/2012.

Simultaneously, M4 money supply has contracted for 14 straight months, as shown in Exhibit 2, and corporate lending has been negative since 2009, as shown in Exhibit 3. (M4 measures all cash in circulation, held in private-sector retail and wholesale bank and building society deposits, and Certificates of Deposit.) Though the decline in corporate lending has eased lately, suggesting credit is slowly becoming more available to businesses, it appears that wasn’t happening fast enough for the BOE’s comfort.

Exhibit 2: UK M4 Money Supply Growth, December 2007 – December 2011

Source: Thomson Reuters, as of 1/4/2012.

Exhibit 3: UK Annual Loan Growth, 2007 – November 2011

 

Source: Thomson Reuters, as of 1/4/2012.

As the theory goes, if banks have more cash, they can lend more to businesses, who can use the money to finance expansion—whether that’s investing in new equipment, hiring more workers, opening more locations, etc. The result, over time, should be faster economic growth, provided all works as intended.

However, it’s too soon to say whether more lending and faster growth will follow more QE. In the US, the Federal Reserve similarly expanded its QE program in 2010, and banks ended up holding much of that new cash in excess reserves at the central bank, rather than lending it. And last year’s drop in corporate lending coincided with “Project Merlin,” under which the banks agreed to increase lending in 2011.

Thus, we suggest taking the BOE’s announcement with the caveat that even well-intentioned economic policies don’t always work out as planned. No matter how the government tries to facilitate lending and economic growth, market conditions ultimately dictate whether banks lend and how companies deploy cash. That said, we’d consider it positive that the BOE remains accommodative, with an eye toward increasing liquidity at a time many perceive that as necessary. (For more on the topic of central banks, see our recent commentary on iStockAnalyst.com, “Central Bank Accommodations.”)

Also, because the QE increase is small (and M4 has been contracting), it seems unlikely to materially impact the inflation rate, which has eased in early 2012. Exhibit 4 shows the breakdown of the BOE’s balance sheet at yearend. A £50 billion increase in the asset purchase facility (pink) is marginal compared to the overall increase since mid-2008. (Remember, though inflation accelerated in 2011, that was largely due to the VAT increase early that year, as described here.)

Exhibit 4: Bank of England Balance Sheet, June 2006 – December 2011

 

Source: Bank of England.

 

Britain’s Industrial Evolution

The Guardian has an interesting take on David Cameron’s mission to “fight for British interests,” as he put it, at last week’s EU summit. In most of his comments on this subject, the Prime Minister has said he’s focused on preventing European officials from implementing measures that would harm the City of London’s global competitiveness (such as the financial transactions tax). The Guardian suggests he take a different approach and devote “some tender loving care to British manufacturers,” citing Britain ’s proud manufacturing history and industry’s falling share of domestic output. In short, it argues, “British industry has been hollowed out.”

This view is also common in the US , which, like Britain , has evolved from a manufacturing-driven to service-based economy over the past several decades. In both nations, the manufacturing sector comprises roughly 22% of GDP (according to the CIA World Factbook). But that doesn’t mean British industry is dying; rather, it means the UK ’s economy is evolving normally. Throughout history, economic development has followed this pattern: agrarian to industrial to service-based (perhaps, in the future, we’ll see more phases, like intergalactic-commerce-based). Britain ’s at the far end of that progression (notice the absence of voices decrying that agriculture is only around 1% of total output). France , Japan , Australia and the aggregate Eurozone also have similarly portioned economies.

By contrast, many countries whose manufacturing sectors comprise a larger share of GDP are less developed and, in many cases, less economically diverse. These nations include Russia (36.8%), China (46.9%), Thailand (44.7%) and North Korea (47.8%). No one in their right mind would argue North Korea ’s economy is anywhere near as strong as the UK ’s. Developed Norway also has a relatively larger manufacturing sector at 40% of GDP, but its entire economy is less than one-fifth the size of Britain ’s. Lesson: percentage weightings alone don’t tell the whole story.

Here’s another way to look at this: According to IMF data, Britain ’s industrial output was approximately $490 billion. That makes it the eighth-largest single-country manufacturer in the world—well ahead of Taiwan , South Korea and Indonesia , which have reputations as strong manufacturers. Britain ’s industrial output is also larger than the entire economies of Poland , Belgium , Sweden , Austria and many others (if British manufacturing were a country, it’d be the world’s 20^th-biggest, which isn’t too shabby).

With these data in mind, it seems a stretch to argue British industry is dying. Its growth rate has fluctuated in sympathy with the recent recession and economic slowness, but when you take a broader, more measured view, it seems clear manufacturing is far healthier than some presume. (And a financial transactions tax won’t make it any healthier, but that’s a discussion for another time.)

 

A Closer Look at Inflation

The UK ’s annual consumer inflation rate fell to 5.0% in October, down from September’s 5.2%. Prices eased a bit more than economists expected (5.1%), but since the annual rate remained above 3%, Bank of England Governor Mervyn King sent a letter of explanation to the Chancellor—his eighth straight.

Mr. King’s letter and Chancellor George Osborne’s response, available online at the BOE and Treasury websites, indicate inflation is expected to slow substantially over the next several months, which would no doubt provide welcome relief for consumers. Part of their reasoning is logistical: In early 2012, the January 2011 value added tax (VAT) increase will no longer factor into the annual rate; excluding the effects of the higher VAT, the annual inflation rate is closer to 3%.

Some price pressures also appear to be easing. Exhibit 1 shows how each category of goods and services contributed to the monthly inflation rate, which fell to 0.1% in October from September’s 0.6%. Housing and household services are responsible for a large share of October’s lower rate, as are moderations in clothing and food costs—the latter thanks to good harvests and supermarket price wars.

 Exhibit 1: Contributions to October’s Slower Inflation Rate

 

Source: Office for National Statistics.

Looking ahead, producer prices (input costs) may support further declines in the inflation rate. The Producer Price Index slowed substantially in October, from September’s 17.7% annual rate to 14.1%. The annual rate of output price growth also slowed to 5.7%. The spread between input and output price growth tends to reflect the pressure on manufacturers’ profit margins—a wider spread typically means a tighter squeeze. That the spread is narrowing now suggests manufacturers will be less squeezed moving forward, which could help further slow price increases (lessening manufacturers’ temptation to increase prices in order to keep profits higher).