DABERIAM LVIII

November 2010

Since September, the major change on the political front has been the elections in the USA, where we now have a political log-jam. In British terms, a ‘hung’ Congress. Legislation going forward is likely to be less adventurous and radical. The good news is that business will become much less nervous of Government intervention, removing one of the hurdles that have inhibited corporate investment in the last two years.

Companies have been holding back on capital expenditure, the recovery in the US so far has come from the re-utilisation of resources that were already in place, producing considerable improvements in productivity. Many businesses are now running at full capacity but were reluctant to add plant or people owing to Obama’s anti-business rhetoric.

The US Feds QE2 programme became a near certainty after “Helicopter Ben” trailed it some months ago and the banks positioned themselves to take advantage of continued low interest rates. We can now expect to see quite a flood of corporate borrowing, again to take advantage of these rates. This too will lead to an increase in business activity. It is, however, unlikely that unemployment will reduce very rapidly as the US, like the UK, suffers from a large percentage of unskilled people and this problem will continue to worry Washington.

The other US longer term problem is housing and retail property. In both areas, there is an over- supply but while prices are down they have not yet declined far enough to clear the market, leaving an overhang of debt defaults to be absorbed, mostly by the provincial banking system.

The UK seems to be in a state of almost suspended animation. Government action has been announced to start rebalancing the budget, but the axe confusingly is scheduled to fall slowly! This leaves the deficit reduction some way off. While the policy and method of dealing with the reduction in Government expenditure is still in many areas ‘work in progress’, there is room for the axe to be blunted as special pleading by those recipients of Government largesse swings into gear.

In the private sector, a large number of near insolvent companies are hanging on in the low interest rate environment, as I mentioned in September, but they are not able to invest in development of sales growth and will eventually succumb when their banks decide to pull the rug. The potential collapse of a lot of businesses keeps being postponed, but it is likely to become a torrent in the early part of 2011.

Northern Europe is doing well, France, Germany and Switzerland and their subsidiaries to the North are not over-geared and have continued to invest and innovate over the last two years, albeit at a slower rate. There is a likelihood, however, that the European Central Bank will not be able to continue to prop up some of the, so called, PIIGS, although the ‘P’, Portugal, may have found an unlikely saviour in China. One or two of the remaining ‘IIGS’ will probably have to reschedule their debt, causing a political and journalistic furore but this will have little impact on the world economy.

Asia is humming away and probably will be seen to have kept the West from total financial collapse. China has its inflationary problems which it will have to accept if it does not allow its currency to re-value. Economics “happens” regardless of political desire. The Chinese do not want to be seen to be acquiescing to US pressure to revalue and domestic inflation is, to a large extent, the economic consequence of this political dilemma. Bizarrely, if they freed their foreign exchange markets, there would be a high likelihood that it would result in an appreciation of the dollar as the domestic institutions in China buy dollars to invest overseas. I know this has been a considerable worry to the Chinese monetary authorities going back five or six years. The situation is potentially unstable but the management of the Chinese economy and, at least for the moment, its method of Government is highly sophisticated and unlikely to have the sort of political accidents that the West can inflict on itself.

The confusing thought that continues to occur to me, is the stated objective of the Anglo Saxon central banks, that they want the consumer to start spending again to boost the economy. US and UK consumers are from a historic point of view, hugely over-borrowed and individually seem to be doing the sensible thing, i.e., paying down their borrowing. The debt that was built up by irresponsible lending, there is no other way to describe it, with the encouragement of government by freeing up the constraints in the banking system.

GDP growth financed by debt is not sustainable and the price still has to be paid. No amount of quantitative easing is I suspect going to persuade “the man in the street” to go on a spending binge for a long time. He may, however, find it difficult to repay debt as wages are held down, and taxes rise along with inflation. Unless we see a genuine reduction in Government expenditure, the old phenomenon of Stagflation starts to rear its ugly head.

The point here is that the US and UK with their potential inflation problems are in a very different position to Japan, which is often held up as a problem country. The lack of growth as measured by GDP gives the appearance of stagnation in Japan, but coupled with deflation, the consequences have in fact been beneficial to the people of Japan. Their savings are high and while salaries have not risen, prices have fallen. In comparative GDP terms, it may look like zero growth, but the results are very different.

While stocks and shares that represent productive enterprise have been very volatile in the last 2-3 years they look like a much safer bet than government debt in the longer term.

Looking through the fog of gloom, most businesses have stabilised and a great many are prospering. There are, however, a number of companies that are in a so called zombie state, ie they survive but will inevitably collapse either when their sales pick up, because they will not have the funds available to finance the increase of work in progress or because at some point their bankers and backers will get fed up and just pull the rug. This group of businesses will probably provide some horror stories at the end of the current year and early next year. For the rest there is evident growth in much industry across Germany and Northern Europe to America with the main drive coming from Asia. Companies are naturally nervous as the political climate in the West is creating continuing uncertainty in general and for obvious reasons among businesses that rely on government expenditure. This nervousness is naturally greater in countries where the government represents 50% or more of GDP.

The overall GDP growth in the over borrowed West cannot improve greatly until the huge borrowing, both private and governmental, is reduced. This will cause a bifurcation in Western Economics as it is likely that sectors that grow and are successful will not be able to absorb the large numbers of people that will be left behind and unemployed, particularly those from the public sector.

Unemployment is likely to continue to be a major social problem for the foreseeable future, particularly in Europe as governments continue to increase the employment tax that businesses have to pay.

It may be optimistic to think that the Autumn will see an enormous increase in economic growth, however betting on disaster and catastrophe looks to me like a no-win bet. While the future may be difficult for a lot of people one can be, in general, much more optimistic than a year ago.

Damon de Laszlo
November 2010