Jeremy Beckwith, former CIO of Kleinwort Benson, gives overview of debt crisis and global economy

February 19th, 2012 by Jeremy Beckwith

Jeremy Beckwith, chief Investment Officer at Kleinwort Benson until October 2011, was guest speaker at the Guernsey Chamber of Commerce lunch at the OGH Hotel in St Peter Port on 16 January 2012.

The following text is a transcript of Jeremy Beckwith‘s talk.

“My newspaper tells me that today is the most depressing day of the year and I don’t think I am going to tell you very much to alleviate that.

The title of this talk is the global market and the economic outlook.

In 2008 we had a global banking crisis.

A global banking crisis happens when everyone realises that the bad assets on the banks’ balance sheets are much greater than their capital, and in Japan in the 1990s they managed to write-off the entire banking sector capital three times, so they wrote it all off, they raised new capital again, and wrote all that off again, and raised new capital and they wrote all that off.

Now, in a banking crisis a few things happen.

The first thing that happens is that banks lie, and it is really important that you understand this because banks have to lie because the moment anybody thinks that a bank doesn’t have enough capital they stop doing business with it, depositing or transacting with it.

Jeremy Beckwith addressing the Guernsey Chamber of Commerce lunch meeting on 16 January 2012 (click image to expand - ©RLLord)

So banks after a banking crisis will always tell you that they are well capitalised, and indeed their balance sheet will always show that they are well capitalised because otherwise they will be seen to be lying, but in practise what happens is that the amount of bad debts that the bank writes off is nothing to do with how much bad debts they have actually got. It’s all to do with how much capital can they show on their balance sheet and how much more capital they can raise, and so banks are always telling you they are well capitalised but they are lying because they won’t tell you all the bad debts they still have to write off, and I am afraid for European banks it is enormous, and we may very well have to write off the capital of European banks another two or three times.

The second thing that happens after a banking crisis is that there is a very, very long period of almost no economic growth and the reason for that is fairly straightforward – banks have just lost loads of money lending to people they shouldn’t have done, and so to correct that mistake they stop lending money to anybody. In fact they are rather more keen that you pay it back to them and that’s the situation we are in now.

Banks earnestly promise governments they will increase their bank lending, and of course they fully intend to but somehow it never quite happens and that means that bank financing is not there to support growth.

The third thing that usually happens after a global banking crisis is that you reduce the number of banks. There are fewer banks. They go bust. Those that are left are ready to be more profitable and take the whole system forward once again.

In Europe we have a bit of a problem with that last bit. Europe is lots of small countries and in any one of those countries every government wants to have two or three banks.

So the top two or three banks in every country are too important, too big to fail so we don’t want banks in these countries to go bust.

Europe as a whole has far too many banks but no government is going to let their banks go under.

That means that they have to be recapitalised. We have to find new money, new capital for them, and the only source of that capital right now is governments themselves. So governments will have to provide the money to recapitalise the banks. The problem with that of course is that governments themselves don’t have any money.

So where do they get that from?

Well, they borrow it from the banks, and so we have this ridiculous situation now where bankrupt governments essentially recapitalise bankrupt banks with money that the banks lend to the bankrupt governments, and its just a complete Ponzi scheme that is going around and around at the moment and at some point will come to a shuddering halt, and there are only actually two ways out of this.

One, is you need a new external source for bank capital. Well, that is quite tough. Maybe the Chinese will buy into all our banks? Maybe the Indians? They’re the ones with the money nowadays but they don’t seem to be in a rush to do that.

Or, we can’t do that, then we have to print the money ourselves, and give it to the banks and that is probably what has to end up happening because no one else has the capital to recapitalise the bankrupt banks.

Now, that is only one of Europe’s problems. The other problem of the Eurozone is a competitiveness problem and it is probably actually the more important one.

Essentially since the Euro started, the average unit labour cost of producing something inside the economies of the periphery have risen by about 30% relative to that in Germany.

Germany has built up a bigger and bigger trade surplus with these other countries in Europe and they obviously have had a commensurate trade deficit.

Germany is just sucking the Euros out of all these countries, which until 2008 it then recycled by their financial system, lending it back to these countries’ financial systems.

The problem now is that the peripheral countries are totally uncompetitive. Their industry cannot compete with Germany.

The solutions to that are one, they cut their labour costs by 25%.

Well, in Greece or Spain or Italy, you do that you might find you have got riots and civil wars, and military coups and that sort of stuff. Second, the Germans raise their wages by 25%. That is a great solution. Persuade the Germans to increase their wages by 25% sorts out an awful lot of Europe’s problems. Sadly, the Germans don’t want to do that.

Or third, of course, you have to devalue. You have to come out of the Euro.

Essentially, what happens in the Euro is all down to what Germany wants.

Germany has to choose between its post-war foreign policy, which is to be good Europeans and supportive of further European integration, and make friends, or its primary economic policy since the war, since the hyperinflation of the 1930’s, which is to have sound money and stability.

We are now in a situation where we can’t have both anymore. They have to choose.

If they want sound money and stability, the Euro has to go hang because the only way to save the Euro is to print loads and loads of Euros.

If they want to stay good friends with the rest of Europe they have to let lots of money be printed and they have to have inflation in Germany.

Germany cannot have both its key foreign policy and its key economic policy objective at the same time anymore. They have to choose. And they have been trying very hard not to choose during the last two or three years but the time is getting nearer and nearer when they are going to be forced to.

So which way will Germany go?

If you look at German politicians they are very pro-Euro. They are very pro European political jobs. German politicians to a man are all pro doing what ever is necessary to save the Euro.

And if you talk to people in Germany who vote they want to protect the German economy and protect the Germany currency and they will tell the rest of Europe to go hang.

Who wins over that debate I really don’t know. We’ll have to wait and see. It’s a too difficult call to make.

Similarly, the European Central Bank (ECB) have a choice to make as well.

They can either maintain the Euro – keep it alive by printing lots of Euros or they can maintain their reputation as a hard fighting, inflation fighting central bank that you can rely on for sound money.

They have to choose between those two objectives – stay alive or have inflation.

Not clear again which way they are going to go.

The trouble is that either option is hugely expensive and hugely disruptive. And so no one wants to make a decision on that so it will happen by default.

The markets will force something to happen at some point probably this year though not necessarily.

What I do think definitely will happen this year is that Greece will leave the Euro. Greece is bust. There are more and more German politicians who have given up on Greece. It is not forming any part of a potential solution to the Euro crisis. Greece will be allowed to go but I think they will try to prevent anyone else going.

The problem is that it is going to be very difficult for the German people to accept that.

Germans have lots of strengths but they don’t really understand markets or economics.

In 1990 when the Berlin Wall fell they took on East Germany, which made a huge increase in their budget deficit. And in 1999 when they went into the Euro they went in at far too high an exchange rate, which made them uncompetitive, and their response to these two problems – a big budget deficit and uncompetitiveness – was to tighten their belts, cut spending, keep wages down, work harder, and from 2005 to the last year or so, the German economy has been one of the strongest in the world.

They took their medicine in the face of these difficulties and it has worked for them.

They now look at the problems the periphery has – big budget deficits and uncompetitiveness – and say, well, we showed you how to get out of this. We did this ourselves just a few years ago. You can jolly well do the same, which is very logical.

The problem is that Germany in a world context is a small and a very open economy. It is able to export all over the world and be influenced by what is going on in the world economy, and you’re able in that situation to cut back and become more competitive and sell more.

The Eurozone is not a smaller economy. It’s a large closed economy and if everybody inside the Eurozone is cutting back government spending, which they are quite severely then there is no demand growth within the Eurozone. And actually there is very little in the way of exports out of the Eurozone to the rest of the world relative to the size of the economy.

So the economic policy prescription which is entirely logical to Germans, and what the did themselves, is entirely the wrong one for the Eurozone as a whole, and the Germans haven’t or won’t realise that.

Essentially what they are doing is forcing Europe into austerity and forcing it into depression that in the end will be unsustainable and is likely to lead to civil war and riots I think across most of Europe unless something changes.

The UK I think is basically pursuing fairly sane economic policies, in the context that there is not much that they can do.

They recapitalised their banks very aggressively and very early. That is good although I think Lloyds and NatWest will find over the next three to five years actually write-off much, much more of the bad debt than you can possibly imagine today, several times more than their capital base is.

The Bank of England was one of the very first to start Quantitative Easing to help keep the economy going, and the UK government has pursued a steady policy of austerity. If you go into savage austerity you try and cut capital spending by 3, or 4 or 5% in any one year you have an immediate impact on the economy as a whole and you send that into recession.

What the UK government is doing is cutting by 1 % during the year which is actually doable in theory, without having too much impact on the real economy.

I think what the UK government is doing is sensible – whether it works or not actually depends on the activities of the rest of the world over which they have very little influence. There’s not much to say about the UK. You just hope they carry on doing what they are doing currently.

Jeremy Beckwith addressing the Guernsey Chamber of Commerce lunch meeting at the OGH Hotel in St Peter Port on 16 January 2012 (click image to expand - ©RLLord)

America is in a really interesting time. It’s in an election year. It lasts all year in America as I am sure you know and we have at the moment probably the greatest level of antagonism between the two parties I have ever seen. This is very much an ideological war. There’s quite a lot of use of the phrase “class warfare” going on in America at the current time.

In an election year nothing can happen on fiscal policy. There’s no way that a divided Congress and the President will ever agree on anything this year so nothing is going to happen on fiscal policy, and in an election year the Federal Reserve always has a preference to do anything it needs to do in the first half rather than the second half. They want to be seen to be doing nothing in the second half of the year during an election campaign.

So if we are going to get any further easing of policy in America, it is going to be early in the year. That’s made more probably by the changes in the make-up of the Federal Reserve Board. There are rotating voting members on the Federal Reserve Board. At the start of this year you had three quite hawkish people come off the voting register of the Federal Reserve, and you’ve had two fairly dovish people come on and one fairly middle-of-the-road person.

So the probability is the Fed is now much more likely to pursue an easing policy of printing more dollars this year.

The economy as a whole is at a critical level of growth, about 1.5% to 1.75% growth, which is stall speed.

Every time American growth has gone down below that it has tended to go into recession, and it is also the speed at which unemployment remains stable.

Unemployment is absolutely critical in an election year. President Obama is desperate to show unemployment falling over this year. There’s not anything he can do about it. He just hopes it happens.

Essentially the American economy is right on this critical level of growth and it depends on how much American consumers and American business decide to spend over the course of  this year. It is very tricky to say.

What we do know is that confidence – both consumer confidence, and the desire to invest by companies is at historically very very low levels. And that makes sense.

It is one of the key features of things that happen after a banking crisis when you go into a period of slow growth.

If you see slow growth coming forward then what is the point of spending.

If there’s no inflation things will probably be cheaper tomorrow so let’s put off doing anything. You don’t need to spend today. And that’s the problem we have got here.

Of course in the good old days just a few years ago when everybody was more confident we all thought life was going to get better and we were going to earn more money in the future. I can borrow today and I am going to spend it, and we’ll drive the economy forward, and so the mindset that people have is a very important part of how well the economy is doing.

I think we have shifted from very positive from 1980 to 2007 now to pretty negative and very much like Japan for the last 20 years with no one knew when it would grow again so no one bothered to spend any more money.

The big issue and I think the big political issue this year is going to be the inequality of income in America. It is worse than ever since 1928 – worst in terms of the most unequal. The top one percent in America earn 20% of all income. The top ten percent of income earners in America earn half of all income in America. The Occupy Movement is all about the 99%. The 99% of people who earn below average pay.

We have this very ideologically driven Republican party and Obama who would be a social democrat I guess in Europe. We’re going to see a very interesting debate in America we are going to see as to whether society is about protecting the weaker members or letting the rich do whatever they want to and get richer and not tax them. At the moment the betting odds are 50:50 between Obama and any Republican challenger. Too close to call.

Where I think there could be a surprise is with a third candidate coming through. I think there are two possibilities here – one is Ron Paul who is currently challenging the Republican primaries who is 76. This is his last go at the Presidential nomination. He is of a particular odd mindset that he thinks most government things should be abolished – most government departments, and apparently he is doing very well with 25 year olds. He could try and stand as a third party candidate.

The other person possibly is Mayor Bloomberg of New York. If the American people could be persuaded they really do need to do something about the budget deficit you might want a technocrat – like someone who has come in in Italy or Greece – a proper business person who knows how to do these things, who is not political, and do it from that perspective.

I think if Ron Paul stands he takes votes from the Republican candidate. If Bloomberg stands he takes votes from Obama and that could swing the election should that happen.

The next major economy you need to be worried about is China. After 2008 the Chinese embarked on probably the largest most dramatic stimulus plan the world has ever seen. Massive amounts of investment- told the banks just to go out and lend and not worry about whether they were going to get the money back.

Jeremy Beckwith addresses the audience at the Guernsey Chamber of Commerce lunch on 16 January 2012 (click image to expand - ©RLLord)

We have had two years of very strong growth which has created an inflation problem in China, particularly food inflation, which really matters to the Chinese authorities because if people cannot get enough food they will tend to riot and the Chinese are terrified of that.

The other sorts of inflation you saw was in residential property. There are tens of towns across China that have been built in the last three years full of blocks of flats, shops, roads, railway lines – all the property has been sold. People have bought it as an investment. They all believe that property is going to go up. Nobody is living there. They’re not getting any rental income. They are just sitting there. Would anyone try to sell these things, and no one seems to be at the moment, there’s the possibility of a big fall back in Chinese house prices, which could do some harm to the Chinese economy.

It is quite important to realise that in China it is very hard to get a mortgage so all this money is actually equity – it’s net savings that people are going to lose. You’re not going to create more bad debts at the banks, which will lessen the impact of the downturn compared to what would happen in this country or in America on a housing crash.

The other problem in China is this massive and sudden surge in investment when all sorts of things got built when there was no economic reason to and essentially the money is wasted – the return on that capital investment is going to be near zero. That is going to create some bad debts for the Chinese banking system, and if the rest of the world is slowing down or not growing then the outlook for Chinese exports is worsening.

The Chinese economy is clearly slowing. If it has a hard landing I think that is a nasty surprise to western investors who are all pretty much of the belief that China can control its economy in spite of the fact that its pretty clear that the west hasn’t learned to control their economies. That would weaken investor confidence further and scare people quite a lot.

That is potentially a pretty cataclysmic economic picture. It doesn’t have to be like that. The more likely scenario is that there is zero nothing, zero growth, not much inflation, just nothing happening, which is very boring but actually livable.

For financial markets I think we know that interest rates will stay low for a long period of time.

In Europe and America interest rates are going to stay very low for a long time. Get used to it. There is no return – no bank interest any more.

Bond yields were people seem to be able to repay them will also be very low.

Central banks will continue to print lots of money just to keep the financial system afloat because if they don’t there’s a danger the banks go under through lack of liquidity and lack of solvency. We’ve seen that already in the UK, in America, Japan, and even in Switzerland where they promised to print as many Swiss Francs as the foreigners want to buy so there isn’t a safe currency.

I think if the Euro is to survive it will only survive by printing loads of Euros so every central bank is going to be printing loads of money. There’s not a good currency. Your best hope is gold, possibly silver. Secondly, banks are not going to lend in spite of governments telling them to and that means you’re not going to get much growth, and also unemployment stays very high.

So how do you invest? Well, I would still own lots of gold. I would probably buy more.  I see one more huge run in gold starting sometime this year, and the biggest shortage in the world, what everybody wants to find is an investment that gives you a long term sustainable income that hopefully goes up over time.

As you look around the world to try and find those I think your best hope to try and find that is in the very largest multinational companies that produce products that most people in the world would like to buy.

They have the advantage that they can produce where ever in the world they chose to, where it is cheapest. They can sell where ever in the world they want to.

Emerging markets in particular got lots of people wanting to buy stuff. These companies have strong brand names and indeed they always choose where they pay their taxes, and this is I think a quite important thing that is going on now.

The most powerful agents, economies, in the world today are not governments. They are multinational companies. This is evident in that something like 50 American companies can now borrow money more cheaply than the American government, and in Japan it is something like 50 or 60 as well.

So the bond markets are cottoning on to this. The multinational companies are a better credit risk than governments.

For Guernsey in many ways you are still very fortunate. You are in a bit of a bubble here – a bubble separate from the rest of the world rather than a financial bubble.

On one hand governments need tax revenue and they are going to be more and more vitriolic about places they perceive to be tax havens and so you should expect that and they will try and find ways to discriminate against you.

On the other hand, their citizens are not going to want to pay much more in higher taxes and they might be quite keen to find ways of using places they perceive to be tax havens in order to protect their wealth so there are good and bad features of that.

In terms of the funds industry it is not a great time for financial markets and won’t be for several years. Funds that require leverage in order for their investment thesis to work will close down. There’s no future in that because no one is going to provide you with the leverage at an attractive price.

However, if there are funds that are designed to produce long-term sustainable income streams from different sources that’s probably something people get quite excited about and those sorts of things I can see a future for, and you’re going to have to winnow out quite carefully what funds are likely to do well in this world, and what funds are not.”

 

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