2013: Recovery arrives, time to count the cost…

This year has been one of change. At the same time it has been one of unyielding deadlock. The year began with America’s two political parties locked in a partisan battle over the country’s public finances. It may end on the same note.

While New Year’s champagne corks were popping, the United States congress was in session, passing the Taxpayer Relief Act of 2012 (although by that time it was already 2013). That legislation postponed the impact of what had become known as the fiscal cliff – a combination of spending cuts and tax hikes which were due to take simultaneous effect at the start of the year. The cliché of choice was a lament that America’s legislators had kicked the can down the road. It would not be the last time they would do so.

In the end the New Year saw higher payroll taxes. By March the prospect of a government shutdown loomed, but a stop gap measure forestalled the event until the autumn. Government spending limits, known as sequestration, were imposed over the summer and imposing a drag on the economy. The statutory limit on government borrowing (the debt ceiling) was suspended.

The summer provided a brief hiatus from political posturing. In its place came the Federal Reserve’s plan to slow the pace at which it printed money to purchase treasuries and mortgage backed securities (known as quantitative easing). Bonds responded by plunging in price, sending long term interest rates for companies and homebuyers soaring. These, allied to spending cuts and higher taxes, meant US economic growth was battling a strong headwind, meaning a challenging environment for investment markets.

The US, however, weathered that storm and, despite dire predictions from some economists, continued to create jobs. America will probably grow by about 3% in 2014, faster than its trend growth rate in the modern economic era.

In recent years the US has been a beacon of growth amongst otherwise stagnant developed markets. The Eurozone has been in recession for four of the last six years; until recently Japan was mired in deflation; and UK growth ground to a halt in 2012. But it seems 2013 may be remembered as the year the world started growing once more.

While the US was kicking its financial problems down the road, financially struggling peripheral European states were facing up to theirs. To believers in the economics of austerity that meant a wave of unemployment would cleanse their labour markets, lowering wages such that peripheral workers would be able to compete with their German cousins. Nowhere was this more clearly reflected than in Spain where some 4 million jobs have been lost during the prolonged economic crisis. Unemployment is still running at 26% of the labour force but mercifully its ascent has slowed during this year. A similar story has unfolded in Greece and other peripheral states such that the headline unemployment rate for the Eurozone as a whole plateaued at more than 12% this year.

Growth next year in the Eurozone should be a little under 1%. Under any normal circumstances that would be a very disappointing outturn but, having shrunk for the last seven quarters in a row, any growth at all is a relief.

To single out peripheral states for their weak economic performance would be to oversimplify things. France, the Netherlands and Finland also suffered crippling double-dip recessions. Even Germany saw growth slowdown noticeably over the last year or so. Germany’s performance since the crisis has generally been pretty robust. Unemployment has fallen to a post-reunification low. Through its exports to China and its flexible labour market policies Germany has actually added 1.5 million new jobs since the beginning of 2009. The broader Eurozone has shed 4.7 million over the same period – implying the Eurozone ex-Germany job losses are some 6.2 million jobs.

This year, however, saw economic activity stabilise and even accelerate in some parts of Europe. Half a million jobs created in the UK in 2012 helped to kick-start economic activity. The better economic outlook had already begun to feed into higher house prices when the Bank of England’s Funding for Lending scheme (designed to encourage banks to lend more) and the Government’s Help to Buy programme injected some more impetus into the market. Forward looking indicators of house prices suggest demand will outstrip new supply from the house builders and that prices will continue to accelerate.

Historically house price growth has been good news for UK GDP and it should be again this time, although not to the same extent as in past property bull markets. The difference is that in the past households have borrowed against their rising property values (through mortgage equity release) to fund consumption. The latest Bank of England figures, however, show households that have been chastened by the excesses of the credit boom and are, on balance, overpaying on their mortgages. On the face of it, that seems like an irrational action; record low interest rates implying that households should be happy to assume higher levels of debt. But perhaps the fear of debt is more rational than it seems at first…

Throughout Europe we have been expecting inflation to be weak. That’s seemed most controversial in the UK where the Bank of England have been derided for their long-standing under-estimation of future inflation. October’s inflation numbers, however, surprised even us as core inflation (the measure which really matters) fell to 1.7%, the first time it has dropped below 2% since 2009.

Part of the wealth-creating miracle of Britain’s obsession with homeownership has been due to the happy coincidence of leverage and inflation. Households would take out mortgages which inflation would erode the value of. Lower inflation means those buying property at higher prices today will likely be feeling much of the weight of that debt long into the future.

In the Eurozone the problem is more acute – most notably in Spain. Government debt as a proportion of GDP has soared on account of falling GDP and persistent budget deficits. Spain will run another deficit next year. Growth is still likely to be marginal and deflation is increasing the real value of past debts. The European Central Bank (ECB) responded by cutting interest rates in October – a show of intent but little more than that. The ECB will have to employ some form of unconventional monetary policy in order to keep some peripheral states out of depression.

Eradicating deflationary expectations would help weaken the euro which remains too strong for its own good. By contrast controlling inflation would help support those more fragile emerging markets that are particularly prone to flights of capital. India, Indonesia, Turkey and Brazil have all ebbed and flowed with capital movements over the course of 2013. As prospective US growth improves and the Federal Reserve become more likely to desist from their money printing activities, they are likely to remain subject to volatility.

The world going into 2014 still seems set to be one that is devoid of inflationary pressure even as growth returns. Fears that central banks will start hiking interest rates in the near-term seem overblown. More of a concern might be that central banks are unwilling to step up their support if deflation were to spread. Assuming that such obvious risks can be avoided the extent of the world’s spare productive capacity suggests a prolonged period of expansion seems likely to lie in wait for the global economy, making for an extremely benign environment for investors

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