Financial Repression and UK Average Weekly Earnings – May 2013 Update

We live in interesting times.  The government and mainstream media would have us believe that these are times of austerity.  Of course we live in no such thing.  The miniscule efforts made by the government thus far has already resulted in much gnashing of teeth and yet for the 2012-13 financial year the UK government still borrowed £120.6 billion that it didn’t have.  Every UK based man, woman and child just added a further £1,925 onto the tab.

So if we don’t live in times of austerity what are we living in?  I think I’ve managed to find the answer.  It’s officially called Financial Repression.  Please do click on the Wikipedia link and let me know if you agree?  It looks to be a method that allows the masses to be a slowly boiled frog as most won’t notice what is going on due to a money illusion.  What makes me think this is the route chosen by our politically masters?

We all know that the Bank of England has been ignoring the 2% inflation target for a long time now but the new Remit for the Bank of England Monetary Policy Committee dated 20 March 2013 now explicitly sanctions it with the statement that “The remit recognises that inflation will on occasion depart from its target as a result of shocks and disturbances. Attempts to keep inflation at the target in these circumstances may cause undesirable volatility in output. This reflects the short-term trade-offs that must be made between inflation and output variability in setting monetary policy. It therefore allows for a balanced approach to the objectives set out in the remit, while retaining the primacy of price stability and the inflation target.”  This gives new Governor Carney official free reign to keep the Official Bank Rate at near zero while continuing to Quantitative Ease (QE) like there is no tomorrow.  The aim here seems to be to keep inflation running without allowing it to run away.  It will be interesting to see if they can walk that tight rope.

So we now have the inflation.  Next you need to control and drive interest rates, such as on government debt, to a value that is less than the inflation you are creating.  QE is and will come to the rescue here by creating a major buyer, in this case the Bank of England.  Basel III then creates another buyer, in this case Banks, by requiring Tier 1 capital levels to be increased from 4% to 6%.  Banks can count government debt as Tier 1 capital creating an additional domestic market for government gilts.  Lots of buyers means rising prices and falling yields.  This has also created a captive domestic market for government debt which Financial Repression requires.

I feel we now have most of the Financial Repression boxes ticked.  Interest rates are controlled, the government owns plenty of banks, reserve requirements are rising and we have the domestic market for government debt.  The one that is missing is capital controls but our Cyprus friends have shown us how easy that is to implement when the time is right.

The Cheapest Loan

You’ve done your homework on understanding how debt works and decided to take on a loan.  No matter whether that loan is a mortgage, personal loan or credit card then the next step is to ensure that you end up with the cheapest or lowest cost loan you can, along with one that actually meets your needs.  To do this you have no choice but to find a quiet place, where with a fresh cup of tea, you can read the small print of each loan provider you are considering and in parallel run some maths to calculate who is the cheapest provider based on all that small print.  It’s key to do the maths because when it comes to loans, as with investments, small amounts over long periods and fees matter.

If you want to do the maths yourself then Excel’s PMT function will get you a long way.  This gives the repayment amount for a loan given an interest rate, the number of constant periods the loan is taken over and the present value of the loan.  If you don’t have Excel or aren't mathematically savvy then you could also use a loan or mortgage calculator to do a lot of the work for you.

Let’s look at a few simple case studies, which build in complexity, to show just how important it is to run the numbers.

Case Study 1 - All else being equal secure the lowest interest rate you can  

Bank A is offering a loan with an annual interest rate of 5% (the interest rate) and Bank B has a rate of 5.5%.  The loan amount is for £10,000 (the present value of the loan), you are going to make the repayments monthly and you intend to take the loan over 10 years (the number of constant periods will be 10x12=120 months because you pay monthly).   To calculate the monthly repayment for the first scenario you would enter the following into Excel ‘=PMT(5%/12, 10*12,-£10,000)’ which would give you a repayment to Bank A of£106.07 per month.  Note you have to divide the interest rate by 12 months as the repayment is made monthly.  If you run the same calculation for Bank B’s interest rate of 5.5% the monthly repayment would be £108.53.

At first glance it doesn’t seem like much of a difference.  After all it’s only £2.46 per month however this is no different to the Latte a Day case study I’ve run before which demonstrates how small amounts matter.  Over the 10 year period the total interest paid is £2,728 and £3,023 respectively.  That 0.5% actually means 10.8% more in interest payments.   It’s also important to remember that the longer the loan period the worse this effect.  For example lengthen the loan term to 20 years and that 10.8% becomes 11.5%.  This is Compound Interest at work.

The New FTSE 100 Cyclically Adjusted Price Earnings Ratio (FTSE 100 CAPE) Update - April 2013

Welcome to the new look UK FTSE 100 monthly stock market review which includes a couple of valuation metrics.  The last time we looked at this dataset was on the 10 March 2013.  This monthly review will now loosely follow the same format we use for the S&P 500 which will enable us to get some consistency across regions going forward.

FTSE 100 Price

At market close on Tuesday the FTSE 100 was priced at 6,430.  That is a rise of 0.8% when compared with the 01 March 2013 Price of 6,379 and 9.5% above the 02 April 2013 Price of 5,875.  How this pricing compares with history can be seen in the chart below.

Click to enlarge

This is a similar chart to that which you will see in many places within the mainstream media.  Let’s now remove the sensationalism by:

• Correcting the chart for the devaluation of the £ through inflation.  For this dataset I use the Consumer Price Index (CPI) to devalue the £.
• Plotting the Pricing on a logarithmic scale as opposed to a linear one.  By using this scale percentage changes in price appear the same.  

Looking at the chart this way reveals the FTSE 100 in a very different light.  That light shows that the compound annual growth rate (CAGR) in today’s £’s has only been 2.0%.  Correct it by the Retail Prices Index (RPI) and that falls to 1.2%.

Click to enlarge

FTSE 100 Earnings

As Reported Nominal Annual Earnings are currently 483, up from 458 on the 01 March 2013.  They are down 18.3% on last year and 23.0% on October 2011’s 628.  Or course this looks better than it really is as inflation flatters the result.  I therefore plot a chart below, again on a logarithmic axis, showing Real (inflation adjusted) Earnings performance over the long term.

Click to enlarge

What type of Investor are you?

There are a multitude of investment opportunities and investment products available today to help investors meet their goals, which might include retirement or financial independence.  Before you look at those products in detail you must first ascend to 30,000 feet and decide what type of Investor you are or intend to be.  At this level I see there are essentially 4 types of investor which can be profiled by answering 2 questions:

1. Am I going to be an Active or Passive Investor?
2. Do I want to be DIY or have somebody make my investment decisions for me in consultation with me?

Let’s look at each in turn.

Active vs Passive Investing

The debate over which of these strategies is better has been going on for years.  Passive investments aim to do nothing more than track a market index.  That could be a stock market index like the FTSE All Share Index or a bond market index like the Barclays UK Government Inflation-Linked Bond Index.  These types of investments don’t need talented managers or analysts but simply a decent computer system that will enable the assets purchased to replicate the market.  Importantly when selecting these types of investments you will be looking for ones that track the chosen index as closely as possible.  Therefore if you are passive investing well you will never beat the market but should get pretty close to its nominal performance.

Active investments on the other hand are run by professional managers who are supported by analysts and researchers.  They will conduct extensive market research on the investment opportunities within their remit with the specific aim of beating the market.  It must however be remembered that the law of averages dictates that for every active investment manager that beats the market somebody or something has to not beat the market.  Some of these will be other professional managers.   Pick one of those and you would have been better off going passive.

Active investments typically carry higher expenses than passive investments.  After all those managers, analysts and researchers aren’t working for free and expect to be paid.  Therefore they must beat the market by at least their expenses if they are to be a better bet than the passive investment option.

DIY or Financial Advisor Investing

The second decision you need to make is are you prepared to go it alone, make all of your own investment decisions and live with the consequences.  It should not be underestimated how important planning for retirement or financial independence is.  In many instances you will only ever get one shot at it.  If you go DIY you must be therefore prepared to read a lot and really think through what you are trying to achieve.  You’ll need to accurately assess where you are today, where you want to go and when you want to get there.  You will need to determine how risk tolerant you are, while also realising that, for example, 100% of the lowest risk asset class today will likely not give you the lowest risk portfolio.  You’ll then need to crash all of that information with a lot of research on different asset classes and investment wrappers to build a diversified, tax minimised investment portfolio, with expenses at a level you are happy with, that will give a high probability of meeting your goals.  You’ll need to t
hen review your portfolio regularly to determine if or when you want to rebalance those investments and also ascertain if you are still on target to meet your goals.

The Best Performing Stock Market in the World

In the modern day we see many of the emerging economies of the world moving forward with high growth while in contrast many of the mature western economies have anaemic growth at best.  This was reinforced last week with the UK reporting preliminary quarterly growth of 0.3% (1.3% annualised) while the US fared better with an annualised 2.5%.  In contrast on the 15 April 2013 we heard that China was growing at 7.7%.  Does this mean we should all be selling our mature market equities and loading up on emerging markets?  Or do we get enough benefit from the fact that many mature market companies are exposed to high growth markets?

To try and get an idea I ran the Google search “the best performing stock market in the world” and was rewarded with the result that in 2012 the Venezuela IBC returned around 300%.  I was disappointed with this result and the majority of the other Google results for three main reasons:

• As a private investor are we really going to put a significant portion of our wealth into the Venezuela stock market?  Or the Turkish XU100, Egyptian EGX, Pakistan KSE or the Kenya NSE for that matter?  Well as somebody who is searching for consistent return over many years I know I’m not.
• The majority of results simply show the performance of the major stock market within each country.  This is flawed because each of these markets is priced in the local currency of each country and we all know that currencies move for all manner of reasons including varying rates of currency devaluation caused by inflation.  You therefore cannot compare one with the other as they have different units.  It would be like saying Car A which is travelling at 110 km/hour is going faster than Car B which is travelling at 100 miles/hour.  A clearly ludicrous statement. 
• As the results only use the major stock market for each country they are only looking at the capital gain of each of these markets.  If we truly want to understand the best performing market then we should also consider the contribution from dividends because dividends matter.

Let’s therefore answer the question from a personal long term investor perspective while considering the three points above.