Want long-term inflation? Raise rates, now

janet_yellen_official_federal_reserve_portrait
Credit: Wikipedia

Central banks across the world have been trying to reignite inflation by injecting a massive amount of liquidity and buying financial instruments, most recently corporate bonds. In theory, a higher supply of money should devalue the currency, thus boosting both exports and domestic demand. In particular, demand translates into more investment, which is a necessary cornerstone for long-term growth. Needless to say, this classic monetary tool has been more than widely used over the last few months. But the target remains out of reach in many countries. Despite more than $1tn of debt now yielding negative interest rates, inflation barely climbed to 0.6% in the UK. The US Fed is considering raising interest rates again although inflation in the US is 2.2% and thus barely exceeds the official 2% target.

Credit: Getty Images
Credit: Getty Images

I have already highlighted in this blog the importance of confidence in driving the decision of individuals. When people are confident about the future (i.e. they can predict with relative certainty the future state of the economy and the implication for their personal wealth) they do not hesitate to invest part of their income in ‘non-vital goods and services’ such as domestic appliances, automotive etc. The same logic applies to companies – this is what we call investment. Today’s environment largely lacks visibility. Geopolitical concerns (elections in the US, France and Germany, Brexit in the UK, tensions in the Middle East) make economic decisions even harder to predict. As a consequence, despite the affordability of debt, households and companies prefer to save today in case the situation gets tougher tomorrow. The resulting drop in demand has been widely pointed out as a cause for low inflation or potentially deflation in some areas (e.g. food in the UK).

Not only are hyper-low interest rates inefficient, they are counterproductive, and central banks should raise interest rates as early as feasible. Let me explain. The excessive amount of non-invested liquidity has led individuals and companies to invest in financial assets such as bonds or funds. Venture capital funds have been particularly in demand given their risk-reward profile; they tend to be more risky than ‘plain LBO’ funds and according to theory should yield better expected returns. Unsurprisingly E&Y in its latest global venture capital trends report states that venture capital deal activity increased by 54% in 2015 to reach $148bn.

Flooded with liquidity venture capitalists are begging for start-up ideas to invest their money – given that the worst scenario for an asset manager is to show his investors that their commitments are sleeping at the bank. The number of start-ups has been logically soaring in all developed economies as a result, sometimes giving birth to incubators, the most famous certainly being Rocket Internet, and a few have been raising tens or even hundreds of millions of dollars to boost their development.

In the 2.0 economy, where marginal costs are almost non-existent and barriers to entry are low, ‘customer acquisition’ and ‘network effect’ are the new mantras. Rather than investing in expensive marketing campaigns, start-ups have decided to invest in prices, most often selling their services at a loss to ensure maximal penetration. Uber is a good example. Rides in London are on average 30% cheaper than a black cab. The company is present in more than 500 cities and has been valued at $68bn in its latest fundraising round completed last year. And yet, Uber reported $1.2bn in losses in H1 2016 – this raises a broader debate about the criteria for start-up valuation, which we will address in a later post.

Credits: bpplan.com
Credits: bpplan.com

Private investors have shown patience so far, hoping that the ‘hockey stick’ will materialise. And if it does not, investors often believe that it is simply due to a lack of scale and that further investment is required to ensure the user base is large enough to prove profitable. The stock market, conversely, has been indifferent to this thesis and very few start-ups have succeeded to make a strong enough profit to reach the IPO stage – a feature that differs from the 2000 ‘dot-com’ bubble.

Exit of VC deals: IPO vs. M&A (value in $bn). Source: E&Y.
Exit of VC deals: IPO vs. M&A (value in $bn). Source: E&Y.

My point is that for months now many aspects of our daily life have been ‘subsidised’ by increasingly risk-seeking venture capitalists and that behaviour has largely been driven by the abnormally high amounts of liquidity made available by Central Banks. Paradoxically, these start-ups have most often been bringing down prices and ultimately favouring deflation, pushing Central Banks further away from their initial objective. I am not saying that price cuts are always bad. But in this case price cuts have only come at the cost of corporate losses – simply put: value destruction.

The argument about the ‘hunt for worldwide scale’ is dubious. Although this hunt is legitimate in a limited number of cases (social networks represent the most typical examples), entering new markets brings limited benefits to most start-ups. When Uber decides to enter Santiago, it cannot rely on network effect: the taxi drivers operating in Santiago are different from the ones in Singapore and the customer base is also very distinct. Given the very lean cost base, the only synergy it can expect is the brand power – which may not justify hundreds of millions of dollars of losses. And, even if you do so, you cannot prevent an aggressive competitor to emerge with even lower prices – only the depth of the investors’ pockets will make the difference.

My recommandation to Central Bank governors is thus simple: raise interest rates and clean up the mess. We will not find growth by artificially subsidising value-destructing activities. The fear of the next crisis and the willingness to avoid recession at all costs are leaving everyone in doubt. Take the hit, start from a fresh and economically sane breeding-ground and build again from there.

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Credit: www.ericnguyen23.com

The future of UK retail in 7 questions (2/2)

[continued from Monday]

Credits: gograph.com
Credits: gograph.com

5. How can retailers use innovation to stop the decline?

To embrace the change rather than trying to fight it in vain, retailers and department stores have started to invest in homegrown start-ups and accelerators. The win-win deal is clear: retailers remain at the forefront of technological innovation applied to their industry while entrepreneurs get instant access to a huge playing field for their products. Unsurprisingly, corporations have become almost as important as VC funds for the funding of accelerators.

Split of accelerator funding by primary source. Source: OpenAxel in the FT.
Split of accelerator funding by primary source. Source: OpenAxel according to the FT.

As previously mentioned, the online and ‘brick-and-mortar’ worlds will be more and more interlinked and the development and use of multi-channel CRM tools will play a great role in ensuring the coherence of the customer journey. Well-designed and innovative apps, allowing fast navigation, speedy checkout and nicely showcasing products will also boost sales – Asos is often mentioned as a ‘best-in-class’ example in that respect.


6. Should retailers own or rent their walls? Or should retailers simply sell their estate and move to an ‘online only’ model?

For years retailers have been told to own their walls. The cost of purchasing and maintaining their estate more than offset the sum of expected future rents which have been increasing at a fast pace – at least more rapidly than inflation. Furthermore, retailers were making a wise investment given soaring real estate prices across the country and especially in ‘prime locations’. Today, one can wonder if the equation still holds. Commercial real estate is expected to take a hit, crystallised by (but not only due to) Brexit, and rent inflation may cool down as a consequence.

This dilemma is worth considering as the ‘online only’ model represents a very difficult customer proposition which has been mastered so far only by a handful of players, including Asos or Made.com. Raising brand awareness and subsequently developing a brand image without any physical shop windows has proved an increasingly daunting challenge in an environment already saturated with incumbent brands. Furthermore, brands with a fading image lose pricing power – Uniqlo is one of the most recent victims of that rule.

Conversely a brand without any ecommerce operations is overseeing a strong growth driver. Some retail experts explain Primark’s recent under-performance by its absence of online shopping website – in this particular case, such a website would prove economically unprofitable for Primark given its low price points.


7. What will be the impact on the commercial property market?

The impact is still hard to assess. One could imagine that the change in culture, lifestyle and demographics, partly embodied by the rise of online, has made the need for physical retailers less obvious and therefore would expect a steady increase in the shop vacancy rate. Actually, the opposite is true: according to the Financial Times, the proportion of vacant shops fell to its lowest level since 2009.

Two possible cumulative drivers can be brought forward. First, service providers, such as restaurants, cafés and hairdressers, have taken the spots left vacant by retailers. Second, historically low interest rates have facilitated the access to debt and therefore boosted the creation of small business ventures – which this kind of service providers typically are.

In practice, though, bargaining power has started to move away from the seller. Two shopping developments have been sold at a significant discount to their original price – the transaction was completed pre-Brexit – and investment into retail property was down 54% in Q1 16 compared with Q1 15. More generally, brands will increasingly focus on prime locations where their products can be showcased at the expense of ‘tier 2’ areas such as suburban shopping centres whose transactional role will be increasingly filled by online shipments. As a consequence, some analysts believe that the UK market can now be covered with 80 to 100 stores as opposed to 200 in the past.

The UK retail industry is definitely facing challenges and shops have been asked with new roles. As announced, this will impact the demand for ‘brick-and-mortar’ sales locations – and ultimately the equilibrium of the commercial real estate market.

The future of UK retail in 7 questions (1/2)

Credits: gcmagazine.co.uk
Credits: gcmagazine.co.uk

Brexit has recently cast light on the future of the commercial real estate market in the UK. We will definitely tackle this topic in the near future. In the meantime, nonetheless, I thought it was worth getting back to the basics of one of the key underlying markets, i.e. retail, and ask ourselves 7 questions to understand the future of this market. Grocers and ‘non-food’ retailers follow different dynamics, I will therefore limit the discussion to the latter.

As usual, I thought this topic would be covered in only one post. In hindsight, I believe it would be more digestible to cut it in two halves – the second part will follow later this week.


  1. What is the current state of the UK ‘non-food’ retail market?

In a couple of words: not great. The recent misfortunes of BHS and Austin Reed are only the visible manifestations of a deeper trend. Total UK retail sales rose 1.2% on a 12-month average basis, the lowest growth since 2009. According to the latest British Retail Consortium – KPMG survey, in-store sales were particularly affected, falling 1.9% over the three months to June, and 2.2% on a like-for-like basis. The industry has been suffering from constant price pressure over the last decade.

CPI evolution for various perimeters. 2008 = 100. Source: ONS
CPI evolution for various perimeters. 2008 = 100. Source: ONS

Note : The informed reader will have spotted the ‘ups & downs’ generated by the bi-annual sales periods.


2. Are there winners though?

As in many other countries, online is the most dynamic segment of the UK retail market, although it is not immune to global market slowdowns – the latest BRC – KPMG online retail sales monitor reported a 9% growth of online in June 2016 compared with 18% a year ago. Massive online marketing initiatives such as ‘Amazon Prime Day‘ generate positive externalities for the online industry as a whole.

Source: FT
Source: FT

Looking at particular brands, Next, Ted Baker, New Look and pure online player Asos have reported relatively positive sales trends compared with their competitors.


3. Is it all about price?

No. Earlier this month Primark reported its first drop in like-for-like sales for 15 years, echoing the similarly difficult times Poundland is facing in the supermarket segment.


4. Can ‘brick-and-mortar’ sales still be considered in isolation from online? And can stores still be considered as pure points of sale?

Historically ‘standalone’ retail sales could be analysed using the following formula:

Sales = Footfall * Conversion rate * Avg. item price * Avg. quantity

Over the last few months, industry insiders have raised the alarm bell based on a drop in footfall and a very modest increase in average item price (see the clothing & footwear inflation chart above as an example) which have not been offset (yet) by a similarly significant increase in conversion rate (i.e. the share of visiting customers who end up making a purchase) and/or the average number of items per basket.

Unfortunately (or fortunately), one corollary of the previous answer is that this formula cannot be considered as valid any more. This is especially true in the UK where consumers buy more online per head than in other developed economies.

Today stores are increasingly considered as showrooms where consumers get to know a brand and its latest products, hence the refocus on prime locations. The trend is likely to accelerate given the progress made in ‘last-mile logistics’ as proved by Amazon or Ocado. Delivery from a warehouse to the end-customer’s house used to be complicated to plan and very often poorly (if not randomly) executed – actually it is still the case for the vast majority of retailers willing to enter the delivery space. As progress keeps being made in that space, we should see customers going to the shop to get information, then shop online and ultimately be delivered at their door or in convenient locations such as Amazon Lockers.

[to be continued on Thursday…]

Brexit – 9 (almost) inexorable consequences

Waving United Kingdom and European Union FlagLast Thursday British people decided to take their country away from the EU. No one knows (yet) how the economic relationship between those two areas will be shaped in the future – for those interested a governmental paper outlines the existing precedents in a very clear and interesting way.

In the meantime, looking at the market reaction, the situation has been seemingly well handled so far and stakeholders believe in a smooth transition rather than an abrupt ending. The CBOE Volatility Index, better known as ‘VIX’ or ‘fear index’, has reached levels which can be considered as modest relative to the ones witnessed in 2008 and is already on a downward trend. As I am writing those words the FTSE 100 is only 3.1% down compared with the 23/06 close and the pound has weakened but not collapsed against other major currencies.

Year-high levels reached by the VIX since 2000. Sources: Yahoo Finance, author analysis.
Year-high levels reached by the VIX since 2000. Sources: Yahoo Finance, author analysis.

In the long-term, however, the usual macroeconomic mechanisms will start acting – some of them are already noticeable. I do not have a crystal ball to tell you when and to which extent those trends will manifest themselves – and the ‘2-year window’ the UK benefits from after triggering article 50 adds to that uncertainty. Other future events could also change the course of action. This list of 9 items has therefore been prepared with the information made publicly available and the convictions I have at the time I write those lines. All in all, though, the picture looks relatively grim and one could fear that the UK is now sitting on a potential economic timebomb.

Credits: http://www.mattgoodwinlaw.com/
Credits: www.mattgoodwinlaw.com
  1. A weakened pound and potentially higher trade barriers will lift inflation. Goods and services from abroad will mechanically become more expensive once their price is translated into pounds – a phenomenon economists call ‘imported inflation’. On top of that, the UK has been enjoying non-existent or low trade barriers, both within and outside the EU,  and it is unlikely that it will be able to negotiate the same terms on its own. Higher trade barriers increase the ‘total cost of purchase’ and therefore inflation.
  2. Lower confidence will weight on growth. The uncertain period we are entering is reinforcing the anxiety-provoking environment in which the developed economies have been living in over the last few months. As a consequence, individuals are likely to save more and consume less and companies are tempted to defer non-essential investments. Thinner money flows ultimately impact GDP.
  3. Interest rates will rise, all other things remaining equal. The UK’s financial strength will decline as it leaves the EU – Standard & Poor’s has already downgraded the country’s credit rating to reflect this point. A weaker credit rating and creditworthiness translates into higher interest rates to reflect a higher probability of default (‘country risk’). I insist on the fact that this is the case all other things remaining equal since we will see later that the Bank of England is likely to have the final word through the benchmark rate.
  4. Rising trade barriers will mitigate the stimulating impact of currency devaluation. Usually, a currency devaluation means that exports are cheaper and therefore more in-demand all other things remaining equal. In our case nonetheless, and as highlighted in point 1, the devaluation comes jointly with an increase in trade barriers that will make exports ‘less more competitive’ than expected. As a result, it is possible that the currency devaluation triggers inflation (as pointed out in 1) without significantly reigniting the economic engine.
  5. There will be a few winners… Companies bearing costs in pounds but selling a large share of their products abroad will benefit from the currency devaluation. The Wall Street Journal mentions Diageo – whose product lines include Scottish whiskey – and pharma behemoths such as AstraZeneca and GSK – whose staff is largely headquartered in the UK while benefiting from a very global sales footprint. Again, this assumes no significant long-term change in the UK’s custom tariffs and policy.
  6. … but there will be many losers: Conversely companies manufacturing goods or providing services with a non-sterling cost base and then selling them in the UK will be negatively affected by the situation. Airlines are a typical example : costs are very often expressed in dollars but tickets are sold in local currencies. Banks got affected since they will not be able to enjoy their ‘passporting‘ right once the UK has exited the EU.
  7. Homeowners may have difficult nights ahead: After several years of continuous (and sometimes impressive) growth, housing prices are likely to flatten or even drop. Several corporations, primarily banks, are thinking about moving part of their operations outside of the UK. This move would impact the demand for housing and thus prices. On top of that, without Central Bank intervention, interest rates are likely to rise, negatively impacting the purchasing power of prospective buyers – and raising the burden on mortgage owners. Homeowners with recent mortgages living in areas where the drop in demand will be the most significant could end up in a ‘negative equity’ situation – a theoretical case where the sale of the house would not be enough to repay the mortgage.
  8. Mark Carney, Governor of the Bank of England
    Mark Carney, Governor of the Bank of England

    The situation will create monetary… We have seen that the Brexit could lead the UK into a period of ‘stagflation’, i.e. inflation with limited economic growth. The Bank of England could use monetary policy to either fight against inflation (by increasing benchmark rates) or stimulate growth (by decreasing the same rates). Whereas in the Eurozone the ECB has a clear mandate to focus solely on inflation (I am not saying that this is an optimal solution), the BoE has both growth and inflation management within its remit and will have to make a trade-off. The Telegraph indicates that growth may prevail as the market is not expecting any interest rate rise before 2020.

chart
Source: The Telegraph
George Osborne, (future ex?) Chancellor of the Exchequer
George Osborne, (future ex?) Chancellor of the Exchequer

9. … and fiscal dilemmas. Separately, the government will also have a difficult fiscal decision to make. With tax receipts dropping due to the lower activity, shall it aim for more austerity (and the political consequences attached) or for a fiscal stimulus? In any case, the fiscal and monetary policies will have to be fully aligned to avoid being trapped in the ‘worst of both worlds’ – a situation that some countries are currently facing.

Again, this is based on the assumptions that economic actors keep behaving rationally. Market volatility in the medium-term will indeed be driven less by the outcome of the negotiations than by the way they progress.

The 3 macroeconomic equations underpinning the theory behind this post's thinking.
The 3 macroeconomic equations underpinning the theory behind this post’s thinking. Sorry, couldn’t help myself.

Housing market update: testing the foundations

Credits: www.christart.com
Credits: www.christart.com

This post extends the series on the UK housing market which is one of my favourite topics, as you may have guessed by now. In earlier posts I discussed the impact of the stamp duty, clumsy real estate agent advertising and future house price trends in London. Today’s update brings a political flavour to the analysis, with Brexit as an obvious figurehead.

I think that a vast majority of industry experts would agree to state that the apparent uncertainty surrounding Brexit – although this uncertainty is largely a statistical artefact – has cooled down the real estate market. Although transaction volume is not officially monitored, this impression is supported by anecdotal evidence: estate agency Savills reported a 6.7% price drop in London’s prime residential areas compared with 2014, with more than half of homes being sold at a 10%+ discount. The momentum has started percolating to lower price layers, with inflation for homes in Central London costing £500k to £1m now standing at 3.4% over the last year. Commercial real estate is also affected, with investment in central London office buildings dropped 52% quarter-on-quarter. Some readers will recall that the market experienced similar turbulence in the weeks leading to the referendum on Scottish independence in 2014.

Nonetheless, the core of the market remains largely untouched. Prices throughout the UK in general, and in London in particular, still show vigorous growth, which tends to indicate that structural house undersupply largely remains a reality.

Mix-adjusted annual house price change by region as of Feb 2016. Source: ONS.
Mix-adjusted annual house price change by region as of Feb 2016. Source: ONS.

Brexit may come on top an artificial rush generated by the increase in stamp duty on buy-to-let and second homes, which led some investors to bring forward their purchase intent to Q1 2016, as demonstrated in an earlier post.

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Zac Goldsmith and Sadiq Khan. Credits: www.telegraph.co.uk.

On the supply side, political uncertainty also takes its toll. Brexit but more importantly London’s mayoral elections have strongly builders to ‘sit and wait’. The Financial Times reported that London boroughs approved 64% fewer homes in Q1 2016 compared with Q1 2015. This does not help.

On the investment side, strategies vary depending on the investor’s mandate. Property funds have been forced to partly withdraw from the market, sometimes crystallising losses, to face increasing outflows and form a sizable ‘war chest’ in case a major bank run happens post-Brexit – public trust in those funds took a hit when some of them had to forbid redemption during the darkest moments of the financial crisis. Conversely, more agile private investors are trying to take advantage from the current feebleness whereas more established institutional buyers’ field of action is restricted by their Boards.

1280px-Barclays_logo.svgFinally, in an environment where investment-grade bonds yield no (or even negative) interest and equity markets have struggled to find momentum, banks rely more than ever on the ‘power of the stone’ to generate satisfactory returns. Yesterday Barclays announced that it relaunched 100% mortgages, a product that got discontinued in the aftermath of the financial crisis, in a hunt for yield – fixed-rate mortgages start at 2.99%, not a bargain by today’s standards. Given that this mortgage can only be activated with a 10% deposit from a guardian, this mortgage is particularly aimed at younger buyers that recent price increases have excluded from the property ladder.

Share of borrowers under 25 within the first-time buyer population. Source: ONS.
Share of borrowers under 25 within the first-time buyer population. Source: ONS.

One cannot forget, however, that London remains one of the most expensive cities in the world, only trailing Hong Kong according to UBS’s well-named ‘Global Real Estate Bubble Index‘, which states in its 2015 edition that “the [London] housing market is in bubble-risk territory“.

Price-to-income benchmark for selected cities. Price-to-income is defined as "the number of years a skilled service worker needs to work to be able to buy a 60 sq. m. flat near the city center". Source: UBS Global Real Estate Bubble Index.
Price-to-income benchmark for selected cities. Price-to-income is defined as “the number of years a skilled service worker needs to work to be able to buy a 60 sq. m. flat near the city center”. Source: UBS Global Real Estate Bubble Index.

Monitoring house prices as the political dust settles will solve the conundrum. Only then will we indeed be able to understand if the London housing market has reached an inflection point or if the political milestones paving the first half of the year were mere bumps on the road to continuing inflation.

bubble204
Credits: http://fixingtheeconomists.wordpress.com