Niels Jensen: Investment Outlook (April-May 2012)


The Absolute Return Letter (April-May 2012)

"You Can't Handle the Truth."

by Niels Jensen, Absolute Return Partners

Remember the scene in A few Good Men where Colonel Jessup (Jack Nicholson) and Lieutenant Kaffee (Tom Cruise) trade insults? Following some pretty intense questioning, Kaffee yells at Jessup: “I want the truth”. With the deadly glare that only Jack Nicholson can muster, Jessop retorts: “You can’t handle the truth”.

I was reminded of this rather famous moment in film history when a long time reader of the Absolute Return Letter asked me recently: Why don’t you tell the truth about the UK economy? Why don’t you tell it as it is – that the situation in the UK is worse than it is in the eurozone? I decided to take up the challenge from the reader. I am not sure that I actually agree that the UK is in a worse position than most eurozone countries; it is worse in some respects but better in others. More about this in a moment.

The UK government’s strategy appears to be based on the age old philosophy that the best line of defence is attack. In recent months, Prime Minister Cameron has been unusually vocal about the shortcomings of the other major European powers at a time when everything is not plain sailing back home. On the major issues facing the UK domestic economy, Cameron and his government have been deceivingly quiet – perhaps because we can’t handle the truth?

It is not all bad news

Back to the outlook for the UK. There is no denying that it is grim; however, and despite all the weaknesses of the UK economic model, it has two key advantages over most of its European neighbours.

Firstly, it is a currency issuer rather than a currency user, meaning that it has full control of its monetary and currency policies and can apply precisely the policy required at any point in time rather than being held hostage to the needs and requirements of the other members of the European currency union. As a currency user, it cannot overtly default unless it chooses to do so, although there are ways it can default covertly as we shall see later.

Secondly, the UK has gone much further than most other countries in terms of restructuring its labour markets (chart 1), granting it key advantages over its European competitors many of whom are still saddled with labour market practices that do not stand a chance in today’s environment where the market place for both labour and goods has turned truly global.

Private sector debt is huge

Having said that, the UK is in trouble. On several fronts. To begin with, the UK has not yet got its debt crisis under control. Despite talking the talk, debt has escalated further since the crisis erupted in 2008, making the UK one of the most indebted countries in the world (chart 2). When combining debt from the three main sectors - households, corporates and the public sector – of the major economic powers only Japan is now more indebted than the UK and it is only by a fraction.

In truth, it is not the public sector that is highly indebted. In fact, most of Britain’s debt problems originate from households and banks (chart 3) both of which have done little so far to address the problem1. Unlike in the United States where households have been deleveraging – to a large degree through personal bankruptcies – UK households have not reduced debt levels at all, mainly because banks have been relatively lenient, granting forbearance to troubled borrowers where perhaps foreclosure would have been a more sensible strategy.

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