Written by Roger Martin-Fagg, Behavioural Economist.
“UK SME confidence remains optimistic but there are economic challenges ahead”
About Roger Martin-Fagg
Behavioural Economist
Roger is an economist turned strategist. He began his career in the New Zealand Treasury, then moved into airline business planning and teaching postgraduates all aspects of economics. He designed and ran the postgraduate diploma in Airline Management for British Airways before joining Henley Management College in 1987, where for 21 years he taught senior managers macroeconomics and strategy.
Roger is an independent teaching consultant. He has been an external examiner to Bath University, worked with the Bank of England and three of the major UK clearing banks, and advised a major London recording studio for 15 years. Roger regularly talks to SME owners in the UK and Europe about economic trends, and is a visiting fellow to Ashridge, Warwick and Henley business schools.
Welcome to the June 2023 Economic Update.
The purpose of the update is to act as a counterweight to the general economic commentary you get from the media. As many of you know I look at the economy through a behavioural lens. I focus on money and how it flows. As I explain in this update, this is missing in the mainstream models which are widely used by mainstream forecasters. Many of you have heard me say that these models and forecasts are precisely wrong. My
approach is broadly right. It’s your choice!
I am naturally optimistic (as most of you are!). As a consequence I tend to accentuate the upside and choose the data which supports my natural inclination.
If you are a pessimist there is a huge amount of analysis and commentary out there to support your mindset.
My optimism is always justified when I spend time with you. Vistage members are thinkers and doers simultaneously. Your adaptation to the reality of lockdown has been remarkable and I know many of you are
producing financial results well above plan. As you are60% of the economy my optimism is justified by your behaviour. Please continue to train, invest, innovate and lead. My forecasts will then prove correct!
Roger Martin-Fagg
June 2023 Economic Update
If I arrived on Earth from another planet and knew nothing of Covid, Trump, Truss, Sturgeon, Boris and Putin whilst considering the macroeconomic data for the G7 I would be close to certain that the G7 would be in recession in 2024.
But I have been around a long time and seen the economic events of recent years. All is not as it seems.
In this update I will try to explain what the data is telling us and give an opinion on the likely outcomes. We begin with the difference between monetary policy and fiscal policy. Monetary policy is setting interest rates
to influence the behaviour of commercial banks and their customers. Interest rates are raised to reduce the demand for loans and hence the growth rate in the money supply.
Lower growth in money supply primarily affects the price of real estate in all its forms, which if falling, hits household confidence and those with mortgages find upon renewal their discretionary income is significantly reduced.
Fiscal policy is primarily changing tax rates and government spending to redistribute income from those in work to those retired. And to fund infrastructure, health, defence and education. And exceptionally to support
employment and business owners during a pandemic. The problem is fiscal and monetary policy are not independent of each other.
During Covid there was a massive expansion in government debt, all of which was financed by the central bank. So Covid drove both expansionary fiscal and monetary policy.
The expansion was $17 trillion globally, and $900 billion in the UK.
The inevitable result is a surge in average price levels of everything ie land, buildings, labour, materials, food, energy, IP, equities.
However G7 governments are currently expecting their central banks to bring inflation down whilst fiscal policy still remains expansionary. Fiscal policy is expansionary if the government is running a budget deficit.
Currently the UK government is spending £45 billion more than its income from tax. The USA is spending $1.5 trillion more. And their central banks are raising interest rates because excess demand is causing inflation.
So government has its foot on the fiscal accelerator and the central banks on the monetary brake. No wonder there are mixed signals from business owners and their customers.
Imagine your are driving a car, you have your foot on the accelerator, you passenger their foot on the brake… how fast forward will the car go, if at all?
If the UK government seriously wanted inflation back to 2% asap, they would raise income tax by 5p, create a recession and prices (after a time lag) would stop rising (except for imported products). Or cut government
spend by up to £45 billion. This is of course not politically acceptable. So we are left with the hope that higher interest rates will do the job without causing a recession.
The core U.K. problem is a lack of productive capacity. The output gap is an estimate of how much spare capacity the economy has. It’s estimated at 0.1% of GDP currently. This means overall the UK has virtually no spare capacity.
The UK’s Growth Rate
Up until 2008 the average real growth rate for the UK was 2.3%; between 2008 and 2016 it was 1.3%; since 2016 it has been 1.1%.
Our productive capacity has barely grown since 2016 due to a collapse in investment plus demographics. The key question is can the UK grow faster than 1.1% per annum without inflation running above 2%.
The answer is no.
This is why.
If governments are serious about taking inflation back to 2% as soon as possible they must reduce demand.
We cannot magic up more labour supply. Investing in capacity creation takes time and simultaneously increases the demand for labour which isn’t available.
A recession would drive out zombie businesses creating more resources for others.
We know this is not current Government Policy. So all the emphasis is placed on monetary policy.
Currently money supply is growing at 3.2%. This could in theory finance 1% real growth and 2% inflation end of next year. And this is the belief of many forecasters.
So there is no need to raise interest rates beyond the current 5% unless wage awards still run in excess of 5%.
However regular pay in the first part of this year was up 7.2%. UK productivity is currently estimated at 1.3%. So arithmetically we are looking at core inflation running at 5-6%. Therefore the 2% inflation rate is unrealistic.
Next year real GDP could be minus 2% or plus 1%. I expect plus 1%. Why? Because although new money is running at 3.2% we still have Covid support money in the system.
Around 125 billion.
This would be sufficient to finance 5% inflation plus 1% real growth even if money supply falls back to 2% growth.
If government presses the BofE to hit the target of 2% then I can see 6% base and a two year recession. Bluntly we need unemployment to be around 7% to ensure employers can pick from a stock rather than poach from others. Even then there will still be wage inflation in Fintech, IT, and high-end engineering.
Over the next ten years our home grown labour supply is likely to expand by about 200,000 a year. This year it will grow by 500,000.
Unless there is significant immigration, our growth rate can only exceed 1.1% even if every business has a mission to automate and implements it quickly. This is effectively needs must.
AI and automation
How good is AI? Can it deliver the required productivity gains? I used ChatGPT to summarise our discussion so far. I cannot find fault with it.
It is important to note that while governments can influence inflation, there are also external factors such as global economic conditions, commodity prices, and market expectations that can affect inflationary trends.
Therefore, controlling inflation is often a complex task that requires a combination of prudent monetary, fiscal, and supply-side policies.
AI is a supply side component and so I asked ChatGPT to give an overview of supply-side technologies. This is its response.
1. Artificial Intelligence (AI) and Machine Learning (ML):
AI and ML technologies are being applied to various areas to automate tasks, optimise processes, and provide intelligent insights. They can assist with data analysis, customer service automation, predictive analytics, and more.
2. Robotic Process Automation (RPA):
RPA involves using software robots to automate repetitive and rule-based tasks. It can significantly reduce manual effort and increase efficiency in areas such as data entry, invoice processing, and HR onboarding.
3. Internet of Things (IoT):
IoT enables the connection of physical devices to the internet, allowing data collection, monitoring, and automation. This technology has applications in smarthomes, industrial automation, asset tracking, and energy management, among others.
4. Cloud Computing:
Cloud computing offers scalable and on-demand access to computing resources, eliminating the need for on-premises infrastructure. It enables organisations to store, process, and access data and applications more efficiently, leading to increased collaboration and productivity.
5. Collaboration Tools and Project Management Software:
There are numerous tools and software available that facilitate team collaboration and project management. These platforms enable remote work, real-time communication, task tracking, document sharing, and seamless coordination among team members.
6. Virtual and Augmented Reality (VR/AR):
VR and AR technologies are being utilised in various industries to enhance productivity. They provide immersive training experiences, virtual meetings, remote assistance, and interactive visualisation for design and simulations.
7. Wearable Technology:
Wearable devices, such as smartwatches and fitness trackers, can help individuals track their health and activity levels, manage schedules, receive notifications, and access information on the go. These devices can contribute to improved personal productivity.
8. Automation and Robotics:
Industrial automation and robotics continue to advance, streamlining manufacturing and logistics processes. Automated systems and robotic machinery can handle repetitive tasks, leading to increased productivity and precision.
This is a good example of how AI has increased my productivity. I would normally spend the best part of a day scanning the web for the data in italics. It took three mins.
We know that since 2021 further advances have been made in automation of health care, drug design, and the automation back office processes.
Proponents of AI argue for its potential to solve big problems by developing new drugs, designing new materials to help fight climate change, or untangling the complexities of fusion power. To others, the fact that AI’s capabilities are already outrunning their creators’ understanding risks bringing to life the science-fiction disaster scenario of the machine that outsmarts its inventor, often with fatal consequences.
The degree of existential risk posed by AI has been hotly debated. Experts are divided. In a survey of AI researchers carried out in 2022, 48% thought there was at least a 10% chance that AI’s impact would be “extremely bad
(eg, human extinction)”. But 25% said the risk was 0%; the median response put the risk at 5%.
The nightmare is that an advanced AI causes harm on a massive scale, by making poisons or viruses, or persuading humans to commit terrorist acts. It need not have evil intent: researchers worry that future AI may have goals that do not align with those of their human creators.
My opinion is AI is the solution to the labour supply shortage in the Western World. It will enable productivity growth. And thus expand the tax base which will be required to support health and wellbeing of the aged.
The USA
Inflation is now 4%, with wages growing by 4.3%, so real incomes are improving. Base rate is 5.25%, so the real cost of money is positive, unlike the UK where the real cost of money based on base rate is around minus 4%.
All US mortgages are fixed for at least 10 years and most are fixed for 30 years. So higher current interest rates only affects new mortgages. The US property market is less vulnerable to rate changes compared to the UK.
Even so in the UK since 2014 any borrower would have shown they could maintain their lifestyles if rates rose by up to 3%. The 3% was breached in the last two months.
Money supply growth is minus 5% primarily due to the Fed unwinding QE. Bank lending is growing by 1%. This data suggest the USA will slow but thanks to the big federal deficit the USA will avoid recession.
The EU
The Euro area inflation rate is 7%, base rate 3.75% so as in the UK the real rate of interest is still negative. Wage growth is 4.4%, so as in the UK real wages are falling. The data suggests that in the last quarter of 2022 and first
quarter of this year the eurozone shrank by 0.1%. Which frankly is neither here nor there and well within accepted statistical error.
The Outlook for Inflation
In the past 12 months energy prices have fallen by 33% (oil) 60% (gas), food commodities are around 33% higher except wheat which is down a third.
Metals are still rising except iron ore. But steel is back to pre-Covid prices.
Labour produces output. Taking the nation as a whole, those who do the work get around 60% of the value created. The owners ie shareholders and landlords get 40%. Demographics in the UK is a driver of this shift.
By definition those who are retired are living off rents and government tax transfers from those working. By definition anyone on state benefits is living off the work of others.
In short, the UK needs more producers and less recipients of money from the efforts of others.
How to do this?
Raise the retirement age, cut state benefits to the bare minimum for survival. Increase taxation on capital gains. Including property.
The politics of this distribution is Labour would like to increase the worker % and Conservatives the shareholders/landlord %.
Since the eighties there has been a shift in the UK. We have an increasing number who live off the ownership of assets and a reducing number of those who live by producing.
In other words there are more inhabitants of working age choosing to receive income from having property and shares rather than from producing.
To grow an economy we need to be more doers and less ‘owners’.
This will require a significant societal shift which I do not think will happen. That is until the rentiers no longer can survive on the income from owning and then have to start doing!
The fact that 100k of the 600k early retirees are back producing may be just the beginning.
The Property Market
Monetary policy is concerned with using interest rate to influence the supply and demand for money. Currently the supply of money growth rate has dropped to 3.2% yoy. This is because both the demand for and the supply of mortgages has softened and banks are more cautious to lend to business.
In the literature on the impact of higher interest rates economists talk of inflationary expectations and argue that rising interest rates and expectations of further increases should moderate wage demands. In a tight
labour market the opposite seems to happen. Employees particularly if changing jobs will demand higher wages to cover their mortgage, and desperate employers pay up. The increase is then put on their selling price, thus maintaining not reducing inflation.
All the evidence suggests that inflationary wage demands only moderate when the supply of jobs falls ie a sharp reduction in order books.
Can higher interest rates deliver a slow down or worse still, a recession?
The so called money transmission mechanism is much debated but the consensus is that it primarily works via the housing market.
The thinking is this.
Most Brits hold their wealth in their primary residence. It gives them a place to live and a tax free capital gain. Ever increasing house prices increases perceived wealth and confidence that the country is doing well.
There is evidence that if property prices are increasing, consumer confidence moves in line and spending flows.
And this can work in reverse as it did in the early nineties.
Inflation in 1990 was just under 10%, base rate was 14%, so typical mortgage was 16%. Wages were growing by 10.6%. Unemployment was 5.6%. House prices were falling by 1.5%.
By 1992 unemployment was 10%, base rate hit 15% and the UK left the ERM. Inflation was 3.2%. House prices were flat. Having dropped 18% in two years.
Many of the journalists are suggesting that there will be a repeat of the early nineties.
However they have missed a key component.
The collapse in prices in 1990-92 was primarily because NatWest and Barclays were insolvent and called in loans, pushing firms out of business and repossessed 300,000 homes which they dumped onto the market, willing to accept any price so long as it covered the debt.
A headline last week trumpeted repossessions up 50% in Q1. The number 750. I strongly believe that we will not see a repeat of the nineties.
Firstly UK banks are well capitalised, they have enough capital to cover delinquent borrowers without repossession. So no auctions of repossessed property to depress average prices.
Secondly the labour market is much tighter that in the early nineties and any increase in unemployment will not push it above 5%.
Thirdly average earnings are up 7.2% and will still be rising 5% year end.
Fourthly energy bills will be lower than expected in the autumn.
Fifthly there is still 125 billion of excess deposits in the Bank of Mum and Dad.
Most importantly 80% of mortgages are joint. So presumably two incomes, both of which are likely to be going up 5-10% depending on job and location. 8.8 million were earning at least £52,000pa in 2022. 9 million households have a mortgage ie just 30% of households.
End of 2022 the monthly average mortgage payment was £2000 per month. End of this year it will be around £2300 a month. The average mortgage is 185k.
In the first quarter of 2023 only 38% of house purchase was debt, the rest cash. Pre-Covid the figure was 47%. We know that for the 1.6 million who will have to renew over the next 12 months it will be a challenge as they shift from 2% to 6-8%.
We also know that 95% mortgages are difficult to obtain.
The big question is will the market crash?
My judgement is it will not. Average real prices have actually fallen by 12% since the post-Covid peak. We can expect a further fall of 9%.
Prices grew up until May and now are flat (this is normal in the selling cycle). Journalists are fond of comparing to the peak which was last August and they are currently 3.7% below the peak.
In nominal terms, on average I expect prices to reduce by 3% by the end of this year.
Transactions peaked in March and fell to 82,000 in April. I guess year end we will see a figure of 850,000 for the year. 23% below the normal number.
Given that we still expect to run at full employment, that average wages will increase by 5%, and that the Bank of Mum and Dad still have considerable funds I do not expect a repeat of the early nineties, or 2008-12.
In fact because the UK has a structural housing shortage for every person unwilling or unable to buy there will be someone who can and will buy.
Will the 1.6 million faced with much higher outgoings on mortgage finance create a recession?
The answer is no.
I suspect any supplier to middle market consumers will experience some impact. I guess skiing, long distance holidays and possibly larger SUV demand might soften but not by much.
The Exchange Rate
As I write this $1.27 is the rate which I forecast would happen by the end of the year. It’s noticeable that the forex markets didn’t move following the 5% interest rate announcement. They had already priced it in.
If the rate moves towards $1.33-35 over the next three months it strongly suggests that the market think the Bank will raise base rate beyond 5%.
Who knows!
The Euro rate is 1.17 and I doubt if it will go beyond 1.18 this year.
Conclusion
The UK non-inflationary real growth rate is 1.1% until productivity improves. The Bank of England will keep interest rates around 5% until inflation falls to 3%. This is unlikely to be achieved for a number of years because labour shortages will ensure wage competition and poaching.
The ‘normal’ rate of interest is real GDP growth rate plus 2.5%. So 3.5% is the lowest we will see in the future.
Any growth above 1.1% will require significant labour substituting investment using AI.
This investment would have taken place since 2016 but for Brexit. It’s now an imperative even though the cost of capital has increased. To repeat, the demographics show labour supply barely growing over the next ten years.
The demise of zombie businesses will release some capacity.
But continuing labour shortage will keep wage growth around 5%.
The housing market will not collapse unless base rate goes above 5%.
Lower than expected energy bills in the autumn will give some relief and support consumer spending before Christmas.
At last the BofE is admitting what some of us have known for years. Their model has a poor record of forecasting inflation because it doesn’t have equations which properly reflect the impact of money supply on activity.
And the MPC committee members are well respected academics who have little or no understanding how a business works.
If I was in charge I would ensure six out of the eight membership were SME owners. I would have a food producer (not an importer), a manufacturer, a logistics company, a construction company, an AI creator, and a training/education business. Only two of them can be from London and the SE.
I think the real economy will still manage to avoid recession. We will experience stagflation. A period of very low or no growth with persistent domestically generated price pressures.
The next 18 months is very difficult to forecast accurately.
Primarily because human behaviour is volatile and strongly influenced by the media which have already begun touting the R word.
Rishi Sunak is perhaps hoping that media misery will cause households to reduce their non-essential spend, increase their just in case savings and reduce demand.
Thus reducing wage inflation via softer demand for employees.
The only advice I can offer to a business owner is: look at all your processes and ruthlessly search for efficiencies which will reduce your demand for scarce and expensive employees. The next 10 years are labour shortage years.
Businesses which invests heavily in process re-engineering will reap considerable benefits. We all know the biggest obstacle is the human resistance to change especially when current performance appears to be ok.
If there was ever a time for inspiring leadership, it’s now.
Sources: Mr Roger Martin Fagg, Vistage International