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This month’s update is longer and contains more geopolitics than usual. This is because, for the first time in two generations, the economies of every country in the world are growing (with the possible exception of North Korea). This synchronised global upswing presents new risks and uncertainties.n

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JSA RMF February 2018 UPDATE

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economic update february 2018 this month s update

Economic Update February 2018

This month’s update is longer and contains more geopolitics than usual. This is because,

for the first time in two generations, the economies of every country in the world are

growing (with the possible exception of North Korea). This synchronised global upswing

presents new risks and uncertainties.

It would appear that the massive stimulus created by central banks’ money creation is

finally flowing through the global system. And this is quickly absorbing existing capacity. In

the next 18 months, the USA, Germany and the UK will probably be running above

capacity. The result will be wage and price inflation. Central banks are aware of this and

2018 will be the year of rising interest rates. It is likely the Fed and the ECB will be behind

the curve (i.e. raising rates too little, too late), but the Bank of England are indicating that

they are on the curve. The B of E will have to accept that they will be criticised for raising

rates when there is so much uncertainty due to Brexit. Rees-Mogg will no doubt accuse

Mark Carney of treason!

It is reasonable to assume that, by 2020, the base rate in the UK will be 3%, and 3.5% in

the USA.

The recent gyrations in share prices reflect the change in expectations. The yield on 10

year US bonds last month was 2.9%; the S&P dividend yield was 2.2%. The algorithms

which now trade 90% of US shares were clearly programmed to sell when the yields

crossed over and then buy again a day or so later – hence the volatility. The Index in the

US is back at 2700; the same level as in January. A key question is: will US company

profit growth support the current valuations? The answer is that the Trump tax cuts make it


This year, I think the risks are more political than economic. The UK is in disarray;

Germany has just forged an uneasy coalition. Trump is difficult to comprehend, particularly

in relation to the Middle East. Italy may return Berlusconi as Prime Minister. Of the major

economies only China and France appear to have stable and strong leadership.

There will be consequences but we do not know what they might be.


It is best to ignore the words of Trump and look at his actions. So far the actions have

been good for the US economy. Trump has given Middle America a big confidence boost.

The tax cuts on business will be shared with employees because labour is now scarce

across all sectors. There is going to be effectively a $1.2 trillion boost over the next five

years to an economy which is already near the top of its cycle. This is an economic risk,

but a political gain.

Trump is ensuring success in the midterm elections. It is not widely understood that two

thirds of federal spending is mandatory i.e. spending on welfare. This will increase due to

US demographics over the next twenty years.

the surge in wages and job availability should

The surge in wages and job availability should attract people back into the workforce. If

this happens then a 4% real GDP growth rate is possible with only moderate inflation.

If inflation remains moderate (below 2.5%) then US interest rates will still be negative in

real terms and remain so until they exceed 2.5%.

However it is possible that wage growth and inflation will soar due to capacity constraints.

Then interest rates will be at or close to 5% over the next two years. Ten year bonds are

now yielding 2.8%.

The growth in the USA is boosting global growth. The EU and China are growing strongly.


the uk and brexit

The UK and Brexit

It is impossible to detach oneself from the politics of Brexit. As a behavioural economist, I

am always concerned with how people feel about things. I believe this affects the

decisions they take.

It is my opinion that Brexit is the consequence of the financial crisis, and its aftermath. It

has been suggested that many people voted leave as a protest against austerity. The

result of the vote is higher inflation, lower real incomes, uncertainty, the holding back of

investment and a divided country. We have always enjoyed the reputation for being a

stable parliamentary democracy with a pragmatic approach to issues. But this has faded.

Today we are experiencing what can only be described as a civil war but without the



the nation is seemingly unable to shift towards

The nation is seemingly unable to shift towards a pragmatic approach to current issues.

On both sides of the debate there is no recognition of each other’s position. It would seem

the issue is irreconcilable. Families are divided and for many, the topic cannot be

discussed or debated.

The conflict is over the nation’s destiny. It is 20 months since the referendum; nearly a

year since the letter was sent announcing that we intend to leave the EU. And there is no

vision, no defined strategic goal, no discussion on the desired outcome. Anyone who looks

at the numbers and comments on them is told they are biased (on both sides). Nobody is

considered neutral.

This state of rudderless drift is impacting on hearts and minds. I am struck by the number

of young professionals in their late twenties who are leaving the UK to work in Singapore,

Australia and Europe. We know too that young EU workers are returning home. And we

have many retired people who bury their heads, muttering it will all be ok in the end

because we were once a superpower and, released from the shackles of the EU, we will

be again.

The UK is divided, our politics are in disarray (on this we are not alone – I look at

Germany later on), our economic performance is below the average of other wealthy

countries. Our bargaining position appears to be weak.

As we chose to leave EU without a post-Brexit vision, I expect the EU will tell us on what

basis we may or may not interact with them.

We are 16% of the EU economy. We have a balance of payments deficit of around

£100Bn. Most of this is with the EU. If you add in our subscription this amounts to 6% of


It is essential that we buy less from the EU and sell more to the EU. Our trade in goods

with the EU was a deficit of £40Bn in 2008. It is now £100Bn. Our trade in services is not

sufficient to offset this deficit. We only balance the account by attracting money into the

London launderette.

The only way this deficit will reduce is by a (significant) change in relative prices. Sooner

or later this will happen. Sterling will fall against the Euro. The UK will compete with the EU

by being cheap.

In 2016, the UK was home to 5.5 million businesses employing 26 million people.

Manufacturing accounted for 5% of businesses, 10% of employment and 15% of GVA.

The University of Sussex and Chatham House have conducted a comprehensive analysis

of the outcomes of five possible Brexit models for UK manufacturing. This analysis has not

been funded by one faction or the other, so I consider it to be as objective as possible.

If you want the detail go to:

industry/, but I summarise their key findings below:


none of the 5 possible brexit scenarios leads

None of the 5 possible Brexit scenarios leads to a positive outcome for UK manufacturing,

with the exception of food processing.

There is considerable variation across manufacturing sectors: textiles, clothing and

footwear production have the largest decline. Food processing will expand. Currently we

import 34% of our food from, the EU. This is expected to reduce.

Higher prices will be required to cover the cost of customs formalities, logistics and greater

working capital.

High tech and medium high tech are more at risk than low tech companies.

Professor Minford, Jacob Rees-Mogg, and Liam Fox would probably argue that the

Sussex research fails to take into account the animal spirits of British entrepreneurs.

Minford argues strongly for a hard Brexit and assumes that, released from the shackles of

the EU, the UK will grow at 2.8% per annum.

The FT paid a consultancy to look across the globe for markets with the best fit with the

UK in terms of history, legal system, language, demographics and distance for the next 35

years. The chart ranks them in importance for potential trade.

The EU is and will remain the biggest opportunity for British business. The Brexit

uncertainty is dampening investment by big companies.


the fall in net migration is constraining labour

The fall in net migration is constraining labour supply. To monitor the impact of this, keep

an eye on Harrogate. Until recently 10% of the workforce there was from the EU. They

worked in social care, retail and hospitality. Waiters are in high demand. Local

unemployment is 3.6%. Prices for cheap housing are growing at half the regional average.

Teenagers are being paid above their minimum wage because there are few student

casual workers (there are no large local colleges or universities). For the ‘vote leave’

brigade this is the desired outcome: young people enjoying above inflation wage awards

and being priced back into the housing market. The owners of local restaurants may have

a different perspective.

We should expect to experience a lot of charming old waiters in Harrogate in the near


Source: The Economist Feb 6 2018

The Bank of England is clear that labour supply is a limit to growth. They are assuming the

maximum non-inflationary growth rate is now 1.5%, not 2.25%. And they are posting that

interest rates will be raised to keep growth at or around 1.5% real or 4% nominal. As the

UK is a major trading nation and our two biggest markets, the EU and the USA, are

booming, we can expect net exports to rise strongly until we hit the capacity ceiling. The

Bank has to judge when this is. My guess is March 2019, a year from now. Because there

is a 9 month lag between a rise in rates and a moderation in inflation, we should expect

+0.25% in May, and again in October. So a 1% base rate by the end of this year.


the chart below shows that our workforce

The chart below shows that our workforce participation rate is already very high. There is

of course scope for bringing the newly retired back into the labour supply. I suspect we will

need a cut in pensions to achieve this. Lower growth plus the cost of leaving the EU will

strain Government finances so more austerity is likely. But as has been said before the

best solution is labour substitution using AI and automation.

The outlook for the UK is moderately good for 2018:

The outlook for the UK is moderately good for 2018

GDP in real terms will be 1.9%

Wages will grow at 3.5%

Inflation will stick at 3%

Retail sales will improve in the second half of the year

House prices +1-3% depending on location

Interest rates 1% by year end

Exchange rates – so much depends on politics and negotiations

Given relative interest rates, inflation rates and current exchange rates, Sterling

should be weaker against the dollar at $1.33, and 1.12 against the Euro. The chart

summarises the possible movements.


the eu the eu is enjoying a strong recovery

The EU

The EU is enjoying a strong recovery. As Germany is 21% of the EU I am going to focus

on its performance. Germany has an unemployment rate of 3.6%. There is some scope to

raise the participation rate but Germans are big into work life balance. IG Metal Union has

agreed to a 28 hour week and workers can take time off to care for sick children or elderly

relatives. They can opt to work 40 hours for extra payments. The basic wage will rise by

4.3%. We can expect more deals like this because Germany is clearly at full employment.

Germany will be investing heavily in automation and AI over the next few years because

local politics will limit immigration. Its membership of the EU has not prevented it from

exporting around the world. It is currently running a massive trade surplus at 8% of GDP

(the UK is minus 4.5% of GDP). The UK is the biggest global customer for German

business. As in the UK, Germany has under-invested in basic infrastructure because the

Federal Government cannot run a budget deficit by law, but it is responsible for paying

social security which, due to a rapidly ageing population, is a significant cost.

In so many ways Germany has similar issues to the UK (apart from its success in global

markets). It hasn’t had a proper government since last September as various factions

squabble for power. Angela Merkel is in a much weaker position than before the election.

The German right wing party, the AfD, is the third largest in the Bundestag. The AfD is

nationalist, anti-immigration, against same sex marriage, Eurosceptic, and believes

strongly that Germany has given up sovereignty to the EU. In particular they believe

Germany should not provide financial support to Greece and other member states. Merkel

is trying to forge a coalition of conflicting interests. The consequence is no clear vision for

the future of Europe, and policy choices constrained by the need to keep the unhappy

marriage together.

Meanwhile there will be growing disagreement between the Bundesbank and the ECB.

The Bundesbank will press for higher interest rates and /or a significant reduction in the

ECB balance sheet achieved by selling the bonds purchased under QE back into the

market. Yet again, the one size fits all monetary policy and the survival of the Euro will be

questioned. The state of German politics will give Macron the opportunity to deliver the

French vision for the future of Europe. The cornerstone of French thinking is an EU with


different levels of membership in short a multi

different levels of membership. In short a multi-speed Europe which harks back to pre-

Euro thinking. However France believes that the core countries (unspecified) should create

an EU finance ministry with a tax system which redistributes incomes across member


In my judgement the only supporters of this idea will be in the secretariat; not the EU

Parliament. The Parliament has already thrown out the French proposal for pan-EU


Why there is so much politics in this update?

The reason is simple. The current risks to business are more geopolitical than macro-

economic. There is a seismic shift under way. The rise in income inequality is being

magnified by the digital and AI revolution (this still in its infancy). The bottom 70% are

missing out. In the UK 23 million adults pay no income tax. Only 13% of the population pay

tax at 40% or above.

Populism is a belief in the power of ordinary people, and in their right to have control over

their government rather than a small group of political insiders or a wealthy elite. The

French Revolution overthrew the monarchy but in the ensuing chaos, the dictator

Napoleon emerged. Trump is a populist; in Italy, Berlusconi could win a majority on 4

March. And in the UK we have the three musketeers: Johnson, Fox and Gove.

In 2010, populist candidates around the world captured 7% of the vote. In 2017 it was

35%. The last time a swing of this magnitude occurred was in 1938.

In previous updates I have shown how an increasing share of added value created by

business has gone to the owners rather than the workers. This is now affecting political



the global economy is on a synchronised upswing

The global economy is on a synchronised upswing for the first time in two generations.

Labour markets are tight. There is little spare capacity in all the major economies. Market

forces move faster than political change. The share of added value going to labour will

certainly increase at the expense of owners.

The macroeconomic implications are as follows:

Faced with higher labour costs but not wishing to reduce margins, companies with price

making power (this is a function of market share, and/or distinctive, compelling market

positions) will raise prices.

As prices in general increase, central banks will curtail the growth in money supply by

raising interest rates. With a time lag, consumer discretionary income and company

investment spending reduce and sales volumes slow, reducing the demand for labour and

its price.

This typical economic cycle may not take place this time around. If the rate of labour

substitution increases due to technology then the main wage and price pressures will be in

the businesses which design, supply and maintain AI systems and businesses where

labour substitution is not yet possible.

We can be sure that it will be complex, difficult to predict, and there will be unintended

consequences. The science of complexity shows us there are no straight lines: there will

be a dynamic emergence with significant political implications.


I confess I have been consistently wrong about China. I assumed the country would

implode under the pressure of significant excess capacity in most manufacturing

industries. It hasn’t. The command and control economy is clearly being well managed by

the Politburo Standing Committee. Xi Jinping has tightened his grip on all aspects of

Chinese life and the economy is booming. My preferred measure of economic activity is

electricity consumption. Given the fact that heavy industry has significantly reduced its

demand for electricity, consumption in 2017 suggests the economy is growing at over 7%.

At $8,000 per capita, China is in the middle income trap. This occurs when the income

growth from traditional manufacturing has to be replaced by growth from services. It would

appear China is avoiding the trap by driving the transition to higher added value activities.

The government's 13th Five-Year Plan, unveiled in March 2016, emphasises the need to

increase innovation and boost domestic consumption to make the economy less

dependent on government investment, exports, and heavy industry. China appears to

have made more progress on subsidising innovation than rebalancing the economy.

Beijing is committed to giving the market a more decisive role in allocating resources, but

policies continue to favour state-owned enterprises and emphasise stability. China has

renewed its support for state-owned enterprises in sectors considered important to

economic security, explicitly looking to foster globally competitive industries. The

leadership have undermined some market-oriented reforms by reaffirming the dominant


role of the state in the economy the acceleration

role of the state in the economy. The acceleration in economic growth in 2017 gives

Beijing more latitude to pursue its economic reforms, focusing on financial sector de-

leveraging and its Supply-Side Structural Reform agenda, first announced in late 2015.

Geopolitically China appears keen to fill the vacuum on the world stage created by the

introspection in Trump’s America. Its defence budget is the second largest in the world at

$146Bn – which is 2% of GDP. The UK also spends 2% of its GDP on defence, but our

economy is 4 times smaller.


If you are running a business in the UK, train and develop your people so that they are

able to leave but manage and lead them so they want to stay. Talent is key to your

success and it will become increasingly scarce over the next two years.

Roger Martin-Fagg 15 February 2018

Roger Martin-Fagg

4-5 Gray’s Inn Square, Gray’s Inn,

London, WC1R 5AH

T: +44 20 7688 1928