Waiting for Godot

15 mins. to read
Waiting for Godot

As featured in this month’s Master Investor Magazine.

In the dark days of the 1930s Depression, policy-makers were divided into those who believed that the best response to the crisis was to stimulate demand and those who believed (for good classical economic reasons) that demand should be choked.

In the current policy crisis – for that is what it is – the only real intellectual controversy is between those who believe that inflation is the peerless enemy, and those who believe that deflation is the real ogre.

If you don’t happen to have much of a leaning either way, you are not alone. The debate is currently being argued out, far from democratic intervention, within an elite patriarchy (and matriarchy) of elders. They are called Central Bankers. And your view does not count; because in Post-Crash Capitalism, they are the people who get to decide what happens, not people like you or me.

Economic priorities change with economic conditions. Demand management, to obtain full employment was the universal economic mantra from the 1940s to the late 1970s. This gave way to the fight against inflation in the 1980s; and then to sustainable non-inflationary economic growth from the 1990s to the late noughties of the new century. In the weird world that emerged after the dust clouds of the Credit Crunch dispersed, monetary policy, previously the domain of academic economists, took centre stage.

I could not have imagined ten or more years ago that, by the 20-teens, monetary policy would have become sexier than fiscal policy. Central bank chiefs, these days, are more prominent and more influential than finance ministers. Globally, everybody who follows the markets knows that Janet Yellen is the Chairman of the Federal Reserve (the central bank of the USA) because the markets hang on her every word. But who is Barack Obama’s finance minister?

(Well done, if you know it is Treasury Secretary Jacob “Jack” Lew! But you get my point).

The world is now run by this priesthood of unelected sages whose awesome responsibility it is to do three things, exercised away from the prying eyes of elected legislatures.

First they set interest rates (the price of money); secondly, they regulate the banking system; and thirdly (and most obscurely) they maintain price stability. But in practice, these three things are all one and the same.

And that thing is: managing the money supply. Crudely, too much money in the system (and most money is in the form of credit) and prices go up (inflation). Too little money in the system and prices go down (deflation).

The first function – setting interest rates – is easy to understand. This has been undertaken in the UK since 1997 by the nine-member Monetary Policy Committee of the Bank of England. What is harder to understand is why interest rates in the USA have been held at near zero since December 2008 and the Bank of England’s base rate has been held at just 0.5% since March 2009.

If you look at the graphic of the Bank of England’s key lending rate over the last 321 years you will see that such a low rate is historically unprecedented. Back in 1694 when the Bank of England was established, the rate was set at 6%. And for long stretches of the 18th and 19th centuries the rate fluctuated languorously between 3% and 6%. In the 20th century, rates were more volatile, peaking at a record 17% in November 1979. But before 2008, the Bank of England base rate had never been below 2% in over three centuries[i].

So why have rates been so low for so long?

When Gordon Brown handed over control of interest rates to the Bank of England in 1997 – following the trend of other major economies – we thought that the Old Lady of Threadneedle Street, liberated from political chicanery, would be compelled to set a natural rate of interest. That is, in Keynesian terms, one which keeps savings and investments in equilibrium. That is not how things have turned out.

Instead, the Old Lady, just like the Bank of Japan, the Fed and most recently the European Central Bank (ECB) has set a rate which she believes will maintain liquidity in the banking system. In decades to come, this could be seen as a huge gamble. And the politicians will be able to turn around and say: It was nothing to do with us, Gov., it was all them Central Bankers what done it.

Why are artificially low interest rates bad? Because they dis-incentivise savings (and therefore investment); they distort investment decisions; they encourage excessive borrowing and sustain zombie companies which, in an ordinary world, would go to the wall. In normal times the zombies’ assets would be re-allocated to more productive activities in the glorious process of creative destruction that is capitalism.

Ultimately, I believe that zero interest rates imply zero growth. Stagnation: that is where the world is headed, in my view.

And yet, you say, here in the UK we finally recovered from the 2008-12 recession and we are now growing in the UK at a clip of 3% – well above our long-term trend growth rate. Wages are finally picking up after flat-lining for years. Household debt is on the rise. The banks have raised their capital cushions. Surely, rates should now be back at normal levels of 3-6%?

The reason that rates are still on the floor is that our central bankers are haunted by the spectre of deflation. Just consider how, as well as holding rates at rock bottom, they have printed money like crazy through Quantitative Easing (QE) in a desperate attempt to slay this ghost. In fact, without QE, deflation would already be endemic.

QE is accomplished by arcane means; but the basics are not rocket science. Central banks can lend money to banks (inject liquidity); they can buy banks’ bonds; or they can tell their counterparts in the Treasury to issue bonds, which they then buy with freshly minted electronic money.

Central banks make the illusionist David Blaine look like an amateur: they can conjure cash out of thin air. And they have been doing so, on a historically unprecedented scale, from 2008 until today, pushing asset prices (including stocks) to now unsustainable levels.

If the spineless politicians have outsourced to their central banks the task of fighting deflation, it is because the central bankers know from history how deflation can erupt.

Firstly, deflation often follows financial crises. This is because, after severe banking crises (and the 2008 Credit Crunch was in historical terms gigantic) banks de-leverage. That is, they contract their balance sheets by calling in uncommitted lines and withdrawing deposits made with other banks. As committed loans mature, they refuse to renew them, except to borrowers of the highest credit quality.

Moreover, as now, there are always calls after bank failures for bank capital adequacy requirements to be tightened. You may very well think that is sensible – HBOS and others were woefully under-capitalised before the Crunch. Hence Basel III and all that jazz. But the point is that this accelerates bank de-leveraging.

By way of illustration, consider that much loved financial institution, Royal Bank of Scotland (RBS).

In 2008, RBS was sitting on total assets of £2.2 trillion. By the end of 2013 they had total assets of just over £1 trillion. So the balance sheet more than halved. The reduction in RBS’s assets should be multiplied by roughly 10 to determine the amount of cash that has been sucked out of the economy because of the multiplier effect. That’s because when you spend £1, that coin is then used by someone else to buy something. And so on, ad infinitum. In fact, the multiplier effect would be infinite if banks did not have to hold reserves.

Now UK GDP last year was about £1.75 trillion. So the contraction of RBS’s balance sheet alone has reduced the money supply in the UK by an amount equal to – get this – seven-and-a-half times our total national output. Now add the balance sheet contraction of all the other banks, and you begin to see that the deflationary impact of bank de-leveraging is dramatic.

Secondly, deflation can occur, as in the USA in the 1870s, in times of rapid mechanisation, when relative labour costs are falling as a result of technological innovation. The 19th century American experience was related to the opening up of the grain belts of the mid-West by the railroad. Our experience is one of robots taking over production lines. It’s not yet consensus thinking, but it soon will be: Google is deflationary.

Thirdly, there has been deflation in a swathe of consumer products in the first years of this century as a result of cheap imported goods from China, India, Vietnam and the rest. Go to Primark, about which I posted recently on the MI website.

Fourthly, commodity price falls can trigger deflation. The oil price collapse, which in the last month seems to have accelerated, is certainly deflationary. On 21st August oil fell below US$40 for the first time in the current slump. Commodities generally are in free-fall. Quite why this is happening is a complex inter-play of technology and geopolitics which I would like to discuss in detail soon.

Fifthly, demographics. The retirement of the post-WWII baby-boomers is conducive to deflation. The world’s population is still getting bigger, but the rate of growth is slowing. That means the human race is getting older – fast[ii]. People about to retire tend to stash cash and, once in retirement, they curtail consumption. An ageing global population is deflationary.

Policy makers fear deflation even more than inflation because they know that it would render the management of government finances a nightmare.

JM Keynes, in the General Theory of 1936, points out that there is an asymmetry between inflation and deflation. Inflation just affects prices. But deflation diminishes both prices and employment[iii]. This is because, in the Keynesian model, deflation stifles investment and therefore reduces demand.

In a deflationary world, output contracts in both nominal and real terms, but debtors still have to repay debts that were taken out when price levels were higher. For a person or company with no debt, net-net, life continues as before. But for companies that have financed investment by debt, their capacity to repay that debt is enfeebled.

This is especially problematic for debt-laden governments, which would struggle to service their debt repayments as the economy contracts and tax revenues dwindle.

Both inflation and deflation have been regarded by policy makers as negative, yet perfect price stability is historically exceptional. Overall, our rulers have opted for modest inflation – the current official target in the UK is still 2%. This is at a level that most people will hardly notice if wages are rising modestly. And it also acts as a surreptitious wealth tax on the cash-rich.

In the USA, over the 214 years between 1800 and 2014 for which we have data, in no fewer than 54 of those years the price level fell[iv]. Though, for people like me who gained economic consciousness in the late 1970s, it will always seem that inflation is the real ogre.

QE may now be officially over in America and in the UK but in Japan and Europe the money presses are working round the clock. Last January, ECB Chief Mario Draghi inaugurated a massive 20-month programme of QE in the Eurozone. Since then the ECB has been hoovering up Eurozone government bonds like crazy – much against the Germans’ better instincts.

Here in the UK, Bank of England Governor Mark Carney is now agnostic on QE and has blown hot and cold on the prospect from rate rises since his appointment in July 2013. Most recently, on 16th July he expressed the rather vague view that interest rates could start to rise by the end of this year. This of course was seized on by commentators as the strongest signal yet that policymakers are preparing to act[v].

There is only one model of an economy that has been sustained on QE and zero interest rates for a protracted period, and that is Japan over the last 25 years. And yet Japan’s growth problem has not been solved. Japanese productivity is exemplary, but their demographics are against them. If QE were a long-term wonder-cure, you would expect Japan (ferociously conscientious workforce, state-of-the-art technology) to be doing better.

On 18th August, the Bank of England announced that Consumer Price Inflation (CPI) rose to 0.1% in July on a year-on-year basis. BBC hacks broadcast that inflation was on the rise. Yet this titbit, even one so long awaited and chewed over by the journalistic pack, is anodyne.

It would not be quite correct to say that it is within the margin of error. It’s just totally, statistically speaking, insignificant.

But OK, if it does happen, who would be the winners from rising interest rates?

First of all, insurers. Their pension liabilities (such as the value in today’s money of all future pay-outs on annuities) are calculated using discount rates that are derived from gilt market yields. That means that, if UK gilt yields were to rise, the value of the insurers’ pension liabilities would fall. Thus, their balance sheets would strengthen.

I talked about Aviva PLC (LON:AV) on the MI website a little while ago, and I am still medium-term bullish on this stock, although the share price has been skiing a little hors-piste of late.

Secondly, banks. Of course, if all of a bank’s loan assets were extended on a floating rate basis then, margin-wise, changes in interest rates should be revenue-neutral. But, of course, it doesn’t necessarily work like that. Banks fund their loan books from a number of different sources –customer deposits, inter-bank deposits, discount papers, the bond markets, and so on. So they are really focussed on the composite cost of funds or, if you prefer, the weighted average cost of funds.

When interest rates rise, it doesn’t necessarily follow that banks’ cost of funds will rise. For a start, they will probably not pass on the full rate rises to savers (depositors). And they will doubtless find ways to raise their lending rates more than the increase in the base rate. Thus lending margins, overall, are likely to increase – a trend already in play – and, all things being equal, so will their return on equity.

I am still negative about the two banks bailed out in 2008 (Lloyds and RBS) because, as already mentioned, they have restored their solvency by massively shrinking their balance sheets. Barclays looks accident prone. HSBC (LON:HSBA) has taken risks by leaving the question of its eventual domicile unanswered and conducting a savage down-sizing at the same time. (County towns of England now have boarded-up HSBC branches alongside boarded-up fishmongers, butchers and bakers. It’s not pretty).

If I were to hold one bank stock right now I would go for a slim, well managed niche player with an excellent business model like Close Brothers PLC (LON:CBG). (By the way, it is a bank even though it is sometimes described as a finance company). When analysing bank stocks, forget about the Operating Costs Ratio and all that brokers’ nonsense and just focus on trends in ROE (adjusted for regulatory and reputational risk). It’s that simple.

Thirdly, real estate investment trusts (REITs) in North America. As an asset class, they have taken a battering this year. Essentially, the markets have taken the view that with bond yields rising, shares in REITs looked less favourable. (In technical terms the present value of their future cash flows has been computed using a higher discount rate). This has been massively overdone.

North American REIT’s are weathering the storm. Citigroup’s Michael Bilerman believes the worst is over and is optimistic. He expects that REITs can deliver attractive returns in the next year and has lifted his 12-month return forecast to plus 10-15%, with some stocks capable of 20%.

Always favour high quality, diversified real estate portfolios – diversified geographically and by property segment. Check out Artis Real Estate Investment Trust, the units of which trade on the Toronto Stock Exchange (TSE:AX.UN). This is a classy Canadian real estate outfit with about 25% of its assets in the USA.

Fourthly, companies financed by equity with little or no debt. This means that mature, cash flow-stable companies, which tend to have high debt burdens will be disfavoured, while young growth companies, which are overwhelmingly financed by equity, will get a boost.

Look out for opportunities on the AIM – but tread carefully, as there is more chaff than wheat in this barn. If you can get your head around specialty chemicals and materials, take a look at Alent PLC (LON:ALNT), which has been going places of late.

And the losers? There are zombie companies out there which have been sustained on life support since the crash by artificially low rates. It would be unkind to mention names, but beware the debt-financed pub sector on the London market.

Last year I doubled my money on Spirit Pub Co. between May and November when they were taken over by Greene King (LON:GNK). But since then, the sector’s debt-financed, fixed asset-heavy, low margin business model has given me pause.

You will have gathered that I am not at all convinced that interest rates will rise this year, next year, or even beyond. The model has changed. Yet central bankers have to intimate that there will be some kind of return to normality in order to legitimise their new-found priestly status.

When Janet Yellen and Mark Carney tell us that we should prepare ourselves for rate rises, they are doing what good vicars do. They are telling us to prepare for the hereafter, while they are really focussing on the success of the upcoming church tombola.

Of course I may be wrong and it’s important to have an insurance policy, dear reader – even if, at the end of the play, we shall both feel like those two hapless tramps in Samuel Becket’s Waiting for Godot. Still waiting.


[i] A spreadsheet is available from the Bank of England at: https://docs.google.com/spreadsheets/d/1OKo38R1blO71SGNIVuhaRZ4P2GYPpJQklmOymQiXixQ/edit?hl=en&pli=1

[ii] Falling populations in richer countries fuel fears for future, Leo Lewis, The Times, Saturday, 22/11/2014.

[iii] The General Theory of Employment, Interest and Money. JM Keynes, Macmillan, 1936. See the final paragraph of Chapter 20, The Employment Function (on page 291 of the 170 Macmillan edition).

[iv] My calculation sheet is available. The price level data comes from the Federal Reserve Bank of Minneapolis website at: https://www.minneapolisfed.org/community_education/teacher/calc/hist1800.cfm

[v] Szu Ping Chan, Daily Telegraph, 16 July 2015.

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