Global Market Insights | A Fisher Investments Blog

Downgrade Redux

Fitch jumped on the downgrade bandwagon on Friday, cutting the UK’s credit rating one notch to AA+—just like Moody’s did in February. And like Moody’s downgrade, Fitch’s move shouldn’t be much of a game changer for UK debt markets. 

In its statement, Fitch cited the “weaker economic and fiscal outlook” and claimed the UK has “no fiscal space to absorb further adverse economic and financial shocks.”

I polled a few of my colleagues, and none of us have any idea what “fiscal space” means—leave it to a ratings agency to use indecipherable lingo instead of plain English. But if Fitch is referring to the UK’s ability to continue servicing debt if the economy worsens, I disagree—some simple data from gilt markets show the Treasury has plenty of breathing room.

The chart below shows the average maturity and yields of all outstanding gilts, excluding those the government owns itself (which effectively cancel). The longer the maturity, the longer the UK has to repay its debt—and the less near-term economic troubles impact repayment risk. The lower the yield, the cheaper that debt is. As you’ll see, the maturity’s lengthened by nearly three years since June 2005, and the average yield has fallen by more than half. That means UK debt is arguably more sustainable today than it was eight years ago—that hardly merits a downgrade. 

Exhibit: Average Maturity and Yield of Outstanding Gilts (Net)

 

Source: UK Debt Management Office, 6/1/2005 – 12/31/2012.

 

Another piece of Fitch’s rationale seems similarly flawed: The agency doesn’t believe UK debt will get under 90% of GDP in a reasonable amount of time. 

What’s so magic about 90%? Well, that’s the level two well-respected US economists claimed is the tipping point for a country’s public debt—in a study they conducted three years ago, they found that once debt hits 90% of GDP, average economic growth falls from 3% to -0.1% (based on historical data since WWII). Those findings have underpinned many nations’ and organizations’ policies and recommendations since 2010. But last week, a few researchers from the University of Massachusetts debunked those findings. After they examined the dataset and methodology used in the initial study, they found the results were skewed by an Excel coding error, omitted data and a strangely high weighting of one datapoint (New Zealand in 1951). After accounting for those errors, they reran the analysis and found that growth averages over 2% once debt hits 90% of GDP. The 90% mark simply isn’t a dividing line between sustainable and unsustainable debt (as history would tell us, considering the UK’s grown tremendously over time despite having debt levels far higher than 90% at times).

So once again, it seems a rater has based its decision on an arbitrary benchmark, not the UK’s creditworthiness. 

Lessons From Japan

On April 11, the Post Office made a big announcement: In the near future, it will begin offering personal bank accounts, making it a full one-stop financial services provider. 

On the one hand, this may seem like a good idea on the surface. The Big Four high street banks hold almost 75% of the personal account market, so clearly competition is needed. And the Post Office, with its strong network of 11,500 branches, might have the clout to give them a run for their money.

Pick this apart further though, and it’s fraught with problems.

The Post Office is state-owned. Technically, it’s a subsidiary of Royal Mail, which should eventually be privatized under the Postal Services Act of 2011, but for now it’s 100% government-owned. Plus, the Act doesn’t include plans to privatize the Post Office—instead, there are provisions to spin it off into a separate state-owned company.

So the Post Office is and likely remains a state-owned banking/insurance/postal services firm. That sounds a lot like Japan Post, Japan’s state-owned banking/insurance/postal services firm. Or, as The Wall Street Journal once dubbed it, the bank that ate Japan.

In terms of deposits, Japan Post is the biggest bank in the world, with about £1.39 trillion. Savers love it because it offers a small but guaranteed return, which it can do because it has state backing. And it uses most of those deposits to buy Japanese government debt—essentially, it provides the government backdoor financing, which has helped the government run its debt load up to more than 220% of GDP. If it weren’t state-owned, it wouldn’t have this luxury. Like all banks, it would have to compete and fend for itself without a government guarantee, so it would probably have to diversify away from Japanese sovereign bonds, and the government would have to get its finances in order.

I’m not saying the UK’s setting itself up for this exact same scenario once the Post Office begins taking retail deposits (in addition to the ISAs it already offers), but there’s clearly potential to distort competition and public finances. With state backing and control, the UK Post Office could easily follow Japan Post’s lead and over-concentrate in gilts. It could also offer artificially high deposit rates since it wouldn’t have to worry about maximizing shareholder value. That may help increase competition in UK banking, but it wouldn’t be free and fair competition—which is how all proper competition should be.

If policymakers want to challenge the Big Four’s dominance, offering personal accounts through the Post Office isn’t the answer. Instead, they should make it as easy as possible for challenger banks (small, upstart high street banks) to launch and grow. For example, they could make it easier and cheaper to get a banking license, reduce the business tax, further reduce corporation taxes, lighten regulations and make capital requirements more flexible (as I recently wrote on MarketMinder, current plans to temporarily reduce challenger banks’ capital requirements miss the mark badly). That will allow a healthy competition—without distorting markets.

On Lady Thatcher

Head over to MarketMinder for my eulogy of Margaret Thatcher. 

On The Legacy of Margaret Thatcher

Cyprus and Precedent

Ever since Dutch Finance Minister and eurogroup head Jeroen Dijsselbloem suggested Cyprus’s bailout package could be the blueprint for future eurozone bailouts, investors have fretted the possibility large bank deposits in Spain, Italy or Slovenia may not be safe if those nations need a rescue. Never mind that Dijsselbloem’s spokeswoman said he didn’t mean it and Dijsselbloem himself issued a short statement calling Cyprus a “special case” and not a template. Eurozone officials aren’t exactly known for sticking to claims like this.

So, setting aside Mr. Dijsselbloem’s comments, what’s the likelihood eurozone officials go after large deposits in future bailout negotiations?

I suspect they’re lower than you might think.

I believe Cyprus was indeed a special case—not just because of the alleged money laundering, but also because of the sheer amount of foreign capital it attracted. German Finance Minister Wolfgang Schäuble suggested as much, saying Cyprus’s model of “attracting capital with low taxes and lax regulation” doesn’t work.

Hmm…that reminds me of 2011, when Mr. Schäuble told EU finance ministers Ireland’s 12.5% corporate tax rate “can’t stay like this.”

Core Europe—particularly Germany and France—has long sought to “harmonize” (a euphemism for synchronize) financial, tax and regulatory policy throughout the eurozone. They say this is to restrain “uncompetitive” behavior, conveniently ignoring that the outliers with more internationally favorable policies are actually competing. Ireland’s tax rate—one of the most competitive globally—was deemed uncompetitive, and Germany and France tried to force a raise. Officially, they argued this was necessary to raise Ireland’s tax revenues, but it soon leaked that they wanted a more equitable distribution of multinational corporations throughout Europe. Or, more simply, they thought Ireland was “hogging” all the business.

And today, I suspect they think Cyprus (and to some extent Luxembourg and Malta) is “hogging” all the foreign capital—that, by offering easy tax treatment and a light regulatory environment, Cyprus wasn’t playing fair with the rest of Europe. And it follows that, rather than make their own tax codes and regulatory schemes more attractive, they’d rather Cyprus and the eurozone’s other financial havens handicap themselves in order to spread the foreign capital around the continent. This gives officials every incentive to whack the banking sectors in these nations—and officials have made some telling comments about Luxembourg’s financial sector in recent days (Luxembourg, rightly, thumbed its nose).

The corollary of this is that officials have far less incentive to force losses on depositors in nations with smaller, less internationalized financial sectors. There’s no overarching (and misguided) desire to cut them down to size in the name of supposedly fair play. If these nations need a sovereign bailout, officials likely revert to the old bailout-for-austerity model, with taxpayers, shareholders and junior bondholders shouldering the financial burden.

Japan’s Political Morass in One Handy Chart

There’s a new word in Japan these days: Abenomics. 

That’s code for the economic policies of new Prime Minister Shinzo Abe, who believes his plans for massive fiscal and monetary stimulus will finally break Japan out of its long-running economic funk (and judging from his recent poll numbers, many Japanese citizens have bought in).

My colleagues and I have written at length about Abe’s plans and whether they’ll work—suffice it to say fiscal stimulus may give the economy a near-term boost, but the monetary stimulus appears rather feckless, and neither addresses Japan’s underlying economic issues.

Shinzo Abe’s Unstimulating Stimulus

(MarketMinder Editorial Staff)

Unlimited Easing, Limited Impact

(Yours Truly, Equities.com)

What Japan needs more than stimulus, in my view, is deep economic reform to address these issues, which include weak demographics, waning productivity, narrow labor markets, outdated immigration policy and too much trade protectionism, just to name a few. Japan’s also hampered by a weak corporate environment, where mega-conglomerates’ bank holding companies have a vested interest in keeping unprofitable subsidiaries afloat. The preservation of unprofitable firms has contributed to business investment’s steady decline over the past 15 years (in real and nominal terms) and makes it difficult for new businesses to penetrate domestic markets.

Many Japanese officials seem to understand this, yet reforms have been few and far between in recent years. One big reason: Japan’s premiership has a revolving door, which tends to turn about once a year, limiting each government’s ability to effect meaningful change. You can see this in Exhibit 1, which is the handiwork of Fisher Investments Research Analyst extraordinaire Tim Schluter.

Exhibit 1: Recent Prime Ministers’ Days in Office

Source: Fisher Investments Research.

Yes, Abe really is on his second turn at the helm.

Junichiro Koizumi is the last Prime Minister who stayed in office for any real length of time—and, not coincidentally, the last real reformer. Since then, however, not only has reform stalled, but the succeeding administrations have slowly unwound one of his crowning achievements: The privatization of Japan Post, the state-run banking behemoth. Some of these gentleman have had good ideas—the most recent Prime Minister, Yoshihiko Noda, pushed heavily for trade liberalization—but falling poll numbers, political turnover and (to be fair) the Great Tohoku Earthquake/Fukushima Daiichi nuclear disaster have kept meaningful change at bay.

Interestingly, Abe was Koizumi’s hand-chosen successor, and he pledged to see Koizumi’s reforms through during his first term. That didn’t happen, as Abe instead focused on more nationalistic issues, like making Japanese school curriculum more “patriotic.” Meanwhile, the economy stalled, his poll numbers sank, and his Liberal Democratic Party lost control of the Japanese Parliament’s upper house. Shortly after that election, he stepped down as party leader, citing health issues.

This time around, Abe seems more focused on the economy, though his plans are focusing on the symptoms of Japan’s economic issues more than the issues themselves. Plus, his nationalist agenda, which includes removing pacifist language from the constitution and increasing Japan’s military presence in light of escalating tensions with China over the Senkaku/Diaoyu islands, could again distract him from economic issues. If that happens, and Japan’s economy doesn’t improve, the revolving door could turn again. Will he change course and go back to his mentor’s reform roots before that happens?

Dissecting Cameron’s Speech

Curious about what Prime Minister David Cameron’s plans to renegotiate the UK’s relationship with the EU could mean for Britain? My latest column on MarketMinder has the scoop: 

On David Cameron’s Vision for Europe

An Encouraging Development

China has handed down a rare conviction for counterfeiting: 

China Hands Down First Jail Sentence Over Bootleg Scotch

Nathalie Thomas, The Telegraph

Counterfeiting has long run rampant in China. Electronics, brand-name and designer clothing, wine and spirits, and even buildings and whole towns are ripped off with frightening ease. On paper, China’s intellectual property laws are among the world’s strictest, and Chinese officials talk tough on the issue. But enforcement is weak, so counterfeiters don’t have much incentive to clean up their act—the threat of a loose fine or slap on the wrist isn’t much of a motivator.

This is a big problem for foreign firms trying to do business in China. Imagine you design and sell £500 handbags, and you expanded into China a year ago—a sensible move, considering how much China’s luxury consumer class has grown in recent years. But because £20 knock-offs of your work are available at train stations, swap meets and even shopping malls, you’ve scarcely been able to capitalize on that demand, and your return on investment is negative. Would you keep your Chinese business open in hopes of a government crackdown on counterfeiters, or would you pull out and look for more favorable Emerging Markets?

This is why Scottish whiskey producers—and businesses in general—are hailing the four-year jail sentence China handed to a wholesaler found guilty of selling counterfeit Scotch. Only time will tell whether it starts a trend of tougher intellectual property enforcement in China, but in the meantime, it likely sends a strong message to other counterfeiters.

Will Spain Get a Break?

Spain may get some much-needed flexibility from EU taskmasters: Chief budget enforcer Olli Rehn said he might relax Spain’s 2013 deficit target “if there has been a serious deterioration in the economy.”

I’m not sure what constitutes a “serious deterioration,” considering Spain’s already in pretty bad shape. Considering the recession has worsened since Rehn loosened the 2012 target last March, a reprieve seems likely.

In an ideal world, the EU wouldn’t just grant an easier target, but it’d change its metrics. Currently, officials use the deficit-to-GDP ratio—a useful means of comparing different countries’ deficits, as it scales the overrun relative to the size of the economy, but not so useful when charting an individual country’s progress. A country’s absolute deficit could narrow from one year to the next, but if its economy contracted enough, the debt-to-GDP ratio could weaken, disguising the fiscal progress. This could force the country to enact tougher tax hikes and spending cuts in the following year to compensate, further hurting growth and trapping the country in a vicious cycle. If the EU were to set absolute deficit targets instead—merely making sure Spain overspends by less and less each year—troubled states could likely avoid some of the crippling tax hikes they’ve had to pass in recent years.

Without additional flexibility, Spain could get caught in this trap. Even with the reduced deficit-to-GDP target in 2012, Spain still had to pass one of the toughest tax hikes in its history to comply with EU budget monitors. Rising taxes have already weighed heavily on Spain’s consumers and private sector (Exhibit 1), and the 2012 hikes could further dampen these key economic components.

 

Exhibit 1: GDP, Business Investment and Consumer Spending

Source: Bank of Spain.

If the EU were to grant Spain a looser deficit target for 2013—ideally, one that stipulated the absolute deficit, not a deficit-to-GDP ratio—Spain might be able to unwind at least some of these tax hikes, giving consumers and private firms a break. That would improve Spain’s economic growth prospects, and with higher growth comes higher tax revenue, which would help Spain narrow the budget gap much more quickly—and in a manner that would make its people better off.

More Trouble in Hungary

Storm clouds are gathering once again in Hungary. 

Over the summer, things appeared to be improving there. Prime Minister Viktor Orban’s government had amended prior legislative changes that would have limited the central bank’s independence and eroded some personal freedom. The need to comply with EU treaties, it seemed, would trump Orban’s ultra-nationalist aims.

Now, however, it appears optimism was premature. Orban may have adjusted the central bank legislation to comply with the EU’s requirements, but in practice, he’s still managed to strip the bank’s independence. In 2011, Orban appointed four “non-executive members” to the bank’s board, and these individuals have steamrolled monetary policy in Orban’s preferred direction, overruling bank President Andras Simor and his deputies.

Orban has been dissatisfied with Simor’s monetary policy since he took office in 2010. Simor has focused on preventing runaway inflation—a real risk in Hungary, where the currency is near all-time lows. Orban, however, wants monetary policy to be much more accommodative in order to offset the contractionary effects of his economic policy. Because he’s slapped banks, telecom and energy firms with extraordinary taxes, banks aren’t lending, businesses aren’t investing, and Hungary’s economy continues stagnating. Hence, Orban wants to slash interest rates to get capital moving again so he can keep these harmful taxes in place.

Simor would rather not play along—he understands loosening monetary policy will increase the risk of inflation and won’t fix Hungary’s underlying economic and policy issues. But rather than listen to reason, Orban seems content to continue forcing his agenda. Simor’s term expires next March, and Orban’s deputies are already eyeing a “new strategic alliance” with a central bank chief much more aligned with their interests—interests that likely include doing whatever it takes to artificially boost growth before the 2014 general election. A policy turnaround—something Hungary needs desperately—appears sadly unlikely.

Austerity in the UK

After Chancellor George Osborne read this year’s Autumn Statement, I could hardly visit a financial news website without seeing an article about the economic consequences of the UK’s austerity plan.

Here’s the trouble with this: Austerity means different things to different people, and no two austerity plans are alike. In countries like Greece and Spain, austerity means crippling tax increases and real public spending cuts—one big reason these nations are in deep recessions.

In the UK, austerity means something different: Yes, there are tax increases, but there aren’t actual spending cuts. Or, put simply, spending hasn’t fallen from year to year, and it’s not projected to. Instead, the government’s cut the rate of future projected spending increases—it will spend more from year to year, but not as much more as initially planned. That makes articles referring to broad spending cuts inaccurate.

To help put this in perspective, here’s a chart of the projected spending from each of the Autumn Statements (or the previous government’s equivalent, the Pre-Budget Report) since 2009.

 

*Shaded areas represent actual outturn. All other figures are official projections.

In 2009, the previous government planned to increase spending by approximately £20 billion each year through 2015. When the coalition took over in 2010, Chancellor George Osborne cut the planned increases to £10 - £15 billion per year. He eased a bit in 2011, but in this year’s statement, he reduced the planned spending increases again.  

Here’s another way of looking at it.

 

 *Shaded area represents actual outturn. All other figures are official projections.

Of course, that’s not to say the UK’s version of austerity has been easy on UK citizens. Civil service jobs have been cut, pension and benefit increases haven’t kept pace with inflation, and some programs have received real spending cuts. Many folks have felt a pinch from these cuts and the tax increases. But the continued spending increases do make it tough to argue the austerity program alone is responsible for recent economic weakness—something I’d encourage readers to keep in mind as they sift through the media’s analysis. 

 

 

 

¹Source: 2009 Pre-Budget Report, HM Treasury

²Source: November 2010 Economic and Fiscal Outlook, Office for Budget Responsibility

³Source: 2011 Autumn Statement, HM Treasury

⁴Source: 2012 Autumn Statement, HM Treasury