How QE plays out – and other guesses

15 Sep 2016

This is a follow up to my last post about how QE is a wrecking ball that distorts financial markets and economic decision making. I have no opinion – despite a sceptical mindset – about whether QE is being applied correctly or about whether it will work. I doubt if even hindsight will allow people to agree about whether it succeeded.

As an investor I need to weigh the probable outcomes of the distortion itself. Even this is not the same as making a definitive call on what will happen. That is gambling. As always, investing is about probability.

THE WEALTH GAP – ONLY SHARES ARE CHEAP

As long as QE carries on and the pool of safe assets shrinks further, savers in search of yield will keep chasing other assets. The stock market has been climbing the wall of fear this year. Before the referendum vote, George Soros and others forecast a decline of up to 20% in UK shares. Chancellor Osborne did not rule out suspending stock exchange trading in the face of the expected panic.

With the atmosphere so full of “markets hate uncertainty”, that notorious cliché so readily embraced by third rate market commentators, many people will have assumed that the stock market would have performed its patriotic duty and dived after Brexit.

But shares are cheap and quick to buy and sell, five days a week. I have just been offered a two year fixed rate bond by a building society that yields 0.95%. That’s a decision that ties up my money for two years. Were I to choose to buy Marks & Spencer shares instead I could get a dividend yield of more than 5% – and if I change my mind and decide that M&S is too racy, I can sell it in two minutes.

Back in verdant Blackheath and vibrant Lewisham near to my house, yields on buy-to-let properties are between 3.6% and 4.5% (source portico.com). That seems like a lot of cost, time and risk compared to being a passive and better-rewarded owner of M&S.

There is no hint that QE will be curtailed or reversed. On the contrary, the central banks of the UK and Europe are running out of assets to buy according to their original “safe” criteria and are being encouraged (invariably by smart people who own assets) to broaden the scope of their purchases.

It frightens me to write this but as long as equities are cheap relative to other assets, stock markets will continue to rise. The hunt for yield satisfies most of the conditions for a bubble and bubbles burst in the end. But to paraphrase the young hotelier in The Best Exotic Marigold Hotel, it will burst in the end but if it hasn’t burst it’s not the end.

This is obviously very dangerous. It seems probable to me that when any asset bubble bursts they all will, quite rapidly. But I don’t see why equities should crack first.

It is worth remembering that stupid valuations generally outlive the people who denounce them as stupid. Bill Gross, who was probably the world’s best known bond investor, said in January 2010 said that gilts were resting ‘on a bed of nitroglycerine.’ That was when 10 year gilts were yielding 4.0% compared to 0.9% today. Maybe that’s part of the reason why Mr Gross had to get a new job.

Stupid is a persevering fellow who is generally in for the long haul. He is hard to shake off and usually relents only when sceptics have begun to wonder if maybe he isn’t so dumb after all.

So I believe that the right strategy is to stay in the stock market and to watch out with great care for signs that more expensive asset prices are cracking. Some people say, with probable good reason, that the biggest red flag is the sight of all assets falling at the same time. This looks like a truism (How can you tell if everything is screwed? If everything is screwed) but it is a valuable observation because it tells you that assets are not acting as rival investments and that consequently the normal rule of relative value has been suspended. A simple rule of thumb is that when bonds go up (i.e. yields fall) equities go down and vice versa. If they both perform well for a period of time investors are generally bullish (and markets are possibly overheating with some indiscriminate buying). If they both perform badly investors are generally bearish (and possibly about to tip over into indiscriminate asset dumping).

The wealth gap will probably get worse. There may be strange political developments – Brexit, Trump, Le Pen, Wilders, Corbyn (!) – as a result. People will complain about large businesses legitimately avoiding tax and some will demand a wealth tax.

I doubt if there will be a wealth tax because the UK is so far away from that politically. As so many beneficiaries of QE-induced wealth are older people who frequently have low incomes it would create vast amounts of negative publicity. A notorious example was in France where the Ile de Ré, once an isolated island off the Atlantic coast occupied by soil-tilling peasants and local fishermen, was turned into a fashionable holiday resort after a bridge to the mainland opened in 1988. Property values rocketed and smallholders found themselves classified as rich enough to pay the annual wealth tax on a scale that dwarfed their annual income.  Even the French seem to think that a basic rate of tax above 100% is excessive.

(Before I continue, is everyone quite clear about the difference between gross assets, net assets and income? If you ever find yourself using the word “rich” without being clear about which of these three you are referring to, can I respectfully ask you to shut up?).

PENSIONS – PREPARE TO EAT YOUR HOUSE

The newly old and (net) asset rich continue to get lower returns on their savings and more pitiful offers of annuity rates. Next time that grandma invites you for lunch in her panelled dining room you can expect soup, bread and cheese along with her old silver cutlery.

It seems inevitable (or rather highly probable) that old people will have to start eating their houses by downsizing and releasing capital. Many British people cling to the pernicious and frankly selfish view that houses belong to families and should be bequeathed to future generations. I strongly suspect that old people are lobbied by their own children not to monetise their property. There are not many Victorian values left in 2016 but the idea that one family generation has a moral duty to enrich the next is one that lingers.

The outlook for future pensioners is poor. The view that my house is my pension is widely held among the baby boomer generation (and Andy Haldane). We have been warned. Critical to their financial planning is that someone buys their house from them. Then they can take their capital and buy a retirement home.

If there will be any retirement homes. Consider this amazing statement contained in a profit warning from the biggest retirement home builder McCarthy & Stone.

“The market for retirement housing remains highly attractive. 3.5 million people in the UK over the age of 60 have expressed particular interest in buying a retirement property and yet only c.141,000 specialist retirement properties for owner occupation have ever been built.”

So there you have it. There are 3.5 million downsizers already out there. Due to the QE-induced wealth gap, they are rich (net assets), on paper. The problem is that the generation of new buyers needs to commensurately rich (income) to pay the prices that will be expected.  Everything is going to be in favour of the youngsters if they hold their nerve. The sellers will be more numerous and more desperate.

So here is a warning. If your house is your pension you might consider downsizing while the going is good.

THE NATIONAL DEBT – THERESA MAY AND PHILIP MUST

It is not surprising that there are plenty of people calling for the UK government to spend directly on projects that might stimulate the economy. Even the most one-eyed monetarist must be uncomfortable with the insipid growth following seven years of QE. The new Chancellor Philip Hammond has said that he will look at infrastructure projects that will yield relatively quick results.

Hammond’s predecessor, George Osborne, preached austerity and asked to be judged on his moving target to eliminate the annual budget deficit. In one sense he got his wish when the new PM Theresa May fired him. The UK has not come close to eliminating the deficit – that is the amount by which government debt rises each year.  

Total declared government debt is now around £1600 billion or 83% of GDP. Due to unprecedented low borrowing costs (thanks, QE!) the annual cost of servicing the debt is a mere 3% of GDP. (In the 1930s it was 9%: in the 1980s it was c.4%).

On this basis there is no immediate cash flow problem. The UK government is like any other free-spending debt junkie that relies on helpful creditors who know that their best chance of getting their money back is not to bring things to a head by sending round the boys with baseball bats.

But there are a couple of uncomfortable lurking problems. For one thing, as I pointed out in the last post and before, the Bank of England is merely the Treasury’s broker. The losses it is incurring are the Treasury’s losses. Effectively, the UK government is lowering its own current borrowing costs by loading up its own long term liabilities.  

Anyone who cares to look can also see that the off-balance sheet items like public sector pension liabilities would increase the debts hugely if we could calculate them.

But we must be consistent. These are gross debts which must be set against the country’s assets. Some of the country’s assets are physical and can be (and are) flogged off for cash or into PFI schemes.

But by far and away the UK government’s greatest financial asset is its ability to generate tax revenues. HMRC collected £533 billion last year. This means that the official national debt of £1600 billion is around 3x the nation’s annual tax income. The interest payments are covered approximately 12 times.

That doesn’t sound too bad does it? As long as we ignore the fact that the UK government is not a responsible borrower but a compulsive spender continuously in thrall to a professionally lobbied electorate with infinite demands. So thoroughly has the population been hypnotised that it actually believes that it has been subjected to years of austerity.

The UK’s credit rating is relatively good. It is mostly AA along with the likes of France, Belgium, New Zealand and South Korea. Not as good as the USA, Switzerland and Germany but better than Spain, Italy, Portugal and Malta. International credit ratings are supposed to offer international lenders a realistic view of the risk that they will not paid back.

You can see from our relatively low bond yields that investors think that the UK government is almost certain to be good for its debts. Though one should add the caution that post-Brexit the perceived currency risk has increased.

Investors in Eurozone government bonds must be more comfortable with the currency and, by implication, with the idea that the ECB will help its favourite member states to make good their debts, despite the glaring evidence to the contrary from Greece. How else to explain that French and Belgian 10 year government bonds both offer a yield of just 0.3%? Even Ireland (no offence intended) pays just 0.5% compared to the UK’s 0.9%.

With an ageing population looking forward to uncertain pensions and students being piled up with debt on penal terms it seems probable that the long term outlook for UK economic growth is not so good (this applies to most “developed” nations). Economic growth is the source of future tax revenues. It is easy to see awkwardness on the far horizon.

On that basis I think two developments are probable. First that Chancellor Hammond will indeed decide that the government will have to be the investor of the last resort and pursue public infrastructure projects, letting deficit reduction go hang. Second that the Treasury will start to go the way of Japan and borrow from its own people.

Japan has the worst debt to GDP ratio of any nation on the planet but its 10 year government bonds yield less than zero (literally). Its international credit rating is mediocre but it appears that this doesn’t matter because foreign investors have long since shunned long term Japanese government paper. They are bought by domestic institutions and by the Bank of Japan (QE again).

Given that private savers in the UK are desperate for yield and that the Treasury is paying somewhere between 2.5% and 3.0% to borrow, why is the government not tapping its own people directly?

The UK Debt Management Office seems to take great pains to prevent ordinary citizens from buying gilt issues directly. No doubt all its investment banking advisors have told it that there is no need.

According to a website that appears to have been last updated in 2004 I can register to be an Approved gilts investor with Computershare by proving that I am probably not a money launderer or a terrorist fundraiser.  Having done this I can fill in a Gilts Stock Dealing Form and post it along with a cheque for the amount that I wish to invest. When my cheque has cleared, my purchase will be effected. Whether the application has to be signed with a quill pen is not made clear.

If gilts are too complicated, the government could easily offer a vast raft of savings bonds. The NS&I already exists as an agent of the government. The first offer on its website is for premium bonds. Its savings products seem priced to avoid competing with other banks and building societies. An investment account that can only be accessed by post (again!) pays a derisory 0.45%. The clear message is that NS&I does not want your money and does not want to help you.  

It is perfectly obvious that most of our banks and building societies also do not want our money. I wrote about this some time ago. I can see no rational objection to the government bidding its citizens 2% for £10 billion of bonds. It’s cheap funding for it and generous saving returns for us at a stroke. The people who would buy such a bond would not otherwise be funding tech start-ups.

Contrary to the belief of many common sense people that the country’s debt is unsustainable it is likely to be growing and lingering for a long time to come. There is more merit to the argument that the debt is immoral due to the ruthless way that its consequences are being dumped on future generations. That is why the government needs to grow a pair (I’m sure that Mrs May can do that) and become a direct investor and borrower.