Britain Is In The News, Is It Also An Opportunity To Buy?

|
Includes: DBUK, DXPS, EWU, FKU, HEWU, QGBR
by: Alan Longbon
Summary

The UK stock market is moving into all time new highs.

The winds of change are afoot with the election today and Brexit in the near future.

Macro fiscal flows are weak and getting weaker and showing that dark clouds are gathering over merry England but could a change of government or policy avert a coming recession?

The purpose of the report is to see if the election and emotion around it offer an opportunity to invest in a UK ETF. Is the local UK stock market worth investing in via exchange traded funds (ETFs)? These funds are available to all investors, even for non-residents or those not able to trade in the stock market of that country directly.

In this article, we examine Britain from a sectoral flow analysis perspective to see if the private sector, containing the local stock market, is getting the support it needs from the government and external sectors to continue its march upward.

This report was produced using a balance of national accounts assessment of Britain.

One can summarize the national accounts in the following formulas:

Private Sector [P] = Government Sector [G] + External Sector [X]

and

GDP = Private Sector [P] + Government Sector [G] + External Sector [X]

These are accounting entities. See the methodology section below for more detail on this formula.

The private sector is where the stock market is, and we as investors want the stock market to go up. The stock market can only go up if the flows into it are positive. The private sector derives income from three sources:

  1. Credit creation from banks.

  2. Externally from overseas commerce.

  3. Government spending.

In an ideal scenario, the private sector would receive large, and growing income flows from all three sources, and at the very least, the overall impact should be a positive flow even if one or two of the three flows are negative. The stock market in the private sector, as well as all other private financial assets, should rise if the overall income flow into the private sector is positive. Certainly, the stock market would be unlikely to rise if the income flows were negative. Even in a shrinking economy, some sectors can grow while the rest of the pie shrinks.

We will look at each inflow in turn and start with the private sector.

Britain

We shall start our analysis with the private sector.

Private Sector

The chart below shows the level of private credit creation entering the private sector through commercial banks at interest.

The chart shows that private credit creation is flat and has been flat since peaking in 2009. Credit creation appears to have bottomed after its peak in 2009 and is now rising again which is a positive sign.

The chart below shows the stock market:

The chart shows the stock market is moving again into all time highs which is a bullish sign as there is little overhead resistance and in general all previous buyers of stocks are now no longer underwater on their investments.

The chart below shows GDP:

The chart shows that GDP has been largely flat since the 2007 GFC boom-bust. This is the price of austerity a theme we will come back to later.

The following chart shows the M3 money supply. The money supply is still rising despite a flat to falling GDP. Since 2010 the money supply has been at the same level and has started to rise again over this last year into all time new highs.

The chart below shows inflation:

The chart shows that inflation has been falling and moving in a narrow band since 1995. In the near term, inflation fell to zero and has over the last year risen to just over two percent. Low by any measure.

In any private sector, one would like to see the customer base expanding and ever more transactions, and for that, you need people and lots of them. The chart below shows population:

The chart indicates that the population has steadily grown, and there are over 65 million people in the economy. A healthy growth rate and a positive chart.

One must also have jobs for this population so they can earn an income, produce things and make sales to. The chart below shows total employed persons:

The chart reveals that the number of employed persons has steadily grown with barely an interruption. Over 31 million people with pay packets to spend. One notices the dent that the 1990 housing crisis and GFC boom-bust made in the employment macro trend.

The flip side of employed persons is unemployed persons and shown in the chart below:

The chart shows that the unemployment rate is trending down from an 8+% peak in 2008-2014 and is now at just over 4%. Historically one can see that unemployment has had a bumpy ride since the 1970s and has been relatively high most of the time. This is in contrast with inflation that has been relatively smooth and low over the same period. One sees that Britain will tolerate unemployment more so than inflation.

Current neo-liberal economic principles dictate that the inflation rate is more important than the level of employment and that a stock of unemployed people can be used to both set a low price for labor and keep inflation down by reducing aggregate demand. The unemployment level could, therefore, be intentional public policy.

The government could have employed this idle labor force, which the private industry had no use for, and set them to work improving the public realm. It chose not to, and if full employment is the government's policy, it achieved this from 1960 through to 1975 and has since failed miserably. Regardless of which party was in power, the result has been the same.

Land and capital can be unemployed too, and this rate is shown in capacity utilization below:

The chart shows that capacity utilization is rising from a 20-year low set in 2009 at just over 70%. Since then, it is now making a second attempt at reaching the high set in the peak of the GFC boom-bust in 2007 of nearly 85%. 100%+ capacity represents the laying down of new additional infrastructure, and this has not occurred since the end of world war two.

House prices in Britain are rising from the low set at the bottom of the GFC boom-bust reached in 2009. House prices are once again moving into all time highs which is good for homeowners building equity and means that in general there are no more people now underwater on their house or real estate investment left over from the GFC.

In 1990 there was a housing crisis in Britain, known as the Savings and Loan crisis in America, where house prices plummeted in a financial crisis that rivaled the recent GFC for severity. Hard hit in 1990 Britain was hit again in 2007. The 1990 housing crisis hit a number countries especially hard due to the high private debt levels that had accumulated. Japan is another key example, Japan unlike Britain was less hard hit the second time around 20 years later because private debt in housing had not been allowed to reach former levels.

The home ownership rate is falling at just over 62.5% as the graph below shows.

A return to a feudal system of land tenancy is now in trend. A nation of renters paying rent to a long established landlord system that began with the enclosures by Henry VIII in the 1600's. One rents or becomes a debt serf.

In most "advanced" western countries with market driven housing rents, it is not uncommon for over half the household disposal income to be allocated to accommodation costs. In Britain, it does not matter if you are buying or renting, your accommodation costs are high and consume a large part of your income.

Households have some debt though, as the table below shows:

Domestic credit to private sector (% of GDP World Bank 2015)

134.1 %

HOUSEHOLD DEBT TO GDP

87.6%

HOUSEHOLD DEBT TO INCOME

125.2 %

Household debt Total, % of net disposable income, 2015 (OECD)

149.5 %

(Sources: World Bank, OECD, Trading Economics as marked)

The private household sector has relatively high debt like most advanced western nations. Britain is vulnerable to a shock such as a dot-com or GFC boom-bust. Professor Steve Keen posits that private debt levels of 150% are the critical point regarding household debt to income. Britain is at this critical level.

The bottom line is the private sector is in fair condition. While private credit creation levels are rising, as is population growth The economy is slowly still growing, the number of employed people is steadily rising, and there are high private debt levels. Above all the stock market is doing well and is among the largest and strongest in the world.

We will move onto the government sector

Government Sector

The following extract from the last British budget sets out the fiscal plan going forward:

"Significant progress has been made since 2010 in fixing the public finances. In 2009-10, the government borrowed around £1 in every £4 it spent. In 2015-16 the government is forecast to borrow around £1 in every £10 it spends, and this is expected to reduce to around £1 in every £14 in 2016-17.39

The deficit as a share of GDP is forecast to be cut by almost two-thirds from its 2009-10 post-war peak and will reach 3.8% of GDP in 2015-16.40 The government has addressed the rapid rise in public sector net debt (PSND) which more than doubled as a share of GDP between 2007-08 and 2011-12. Net debt as a share of GDP is forecast to fall over this Parliament, reaching 77.2% of GDP by the end of 2019-20.41

The public finances would be in a much worse position had the government not undertaken the fiscal consolidation that has occurred since 2010. Analysis in Chart 1.5 shows that the government would have borrowed an additional £930 billion over the period 2010-11 to 2019-20 compared to the outturn and the OBR forecast.42 This is calculated as the path of public sector net borrowing if cyclically adjusted public sector net borrowing (the structural deficit) had been fixed as a share of GDP since 2009-10 at its 2009-10 level. The chart shows the cyclical improvement in the economy since 2009-10 which would have reduced public sector net borrowing from its post-war peak of 10.3% of GDP. However, the persistence of the structural deficit means that borrowing would have been higher in every year from 2010-11.

However, more work needs to be done - the deficit and debt levels are still too high. The government remains committed to continuing the job of returning the public finances to surplus by 2019-20 and running a surplus after that in normal times, so Britain bears down on its debt and is better placed to withstand future economic shocks. In a low inflationary environment, with the risk of economic shocks, the only reliable way to bring debt down as a share of GDP is to run a surplus....

...This Budget sets out the action the government is taking to meet the fiscal mandate, achieving an overall surplus of £10.4 billion on the headline measure of public sector net borrowing in 2019-20 and a surplus of £11.0 billion in 2020-21."

(Source: HM Government budget 2016)

The budget is steeped in neoliberal debt obsession. Nearly every paragraph parrots the debt reduction must have a surplus mantra. One must remember that the government's surplus is the non-government sector's loss.

The ultimate government plan is to reach a level where it is draining 10B GBP out of the private sector each year. The whole budget is dedicated to this aim, and I have not read a budget so singularly dedicated to the drainage of the private sector as this one while writing this series of articles. When one adds the external sector drainage, covered later in this article, to the government sector drainage, the private sector looks to be in an extremely challenging position going forward.

There appears to be no hope from the other side of British politics either. The Labor party follows largely the same neo-liberal narrative. Their distinguishing feature is that they will not be so cruel at doing it.

The chart below shows the government budget picture.

The British government has been a net add to the private sector long-term.

The chart shows the familiar pattern of decreasing deficits heading into a boom-bust, recession and a return to larger deficits as the automatic stabilizers deploy to catch all the people whose job disappeared in the downturn.

If the deficit cuts and surplus budgets had not taken place, the downturn would either have not occurred or been less severe because aggregate demand would have been maintained. Capitalism runs on sales and sales are income. It you take away someone's job you remove their income, and they stop buying things, when this happens en masse, there is a recession.

The explicit government plan to achieve a surplus in 2020 and the current declining trend in deficit spending puts the next recession only two to three years away regardless of who wins the election. Both parties have one thing in common, and that is that the deficit is too large and must be reduced by higher taxation and cuts to government spending programs.

The next chart shows the value of the budget and a measure of how much money is added or drained from the private sector by the government sector.

The chart shows that the government has net added to the private sector but has often also drawn money out. The huge surplus in 2006-7 would have helped make the GFC boom-bust much worse than it needed to be. Right at the time the economy was reaching a peak level of transactions and debt and needed as much liquidity as possible the government removed 40000 GBP million out the private sector over four consecutive quarters. Madness.

Britain has the following tax rates:

(Source: Trading Economics)

The rates of taxation are relatively high and skewed heavily for business with a 19% corporate tax while the wage earners are paying a 45% top marginal rate plus a 20% consumption tax on all they buy.

The British government is the sovereign issuer of its currency unit; as the source of all money in the economy it does not need to obtain funding from the private sector via taxation or borrowing. This sort of economic thinking shows that the government is acting as if the gold standard still exists and that its spending needs to be squared off against a fixed quantity of gold; this has not been the case since 1971.

One must ask where does the debt mantra come from? The debt mantra comes from the self-imposed constraint of issuing a government bond at interest whenever the government spends money into the economy.

The following diagram shows how the fiat money system works and the role of taxation in such a system.

(Vertical and horizontal macroeconomic relations, Wray, L. Randall; Watts, Martin. Modern Monetary Theory and Practice: An Introductory Text (Page 346))

Taxation is a vent for excess aggregate demand and serves no other useful purpose. Politicians of both sides of politics speak and prepare budgets as if the government was still funded by taxation and bonds when the gold standard applied.

The British government budget paper uses the term borrowing to refer to its spending as if it were a foregone conclusion that the money would be borrowed and not created as more medium of exchange is required to be added to the system as it expands. If the current "borrowings" were paid back in full, there would be no money in circulation as it is all 'debt.'

The budget papers paint a picture of a government that is not aware of its currency creation powers, is obsessed with debt and driven by a now redundant gold standard budgeting mentality, and is unaware of its role as the provider of the medium of exchange. There is a belief system in the financial and government system that will take generations to undo and has barely started. In the mean time, a generation of people have suffered and continue to suffer austerity from a false belief that the government debt should be repaid as if it were a household or business loan.

This sort of gold standard thinking is further reinforced by Britain's 'half' membership in the EU. In the EU the full members have given up their sovereign currency creation powers and are now the users of the Euro and really must borrow from the ECB at interest to fund themselves. The debt is real. The EU is the private bankers dream fully realized. Nations states in thrall to private bankers.

Britain, on the other hand, retained its currency sovereignty and has voted to leave the EU. Leaving the EU also means leaving the debt mantra culture, the three percent fiscal compact and other artificial budgetary mechanisms with the focus on inflation control and little regard to unemployment.

The Southern European States\countries can have great depression level unemployment, and that is alright so long as inflation rate and bond yields are low.

By leaving the EU Britain has a chance to throw off the redundant gold standard thinking debt culture mantra and embrace modern monetary thinking and prosper.

Taxation that dampens aggregate demand and creates enormous and unnecessary collection dead-weight losses could be dropped and that resource more productively allocated.

Fiscal policy that is hemmed in by self-imposed constraints, such as bond issuance, expanded by dropping those artificial restrictions.

Expanding the money supply, debt free and not at interest, within the limits of set inflation, employment and currency exchange rates could begin. This is a far more intelligent basis than the current "old think."

America has made some progress in this regard, and a bill stands before Congress that would remove the bond issuance financial constraint. If Britain passed its version of the NEED Act, this bond issuing process could be deleted and the money issued by the Treasury with no bond creation via a third party. This would eliminate the "national debt" that so many people misinterpret as a bad thing and politicians use as an excuse for defunding the public purpose.

Given how deeply ingrained this debt mantra is, plus the feudal landlord culture, this is highly unlikely to happen. Landlords and bond holders can rest easy and collect the unearned income for many more years to come. The seed for change will find stony ground in Britain.

We now move onto the third and final sector of the economy, the external sector.

External Sector

The chart below shows the current account situation.

The current account chart shows a large and increasing financial drain on the private sector. This situation is unlikely to change as there structural and geographic reasons why the trade and fund flows are what they are. Britain is materially better off and can create as much computer currency credits as foreigners are willing to hold.

The government sector has the stated aim of wishing to drain the economy of 10B GBP per year by 2020. The existing drain from the external sector on the private sector is 108B GBP per year (2016). This makes a total drain of some 120B GBP per year if present trends and plans remain in place, though one notes the current account is trending to further deterioration and so the number is likely to be more and not less.

So where can this 120B GBP per year come from? The private sector! The private sector must run down its stock of wealth and\or go into debt to fund the government surplus. The mathematics are simple and irrefutable as illustrated by the sector flows.

The private sector will go into further debt until there are no more creditworthy borrowers left who are ready, willing and able to take out a loan. At this point, aggregate demand will collapse, as it did in 2007 and another recession will come.

A government that is running a country that is being drained by the external sector cannot also afford to drain the private sector with surplus budgets. The opposite is true. Such a government needs to be injecting money into the economy to match the external deficit PLUS more to grow the economy and enable people to save and invest.

Such a government is only limited by its target inflation rate and the real resource available for purchase in that country in GBP.

Sectoral Analysis Methodology

Each nation state is composed of three essential components:

  • The private sector

  • The government sector

  • The external sector

The private sector comprises the people, business, and community, and most importantly for investors, the stock market. For the stock market to move upward, this sector needs to be growing. This sector by itself is an engine for growth and innovation. However, it needs income from one or both of the other two sectors to grow in value.

The government sector comprises the government with its judicial, legislative and regulatory power. The key for the stock market is that this sector can be both a source of funds to the private sector through spending and also a drain on funds through taxes.

The government through its Treasury also sets the prevailing interest rate and provides the medium of exchange. Too much is inflationary and too little is deflationary. It puts the oil in the economic engine and can put in as much as its target inflation rate allows. It is not financially constrained, for a sovereign government with a freely floating exchange rate any financial constraint such as a matching bond issue is a self-imposed constraint. A debt ceiling is also a self-imposed constraint.

The external sector is trading with other countries. This sector can provide income from a positive trade balance, or it can drain funds from a negative trade balance.

One should note that a negative trade balance also means that a country has traded currency, that is in infinite supply, for real resources that have a finite supply.

For the stock market in the private sector to prosper and keep moving upward, income must enter the flow. Otherwise, the sector can only circulate existing funds or is being drained of funds and is in decline.

The ideal situation is that the private sector has a net inflow of funds and is constantly growing, thus giving the stock market headroom within which to expand in value. For this to happen, one or both of the other sectors have to be adding funds to the circular flow of income.

The following formula expresses this simple relationship.

Private Sector [P] = Government Sector [G]+ External Sector [X]

P = G + X

Non government sector $ = Government sector $

For the best investing outcome, one looks for countries where the government sector and external sector are both net adding to the private sector and causing the local stock market index to rise with the receipt of additional funds.

Applying the Sector Flows, Summary and Recommendation

The sector flows at present are shown in the table below. GDP is declining, so each year these numbers get smaller in absolute terms.

Private Sector Credit Creation

[P]

External Sector

[X]

Government Sector

[G]

TOTAL

[P]+[X]+[G]

Yearly

3.0 %

-4.4%

3%

1.6%

(Source: Trading Economics and author calculations based on same)

Britain is not a buy. Our assessment criteria are not met in that both the government sector and external sector are (or plan to) draining funds from the private sector and this is finding expression in slowing GDP growth and rising private debt levels.

Private debt levels are near the critical 150% of income mark reached in the GFC boom-bust and so private credit creation levels will likely peak and flat-line again soon. This will take 3% GDP fiscal flows out of the economy and put downward pressure on GDP.

When one looks at the sustainability of the income flows one can read that the government has single-mindedly dedicated itself to draining the private sector as soon as possible of 10B GBP per year. External flows will drain some 110B GBP per year out of the private sector, tendency rising.

If an investor believes that the British government will see the error of its ways and suddenly develop an understanding of basic national balance of accounts sectoral accounting and begin injecting 120+B GBP per year into the private sector then the following ETFs will be of interest:

  • iShares MSCI United Kingdom ETF (NYSEARCA:EWU)

  • iShares Currency Hedged MSCI United Kingdom ETF (NYSEARCA:HEWU)

  • First Trust United Kingdom AlphaDEX Fund (NASDAQ:FKU)

  • iShares MSCI United Kingdom Small-Cap ETF

  • WisdomTree United Kingdom Hedged Equity Fund (NASDAQ:DXPS)

  • Deutsche X-trackers MSCI United Kingdom Hedged Equity ETF (NYSEARCA:DBUK)

  • SPDR MSCI United Kingdom Quality Mix ETF (NYSEARCA:QGBR)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.