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Restoring UK growth is more urgent than cutting public debt

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Do the UK and many other high-income countries face the risk of severe fiscal crises? And is it advisable, as an independent Wealth Tax Commission recommends, for the UK to introduce a one-off wealth tax in order to reduce its soaring post-pandemic public debt? The answer, almost certainly, is no. We are using out-of-date metrics when assessing today’s fiscal risks. As important, we are missing a profound transformation in how macroeconomic stabilisation will have to be conducted. Whether we like it or not, we must rely on active fiscal policy.

Of the scale in the increase in public debt there is no doubt. In the case of the UK, the Office for Budget Responsibility forecasts a jump in the ratio of net public debt to gross domestic product from 34 per cent in financial year 2007-08 to 109 per cent in 2023-24, close to where it was in 1960, soon after the second world war. Yet, crucially, the debt interest paid by the government (net of the Bank of England’s holdings) is a mere 1 per cent of GDP, down from 2 per cent in 2007-08 and also the lowest in the postwar era.

Debt service is a far better indicator of the burden of debt than the ratio of the gross stock to GDP. Yet the nominal cost of debt is also defective. What matters, instead, is the real cost. Remarkably, the latter is negative: lenders are paying the government to borrow from them. According to the Bank of England, the UK government can now borrow at minus 2 per cent for 40 years.

Line chart showing Public sector net debt (PSND) as a per cent of GDP v entral government debt interest, net of APF as a per cent of GDP

Borrowing by the government for any programme or project with a zero or better real return must be profitable. Such a programme might be to sustain aggregate demand, in order to minimise long-term scarring caused by the pandemic. It might be investment in physical or human capital. Either should be economically beneficial, now that debt is so cheap, so long as it is implemented successfully. Indeed, things might be better even than that. As Jason Furman and Lawrence Summers of Harvard argue in a recent paper, a successful fiscal expansion might improve long-term fiscal sustainability if implemented in a depressed economy.

A slightly different way of thinking about this overall picture is that, so long as the growth rate is higher than the real interest rate, debt ought to be manageable: after all, under those assumptions, the present value of GDP is infinite. Today, the prospective growth rate must be above the negative real interest rate. If that were not true, the country would face a far grimmer future than anything the burden of public debt could inflict.

Yields on 10-year maturity gilts (%)

As things stand, then, the burden of public debt is not an issue. This is important because, as Furman and Summers argue, conventional or even conventionally unconventional monetary policy cannot be very effective any more. Indeed, a forthcoming paper co-authored by Summers and Anna Stansbury of Harvard argues that there may exist no monetary policy able to deliver full employment without dangerous side effects, including risks of serious financial instability. In the world of “secular stagnation” fiscal policy, they suggest, is the only sensible option.

In brief, it is quite wrong to think the UK faces fiscal Armageddon. Gross debt stocks relative to GDP are a useless metric. Yet there are risks, and they must be bigger for the UK than the US. Nobody has to hold UK debt or sterling. People, including British people, could decide to dump these assets, generating a collapse in the exchange rate, a spike in inflation and economic and political turmoil.

So what has to be done?

UK gilts yield curve, Dec 8 2020 (%)

First, it is essential to lock in the low interest rates. The maturity of UK public debt has always been relatively long. The aim now should be to make it as long as possible, by taking advantage of exceptional borrowing conditions. It is true that the fall in real interest rates has been consistent over at least a quarter of a century. But this might reverse. Insurance against that risk must be taken out now, to the greatest feasible extent.

Second, the government needs to plan on how to close the structural fiscal deficit once the economy returns to normal. This is not urgent. On the contrary, it is far more important to sustain the recovery. But, especially as populations age, tax increases may be needed. It must plan how to do so now.

Last, but most important, the government must sustain confidence that the UK is run by sensible and competent people. Without that, the room to use fiscal policy might vanish. The chaos of the pandemic response did not help. Nor will a “no deal” Brexit. But a smooth rollout of the vaccine and swift return to a more normal economic life would help a great deal. There are indeed things to worry about. The level of debt relative to GDP is just not one of them.

martin.wolf@ft.com

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Pimco’s Ivascyn warns of inflationary pressure from rising rents

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US Inflation updates

A leading US bond manager has warned of inflationary pressure from housing rental costs that could push interest rates higher and overturn a sense of complacency among investors.

The comments by Dan Ivascyn, chief investment officer at Pimco, which has $2.2tn under management, comes after US 10-year interest rates eased in recent months to about 1.25 per cent. Fears of an inflation surge sparked alarm among bond investors at the start of the year and pushed the important benchmark to a peak of 1.75 per cent by the end of March.

“There is a lot of uncertainty on inflation and while our base case is that it proves transitory, we are watching the relationship between home prices and rents,” Ivascyn told the Financial Times. “There may be more sustained inflation pressure from the rental side.”

Owners’ equivalent rent is a key input used for calculating the US consumer price index. As rents become more expensive, investors could become increasingly concerned about “sticky inflation”, pushing the 10-year Treasury yield back towards 1.75 per cent, said Ivascyn. 

Line chart of US 10-year expected rate of inflation showing long-term bond market inflation expectations loiter near decade peaks

The Federal Reserve said in its latest policy statement last week that it had made “progress” towards its goals of full employment and 2 per cent average inflation. Jay Powell, the Fed’s chair, said there was more “upside risk” to the inflation outlook, although he expressed confidence in transitory price pressure over time.

The latest measure of core consumer prices, which is followed by the central bank, ran at 3.5 per cent over the 12 months to June, the fastest pace since July 1991.

“There is a lot of noise and uncertainty in the data” and “the Fed has a difficult job deciphering the economic information coming in”, said Ivascyn.

The fund manager said the potential for much higher bond yields is probably capped by the prospect of the central bank tightening policy in the event of inflation expectations breaking higher.

Bar chart of assets under management ($bn) showing Pimco Income ranks as the largest actively managed bond fund

“We do believe if the Fed sees inflation expectations rise out of their comfort zone, that they will probably act,” said Ivascyn. “That has been the message from Powell’s last two press conferences.”

Pimco expects the central bank will announce a tapering of its current $120bn monthly bond purchases later this year, with a view to starting the process in January. While the policy shift is being “well telegraphed” and data dependent, Ivascyn said higher bond yields and more market volatility were likely.

“This is a tough market environment and it is a time when you want to be careful,” he said, adding that Pimco had been reducing its exposure to interest rate risk as the bond market had pulled borrowing costs lower. 

“Valuations are stretched and it makes sense to adjust our portfolios.”

Ivascyn oversees the world’s largest actively managed bond fund, according to Morningstar. The $140bn Pimco Income Fund co-managed with Alfred Murata, has a total return of 2 per cent this year, versus a slight decline in the Bloomberg Barclays US Aggregate index. Over the past year, the fund has extended its long record of beating its benchmark, according to Morningstar.



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Wall Street stocks follow European and Asian bourses lower

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Equities updates

Wall Street stocks followed European and Asian bourses lower on Friday after markets were buffeted this week by jitters over slowing global growth and Beijing’s regulatory crackdown on tech businesses.

The S&P 500 closed down 0.5 per cent, although the blue-chip index still notched its sixth consecutive month of gains, boosted by strong corporate earnings and record-low interest rates.

The tech-focused Nasdaq Composite slid 0.7 per cent, after the quarterly results of online bellwether Amazon missed analysts’ forecasts. The tech conglomerate’s stock finished the day 7.6 per cent lower, its biggest one-day drop since May 2020.

According to Scott Ruesterholz, portfolio manager at Insight Investment, companies which saw significant growth during the pandemic may see shifts in revenue as consumers move away from online to in-person services.

“[Consumers are] going to start spending more on services, and so those businesses and industries which have benefited in the last year, companies like Amazon, will be talking about decelerating sales growth for several quarters,” Ruesterholz said.

The sell-off on Wall Street comes after the continent-wide Stoxx Europe 600 index ended the session 0.5 per cent lower, having hit a high a day earlier, lifted by a bumper crop of upbeat earnings results.

For the second quarter, companies on the Stoxx 600 have reported earnings per share growth of 159 per cent year on year, according to Citigroup. Those on the S&P 500 have increased profits by 97 per cent.

But “this is likely the top”, said Arun Sai, senior multi-asset strategist at Pictet, referring to the pace of earnings increases after economic activity rebounded from the pandemic-triggered contractions last year. Financial markets, he said, “have formed a narrative of peak economic growth and peak momentum”.

Column chart of S&P 500 index, monthly % change showing Wall Street stocks rise for six consecutive months

Data released on Thursday showed the US economy grew at a weaker than expected annualised rate of 6.5 per cent in the three months to June, as labour shortages and supply chain disruptions caused by coronavirus persisted.

Meanwhile, China’s regulatory assault on large tech businesses has sparked fears of a broader crackdown on privately owned companies.

“It underlines the leadership’s ambivalence towards markets,” said Julian Evans-Pritchard of Capital Economics. “We think this will take a toll on economic growth over the medium term.”

Hong Kong’s Hang Seng index closed 1.4 per cent down on Friday, while mainland China’s CSI 300 dropped 0.8 per cent, after precipitous slides earlier in the week moderated.

Japan’s Topix closed 1.4 per cent lower, after the daily tally of Covid cases in Tokyo surpassed 3,000 for three consecutive days. South Korea’s Kospi 200 dropped 1.2 per cent.

The more cautious investor mood on Friday spurred a modest rally in safe haven assets such as US government debt, which took the yield on the 10-year Treasury, which moves inversely to its price, down 0.04 percentage points to 1.23 per cent.

The Federal Reserve, which has bought about $120bn of bonds each month throughout the pandemic to pin down borrowing costs for households and businesses, said this week that the economy was making “progress” but it remained too early to tighten monetary policy.

“Tapering [of the bond purchases] could be delayed, which in many ways is not bad news for the market,” said Anthony Collard, head of investments for the UK and Ireland at JPMorgan Private Bank.

The dollar, also considered a haven in times of stress, climbed 0.3 per cent against a basket of leading currencies.

Brent crude, the global oil benchmark, rose 0.4 per cent to $76.33 a barrel.

Unhedged — Markets, finance and strong opinion

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US regulators launch crackdown on Chinese listings

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US financial regulation updates

China-based companies will have to disclose more about their structure and contacts with the Chinese government before listing in the US, the Securities and Exchange Commission said on Friday.

Gary Gensler, the chair of the US corporate and markets regulator, has asked staff to ensure greater transparency from Chinese companies following the controversy surrounding the public offering by the Chinese ride-hailing group Didi Chuxing.

“I have asked staff to seek certain disclosures from offshore issuers associated with China-based operating companies before their registration statements will be declared effective,” Gensler said in a statement.

He added: “I believe these changes will enhance the overall quality of disclosure in registration statements of offshore issuers that have affiliations with China-based operating companies.”

The SEC’s new rules were triggered by Beijing’s announcement earlier this month that it would tighten restrictions on overseas listings, including stricter rules on what happens to the data held by those companies.

The Chinese internet regulator specifically accused Didi, which had raised $4bn with a New York flotation just days earlier, of violating personal data laws, and ordered for its app to be removed from the Chinese app store.

Beijing’s crackdown spooked US investors, sending the company’s shares tumbling almost 50 per cent in recent weeks. They have rallied slightly in the past week, however, jumping 15 per cent in the past two days based on reports that the company is considering going private again just weeks after listing.

The controversy has prompted questions over whether Didi had told investors enough either about the regulatory risks it faced in China, and specifically about its frequent contacts with Chinese regulators in the run-up to the New York offering.

Several US law firms have now filed class action lawsuits against the company on behalf of shareholders, while two members of the Senate banking committee have called for the SEC to investigate the company.

The SEC has not said whether it is undertaking an investigation or intends to do so. However, its new rules unveiled on Friday would require companies to be clearer about the way in which their offerings are structured. Many China-based companies, including Didi, avoid Chinese restrictions on foreign listings by selling their shares via an offshore shell company.

Gensler said on Friday such companies should clearly distinguish what the shell company does from what the China-based operating company does, as well as the exact financial relationship between the two.

“I worry that average investors may not realise that they hold stock in a shell company rather than a China-based operating company,” he said.

He added that companies should say whether they had received or were denied permission from Chinese authorities to list in the US, including whether any initial approval had then be rescinded.

And they will also have to spell out that they could be delisted if they do not allow the US Public Companies Accounting Oversight Board to inspect their accountants three years after listing.



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