Life After Death

Economists in the UK have been debating an interesting point in recent months. Why is the rate of employment in the UK rising when economic output (GDP) is, at best, flat-lining? A number of reasons have been suggested.

One theory is that employers are hoarding labour, in the hope that activity will pick up in the not too distant future. This is credible because despite a relatively high level of unemployment it can prove difficult to find staff of the required calibre, particularly in specialist fields. Also, the cost of recruitment is very high once you take account of time spent interviewing and training.

Certainly, one factor that has made a difference is the significant decline in production of North Sea oil and gas. Output declined by approximately 15% in 2012, acting as a drag on GDP. Perhaps, as a nation, we are becoming less productive. Certainly, the official productivity figures show that the UK has recently fallen well behind productivity improvements in other G7 nations. If this trend cannot be reversed we will need collectively to become used to a lower standard of living in the future.

Why are we less productive? A likely explanation is an unintended consequence of the Bank of England’s quantitative easing (QE) programme.

In a ‘normal’ recession companies that have not previously performed well tend to fail. However, because the economy is awash with liquidity provided by the Bank of England, commercial banks have been reluctant to ‘pull the plug’ on failing businesses. This helps them to delay writing down commercial loans that are unlikely ever to be fully repaid, a strategy that suits at a time when the regulatory requirement for bank capital is increasing. The benefits of QE are, in effect, indiscriminate.

Extending the life of failing businesses might sound like a positive act, but business failure is not necessarily a bad thing in the long run. Although unfortunate in the short term for those directly affected, business failure is nevertheless an important component of the evolutionary cycle of business and an important contributor to long term economic advancement. The reason is straightforward. There is a finite resource of both labour and capital available to the business sector. If failing businesses are kept afloat beyond their useful life by benevolent creditors, they deprive successful businesses of the labour and capital needed to leverage their success. As a consequence productivity gains that would otherwise have been achieved fail to materialise.

The big question is whether policymakers will address this issue head on or take a view that, in time, the position will correct itself. Although the latest Monetary Policy Committee (Bank of England) minutes indicate that QE remains firmly on the agenda, the likelihood is that we are closer (in monetary terms) to the end rather than the beginning of QE in its present form. As a nation, we cannot keep printing money forever. This view would support the argument to leave the business environment to self-correct over time, with initiatives such as the Funding for Lending Scheme providing some support in the meantime.

What might this all mean for private investors? If the central proposition is that the rate of business insolvency will spike when QE ends, and base interest rates rise, the greatest negative impact might ultimately be felt in the bond markets, particularly in the high yield sector. High yield bonds have provided fantastic returns over the last three years, with the IMA (UT) Sterling High Yield Bond Sector up over 30% gross over the three years to 31 January 2013. The return over the period has been driven by artificially low interest rates, liquidity from QE and default rates that have been lower than expected. However, when the economic cycle eventually turns, those three factors are likely to go into reverse and for those investors not prepared, recent gains could disappear just as quickly as they appeared. If you would like help in realigning your investment or pension portfolio to mitigate some of these risks, please contact us.