I don’t want realism. I want magic!

The balance of payments will always balance, by definition.  UK citizens buy and sell goods, services and assets to and from foreigners and in the end what moves are the prices of those goods, services, assets and the value of the pound. It’s not really Mark Carney’s “kindness of strangers” which keeps the UK afloat. The question is rather by how much the pound, or bond yields, share and house prices might have to move in order to balance the payments….

Since I can’t reasonably use a personal blog to write anything that anyone could see as investment advice, I thought I’d put some of the UK’s balance of payments data into pictures and lay out a few of the facts as I see them…

There’s a world of data to play with on the balance of payments, but here are the big items, shown annual sums in billions of pounds unseasonably adjusted. Unadjusted because the financial account data I show in the following charts doesn’t come in adjusted form so i’d rather stare at annual sums of apples vs apples than confuse the picture…

The orange (?) line is the overall current account, showing its steady deterioration that made plenty of headlines this week. The pink line at the top shows the UK’s surplus in services, which has stopped improving recently. The UK is, at this point in time, extremely good at exporting services.

At the other extreme the light blue line shows the ever-growing deficit on goods. I’d point in particular to the modest decline in the goods deficit after 2008 as evidence of what happens when the economy slows and the pound falls….

The other two lines show primary and second income on overseas investment. Secondary income includes, mostly, bilateral aid, military grants and subscriptions to international bodies (like the EU).  Primary Income is the income from investment overseas and it’s getting a lot worse. After years of selling assets to finance the current account deficit, the UK now earns less on its stock of foreign assets than it pays on the growing stock of UK assets owned by foreigners, but the most recent deterioration is a bit more complicated. The ONS wrote about this in some detail  here. The biggest driver of the deterioration appears to be falling revenue on a growing net stock of foreign investment owned by a coupe of dozen huge multinationals. If those multinationals are all in the oil and commodity business, you could imagine that what has really hit this part of the balance of payments is the weakness of commodity prices.

So, the overall position is that the UK currently has 1) a huge and growing deficit on goods; 2) a huge but stalled surplus on services; 3) a horribly trend from surplus to deficit in the income on foreign assets which may or may not recover once the sterling price of oil and other commodities bounces; and 4) Brexit, but I’ll just leave that there…

My second picture shows the balance of portfolio and direct investment – the net purchases of UK assets by foreigners, again in billions of pounds as an annual sum.

There has been huge appetite in the last year to to to buy UK assets, particularly  in the form of portfolio flows. Q1 saw the combined total of portfolio and direct investment inflows at GBP 94b, nearly three times the current account deficit.

That Q1 figure though, was as much due to UK investors selling foreign assets, as anything else. So I’ve thrown in a final chart showing foreigners’ purchases of UK assets (still as an annual sum) in direct investment (measly) and in portfolio investment (most of which is is bonds).

Foreigners bought GBP 20.3bn in UK bonds in Q1. GBP 4.7b in short-term debt and GBP 15.6bn in long-term debt. They sold sold GBP 2.9bn worth of gilts. Clearly, the grey line showing the annual sum of inflows into the UK debt market is still very big and equally clearly, it’s stopped increasing. UK bond yields are internationally quite attractive and the pound’s weaker than it was before the referendum, so time will tell whether that’s enough to encourage inflows to continue,  just as time will tell whether that mix of strong services exports and a big goods deficit makes international trade negotiations easier or harder.

If you want the Q1 data release, by the way, it’s here

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Are we really stupid enough to prefer 2006-2010 to 1995-1999?

I have spent the last week seeing investors in the US. there is a huge debate going on in markets at the moment about whether the US Federal reserve should, or will, slow down the pace at which they have been buying Treasuries, and what it might mean for markets. This note is a short update on the previous post I put on this blog – which was intended as a basic aide-memoire for anyone who wanted to understand a little about how the 1994 ‘bond crash’ played out in financial markets. That period being a reference point for what happens when the Fed starts the process of exiting periods of extraordinarily accommodative monetary policy

The chart below shows US jobs and GDP growth through the 1990s. You can clearly see how in 1994/1995 (when the US Federal Reserve increased its target for Fed Funds from 3% to 6% in 12 months), employment growth slowed from around 350k/month to a trough of around 100k/m, and GDP growth slowed from 5% to 1%. Briefly. Now that is a pretty sharp slowdown and is the basis for arguing that the ‘bond crash’ represented at the very least a poor piece of policy communication on the Fed’s part. Let’s forget anything else going on in the world, and accept that if the Fed had either done a better job of preparing financial markets for the necessary monetary policy normalisation, or if they had tightened more slowly, the economy’s path would have been smoother.

That’s all fine. But what I find surprising is that even now, there is a general sense that the Fed should do everything in its power to avoid a repeat. “We remain unconvinced that the eventual tapering of the central bank’s asset purchases will trigger a 1994-style bloodbath in the bond market”, John Higgins of Capital Economics is quoted as saying in the Sunday Times today.

The sense that is conveyed is twofold. Firstly, that  there is a risk that ‘tapering’ could be as bad in 2013 or 2014, as raising rates from 3% to 6% was in 1994. And secondly, that the crash was so disastrous everything that can possible be done to avoid a repeat, should be – despite what we have learnt since.

Here is GDP and employment (and Fed Funds) in the period of the last policy tightening that started in mid-2004. This time, rates increased from 1% to 5.25% in 2 years. The start of the process still saw employment growth slow to 100k/m, but GDP growth held up much better  – until the end of the move. Then, of course, after the Fed had finished raising rates, everything went very, very badly wrong.

So I will concede that 1994 could have gone better. In particular, If the Fed had worked harder on communication, the markets would have been less surprised when the first rate hike was announced. But, the economy didn’t slide back into recession and 1995 to 1999 was simply a very good period for the US economy. This, overall, was no disaster.

The 2004-2006 rate hike cycle by contrast, allowed asset prices to go on rising far too fast, for far too long. Allowed leverage to increase throughout the US and global economies. Again, this is not the place to argue against the general view that the great Crash was mostly caused by greed, and poor regulation. But just as Fed policy caused a slowdown in 1995, Fed policy helped cause a massive recession. So the exit from the last two significant periods of very easy monetary policy both have faults – but are we really supposed to err on the side of a 2004-2006 outcome because we must, at all costs, avoid a repeat of 1994-1995? . But are we that stupid? Employment growth running at 170k/m, and GDP at 2% justify accommodative policy, but not zero rates and massive bond purchases for ever.

Sell sterling after horrid trade figures

The UK saw a fair amount of data today, starting on a positive note with the BRC sales figures (bouncing back in September). That was tempered by a gloomy assessment of the economic risks from the IMF. Weak manufacturing output data aren’t friendly either, but the really worrying figures were from the trade data. The NOS advises us to look away from the noise of the monthly series but on a 12-month sum, the deficit is now a GBP 33.3bn (see chart in daily attached). That the deficit should be widening so sharply when the economy (and hence demand) is growing so slowly, is not good news. There’s a loose but logical correlation between recession and better trade data and when you go the other way it’s alarming.                                                                                                    On the month, exports fell to two of the three biggest markets (Germany and the Netherlands), and to China, Spain and Italy. Over the last three months, there has been a deterioration of GBP 1.4bn in combined balance with Germany and China, which has reached GBP 11.6bn. With this kind of data as a backdrop and a worry, GBP/USD remains an attractive short. This is a country trying to finace a gargantuan curent account deficit with massiovely negative real rates and Prime Minister who doesn’t have ‘Plan B’ just a ‘Plan A-plus’. 

The overnight session saw a slightly more upbeat mood in markets, despite IMF gloom, a further fall in Japan’s Eco-watchers’ survey, soft Australian business conditions and a very sharp fall in reported car sales to China by Toyota. Risk aversion rather took hold on renewed European flows, attributed to confusion about what is the current benchmark 10-year Spanish government bond and therefore how much 10year Spanish debt yields (answer, 5.75%, slightly more than yesterday). This reflects a build-up of bullish risk positions in recent days as QE-liquidity has swamped any negative sentiment. 

With only US small business confidence due this afternoon ahead of the start of the Q3 earnings season significant follow-through to bearish sentiment may be hard to muster. EUR/USD and USD/JPY remain in ranges. We will stick with EUR/USD shorts and USD/JPY longs but patience will be required. We like long NOK/SEK too. Yield hunters are more likely to look further afield at more exotic markets (the very nimble are nibbling USD/ZAR after its sell-off and otehrs are buying BRL as three months of stability make the yield pick-up look more attractive). Good luck.  

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