Friday, 26 March 2010

A Tale Of A Jig-Saw

It sometimes helps to view the future as a very large and very complex jig-saw puzzle where, in the present, we have most of the pieces to the jig-saw. The skill of the futurist is to fit those pieces together in a way that allows us to view the future usefully. This process is often made more difficult by the ambiguities of the final result – a blue jig-saw piece could be part of a sky scape, or it could be part of a sea view, or it could even be part of a more obtuse mountain scene – and the fact that the future will also make up its own pieces as we go along. However, despite these problems, sometimes a group of pieces just fall into place together at more or less the same time to reveal something quite useful about the future. Just such an event has happened recently.

As our readers will be aware, we have been tracking the course of UK unemployment for the past year. About fifteen months ago, many commentators expressed the fear that UK unemployment would rise to 3 million by the end of 2009. In the autumn of 2008, we felt that unemployment would rise to 2.25 million. As the full impact of the recession started to be felt, we revised that forecast up to 2.5 million. The difference in the forecasting can be attributed to different modelling techniques. In the event, unemployment reached 2.46 million in December. We were interested in this because the out-turn of actual unemployment is quite likely to shape the course of the UK economy for the next decade – it is one of those things that may have a small impact in the present, but with large consequences in the future.

Moving the story forward, if unemployment is not as bad as forecast (remember, the forecast error is 100% – a rise of 1 million was forecast whereas unemployment only rose by 0.5 million), then all other subsequent forecasts will be wrong as well. The impact of the automatic stabilisers (welfare benefit payments increasing and tax receipts falling as unemployment rises) will be lessened. It transpired this week that the lesser impact was to reduce PSBR by £11 billion this year, with a consequential impact of £14 billion next year. Of course, this is money that the government doesn’t have, which means that the stock of debt will be smaller by £25 billion over the next two years.

In turn, this makes the UK debt look just a bit more manageable. The half life of the UK stock of debt (the period of time by which 50% of the stock of debt needs to be repaid or recycled) is 14 years with a coupon of just over 4%. This is one of the better profiles in the OECD (by way of comparison, the US stock of debt has a half life of just over 4 years and a coupon of just under 6%, which suggests a very pressing issue for the 2016 US Presidential Election). We have already pointed to the impact of inflation in reducing the real value of the debt. If the Bank of England hits it’s 2% inflation target on average to 2024 (when the half life falls due), then £1 borrowed in 2010 will only take £0.75 to repay in real terms in 2024. Added to that, if we also factor in the possibility of inflationary drift in the taxation system, then the impact of inflation on the debt will be to reduce the debt burden even further. It is no surprise to us that the Chancellor neglected to increase the tax thresholds by the rate of inflation in the recent Budget – it is a sneaky 3.5% tax rise in real terms that took the Opposition days to recognise.

We were also told, for the first time, in the recent Budget that the Government intends to sell it’s bailout holding in the UK banking sector, when conditions allows, to repay some of the UK debt. Ignoring the question of the wisdom of this approach – the Government currently receives interest and fees of about 12% on every £1 used to bail out the banks, which explains why the banks are very keen to repay this money – the issue arises of how much they might receive. Our previous estimate of between £350 billion and £400 billion in a time frame of 2018 still looks good to us. All of this suggests that the plan to pay down the bulk of the stock of debt by the second half of the decade looks to be quite credible if about a third is covered by bailout repayments and about a third by the impact of inflation.

And yet the markets don’t quite believe it. UK sovereign debt currently trades at a premium of 120 basis points (that’s 1.2% in ordinary language), despite the Triple A rating for the UK. This isn’t sustainable. Other Triple A economies (e.g. France and Germany) trade at a premium of 50 to 60 basis points. Looking at it another way, the UK debt is trading at about the same premium as Greece despite the clear differences between the two economies. There is talk about the UK being downgraded from Triple A. If that were to happen, then we would see that as a buying opportunity because the UK would be undervalued at that point. If, as is more likely, that doesn’t happen, then we can expect the premium to fall back to Triple A levels.

In many ways, this suggests that Sterling is undervalued, in a long term sense. It may be quite deliberately kept so because the low value of the Pound against the Euro and US Dollar is quite handy for UK exporters to the Eurozone, the US, and those parts of Asia that peg their currencies to the US Dollar (read: ‘China’ here). The UK is exporting – some might say ‘dumping’ - its excess supply overseas by, as a matter of policy, keeping low the cost of British exports in overseas currency terms. A low currency does contain the danger of inflation, but this is held in check at the moment by the output gap – the difference between actual GDP and potential GDP.

The size of the output gap is difficult to measure because potential GDP is a rather speculative concept and actual GDP in the most recent past is subject to significant revision. However, despite this, we are comfortable with a view that the output gap is between 5% and 10%, which suggests that Sterling could appreciate, over the course of this decade, by a similar amount. And that really brings us back to the starting point. We are of the view that the doom and gloom in the UK is overdone. There are areas and sectors which have been very badly hit by the recession, but there are also sectors and regions that are very much untouched. It is worth remembering that the pain has not been spread evenly. However, the prospects for the next decade look quite good – a decade of slow recovery, but where the UK is more likely to fare better than our comparable partners in Europe.

Of course, there is still scope for policy blunders, both at home and abroad, which could make things worse. Let us hope that we get the political masters that we deserve!

© The European Futures Observatory 2010