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Michael Baxter

Bull and bear: UK defies optimists

Written by: Michael Baxter on January 28th 2013

Category: Bull & Bear

Bull and Bear – an optimistic and pessimistic view of investment news. Today’s stories: Animal spirits return, Flight from safety, Cheery Davos, UK defies optimists, Japan sees more deflation, What to do about central bank losses

Animal spirits return

So far this year all has happened as it is supposed to. Well, all if you ignore some inconvenient economic stats, that is. There was no one trigger.

In Europe, the optimism partly related to hints, rather than real solid reasons lurking in the latest Purchasing Managers’ surveys. The latest flash PMIs were out at the end of last week, and the flash manufacturing PMI for the euro area rose from 46.1 to 47.5; the services PMI rose from 47.8 to 48.3. It was good to see the indices improve, but they are still below 50. Usually, readings like that are considered to be awful. Even so, Markit, which produces the PMIs, predicted that the Eurozone recession will end later in the year, so that left the markets feeling pretty chuffed.

Perhaps a bigger source of optimism was the way in which yields on bonds drawn on the euro area have fallen this year. Evidence suggests Eurozone banks are finally repaying some of the money provided by governments to bail them out.

The best piece of news to come out of Euroland relates to Germany. Last week it was told here how the latest ZEW index – which measures investor sentiments relating to Germany – had risen to a two and half year high. Then on Friday we saw the IFO business survey. January’s index rose – it was the third successive monthly rise. The business expectations indices now stand at their highest level since May last year.

The surveys suggest that Q4’s pretty awful data on German GDP probably won’t be repeated in Q1, and Europe’s largest economy will probably avoid falling into recession.

There is a but. Germany’s recovery does seem largely export based. If the UK suddenly started exporting a lot more, or indeed Spain and Greece did, then we might point to evidence that the Europe was re-balancing, but when export growth is applied to Germany it feels much like the same old imbalances.

Flight from safety

Whatever the latest data says the markets seem to think they have spotted something. It is tempting to say we have seen the return to risk, although there is another explanation.

The FTSE 100 has enjoyed its best January in 13 years, the S&P 500 rose above 1500 for the first time in five years, and it is now just 4.5 per cent short of an all-time high (global stock prices are 19 per cent off peak). Meanwhile, yields on UK and US government bonds rose. Is this the long awaited return to the old status quo – you know, a return to the days when bonds paid out higher yields than equities. Some think this is precisely what is going on.

So are we witnessing a flight to risk.

January has also seen the euro rise, and the dollar, yen, pound, and even the Swiss franc fall. Gold has pretty much been flat. But does this really suggest markets have embraced risk? Maybe they have redefined risk. Certainly it is hard to see how the UK, or indeed Japan, can continue to justify their safe haven status.

Cheery Davos

What is clear, however, is that last week’s Davos saw an air of optimism. Maybe it was the recent spate of encouraging news out of China, where the economy does clearly seem to be in recovery mode. Maybe it was all that talk about shale gas, and how the US is close to energy self-sufficiency again. Maybe it was all that doveishness coming out of Japan, with Prime Minister Abe pretty much forcing Japan’s central bank to independently decide to boost the economy. Maybe it is that China and Japan have started having high level meetings over the future of those little rocks that have been threatening to bring the two countries to war.

Or maybe delegates at Davos hit upon some tacit consent that it has now fallen to them to talk up the economy; that they need to create confident, just by appearing confident.

Whatever the reason, right now there is a moody of optimism that we have not witnessed probably since before Lehman Brothers went down.

UK defies optimists

And yet the UK went against the grain. Official data out on Friday had the UK economy contracting by 0.3 per cent in Q4. Following fairly dismal figures on public finances earlier last week, it made a pretty bad week for UK plc – except of course for another set of positive, albeit confusingly, job data.

The GDP does not mean the UK is heading back for recession, however. For one thing, it may get subsequently revised. For another thing, there was an unwinding effect from the Olympics. Capital Economics reckons this knocked between 0.3 and 0.4 percentage points off GDP. So once we have taken into account this one-off, the UK was probably flat in the quarter. That is not good, of course, but at least it suggests there is a good chance that the UK will avoid a triple dip, if indeed revisions of past data don’t eventually say that the UK never actually had a double dip.

Don’t read into this that the UK is fine, far from it; it is just that there is a good chance it is not technically in the midst of a recession.

Japan sees more deflation

Meanwhile, in Japan, the task confronting Shinzo Abe was given some perspective with the news that Japan’s consumer price index fell 0.2 per cent in December, over the year. The index has been negative for six out seven of the last months.

Mr Abe has vowed to end deflation, and – more to the point – end falling wages.

Well, he may be successful but alas he may only be half successful.

Japan’s savings ratio has fallen sharply over the last year or so. Under different circumstances this may have been said to be a good thing, but there is this sneaky suspicion that the Japanese are saving less, because a high proportion of the populace are now retired and have no choice but to draw down savings.

The fear is that as savings rates fall, Japan’s government will no longer be able to fund debt internally.

The hope is that as Japan’s saving falls, demand will rise, and with that deflation.

The fear is that as Japan borrows from abroad, interest rates will rise, inflation will occur, but wages will continue to decline.

And by the way, the Bank of Japan did reveal plans to buy more bonds last week. But the critics lined up. It is only going to buy short-term bonds, which will mature soon, meaning that the bank’s efforts won’t do much. Oh dear, we may have to wait until the current boss at the bank steps down, and is replaced by another independently minded soul, who just happens to agree with Mr Abe. We won’t have to wait long because the change-over at the bank is due in a few months.

What to do about central bank losses

When George Osborne revealed plans to use profits made by the Bank of England from QE to pay down debt, some cried foul.

The bank had previously said it needed these profits to cover future losses that may occur if QE was reversed.

According to an analysis by Merrill Lynch, the value of the Bank of England’s holdings fell by 3 billion in the first 10 days of this year, as bonds held by the bank rose in value.

If we are indeed seeing a return to risk, and the relationship between bonds and equities flips, just like the Bank of England wants, then it will make heavy losses. The Chancellor will have to repay the money. When that happens the headline writers will have a field day.


These views and comments are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Tags: Central bank losses, cheery davos, Japan deflation, UK defies optimists

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