Introduction
Stuart Thomson graduated from Edinburgh University in 1985 with an MA honors degree in economics. He began his career in 1985 as a junior economist with Britannia Asset Management and a year later joined Chase Manhattan Securities. In 1988 he took up the post of chief international economist at Nikko Europe Plc, and in 1997 moved to Credit Agricole Indosuez, where he worked as chief market strategist. In 1999 he joined Sutherlands Limited as a senior economist, and from there went on to be founding director and investor of RIA Limited. Thomson joined Charles Stanley Sutherlands as a senior economist in 2003, remaining there until he joined Ignis Asset Management in August 2006, where he is responsible for international bonds and currencies.
There is a lot of concern that developed economies are finding it extremely difficult to generate any real, sustained growth. Do you see a third round of quantitative easing as a possibility?
We have seen a marked slowdown in the economic data since the middle of 2010, with another distinct slowdown in May 2011. The 2010 slowdown prompted the president of the St Louis Federal Reserve, James Bullard, to warn that there was a very real danger that US consumers, corporates, and investors could all become accustomed to low nominal GDP growth and a quiescent central bank. That kind of attitude is already a few steps along the path to a pernicious deflationary era, and the Federal Reserve will do all it can to avoid the US economy falling into that trap.
As we saw with the second round of quantitative easing, QE2, which ended in June 2011, it is not necessary for the US economy to be seen to be sinking back into a double-dip recession for the Fed to resume quantitative easing. It remains an option if the US economy stalls. The Federal Open Market Committee (FMOC) will keep this under review. (The FMOC consists of 12 members, including the seven members of the board of governors of the Federal Reserve System, the New York Fed president, and a rotating quorum of four of the remaining 11 Fed presidents. At its eight annual meetings the FMOC reviews economic and financial conditions and determines monetary policy, including whether or not to proceed with more quantitative easing.)
Quantitative easing, or QE, is designed to produce effective negative interest rates, which is a disincentive to hold dollars. It has the side effect of exporting deflation to those high-saving economies which do not link their currencies to the dollar. For high-saving, mercantilist economies that do link to the dollar, the inevitable result of the United States rolling the printing presses is inflation.
One country with a great deal of experience of deflation in the modern era is Japan. It is a major exporter, and the yen strengthening even as Japan’s interest rates hit zero in real terms is crippling the country’s economy. What is your view of Japan’s prospects?
Japan is confronted by persistent and stubborn deflation and when, in 2010, we saw Japan’s overnight rate cut by the Bank of Japan from the ultra low rate of 0.1% to effectively zero, this was a signal that the Bank of Japan itself intended to engage in QE, which it initiated by mid-October 2010. This should have the spin-off benefit of weakening the yen, the current strength of which is undoubtedly crippling Japanese export trade.
Japanese nominal GDP has averaged –0.2% since 1995. In the first quarter of 2010, however, a recovery in Japan’s export markets enabled the country to become, briefly, the world’s fastest growing economy. However, currency appreciation has undermined all the growth the economy achieved in that first quarter, and by the end of the second quarter of 2010 Japan had become one of the world’s slowest growing economies.
To make matters worse from the Japanese perspective, China has been diversifying its foreign reserves by buying yen in substantial quantities, in the shape of Japanese government bonds. As an appreciating currency, the yen provides China with a welcome diversification of a small part of its reserves (3% according to Chinese officials) away from depreciating US Treasury bills, which could be further impacted by the next round of QE from the United States. Japan is countering China’s impact on the yen in two ways—by calling for talks with China, and by intervening directly in the markets to weaken the yen by buying dollars aggressively.
This is in the teeth of explicit warnings by the US Treasury back in autumn 2008. At that time, in its semiannual currency report, the US Treasury called on Japan not to intervene directly in the currency markets. The crisis at that point was a surge in the yen in the wake of the collapse of Lehman Brothers. The United States was worried, and still is, that intervention in the currency markets by a leading global economy like Japan sends the worst possible signal to the developing nations, which the United States is trying to move away from mercantilist currency intervention policies—i.e. deflating their currencies to make their goods more acceptable to foreign buyers. For a while Japan heeded the United States’ warning, but its domestic concerns have now apparently overridden its anxiety not to upset the United States. This also represents a real change of heart by the Japanese Ministry of Finance, which had viewed currency intervention as the kind of thing that developing nations indulged in to assist their weak economies. It was thought of as beneath the dignity of a mature, developed economy. However, the Japanese coalition government’s position is fragile, and it has to respond to pressure to improve the prospects of the country’s exporters by acting against what many see as the “unfair” manipulation of Japan’s currency by China.
In this spat between Japan and China, are we seeing yet another instance of the protectionist mood that seems to be sweeping across the globe as a reaction to the global recession of 2008–09?
Protectionism has been admirably restrained through the credit crunch, but there is no doubt that it has the potential to break out in many different directions. It is merely resting, not gone. There is considerable pressure from Western economies for emerging market economies to buy more of their goods. Not only would this help to rebalance global trade flows, it would give Western economies, which are struggling to achieve even very low growth rates, access to demand from countries that are growing in the high single figures.
However, this will be very difficult to achieve. Chinese consumer spending has fallen as a percentage of GDP to a record low of 36% from a more respectable 46% in 2000. The United States’ second round of full QE forced China to hike rates continuously as it tried, and continues to try, to dampen down rampant domestic inflation without allowing its currency to appreciate against the dollar. Neither option is particularly palatable to the Chinese authorities, and geopolitical tensions are on the rise as a result.
In the United Kingdom the coalition government is committed to cutting the country’s deficit, which means steep public-sector cuts despite warnings, not least from the United States, that austerity now could push the country into a double-dip recession. How do you see the UK austerity measures impacting the economy?
The UK economy performed exceptionally well during the second quarter of 2010. This was due in no small part to the economy benefiting from an unprecedented monetary, fiscal, and foreign exchange stimulus. This strength continued into July, helped by strong demand through the Football World Cup. However, leading consumer, construction, housing, and business sentiment indicators turned weaker in the wake of the election, and there is no doubt that the first hundred days of the coalition government passed in a blaze of austerity.
We are now seeing a marked weakness in the economy that will get worse as cutbacks in the public sector start to bite. By mid-2011 the coalition government was already being faced with waves of strikes and protests from the public sector, which will further depress consumer confidence. I do not expect these strikes to deter the government from pursuing its austerity program, but it seems inevitable that they will weaken sterling still further, and taking money out of the public sector will dampen economic activity.
We have already seen warnings from the European Central Bank (ECB) president Jean-Claude Trichet that ECB rate rises are possible. Bundesbank members on the ECB governing council are very much in favor of tightening monetary policy. We saw German GDP growth for the full year 2010 come in at 3%, well above earlier estimates of 1.5%, and in the light of that withdrawing liquidity from the Eurozone as early as possible will be attractive to the Bundesbank. However, we have to remember that it was the ECB decision, made at the behest of the Bundesbank, to signal the withdrawal of liquidity at the end of 2009 that triggered the sovereign debt crisis in Greece.
In light of this it seems clear that the situation of peripheral Europe is set to worsen substantially. Growth is already contracting in those countries. The Irish position is particularly desperate, with deflation being imposed by fiscal austerity. If we look to the sovereign bond market, it is clear that the next stage of peripheral bond spread widening is already upon us.
One of the problems with QE, apart from the potential long-term and largely unpredictable impact on inflation, is that the new regulatory demands in banking and insurance will act to deter banks from selling their triple AAA holdings. The impact of QE2, therefore, as we saw, was to drive down yields and returns, which in turn prompted central banks to run the printing presses even harder. The laws of economics dictate quite straightforwardly that if you pump enough money at an economy, it will grow.
On the positive side for the UK government, it has already made clear its intention for debt issuance in 2011 to be less than Germany’s. This would be a remarkable achievement if it were able to hit this target, though there is considerable execution risk here. One area where the United Kingdom gains is that it turns over its debt on a 14-year cycle. Most other countries, including the United States, are on a far shorter debt cycle of six to seven years. This gives the United Kingdom a great deal of protection against having to go to the market to refresh debt when conditions are highly unfavorable.
What is the impact of QE on the debt markets?
Clearly, if you are a creditor to a particular sovereign state, you do not want to see its currency depreciate. About 35% of UK debt is held by foreign investors, and through the Bank of England’s first phase of QE we saw a sharp drop in the three-month rolling demand. It fell to about £11 billion, and after the election of the coalition government, with its commitment to austerity, demand rose to £20 billion. The government’s commitment to cutting the deficit improved investor confidence in the United Kingdom’s ability to maintain its triple AAA sovereign rating. This in turn made investors more willing to hold UK bonds.
In summary, it is quite clear that deflationary forces are still dominant in the developed economies, despite the optical illusion created by such factors as the United Kingdom’s rather “sticky” 3.1% rise in inflation over the last year. This has been driven by several factors that are unique to the UK context, including the VAT increase, the lagged impact of the weakness of sterling, which pushes up import prices, and the general effect of higher global commodity prices. Much more important for the deflation/inflation debate is the slowdown in global trade, which remains quite palpable in mid-2011. The stimulus-induced bounce in global trade has now largely faded away, and the risk is much more that domestic fiscal tightening at a time when unemployment is high and there is overcapacity in the market will create deflationary pressures and a significant risk of a double-dip recession in the year ahead.
QE2 was a rising tide that lifted all boats in the investment universe as far as asset class performance is concerned, until a fresh and rather intense bout of European sovereign debt worries troubled the markets in May 2011. Further out, at around 2015, the QE that we have already seen may well generate an inflationary risk. The logic here is that, since debt deflation is so depressing to the economy, it is likely that central banks will err on the side of too much QE rather than too little—and too much QE can drive inflation quite sharply. We are definitely in for an interesting few years ahead.
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