What Happens if (or when) the Euro Zone Cracks?

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Europe is still wrestling with this issue and that is not surprising given the scale of it.

In many ways it is a “Catch-22” situation (with apologies to Joseph Heller).

As the debtor nations in the Eurozone struggle to conform to the stringent fiscal constraints placed upon them to balance their public and private spending, the short term impact is that demand in the economy (and hence economic activity) declines. This cuts tax receipts and increases social welfare making even more cuts a necessity. Catch-22.

Fortunately it is not a ‘bottomless pit”.

As one famous American Economist once put it, economy’s work despite the Government’s best efforts, but in the meantime it certainly isn’t comfortable.

And the UK is not immune – and is in fact one of the basket cases.

When the recession started in 2008/2009 people started talking about “the spectre of deflation”.

At the time we said it was nonsense and so it proved to be.

But times have now changed.

The spectre is now real.

“Why?” you may ask.

Well, we have reached the point where Government spending cuts at home and in Europe are becoming painful realities not just for the “frothy minority” parts of the public sector (the special interest clubs and quangos who looked after the welfare of ever-smaller groups of vulnerable minorities) but for mainstream services.

Especially so in places such as Spain, Italy, Greece and Ireland.

There is now an increasing possibility that some re-alignment within the Eurozone will be necessary.

What does this mean?

Essentially it means that the “debt” in these countries has be “re-based”. Techno-babble I hear you say. Indeed it is.

What it means is that by some sleight-of-hand the Eurozone manages to “devalue” the “Euros” in the heavily indebted nations.

It is tricky to achieve because allegedly they are all locked together in the one currency.

How can a Euro be worth “less” in one country than in another?

Well as things stand at the moment it can’t but do not underestimate the skills of bankers and politicians.

Our view at the moment is that the Eurozone will crack – not explode.

Like an earthquake fault-line, a method will be found to re-align the nations finances so that they can begin again – and this time be more careful in how they manage their finances or risk the wrath of the mighty Bundesbank who will not let them off the hook next time round.

Once the method for allowing this re-alignment has been defined, it will have repercussions though – particularly for UK plc.

What it amounts to is an Orwellian re-badging of “defaulting on sovereign debts”.

It is what the Bank of England has done with some success since 2008 owing to its policy of “QE” (expanding the money supply to allow inflation whilst keeping interest rates close to zero so that this in turn erodes the value of the debt). No wonder Mr King is looking forward to stepping-back from the limelight.

The currency depreciates and all is well in the financial markets.

And it is all paid for by UK pensioners.

In the Eurozone, the mechanism that has been spoken about so far (though not too loudly) is the issuing of bonds by the debtor nations.

But issued in such a way that they are somehow disconnected from the Euro.

Tricky to achieve but we’ll see. I’m sure there are a few traders from the derivatives market who would be willing to have a go at it.

Once the mechanism has been found, however, the problems do not end. They actually just begin.

It will relieve some of the stresses within the Eurozone but the economies will still be flat on their backs.

The UK will struggle to do business with a Eurozone that is moribund and the UK too will continue to ‘flatline’.

That then, is what brings the spectre of UK deflation.

The Bank of England has probably now used up all its slack on QE. Expect some more to come but we must be nearing the end of that road.

With interest rates low, economic growth low, government spending unable to be expanded, and money supply expansion left impotent, companies will start to cut prices to try to attract business and achieve their sales targets. The price cuts we have seen so far will look like weekend deals.

There is tremendous productive capacity in Asia that will enable companies in the UK to cut prices and still make profits.

What stops them so far is there has been no need to do so up to now.

Will this matter? Well it well to UK-based businesses that produce mass-market products that can easily be produced elsewhere.

According to McKinsey – that amounts to about 60% of all UK industrial production.

And that is the big area of risk for the UK. If UK-based business start to come under intense pressure from abroad – as seems increasingly likely – the only place they can go to reduce their costs is reducing wage bills. Either by laying people off or cutting wages. We are not there yet but that takes us towards “depression” – not a good place to be.

Against all this backdrop the need for scenario planning, having a baseline sales projection and series of alternative scenarios mapped-out, has never been greater.

Fortunately the data sources to enable such scenarios to be run have never been better. It may not be pretty, but it should be manageable.

So our advice at the moment is to plan for the worst and build capability to quickly exploit opportunities if they arise.

Counting on a rosy future come what may is not a good basis for business planning just now.

We will see what happens.


Banking on Growth?

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In his interviews with the media last week the governor of the Bank of England was quite candid. Firstly, whilst insisting the bank acted independently of parliament the fact that he felt the need to justify that independence at all is naturally quite telling. The issue is that the headache for the government is also a headache for the BoE. Extensive debt, bloated by the need to prop up the banking sector of which the BoE is the custodian.

The second telling point was that he actually did look genuinely concerned that the necessity of the Bank’s actions would, as a direct result, decimate the savings of pensioners and anyone else with a nest egg they have been nurturing.

Thirdly, he also felt the need to clearly state that the Bank was still committed to monetary stability and low inflation – it’s just that this will have to take a back seat for a while until the real value of the debt that the government owes has been materially diminished.

These are probably the closest thing to an admission that one is likely get that a key part of the strategy for dealing with debt is to reduce it’s value through high – but controlled – inflation. But there is the rub. Inflation can easily take hold and accelerate. There is a limitto which real incomes can be squeezed before people – especially those in the public sector – begin tonight back. I do not think we are at that point just yet – but come Spring of next year, if inflation has reached 6% or higher then it will be highly likely that it will not come down again for at least 3 years.

Is economic growth the answer? The Bank does not think so. It openly admits that much of it’s new round of QE is likely to simply fuel inflation. There is a possibility that this will, in turn, put downward pressure on the exchange rate but the crisis in the Eurozone may undermine this hope – possibly sending the pound in the wrong direction.

So where are we?

Well the way things are panning out, our views remain much the same as they have been for the past 3 years. Now is a good time to borrow – interest rates are low and inflation is set to stay high for at least another 3 years and if it now gets out of control it could erode the real value of your borrowings even quicker. Keep some cash in reserve of course, no need to be reckless (!) but it’s a good time for some consumerism.


Now It’s official

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It was reported last week that the Bank of England recently issued a report which confirmed that its programme of quantitative easing (printing money) had increased the UK inflation rate. The ‘official story’ is that it added 1.5% but that, of course, is unlikely to be the real figure – that is the politically acceptable figure. Independence only goes so far – and even people at the Bank of England like to hold onto their jobs.

Regular Schezzer readers will be aware of our previous “what to expect” articles on the economic front and so this news will come as no surprise to them. For others, welcome on board!

The report also concluded that QE did boost the economy as well, it was not all inflationary. But this is true more-or-less by definition also. The more fundamental point is that it increased inflation. This actually means that the boost “topped-up” economic activity – it did not act as the cure for an impending deflationary depression, talk of which greatly exaggerated at the time to lay the ground for the ‘printing money’ policy.

The real problem the authorities find themselves with is that it did not produce enough inflation.

The debt burden is still high and the slow down in world economic growth makes it harder for us to pay our way. So the odds are now strongly in favour of the likelihood of more QE happening this Autumn. So expect inflation to remain at well above 5% at least until 2013, and as we mentioned last time, the risk is that it will go even higher if the inflationary spiral kicks-in.

So the bottom line is still – as we have been saying since 2009 – that now is a good time to spend and to borrow – because prices in the near future will be much higher than today, and with savings rates at artificially pathetic levels and stock markets providing returns that would be unlikely to support a large family let alone the whole nation, savings should be minimised.

How much to save?

Someone reading our comments above could be forgiven for interpreting our advice as being not to save at all. This would be incorrect though.

Analyses of the motivations for savings indicate that there are 3 key reasons to save. The first is ‘precautionary’ or, ‘saving for a rainy day’. The amount you need for this is easy to calculate. It is about 3 times your essential annual outgoings. What you class as “essential” is clearly a personal preference (!).

The second is savings that are made to afford a better life in the future. These are discretionary and if you do not have a specific near-term goal in mind (such as buying a house or buying a plane ticket to emigrate from the UK because things are so bad) then this is the type of saving it’s worth economising on.

The third type is savings through financial instruments. This includes everything from insurance policies, life assurance and stock Market ISA’s to pension plans. These are the investments that should be avoided. There was a great poster ad for an insurance company a couple of years back which put it well. It asked people what their reasons were for choosing a pensions provider. The best response ever was “I want a pensions company that won’t retire before I do”. Enough said.


The Return of Stagflation?

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The Bank of England Governor cannot say it. Politicians dare not admit to it. But the truth is, high inflation and low interest rates is a most effective way to reduce the debt burden. It has been used before in the 1970’s and will no doubt be used again in the future.

It is basically a way of defrauding the public. Rewarding borrowers and penalising savers. In the 1970’s vast numbers of people saw the value of their life savings wiped out in just a few years by inflation rates of up to 25%. We’re not there yet.

But the difficulty, which we are now beginning to have to struggle with is that once you have released the Genie from the bottle it does tend to have a mind of its own. What we can see happening now is things may be beginning to unravel.

It looks worrying. Not helped by the turmoil in surrounding the Euro.

When “QE” was first announced in 2009 we highlighted (“So the nuclear button has been pressed then!”, 6th March 2009) that:

“Well it will take at least 18 months to feed through but come the middle of 2010 prices will be rising strongly whilst interest rates will still be being held artificially low at close to zero percent.”

We also went on to say:

“The risk this raises, though, is that the government will wrongly see any "lack of progress" in its official statistics as evidence that the medicine isn’t working and so administer more of as we get towards the second half of the year.

The result would be that by 2012 we could be in an "unwise boom" with already relatively high inflation being fuelled by previous decisions taken to stimulate the economy which cannot quickly be reversed.”

Well the new Tory government has not yet lost its nerve and taken steps to over-stimulate te economy which is good. But at the same time they are actively considering a further round of QE (and may quietly be implementing it even as we speak – they are under no obligation to reveal these things unless it suits them.

The greater danger at the moment however is that RPI inflation – which is used as the basis for wage negotiations, benefits payments and many other contracts, is running at well over 5% a year and this will begin to bite over the coming 12 months adding another twist to the inflationary spiral. Coupled with yet further depreciations of Sterling against the dollar – caused in this instance by our exposure to the turmoil in the Euro-zone – and we have the makings of a perfect storm: rising domestic inflationary pressures, pressures from import prices and a government who may react by pumping more cash into the economy. To many of us who were there at the time this sounds so familiar to the 1970’s that it is hard to avoid extrapolating the consequences and see a rather unsavoury outcome.

So what should you expect?

Well, we don’t like to have to say this but it does look as though it is about to get rougher. Rising inflation and rising unemployment – the return of “stagflation”.

So our advice is to borrow money on fixed interest rate deals wherever you can. Investing in assets is also good – although the price of gold looks a little over-egged.

Holding cash (whether directly or in financial plans) plans looks a little dodgy for now.

Investing in “staples” (companies like supermarkets, utilities and so forth) would be a safer bet.

Then keep an eye on how the authorities are reacting to the situation. If they do act to reign-in the inflationary pressures then we may stave-off some downside risk. But if they “go for growth” (a phrase borrowed from the “unwise Barber boom” period of the 1970’s – named after the chancellor at the time, Antony Barber) expect things to get a little sticky through 2012 and into 2013.

In sum, don’t panic yet, but take some precautions and batton down the hatches just in case.


It’s the economy, stupid

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As US economist Joseph Stiglitz shrewdly observed yesterday, the riots in the UK are evidence not of a "broken society" but of an under-performing economy.

An economy which is failing to deliver rising prosperity to a generation who have previously known nothing but rising prosperity. Unfortunately, as we observed in our earlier comments, the dislocation caused by the arrival of the digital age and it’s multi-layered impact on society is not something that will evaporate quickly.

People have likened the current times to those of the 1930′s but the analogies they make are usually only superficial. What underpinned the problems of the 1930′s was the shift in technology from a steam-based infrastructure to one based on electricity. This caused tremendous dislocation and disorientation within the economy with winners and losers, riots that needed to be contained by the police and other unsavoury outcomes like mass unemployment.

Regretfully the decision to print money taken in 2009 did not help. As we said at the time (see our earlier comments) this would simply create inflation and delay the date at which the adjustment would be needed.

Mervyn King’s statement yesterday that the economy would struggle for years to come needs to be heeded and again accords with the comments we have been making here since 2008. This time it is different and it is different for three reasons: the impact of the digital economy; the need to change the economy to be based on low carbon energy sources; and the reluctance of financiers to lend money. It was no coincidence that it was announced yesterday that the latest available data on bank lending to small businesses showed that, adjusted for inflation, it was at it’s lowest EVER level since they first started publishing the figures in the 1970′s.

So what’s in store?

"Not a lot" you might say after viewing ransacked shops but we need to be practical.

Firstly, Britain is well-placed to adjust to the needs of the digital age. In fact, it has been in the forefront of leading that change for many years. The trick, as ever, is to think global, act local. As we have said before, leverage the technology to find ways to better meet consumer needs at a price that’s lower than it was before.

Secondly, the government are getting some aspects of their policy-making wrong. The decision to expand the money supply was a mistake but is a genie that cannot be put back in the bottle. Expect inflation to continue at a heightened level for at least the next five years. That wil squeeze real incomes making the need to follow point 1 even more important. They are trumpeting traditional manufacturing. But that now accounts for less than 12% of employment. They still haven’t woken up to the fact that that the digital age changes the way we export and that the post-industrial age in which we live has changed the nature of what we export.

Thirdly, think social inclusion. The real winners will be companies who reach out across social divides and avoid an ‘us and them’ culture. In some cases that may mean having multi-branded solutions, in others simply supporting community programmes that help people to orientate themselves in an unfamiliar and evolving situation.

If you want to understand these things better and use them to help navigate your own business in this new post-industrial age please give us a call or drop us a line.


The Green Shoots of Recovery: Number 53

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Over the past 18 months, economic and political commentators have been searching, usually in vain, for the green shoots of recovery. But there was a tiny paragraph in today’s newspaper (March 10th) that perhaps really does indicate that confidence is returning.

Rolls Royce Motors, now owned by BMW, reported that they had sold 154 cars in the first 2 months of this year – 50 more than in the same period last year. I doubt whether this was caused by the car scrappage scheme.

When the rich feel comfortable about being ostentatious once more, then surely this is a sign that recession is over.

Or maybe it’s just the bankers spending their bonuses.


Clutching At Straws

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Looking for the green shoots of recovery now looks more like clutching at straws. Over the past few weeks economic commentators have been making much of the indicators that seem to suggest that recovery is about to start: clothing sales have risen strongly (but this has been fuelled by fine weather and heavy discounting); mortgage approvals in June were the highest since March 2008; and the FTSE index has risen for ten trading sessions in a row.

All of this came crashing to earth with the release of figures showing that output shrank more than expected in the past quarter and that GDP has fallen by 5.7% since peaking in the first quarter of 2008.

The National Institute of Economic and Social Research expects growth of only 1% in 2010 and warns that it will be the autumn of 2012 before the economy is back to the size that it was at the start of 2008. In terms of living standards we will not be back at 2008 levels until 2014.

How does that fit in with your long term business plans?

Oh well, Stella is down to £8 per case at Sainsburys. How desperate can you get?


Green Shoots or Dead Cat Bounce?

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Are you getting excited by all the talk of the green shoots of recovery’? By the report from purchasing managers on July 1st of the first increase in output since March 2008? By the news from Nationwide Building Society that house prices rose by 0.9% in June? By the report from the Home Builders Federation of the biggest annual rise in net reservations to buy new homes in May for three years?

So, is the recession at an end and is the recovery now under way?

Probably not.

The increase in manufacturing output looks more like a temporary correction to the savage reduction of inventories rather than sustained recovery, and the house price recovery may turn out to be just a dead cat bounce’. At the heart of the problem is that the economy needs to recover from a lower point than previously assumed. New data shows that output is down by 4.9% since the start of 2008 and not 4.1% as previously reported.

The OECD still takes the view that past growth in the UK had been unsustainable and driven by a credit boom. Any recovery will be sluggish, they say, with growth “expected to remain well below trend as households and firms rebuild their balance sheets.” A gloomy forecast that seems all too realistic following so grave a financial crisis.

So what assumptions are you going to make for your 2010/2011 business plans?


Which Scenario for 2010?

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Robert Schiller, Professor of Economics at Yale University, and allegedly one of the world’s most influential economists, predicts that the UK faces the prospect of two recessions in quick succession.

Such a double-dip slowdown is called a “W-shaped” recession by economists, where recovery is so fragile that the country will be plunged into another slowdown just as soon as it starts to emerge from the current recession.

Chancellor Alistair Darling dismisses doubts that his Budget forecasts are too optimistic and predicts that the recession will be over by Christmas. However, most UK economists believe that the UK will stagnate until the end of 2010 and that unemployment will continue to rise well after that.

So – when you begin to contemplate Plans and Budgets for your business in 2010, which of these scenarios will you be planning against?


Spin, Spin and Selling News

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If you look at the news headlines today you would be forgiven for thinking that we really were in the biggest recession since the 1930′s.

For example the BBC web site has:

"Retail sales growth almost stalled in February as consumers cut back on spending, official figures show."

The reality, however, is that retail sales are 0.4% UP versus the "boom" period before the crash in 2008.

I am only a simple guy, but to me if sales are at a peak and then they go EVEN HIGHER then that is hardly cause for a wake.

Sure, they are ONLY 0.4% higher BUT they are HIGHER not LOWER.

We know we are in tough economic times.

We know we are having to "mend and make do".

The official stats just keep confirming all the views Schezzer has been writing here since in December.

So Schezzer’s advice to everyone is – watch out for the media (the "repeaters" as some people call them).

Just look at the facts and make your own mind up.

The journo’s have rating points and sales to keep up and this clouds their reporting of the facts.

Unfortunately they do have an influence on people’s decisions and in the current circumstances that influence is unjustified.

Ignore them. Look at the facts. The future will be as we have described it before.