You would think that, given the press coverage, much of the US economy is making great progress. Apparently interest rates will continue to rise in response to the Fed’s feeling that the economy is doing well; near-full employment, GDP recovery, stock market growth, bond and dollar strength and all that jazz. But these data points mask some other troubling items that suggest any recovery will likely be lopsided and even short-term based. You only have to look under the covers at, say, unemployment, credit, or housing.
Unemployment: despite low levels of reported unemployment many economists are concerned that the participation rate is at very low levels. In other words, there is a lot of unemployed that is not being reported in the official KPI. Some economists suggest that real effective unemployment maybe nearer 6 or even 9 percent. Thus the result of economic growth may not lead to wage price pressure so soon, since the participation rate may improve the so pick up some of the slack. This is good news overall but not if the Fed believes that they need to head off wage inflation likely to appear due to pressure on a really tight labor market
Consumer Credit: Student and auto loans are running ahead at full steam, and mortgage debt continues apace. While many firms have cleared their balance sheets of bad debts, consumers – which drive a massive part of the US economy – are amassing debt easier than looking for a hot meal. On February 27th the US print edtion of the Financial Times carried an article, More US car owners behind on loan payments than at any time since 2009. What is realy funky here is that if you go into the market now to look for a new or used car, you will be offered a loan for repayment now past the 5 year window. It used to be that 5 years was the maximum and this was only a few years ago. Now you can get a loan over 6 years or longer. So the consumer part of the market is building up a nice bad-debt situation.
House prices: Yes, house prices have recovered, so we are told, to near pre-crisis levels. So that part of the market is secure, right? Wrong. Home ownership is a its lowest levels in years. It turns out that the buyers that are driving up prices are investment firms and conglomerates that are snapping up property then leasing them to. So first time buyers are being squeezed out. The housing market has not recovered in the way we would want it or need it to for effective sustainment.
So we have a very lopsided economic recovery. It is not stable and even the strong shoots are some challenging weeds hiding just under the covers. Even if Trump can delivery on +2% GDP growth, I am not altogether sure that woudl mask the issues that are building up today.
As a ‘leave’ supporter I calculated that Brexit in the short term the UK would suffer political, economic and business turbulence. This is very clearly seen today, from resuming Prime Ministers, ministerial revolts, investment fund contractions, a crashing pound and stock market. But in the medium term I am excited at the opportunity afforded to the UK. This is predicated on the idea that rational heads will prevail and reasonable actions and negotiations will emerge to supper mutual gain. As such there are a few key metrics to watch, that will signal when the market percieves that opportunity is on the cards.
The key metrics to watch are:
FTSE 250: This key metrics fell just under 15% post vote, recovering so far but still down about 9% down. The FTSE 100 is not useful in this regard as it is not representative of the U.K. business population at large. I would expect the FTSE 250 metric to take 6-12 months to stabilize, then 12-24 months to recover losses and head into positive territory. Interestingly if you agree with my premise there will be some great “buys” in the FTSE.
Sterling/Dollar: more volatile than the stock market, the pound dropped to several new 30-year lows against the dollar. This is more interesting and important than the stock market for multiple reasons. First, the drivers of the other currencies are less grounded in knock-on results of Brexit and more grounded in local economic and political uncertainty. The dollar is a very safe haven, and the U.K. was too, until Brexit, compared to (say) the Euro. Sterling is floating around $1.28 at present and may yet fall further. I would assume a depressing effect on the exchange rate for 6 months. After that it will be flat and slowly recover losses through the next 6 months. A year from now it will be close to Brexit levels and even stronger. And don’t forget: at present, with a declining pound and the UK still part of the EU, the country’s trade is operating as if with a competitive devaluation. Exports will see higher demand and imports will be more expensive, thus improving the balance of payments. No wonder there is no rush to initiate Article 50.
U.K. 10 year gilts (bond) yield. This is where things get interesting. If market confidence in the UKs long term stability falls, the price on its 10 year gilts should fall and its yield rise. When confidence increase, as seen in the US and German 10-year bonds, process rise and yields fall. The odd thing is that UK 10 year gilt yield dropped post Brexit and remain well depressed. It is as if the long term market confidence in the UK economic position remains strong. It is also partly a reflection in the market’s belief that the Bank of England may need to lower interest rates (or even increase QE) in order to head off any potential economic contraction.
And for a long term metric to watch:
UK company start-ups rate: this less-sexy and less-reported statistic is running at historically high rates and in excess of many other advanced economics. This is a great long term metric to monitor since it should support the idea of creative destruction in that resources are automatically reassigned to more productive use via (free) market operations. Second, the fact that the metric is rising is also a reflection of the proportionately lower levels of red tape in place in the UK, even compared to other economies. For example in the US such red tape has increased, and the US company start-up rate is at historically low levels.
The reality though is that all bets are off should negotiations for Brexit turn ugly. Rational responses to negotiation are required, all round. If the EU seeks to cut off its nose to spit its’ face, everyone will lose even more than we have seen so far, and more so in the Euro.
For all the data I would keep my eye on the 10 year gilt yield. The U.K.’s fiscal and monetary policy will be managed closely to help preserve economic stability. Negotiation re Brexit, and especially trade deals, will be keenly watched. Confidence in sterling vis-a-vis the dollar, yen, yuan and euro is critical. So the minor changes in the gilt yield will represent a single KPI representing market confidence in the UK.