by Brian Durrant
Many people in Britain are perplexed by UK's apparent prosperity. How can we
enjoy such a rising standard of living while at the same time we do not seem
to produce anything? City and town centres, even in the formerly depressed
industrial regions of the north, are buzzing with busy shopping complexes
and restaurants. Out-of-town supermarkets and D-I-Y superstores are
springing up everywhere as are new private housing estates. People dress
well, eat out more often and drive bigger cars.
When whole swathes of manufacturing industry closed down in the early 1980's
and the coalmines were shut down in the second half of the decade, a bleak
future of economic decline beckoned with mass unemployment, boarded up shops
and crumbling amenities. Somehow Britain has, in most parts, escaped this
outcome of economic hardship. But people still harbour nagging doubts that
their apparent prosperity is built on sand. This Easter there will be a
credit-fuelled spending spree on D-I-Y goods made in China, Swedish
furniture and Australian wine, while our wealth is somehow based on
homeowners bidding up the value of each other's property. It is
understandable that people who measure their own wealth in terms of material
possessions tend to see prosperity based on services like entertainment as
some kind of statistical trickery.
Scepticism about our economic prosperity is deep rooted particularly among
those endured the trials and tribulations of the 1970's. This miserable
decade included a three-day week, power cuts, a near 70% fall in share
prices in the 1973-75 bear market, inflation at 26%, an IMF loan and the
winter of discontent. Sir Nicholas Henderson, the British Ambassador to
Paris, sent a telegram to the new British Prime Minister Margaret Thatcher
in June 1979 saying "our economic decline in relation to our European
partners has been so marked that today we are not in the first rank even as
a European one". He supported the message with a table which showed how
Britain's GDP per head had fallen to 46% below the German level and 41%
below that of France. Britain's economic success particularly in relation to
Europe over the last 15 years bucks a century old trend, which is still
embedded in the psyche of those who suffered in the 1970's. It is indeed
difficult to believe that in 2005 British per capita income was over 8%
higher than France and 6% above a united Germany, despite the fact that
Britain no longer makes anything that one can lay one's hands on.
While it is true that almost everything we buy today has a "made in China"
label, this does not mean that the all money we spend on these goods ends up
in China and drains jobs and resources from our economy. Here is an example
that may seem trivial but it makes a point.
Later this month the shelves of toy shops will be flooded with Spider-man
merchandise ahead of the launch of Sony Pictures third block buster movie
"Spider-man 3" in May. A simple action figure toy will have "made in China"
embossed on it. Say for example it retails at £10.00, roughly half the
retail price will go to the UK retailer and distributor, with another 20% or
so paid to Hasbro, a US toy company which will spend much of this on
advertising, promotion and distribution in the UK. A further 10% or so will
go Sony Pictures Limited, which owns the Spider-man film rights and
additional royalties will be paid to Marvel Enterprises Inc. Furthermore
£1.49 will go to the UK Treasury in VAT, and there's the cost of shipping
and insurance too, leaving a small remnant of the purchase price going to
the toy manufacturer in China, who has to buy materials and plastic moulding
machines, probably imported from Korea or Japan. In the end less than 5% of
the £10 you paid for the Spider-man toy will end up as wages for Chinese
workers or profits for Chinese manufacturers. Meanwhile the retail and
wholesale margins, advertising and promotion will probably contribute around
£7 to Britain's GDP.
In the 1960's and 1970's the economic success stories were West Germany and
Japan. These countries enjoyed strong growth led by manufactured exports.
The nature of the world economy has been turned upside down since then.
Manufactured goods, whose production can be readily transferred to the
lowest labour cost economies like China, are falling relentlessly in price.
This process of outsourcing has created a new type of business, called a
"platform company" which sell everywhere but do not own factories. Examples
include Dell, Nokia, L'Oreal, Ikea, GSK and Apple. These companies
subcontract almost all their manufacturing to other businesses, mostly in
developing companies. A generation ago production and manufacture was the
key to business success. Today design and marketing add the most value,
because manufacturing is in the hands of subcontractors in developing
countries that compete intensely to drive down costs.
Moreover if there are changes in demand for goods, it is the manufacturing
part of the business that bears the brunt of the adjustment, so the
volatility of the business cycle is outsourced to developing countries while
mature economies enjoy greater economic stability. This new found stability
has in turn made higher levels of borrowing safer and more attractive for
businesses and consumers in advanced economies. And it is the countries
which are financially the most deregulated like the UK that have benefited
most from the processes of globalisation and outsourcing. The new world
order has played into the hands of Britain, which throughout the last
century always struggled to compete in manufacturing goods, but has always
enjoyed a comparative advantage in finance and other knowledge based
services. The prices of manufactured goods have collapsed in the last 15
years, while the prices of knowledge based services like finance, law and
entertainment have risen in price. In economics jargon Britain has enjoyed
an improvement in the "terms of trade".
To illustrate this point, an international lawyer earning £250,000 a year
today probably works no harder than his counterpart in 1990 when he probably
earned less than half this amount. Although the lawyer's productivity has
not doubled, his contribution to the British economy from his foreign
income, his taxes and his consumer spending has.
However for Britain to be in a position to benefit from this new world
order, it had to lick itself into shape domestically. Two events are crucial
to the story: the election of Mrs Thatcher in 1979 and the ERM debacle of
September 1992. The trade union reforms, deregulation and privatisation of
the Thatcher era created a truly competitive market economy in Britain for
the first time since before the First World War. Cast your mind back to the
world of the 1970's when you had to "queue" for a mortgage, have
restrictions on how much money you took out of the country and the
nationalised telecoms industry lacked funds for investment because the
government was too busy backing losers like British Leyland.
But Thatcherism alone was not enough, the government was still making a mess
of the economy by using interest rates to target the exchange rate. This
resulted in the Lawson boom and bust of 1988-90 and the unnecessarily long
recession that followed. It took the climactic events of 16th September
1992, which I like to call "White Wednesday"
to bring economic policy makers to their senses. Thereafter interest rates
were set according to the domestic needs of the British economy and our
decision to stay out of the euro has ensured that this framework that has
delivered economic stability has remained in place.
The market reforms of the Thatcher era, the sane monetary policy framework
after White Wednesday and fall in the prices of manufactured goods relative
to knowledge based services have helped transform Britain's economic
performance and reverse a 100 years of relative decline.
How long Britain's economic renaissance lasts depends on the wisdom of
policy makers and the evolution of the world economy. But for now, Britain's
prosperity is no illusion.
Regards,
Brian Durrant
What's it all about, Alpha?
Alpha (above market returns) is what hedge funds are supposed to bring
investors. Alpha is why they get away with charging outrageous fees (usually
2% of capital and 20% of performance).
Alpha is why, developing a case of 'mission creep,' the funds then began
speculating rather than hedging.
But after that came news of another extraordinary
development: hedge funds started going public. The lay public, it seems is
willing to pay for alpha and pay more for alpha than alpha is making for the
funds. What gives?
Take a look at the amazing sale of shares in the Blackstone Group.
Blackstone is one of the multi-billion dollar groups of 'Private Equity'
money that prove to us that Wall Street is no place for an honest man.
Think about it a minute and it almost makes you stop breathing. The idea of
the hedge fund was, primarily, that it could protect investors by hedging
risk. It did so by being able to go both long and short. Mutual funds, by
contrast, are always long. You buy a fund that invests in China, for
example, because you want a little sliver of the China pie. If Chinese
shares go up, you want to go up with them. And you know you're not
competent to select shares in China yourself. So, you don't mind paying a
mutual fund manager for helping you. It wouldn't make any sense for the
manager to hold cash…you could do that yourself without paying a commission
or fee.
Along comes the hedge fund with a different mandate -- to make money even
if shares go down. The idea was to protect the investor on the downside.
All very well to own shares in China and the US, but what if the shares went
down? The hedge fund manager hedged an investor's bets, by shorting
(selling shares he didn't own) or by using put options (giving him the right
to buy shares at a lower price) or other strategies designed to make money
when most investors lose it.
Then came the curious news that a few hedge funds were selling shares to the
public. That too took our breath away. The only justification for the high
fees was the 'alpha' performance. But if a hedge fund manager could get
'alpha,' why would he want to sell shares to perfect strangers? Hedge fund
managers can do math. They wouldn't sell shares of their own fund unless
someone else thought they were worth more than they did. You could infer
from that that either the public was paying more for alpha than alpha was
worth. Or, that there really wasn't any alpha at all.
And now, before us is Private Equity, the hottest thing on Wall Street,
because it delivers alpha. In theory, you can't really beat the public
market – because it has so much more information than any individual
investor or group of investors. But along came the Private Equity money…and
phyzzzt went the theory. In fact and in practice…the smart, well-informed,
well-funded private investors were letting us know that they were the ones
making money, not the rubes in the public marketplace.
But Private Equity is going one step further now…a step too far, in our
opinion. The Blackstone Group is going public to raise billions of dollars.
"Look," it says to the rubes, yahoos, and lumpencapitalists, "We can get you
alpha; buy our shares."
But the Blackstone Group is not a religious or charitable order. They are
not going to give away alpha. Nor are they innumerate; they can do the
math. The only circumstance in which they would possibly sell their shares
to the public was if they felt their alpha was over- estimated by the
share-buying public...or, they didn't have any alpha.
What is happening to Private Equity is what has happened to hedge
funds...and happens to everything else in the markets...and indeed, to the
rest of life. Alpha – the extraordinary, the special, the above-market -- is
in short supply. And the more people chase after it, the harder it is to
get.
As more capital sought out more above-market returns, the returns fell.
That's why hedge funds are already yesterday's news.
Now Private Equity too is running into the Law of Diminishing Returns. Or,
the Law of the Declining Marginal Utility of capital chasing alpha.
Private Equity is probably selling to the public for the same reason hedge
funds did: they've lost alpha.
Meanwhile a look at the headlines tells us immediately what 'gives' in the
market these days:
"Subprime Bust Forces Families From Homes," says the AP.
"American dream becomes nightmare as millions face foreclosure," trumpets
the AFP.
Is the problem containable, as Treasury Secretary Paulson says?
We don't know...but we wonder if he does either.
And more news:
-------------------------
Adrian Ash, reporting from BullionVault in Hammersmith:
- So the US housing market picked up in February, or so said the National
Association of Realtors in Washington on Friday. Sales of previously owned
homes in the US, said the real estate shills, rose 3.9%.
- Phew! That was close. And there we were thinking the biggest housing
bubble in US history might take more than a few months to unwind.
- Forty-four lenders in the subprime market have now gone kaput since late
2006, reports ML-implode.com. "It is clear that some subprime lenders have
engaged in abusive practices," barked Emory Rushton, senior deputy
comptroller, at a senate hearing in Washington last week.
- In the wider economy, "the US housing recession has contributed to pushing
overall GDP growth down to a 2% annual rate over the past three quarters
ending 1Q07," says Stephen Roach, chief economist at Morgan Stanley – "well
below the 3.7% average gains over the previous three years."
- But c'mon! What's to fear as the world's biggest economy, driven by
consumer debt, moves from those super-low "teaser" rates onto full-fat Fed
funds rates nearer 5.25% and above?
- "The headlines in the financial press proclaim (for the umpteenth time)
that the worst of the housing slump is behind us," notes our friend John
Mauldin in his latest missive. "Home prices are down a mere 1.3% from a year
ago, although the number of homes for sale rose slightly to a supply of 6.7
months, meaning homes are staying on the market longer, as sellers are still
reluctant to sell at lower prices."
- "But the problems for new and existing home sales are in the future," says
John. "Last year there were 400,000 foreclosures. Moody's estimates that
that number will double in 2007. That means that there will be an additional
800,000 homes added to the supply of existing homes this year, which is at a
seasonally adjusted 6.69 million homes."
- Outside the real estate offices, "jobs are supposedly plentiful," adds
Mike Shedlock for Whiskey & Gunpowder.
"Yet 2.1 million Americans with a home loan missed at least one payment at
the end of 2006. That seems pretty hard to me. And it's going to get a lot
harder paying that mortgage when ARM interest rates reset and unemployment
starts to rise. Both are going to happen."
- And still there's nothing to fear. "Most of the housing adjustment is
completed," reckons one Californian economist interviewed by Bloomberg. Put
another way, "House prices to recover next year," as the Times of London
announced in November 1989...just before the UK real estate market lost
one-third of its value over the next 7 years.
- Regular readers won't need reminding, but that's never stopped us before.
"Recovery [was] forecast for house prices in market awash with loan funds,"
reported the Times in Jan. 1990. Not even broad money supply growing by 18%
year-on-year could stop the rot, however.
- By July 1990, "the bottom of the current house price cycle may have
passed," the paper went on. Come the autumn of that year, however, The Times
had to repeat itself again.
- "House prices bottom out...the long slide in house prices could be nearing
its end," it said. National prices continued to slide regardless.
- By Sept. '91, real house prices - adjusted for inflation
- stood 25% down from the peak. "House-price surge is on the way," said The
Times, "but wait for it."
- No fooling! The following month, Oct. 1991, The Times finally admitted
that "Fall in house prices dashes market hopes."
- Why so glum? Well, mortgages more than 6 months in arrears accounted for
3.5% of all loans outstanding at the start of 1992. Cue The Times to report
that "record repossessions are keeping down house prices" - even though the
mortgage lenders themselves had long since stopped repossessing when they
could possibly help it.
- Ahead of the United Kingdom's last house-price crash, nine out of every 10
late-paying mortgages more than 12 months in arrears were taken into
repossession. By the bottom of the slump, however, the mortgage lenders
slashed that kill rate beneath one-in-5. America's mortgage lenders may well
try the same remedy in 2007.
- US foreclosures rose 42% in 2006 according to RealtyTrac.com, up from
855,000 in 2005 to 1.2 million nationally. But throwing young families out
on the street rarely makes for good PR. And during a genuine real-estate
slump, it only adds to the downward pressure on home prices.
- For now, reports Bloomberg, many US lenders are urging their late-paying
borrowers to sell their homes themselves...and redeem whatever they can of
their outstanding debts. Better that, the lenders are thinking, than collect
ever-more default properties on their books.
- But leaving late-payers where they are could soon become the subprime
strategy of choice. What that decision will do to America Inc's credit
rating – and the implied value of its paper promise, the Dollar – we'll just
have to wait and see...
And more thoughts…
*** Remember Harry Dent?
He's the one who forecast the Dow at 40,000, based upon his reading of
demographic trends. All those aging baby boomers had to save for their
retirement, he said. And the logical place for them to put their money was
in the stock-market.
Well, as the years have passed…it now becomes clearer that the boomers
aren't all that interested in saving money – not when credit is easily
available and when their houses are rising in price. So, this past November,
Dent felt it was time for a little backtracking. Now he says the new bubble
will reach its maximum in late 2009, with the Dow near 20,000 and the Nasdaq
at 5,000.
Could he be right? Anything is possible. We suspect that the boomers will
start saving again. They've been on a spending binge for the last 10 years.
They're probably about ready to go on a saving binge. Not only will they
need the money, we've noticed signs that saving money is becoming avant
garde. There may be a backlash against conspicuous consumption coming.
We'll have to explain more tomorrow – when we take up our new theory of
modern politics. But there are times when spending is hip, stylish and
trendy. There are other times when spending is regarded as vulgar, crass
and foolish. The times could be changin' now.
*** If boomers begin saving…what will they do with their money? Will they
put it in stocks? Or real estate?
We noticed, recently, how much of a drag owning real estate is. You're not
bothered by it when prices are rising sharply. But when they begin to
flatten out…and when sales sag…you begin to resent having to fix the roof or
the dishwasher.
This came home to us when we looked at what it costs us to hold onto our
farm in Maryland. There are a couple of houses on the farm, which are
rented out. It should be making money for us. Instead, we get this message
from our property manager:
"Last year there was around an $8,500 loss. The main house was rented for
$2,500 a month for six months. We had to replace an HVAC in the dairy
apartment, a water heater in the tenant house, a heating stove in the barn,
carpet in the dairy apartment.
Last year we spent the following for maintenance and repairs (parts & labor)
on each of the buildings:
Barn-$1,665
Dairy $3,667
Main House $17,250
Tenant house $890
Grounds $9,659 ($2,547 for labor, the rest for mulch, gravel, etc.)
Management $2,770.00"
We doubt boomers will want to deal with these problems.
And we wouldn't be surprised to see attitudes to real estate revert back to
what they were 30 years ago – when people regarded property as an expensive
burden, not as an investment.
*** Want to buy property where property is still going up.
Buy in Japan. For the first time in 16 years, Japanese real estate prices
are going up nationwide.
The biggest gains came in Tokyo commercial property – where prices were up
by 9.4% in 2006.
ores why and how Britain has become so prosperous...
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