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Don’t get too excited about Britain’s economic recovery. It’s built on shaky ground

25 July 2014

11:03 AM

25 July 2014

11:03 AM

When I think about global stock markets these days, the image that springs to mind is the final scene of The Italian Job— the 1969 original, not the tacky 2003 remake.

‘Hang on a minute, lads,’ says Charlie Croker, Michael Caine’s heistmaster-in-chief, as he and his rogue brethren balance precariously in a bus loaded with gold on the edge of an Alpine cliff. ‘I’ve got a great idea.’

The film ends ambiguously, of course. As the credits roll, viewers are left guessing as to whether the gang manage to get the loot and themselves to safety, or plunge into the depths of a ravine. Well, I’m similarly ambiguous about the state of global markets and the related prospects for the world’s large economies, not least the UK. It strikes me, in fact, that the whole economic shebang is balanced on a cliff edge.

There’s no shortage of commentators (and stockbrokers) insisting the outlook is rosy and share prices will keep on rising. And almost all political punditry assumes the UK economy is improving fast and, as next May’s general election approaches, will get better still.

Yet alarming evidence is amassing that the global recovery is shaky, stock markets are over-hyped and the large western banks, for all the talk of reform, remain a serious liability. The reality, and it gives me no pleasure to write this, is that we could see a re-run of the ghastly credit crunch of 2007/08.

America, still the world’s largest economy by far, contracted sharply during the first quarter of this year. US GDP fell at an annual rate of 2.9 per cent on official figures, the first drop we’ve seen since the dark days of 2011. The eurozone, meanwhile, remains on the brink of recession, with GDP across the 18-nation currency area expanding a mere 0.2 per cent.

Despite this lack of growth, stock indices in the US and across the western world have repeatedly hit all-time highs in recent months. No matter that GDP is contracting or that US first-quarter corporate earnings were down 3.4 per cent. America’s S&P500, the world’s most watched stock index, has broken its daily closing price record more than 20 times this year.

The reason, of course, is the Federal Reserve’s money-printing machine. Since ‘quantitative easing’ began in response to the late-2008 collapse of Lehman Brothers, the Fed has created thousands of billions of virtual dollars, with the Bank of England chipping in hundreds of billions of similarly computer-generated pounds. Much of this has found its way into global stock markets, sending equity prices sky-high. Designed as an emergency measure, QE has since become a lifestyle choice, the financial and political equivalent of crack cocaine.

While the Fed has begun ‘tapering’, slowing down the rate of its de facto money–printing, the scale of QE remains vast, some $45 billion a month. That’s driven the absurd ‘bad news is good news’ mantra that still dominates the thinking of investors on Wall Street and other major stock markets. Weak economic numbers make it more likely the Fed will relent and slow down or even reverse its tapering, turning up the funny–money dial, and thus stock prices, even more. Forget economic growth and forget corporate earnings. It’s all about the Fed.

This blatant rigging of western equity markets has gone on for several years, with stocks soaring despite weak economic fundamentals. While everyone in financial circles knows this, to say as much out loud is to guarantee pariah status — and I should know. But eyebrows are now being publicly raised by genuine insiders, with the Swiss-based Bank for International Settlements, an umbrella organisation for the world’s leading central banks, warning of ‘euphoric’ equity valuations. ‘It is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally,’ it argued in its annual report published earlier this month.

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Systemic global risks today may be greater than before the Lehman crisis, the BIS warns, as debts have risen. Across the developed world, the average combined public and private debt ratio is at 275 per cent of GDP, compared with 250 per cent in 2007. And no less than two fifths of new syndicated loans are now sold to dodgy ‘sub-prime’ borrowers, the BIS adds — above the pre–Lehman high.

With QE having pumped up credit markets across the developing world, as western investors have ‘searched for yield’, many of the large emerging markets are now in the throes of a dangerous credit boom. Such countries have taken on over $2 trillion of foreign currency debt since 2008, the BIS points out. Having helped stabilise the global economy after the last credit crunch, even helping to pay for western bailouts, the big emerging markets now themselves pose systemic risks.

It’s undeniable, for those willing to look, that numerous technical stock-market indicators are now flashing red. For one thing, the S&P500 sports an average cyclically adjusted price-earnings ratio of 25.6, according to Professor Robert Shiller of Yale University. That’s way above the historic average of 16.5, suggesting prices are unsustainably high.

Trading volumes, meanwhile, are wafer thin, with just 1.8 billion shares trading daily within the S&P500 over recent months — that’s a six-year low. High valuations and low volumes amount to classic crash conditions. Yet still the rally continues — because investors can’t quite bring themselves to believe that the Fed will fully implement the planned end of QE in October as planned, or raise interest rates from ultra-low levels any time soon.

So we’re now in a situation where US stocks have gained over 200 per cent since 2009, despite the lack of a convincing economic recovery. Last year, the S&P500 rose no less than a third. European equities have surged 15 per cent in 12 months despite practically no growth and a 3 per cent cut in expected earnings. Western share prices generally have ballooned amid slow profit growth and still deep-rooted concerns about where the world economy is actually going. As such, global equities valuations are detached from reality and propped up by printed money.

Authoritative figures are now speaking out, going further than the BIS ever can in explicitly criticising central banks and pointing to the dangers still posed by a largely unreformed western banking sector, particularly if QE-primed equity markets collapse.

‘I would be extremely wary of stock markets right now,’ says Professor Michael Dempster, co-founder of the Centre for Financial Research at Cambridge University. ‘The last crisis was caused by cheap money and it’s happening again via QE, which is very, very worrying. QE started as a way of priming the pump, but no one knows how to turn it off without causing financial havoc.’

Dempster is particularly concerned about the growth of derivatives, designed for the legitimate hedging of risk but famously dubbed ‘weapons of financial mass destruction’ by American investment guru Warren Buffett.

‘Derivatives are now all about playing games, creating confusion to hide losses,’ Dempster says. Total global derivatives outstanding currently amount to $620 trillion, he calculates, a jaw-dropping ten times global GDP and back above the pre–Lehman total.

‘Credit derivatives were a major cause of the last crisis, but now the Fed and Bank of England are pushing banks to buy them again,’ he says. ‘Central banks are encouraging securitisation again [pooling of debt into investments that can be traded] — all the things that originally got us into trouble.’

Anat Admati, professor of finance at Stanford University, is similarly concerned. ‘Derivatives allow significant risk to build within the financial system, and with extreme opacity,’ she says, ‘exacerbating the fragility of the system.’

Admati points also to the failure of policy-makers to reform the ‘too big to fail’ western banks at the heart of the worst economic collapse in almost 80 years. ‘Our financial system remains bloated, inefficient and reckless,’ she says. ‘It endangers innocent citizens unnecessarily and distorts the economy to benefit the few. This recklessness isn’t only tolerated but, perversely, encouraged and rewarded by flawed policies and ineffective regulation.’

Admati pillories the official attempts to fix our banking system. ‘Supposed tough reforms are just tweaks to the previous rules that failed spectacularly, maintaining key flaws,’ she says.

Dempster concurs, observing that ‘nothing much has been addressed in terms of bank reform’. He points to ‘an awful lot of gaps in Dodd-Frank’ — the legislation at the heart of America’s renewed attempt to control its biggest banks. ‘And the Vickers reforms don’t go nearly far enough,’ Dempster adds, referring to UK safeguards, to be implemented by 2019, that rely on ‘Chinese walls’ between the retail and investment banking arms of large UK banks.

‘Chinese walls don’t work,’ says Dempster. ‘Glass-Steagall should never have been taken down,’ he argues, referring to US legislation that, between 1933 and 1997, kept such activities in separate companies, insulating taxpayer-backed deposits from risky investments. ‘It was the reason we had a reasonably stable banking system for almost 70 years.’

The balance sheets of the six largest western banks totalled $14.6 trillion at the end of 2012, compared with $10.7 trillion in 2007. In March, the International Monetary Fund admitted such banks still receive annual implicit subsidies of $590 billion, with creditors judging that state bailouts will indeed be forthcoming when reckless, highly leveraged investments go wrong. This flies in the face of political rhetoric that the problem is solved and taxpayers will never again have to bail out bonus-fuelled traders.

Both Admati and Dempster complain that the closeness of our political and financial classes is stymying genuine banking reform. ‘There’s a lack of political will to challenge bank lobbies,’ says Admati. ‘If I was Obama, I’d tell Goldman to get lost,’ ventures Dempster, ‘but that’s not how the world works.’

This autumn, as the end of Fed ‘tapering’ and rising interest rates loom larger, overvalued western stock markets will come under intense pressure. Our largely unreformed, debt-soaked, loss-hiding banks mean a sharp asset price correction could spark a systemic crisis, involving not only the ‘advanced’ world but the large emerging markets, too. I don’t want it to happen, but there’s a good chance it might.

As The Italian Job ends, viewers are left with a strong impression that Charlie Croker’s ‘great idea’ will somehow resolve his gang’s predicament, using the same nous that outsmarted the Turin police. That’s where the analogy ends.

Liam Halligan has written the Sunday Telegraph’s ‘Economics Agenda’ column since 2003.

This article first appeared in the print edition of The Spectator magazine, dated 

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  • Guest

    I thought this was signifying the UK adopting Islam.

  • asalord

    Looks like an independent Scotland will be in good financial shape:

    Investors Chronicle (part of the Financial Times group), 25 July 2014:

    “In the 12 months since we recommended EnQuest (ENQ) as a speculative buy
    option, the share price of the North Sea independent has oscillated
    within a relatively narrow range (-11p/+16p) either side of the current
    share price of 132p. The relative stability (or stagnation) of the share
    price – depending on your point of view – is partly attributable to
    repeat production delays on the Alma/Galia project.

    But oil from the 34m barrel development is now imminent, which will help to
    shore-up near-term sentiment, particularly if output is cranked-up in
    fairly short order. However, even beyond the immediate quest to bump-up
    EnQuest’s daily production volumes by another 13,000 barrels, the
    driller’s strategic focus on exploiting maturing assets and
    underdeveloped fields in the UK North Sea places it in an ideal position
    to benefit from likely regulatory reforms, and we recommend buying in
    anticipation.

    We think that Westminster has been deliberately downplaying the potential
    of the UK Continental Shelf (UKCS) ahead of September’s referendum on
    Scottish independence.

    The Department of Energy has certainly been far more subdued than it was at
    the time of the February publication of Sir Ian Wood’s preliminary
    findings on the future of offshore oil & gas in the UK.
    According to the report, the UK economy could generate £200bn over the next 20
    years through the recovery of only 3-4bn barrels of North Sea oil and
    gas. Many analysts believe that the potential is much greater.“

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  • CraigET

    I share your pessimism. If you measure the health of an economy by the total value of all transactions A.K.A GDP, then a general increase in prices would look like an increase in GDP, even though no real growth has occurred. What today’s numbers represent is inflation, officially reported as around 2%, yet anyone who counts what they spend will know it is closer to 10%.

    A conversation with the ordinary man will always tell you more about the economy than a conversation with an economist. From what I see and hear we are in a recession.

    • lgrundy

      Exactly. I’m on average earnings and I’m getting poorer and poorer with every passing month and have been for nigh on 4 years. The decline in my standard of living is becoming quite dramatic and all of my friends – including those who earn considerably more than me – are in the same boat.

  • what a coincidence

    Well, its amazing this made up recovery is coinciding with the Scottish referendum.

  • Makroon

    The DT has it’s gruesome twosome – Warner who specialises in random daft scare stories and AEP who specialises in “broad-brush” apocalyptic fantasies.
    Now old Liam Halligan (who I remember as a chirpy, interesting,economic commentator on Channel 4), has joined the darkside – speciality: dark hints at poorly specified “perils ahead”.
    Bit of a waste of a decent commentator really. I guess the DT pays better.

  • Ordinaryman

    I would have thought that a true recovery would be based on the value of the end products manufactured in the UK and sold outside the Stirling area. If the “recovery” is based, in the main, on services, then it is a cost to the national purse or, if it’s a service provided to overseas clients, is ultimately added to the price of the imported goods that the consumer purchases. As a nation we are a net importer of end products, therefore, the so called earnings of the service sector are, in fact, a financial loss.
    In other words, if we don’t export more end products than we import, we are in deep, deep trouble regardless of how it’s glossed over.

    • Makroon

      Well, you thought wrong then.

      • Ordinaryman

        I’m only too willing to learn. Please explain why I’m wrong. At the very least it may give me reason not to worry so much.

  • swatnan

    when I saw that photo, I honestly bthought bit was someone dressed up in a burka; and not the Gerkin

  • English Majority

    What Recovery?

    Maybe you haven’t noticed, but due to decades of immigration, multiculturalism and Islam, we’re now suffering permanent austerity, unpayable colossal debt, a crippled NHS, low wages, and a savage housing shortage/housing bubble that can never be fixed.

    There is no Recovery. This is a slow collapse.

    • Jack

      When were the Left in power? You can’t mean Blair, surely.

      • English Majority

        The Left have been in cultural power for decades, hence our present terrible situation.

  • anyfool

    The West is relying on China as a white knight, but the white knight is riding a horse that will be in the knackers yard anytime soon.

  • The Masked Marvel

    It’s not built on a bed of roses, no. But there’s no doubt the fragile ground is at least real and not the smoke and mirrors on which the boom years were built.

  • global city

    Why has somebody placed a Burqa over the Gerkin?

    • Mr Grumpy

      Beware of Trojan Vegetables.

      • global city

        Definitely!

        I see about 25 people beat me to the burqa gag?

    • anotherjoeblogs

      If you put a mask on the Gherkin, it becomes a merkin.

    • English Majority

      I also saw the headline pic as a Muslim egg-woman in a Burka overlooking London.

      Quite fitting, in a way, given that Muslims are one cause of our economic collapse.

      • global city

        Stick on a crescent and a tannoy system and hey presto…..!

  • Mr Grumpy

    I’ve reached this via a picture of a large pointy-headed person in a burqa. I’m not sure I understand the connection.

    • Holly

      Subliminal.(ish)

    • anotherjoeblogs

      Same here. We have burkhas on the brain, Mr. G

      • Mr Grumpy

        Not what you want on the brain in this kind of weather.

  • JoeDM

    The real economy is still adjusting following the crash. It will take a long, long time !!!

    • Blindsideflanker

      I would agree with you that it will take a long long time for the 2007 crash to unwind. The 1920’s crash took 25 years to unwind, and then it was WWII that created the change.

      Unfortunately George Osborne is not fundamentally changing things, for nothing has materially changed about our trade deficit which remains stuck at £80 billion a year. When you get past all the slick financing and funny money, this is a bill that has to be paid. Just like Gordon Brown, George Osborne is hiding our trading deficiencies in a bubble housing market which he has created for electoral requirements.

      Osborne and Cameron had the chance to change our nations prospects , but they didn’t, they were the wrong people to have around at the wrong time. When they should have been preparing people for the consequences of Brown’s fiscal incontinence they were seeking to ‘ share the proceeds of growth’ , as a result our economic woes got blamed on the bankers, and we are back on the roller coast ride of another economic bust.

      • Colonel Mustard

        They should have ruthlessly cut Labour’s unelected shadow government to the bone, canned overseas spending and reduced taxes, including VAT, to encourage growth. Basically the economy is being structured to support government spending rather than government spending being structured to the economy.

        Government ‘Big State’ spending is out of control with a PM who signs up for more borrowing every time there is a call of ‘something must be done’. Instead he should have had the courage to say “We simply cannot afford it”. Difficult when huge bonuses were still being paid and the top public sector salaries were emulating the private sector.

        Labour know what they are facing and they too are trying to squeeze the economy (by inventive taxation) to pay for ‘big state’ spending.

        • Blindsideflanker

          Because Cameron and Osborne had thrown in the towel on the economy, in fact stating that the 2010 election wouldn’t be fought over the economy (god how wrong could they have been) the public were never prepared to what was economically facing them, with the result the economic medicine was never administered.

          Though an ardent critic of Osborne’s economic management, I wouldn’t criticise him on raising VAT rates. One thing our economy has never suffered a shortage of is consumption, unfortunately as you say he didn’t do the rest of what was needed, i.e rip the guts out of state spending. He also needed to keep a lid on the housing market instead of inflating it.

          I look at the Osborne economy and really don’t see much difference to the Brown one, the structural shift that needed to take place, hasn’t, and I fear we are back to the boom and bust, for we have the debt, we have the bubble housing market, we have the unsustainable consumption, and we have the rising sterling waiting for the inevitable interest rate rises, and so have the makings of the next bust.

        • HookesLaw

          Encourage growth? we have growth. You are just spouting ballsonomics.
          Spending is not out of control. You only need to look at the actual figures to see where it is being cut back.
          For instance in 2011 ‘Other Spending’ was 89 billion; in 2015 it is set at 86 billion.
          In 2012 ‘Welfare’ was 112 billion; in 2015 it is set at 110 billion.
          How is that a sign of being ‘out of control’ ?? ts a sign of you not knowing what you are talking about.

          • Colonel Mustard

            There is no contradiction between encouraging growth and actual growth.

            “For instance in 2011 ‘Other Spending’ was 89 billion; in 2015 it is set at 86 billion.”

            £3 billion and £2 billion reduction. Big deal. Cameron hosed £11 billion overseas on foreign aid.

            It’s not about how much is being cut, paltry though that is, it’s about how much is being spent and on what. State spending began climbing steeply from about 1999. In 1981-2 it was less than £40 billion. So yes, it’s out of control alright.

  • Peter Stroud

    Liam Halligan sets a very depressing scenario, but I trust his judgement above many other economic commentators. We, and the USA, are generating far too much funny money

    • Blindsideflanker

      Not only are we creating too much funny money, our budget deficit is no longer being reduced, and our trade deficit is stuck at historically high levels.

      Gordon Brown’s ‘economic miracle’ was based on a bubble housing market that was underwriting consumer debt and a bloated public sector.

      Wunder Kind George Osborne has created another bubble housing market, that is still the driver of the economy, still underwriting an unsustainable trade deficit, and still underwriting bloated public spending, but this time we have added the toxic funny money.

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