Buttonwood's notebook

PUBLIC-sector workers are on strike over pensions in Britain today; from my window, I can see the police helicopter patrolling the demonstration. One of the key issues in the dispute is the affordability of pensions and Evan Davis of the BBC's "Today" programme has been cross-questioning ministers on the issue. The government is basing its reforms on a report by Lord Hutton, a former Labour minister; his report seems to show that the cost of public sector pensions is declining (see p23) from around 1.9% to 1.4% of GDP. So there is no affordability problem at all. Hence there is no cost need for reform (fairness between public and private sector workers might be another matter).

The government hasn't been very good at responding to this line in interviews but it does raise some puzzling questions. Why would the cost be scheduled to decline? There are two plausible reasons; fewer retirees or less generous benefits. Since longevity is still rising and the number of public sector workers has gone up since 1997, it doesn't seem likely to be the former. So it must be that the value of benefits is slated to fall.

If you look at page 22 of the Hutton report, you will get a clue. It says

There have been significant reforms to the main public service pension schemes over the last decade, including increased pension ages for new members and a change in the indexation of pensions from RPI to CPI indexation. Some of these changes have reduced projected benefit payments in the coming decades

One of these changes is at the heart of the pension dispute. It is quite significant in terms of cost saving. Note that costs in the Hutton report graph are declining from the current date. But if you go back to the report on public finances compiled by the Treasury in December 2009, before the change in indexation (CPI rises less quickly than RPI which is why it saves money for the government), you will see that the cost was scheduled to increase over the next two decades. This is a little awkward for the unions since their affordability claim is based on a change taking place to which they object.

When you start going beyond 2030, a key element in the cost savings is employee turnover. More of the workforce will be new entrants who, since 2005, will have to retire at a later age than 60. This was a change the unions did agree to, but it does raise a further issue; if it is possible for new employees to keep working till 65 (or 68) why is it impossible for existing employees?

The 2009 study gives us some further clues. The same 2005 agreement that pushed up the retirement age also included a "cap and share" agreement; all future improvements in longevity will be shared between employer and employee, subject to a cap on the employer's payment. Beyond that, benefits had to take the strain. On page 48 of the report, it states that

The scenarios for the PAYG public service pension schemes shown in Chart 6.E include allowance for the potential savings as a result of cap and share due to increasing life expectancies. The projections show gross benefit expenditure, which is not affected by changes in employee contributions, and the allowance for cap and share in these projections assumes that two-thirds of the savings are realised by reductions to benefits

In other words, the assumed affordability of public sector pensions is dependent on future reductions in benefits. Of course, how these reductions in benefits are applied wasn't made clear. But some sort of future reform was assumed. A government actuary department report of 2009 said that (on page 9)

The allowance for cost sharing and cost capping in these projections assumes that two-thirds of cost pressures which fall to employees are met by reducing benefits. It is assumed that the remaining third of cost pressures are met by changes to member contributions

So let us try to sum up. The claim that public sector pensions are affordable over the long run is based on the assumptions that employees work longer, pay more, and get less generous indexation. In all aspects bar timing, these are issues to which the unions are objecting. But it is tough for them to argue that the system that was established before the current parliament was affordable, since significant reform was built into the cost estimates.

For US readers, this week's column is on the dodgy state of pensions accounting in America.

UPDATE: A week's hiatus while I go on a trip. Back on July 11

TWO meetings gave me pause in my bearishness this week. Both meetings were with independent strategists (i.e those not employed by investment banks) who had just come back from tours of clients and had been struck by their overwhelming air of gloom.

That was striking because a lot of the material that comes my way is from economists who generally take a fairly rosy view—the recent weak data are simply a repeat of the soft patch in 2010. In the optimists’ eyes, Japan will recover from the earthquake disruption, the oil price has reversed direction and China may have finished tightening. The three factors will combine to ensure a more robust economy in the second half of the year.

But maybe investors aren’t swallowing this rosy talk. According to Martin Barnes of Bank Credit Analyst and David Bowers & Ian Harnett of Absolute Strategy Research, clients are gloomy about a whole range of things. In fact, the central view of this blogger (that the economy has only been sustained by massive official intervention and that the authorities have now run out of ammunition) is the consensus.

The consensus isn’t always wrong but nevertheless the right question to ask is whether this gloom is priced in. there is a case for saying so in Europe. In Britain, the dividend yield on the All-share index, at 3.1%, is almost as high as the yield on the 10-year gilt (3.26%). That proved a good buy indicator in 2003 although it is worth noting that equities yielded more for the first 60 years of the 20th century. On a cyclical p/e, Ian Harnett finds that European shares are valued towards the bottom of the range for the last 25 years (at around 15). As a check, dividend yields in the euro-zone are 3-4% and the historic p/es are 12-13. ASR also points out that very few sectors are trading on a p/e of more than 20, a sign that there are no great pockets of investor enthusiasm.

Things look rather different in the US, however. The latest Shiller p/e is 22, well above the historic average. Nor does a dividend yield of 2% (according to Thomson Reuters) make the market look cheap. It may well be that optimism in the US is simply greater (it often is). While it is easy to find people who proclaim “the end is nigh” for Greece, most investors assume the politicians will reach a deal on the US debt ceiling. And while Europe has already seen a rate rise and fiscal austerity, the last US fiscal deal was a tax cut and QE is only just ending.

Of course, optimism has its own rewards. Business in Europe might be reluctant to invest while conditions are so gloomy. But Harnett and Bowers point out that in the US, the recovery in real private capital expenditure is the strongest since 1975, as is the recovery in capacity utilisation. This may be driven by the advantage of a weak dollar; US exports have also seen their strongest pick-up since 1975. 

In other words, if Europe does descend into chaos, and if China doesn’t manage a soft landing, then some of that US optimism will need to be tempered. It doesn’t seem like time for bears to throw in the towel—yet.

SALES of gold coins in Greece have soared, according to the FT, as citizens empty their bank accounts in fear of default and devaluation. But on the basis of the last few years, Britons should have done the same. The price of gold, in sterling terms has risen from £324 an ounce at the start of 2007 to a recent record high of £958. From the early 18th century to 1971, the value of the pound was set in terms of gold or, under Bretton Woods, in terms of the dollar, which was linked to gold. On the basis of that 250-year old system, the pound has just been devalued by 66%. As far as I can tell, that is a record; there was a 25% decline when Britain left the gold standard and a 30.5% devaluation in 1949. It is not too hard to imagine that a central bank governor would have felt obliged to resign after presiding over such an event in the old days; instead, Mervyn King has just been knighted. And Britain seems unlikely to stop there; another round of quantitative easing was hinted at in the latest minutes.

Just to change the subject to Greece, I came across this great quote (courtesy of Dhaval Joshi of BCA)

Should we fail to aid Greece in this fateful hour, the effect will be far reaching to the west as well as the east. We must take immediate and resolute action.

Jean-Claude Trichet? Christine Lagarde? Angela Merkel? No, it was Harry S Truman in 1947.

"DON'T believe the doom merchants" is the headline on the latest piece from the asset allocation team at Societe Generale. This is the same Societe Generale whose strategist, Albert Edwards, has a target for the S&P 500 index of 400. It is currently at 1,278.

One has to admire Albert, who has been plugging a bearish line at investment banks for well over a decade, even though such places are normally dominated by bulls. The banks make more money when equity markets are rising, so do the strategists and so do the clients. At times, Albert has looked out of touch but he has stuck to his guns and, broadly, he has been right; the last decade has been better for bond investors than for equity holders. Along with his colleague Dylan Grice, Albert has regularly topped analysts' polls.

Much of the stuff that comes out of investment banks is pretty consensual. They tend to extrapolate recent trends, whether they are talking about economic growth or profit forecasts. When forecasting individual company profits, they tend not to stray far from the line of the company itself; the range of forecasts can be quite narrow. the result of all this is that analysts are poor at predicting turning points. Analysts tend to focus on short-term valuation measures not long-term metrics like the Shiller p/e.

The great thing about an out-of-the box forecast like that of Albert Edwards is that it makes you test your assumptions. Your blogger is a fairly gloomy sort but 400 on the S&P seems a bit extreme. is is impossible? Not at all. It would equate to a Shiller p/e of below 8, which was seen at various points in the 20th century and as recently as 1982. The forecast depends on America following Japan's pattern of a long period of deflationary doldrums; arguably, America has a more flexible economy and better demographics. But one Albert is worth a host of consensus-driven strategists; after all, we know he's not talking his bank's book.

FURTHER to the last post on whether the authorities could or should attempt to solve the debt crisis via inflation, there is a new report from the respected Institute for Fiscal Studies on the British experience over the last decade.

The characteristic of recent inflation is that it has been concentrated on food and energy, two items which absorb a higher proportion of the spending baskets of the poor than of the rich. As a result, lower income households tended to experience higher inflation rates than higher income groups over the last decade. The worst rates of all were suffered by the single pensioners. The trends seem to have accelerated; the poorest quintile suffered an inflation rate of 4.3% between 2008 and 2010, the richest 2.7%.

The details refer to Britain but I suspect they have wider implications. The last decade has generally been marked by falls in the relative prices of manufactured goods, which can be made more cheaply in Asia. The better-off may benefit from cheaper flatscreen TVs or iPads but these are beyond the budget of the poorest; worse still they may have lost their jobs in the factories that made these goods. 

What this report does not cover, of course, is the effect of higher inflation on the savings of the richest. But this is quite a complex area. The richest only spend around half their income, so consumer inflation only affects that portion; they have more of their savings in equities and property, asset classes that are better protected against inflation, than on the cash deposits which middle-income savers might depend on for the bulk of their interest income.  

For Britain in particular, a further bout of inflation might particularly hurt the poor since benefits are now linked to consumer price inflation, which tends to rise at a slower rate than retail price inflation (the old benchmark). While the motivation for this shift was undoubtedly financial (£5.8 billion of savings a year by 2014-15), the government claimed that the CPI better matched the spending patterns on the poor. The IFS comments that

it is not at all clear that one particular index that may have more closely captured the inflation experience of one particular group in the past will continue to do so in the future, unless it is explicitly designed to do so

UPDATE: The US inflation numbers out today illustrate the theme. The headline rate is 3.6%, well above the 10-year bond yield, indicating that real rates remain negative across the spectrum. Now the Fed may focus on the core rate (at 1.5%); that number excludes food and energy, but the poor spend more proportionately on food and energy. To add to the gloom, the Empire manufacturing survey was very weak on measures from new orders to employment. The hope is that this is all linked to Japan and will thus rebound shortly.

GREECE has just seen its long-term debt rating downgraded to CCC by Standard & Poor's, which cheerfully remarks that the country is now "the lowest rated sovereign in the world - fallen below Ecuador, Jamaica, Pakistan and Grenada, "

For those of us brought up to regard Greece as the cradle of democracy and the birthplace of western intellectual thought, it is a very sad moment. S&P's rationale is that

In our view Greece is increasingly likely to restructure its debt in a manner that, under the conditions of any package of additional funding provided by Greece's official creditors, would result in one or more defaults under our criteria.

We are also of the view that risks for the implementation of Greece's EU/IMF borrowing program are rising, given Greece's increased financing needs and ongoing internal political disagreements surrounding the policy conditions required by Greece's partners.

There will doubtless be an attempt to blame the rating agency. While they did fail to assess the risks of subprime housing loans, their record on sovereign debt is pretty good. The agency has really only caught up with the message implied by market yields; Greece is unable to repay its debts. This message will not be welcomed by EU politicians or the ECB, both of whom want to cobble together a deal in which more aid is tied to economic reform.

The irony of this is that it looks pretty anti-democratic. It is far from clear that voters in either the creditor countries or in Greece approve of such a deal or are likely to see it through to the end. The authorities think they are buying time for Italy and Spain but the risk is that their efforts will drain the European project of legitimacy.

PAUL Krugman has responded to comments on his rentier post, reiterating the point that the ownership of wealth in the US is focused on the elite whereas the poor and middle-class tend to be indebted. The rentiers - those who derive their income from investments - are thus a small group.

There are two points at issue here. The first is the composition of the rentier class. The second is the nature of the policies that will benefit that class, and whether the current regime is designed for that purpose.

On the first issue, the balance sheets of individuals are not static. The well-established lifecycle theory states that people accumulate debt in their youth and then pay off their debt in their 40s and 50s, becoming net savers before retirement. Clearly that is more of a middle class pattern than one that applies to the poor, but it is not a purely elite phenomenon. Thus elderly savers do suffer when rates fall; those who buy an index-linked annuity on retirement (the prudent course) get a lower income for their lump sum.

On the second issue, we know what policies are designed to benefit rentiers because they were put in place in the 19th century. As one commenter on the last post remarked, William Jennings Bryan ran for the presidency in 1896 on the free silver platform - bimetallism as it was known. The idea was to expand the money supply by adding silver in order to ease the debts of the farmers. In short, he wanted QE. He was defeated by the sound money forces behind William McKinley.

The sound money school believed in the gold standard and the balanced budget. As Barry Eichengreen pointed out in his book Golden Fetters, central bankers in the Victorian era were able to operate the gold standard because they were largely operating in an era of the restricted franchise. They were members of the rentier class themselves and naturally favored such policies; the system kept down inflation but at the expense of forcing the burden of economic adjustment on to the working class, through regular sharp recessions. The wealthy of that era lived off their investment income which was positive in real terms because inflation was kept low.

So if rentier rule was marked by sound money, balanced budgets and positive real rates, what do we have now? Two years of quantitative easing, huge budget deficits and negative real rates. 19th century central bankers would regard this era with anathema. That is what struck me as so strange about Mr Krugman's argument.

One element of confusion in this argument is the rule of QE this time. It has been designed to push up share prices, as Mr Bernanke and its supporters attest. But it has been more successful (in my view) at bolstering equities than it has in boosting the economy (unemployment was 9.5% in August 2010, when the QE2 policy was unveiled and is 9.1% now). The stockmarket seems to be drifting lower in the absence of a QE3 programme (which Mr Krugman desires). But higher share prices do benefit the wealthy, Wall Street bankers and CEOs. If they are to be defined as the sole members of the rentier class, then he is in favour of handing them a huge bonus.

THERE is a long Bloomberg article on the credit markets which highlights that the Fed's attempt to offload mortgage securities, acquired through its Maiden Lane vehicle, is putting a dampener on the credit markets. The latest auction attracted bids for just $1.9 billion on a $3.8 billion portfolio; some of the ABX indices linked to these debt vintages have fallen sharply in recent weeks. That highlights a long-standing worry about these kind of support schemes; it is easier to get into them than it is to get out of them. So what happens when the Fed reverses QE? Clearly, the Treasury bond market is a lot more liquid than the mortgage-backed market but the Fed will have more bonds to sell; it is only offloading a $31 billion portfolio from Maiden Lane. Unless the US government has eliminated its deficit (dream on), the Fed will be competing with the Treasury to sell securities. 

On the subject of the debt limit, David Bloom of HSBC has an interesting research note on the dollar, arguing that the factors that move the US currency have changed. Take last week's payroll numbers. He writes that

In the pre-crisis world, a strong payroll number would be unequivocally USD positive. That is, a stronger number would imply a stronger economy which would need higher policy rates and this would drive the USD up. Today however, there is a counter-argument: a stronger payroll number is good for risk assets and, as one buys them, this drives the USD down.

In effect, he argues, markets are more interested in events in emerging markets than they are in the US economy or US policy. The dollar has become a residual, driven by the risk-on/risk-off trade.

So when it comes to the debt ceiling, investors may have to be counter-intuitive. One might assume that, if Congress fails to raise the ceiling and there is a technical default, the dollar would suffer. On the contrary, such bad news would cause a flight from risky assets back into the US, driving the dollar up; by contrast, an agreement on the ceiling would be positive for risk assets and push the dollar down.

Finally, a note on Korea which pushed its interest rate up by a quarter of a point today. It followed Thailand and the Philippines in raising rates over the last month; Taiwan is expected to follow suit and, of course, China has been steadily tightening (mostly by raising the reserve ratio for banks). While the developed world continues to worry about a faltering recovery, Asia is still worried about inflationary pressures. Of course, to the extent that Germany is dependent on Asia for its export drive, this is bad news for Europe as well.

ONE of the most persistent arguments in favour of emerging markets is that they have superior growth prospects. So the bulls have been challenged by data showing that past growth and equity returns have not been linked; a subject covered in my column a few weeks ago.

That column provoked a response from the strategists at UBS in a note called "Explaining the Equity-Growth Puzzle in EM" say that

Most of (the) studies are looking at the wrong relationship, or at least wrong from the point of view of the average portfolio manager.

Global investors don't care per se about inflation-adjusted local stock market returns, nor do they particularly care about the real growth rate of GDP or earnings - what they care about are currency-adjusted (e.g. US dollar) returns, currency-adjusted earnings and currency-adjusted growth. 

If one compares equity returns with the annual growth rate of dollar GDP, (i.e. nominal growth plus or minus the change in the local currency versus the dollar), UBS says the link is much stronger. Investors should look for a strong rate of real economic expansion, strong nominal pricing power and reflationary pressures and currencies that are either undervalued or at least stable on a forward-looking view. UBS concludes that

Put these all together and you get a very buoyant all-in growth story - and one that historically leads to buoyant equity returns as well.

So I asked Professor Elroy Dimson, who together with Paul Marsh and Mike Staunton of the London Business School wrote the original study into global growth and returns, to have a look at the paper. He says that

UBS has not demonstrated that returns can be predicted from past GDP. They have a trading rule that will be profitable if an investor has clairvoyance about GDP growth. What would be crucial would be to get the GDP call right relative to the consensus.

But we don’t know beforehand whose GDP crystal ball will work, and whose will not.

On the dollar GDP argument, the Professor adds that

The UBS view blends equity and currency investment. If an investor has a view about currency strength/weakness, then he can trade in money market instruments. That way, he can benefit from the extent to which an EM currency is misvalued.

If you can forecast currencies, it’s best to take advantage of that skill. But where do we find the reliable currency forecaster? Depending on which time period you look at, emerging markets have done better or worse than developed markets. The same is true of currencies. Put the two together, and there will be intervals over which dollar exposure is helpful. And others when it isn’t.

All told, the UBS paper doesn't shake the Professor from his case that one can show stockmarkets anticipate future economic growth but not that past growth is a guide to future returns. (He has one or two statistical issues with the paper which are too complex to discuss here.) Of course, if you can correctly predict future GDP changes and currency movements, you've got it made. But while you're doing that, perhaps you can send me next week's national lottery numbers.

THERE have been plenty of books about the Wall Street crisis of 2008 but fewer, to date, about the sovereign crisis that followed it. (The standout work to date is This Time is Different by Carmen Reinhart and Ken Rogoff but that takes a very long-term view.) So it is good to be able to recommend Jason Manolopoulos’s work, Greece’s Odious Debt: the Looting of the Hellenic Republic by the Euro, the Political Elite and the Investment Community.

Don’t let the overlong title put you off; for a while, I thought it might be a nationalist polemic against the Germans or international speculators. But Mr Manolopoulos is actually a hedge fund manager who takes a very clear-headed view of the crisis. Blame is spread liberally around, with his fellow citizens taking their share. On Greek corruption, there is a nice list of fun facts, such as: 321 dead individuals over 100 were receiving a pension; 324 homeowners in northern Athens said they had a swimming pool but 16,974 were detected by satellite photography; and (best of all) although Lake Kopais was drained 53 years ago, a staff of 30 full-time civil servants still manage its “affairs”.  

The author draws some nice parallels between Greece and Argentina, two economies that initially appeared to benefit from a currency link (in the 1990s, Argentina had a currency board based on the dollar) but which did not undertake the reforms necessary to maintain the link. As Mr Manolopoulos rightly remarks

A currency arrangement can bolster a strong economy but it cannot create one

The combination of a currency link and weak economic policies doomed Greece to its eventual crisis. But the author entertaining recounts the long series of denials by EU officials, Greek politicians and investment banks. In November 2009, HSBC said that “Greece is no Iceland or Dubai” while Societe Generale said in December that “This current bout of nervousness around GGBs (Greek government bonds) will not go far” dismissing the sceptics with the line “Pigs can fly and Armageddon could be for tomorrow. Just silly talk.” As late as January 2010, Joaquin Almunia, then the EU commissioner for economic and monetary affairs, was declaring of Greece that

A bailout is not necessary and will not exist.

The author's conclusion is that Greek debt will have to be forgiven but that the Greek economy will also need substantial reform. And he warns that

Experience repeatedly indicates that the German-speaking countries plus Benelux and perhaps one or two other neighbours comprise the only true converged optimal currency area in Europe.

All this and (much to my surprise) a quote from this blog as well on page 176. What more can a reader want?

FREE Exchange inevitably responded to my blog on QE yesterday. It may well be that readers tire of such internecine disputes but as it brings out some of the key issues, I will prolong things for a little while longer. My note took the data on unemployment from August when a second round was suggested at the Fed meeting in Jackson Hole to show that there had only been a fall from 9.5% to 9.1%. But it seems I was measuring things from the wrong point. His note says that

By November, when new asset purchases actually began, the rate had gone up from 9.5% to 9.8%. Thereafter, it tumbled by a percentage point; the drop in the unemployment rate in the three months after November was among the largest of the postwar period

So QE2 only started working in November, when the Fed actually started buying bonds. But hold on a minute. Back in April he wrote that

Early in the third quarter of last year, immediately prior to Ben Bernanke's strong hint that additional asset purchases would be forthcoming, expectations for growth and inflation were falling, the probability of a double-dip recession was rising, confidence was lagging, and private employers were creating around 100,000 jobs per month. This deterioration is why the Fed acted. Did the Fed hope to influence interest rates? Sure, but that's just one of the means available to the Fed as it pursues its desired ends: a stable rate of inflation supportive of economic growth.So what happened after Mr Bernanke made it clear to markets that the Fed would act again? Growth accelerated, from a 1.7% annualised pace in the second quarter to 2.6% in the third quarter and 3.1% in the fourth quarter.

And if we go back to November, he wrote that

the good October jobs numbers were no doubt boosted by anticipation of the Fed's new easing programme, which has been lifting share prices and inflation expectations and reducing interest rates and the dollar since late August.

So it seems as if, at one stage, August was deemed to be the key date. Now Free Exchange could rightly accuse the sceptical camp of pursuing two contrary positions; that QE would either be ineffective or would cause hyperinflation and can probably find examples of such confusion in this blog. My fundamental issue is that QE has tended to have more of an impact on markets than it has on the real economy, and that this is part of a long-term trend whereby central banks have artificially propped up asset prices, something I think is doomed to failure unless it is accompanied by more general inflation. (The obvious example is house prices which are linked to incomes. An attempt to maintain house prices at a high level is doomed unless incomes are boosted too.)

Indeed, there is a certain amount of moving the goalposts about the rationale for QE. Here is Ben Bernanke in October 2010 explaining why QE works

Empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery.

So it works via lower bond yields, right? Well, on this measure, it can't be called a roaring success. At the start of August 2010, the 10-year bond yield was 2.96%; at the start of November, it was 2.6%; now it's 3%. In February, it was 3.7%. The latest level is only due to a slew of data suggesting the US economy is weakening, not strengthening, despite all the supposed benefits of QE. But in Bernanke's November Washington Post article, he emphasised that

higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

So higher stock prices, not bond prices, seem to be the key. (Incidentally that piece also seemed to argue that QE started to work in August, not November, as investors anticipated a second round.)

Anyway, last night's speech disappointed those hoping for a further round of QE with Bernanke stating only that

The FOMC has indicated that it will complete its purchases of $600 billion of Treasury securities by the end of this month while maintaining its existing policy of reinvesting principal payments from its securities holdings. The Committee also continues to anticipate that economic conditions are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

My view (for what it's worth) is that the Fed should only contemplate more easing if unemployment starts to rise sharply again. Absent some calamitous crash, the level of the stockmarket should play no part in the bank's deliberations whatsoever.