Implied Inflation. Corporate Spread

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1 EconForum Update Are we facing a Japanese style lost decade? 5 November 2010 UK Month in Charts FTSE Implied Inflation USD per GBP Oct 1 0 Oct 1 0 Oct LIBOR Spread Corporate Spread Real Yield Oct 1 0 Oct 1 0 Oct 1 0 Series plotted relative to the closing position in the previous month. Source: DataStream This edition of EconForum examines the difference between the Japanese financial crisis, experienced in the1990s (which resulted in a lost decade characterised by low growth and deflation) and the current global financial crisis, in an attempt to discover whether the US and UK economies face a similar fate. UK Market Review The FTSE 100 index rose 3.5% from 5549 to 5741 over the first three weeks of the month before falling back to 5675 on Friday 29 October 2010, a 2.3% rise over the month. Part of the fall can be attributed to the falls in mining shares, amid fears that the proposed US quantitative easing would be less substantial than expected. Over the same period, the MSCI US and European equities rose by 3.8% and 3.0%, respectively. In addition, there has been a significant decline in volatility in global stock markets with the VIX index falling 11.8% from 23.7 to 21.2 over the month MSCI US Equity Oct 1 0 Source: DataStream 1 The above charts show the evolution of the daily time series over the past year relative to the horizontal axis, which is set at the last closing value of the last Friday of the previous month. The close of play values at the end of the last four weeks are shown as bars. A bar below the horizontal line indicates that the series has fallen below the value on the last Friday of the previous month. Conversely, if the bar is above the horizontal line the series is above value on the last Friday of the previous month. Page 1 of 21

2 15 year implied inflation has risen from 3.0% to 3.1% over the month, in response to rising oil prices and positive economic data. UK CPI inflation remained at 3.1% in September, the same as in August. In the year to September, RPI annual inflation was 4.6% down from 4.7% in August. Core CPI inflation fell from 2.8% in August to 2.7% in September. However, the bad news was that core goods inflation rose from 1.0% to 1.3%, the first rise in seven months. This was largely driven by a sharp rise in clothing and footwear inflation. Goods inflation is likely to continue on an upward trend over the next few months, given the recent pick up in cotton prices and other temporary factors such as retailers starting to raise their prices ahead of the coming VAT hike. The corporate bond yield (based on the non-gilts iboxx 15+ AA) increased from 5.0% to 5.2% while the 15 year gilt yield increased from 3.5% to 3.7%. Therefore, the corporate spread, as reflected by the difference between corporate bond yields and 15 year gilt yields, remained stable at around 1.5% over the last month. The rise in the yields can in part be attributed to positive Q3 GDP growth that effectively ruled out the prospect of further quantitative easing over the remainder of Over the last month, the real yield rose from 0.5% to 0.6%, reflecting rising inflation expectations Crude Oil ($) per barrel Oct 1 0 Source: DataStream Gilt Yield Oct 1 0 Source: DataStream Sterling strengthened against a basket of the major currencies in September, again supported by stronger-than-expected Q3 GDP growth. The sterling effective exchange rate index rose 0.4% from 79.9 to 80.2 over the month. In particular, sterling appreciated against the US dollar, rising 1.3% from $1.58 to $1.60 over the month. Against the Euro, the value of sterling remained unchanged at In the short term, sterling is likely to remain vulnerable due to persistent expectations of additional quantitative easing by the Bank of England undermining Sterling sentiment Sterling Effective Exchange Rate Oct 1 0 Source: DataStream The LIBOR spread (the difference between the rate of interest at which banks borrow funds from each other and the base rate) remained stable at 0.2% over the month. In October s MPC meeting, Andrew Sentence was again alone in putting in his fifth consecutive vote for a 0.25% rise in the Bank rate, while Adam Posen voted for an extra 50bn worth of quantitative easing. The minutes also stated that for remaining members the likelihood that further monetary stimulus would become necessary in order to meet the inflation target in the medium term had increased in recent months. This sentiment is largely unchanged from last month and suggests that the Committee is moving closer to recommencing quantitative easing possibly early next year. Similarly, in the US, the Fed introduced a second round of $600 billion of quantitative easing. Page 2 of 21

3 Is the developed world facing a Japanese future of stagnation over the next decade? There has been a spate of US and UK economic data that suggests that both economies are facing lower growth prospects over the next few years. This has raised concerns that the US (and possibly the UK) are facing a lost decade similar to the one experienced by Japan from 1991 to During this period, Japan experienced bad loans, deflation and economic stagnation, which has some similarities to the current financial crisis. This article examines the Japanese experience in the 1990s and compares this to the current global financial crisis. In particular, it highlights the key differences that may well help the UK and US avoid a lost decade. Introduction Japan, the world s second largest economy, continues to have a well-educated workforce, modern infrastructure and capital stock, and advanced technological knowledge. Unlike many of the developed countries, it is a creditor nation and is not dependent on the goodwill of foreign investors. The sheer magnitude of its economy means that its producers sell mainly to the domestic market, which gives Japan a broad freedom of action denied to lesser nations. However, despite all these advantages, Japan spent most of the 1990s in a slump, alternating between brief periods of economic growth and ever deeper recessions. Towards the end of the 1990s Japanese industry produced less than it had at the beginning of the decade. Even worse, the ability of public policy to turn the situation around appeared to be limited at best, or at worst, completely ineffective. This naturally leads to the question: if this can happen to the Japanese, could other developed countries be facing a similar problem today? The Japanese Experience of a Bursting Asset Bubble and Ensuing Banking Crisis During the second half of the 1980s, Japanese policymakers pursued expansionary fiscal and monetary policies to offset the effects of an appreciation in the yen due to currency market interventions, which were agreed in the 1985 Plaza Accord. This resulted in abundant liquidity and self fulfilling expectations of ever increasing prices of stocks and land. Towards the end of the 1980s the market capitalisation of Japan (i.e. the total value of all stocks in Japanese owned companies) was larger than that of the United States, which had twice Japan s population and more than twice its GDP. Land in Japan was incredibly expensive. For example, Tokyo s Imperial Palace was worth more the entire state of California at the height of the bubble, which was equivalent to the roaring twenties in the United States. Some prime properties in Tokyo were selling for in excess of $1.5 million per square meter! Like all bubbles, sooner or later they burst. The bursting of the Japanese bubble was not entirely spontaneous. The Bank of Japan started to steadily raise interest rates, raising them from 2.5% in April 1989 to 6% in September 1990 (where it remained until June 1991), in an effort to slow the rate of increase in asset values. Initially, higher interest rates were not a problem; share prices were continuing to rise at a rapid rate and the capital gains outweighed the increase in interest payments. Land prices in Japan had started a Page 3 of 21

4 gradual decline by the end of The higher borrowing costs eventually started to have an impact as the growth in share prices started to slow as well. Many people in Japan had borrowed heavily to finance share and real estate purchases, taking advantage of lax lending criteria offered by Japanese banks. Once the markets started to fall, large numbers of investors were forced to unwind their positions. What started as an orderly exit eventually resulted in a vicious downward price spiral, reinforced by enforced liquidations. This eventually led to a steep decline in land and share prices in the beginning of 1991, which over the next few years brought them around 60% below their peak. While the Japanese authorities welcomed the return of more realistic asset valuations, it broadly became apparent that this had contributed to a severe banking crisis and a long lasting, deepening economic malaise, rather than returning the economy to health. After some delay, monetary policy was gradually loosened through the 1990s, with interest rates falling all the way to zero by the end of the decade, the first time this had happened in an advanced country in the post-war era. What are the key similarities and differences between Japan in the 1990s and the current global financial crisis? Similarities in bubble evolution and policy steps undertaken Japan Property Prices vs Equity Prices Property Prices Nikkei225 Source: DataStream There are remarkable similarities between Japan s banking crisis in the 1990s and the present global financial crisis. Although countries have different economic environments, the sequence of the policy response to the global financial crisis is similar to the Japanese crisis in the 1990s. This should not be surprising, as policymakers argued that if bank recapitalisation was not meticulously planned, learning from history, then this would appear to risk facing the same problems that crippled Japanese policymakers. Similarities in the development of the crises include: the formation and bursting of an asset price bubble, which caused debt levels to expand too much and then subsequently drop under pressure from deleveraging; subsequent extensive damage to the quality of bank assets caused by a collapse of real estate prices, and a failure of large financial institutions: Yamaichi and two long-term credit banks in Japan, Lehman Brothers and other highly-leveraged institutions in the US and nationalisation of a number of problem banks in the UK. In both cases, management of the financial crisis started with the central banks providing liquidity to banks, then the banks recapitalising the banks with public funds. An interbank credit guarantee was introduced for banks which heavily relied on wholesale funding. Finally, after a detailed assessment of bank balance sheets, the government introduced an asset purchase scheme (as part of a quantitative easing policy). Although the stages of the crisis and the steps taken to resolve it followed a similar sequence, there are marked differences between the crises. Page 4 of 21

5 Different Sources of Financial Crisis In the Japanese case, bank loans (particularly loans to the corporate sector that were backed by real estate collateral) were the major problem in the financial sector, while the share price collapse also damaged bank balance sheets. In the recent global financial crisis, securitization played a critical role in amplifying the crisis among a wide range of global financial institutions. In the UK and US deleveraging is required for households, whereas in Japan this was required for firms. Secondly, the causes of the failures of financial institutions are different. In the US, in addition to investments in toxic assets, failed institutions turned out to be extremely vulnerable due to their heavy reliance on wholesale funding. In this sense, liquidity and counterparty risk played a critical role in destabilizing the shortterm funding market. In contrast, Japanese financial institutions had fundamental problems in their business strategies and asset management, and liquidity shortages triggered their failures. Yamaichi Securities committed misconduct in the management of their clients assets, and the two failed long-term credit banks were engaged in excessive lending activities not only to the domestic real estate sector but to overseas resort projects, rendering them unable to fund the wholesale market. The Japanese Asset Bubble was larger than those that occurred in the US Another factor that makes the Japanese experience different from that of the US is the size of exposure to the imploding real estate markets. In Japan, real estate was valued at a much greater share of the economy than in the US. In addition, real estate was a larger proportion of net worth for both households and businesses in Japan than is currently the case in the US. This overexposure to the asset class, in addition to the slow Japanese policy response, dragged out the adjustment process far longer than necessary. The recent global crisis was a world event and developed quickly The Japanese banking crisis was mainly a domestic crisis. The crisis developed slowly and gradually because the problem was largely confined to bank loans and the accounting standards were slow to reflect a change in economic values. This enabled financial institutions to avoid recognising loan losses. This elicited a slow policy response, with decisive action only being undertaken after major banks started to fail. In sharp contrast, the global financial crisis, which originated primarily in the US, proved to be highly contagious and spread rapidly around the world and infected financial institutions that were heavily exposed to derivative securities and US subprime mortgages. Very rapidly even countries with healthy financial institutions felt the shockwaves as global commodity and financial markets seized up. The global nature of the crisis resulted in a collective sense of urgency and has led to prompt, co-ordinated action by governments worldwide. However, despite massive write-offs by banks, insurance companies and other financial institutions to date, the full scale of the losses remains uncertain, as the full exposure of financial institutions is obfuscated by the use of derivatives (where the liabilities fall are unclear) and the fact that the losses are dependent upon the timing and speed of the recovery of the real economy. Page 5 of 21

6 In there were well-functioning credit risk markets which provided an early warning system During the 1990s, there were no well-functioning markets for credit risk products that might provide a good measure of the market price of credit risk. This meant that when the asset bubble burst the extent of deterioration in bank asset quality posed the greatest uncertainty. The regulators did not even clearly define non-performing loans until 1998 when financial reconstruction schemes and prompt corrective measures were introduced. When the current global financial crisis started in 2007, a system for timely disclosure of non-performing loan levels was in place for developed global financial markets; however, some ambiguity about the valuation of disclosed bank assets still exists when the market is under severe stress. This is especially true for newly introduced financial products, which may rely on complex valuation models. Despite this, when the global financial crisis started, developed countries were in a much better position to judge the likely impact and take prompt action, due to an early warning system. Policy response to the global financial crisis was rapid and co-ordinated The rapid evolution of the global financial crisis sharply contrasts with the lingering Japanese non-performing loan problem and its resolution process. Policies were deployed in a similar order in both crises, but the period over which they were deployed differed considerably. The Japanese policy response was slow, with only decisive action being taken several years after their asset bubbles burst. Japanese interest rates and 10 year government bond yields were allowed to climb in the early stages of the crisis ( ). Furthermore, the fiscal policy response was dubious at times, with resources ploughed into projects of questionable economic value (such as investing in golf courses) and underutilised infrastructure projects (such as bridges and roads in remote locations). In contrast, the US and UK reacted promptly to the crisis and made rapid capital injections into the financial system, followed by asset purchases using public funds, and then a strict examination of bank assets for stress-testing. In the US case, although the Board of Governors of the Federal Reserve System introduced various measures to support market liquidity during 2007 and 2008, the first important step in using public funds was taken in October 2008; a package of $700 billion aimed at restructuring troubled institutions, of which $250 billion were set aside for capital injections. All major financial institutions were involved in this recapitalization program. US interest rates were lowered close to zero quickly and it bought around $1.5 trillion of mortgage backed securities and undertook unconventional monetary policy measures to pump money into the system. The collapse of Lehman Brothers in September 2008 highlighted the uncertainty that prevailed in the financial markets. In addition to Lehman s collapse, there were other financial shocks, including the bailouts of two government-sponsored enterprises (Fannie Mae and Freddie Mac) and American International Group (AIG), and upheavals at Merrill Lynch among others. These shocks resonated across US markets and major financial markets globally. Page 6 of 21

7 In the UK, in October 2008, the government provided a rescue package for the banking system worth 50bn. The government also offered up to 200 billion in short-term lending support. Shortly after the government injected 37 billion of taxpayers' money into three UK banks Royal Bank of Scotland (RBS), Lloyds TSB and HBOS) in one of the UK's biggest nationalisations. The UK also cut interest rates rapidly from 5.5% in January 2008 to 0.5% in April 2009, remaining at that level to present, and adopted an aggressive quantitative easing programme in March 2009 as part of its monetary policy. 200 billion has been spent on asset purchases, most of it being spent on government bonds. This was combined with a 25 billion fiscal stimulus, including a VAT cut from 17.5% to 15%, with the VAT being restored to 17.5% in January Other measures were also introduced in April 2009 by UK policymakers aimed at increasing lending. First, a guarantee for lending was introduced for small firms to allow the banks to use the capital freed up by the guarantee to increase lending. Second, a guarantee scheme for asset-backed securities was offered, which guaranteed securities backed by mortgages, corporate and consumer debt. The scheme covered around 100bn of assets. European authorities have also adopted several measures of government intervention, such as guarantees of bank credits, bank recapitalisation, and asset purchases. However, they were much slower to react than the UK and US, but still quicker than Japan in their response. European Authorities conducted stress tests in July 2010 of key euro-area financial institutions and are now only just starting to put in place measures for a coordinated euro-area response for future crises. Modern accounting practices more quickly reflect changes in asset values but tend to undervalue assets in times of extreme stress... Japanese accounting and disclosure rules during its crisis in the 1990s resulted in financial statements that were slow to reflect economic reality and incomplete in doing so. Japanese banks were permitted (and encouraged) to carry non-performing debt at par. Holding assets naturally put Japanese banks in a cash-flow bind. In the current global financial crisis, in contrast, financial statements are released quarterly or semi-annually and are based on mark-to-market valuations. Although this practice has the advantage of reducing the uncertainty involved in the valuation of assets and financial health of banks, it tends to reflect market overreaction under extreme stress. When no reliable data are available as a result of a severe liquidity crunch, the market often temporarily misprices or excessively undervalues assets. Banks have still not fully disposed of all their bad assets and non-performing loans in the hope that an economic recovery will restore value to them before disposal....however, bank bailouts in the global financial crisis have prevented zombie banks That said, it is important to recognise that the US bank bailouts that were initiated during the Bush administration went a long way toward preventing an infestation of zombie banks. These institutions, which typically have a net worth below zero but continue to operate through government backings or bailouts, were Page 7 of 21

8 one of Japan s biggest problems during its lost decade. They actually ended up preventing economic activity by hoarding large amounts of money that might have been used for loans or investments. Although the US bank bailouts were unpopular at the time, politicians recognised their necessity, and they managed to prevent a devastating meltdown. As a result, the US financial system is slowly repairing itself, although the process still has some way to go. Similarly, in the UK, policymakers recognised the threat from the financial crisis and carried out a recapitalisation of the banks using public funds and removed impaired assets from banks balance sheets, restoring the health of financial institutions. In both cases, the central banks simultaneously purchased impaired assets from financial institutions, while purchasing their preferred stocks. This has allowed some tax payer funds to be retrieved by higher asset prices, as the health of the troubled institutions gradually improved. While the banking system is much healthier than it would have been without intervention, in the aftermath of the credit crisis, banking systems still remain somewhat dysfunctional in both the UK and US. Banks continue to sit on a vast amount of excess reserves, investing in government bonds rather than lending the money to businesses and households. However, the situation does not appear to be as intractable as it was in Japan during the 1990s. The UK and US corporate sectors are healthier than Japan s corporate sector was in the 1990s The UK and US corporate sectors are in far better shape than in Japan during the 1990s. Cash flows, returns on investment and profit margins in the UK and US rose to record levels before the onset of recession. By contrast, Japanese companies did not pay attention to what they earned versus their cost of capital; market share gains were achieved at the cost of profitability and poor deployment of assets. Even during 2008 (at the peak of the financial crisis) large nonfinancial corporate businesses managed to maintain cash surpluses. Furthermore, UK and US businesses are not overly saddled with bad assets and larger firms have been able to supplement their credit needs in active commercial paper and corporate bond markets. (Although smaller businesses are still struggling to obtain credit). By contrast, the Japanese keiretsu system encouraged cross-holdings of equities and other corporate assets that depreciated sharply during their lost decade. This undermined corporate and banking balance sheets, as bad debts and loans mounted. This in turn severely restricted domestic credit lines and inhibited economic recovery. The financial crisis has had a severe impact on the real economy and the economy is facing considerable headwinds in the near future There is no denying that the recent financial crisis has had a severe impact on the global economy. Some industries (such as the car industry and construction sector) experienced a steep decline. US GDP fell by around 4% and UK GDP fell by 6% from the fourth quarter of 2007 to the third quarter of UK and US unemployment peaked at 8% by the end of February 2010 and 10.1% by the end of October 2009, respectively. While both the UK and US experienced a period of deflation, the US experience was deeper and more protracted. Page 8 of 21

9 Since then, global output has started to recover, rising by 2.6% in the US and 2% in the UK from the third quarter 2009 to the second quarter of However, unemployment has remained stubbornly high at 9.6% in the US and 7.7% by the end of September UK inflation has remained relatively sticky, with annualised headline CPI inflation remaining above 3% over the first three quarters of 2010 and is currently 3.1% for September However, US inflation is fairly low standing at 1.1% for September The Federal Reserve has indicated that they would like to see inflation run at 2% per annum. While it is likely that both countries structural rate of growth will remain subdued relative to the gains achieved prior to the crisis. This is a typical outcome following a bad financial collapse. However, unlike Japan in the 1990s, it should not provide a knockout blow to the overall economy. Japan, meanwhile, continues to face intense competition from other Asian exporters (as it did in the 1990s) at a time when its currency is much stronger than policymakers would like. Over time, the country has lost market share to China and other emerging-market manufacturers. Although the UK and US naturally faces competition from abroad, its deep domestic markets are assets that provides the chief base of growth for domestic companies. The US and UK have different spending habits and demographics In the 1980s and 1990s Japan had the highest saving rate among the industrial countries. In the early 1980s, Japanese households were saving about 15% of their after-tax incomes. This rate came down gradually and was still 10% in The household saving rate continued to fall until it was below 5% at the end of the 1990 s. A variety of forces contributed to a continuing decline in Japan s household saving rate. The country s demographic structure is changing, with an increasing number of retirees relative to the workers who are in their prime saving years. By contrast, the US and UK are a nation of consumers, funded by high levels of personal debt and comparatively low savings rates. The UK and US populations are expected to grow, helped by immigration and a higher birth rate than prevails in Japan. The average age in the UK and US is also considerably younger and rising at a slower rate. A younger and growing population and a higher propensity to consume should better help sustain economic growth in the US and UK in the future. That said, high levels of debt are likely to weigh on household consumption as debt is repaid. US consumers continued to reduce outstanding debt in the third quarter of 2010, which is down 4.3% from its peak in December American consumers are also saving more, at a rate of 5.5% in the third quarter of 2010, up from 2.1% in the fourth quarter of UK households also increased their savings rate in response to the crisis, with savings rising from 2% in 2007 to 6.3% in 2009; however, since then, the savings rate has fallen back to 3.2% as households pay off debt more aggressively. Monetary and fiscal policies are being or have been exhausted The UK and US have both undertaken substantial fiscal and monetary policy action since the crisis began. With both the US and UK having large public debts and public deficits running in excess of 9% and 11.4% of GDP, respectively. This makes further fiscal expansions highly unlikely. In fact, the UK government is now committed to reducing public sector borrowing over the next four years (mainly through public spending cuts but also tax increases, such as an increase in VAT to 20% in January 2010) and the US is proposing to Page 9 of 21

10 reverse the Bush tax cuts at the end of Furthermore, the US will eventually need to start reducing its public deficit more aggressively, if it is to avert its own sovereign debt crisis in several years time. Tax increases are one reason Japan has had so much difficulty breaking out of its long stagnation. Japan made the policy mistake of increasing its consumption tax in 1997 a few months before the onset of the Asian crisis. Japan s economy declined over the next two years, as consumption declined sharply at the same time exports were badly hit. It remains to be seen if the increased tax burden will hamper the economic recovery of the UK and US. (That said, Obama may decide to delay the reintroduction of tax hikes, given the Fed is leaning towards more quantitative easing and unemployment is remaining around 10%; however, the UK is unlikely to get such a reprieve). There is therefore a careful balancing act between reducing the deficit and eventually reducing public debt and ensuring the economy stays on track. The UK is unlikely to pursue further quantitative easing for the rest of 2010, as inflation remains well above the 2% target and growth in the third quarter of 2010 was higher than expected, standing at 0.8%. The UK economy is likely to slow in 2011 as it begins to feel the effect of the biggest spending cuts in decades. Pay growth remains subdued, broad money growth weak and there is still a large amount of spare capacity in the economy, so price pressures still look likely to ease over the medium-term. Further quantitative easing may therefore be needed to offset the effects of the fiscal squeeze and the potential upward pressure on sterling from quantitative easing being undertaken in other countries. The Federal Reserve in the US has outlined a new 2% target for inflation and indicated that a further $600bn of quantitative easing will be undertaken up to June 2011, in an attempt to avoid deflation and lower unemployment. This is larger than the market consensus expectation of $500bn. However, the Fed s speed of buying, at about $75bn a month, is a little slower than previously thought and there was no signal that the Fed would continue to buy further assets once the initial programme ends; although, this is still a possibility. The prospect of additional quantitative easing has had a positive impact on the stock market, which rose sharply in September. The Fed has said it will concentrate asset purchases on 7 to 10 year treasuries. (These moves in yields are important as the duration of home and company loans average around 7 and 10 years). This could well push 10 year treasury yields to 2% or lower. Should this occur, it should push the stock market higher (as the present value of corporate earnings rises due to a lower discount rate), providing a boost to household wealth, while lowering the cost of borrowing. It is hoped that these effects will stimulate demand and inflation. However, there is no guarantee that higher inflation expectations and hence lower real interest rates will increase expenditure within the economy. With corporate bond yields and mortgage rates already at or near record lows, the cost of borrowing is not the problem. Even lower rates may do little to stimulate demand when half of all mortgage borrowers don't qualify to refinance at lower rates because they don't have the required 20% equity in their homes. Large businesses already have large cash surpluses, while small businesses, dependent on banks for their financing, are still finding it hard to obtain credit at any price. Page 10 of 21

11 As fiscal policy is essentially paralysed, if the Fed's renewed quantitative easing has little impact then Congress might be forced to turn to other policy initiatives. For example, a protectionist trade policy might be successful in boosting economic growth and it is one of the few policies that has a hope of garnering bipartisan support in an otherwise split Congress. The House has already passed a bill targeting China for its currency manipulation. More generally, focusing more on the outsourcing of American jobs to all low-cost producing countries may become a key issue. Over the long term, quantitative easing is likely to be building up large scale problems. Quantitative easing is resulting in a further devaluation of the US dollar against other key currencies. The euro-area and Japan can ill afford to have appreciating currencies, which threaten to reverse their recovery in exports. The increased threat raises the likelihood that their economic recoveries will reverse or even experience a sovereign debt crisis as a result. Furthermore, as quantitative easing is expected to lower US interest rates further, relative to other regions, it is causing hot capital to flow into emergency markets, resulting in an appreciation in their currencies and increased currency volatility. The economies hurt by currency appreciation against the dollar are responding with measures to protect their exports and limit their imports, measures that could lead to trade conflict. Thus quantitative easing undertaken by the US may be starting to have a destabilising effect on other regions. When the UK and US economies recover (and they will eventually), central banks will need to shrink their balance sheets by reselling bonds, in order to reverse quantitative easing. Most likely at a time of economic recovery, commercial banks will follow suit. Yields will leap higher in the ensuing bond glut and so too will interest rates. In order to compensate for higher government borrowing costs, governments will need to slash spending further. (This is what happened in Japan in 2006). Economies will then face another round of tightening from higher interest rates and from lower government spending. Furthermore, the bursting of the bond bubble will hit leveraged investors, including individuals who bought these assets with borrowed money, and banks that hold long-term securities. Higher interest rates will also affect growth assets, which could lead to sharp downward adjustments in market value. That raises the likelihood of another recession combined with another credit crisis, as asset bubbles burst. Furthermore, when the US economy does begin to grow, the increased cash on banks balance sheets will make the Fed s exit strategy harder. Once the second round of quantitative easing is completed, excess reserves will have doubled to around two trillion dollars (and if further rounds are undertaken it could go to higher multiples). This will make it substantially harder to contain inflation, once a recovery is underway. This could lead to much higher interest rates to restrain demand or to an unwanted rise in inflation. Conclusion: Will we avoid the Japan style scenario? Given the magnitude of Japan s problems and its tardy response, it is easy to understand why financial and economic recovery developed so slowly and, consequently, why a deflationary spiral developed and compounded both financial and economic problems. The UK and US economies, in comparison, learnt from the Japanese experience, and as a consequence acted promptly to tackle the financial crisis. This suggests that the UK and US has a much better chance of avoiding a Japan style lost decade with deflation. Furthermore, if they do suffer deflation at all, it may well do so for only a short time. Page 11 of 21

12 However, there are still considerable global economic headwinds, which could reverse an economic recovery. These include a renewed euro-area sovereign debt crisis, bursting of bond and other asset bubbles (due to an economic recovery, when QE is reversed, or renewed concerns over sovereign debt) and commodity shocks, such as a steep rise in oil prices. The Japan 1990s analogy, would be the downturn created by the Asia crisis in , which led to a further contraction in its economy. Thus while we can sensibly conclude that we have a better chance of avoiding a lost decade, it is by no means inevitable that we will do so. Accounting The accounting deficit for Britain s largest 200 final salary schemes shrunk during October from 80bn at the end of September to 70bn at the end of October. The improvement arose largely due to increases in the yield on corporate bonds during the month with strong equity performance largely offsetting falls in the price of bonds. The improvement in the deficit during the month suggests that end of year accounting results may be more favourable than at 31 December 2009 (when the aggregate deficit stood at 88bn) but finance directors should be aware that markets are still volatile and relatively small changes in market conditions could lead to dramatic changes in the position before the year end. - 40bn - 50bn - 60bn - 70bn - 80bn - 90bn - 100bn - 110bn - 120bn Oct Dec Feb Apr Jun Aug Sep Week 1 Aon 200 Index Week 2 Week 3 Week 4 Source: Aon Hewitt Funding Another positive month for funding. On the assets side, UK and overseas equity markets experienced steady gains, although there were small falls on the bond side. For the liabilities, real and fixed gilt yields rose over the month, as did corporate bonds. This will have led to a small reduction in liabilities despite slightly higher inflation expectations at most durations. Taken together, this will have led to an improvement in funding for the typical scheme. During the month, the annual increases in RPI (4.6%) and in CPI (3.1%) to the month of September were published. September is the reference month for statutory increases in deferment and in payment, with many occupational schemes also using this same reference date for pension increases linked to inflation. For schemes expected to be impacted by the Government's change in indexation requirements from RPI to CPI, the difference this year is therefore a reduction of 1.5% to the increase that would have previously applied. At the end of October, the Pensions Minister stated that the consultation on provisions for occupational pension schemes switching from RPI to CPI would be published "shortly". When this is published, the impact of the change on the benefits pension schemes provide should become clearer, which in turn should provide greater clarity on funding. Page 12 of 21

13 Whilst care has been taken in the production of this EconForum and the information contained within, Aon does not make any representation as to its accuracy and accepts no liability for any loss incurred by any person who may rely on it. In any case, the recipient shall be entirely responsible for their use of this EconForum. Page 13 of 21

14 Appendix All charts are as at close of business on 29 October 2010 except where stated otherwise. LIBOR The graph below shows the extra amount banks have to pay above the Bank of England base rate to borrow and lend to each other. The LIBOR rate is the London Inter-Bank Offered Rate that is one of the global benchmarks for the cost of borrowing. It reflects the ability and willingness of banks to lend and as such it can be considered as a barometer of banks faith in each other. During the last month, the 3-month LIBOR rate spread remained unchanged at 0.2%. 3.0% 2.8% Spread between Bank of England Base Rates and 3 month UK LIBOR Collapse of Lehmans and bail out of AIG 2.6% 2.4% 2.2% Interest rates reduced to 4.50% Interest rates reduced to 3% Interest Rates reduced to 2% 2.0% 1.8% 1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% Interest rates reduced to 4.5% Interest rates raised to 4.75% Interest rates raised to 5.75% Interest rates raised to 5.5% Interest rates raised to 5.25% Credit crunch Central banks global intervention Banks stop lending to each other hence central Banks become the only lender in the markets Interest rate reduced to 0.5% Interest rate reduced to 1% Launch of Quantitative Easing Gilt auction failure 50bn QE extension 25bn QE extension General Election % 0.0% Interest rates raised to 5% Interest rates reduced to 5.5% Interest rate reduced to 5% Interest rates reduced to 1.5% -0.2% Interest rates reduced to 5.25% -0.4% Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Source: DataStream Page 14 of 21

15 Currencies The graph below shows the value of the US dollar relative to a basket of seven of the world s major currencies including the Euro, Canadian dollar, Japanese yen and British pound. Against a basket of other major currencies, the US dollar index rate declined 2.0% from 73.6 to 72.1 over the last month. In the short term, the dollar is likely to maintain a relatively weak tone as confidence in the US fundamentals deteriorated, especially in the housing and consumer sectors, and further quantitative easing was undertaken. 95 USD vs a Basket of Major Currencies Index Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Source: Federal Reserve Page 15 of 21

16 The other two graphs shown below are the effective exchange rate of Sterling and the Euro. These rates are calculated using the weighted average against other major currencies and then converting them into an index using a base period. During the last month, the UK Sterling index rose 0.4% from 79.9 to 80.2 while the Euro index rose 0.8% from 96.2 to Effective Exchange Rate Index, in Sterling (Jan 2005 = 100) Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Effective Exchange Rate Index, in Euros (1990 average = 100) Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Source: The Bank of England Page 16 of 21

17 The graph below shows the value of both the US dollar and the Euro relative to Sterling (i.e. relative to 1). Sterling appreciated against the US dollar, now buying $1.60. Against the Euro, the value of sterling remained unchanged at USD, Euro vs GBP since Oct US Dollars Euros Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep US Dollar vs UK Sterling EU Euro vs UK Sterling Source: DataStream Page 17 of 21

18 Equities UK equities rallied in October with the FTSE 100 index rising 2.3% from 5549 to Over the same period, the FTSE 100 implied volatility index declined 5.8% from 20.8 to However, as the UK economic outlook will remain highly uncertain for a considerable time, the UK equity market looks set to continue to experience greater volatility. Price level of FTSE 100 UK Equity Index 7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Source: DataStream Page 18 of 21

19 Fixed Interest As at 29 October 2010, the credit spread remained at around 1.5% over the month. Corporate bond yields (based on the non-gilts iboxx 15+ AA) rose from 5.0% to 5.2% while the long term gilt yields rose from 3.5 to 3.7%. Over 15 Year Gilt Yield vs Corporate Bond Yield 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Corporate Yield Gilt Yield Credit Spreads between Iboxx AA 15+ Corporate Yield and Gilts 15+ Yield 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Source for both graphs: DataStream iboxx AA+15 yr yield vs Gilts +15 yr yield Page 19 of 21

20 The Shape of the Gilt Yield Curve The yield curve is a measure of the market s expectations of future interest rates given the current market condition. The shape of the yield curve should normally be upward sloping, i.e. the interest rate you should receive for lending your money to someone should increase as the term of the loan increases. The graph below shows the UK gilt yield curve on 8 October, 15 October, 22 October and 29 October It can be seen from the graph that short-dated yields remained stable while medium-dated and long-dated yields rose significantly over the month. 4.90% UK Government Bonds Yield Curve 4.40% 3.90% 3.40% 2.90% 2.40% 1.90% 1.40% 0.90% 0.40% 1 Years 2 Years 3 Years 5 Years 7 Years 10 Years 15 Years 20 Years 30 Years 8-Oct Oct Oct Oct-10 Source: Bloomberg Page 20 of 21

21 Property The IPD UK Monthly Total Return Index below is the benchmark for most UK property funds. The index continued to rise but at a slower pace, rising only 0.7% from 751 in August to 756 in September. The fears that credit conditions may be tightening again and the possibility of renewed weakness in the labour market will continue to weigh on property market. UK IPD Total Return Index 1, Source: DataStream For further information and questions, please contact: Mark.Jeavons@aonconsulting.co.uk Editor: Mark Jeavons Sub-Editors: Trevor Connor Wen Zhang Sarah Abraham Regular Contributors: Andrew Firth Andrew Claringbold Yusuf Samad END Page 21 of 21