Friday, 14 June 2013

ID Lowe Caledonian Trust . UK prospects considered.

The "Irish" joke, paraphrased, goes: "You know, sir, if I was going to Balbriggen I wudnae be starting from here at all".  So it is with the UK economy. The fictional Irish yokel might not have rephrased his directions quite so enigmatically, but the adjustments necessary to improve the UK economy can be discerned within the following quotations: "the questions in the Cambridge Economics Tripos examination are often the same, but the answers vary" (anon). During the Bay of Pigs crisis Kennedy opined it was necessary "to avoid feeling that just because they were military men their opinions on military matters were worth a damn" (Michael Burlington); "if we want things to stay as they are, things will have to change" (Giuseppe di Lampedusa); "the greatest danger in times of turbulence is to act with yesterday's logic" (Peter F Drucker).

The context of the need to consider change is that the current economic policies are not leading to a similar recovery in output as has occurred following previous major economic shocks. In the 19th century the "Panic of 1857", originating in the US following the railroad boom after the failure of the Ohio Life Insurance and Trust Company, quickly spread to the UK bankrupting exporters and Banks.  In the 20th century the post WWI and 1930s Great Depression caused falls in output of 9% and 7% respectively, and shallower falls in output resulted from the mainly inflationary bubbles in 1973-1976, 1979-1983 and 1990-1993, but in all these circumstances output had recovered to the pre-crisis levels within four years and often earlier and further growth followed. In the sixteen UK recessions since 1847 consumer spending was 2% or more above the pre-recessionary peak within three years except on three occasions of which the current instance is by far the worst.

The current economic depression commenced sixty months ago, but output is still about 3.5% below the pre-recession level. Unsurprisingly 12% of Britons expect their "household finances" to improve next year, but 52% think they will worsen, a finding probably influenced by a 4% fall in consumer spending during the depression, low wage rises of 2%, more than offset by price rises of 3%, and a saving rate of 6% to 7% compared to 0% in 2007.

If the NIESR forecasts of growth at 0.7% in 2013 and of 1.5% in 2014 are correct, the pre-recession output level will not be attained for at least eight years - apparent Cassandras who forecast a "lost decade" may, unfortunately, be proved correct! The current UK recession, based on three-month moving averages, was no deeper than the Great Depression and shallower than the post WWI recession, but these regained previous output levels about 48 months from the onset of recession and the economy grew strongly thereafter. Unlike the UK, other economies, apart from the aggregate of the Eurozone economies, recovered quickly from the 2008/09 downturn. The US economy grew 2.2% in 2012, the "Transition economies" 2.6%, Asia and Australasia 4.0%, Latin America 3.0%, Middle East 3.6% and Sub-Saharan Africa 4.5%, and all these economies are expected to maintain or increase their growth rate in 2013 and 2014.

In most recessions, once recovery starts, growth is above average, a "catch-up". In the 1990-93 recession growth was 12% in the three years after recovery commenced and in the Great Depression of 1930-34 it was 11% in the two-and-a-half years following recovery. In the current depression growth is forecast at about 1% pa for 2013 to 2017. Thus there is no projected "catch-up", or recovery when growth returns. Before the recession the economy was growing at over 2.25% pa and, had this been continued, output now would have been about 10% higher than in 2007. Output is currently about 3.5% lower than before the recession and the margin between expected output with normal growth of 2.25% and the current position is 14.4%. Unfortunately if growth remains below the historic 2.25%, as is forecast, this gap will continue to widen.

Unfortunately there may not only be no "catch-up", but there may be no return to the growth rate achieved before the current depression. Between Q3 1999 and the start of the recession in Q1 2008 labour productivity rose at about 2.25%. However productivity is currently at 95% of the pre-recession level and at 86% of the level that would have been achieved had productivity growth continued the pre-recession trend. This fall in productivity largely explains the low current unemployment figures as, simplistically, more hours are required per unit of output and as output falls employment does not fall proportionately. It is likely that the long depression will so impair the economy that not only will there be a permanent and continuing loss of output, but there will also be a reduction in the rate at which that reduced output is increased.

A return to a pre-depression economic growth rate is proving like the Holy Grail - as ephemeral as it is valued and still undiscovered, though often heralded. In June 2010, soon after taking office, the coalition Government announced its economic strategy, principally one of fiscal tightening.  However, when the OBR produced its Economic and fiscal outlook in December 2012 its forecast for GNP in the fiscal year 2013-14 was 6.3% lower than it had expected in 2010. Largely because of this poor growth the 2010 Treasury forecast for public sector net borrowing for 2011-12 to 2015-2016 inclusive, has risen from £322bn to £462bn and, according to the Institute of Fiscal Studies, borrowing may be even higher, as the 2012-13 outturn will exceed that forecast level.

Like the Scarlet Pimpernel economic growth is elusive. This bright red flower closes up when overcast, reopening when conditions improve, but, on cutting, subsequent flowering only follows morphological change. Reinhart and Rogoff in their seminal analysis "This Time is Different" distinguish two main categories of downturn, cyclical or inflationary crises and Great Depression Crises, the latter including the current Second Great Depression. For the first category, regaining the pre-recession level of output took two to eight years with an average of four years, but in the Great Depression crises the pre-recession level of output was regained only after four to twelve years with an average of ten years.

The UK economy is already five years into this Great Depression which may well last a full ten years. The Government's view is that the policies are working and that "there is no alternative". Unfortunately, they are not working very well as evidenced by the results and there are indeed several other policy options which would provide better results. The kernel of the Government's policy seems to be to utilise monetary policy to control the economy and fiscal policy to achieve a balanced cyclically adjusted budget i.e. fiscal policy is not an appropriate tool for economic management. The emphasis on monetary policy is reinforced by the appointment of Mark Carney as the new Governor of the Bank of England, who seems to favour further expansion and relaxation of monetary policy and by independent reports of a more flexible mandate. This further emphasis on monetary policy, given that the economy has already been boosted by four years ofinterest rates at an unprecedented 0.5%, and by £375bn of unprecedented Quantitative Easing which has certainly ameliorated conditions but has not gained a recovery, is reminiscent of the aphorism that "the Generals always fight the last war". The Government may be influenced by Margaret Thatcher's handling of the 1979-83 recession whose words Mr Cameron used, "there is no alternative", when she eschewed the Keynesian expansionism then recommended to her in favour of monetary control. In that instance however a peak bank rate of 19% was used to reduce demand (and control inflation), but as inflation fell, rates were slashed to 8.5%, fuelling a massive growth in credit and money, an expansion already occurring due to deregulation, and with such a monetary stimulus the economy recovered rapidly.

In contrast, monetary policy has already been exhaustively developed and alone cannot now achieve dramatic results or even sufficient stimulus to increase growth. Even the current stimuli, the lowest official bank rate in history in place for four years and £375bn in asset purchases has not prevented the broad money supply - equivalent to lending - falling by 12 per cent between March 2009 and December 2012.  The contraction in credit is a clear indication that existing monetary policy is insufficient to effect a recovery.

The policy makers have used several techniques to expand credit starting with exhortation, then moving to "Project Merlin" and now to LFS, as the previous "processes" proved inadequate. The Bank of England Inflation Report confirms that the stock of loans to Private Non-Financial Corporations has fallen 3% to 4% each year since 2009. New loans to small businesses in Q4 2012 fell 6.25% and to medium-sized companies 12.2%. The FLS launched in June 2012 is still in the early stages, but has made little impact. Of the £68bn potentially available, the 39 banks responsible for 80% of lending have drawn only £14bn. However, in the last three months of 2012 net lending by all FLS eligible banks was reduced - not increased - by £2.4bn. Of the major UK retail banks only Barclays - and Nationwide, the Building Society - expanded lending in Q4. The "state" banks, RBS and Lloyds, drew funds under FLS but reduced lending to UK businesses and householders. The Bank says that reduced lending was caused by "The combination of the tight supply of, and the weak demand for, credit ..  .." and the BBA says that eight out of ten loan applications for medium-sized businesses are approved. The Federation of Small Business says more loan applications are rejected than are approved!

The Chairman of the Fed, Ben Bernanke, in his seminal paper on causes of the Great Depression included this quotation:         

"We see money accumulating at the centers (sic!), with difficulty of finding safe investment for it; interest rates dropping down lower than ever before; money available in great plenty for things that are obviously safe, but not available for things that are in fact safe, and which under normal conditions would be entirely safe (and there are a great many such), but which are now viewed with suspicion by lenders".

(Frederiksen D M 1931 Harvard Business Review)

To Frederiksen's "suspicion" may be added "outwith policy". Policy restraints operating on many banks include an overriding need to reduce lending in order to ensure that the lending: capital ratio complies with regulation. If the ratio is, say, ten then any change in the capital requires a tenfold or larger drop in lending. Unfortunately the capital denominator of some banks has been shrinking fast due to past losses and technical changes in its computation, and, in some cases, has not yet taken account of actual but unaccounted losses, all of which require the affected banks to reduce lending, or to raise equity, an option either excessively dilutive or impractical. To attain the appropriate ratio the RBS, Lloyds and Santander UK are all dispensing with "non-core" parts of their businesses. Indeed, some commentators, including John Kay, consider that many central banks' monetary operations, such as the Bank of England's Quantitative Easing from which the public have gained little directly and which have provided little economic stimulus, because in reality a major objective of such monetisation has not been to put money in the hands of consumers and businesses, but to put money in the vaults of the banks. Certainly, the central bankers who disbursed it hoped it might work through to the real economy, but their primary objectives were to underwrite the losses of the banking system and to strengthen banks' balance sheets.

A relaxation of fiscal policy would add additional stimulus to the economy. Indeed, a forced relaxation has already taken place as evidenced by the failure of the present monetary-based strategy to meet the target for reducing the structural deficit. For instance the IFS concludes that by 2014-2015 the fiscal deficit will be £64bn more than planned two years ago.

There are cogent arguments for a measured further relaxation but a main obstacle is that such fiscal changes may conflict with ideology. The Government argues that there is no "magic money tree" and that increased borrowing will threaten the UK's credit rating and increase borrowing costs. However ample lending is available to the UK and at the lowest cost in UK history. The recent Moody's downgrade was due to poor economic growth which austerity has made worse and in practice it has not changed the UK's costs, as indeed it has not for the US. The Government argues further that the deficit reduction plan is not responsible for a reduction in growth but the OBR note that "every forecast .. .. published but the OBR since June 2010 budget has incorporated the widely held view that tax increases and spending cuts reduce economic growth in the short term". Indeed the extent of any such reduction in the current depressed economy may, according to the IMF, be much greater than previously thought. The ratio between tax changes and output, technically the "fiscal multiplier", may now be greater than 1.0 and fiscal tightening could raise the debt ratio as losses in output exceed fiscal gains.

The Government's apparent reluctance to accept further fiscal flexibility is perverse as the UK's net debt as a percentage of GDP compares favourably with other members of the G7, being equal to that of the US and France, but below that of Japan and Italy. Moreover, debt rises in current circumstances are normal as Reinhart and Rogoff show that on average during a banking crisis government debt rises 86%. UK debt was about 30% of GDP in 2008 and is estimated to rise to 76% in 2018 which compares well with 150% after WWI and the 1930s and over 200% after the Napoleonic War and after WWII. The rise in debt is accentuated by the gearing effect on debt of a downturn in GDP. Forecasts for 2012-13 made in 2008 compared with those in 2012 showed that a drop in nominal GDP of 13.6% reduced current receipts by 17.6% but increased public sector borrowing by 372%. However if growth could be restored then there would be an equivalent improvement in the figures. In these circumstances an appropriate fiscal stimulus could contribute to a recovery provided the correct sectors were targeted and such stimulus was accompanied by appropriate reforms.

I write before the 2013 Budget statement and on the presumption that the Eurozone continues its stable unstable condition!   It seems unlikely that there will be an appreciable fiscal relaxation and also unlikely that investment will be redirected from the current "sacred cows" but likely that over the next few months further changes to monetary policy will take place, probably allowing a further devaluation of Sterling. I consider that in these far from optimal policy circumstances a good outcome would be economic growth of approximately 1% this year with a rise in 2014 as the election nears! What is certain is that there will be no swift recovery, no return to pre-crisis growth levels. I wrote in 2008 "Fortunately the recession (depression) will pass, but it will not leave its passage unmarked".

Property Prospects

The IPD Index commercial property returns were 2.7% in 2012, 8.1% in 2011, 14.5% in 2010, 2.1% in 2009 and - 22.5% in the disaster year of 2008. The 2012 return comprised 6.0% "Income" return and -3.1% "Capital" return. Equities returned 17.2%, Property Equities 19% and Gilts 8.8%. Values rose in Central London by 5% but fell 5.8% outside London.

The CBRE All Property Yield in December 2012 was 6.3%, a nominal 0.2 percentage point yield increase in the year. However the 10 year Gilt Yield fell 0.2 percentage points in December 2012 to 1.8%, 4.5 percentage points lower than the All Property Yield. At the market peak in May 2007 the All Property Yield was 4.8% compared to the current 6.3%, or equivalent to a fall in property value of 23.8%, assuming unchanged rents. The All Property Rent Index was 188 in May 2007 compared with 169 in December 2012 which, with the yield change, is equivalent to a fall of 31.5% in value since the peak. Over the year yields of all sectors in all geographical areas without exception were similar or higher, notably for shops outside London and for offices outside London and the South East. The Rental indices for all sectors were unchanged over the year but within shops there were some falls of around 5% in England outwith the South east, but not in Scotland.

The immediate prospects for commercial property continue to be unfavourable, particularly as shown by forecasts derived from derivatives. The All Property contract implies a return of 1.5% in 2013, 3.00% in 2014 and 3.0% in 2015. The expired 2012 contract implied a return of 2.0%, an improvement over the nil return for 2012 implied exactly a year ago. The February 2013 IPF UK Consensus Forecast, which reported that its forecast for 2012 of a 2.0% return compared with the IPD reported return of 2.7%, forecasts total returns of 5.2% in 2013, 7.4% in 2014, 8.4% in 2015 and 7.8% in 2017. The 2013 return reflects minimal rental growth and a further small fall in capital values, but from 2014 onwards both rental growth and capital growth are forecast. Forecasts by individual surveyors of the All Property returns show a similar expected recovery from the poor results of 2012. In 2013 the retail sector is forecast to generate poorer returns than any other sector.

I repeat my previous statement "I see no recovery in the investment property market except in certain specialised areas until 'normal' economic growth returns. In due course there will be a recovery, but the investment market will continue to suffer a secular erosion caused by technical obsolescence, loss of locational primacy and competition from new formats".

House prices changed little in 2012 following little change both in 2011 and in 2010. In 2012 Nationwide reported a fall of 1% (rise of 1%), Halifax a fall of 0.3% (fall of 1.3%) and LSL Acadametrics a rise of 3.2% in England and Wales. LSL observes that the England & Wales market is strongly influenced by London prices which rose 9.9% in the year (2% rise) but only 1.4% outside London (fall of 2%) with some outlying areas falling slightly, notably Wales by1.3% (North 4.0%).

Figures for Scotland are varied, LSL report house prices fell in 23 of the 31 local authority areas in 2012 and by 4.2% overall (1.9% fall) probably caused by falls of over 10% in three Ayrshire council areas, by 17.5% in Clackmannanshire and by 7% falls in Edinburgh and Glasgow. Argyll and Bute prices rose 5.3% the second largest increase. The average price was £140,846 in December 2012 and price falls in the 16 higher priced local authority areas were 0.9% compared with 6.3% falls in the 16 lower priced local authority areas. The two mortgage providers publish contrasting figures for 2012 the Nationwide report a 3.3% fall but Halifax a 5.4% rise (sic).

Independent forecasts published by HMT show an average increase of 0.5% in 2013 with Capital Economics, a long standing bear of the housing market, forecasting a fall of 5.0%. Further increases are forecast by HMT for 2014 (1.7%) for 2015 (3.0%) and for 2016 (3.6%). Interestingly the forecasts for these three years made last year were:  2014 3.2%, 2015 5.0% and 2016 6.4%.

Savills distinguish between "Mainstream" and "Prime" housing markets. UK Mainstream prices are expected to rise by 0.5%, 1.5%, 2.0% and 3.5% from 2013 onwards rising 11.5% in five years, but London prices are expected to rise by 21% over five years and Scotland, like the Midlands and North of England, by around 6.0%. "Prime" housing markets are expected to rise more quickly.

The performance of the economy will be the main determinant of the housing market. Supply from repossessions will be limited by the surprisingly high employment figures and by the continuing low interest rates. Supply of new houses is curtailed primarily by the existing and expected price levels but also by the risk of price falls and protracted selling times.  Demand will be increased by existing Government schemes, which may be extended, including "Newbuy" "Firstbuy" and the Funds for Lending which are reported to have increased sales, particularly for "First Time buyers". Demand will continue to be constrained by rationed mortgage finance, shortage of equity capital and lack of confidence.


We are continuing to endure the longest documented depression in history, already extending much longer than the "Great Depression" of the 1930s which is likely to persist for at least another two years. The depth of the recessions has been limited by the intervention of the authorities and, barring exogenous shocks, such as a "major" Eurozone crisis, the main variables likely to determine the length of the depression are the supply of credit, the extent of any fiscal stimulus and the rate of removal of industrial, social and institutional barriers to growth. Scotland traditionally has a large state sector which will expand with any further transfers of powers, and, while this may provide desired social benefits, will be at the expense of economic growth.

The housing market will improve only slowly, but the continuing reduced level of house construction will reduce the supply, particularly of family homes, while unfulfilled demand continues to increase. We have an increasing number of sites tailored to this market which have gained consent or are likely to do which we propose to develop or to sell.

We continue to promote our strategic land sites and expect that over the next few years some of them will be ready for development by which time the market will be significantly better. In our existing portfolio most development properties are valued at cost, usually based on existing use, and, when these sites obtain consent and are then developed or sold, the considerable upside value will be realised. Over the next twelve months we expect to market fourteen completed houses or house plots with a sales value, excluding the Mansionhouse and staff building plots at Strathtay, of over £2.0m.

I D Lowe           
Chairman                                                                                                                      21 March 2013

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