The spectacle of the Olympics will be upon us shortly. And quite frankly from a sporting perspective I personally can’t wait. I gave up my Olympic hockey ambitions to pursue the competitive battleground of the financial markets some twenty years ago. The right decision then and now. Great Britain needed talent not sweat and aspirations. For those who love competitive sport and athleticism it will be a much needed distraction from the ‘Greek tragedy’ that still haunts us.
I can’t help but feel that the handing over of the Olympic torch in Greece to Britain recently by eleven Vestal Virgins was more symbolic of the passing over of burning economic woes from one ruined nation to another, than the commemoration of the theft of the continuous Olympic flame from the Greek god Zeus by Prometheus. I wish it were otherwise, but we cannot stand by and walk with our Eyes Wide Shut, as many citizens, perhaps, understandably do today.
At Hinde Capital it is our fiduciary responsibility as an investment management firm to protect our client’s wealth, whilst it is our right as free citizens to create a discourse on how we maintain a free economy and society. So we wanted to outline the gravity of the situation the UK finds itself.
In the first of a two part series on the state of the UK, Eyes Wide Shut, part I – the UK Hitting the Wall, we discuss how the UK is not capable of achieving any sustainable growth, due to an over-reliance on credit-based sectors, namely the F.I.R.E. (Finance, Insurance, and Real Estate) sectors.
The ‘naughties’ was a decade of growth, but this growth was not real. It was not a growth borne out of production from savings, but it was a false growth borne out of rising debt levels. The UK’s seeming prosperity was, and still is, an illusion.
The UK experienced a credit-fuelled boom predicated on escalating private sector borrowing drawn primarily out of the equity of rising house prices. The tax revenues this spawned allowed the Labour government to grow the hand of the State, leading to an unsustainable growth in public sector debt.
Money was not earned, it was borrowed and spent on fancy clothes, smart cars and endless electronic devices whose fads changed by the hour. The rise in public sector employment as a share of the UK economy not only helped reinforce this debt binge, as the new gainfully employed enjoyed the fruits of their labour, but it no doubt did not harm New Labour’s re-election potential. A prosperous electorate, after all, is a happy electorate.
As dreary as it is to rehash the point that we have too much debt, (I hear you yawning), it does not negate the reality that the UK has not managed to deleverage its burdens some 4 years since the ‘Great Financial Crisis’ began. This reality has very grave implications for the UK economy and its people.
If growth will continue to be worryingly absent then so the UK will have structural tax problems. As each year passes, not only does the cyclical fiscal deficit grow worse but the structural primary deficit threatens to rise exponentially. Public sector finances are not rebalancing. In fact, as we will show the public sector net borrowing requirement (PSNBR) is continuing to grow despite the Coalition government’s promises of austerity.
Historically, countries with such high indebtedness as the UK have been associated with a rising incidence of default, or even restructuring, of debt. However, a more subtle means of maintaining the ‘debt affordability’ is through a form of debt restructuring called financial repression whereby a central bank maintains rates below the natural market rate and performs purchases of government debt – quantitative easing (QE).
Recent BoE bond purchases serve two purposes. First, they enable the fiscal gap to be plugged and, second, because the purchases prevent bond yields rising, they enable the UK government to service its growing debt at lower rates, whilst the incidence of negative real rates erodes the real value of government debt.
The state has in effect chosen to fight the collapse of credit by underwriting private balance sheets, namely the banks, pension and insurance companies by issuing more debt, injecting money and making purchases of both private and public debt to keep yields low.
This has prevented assets clearing to their ‘true’ market value. The base money increase prevents banks’ troubled asset prices from adjusting to lower levels. For example, mortgage-backed securities worth billions have still not been placed at market-clearing levels with private investors, instead remaining artificially supported either directly by central banks or indirectly by the financial sector.
Easier credit availability sourced by new sources of collateral (think ‘securitisation proliferation’) and lengthened repayment schedules have led to the production of goods underpinned by effectively less cash, and higher debt backed by spurious collateral.
This is also a problem because the collateral that underpins these loans is not valued in line with the real market, but is held at opaquely valued prices on balance sheets. The asset write downs are not being taken, as clearly evidenced when we examine how the Spanish financial sector values property. Value is overstated.
The impact of lower rates from QE creates many distortions in the economic and financial structure. Company pension funds must discount future liabilities at a lower rate, driving asset/liability mismatches higher. Company actuaries demand more bonds (assets) to cover the higher liabilities.
These low rates have also masked the extent of UK problems as they have forestalled consumer deleveraging which is essential if the economy is ever to grow productively absent of debt burdens.
Higher mortgage rates are squeezing low disposable incomes still further, which will significantly impact consumer growth in the UK economy. Aggregate demand will fall as a consequence and with it government (tax) revenues will also fall, hampering the government’s attempt to reduce the fiscal deficit.
The commensurate rise in sovereign debt levels will see the UK witness the continued presence of the BoE in the gilt market but this does have important psychological limitations. Investors will become increasingly perturbed at the use of printed funds to service the UK debt situation and will want compensation in the form of higher returns to cover potential inflationary implications.
In a world of turbulence the UK currency and its bonds have benefited from the best of a bad bunch approach, and in a financial system so heavily financed by the bank and pension industry, such entities have little alternatives, or often choice, but to maintain bond holdings of nations. Given the choice of Greek government debt or gilts the immediate choice is easy. But the domino effect of collapsing fiscal balances will leave fewer and fewer so called safe-havens.
There is an ever present and real danger that the debts of the UK will not be tolerated by financial participants. The UK faces a very significant debt issue which threatens to become a full blown sterling crisis. This is clearly not an eventuality that markets are currently assigning any probability.
In the second part of this series Eyes Wide Shut – Economic Repression and End Solution, which will be released tomorrow, we have examined how the UK is choosing to deal with its debt profile, the implications for the UK property market, (please see our colleagues teaser blog – UK Mortgage Rates: The Slow Drift Higher and the Impending Danger for UK House Prices), and finally we offer some potential solutions. Although these are by no means comprehensive or detailed, they are written to hopefully engage a positive dialogue for an ‘end solution’.
Let’s walk with our ‘Eyes Wide Open’.