I wasn’t even able to enjoy George Osborne’s miserable 2011 Autumn Statement with a dash of schadenfreude.
The forecast for UK GDP growth has been lowered to less than 1% for both 2011 and the 2012. I can’t pretend I foresaw such a dramatic downgrade.
True, it’s been nearly two years since I correctly called Britain’s exit from recession, in stark contrast to invariably gloomy pundits elsewhere.
Yet even then I concluded…
Growing public and private debt will constrain consumption and tame future expansion. We’re richer now than we expected to be 12 months ago, but we’ll be poorer in five years than you might imagine.
… which sounds about right today.
I also thought markets would rise – which they did for a while – and predicted higher inflation. It’s over 5%, so I’ll take that as a win, too.
My big miss was on UK government bonds, where I expected gilt yields to rise and that – together with inflation – to send interest rates higher.
Not so far! As it’s turned out, UK government bonds have been a superb investment as yields have steadily fallen. And they’ve been much less choppy than shares.
You can bank on bankers
The truth is I was looking for a return to sustainable growth to drive the key variables I just cited, whereas what we’ve had is more like gentle stagflation.
Partly that’s down to the bludgeoning of embattled animal spirits by a succession of further shocks. In particular, I thought Europe would sort itself out sooner than it has.
I believe Europe has what’s required to deal with its problems. Don’t believe the hype! Italy, as a nation, is loaded. Germany is the sovereign equivalent of Rich Uncle Monty from Withnail and I.
But while its members tussle to discover if that’s true, Euro zone fear has hit all the banks hard (even the UK ones) and confidence has seeped away, which has compounded my bigger error – I underestimated the impact of financial deleveraging.
It’s ironic that having bemoaned the UK credit bubble for many years and predicted its messy end (though I certainly didn’t foresee the US epicenter, nor the exotic machinations), I’ve been too optimistic about how quickly we can return to ‘normal’ (whatever that means).
I partly blame the bankers. It turns out bankers, in aggregate, are even more valueless than I’d previously given them (very little) credit for.
For most of the past decade, they’d lend millions to anyone with an Irish accent and a building site. They geared their banks up to a level that would make a card shark wince.
Now, though, they’re hoarding money like Ebenezer Scrooge caught short at a misers’ convention. Financing for everything from houses to investment to factories has vanished, even for those who look a good credit risk. Today you have to be a great one.
I suspect most of the old-fashioned bankers who actually knew how to assess a loan were long ago put out to pasture. Instead, today’s rocket scientist bankers spend their days trying to figure out how to game capital ratios, and not making very much money for their employers. Meanwhile their prop trading desks have been unmasked as directional punts on the herd (or simply fantasists, in light of fraud at UBS and Societe Generale).
Why we as a society (and as shareholders) still pay these bozos billions more than they deserve for the measly value they add (in aggregate) is for another day.
The point here is that their excessive profits puffed up UK GDP even higher than we previously thought in the boom.
Now the tide has gone out, we’re even more pasty and skimpily-clad than we’d feared.
Unemployment benefits nobody
Bankers would say deleveraging is a problem for society as a whole. Some might even add that excessive debt got us into this mess.
Which is pretty rich, but true.
While I think bank lending is more subdued than it needs to be – I’d happily borrow £1 million today at 4% if I could get it – there’s no doubt many households need to pay off what they’ve already wracked up. With falling house prices outside of London cutting off the other main supply of fantasy money, consumer spending will be stifled for years to come.
While some will lose out more than others, clearly it’s not going to be a great time to be a worker in Britain. Hundreds of thousands more public sector workers are going to be dropped now we’ve belatedly realised we can’t afford them, and their pay is falling fast in real terms, which may be good news for the UK in the long term, but is terrible for the individuals concerned, as well as for GDP and the job market.
Blogger and Monevator reader ermine has posted some comprehensive stuff on dealing with these dark times, writing:
It’s time to get a personal finance tin hat – you need to electively choose to start living on less that your income even if it means doing without things, so you have space to deal with this loss of purchasing power. There’s no point in burying your head in the sand – deal with reality, otherwise reality will deal with you in its own way.
You might also read The Accumulator’s thoughts on cutting spending where it matters least to you.
Whether the government should also be quite so obsessed with its timetable for austerity, given the tiny interest rates it currently pays, is another matter.
I’m not suggesting we don’t need to hack down our debt over a reasonable timeframe and get away from the previous culture of higher taxes and higher public sector spending.
But surely now is the best time to invest in high impact infrastructure, like new railway connections and energy supply, as well as more social housing? Bold and targeted government action could create far more jobs now, when they’re needed, and many of the assets, especially housing, could be sold off in better times.
I’d far rather my taxes went on that than on higher unemployment benefit bills – let alone the other nonsense we still spend too much on.
Don’t bet on GDP
From the standpoint of a private investor, too, I also maintain that panicky action would be a mistake.
While things look dark for Blighty PLC, some of the measures being taken – such as the modestly higher infrastructure announced by Osborne – might help certain UK companies.
I wrote the other day about why housebuilders might make attractive investments, for example. Admittedly it’s already harder to see house price inflation taking off anytime soon, but interest rates also look even less likely to go up. And my main point was housebuilders are already making profits on today’s much lower volumes and prices.
More importantly for investors, though, national GDP growth has been shown to be a very poor predictor of that country’s stock market returns. The lowered outlook for the UK therefore doesn’t say diddly about what to expect from the FTSE.
I plan to write more about GDP growth and equity returns, but here’s a taster of the reasons behind the lack of correlation:
- GDP estimates national output, whereas listed company output comprises just a subset of output
- UK listed companies get most of their sales overseas, anyway
- Slow growth usually means interest low rates (good for shares) and little pressure on wages (good for margins)
- Companies may also be more careful with their cash, reducing wastefulness and empire building
- In contrast, investors get over-enthusiastic in the good times, bidding up multiples to earnings
The last point, valuation, is the critical one. Buying when shares look cheap to fairly-valued (like now, in my view) is much more important than buying when higher GDP growth – or smiling UK politicians – makes it feel good to do so.
UK companies are doing fine, on the whole. They have low debt, and the amount they pay out as dividends is already back above crisis levels. And on a P/E rating of around about 10, they’re still good value.
You seem to have prompted the mandarins into action monevator… central bankers working together before europe blows up… ftse gapped up 3%…please say its grim up north more often!
@OldPro — Yes, the authorities seem to have been forced into emergency action by the lack of banking confidence I mention above threatening to turn into a full on bank run on a Euro bank.
Of course you can apply triage to a patient in intensive care, but that doesn’t get him playing football. As such, we continue to need a fully developed and pragmatic response from European politicians towards solving this crisis.
Probably a basic question, but why does gilt yields rising lower the price, and vice-versa?
If I were buying shares in Vodafone, I’d expect a high yield (i.e. dividends), and would expect it to follow that the share price would rise the higher the yeild. (am I way off here?)
Why does this not follow with bonds/gilts?
Gilts (generally) pay a fixed rate of interest relative to their initial purchase price. If gilts are in demand, usually because they pay higher interest than elsewhere, but can also be because they are seen as safer, then people will be prepared to pay more to purchase the gilt from the holder, which means that actual yield will be lower. Gilts also have a fixed term, after which they are redeemed at original value, so gilts with different dates respond differently to demand. Index linked gilts add further complications!
Yields on equities are different. The yield on Vodafone is high because the share price is depressed but dividends haven’t (yet!) dropped. I say “yet” because share prices will often drop because there is something wrong with the business and investors expect lower dividends and dividend growth in the future. If Vodafone’s share price rises, then the yield will drop unless the dividend also rises. As it happens, I hope that Vodafone’s dividends continue and even growth as I hold some of their shares. 🙂
To answer your original question, what changes gilt yields is what people are prepared for them, so price drives yield rather than vice versa.
Because unlike shares the numerical return of bonds are fixed, subject to the risk of the issuer which are listed in the Ts and Cs of the issue as to what conditions the payment of the coupon and indeed the return of your money can be stopped. Take, say NWBD which originally paid 9 pence in the pound. Say the price falls to 45p, as long as they still pay out 9p each then your looking at a yield of 20%, which rocks. As long as the events that cause NWBD to fall to 45p aren’t of the life-threatening sort that cause them to stoppaying out altogether, that is 😉 Monevator has been trading these of late which is his dirty little secret. I’ve just sat on mine and ridden the roller-coaster, the fixed (though still risky, this isn’t N&SI or government bonds but paper from a bank that has been bailed out by you and I) return performs a valuable service in my requirements for income and I am happy to eat the risk of NatWest/RBS going down the pan. I get about 10% return on the price I bought these at.
I’ve also sat on a few £k worth NWBD and LLPC, and I’m double digit down on both, but the divis from NWBC have kept coming in. I expect them to come good long term, but they do only represent a small percentage of my portfolio.
Thanks for explaining guys! @Jonny, you might want to look at these two articles:
How to calculate bond yields
What causes corporate bond prices to fluctuate
I’d make one other point. While it’s true as the chaps have said that the price which people pay for bonds technically drives the yield (it’s simple mathematics) it’s worth noting that people invariably talk about yields in bond investing, and see changes in the yield (i.e. forces acting on the attractiveness of the yield) as being what drives the price.
This is because with fixed interest, risk is priced along curves that can neatly be represented by the yields on different securities. If the yield on ten-year gilts goes up 1%, you can expect that to ripple across other fixed income investments (and by extension equities, although more faintly, and much more imperfectly).
I used to get frustrated by the way investors and traders would talk about yields as opposed to prices for bonds when I first began investing, but with time I saw it makes more sense.
Re: The bank prefs, I have indeed been trading in and out of these over the past 18 months, as mentioned in various comments but not a full post. (As I always warn, these posts are my hopefully interesting thoughts and ideas, not an FSA regulated broking service… I don’t issue Buy and Sell ratings! 😉 ). I pretty much ended up flat on the deal, as gains on NWBD (I got out at over £1) outweighed losses on LLPC (mainly from the spread).
If the main equity market went up another 15-20% and these didn’t move too much I’d consider reinvesting in them, all things being equal, but they are definitely still a risky special situation investment where all capital is at some risk.
I see the bank prefs as a medium/long-term recovery play, with lots of potential upside. As always, total loss is a risk, but we shouldn’t see the long-term doldrums that could well affect the price of the ordinaries.
@Gadgetmind — I agree, and thought the comments about reinstating the dividend in Lloyds’ most recent results were very promising WRT to the prefs.
Thanks for the explanations everyone, it certainly seems to make more sense now 🙂