Thursday, 2 April 2009

A turning point?

One of the hardest things in life is to recognize a turning point. Identifying trends is always easy, but knowing when the world is about to move in a different direction is so much more difficult.

Over last 18 months, the path taken by the UK economy has been easy to make out. After August 2007, financial markets froze up. Credit conditions tightened, large seemingly invulnerable banks unexpectedly failed, and in due course the economy slipped into a recession.

Some observers took this trend and followed it all the way to the bottom, suggesting that the credit contraction would be so powerful that consumer prices and asset values would to fall in absolute terms. In other words, the UK economy was on course for deflation.

For a time, the deflation story was tracking the data nicely. Inflation has moderated somewhat in the last few months, coming off a 16 year high in September. Asset prices, particularly equities took a battering, and house prices fell by just over 20 percent.

Nevertheless, recent data has gently pointed in a different direction. While the real economy continues to weaken, there are now compelling reasons to think that the risks of deflation, in the sense of falling consumer prices, were overstated. Has the UK economy approached the turning point? Will inflation begin to re-emerge? There are at least eight reasons to think so. Some of these points you have seen from me before in previous posts, but it never hurts to repeat them.

  • The FTSE had a very good month in March, with the headline index now over 4000. Equity markets have stopped believing in deflation.

  • The spread between the BoE bank rate and government yields remain surprisingly high. After dipping down slightly, as the Bank of England began its much anticipated quantitative easing, rates promptly rose again. The bond market doesn't seem terribly convinced by deflation.

  • February CPI data was a serious blow to the deflationist case. The 12 month rate rose by 0.2 percent, with many of the underlying sub indices rising alarmingly. Declining utilities prices were the only thing that kept the February inflation rate from looking positively ugly.

  • Commodity prices are creeping up. Gold is on an upswing. Oil prices are up 25 percent since February. While recently, the oil price has given back some of its recent gains, the general direction seems clear.

  • Unit labour costs for the fourth quarter of last year were disturbing, rising at almost 5 percent. Again, it is another example of a key sector of the economy, this time the labour market, taking a skeptical view about deflation.

  • Mortgage availability improved in February. True, lending volumes are a long way from the heady days of 2004, but the Bank of England and the government have put in place a series of measures that have made it impossible for a bank to lose money on the housing market. There is a real danger that mortgage lending is about to explode.

  • House prices increased in March. I know, it's just one month, and in historical terms, house prices still look overvalued. Nevertheless, the March number does not look out of place in relation to improving mortgage availability. Moreover, houses have always proved to be an effective hedge against inflation. It pains me to say it, but I wonder if house prices might be close to bottoming out. Believe me; I would love to be wrong here.

  • The money supply is growing at 17 percent. I know, you've heard this old song from me before, but that doesn't make it any less true. Since early winter last year, monetary growth began to accelerate. Sooner or later, a larger money stock always means higher prices.

    So what is the counterargument? Well, there's no denying that the world economy is spinning into the worst recession since the 1930s. Every indicator points in that direction. At the same time, monetary policy across the world is extraordinarily expansionary. There is no reason to think that a devastating recession cannot comfortably coexist with rapidly rising inflation. This was, after all, the great lesson of the 1970s.

    Anonymous said...

    Deflation - the most over used word this year.

    Unknown said...

    I agree- if we are in the middle of a turning point it's from deflation to inflation (not downturn to recovery).

    Anonymous said...

    The best way to understand this is to use the whirlpool principle. This views the economy not as one thing, but a collection of various individual whirlpools. With whirlpools, you can have a very healthy economy for some people and in some sectors or regions, while a very sick economy right beside this for other people. The two can sit side-by-side.

    Anyone who has lived and worked in a developing country has seen this at work. And I am afraid the UK behaves more like a developing economy. With the UK's multitude of castes and classes, you can have some supping on Gentleman's Relish and champagne (with prices rising), while others eat baked beans and collect the dole.

    With all the stimulus, with the inherent inefficiences of the UK economy (and general laziness and wheel spinning), access to goods and services will become constrained, and thus prices will go up for those who can afford them.

    CityUnslicker said...

    bear market rally, don't get too confused by it.

    once the g20 is gone and people look at all the data coming in again, we will be sunk by May.

    Sell in May and go away is the phrase they use in the City.

    hard to see how we don't get a little bit of deflation in the next 2 quarters given the mad comparitives for oil and commodities from this time last year when the bubble peaked.

    dearieme said...

    Why does everyone fear hyperinflation? Surely 3 or 4 years at 10%-30% p.a. will do the trick of defaulting very satisfactorily.

    Sackerson said...

    Agree CU.

    mab said...

    Look at the longer term trends, they still seem to be intact. The Pound will continue to fall, North Sea oil will continue to wane, and Britain's standard of living gains will be less than ever relative to the gains around the globe.

    Price is what you pay. Value is what you get. Inflation vs. deflation? It's all relative. Unless you are in the protected banker class. Then you get to have others do bear your mistakes.

    Anonymous said...

    Even dead cats bounce in the Spring!

    The shortage of credit means an horrendous contraction is unavoidable.

    B. in C.

    mike said...

    House prices will be impacted by high levels of unemployment, lack of bonuses and general decrease in salary of the working population.
    My view is that we are still at least 1 year from the bottom.

    Electro-Kevin said...

    Off topic. Ajay says:

    Halifax have reported one in Jan 2009.

    Rightmove reported one in Feb 2009.

    Now Nationwide have reported one in Mar 2009. Read it now!

    Get used to it! House price rises and the reporting of them I think will become common place. The question is will they creep up or shoot up?

    Do I care? Well I used to say I did not but now I am a little bit worried. If prices shoot up then this window of opportunity will disappear quicker than I ever thought.

    If we really look at it we have the world leaders meeting up in London to talk solely about getting loans to borrowers. It is quite amazing but when you breakdown why we have one of the most historic days happening to day with regards to finance it is all about getting loan funds to you, me and everyone!

    So getting loans to us is deemed to be very important. GREAT! This is why property is such a good investment as you can use the banks money to make you a return far greater than any other investment.

    So as they sort the problems out property prices will rise. How quick they rise will depend on how quick they sort the problem out.

    Now I know the government have let us down as they should have seen all these problems coming but hindsight is a great thing. The good thing is they are over compensating for their balls up and now applying every resource at hand to fix the problem.

    In other words they are going to fix this problem quick time. It is kind of obvious simply because we have the greatest minds and powers at be sorting this problem out.

    So being a businessman all I care about are the loans that I can get today, tomorrow and next week. Expect the mortgage market to get flooded with new products during 2009 and so good bye to the mini crash that changed the face of lending forever.

    Anonymous said...

    Let's not kid ourselves that this is anything other than a bear market rally. In the 1930's 4 years out of 10 90% of the Dow Jones stocks gained in value. The other 6 years did all the damage.

    Most of the investors who went bust in the great depression thought the bottom had come, so jumped into bear market rallies and got crushed in the vicious pullbacks that followed.

    We are at the dawn of a major structural change in world economics. The dollar will lose it's status and the US will become a second-rank economic power.

    The UK has way way way further yet to fall. As far as house prices go, if you think about it, it really would be surprising if house prices just monotonically fell every month. Things don't work like that. Nevertheless, asset prices will continue to fall. Prices for consumer good will continue to rise.

    Anonymous said...

    The only steps to stop an inflationary spiral would be a death blow to existing borrowers, thereby swamping the market with repossessions.

    Also purchasing land/houses as some form of hard money to prevent inflationary losses depends entirely on having the money in the first place. At some point the BoE would have to get ahead of the curve on inflation with rates. High rates are not supportive of high house prices.

    The real crash is still coming. Repossessions haven't peaked and neither has unemployment, quite aside from any defaults on unsecured debt, company defaults. 2009 is going to be year zero.

    sobers said...

    I think we have swapped one problem (banks with more liabilities than assets being effectively bankrupt) with another - the nation is now effectively bankrupt, as it has taken on all the liabilities of the banking system (plus its attempting to spend its way out of the recession).

    But its easy to see if a company is bust - eventually they run out of cash, cant pay people who they owe money to, and the whole thing falls apart. Its a bit harder to see when a country is bust, because it can always print more money (a bit of a clue there I think) and things have to be very gloomy for the bond market to go on strike.

    I think we have swapped a deflationary depression (banks go bust, companies follow, downward spiral ensues, as in the 1930s), for a national bankruptcy/default. What form that will take is as yet unsure, my money is on the silent default by inflation. Probably not hyperinflation, but definitely 10%+ for a few years. A couple of years of 10%, with a ramp up and down either side would probably half the value of the pound in your pocket. Job done.

    Anonymous said...

    I agree: useful idiots will proclaim house prices are rising (and they will in fiscal amounts) but it will be a mask: the pound will be collapsing in value at the same time, and the country will be flooded with quantitative easing. So, yeah, a studio in Highgate will rise to a £1 million, but with the pound at 25 US cents, and it bugger hard to make money in the UK because of the sick economy, it will be meaningless.

    Electro-Kevin said...
    This comment has been removed by the author.
    Electro-Kevin said...

    Anon @ 21.24

    Well put. All we have to do now is restrict foreign travel so that our people can't see how well countries like Australia or Canada are recovering.

    Devalued £, more red tape around travel (in the guise of anti-terorism) Job done.

    I find Brown so ... soporific.

    eh said...

    Go back and look at the performance of the FTSE in the spring of 2008.

    Anonymous said...

    The turning point IMHO was '99.

    The post '70s recovery was only possible because of North Sea oil. In '99 UK oil peaked and we became a net oil importer. Since then the financial sector has taken up the slack.

    So what's going to fill the hole left by oil & banks?

    There is nothing that I've seen that can bring us out of recession. The UK has nothing left of worth. We are bankrupt, we don't have enough natural resources to even be self-sufficient (Energy, Food) and higher education is being dumbed down to make it 'hip' for the kids.

    Sorry to say it, but England is lost. The recession will only end when we finally merge with someone else. (EU, or USA).

    About the only thing Labour/ Conservatives/Murdoc can agree on is how much they distaste the EU, so that question has been answered.

    The only real question left is, how bad do we let it get before finally saying "Farewell Blighty it was nice knowing you...."?

    K T Cat said...

    Great post. Dig this one from Jim Jubak.

    Anonymous said...
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