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Brexit…

Jim Bondigger

Industry Expert

…a hard landing scenario is not completely out of the question…

In the run up to Brexit, financial markets were extraordinarily complacent, worse they were suffering from a critical case of tunnel vision. The commonly held view from the city was that ‘people would see sense, the polls are wrong and on the day Britain will vote remain’.

After all, the risks were clear, GDP will be x.xx% lower, business confidence will go down by several points, the Chancellor said that taxes would need to be raised and the Governor of the Bank of England cautioned this would deliver us into the grasp of a significant economic downturn.

However, the corollary was the ‘leave’ camp (a whole raft of economic gurus, rocket scientists, businessmen and prominent politicians) who assured us that these projections were all complete and utter nonsense and everything would be just fine. In fact, the economy would eventually thrive and as we were repeatedly told, as a bonus we would save £12bn pa currently paid by the UK into the EU.

So, as two grumpy old men informed me, ‘I have no idea what this all means for the economy. Germany and France are just holding tanks for illegal immigrants who want to come to the UK and frankly, we are fed up and sick to death of being told how straight our bananas need to be”…‘We’re out!!’.

Brexit means Brexit.

And the story thus far; well, the economy knee jerked initially, leading indicators nose-dived, a large number of investment plans were apparently shelved, commercial real estate deals fell through and the residential property market (particularly London) appeared to lose its shine.

The Central Bank almost immediately opened the monetary policy flood gates, cutting Bank rate by 0.25% and providing the banking sector with term funding (that could exceed £100bn) to support lending to the real economy. The Bank simultaneously switched on the printing presses to the tune of a further £60bn (Quantitative Easing) which is in addition to the c.£375bn of government bonds already bought by the Bank of England further providing liquidity to support the economy. The Bank of England describes quantitative easing (QE) as ‘an unconventional form of monetary policy where a Central Bank creates new money electronically to buy financial assets, like government bonds. This process aims to directly increase private sector spending in the real economy and return inflation to target’.

And then the sun came out, literally, the world as we know it didn’t end, the economy wasn’t falling off a cliff and everything felt just a little bit better. Economic data began to rebound, albeit from relatively low levels, property prices are again trending upwards (London and commercial real estate aside), retail sales increased a little and GDP is holding up ok ‘ish’. The currency remains at lower levels and that will be supportive for British exporters going forward and it will also make foreign holidays more expensive, so expect to start hearing more about the Great British ‘staycation’ next year.

But what of the future? How and when will Brexit ‘land’, and will it be a hard or soft landing for the UK economy?

In order to understand the prospects of how Brexit might land, we also need to be cognisant that we are in an increasingly global environment and that financial markets are intrinsically linked. Exogenous shocks in one geography are transmitted almost instantaneously cross-

border with the potential to send shockwaves globally.

It is possible that we will look back in 10 years’ time (or less !!) and observe that the policies being deployed today by Central Banks, which are the largest, untested, unproven multi-trillion monetary policy experiment in the history of financial markets.

In response to the global financial crisis and a systemic lack of growth and a near absence of inflation, Central Bankers are deploying monetary policy easing on a scale and form never before imagined.

These policies are almost certainly now giving rise to extraordinary global imbalances and potentially unsustainable ‘bubbles’ in asset markets.

History tells us that bubbles have a habit of bursting, usually unceremoniously and violently. In turn, this can lead to a material loss of confidence, inducing recessionary forces that are almost impossible to stop. More often than not the recession that follows tends to be quite severe.

So what are Central Banks doing now and what do some of those anomalies look like?

Most major central banks are setting their monetary policy rates at or close to the lower interest rate bound and in a number of cases at negative interest rates Furthermore, a number of other major central banks in addition to the Bank of England have been engaged in QE. The US Federal Reserve Bank has bought trillions of Dollars of government bonds. The ECB continues to pump vast quantities of money into the financial system. ECB president Mario Draghi said in July this year that, “Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough”.

In other words, Central Banks are variously buying government bonds and providing term funding at extraordinarily cheap levels, injecting cash into the financial system with the aim of reducing the cost of borrowing, boosting asset prices, stimulating growth and ultimately to ‘return inflation to target’.

So what happens when the Central Bank sets its policy or deposit rate at zero or even negative?!! Simple – Guaranteed losses on Central Bank deposits. With commercial banks paying little or nothing for retail deposits (and some charging fees on top), the incentive to hold physical cash is increasing by the day. In an age characterised as ‘digital’ or ‘the Internet of things’ it is unusual to find that physical notes and coins in the UK system have increased by almost 20% in the last 2 years. That’s equivalent to almost £10bn of extra cash, or put another way, equivalent to every single adult in the UK carrying around an extra £200 in cash. After all, why leave it with a bank if they pay zero or worse?

In the Eurozone there is some early debate on a remarkable subject, whether large denomination Euro notes might actually be worth more than their face value. Absurd, but true.

Perhaps we should consider investing in domestic safes and mattress manufacturers…

This negative interest rate dynamic exists today to a greater or lesser extent with the European Central Bank, the Bank of Japan, the Swiss National Bank and the Danish Central Bank. Every day the equivalent of trillions of pounds are deposited with Central Banks on this basis.

The Bank of England currently sets its main policy rate at 0.25%, but the direction of travel suggests that the Bank will cut its policy rate again, possibly to zero.

One Bank of England deputy governor stated recently that, the UK is in the grip of a ‘Sizeable economic shock’ (Brexit) and that the Bank will likely add further to stimulus measures to ‘help ensure a slowdown doesn’t develop into something more pernicious’.

As described above, Central Banks have been radically engaged in quantitative easing (printing money), largely through buying of government bonds. However, in increasing efforts to stimulate growth and domestic economies some Central Bankers have also begun buying equities and corporate bonds.

The Bank of England will soon own in excess of £400bn of its own government bonds and is planning to buy £10bn of corporate bonds.

But UK and global growth still remains anaemic at best and economies are failing to achieve ‘escape velocity’ from the historical drag of the financial crisis.

One effect of these money printing policies has been to create a global environment in which the equivalent of almost 10 trillion Euro of government bonds globally are trading at negative rates of interest. At one stage Swiss 50 year government bonds traded at a negative rate of interest!

Imagine investing money for 50 years with an explicit and unconditional guarantee that you will lose money. Frankly, staggering.

Are we really living in a world in which fear drives us to believe that we must invest our money in assets that guarantee losses in order to ensure that we protect the majority of our capital?

Worse, are we certain that those Governments will never default on their sovereign debt? Isn’t this just mind numbing stupidity? More importantly, how long can it last and are the seeds of the next crisis being sown right now? Or will it just be the next stage of the current crisis?

Consider Japan, probably in the process of travelling headlong to their second ‘lost decade’. Little or no growth, job creation or inflation. This year alone the Bank of Japan will buy more sovereign bonds than its government will issue, equivalent to more than $700bn. Furthermore, they are effectively buying domestic equities at a rate equivalent to almost $60bn pa. Policy rate is set at minus 0.10% and 10 year government bonds are at negative yield.

The result so far, still no growth, job creation, productivity or inflation to speak of.

But the Japanese debt to GDP ratio is rapidly going to the moon. The country has been downgraded by the international credit rating agencies and the currency fails to devalue because… Japan is seen as a ‘safe haven’.

Guaranteed losses in nominal terms which could be severe in real terms. Madness.

In the Eurozone, the European Central Bank has set its policy rate at minus 0.40% and is lending cash to banks (another form of QE) at negative rates of interest in an attempt to stimulate spending and inflation in the Eurozone economies.

Some commercial banks are now offering one year fixed rate mortgages at zero (0% interest!!). Eurozone unemployment stands above 10% and inflation is virtually non-existent.

So what has happened to asset prices?

Property and equity prices have increased. In fact, the cost of the average UK property now stands at a record high £220k, almost 25% above levels seen as recently as 2014. Many equity markets are at or close to all-time record levels, but economies still don’t appear to be capable of reaching ‘escape velocity’ even with those vast quantities of central bank support. And the next generation can barely afford to get on the housing ladder to the extent that many need the assistance of the ‘bank of mum and dad’, government help to buy schemes and shared equity initiatives. Estimates suggest that parents are now contributing annually £5bn and are involved in almost 25% of all new mortgage transactions. The whole situation appears rather problematic (if not completely unsustainable) considering that average earnings growth has been running at levels less than 3 percent in recent years. Nightmare.

‘Esoteric’ investments like classic cars, fine wines, stamps and

vintage watches have been recording staggering gains in the last few years. In fact, there is widespread evidence to suggest that some of those assets have recorded near triple digit percentage gains during the last 3 to 5 years. In the early 90’s classic car prices crashed, history shows that bubble bursting was linked to the crash in Japanese real estate and stocks. However, in 1998 classic car prices began to rise and there hasn’t been a single year since then that prices have gone down. Remarkable, where does it all end? Usually in tears.

Central Banks have now injected so much cash into the global financial system it appears there is ‘money for everything’.

One market commentator stated recently, ‘we are currently living through the biggest bubble in 5,000 years of recorded economic history’.

But in the last 2 years the price of oil has more than halved. Less than 5 years ago doom mongers were insisting there was barely enough oil remaining to support global consumption for the next 20 years … and petrol at the pump in the UK is still well above £1 per litre. That decline is not just the preserve of the oil price, global commodities prices have fallen by almost 40% in the last 3 years. Hardly a vote of confidence in a global recovery.

Still, we have insufficient levels of growth or investment to stimulate economies and inflation continues to prove elusive.

One major side effect of lower long term interest rates is the significant negative implications for most pension funds and those companies that need to fund those schemes.

In simple terms, as bond yields and long term interest rates go down (a function of Central Bank policies and their buying of government and corporate bonds) so pension fund future liabilities increase.

Latest estimates suggest that UK pension fund deficits are equivalent to almost £500bn. For example, at the start of this year a certain UK telecommunication company pension fund deficit reportedly stood above £6bn…this was the deficit before the recent collapse in bond yields!! In the United States, current analysis suggests that pension fund deficits are now equivalent to almost $18 trillion. Yes, $18 trillion. Astonishing!

There is recent evidence to suggest that some major UK companies have started reducing (or cutting completely) dividend pay-outs, citing the need to begin closing black holes in their pension funds. This is potentially just the start of a very long and costly process. The deeply troubling question this raises is, to what extent is this factored into equity market valuations today? Buyers beware.

Many years ago, William McChesney Martin, a former Federal Reserve chairman, once famously said the central bank’s role was to “take away the punch bowl just when the party gets going”.

Alan Greenspan, Fed Chairman from 1987 to 2006 commented famously in 1996:

‘Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?’

Greenspan was a little ahead of his time with those comments. The market continued to rise irrationally for a further 3 years before the ‘dot com’ crash.

Going back to our original question – Brexit, what are the chances of a hard landing?

The U.K. must deliver Brexit in the context of an economy that is underperforming its long term potential and under a significant cloud of Brexit uncertainty. The currency will likely remain weak and possibly weaken further. At best those factors will likely undermine investment plans in the short to medium term. Global equity markets (among others) appear to be artificially inflated by extraordinary central bank measures that are flooding the world’s financial system with trillions of dollars of cash and then remunerating those funds at close to or below zero %.

One unfortunate consequence of these policies is highly correlated funding short falls in company pension schemes and that has potentially negative implications for company dividends and equity market valuations. Brexit will continue creating uncertainty and the upward trend in asset prices only looks sustainable if Central Banks keep printing money.

Worryingly, Central Bankers appear to have been drinking from the very (monetary policy) punch bowl they once confiscated, perhaps inadvertently deploying their own form of quantitative irrational exuberance.

The fear is that the current generation of Central Bankers and the extreme policies being deployed may already be on borrowed time.

This raises some key questions:

Are markets about to lose confidence in Central Bank policies?

Quis custodiet ipsos custodes? Or in this case, who is regulating the regulators?

More importantly, who, if anyone, stands ready to remove the punch bowl this time?

Deputy Governor Broadbent told The Times: “We know there is an effect coming, we know the world looks potentially very different.”

Britain has weathered the shock of the European Union Referendum far better than expected but the real damage will come from companies delaying investment decisions due to uncertainty about long term trading arrangements.

Monetary policy will likely be heavily influenced by judgement rather than hard data in the short term.

However, with conventional monetary policy close to the lower bound, and the benefit of extraordinary measures looking increasingly doubtful, it suggests it may be time for our new Chancellor of the Exchequer to lend a helping hand on the fiscal front.

The British Prime Minister has recently stated that Britain will invoke Article 50 before the end of March 2017.

It is possible to argue the case for a soft landing, unfortunately, after more than 3 decades of working in global financial markets I haven’t seen a soft landing yet…

Moreover, if unlimited printing of Central Bank money ultimately leads to a loss of confidence it is possible that the whole financial and monetary system could be at risk.

I sincerely hope that Brexit does not become the least of our worries.

Beware the Ides of March.

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