Economic Update July 2012 The UK The standard view of an economy is that it is aggregate demand which drives output

and incomes, which feed back into more aggregate demand. Aggregate demand is the same thing as total spending. Below is a chart of the split in the sources UK aggregate demand. Average 1990-2008 Average annual growth rate in real terms 2012 Q1 growth rate

Consumption 63%

1.6%

0.1%

Government consumption 24%

0.5%

1.6%

Investment 14% Net exports -1%

0.3%

-4.2%

-0.1%

-1%

GDP 2.3%

GDP -0.3%

Please note that the Government spend gure is spending on health, defence, police, oseas aid, education ie things Government consumes. It excludes transfer payments such as social welfare, subsidies to rms, state pensions, and unfunded public sector worker pensions. The big hope two years ago was that investment spending and net exports would grow to offset the decline in private consumption. This is not happening. Some of you will be exporters and doing really well, you might question the numbers. The way we measure the balance of payments creates an apparent conundrum. Both imports and exports are recorded in sterling. So if the pound weakens, the balance of payments

automatically deteriorates even though volumes are unchanged. It would appear from the accounts that the volume of exports has not grown suffciently to offset the decline in sterling value. And the volume of imports have not fallen enough to offset the increase in sterling value. Hence even though many exporters are doing well ( particularly if you look at their margin), we still have the the overall balance of payments making a negative contribution to growth. We can expect the level of activity to saw tooth as in the chart below for at least another three years.

Source: NOS New is the revised data, Q1 worse than at rst thought. And Q2 will come in at minus 0.5.

There will be no recovery in consumption spending until the following graph reverses. Although CPI has recently dropped to 2.8% ( May) weekly earnings have fallen back to 1.4%. So real incomes continue to fall. This is having a marked impact on the pattern of sales for retailers. We are shopping for food more frequently and buying less each time ( hence the success of convenience stores). And volumes rise after pay day then steadily fall away until the next pay day The UK growth rate will not pick up until earnings are growing at least 1.5% above ination. This years global weather has devastated farming.The worst drought since 1956 in the US midwest and the wettest summer on record in the UK will cause signicant increases in the price of food this Autumn.

The Euro and Sovereign Default The G20 is a club for the worlds largest economies. 55% of the current membership have historically defaulted on their debt. Spain has on 18 separate occasions since 1550, Greece 5 times since 1820. In the light of history it appears that the decision by the Basel Group to treat Sovereign Debt as risk free was a big mistake. It is this which enabled undercapitalised French and German banks to lend massively to Clubmed members of the Euro. With low interest rates, easy credit, asset price ination and no exchange rate risk, the incentive to restructure pensions, subsidies and the retirement age did not exist. There was no incentive to be like Germany. And so something will have to give. The ballot box will create the inevitable: it is just not possible for Greece to meet its obligations, they have already asked for an extension of the bailout plan to 2017 and the new Finance Minister is under intense pressure to renegotiate the terms. The chart shows the interrelationships created by sovereign and private lending. It would appear that a Greek departure and default is containable, possibly Portugal too, but not the others. Be reminded that Greece was barred from international borrowing for 110 out of the past 190 years!

The Clubmed plus Ireland debt distribution.

The break up the Euro in inevitable, the North will not behave like the South and vice versa. Greece rst by the end of this month (!). Then in 2 years Spain and Portugal. Italy to follow in year 3. By 2017 there will be a Nordic Euro, including France. This will be driven by the ballot box, with the Clubmed voters choosing less austerlty and the Nordic voters choosing less nancial support for the South. Watch for the behaviour of Finland they could be the rst Nordic country to leave. The money supply is contracting in Clubmed as high net worth individuals shift their deposits into German and UK Banks ( one of the reasons sterling trades at 1.28 and the yield on German, Danish, Dutch and Swiss bonds is negative ie investors are paying to be safe)). With monetary contraction, scal tightening, low or no growth is inevitable. If you trade with any Clubmed countries, do not be overexposed, know who they bank with, know their credit history, and chase debtors hard. At the time of writing (July 20) sovereign bond prices have risen a little based on the market view that European leaders are creating a solution. All that has happened is this. There maybe a Europe wide bank supervisor by the end of the year. Bailout funds can go straight to banks( this is not debt mutualisation). Thats all folks! Another crisis is just around the corner. The Bank of England has calculated that UK Banks have sufcient

capital to absorb writedowns on European sovereign debt. But it would take them back to 2008 levels. And then they would have to start again. British Banks I can remember trying to explain unsuccessfully the behaviour of LIBOR from 2008. I never considered the possbility that it was being rigged. Stupid Boy. LIbor is the rate of interest which banks lend to each other to balance their books each day. It is the basic price of liquidity and from it almost all bank lending is priced. At 1100 hours 22 Banks are asked what price they can get wholesale money from the market.

The top two highest and bottom two lowest are taken out and the remaining averaged. Because Libor is the determinent of $350 trillion debt instrument prices, any movement out of line with expectations results in big gains or losses for Investment bankers. I hope that recent events will cause the Government to push back on the Banks and insist on complete separation of Investment and Retail with separate share listing. Yet again the cultural problem is the infection of solid, honest, decent retail bankers by the trading mind set from the casino division. I very much doubt Barcap could survive without the retail banks deposit base. British banks have spent 95 million on nancial PR over the past year to waterdown the Vickers Repot proposals. For example the Government has agreed that they can sell nancial derivatives to SMEs ( madness). I am sure there is more to come on rate xing, stitching up customers ( the Muppets), and total self interested behaviour. If the system privatises the prots but nationalises the losses, such behaviour is almost inevitable. We must change the system and quickly because the reputational damage is global. Bob Diamond just doesnt get it: a sh always

rots from its head. The big law rms will be gearing up for proliferation of class actions against banks which will run for years. The Bank of England has told UK banks that they can reduce their liquidity buffer and that it will accept lower quality bonds for liquidity provision. This could release up to 300Bn for new lending. But given the uncertainties from Euroland, I doubt if more than 30-50Bn will become new credit. The announced increase in QE by another 50Bn will enable the Government to fund its debt issuance at current yields. So no change in interest rates for a long while yet, but more QE will not increase the supply of credit, it will just allow the Government to borrow another 130Bn next year at interest rates below 3%. The Global Economy Its rapidly slowing down. The most recent purchasing managers index is at 50 which is the tipping point. Western economic policy is tightish scal policy (with Governments trying to limit their borrowing) mixed with extremely loose monetary policy. And each country is exhorting its industry to export more. Very loose Monetary policy is like pushing on a piece of string. It has prevented a global depression but that is it. The latest news from China is that the demand for commodities and machinery has not been about end use. Anything with a monetray value such as commodities is being used collateral to secure loans which are then fed into the shadow banking system for higher returns. It follows that if commodity prices collapse so will the collateral. This will create a nancial crisis, forced stock liquidations and further falls in price . Be aware that China is becoming more unstable. The Australian Dollar and Brazilian Real will weaken as a consequence of a commodity price slump. The latest gures from China suggest that at 7.3% real growth the economy is at the target level of growth set in the new 5 year plan. As always the GDP numbers are a political statement. The consumption of electricity has not increased for a year now. This suggests much lower growth. GDP and the demand for electricity move in line. For example UK electricity demand adjusted for the weather (!) is down 2% over the past year, this is almost in line with our economic output. Brazil is only just growing as export volumes, particularly to China have fallen sharply. The USA is loosing the momentum established earlier in the year and Europe as a whole is at Zero growth ( strip out Germany and its in recession) As forecast the oil price is at the minimum target price of $100 and it will not fall much below this for long. NB I now expect global growth next year to be close to 1% This will feel like a recession. Here is why. The Euro debt problem can only solved by write down, ination, more debt or growth. It is infecting boardrooms around the world. Finance directors will hoard even more cash. QE doesnt increase the capital base of a bank. Writedowns reduce it and there will be a growing number of these. As the velocity of global money falls so will global GDP.

Is there a solution? Yes. In Europe the slate is wiped clean as countries agree to write down what they are owed. Germany would need to write down about 600Bn Euro, but the total writedown would be around 1.2 Trillion. How big is a Trillion?

From the top. $100, $10,000, on the pallet $100million, in front of it, $1million, On ten pallets $1Bn and then to scale on the right $1 trillion. On the next page you will see the graphic illustration of Goldman Sachs exposure to the derivative market. Please note that they are only 13% of the $350 trillion derivatives market.

These graphics illustrate why Libor is so important and I guess why there is such an incentive to misreport the number. Libor underpins the pricing ( and the value) of the columns in the picture. What you see is double stacked columns, representing 44 trillion dollars. The economic value added of all this is very small despite what the bankers say.

Exchange rates, ination and interest rates. Sterling will weaken slowly to $1.50 by the end of this year. It will gyrate against the Euro, but 1.27 is the correct rate based on nancial fundamentals. The Aussie dollar and the Brazilain real will both weaken. The Rnb is likely to stay where it is against the dollar. Ination in the UK will not go below 2.3% and is likely to pick up to 3% over the next 12 months. In Euroland ination will pick up as the Euro weakens against the dollar. Interest rates: unchanged. What does all this mean if you are running a business? The Economic conditions we can expect for the next 3 years will really sort out the weaker players, and give growth opportunites for the strong. Western economies are beginning to make some signicant transitions with less reliance on nancial services and more focus on high end, innovation led products and services. This is a very good time for SME owners to invest in what they believe in: themselves and their key staff. In strategic terms the key words are focus and engagement. Focus on the customers whose needs t tightest with your distinctive capability, engage with them to test and ensure that you both agree what the value drivers are and how they might be changing. Also engage with your employees, communicate by listening, keep asking them to tell you how they think the product or services you produce can be more compelling for the customer. Be patient in building your distinctiveness. The value of your business will be increasingly determined by its reputation more than the physical assets it owns.

It is now holiday time. A time to reect, do something different, renergise and get ready for a very turbulent Autumn. There will be another Euro crisis in late September. Have a good holiday !!! Rmfagg@aol.com