The Finance

Expatriate tax and finances

GREEN SHOOTS

There are some interesting people around who are claiming to have sighted the green shoots of economic recovery. Raising his head gingerly over the parapet is Spencer Dale, chief economist of the Bank of England. Nothing in the most recent data had caused him to revise the Bank's February forecast, he said recently in the Financial Times. That meant he suggested that "a substantial amount of the total contraction we are going to see has come through."

Back to "normal" times. Analysts will feel able to come up with reasonable forecasting models, price earnings multiples will sigh with relief and multiply in relation to earnings and green shoots will become verdant forests.

Mr Dale may have got it right and he is brave to go against what looks like a much more pessimistic consensus. In particular, he pointed to the large contraction of output at the end of last year, which was largely caused by the drop in production starting around November. This was in reaction to the crisis of consumer confidence caused by the banking crisis and generally was much more ferocious than anybody expected. It continued over the Christmas period with large numbers of companies opting for extended winter breaks and selling from their existing inventory. As Mr Dale says: "For stockbuilding to continue to make that negative contribution to growth we know that companies would need to keep on running down their stocks at ever increasing rates and we know that can't happen". He then went on to talk about evidence of expenditure switching to domestic output from foreign produced output as a result of sterling's fall and also expressed an interesting view about consumer confidence. He reckoned that consumer spending would remain higher than generally expected and implied that while the Bank of England had lost the power to impact consumer confidence via reducing nominal interest rates, the new tool, quantitative easing, the polite word for printing money, would continue as long as the long term inflation target of 2% was not prejudiced.

What he said accords with everything we see from the companies who come to see us every week. Clearly it is something of a "random walk" in that the companies we do see are from a myriad of industries, but certainly there seems to be a common theme that stock levels are clearly seriously run down and that must mean the restocking process is underway.

What probably no-one can know at present is the extent of this stockbuilding. Is it designed to get stocks back to November 2008 levels or just to be able to process the basic backlog of orders in the pipeline. Anybody involved in the retail industry knows that stock levels are low and consumer demand seems to be, as Mr Dale at the Bank of England said, holding up more strongly than most people expected. Perhaps this is not surprising with the increase in consumer purchasing power resulting from the fall in oil and petrol prices, the fall in mortgage rates, and the fall in utility prices.

So investors, as usual, are presented with something of a dilemma. It is a particularly uncomfortable feeling sensing that the equity market is likely to rally when you are sitting in your bunker surrounded by tinned foods, gold bars, cash and gilts. After all, there are plenty of sages out there reminding you that in the 1930's, after the Wall Street crash, the average bear market rally was 30%, with one of 50%, and that’s where people lost most of their money.

But is it realistic for contemporary investors to make comparisons with the great depression/deflation of the 1930's? The initial losses sustained to date have certainly been of a similar magnitude. In the run-up to the 1929 crash there were distinct similarities with today in that the US economy expanded rapidly on the basis of cheap credit, and rising money supply. The exuberance/ greed resulting from combining investment banking with retail banking coupled with inadequate regulation was, as today, a heady mix. But there the similarities end. The then Authorities were very slow to take action and often the actions they did take such as the raising of tariff barriers were counterproductive. As a result, from 1929 to 1933, US money supply fell by 35%. Prices fell by 33%. Banks collapsed because the US Authorities failed to take preventative action. Lending was restricted and deflation accelerated as a result of a totally unnecessary adherence to the gold standard. Compare and contrast what is happening today.

Today the Central banks, possibly with the exception of the European Central Bank, have been swift to act. It was not just a question of protecting depositors, preventing banking failures where possible to reduce counterparty risk, whilst reducing interest rates and providing massive doses of liquidity to the money markets when needed. Unlike the 1930's, the Authorities have quickly recognized the extent of the banking systems' liabilities and thrown every possible lifeline in the form of tax-payers money at the problem. In addition, the Central banks have been quick to recognise that despite all their activity, a large part of the banking system, particularly in Eastern Europe continues to have serious problems.

However, the cavalry in the shape of the UK, Swiss, and US Authorities are riding to the rescue and they are shortly to be followed by the Canadians, the Scandinavians and the Japanese. The cavalry is in the form of "QE", or quantitative easing, something of a buzz word for those in the know. Governments have simply decided to raise that extra $1 trillion which the IMF says we all need by a slightly less direct route, known as printing money. What actually happens is that Central Banks announce a buying programme lasting three to six months for Treasuries and Corporate bonds, which they then buy off banks and other financial institutions. How do they pay? Instead of actually printing notes and sending them around in a wheelbarrow to the selling institution they make an electronic transfer crediting the selling institutions' bank account with the money. This is a simple transfer and a less obvious route than having to go through the more public process of a Congress or the Houses of Parliament requiring enabling legislation for a tax increase.

The net effect of this buying programme is that the balance sheets of banks and other financial institutions are injected with large doses of cash and balance sheet values start to rise as Central Bank purchasing programmes boost the prices of Treasuries and Corporate bonds held as assets in balance sheets. In effect over time financial institutions are being refinanced by this process and the only thing that can stop the process continuing is an upturn in inflation.

The impact of this buying programme on the balance sheet of a reasonably typical financial institution such as the Prudential would be as follows. In very rough terms, Prudential shareholders have exposure to around £60 billion of debt lent to third parties and stated as assets on the Group's balance sheet. This debt is in the form of about £46 billion of debt securities both corporate and sovereign. In addition there is around £1.1billion of equities, £1.4 billion of property, £5.3 billion of mortgage and other securities. This compares with shareholder's funds of around £6 billion .The simple fact is that the sheer size of the Central banks buying programmes could, and in some cases already have, forced up the prices of bonds, sovereign and corporate by around ten per cent. For example, the UK Gilts market rose between 4% and 8% in the week that "QE" was announced and at the same time prices and liquidity in the corporate bond market improved. As a result, at least in theory, the £46 billion of debt securities on the balance sheet could have increased in value by over £2.7 billion. Even if it was only £1 billion, that notional increase in value represented a 17% increase in Prudential’s shareholder equity. The impact of the "QE" buying programme on the geared balance sheets of banks, life companies and other financial institutions is very considerable.

But "QE," as we have learnt to call it has another distinct advantage for Central Bankers and that is that printing money or expanding the monetary base is not immediately inflationary, if nobody has the confidence to borrow and nobody has the confidence to lend. And the Authorities are currently fully aware that the world is in the grip of powerful deflationary forces which need to be countered. And they can also, with some justice suggest that if there is a danger that the velocity of money starts to rise from a much enlarged monetary base to the extent of creating inflation, then they can move to alter lending ratios to turn off the inflationary tap. Here of course their combined sense of timing becomes crucial because being slow to react could then create conditions for a hyperinflation. "QE" therefore presents investors with considerable opportunities as well as considerable risks. The immediate opportunity is to hedge by buying gold and, to an extent, industrial commodities such as oil and copper to provide some protection against depreciating currencies worldwide. This is because investors will be positioning themselves to benefit from the potential longer term inflationary consequences of such monetary growth, particularly in relation to a reserve currency such as the dollar. The recent announcement of "QE" by the US Fed, for example, caused the dollar to collapse, and suffer its biggest weekly loss in 25 years. However, if recent foreign exchange patterns are anything to go by, currency weakness as a result of the announcement of a particular "QE" spending programme does not last too long, because investors are starting to believe that these programmes will be global until the banking system is restored.

If these buying programmes are successful, and there is evidence that they are having an effect, not just in strengthening the balance sheets of the banks and Life Insurance companies, but also in lowering long term mortgage and borrowing rates, then you might start to find that confidence in banks and their balance sheets returns. And that is probably the point at which restocking returns with a vengeance as consumers recover their confidence and the point when Mr Spencer Dale of the Bank of England will be proved correct in his longer term forecasts. Judging the turn in the equity market and avoiding the false dawns will be the key. But in marked contrast to the 1930's the Central Banks have in effect warned investors that they mean business and will do whatever it takes to kick-start the system, inflation not withstanding. Any further setbacks to equities occasioned probably by a blow up in Eastern Europe as well as the difficulty of operating a single European currency within sharply diverging economic geographies will therefore possibly be a good buying opportunity for equities.

Should you have any questions about the information or want to organize a chat with the author, just let chief know.

All future correspondance with be handled directly by the author. We will have no involvement in your financial matters or queries.