Consciousness of Sheep
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The big announcement in yesterday’s budget was not the cut to stamp duty, additional funds for Universal Credit or some extra cash for the NHS. The real showstopper was the announcement that the Office for Budget Responsibility (OBR) had downgraded its growth forecast for 2017 from 2 percent to just 1.5 percent. Worse still, according to Taha Lokhandwala in FT Financial Advisor:
“In 2018, the OBR had expected the economy to grow 1.6 per cent but this has now been cut to 1.4 per cent. The following years up until 2021 have all also been revised down. The economy will now grow 1.3 per cent in 2019 and 2020 instead of 1.7 per cent and 1.9 per cent, respectively. In 2021, the economy is expected to grow 1.5 per cent instead of the 2 per cent.”
The consequence is the British people will continue to see their wages – already lower in real terms than they were in 2008 – continue to fall behind the cost of living. Meanwhile, despite George Osborne’s 2010 promise that the deficit would be cut to zero by 2015, it is now unlikely to be paid off before 2030; meaning another 13 years of Tory austerity if they remain in office.
The UK Chancellor and his supporters have been engaged in damage limitation today, as it became clear that the UK media was not about to be bought off with the belated promise of £3bn to help minimise the damage a chaotic Brexit process is doing to the UK economy. Hammond himself claims to be optimistic, and argues that once there is clarity over Brexit, confidence will return. Meanwhile, the Chancellor’s supporters have been at pains to point out that all of the precious OBR forecasts to date have been wrong. For example, Neil Woodford told David Thorpe at FT Financial Advisor that:
“The OBR has been wrong on productivity over past five years, and as far as I can see, there’s no reason to believe that they will get it right over the next five years.”
This may, however, be cold comfort to those desperately seeking an injection of confidence and optimism into an ever darkening economic twilight. As Thorpe reminds us:
“The OBR has been wrong with previous productivity forecasts, but those errors have been because the body had been too optimistic, rather than too pessimistic, with its forecasts.”
In other words, if the OBR is true to form, a year from now we can expect them to paint an even gloomier picture of the UK’s economic future. However, even the usual downward revision by a fraction of a percentage point may prove to be woefully optimistic because, in addition to ongoing productivity problems, there are several rather big “black swans” circling above the British economy that threaten to cast it down to the very bottom of the G20 league table.
According to Investopedia:
“A black swan is an event or occurrence that deviates beyond what is normally expected of a situation and is extremely difficult to predict; the term was popularized by Nassim Nicholas Taleb, a finance professor, writer and former Wall Street trader. Black swan events are typically random and are unexpected.”
It is the apparent unpredictability of these events that let mainstream economists off the hook for their failure to predict the 2008 crisis. And given the preponderance of the same neoclassical economists in official bodies like the OBR, they are no more likely to be able to spot black swans coming home to roost today. Nevertheless, I can see three giant sized black swans preparing to land as we speak (NB, these have nothing to do with Brexit):
- Oil prices are about to spike
- Firms and households cannot pay their debts
- Central banks are raising interest rates and beginning quantitative tightening.
Oil
Oil prices crashed in mid-2014 in part because of a slowdown in demand in Western economies; in part because projects that had been started years before when prices spiked above $100 per barrel began to come on line; and in part because of the increase in US shale oil and Canadian tar sand production. One result of the collapse in prices back below $40 per barrel was that a lot of exploration and production projects were cancelled. Another result was that OPEC-Russia was eventually persuaded to freeze production. The result is that the oil glut that almost overwhelmed above-ground storage facilities in 2016 has now disappeared. As William Maloney at Forbes notes:
“Today we are approaching a delicate supply-and-demand balance. We see oil prices firming as a result.”
Meanwhile international corporate investment analysts at Natixis have warned investors of large oil prices next year:
“Above all else, the current state of the market shows that OPEC’s sustained efforts to balance markets have had a tangible impact on supply this year. When combined with better-than-expected demand figures, the foundation provided by OPEC has been the springboard for higher prices.
“Although we see prices softening in the short term between Q4 2017 and Q1 2018, we are expecting a sustained rally through 2018, provided OPEC’s deal is extended and fully complied with… At this juncture, we see Brent averaging $63/bbl in 2018 and $68/bbl in 2019.”
The received wisdom is that US shale oil companies will act as swing producers to force prices down in the event that they stay above $60 per barrel for any length of time. That was what happened at the start of the decade, when low interest rates and quantitative easing pushed investors in the direction of risky investments in unconventional oil recovery. However, this is unlikely to happen this time around. Maloney argues that:
“As a world, we use over 30 billion barrels of oil a year. We are currently not replacing the reserves we produce by a wide margin. Additionally, oil fields naturally decline at 5% each year, although I continue to marvel at how advances in technology enable the industry to slow that decline…
“Related to this, some believe that shale in the U.S. can come to the rescue. I would not count on that. Today the onshore U.S. produces approximately 8% of total world oil production. It is hard to visualize a world where shale can take the place of a large portion of today’s conventional oil production…
“The financial markets are pushing companies for even more capital discipline and even further improvements on returns… No longer are the headlines being about growth in reserves. Rather the conversation is all about the growth in profit.”
Amrita Sen at Petroleum Economist is even more pessimistic. He argues that forecasts for slow growth in petroleum demand are wrong:
“Until recently, 100m barrels a day of global oil-product demand seemed a distant prospect. In its World Energy Outlook , published in November 2016, the International Energy Agency’s (IEA) central scenario didn’t think consumers would reach this landmark before 2024. Strong recent tailwinds—particularly from China, India, the US and Europe—have, however, brought the milestone perilously close. We think it will be reached by mid-2018.”
According to Sen, the US shale patch will indeed ramp up production as prices increase. But, echoing Maloney, Sen argues that it will make no difference:
“The fear in the market is that $50-55 oil will unleash a torrent of shale that will overwhelm demand. But look again at the demand-growth trend of recent years. If demand is growing three times as quickly as tight oil output, shale on its own won’t be able to plug the gap. Some of shale’s shine has come off recently too. Several banks have begun changing their tune on tight oil breakevens and many equity analysts are starting to downgrade their producers.”
While the 2008 crash has come to be blamed on sub-prime mortgages, this is only a part of the story. In a sense, the lending practices of the banks were the fuel for the conflagration rather than the spark that set it alight. That spark was an unexpected rise in interest rates. Without that increase, sub-prime borrowers would have been able to continue servicing their debts. The additional interest pushed too many of them into arrears. This, however, should cause the inquisitive mind to ask why interest rates were increased. The answer: oil prices.
After the peak of conventional oil production in 2005, oil prices began to rise sharply. The conventional wisdom among central bankers is that an increase in the price of oil will result in generalised inflation across the economy as production and transportation costs are driven higher. While this is not actually correct, they responded as if it was. They raised interest rates and triggered off the worst economic crisis in human history.
No doubt this time around they will claim that global oil shortages and consequent rising oil prices were a black swan that they could not be expected to foresee. But given that 10 out of the last 11 recessions were immediately preceded by rising oil prices, this speaks volumes about mainstream economics rather than about how we should view events in the real world.
Given how hard pressed ordinary people across the developed economies are, it is most likely that a sustained period of rising oil prices will trigger another recession – the only question is how deep that recession will be.
Private debt
Like the USA, Britain has become something of an “interest-only economy.” The main reason given by the Bank of England for the recent rise in interest rates is that levels of private debt in the UK have risen to pre-2008 levels.
Low interest rates have helped zombie households and firms to service their debts even though many have almost no chance of actually repaying them. At the same time, low interest rates have forced investors to accept an interest-only arrangement in which unprofitable firms continue to pay dividends despite putting investment capital at risk. The alternative – once we account for inflation – is that investors would be getting a negative return on their capital from safer investments.
All else being equal, so long as investors do not ask for their capital back, this arrangement might continue indefinitely. The problem is that all is not equal. Indeed, the collapse in the value of wages for the majority of ordinary workers even as those at the top get ever wealthier, has translated into a two-tier economy that is now translating into falling sales across the economy.
In the USA, the “retail apocalypse” has been brewing for some time. However, a growing number of UK retail outlets are also experiencing a severe slowdown; with some claiming to be just one bad Christmas away from bankruptcy. Although some of the losses can be attributed to the switch to online shopping, it is increasingly clear that large numbers of consumers have simply changed their purchasing habits – buying cheaper brands and buying less often.
This already dire situation may be about to get even worse if trends in the USA are repeated on this side of the Atlantic. According to Pedro Nicolaci da Costa at Business Insider:
“Americans are having increasing trouble paying their credit-card bills, a potentially ominous sign for an economy reliant on consumer spending for some two-thirds of overall activity.”
According to da Costa, credit card borrowing in the USA is back to 2008 levels; suggesting that households have been maintaining their consumption by taking on increasing debt. In and of itself, this does not threaten the wider economy:
“Unlike the mortgage market, the just over $1 trillion or so in outstanding credit-card debt does not appear large enough to pose a systemic threat to the banking system in a $19 trillion economy.”
This is not, however, a reason to be complacent. An increase in the numbers unable to service their credit card debt could be an indicator of something much worse on the horizon:
“The short-term risks from a blow-up in the credit-card sector are not an immediate economic or financial risk per se but could be an early signal of other mounting troubles for other sectors, which together could present considerable challenges to the economic outlook.”
In both the UK and the USA we have seen bubbles develop in car-loans, mortgages and household debt. We have also witnessed households at the bottom of the income ladder using credit card debt to pay their bills. If the increase in defaults (“delinquencies” in the US) is evidence that problems are creeping up the income ladder (as we might expect given the downward pressure on wages), then the danger is that defaults begin to spill over from the relatively small credit card bubble into those areas of debt that could cause another 2008-style collapse.
Interest rates and quantitative tightening
For the best part of a decade, the US Federal Reserve, Bank of England, European Central Bank and the Bank of Japan have worked together to enable the interest-only economy as the best alternative to a complete collapse of the international monetary and banking system. Faced with a complete meltdown in 2008, they cut the base interest rate close to zero (not that we mere mortals got to borrow at that rate) while simultaneously pumping money into the banking sector by buying up government bonds.
That process of “quantitative easing” had never been tried before. And while it has kept the banking sector on life-support, each time the central banks have attempted to withdraw the stimulus, the patient has gone into cardiac arrest. The result is that in addition to “QE1” we have also seen QE2 and QE3.
Last year, however, the US Federal Reserve began to jack up interest rates and announced that they would begin the process of quantitative tightening – selling back the bonds that they had previously bought. This year, the Bank of England and the European Central Bank have indicated that they intend doing the same.
The somewhat warped reasoning behind this is that the central banks need to increase interest rates to three percent or more prior to the next recession to provide them with a cushion to bail out the system once more. The problem with this stems from the relationship between bond prices and interest rates. The higher the price of bonds the lower the interest rate (and vice versa). The trouble is that once bond traders know that the central banks want to sell bonds, they can force prices down simply by refusing to buy. Only a fool would buy government bonds at a time when central banks are flooding the market with them. Indeed, only a fool would not try to sell their bonds before the central banks let rip. But if everyone is selling bonds while nobody is buying, the central banks will lose control of interest rates – in effect overshooting their three percent target and imposing unsustainable rates of interest on an economy that is already struggling to make ends meet.
The black swans are circling overhead
It is entirely possible that all three of these circling black swans may come home to roost in 2018. If they do, they will make current concerns about low productivity and falling wages look trivial. And these are merely the most obvious economic clouds on our darkening horizon. The inevitable failure to cut a post-Brexit deal with the EU27, the collapse of the City of London once it becomes obvious that the UK will not continue to enjoy “passporting rights” in the EU, the coming collapse of the North Sea oil and gas industry (which might otherwise have sheltered the UK from rising oil prices), and the likely relocation of a swathe of UK manufacturers to new locations inside the EU are each potentially economy-destroying events.
Of course – as Yogi Bear once exclaimed – “prediction is really difficult… especially about the future.” It might be that the black swans I have outlined here will pass us by. It might be that Chancellor Hammond is right to be optimistic. The problem is that there is no evidence for that optimism. On the other hand, the UK economy already looks like a highly desirable landing strip for the growing flock of black swans that are circling overhead.
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