UK PMI Numbers and M4 are Indicating Growth

Don't Count Off UK Engineering Just Yet

UK Manufacturing PMI numbers rose to a new high at the start of 2011. According to the report

"UK manufacturing steamed ahead in January as the sector continues to expand quicker than even the most optimistic amongst us could have predicted. As well as improved market conditions abroad, demand in the UK market also showed signs of growth. This is the much needed kick start to 2011 everyone in the sector was hoping for,particularly in the light of last week's poor GDP figures.'

and this demonstrates the resilience of the sector in the face of considerable cost pressures.


It also suggests that the UK is capable of developing a thriving and competitive manufacturing sector in spite of increasing global competition. There was some other good news from the Bank of England.



Bank of England M4 and Lending M4 Figures 


Source: Bank of England



They indicate that some lending is returning to the Household sector and to Private Non Financial Corporations (PNFCs).

Whilst this is nowhere near the levels of the early naughties, I doubt that anyone would want it to be!

What it does indicate is a gradual transition to the much talked about 'new normal' of lending.

Source: Bank of England

The lending effect can be seen when taking a look at the second chart which excludes the effects of securitisation.

Excluding securitisation, M4 growth remains negative. All of which goes to reiterate the importance of getting the capital markets going again in 2009. The recovery would not have been sustainable without it.

Cameron's Economic Priorities

The UK manufacturing sector has demonstrated that it can be competitive and generate growth. The 2001-2003 recession was caused by the aftermath of excess of capital spending which was aided and abetted by a stock market boom. UK corporations learnt the lesson and when the recent recession hit, they were in pretty good shape to handle it. Moreover, they generated good growth in the recovery, despite a major resumption of bank lending. Indeed, Industrials have led the stock market rally.

Unfortunately, by insulating financial corporations from the full effects of creative destruction, the same learning process may not be taking place in the banking sector. I have to gaze on in incredulity as the UK banking sector prepares to award itself £7bn in bonuses, meanwhile its assets are threatened by ongoing doubts about some peripheral European Sovereign Debt.

It gets worse. The last few years have seen a massive shift of resources from the taxpayer (households and PNFCs) towards the financial services industry. I need remind no one that this is a failed industry.

As a consequence, it is fairly easy to see what Cameron and Osbourne should be focused on.

1. Enforce the separation of investment and commercial banks in the UK. Too Big To Fail can never be allowed again. Lending is too important to the economy
2. Allow the market to increase the supply of housing by deregulating. This will spur growth and employment and slowly wean the UK of housing speculation as a career path
3. Support manufacturing and IP based endeavour as a growth opportunity for the UK. Not only by doing the above, but also by encouraging private sector investment

The simple fact is that the default position of UK politicians is to kowtow to the Financial Services industry. In fact this practice has got so insidious that it directly impacts the growth opportunities for the rest of the economy. UK manufacturing doesn't even have to ask for any favours. It just needs a level playing field.

Source:

Sectoral Breakdown of M4 and M4 Lending Bank of England Website (Accessed 1st February 2011)

Markit/CIPS UK Manufacturing PMI  Markit website (accessed 1st February 2011)

The Bank of England released statistics for M4 money supply. These figures are important because historically M4 growth has correlated nicely with future GDP growth. I've added the charts.

A New Approach to The Causes of Inflation and Inflation Targeting

Inflation is a fascinating phenomenon from an investment perspective. Naturally most of the focus and analysis comes from the bond markets, where inflation expectations largely guide the movements in bond prices. However should the rest of the investment community analyse inflation expectations in the same way? Moreover, is the focus on headline inflation the key to understanding economic prospects? In this article, I will answer 'no' to both of these questions.


Inflation Policy is Influenced by Historical Events

Political actions or ideologies only really acquire strength if they are accompanied by emotional involvement and, it takes significant macro events in order to get the public involved with the details of economic policy. However, when they happen, the ramifications can become deeply embedded.

In terms of inflation, consider the hyper inflation experienced by the Germans in the inter-war period. This has had a lasting cultural effect on the willingness of Germans to agree to anti-inflationary Governmental measures. Similarly, the inflationary period in the 70's has caused no end of academic spilt ink to be devoted to formulating headline inflation busting policies. Whatever it took, headline inflation had to be controlled.

Moreover, this approach can be seen in the remits of both the ECB and the Federal Reserve. Although the Federal Reserve is supposed to oversee growth and inflation, very few people argue for a focus on the former if it compromises-in the slightest- the latter.


Academic Focus on Inflation

However, the focus on inflation is not just limited to executive political decision making. Indeed, it is fascinating how this is the one area of policy that the free marketeers (Milton Friedman etc) will insist requires action. Friedman's work focused on the control of monetary aggregate growth as the key to beating inflation. Friedrich Hayek has suggested that currencies be allowed to 'compete' with one another, in order to impose an anti-inflationary discipline upon issuers. Most of the economists focusing on this area of research would advocate inflation targeting in order to keep the economy out of recession.

Inflation Induces Misallocations of Capital

However, it is to an earlier insight of Hayek's that I think attention should be focused. In 'The Pure Theory of Capital'. In this early work, Hayek attempts to explain the cyclical nature of industrial output in a systematic theory of capital. He warns of the dangers of misallocations of capital that are caused by the availability of cheap credit during the boom period. The resulting recession is lengthened by the difficulties inherent in restructuring this capital. Furthermore, this 'cheap credit' is induced by rapid relative movements in pricing.

So for example, if house prices are booming-after the dot com bust, housing, commodities and hedge funds became the new 'dot-com'-then credit issuers will be psychologically induced to issue cheap credit. I need not explain the outcome of this and how much misallocated capital was thrown at new house build in the US. Just look at this chart...

The greatest insights into how economic agents are induced into doing this is given in the behavioural finance research of Kahneman and Tversky. They demonstrate how people tend to use heuristics in order to make decisions under uncertainty and, rapidly changing prices (inflation) are a significant cause of uncertainty.

In this article, I am arguing that it is the effects of these misallocations that are the symptoms and the cause is the psychological inducements. However, you can have these misallocations-with significant effects-without having head line inflation.


Inflation without the Inflation?

As noted above, for historical reasons, the focus on fighting inflation has been on the headline numbers. However, it strikes me that recent history has highlighted the dangers of inflation without, err, the inflation! Combating head line inflation is, in my opinion, far too narrow a political course to guide. In the last few years, we have seen inflation in the risk seeking within housing, mortgage bonds, CDO's etc. All of which was watched over by the Federal Reserve.

 Indeed, Greenspan spoke of a 'bond conundrum' as he had tried to raise rates only to see the markets keep market rates low. Ultimately, was this a problem to Greenspan, given that his remit is headline inflation? I suspect not, or at least, not enough to propel him to act further. Unfortunately, the inflation remit of the Federal Reserve is set up to fight yesterday's battles.

Similarly, with European Sovereign Debt, the market merrily priced in peripheral debt at close to Bund levels for most of the naughties. The Greeks never had it so good. Again, the subsequent misapplications of capital are being dealt with today. Again, the ECB's inflation busting remit does not allow it to make considerations. Bizarrely of all, the history of Communist control in China has created an environment whereby their central authorities can look at these issues in isolation. 


Fighting Inflation in Future

I think a fundamental rethink in inflation targeting is needed. I do not argue for an abandonment of current head line inflation targeting however I do think that policy responses-as with Greenspan and the 'bond conundrum'-should be encumbered because of a narrow focus on inflation targeting. Indeed, Greenspan repeatedly warned of the dangers of derivative issuance. Moreover, Mervyn King has been devastatingly succinct on what he thinks about the banking system.

It's time to rethink Central Banks remits and, to stop forcing them to fight yesterday's battles.




Source:

Hayek, F.A "Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies" , Hobart Papers, Transatlantic Arts, 1977

Hayek, F.A "The Pure Theory of Capital", The Collected Works of F.A. Hayek, University of Chicago Press, 2007

Kahneman, Daniel and Tversky, Amos "Judgement Under Uncertainty: Heuristics and Biases", Cambridge University Press, 1982