JSA RMF February 2018 UPDATE

1. Economic Update February 2018 This month’s update is longer and contains more geopolitics than usual. This is because, for the first time in two generations, the economies of every country in the world are growing (with the possible exception of North Korea). This synchronised global upswing presents new risks and uncertainties. It would appear that the massive stimulus created by central banks’ money creation is finally flowing through the global system. And this is quickly absorbing existing capacity. In the next 18 months, the USA, Germany and the UK will probably be running above capacity. The result will be wage and price inflation. Central banks are aware of this and 2018 will be the year of rising interest rates. It is likely the Fed and the ECB will be behind the curve (i.e. raising rates too little, too late), but the Bank of England are indicating that they are on the curve. The B of E will have to accept that they will be criticised for raising rates when there is so much uncertainty due to Brexit. Rees-Mogg will no doubt accuse Mark Carney of treason! It is reasonable to assume that, by 2020, the base rate in the UK will be 3%, and 3.5% in the USA. The recent gyrations in share prices reflect the change in expectations. The yield on 10 year US bonds last month was 2.9%; the S&P dividend yield was 2.2%. The algorithms which now trade 90% of US shares were clearly programmed to sell when the yields crossed over and then buy again a day or so later – hence the volatility. The Index in the US is back at 2700; the same level as in January. A key question is: will US company profit growth support the current valuations? The answer is that the Trump tax cuts make it possible. This year, I think the risks are more political than economic. The UK is in disarray; Germany has just forged an uneasy coalition. Trump is difficult to comprehend, particularly in relation to the Middle East. Italy may return Berlusconi as Prime Minister. Of the major economies only China and France appear to have stable and strong leadership. There will be consequences but we do not know what they might be. The USA It is best to ignore the words of Trump and look at his actions. So far the actions have been good for the US economy. Trump has given Middle America a big confidence boost. The tax cuts on business will be shared with employees because labour is now scarce across all sectors. There is going to be effectively a $1.2 trillion boost over the next five years to an economy which is already near the top of its cycle. This is an economic risk, but a political gain. Trump is ensuring success in the midterm elections. It is not widely understood that two thirds of federal spending is mandatory i.e. spending on welfare. This will increase due to US demographics over the next twenty years.

2. The surge in wages and job availability should attract people back into the workforce. If this happens then a 4% real GDP growth rate is possible with only moderate inflation. If inflation remains moderate (below 2.5%) then US interest rates will still be negative in real terms and remain so until they exceed 2.5%. However it is possible that wage growth and inflation will soar due to capacity constraints. Then interest rates will be at or close to 5% over the next two years. Ten year bonds are now yielding 2.8%. The growth in the USA is boosting global growth. The EU and China are growing strongly. 2

3. The UK and Brexit It is impossible to detach oneself from the politics of Brexit. As a behavioural economist, I am always concerned with how people feel about things. I believe this affects the decisions they take. It is my opinion that Brexit is the consequence of the financial crisis, and its aftermath. It has been suggested that many people voted leave as a protest against austerity. The result of the vote is higher inflation, lower real incomes, uncertainty, the holding back of investment and a divided country. We have always enjoyed the reputation for being a stable parliamentary democracy with a pragmatic approach to issues. But this has faded. Today we are experiencing what can only be described as a civil war but without the bloodshed. 3

4. The nation is seemingly unable to shift towards a pragmatic approach to current issues. On both sides of the debate there is no recognition of each other’s position. It would seem the issue is irreconcilable. Families are divided and for many, the topic cannot be discussed or debated. The conflict is over the nation’s destiny. It is 20 months since the referendum; nearly a year since the letter was sent announcing that we intend to leave the EU. And there is no vision, no defined strategic goal, no discussion on the desired outcome. Anyone who looks at the numbers and comments on them is told they are biased (on both sides). Nobody is considered neutral. This state of rudderless drift is impacting on hearts and minds. I am struck by the number of young professionals in their late twenties who are leaving the UK to work in Singapore, Australia and Europe. We know too that young EU workers are returning home. And we have many retired people who bury their heads, muttering it will all be ok in the end because we were once a superpower and, released from the shackles of the EU, we will be again. The UK is divided, our politics are in disarray (on this we are not alone – I look at Germany later on), our economic performance is below the average of other wealthy countries. Our bargaining position appears to be weak. As we chose to leave EU without a post-Brexit vision, I expect the EU will tell us on what basis we may or may not interact with them. We are 16% of the EU economy. We have a balance of payments deficit of around £100Bn. Most of this is with the EU. If you add in our subscription this amounts to 6% of GDP. It is essential that we buy less from the EU and sell more to the EU. Our trade in goods with the EU was a deficit of £40Bn in 2008. It is now £100Bn. Our trade in services is not sufficient to offset this deficit. We only balance the account by attracting money into the London launderette. The only way this deficit will reduce is by a (significant) change in relative prices. Sooner or later this will happen. Sterling will fall against the Euro. The UK will compete with the EU by being cheap. In 2016, the UK was home to 5.5 million businesses employing 26 million people. Manufacturing accounted for 5% of businesses, 10% of employment and 15% of GVA. The University of Sussex and Chatham House have conducted a comprehensive analysis of the outcomes of five possible Brexit models for UK manufacturing. This analysis has not been funded by one faction or the other, so I consider it to be as objective as possible. If you want the detail go to:http://blogs.sussex.ac.uk/uktpo/2018/02/06/manufacturing- industry/, but I summarise their key findings below: 4

5. None of the 5 possible Brexit scenarios leads to a positive outcome for UK manufacturing, with the exception of food processing. There is considerable variation across manufacturing sectors: textiles, clothing and footwear production have the largest decline. Food processing will expand. Currently we import 34% of our food from, the EU. This is expected to reduce. Higher prices will be required to cover the cost of customs formalities, logistics and greater working capital. High tech and medium high tech are more at risk than low tech companies. Professor Minford, Jacob Rees-Mogg, and Liam Fox would probably argue that the Sussex research fails to take into account the animal spirits of British entrepreneurs. Minford argues strongly for a hard Brexit and assumes that, released from the shackles of the EU, the UK will grow at 2.8% per annum. The FT paid a consultancy to look across the globe for markets with the best fit with the UK in terms of history, legal system, language, demographics and distance for the next 35 years. The chart ranks them in importance for potential trade. The EU is and will remain the biggest opportunity for British business. The Brexit uncertainty is dampening investment by big companies. 5

6. The fall in net migration is constraining labour supply. To monitor the impact of this, keep an eye on Harrogate. Until recently 10% of the workforce there was from the EU. They worked in social care, retail and hospitality. Waiters are in high demand. Local unemployment is 3.6%. Prices for cheap housing are growing at half the regional average. Teenagers are being paid above their minimum wage because there are few student casual workers (there are no large local colleges or universities). For the ‘vote leave’ brigade this is the desired outcome: young people enjoying above inflation wage awards and being priced back into the housing market. The owners of local restaurants may have a different perspective. We should expect to experience a lot of charming old waiters in Harrogate in the near future! Source: The Economist Feb 6 2018 The Bank of England is clear that labour supply is a limit to growth. They are assuming the maximum non-inflationary growth rate is now 1.5%, not 2.25%. And they are posting that interest rates will be raised to keep growth at or around 1.5% real or 4% nominal. As the UK is a major trading nation and our two biggest markets, the EU and the USA, are booming, we can expect net exports to rise strongly until we hit the capacity ceiling. The Bank has to judge when this is. My guess is March 2019, a year from now. Because there is a 9 month lag between a rise in rates and a moderation in inflation, we should expect +0.25% in May, and again in October. So a 1% base rate by the end of this year. 6

7. The chart below shows that our workforce participation rate is already very high. There is of course scope for bringing the newly retired back into the labour supply. I suspect we will need a cut in pensions to achieve this. Lower growth plus the cost of leaving the EU will strain Government finances so more austerity is likely. But as has been said before the best solution is labour substitution using AI and automation. The outlook for the UK is moderately good for 2018: The outlook for the UK is moderately good for 2018 GDP in real terms will be 1.9% Wages will grow at 3.5% Inflation will stick at 3% Retail sales will improve in the second half of the year House prices +1-3% depending on location Interest rates 1% by year end Exchange rates – so much depends on politics and negotiations Given relative interest rates, inflation rates and current exchange rates, Sterling should be weaker against the dollar at $1.33, and 1.12 against the Euro. The chart summarises the possible movements. 7

8. The EU The EU is enjoying a strong recovery. As Germany is 21% of the EU I am going to focus on its performance. Germany has an unemployment rate of 3.6%. There is some scope to raise the participation rate but Germans are big into work life balance. IG Metal Union has agreed to a 28 hour week and workers can take time off to care for sick children or elderly relatives. They can opt to work 40 hours for extra payments. The basic wage will rise by 4.3%. We can expect more deals like this because Germany is clearly at full employment. Germany will be investing heavily in automation and AI over the next few years because local politics will limit immigration. Its membership of the EU has not prevented it from exporting around the world. It is currently running a massive trade surplus at 8% of GDP (the UK is minus 4.5% of GDP). The UK is the biggest global customer for German business. As in the UK, Germany has under-invested in basic infrastructure because the Federal Government cannot run a budget deficit by law, but it is responsible for paying social security which, due to a rapidly ageing population, is a significant cost. In so many ways Germany has similar issues to the UK (apart from its success in global markets). It hasn’t had a proper government since last September as various factions squabble for power. Angela Merkel is in a much weaker position than before the election. The German right wing party, the AfD, is the third largest in the Bundestag. The AfD is nationalist, anti-immigration, against same sex marriage, Eurosceptic, and believes strongly that Germany has given up sovereignty to the EU. In particular they believe Germany should not provide financial support to Greece and other member states. Merkel is trying to forge a coalition of conflicting interests. The consequence is no clear vision for the future of Europe, and policy choices constrained by the need to keep the unhappy marriage together. Meanwhile there will be growing disagreement between the Bundesbank and the ECB. The Bundesbank will press for higher interest rates and /or a significant reduction in the ECB balance sheet achieved by selling the bonds purchased under QE back into the market. Yet again, the one size fits all monetary policy and the survival of the Euro will be questioned. The state of German politics will give Macron the opportunity to deliver the French vision for the future of Europe. The cornerstone of French thinking is an EU with 8

9. different levels of membership. In short a multi-speed Europe which harks back to pre- Euro thinking. However France believes that the core countries (unspecified) should create an EU finance ministry with a tax system which redistributes incomes across member countries. In my judgement the only supporters of this idea will be in the secretariat; not the EU Parliament. The Parliament has already thrown out the French proposal for pan-EU members. Why there is so much politics in this update? The reason is simple. The current risks to business are more geopolitical than macro- economic. There is a seismic shift under way. The rise in income inequality is being magnified by the digital and AI revolution (this still in its infancy). The bottom 70% are missing out. In the UK 23 million adults pay no income tax. Only 13% of the population pay tax at 40% or above. Populism is a belief in the power of ordinary people, and in their right to have control over their government rather than a small group of political insiders or a wealthy elite. The French Revolution overthrew the monarchy but in the ensuing chaos, the dictator Napoleon emerged. Trump is a populist; in Italy, Berlusconi could win a majority on 4 March. And in the UK we have the three musketeers: Johnson, Fox and Gove. In 2010, populist candidates around the world captured 7% of the vote. In 2017 it was 35%. The last time a swing of this magnitude occurred was in 1938. In previous updates I have shown how an increasing share of added value created by business has gone to the owners rather than the workers. This is now affecting political choices. 9

10. The global economy is on a synchronised upswing for the first time in two generations. Labour markets are tight. There is little spare capacity in all the major economies. Market forces move faster than political change. The share of added value going to labour will certainly increase at the expense of owners. The macroeconomic implications are as follows: Faced with higher labour costs but not wishing to reduce margins, companies with price making power (this is a function of market share, and/or distinctive, compelling market positions) will raise prices. As prices in general increase, central banks will curtail the growth in money supply by raising interest rates. With a time lag, consumer discretionary income and company investment spending reduce and sales volumes slow, reducing the demand for labour and its price. This typical economic cycle may not take place this time around. If the rate of labour substitution increases due to technology then the main wage and price pressures will be in the businesses which design, supply and maintain AI systems and businesses where labour substitution is not yet possible. We can be sure that it will be complex, difficult to predict, and there will be unintended consequences. The science of complexity shows us there are no straight lines: there will be a dynamic emergence with significant political implications. China I confess I have been consistently wrong about China. I assumed the country would implode under the pressure of significant excess capacity in most manufacturing industries. It hasn’t. The command and control economy is clearly being well managed by the Politburo Standing Committee. Xi Jinping has tightened his grip on all aspects of Chinese life and the economy is booming. My preferred measure of economic activity is electricity consumption. Given the fact that heavy industry has significantly reduced its demand for electricity, consumption in 2017 suggests the economy is growing at over 7%. At $8,000 per capita, China is in the middle income trap. This occurs when the income growth from traditional manufacturing has to be replaced by growth from services. It would appear China is avoiding the trap by driving the transition to higher added value activities. The government's 13th Five-Year Plan, unveiled in March 2016, emphasises the need to increase innovation and boost domestic consumption to make the economy less dependent on government investment, exports, and heavy industry. China appears to have made more progress on subsidising innovation than rebalancing the economy. Beijing is committed to giving the market a more decisive role in allocating resources, but policies continue to favour state-owned enterprises and emphasise stability. China has renewed its support for state-owned enterprises in sectors considered important to economic security, explicitly looking to foster globally competitive industries. The leadership have undermined some market-oriented reforms by reaffirming the dominant 10

11. role of the state in the economy. The acceleration in economic growth in 2017 gives Beijing more latitude to pursue its economic reforms, focusing on financial sector de- leveraging and its Supply-Side Structural Reform agenda, first announced in late 2015. Geopolitically China appears keen to fill the vacuum on the world stage created by the introspection in Trump’s America. Its defence budget is the second largest in the world at $146Bn – which is 2% of GDP. The UK also spends 2% of its GDP on defence, but our economy is 4 times smaller. Conclusion If you are running a business in the UK, train and develop your people so that they are able to leave but manage and lead them so they want to stay. Talent is key to your success and it will become increasingly scarce over the next two years. Roger Martin-Fagg 15 February 2018 Roger Martin-Fagg rmfagg@aol.com 4-5 Gray’s Inn Square, Gray’s Inn, London, WC1R 5AH T: +44 20 7688 1928 E: info@jsacs.com W.: www.jsacs.com 11