Libor, Currencies & Inflation

There are two broad subjects that I like to research and occasionally write about. Both are very broad but perhaps surprising to a lot of people there are often cause and effect links between them. The first is change management and improving business performance, and the other is finance, economics and investing. Finance, economics and investing are indeed subjects in themselves but there are so many joins and overlaps between them that it’s often hard to cover one without referring in some way to the others.

On the face of it LIBOR (Intercontinental London Interbank Offered Rate) appears irrelevant to most people and is often only vaguely understood by those outside of the financial services industry. Like the FED funds rate LIBOR is a global benchmark rate; in other words it is important.

I’ll resort to Investopedia for a full definition:

‘LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It stands for Intercontinental Exchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world. LIBOR is administered by the ICE Benchmark Administration (IBA), and is based on five currencies: U.S. dollar (USD), Euro (EUR), pound sterling (GBP), Japanese yen (JPY) and Swiss franc (CHF), and serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. There are a total of 35 different LIBOR rates each business day. The most commonly quoted rate is the three-month U.S. dollar rate.

LIBOR (or ICE LIBOR) is the world’s most widely-used benchmark for short-term interest rates. It serves as the primary indicator for the average rate at which banks that contribute to the determination of LIBOR may obtain short-term loans in the London interbank market…..’

What is slightly more interesting feature of LIBOR is that ‘…it helps to evaluate the current state of the world’s banking system as well as to set expectations for future central bank interest rates.’

It is this latter comment which is perhaps of more interest. With the notable exception of the Federal Reserve and, some would say, its quixotic notions of increasing interest rates, most of the world’s central banks are positioning lower or ‘low for longer’ interest rates. Dollar LIBOR seems to support this. If we look at a chart for the past few years there is a noticeable increase in rates. Each of the standard maturities are showing tangible increases with the trend starting somewhere towards the end of 2014. The Brexit vote in mid-2016 interrupted this trend but as you can see from the chart, within a week or two the earlier upward trend re-established itself rather quickly.

The FRED chart of U.S. bank excess reserves is also of interest. Peaking in August 2014 at $2.7 trillion it started a downtrend about the same time as Dollar LIBOR started to move upwards. Given the subject matter, availability of money, it seems reasonable to assume that the two things are connected. In other words demand for money has been increasing and it is being sourced from US bank excess reserves deposited at the FED. As of the end of July 2016 these reserves had dropped to $2.2 trillion, representing almost $500 billion only recently injected into the U.S. economy.

For information U.S. ‘excess reserves’ basically represent cash held at the Federal Reserve above the minimum the FED requires banks to hold on their balance sheets. It is a nuance of the U.S. banking system which is why you don’t see reference to it in UK discussions. Excess reserves rocketed upwards in alignment with the $4 trillion QE money printing exercise initiated in 2008 following the banking crisis. Starting in 2008 the FED used QE to buy assets from the private sector while at the same time announcing that interest would be paid on any private bank cash deposited back at the central bank. Given the waning appetite of business to borrow and a significantly increased reluctance by the banking system to lend, much of that QE cash swilling around the private banking system did not end up getting loaned out to business but was re-deposited with the FED. US banks took the view that low risk FED interest was a much better bet than lending to business in a shaky post-2008 business environment. Some QE did filter out into the real US economy but a massive amount ended up back with the FED. In other works the stimulus real economy effect of Dollar QE was muted at best.

Rolling forward to 2016 and demand for dollars has been slowly increasing, represented by Dollar LIBOR rates edging upwards. It is therefore moot as to whether we could see U.S. inflation also edge upwards. Much will depend on how fast this $2.2 trillion of excess reserves finds its way into the real U.S. economy. Currently ‘locked-up’, the money might as well not exist. But if hundreds of billions are released into the U.S. economy over a short period of time then there are bound to be consequences for the value of the U.S. dollar. More dollars chasing the same goods and services ultimately translates into inflation in one form or another, both in consumer prices and hard assets.

If U.S. inflation lurches upwards the FED may need to act to prevent a sharp fall in the value of the Dollar. At the moment the Dollar is regarded as ‘the cleanest dirty shirt in the laundry’ and remains the favoured currency in volatile and capricious markets. A Brexit vote and Cable moves in favour of the Dollar; a Eurozone crisis and the Euro falls and the U.S. Dollar increases. However, a sharp increase in U.S. money supply sourced from U.S. bank excess reserves and sentiment could well shift in favour of those other currencies, including of course gold. While the longer term goal of the FED is probably to help inflate away the ballooning U.S. debt (projected at $20 trillion by early 2017) short sharp drops are not usually regarded as desirable.

The FED is somewhat cornered. It needs a gradual drop in the value of the Dollar but would also like to increase rates in preparation for the next crisis. Notwithstanding the claims of the Democrats and the (allegedly) goal-seeked BLS economic statistics, outside of the large cities the US economy is not generally in a healthy state. A dose of inflation would probably help get things moving but the FED will not be able to achieve this if it starts putting rates up. Indeed, the opposite is a more likely result. For this reason there doesn’t appear to be much of an immediate case for increasing US rates in the foreseeable future, whatever the periodic ruminations of FED members. Nonetheless an increase in inflation above 5% and the FED could have its hand forced, whatever the longer term benefits of eroding the real value of US debt.

Back in the UK the BoE is still positioning a ‘low for longer’ policy, perhaps capping the current ‘crisis’ interest rates until 2020. Sterling LIBOR still supports these signals but a structural change in U.S. Dollar sentiment could well force a re-think of this intent. The current ‘Brexit bonus’ of a 10% drop in the value of the Pound could evaporate just at the time we need it most: during the uncertain two year countdown to formal exit from the EU.

In a world driven by central bank interventions forecasting is virtually impossible; even directional thinking is a tough challenge. Nonetheless herewith are some thoughts. If the US is about to experience higher inflation rather than the more widely assumed deflation there will be some consequences for Cable. Sterling could well increase against the Dollar which will put the BoE in an equally challenging situation. With Brexit fear and potential further EU referendums over the next couple of years the Euro could also drop in value against Sterling.

What short term strategy could the BoE deploy if faced with a currency increasing in strength against its major trading partners? How will the UK Treasury and BoE manage the UK’s own burgeoning national debt load, already exceeding £1.6 trillion? Faced with a shorter term challenge of a rising currency and the longer term problem of a growing national debt it really has few moves available. It no doubt feels that it must keep rates at low levels for as long as possible. Alas another 25 basis points fall in UK interest rates and the country risks entering the Twilight Zone world of negative interest rates.

Interest rates have now been at these crisis levels for eight years. Failing banks have been protected but at the expense of current and future pensioners. Defined Benefit pension funds are mostly in deficit with bond yields at their lowest in hundreds of years and asset values in bubble territory. The economic infrastructure is creaking under the weight of systemic and polarised financial forces pulling in all sorts of directions. Add Brexit uncertainty and a global slowdown to this and the prognosis for the next few years looks less than healthy for the UK economy. Even if Brexit acts as a palliative factor the implications of continued lower interest rates look more likely to hinder economic progress rather than help it. The BoE looks like it is as cornered as the FED with many of its remaining ‘new normal’ economic manipulation tools now looking very blunt indeed. What exactly is the point of lowering interest rates even further and what evidence is there that this strategy still has any residual stimulative economic benefit, if indeed there ever was any?

Whatever the choices of the FED, BoE and ECB economic activity looks more likely to decline rather than increase. This of course suggests that businesses should be starting to look at 2017 and 2018 as revenue challenging and should thinking about paring costs to align with those less than stellar increases in income. The better companies undertake scenario analysis, plan and prepare in the good times rather than wait to see declining revenues on their profit and loss statements. Now is the time to think this through and take action rather than put your hands together and pray that the central banks, economists and political class know what they are doing.

The dénouement of the great monetary experiment could soon be upon us.

Offshoring and the anti-globalisation movement

A Donald Trump presidency would mark a major turning point for the anti-globalisation movement if he follows through on his pre-election statements on trade. A key attraction for disaffected Democrats, the Bernie Sanders contingent, are Trump’s statements on ‘bringing jobs back to the United States’. His declared intent is to introduce a 35% tax on companies who offshore the manufacture of products and then import those goods back to the U.S. 35% is certainly a big number and would no doubt get the attention of all those well-known industrial and consumer brand names who currently outsource and offshore a lot of their activity to India, China and Mexico. A policy like this could therefore mark a major turning point for one of the dominant management trends of the past twenty five years.

Before delving further into the subject and assessing some potential implications it is probably worthwhile to pause on a few basic definitions. Outsourcing and offshoring are often used interchangeably but there is a difference, albeit in some cases you see instances of outsourcing and offshoring occurring at the same time. Outsourcing simply describes a situation where an organisation buys goods or services from a third party with the third party being located either in the same country as the buyer or potentially overseas. Offshoring usually describes a situation where the location of the manufacture or service has been moved overseas. The ownership of the offshored facility may not necessarily change; it simply becomes a more remote manufacturing or service unit. Companies often outsource an activity to an overseas operator so it is not uncommon to find outsourcing and offshoring taking place concurrently.

It may be time for the offshoring industry to wake up and smell the coffee. Despite an army of ‘expert’ economists, the media and senior business managers and politicians forming an alliance to defend EU membership the British people voted for a Brexit. Represented by much of the UK media as an anti-immigration rebellion the story is also very much one of dissatisfaction with the effects of a generation of globalisation initiatives. The EU and the offshoring of jobs are appear to conflate in this argument in that millions of jobs have been allowed to migrate ‘offshore’ to Eastern Europe and Asia while at the same time hundreds of thousands of EU citizens have been encouraged to find work in some of the most deprived areas of the United Kingdom. The people in these areas quite naturally rebelled. They have seen little or nothing of the benefits of globalisation and yet have been faced with all of its negative impacts. Donald Trump’s support in the United States and the rapid rise of anti-EU political movements across Europe are arguably just more localised manifestations of this general rejection of a pattern of corporate behaviour that has channelled the rewards of globalisation to a small minority. It remains an irony that the EU’s broadly protectionist stance has not in fact been effective in protecting the constituencies most in need: fortress Europe has failed.

The politics of this new anti-globalisation paradigm suggests that regulation could lurch in the direction of state based protectionism along the lines of Trump’s proposed punitive taxation regime. ‘Fair trade’ will likely mean something different in this new world. It could well evolve to describe situations where the central banking tools of international trade, currency manipulation events, are blunted by international agreements that are created with tariffs and taxes that adapt to relative values in currencies. Perhaps they will also seek to control the migration of labour and impose a better balance in the movement of jobs between states. However these international trade agreements evolve it is likely that the focus will be more on recognising the imbalances that have occurred in the past and making sure they are not repeated. The people have spoken and will not react well if they are ignored. For ‘fairness’ read protectionism.

Away from the politics of anti-globalisation the offshoring industry will need to re-think its business model. Sustainable business solutions will need to be closer to home and corporate social responsibility will be much more about looking after jobs and people in domestic markets than introducing a few green recycling bins and promoting an energy reduction campaign. Whether the offshoring industry could actually die is moot although it clear that the political pressures to reduce its impact on the domestic social and economic infrastructure will translate into a far smaller industry. It may even accelerate a newer trend of ‘Inshoring’, the practice of moving an overseas activity back into a domestic market.

The regulatory and taxation aspects of this new world could still be some years away which presents something of a challenge for those companies currently looking at the relative advantages of moving production and service tasks overseas. At the moment it is still very much a cost and service calculation: can the same activity take place overseas at a cost lower than the domestic market but at the same price? If the answer is ‘yes’ then the business case is made and the operating model can change. In the future the tariff and taxation regime could well be substantially greater and the impact on corporate reputations will be more of a consideration. Even today companies regarded as significant exporters of domestic jobs are at constant risk of having their brands impacted by these behaviours. They are not seen as good corporate citizens. Corporate social responsibility will become much more important in the coming decades.

In a 2008 report the Nottingham Centre for Research on Globalisation and Economic Policy delivered a broadly benign piece of research on the impacts of offshoring on the UK economy. Its findings indicated that offshoring was responsible for an estimated 3.5% of job losses in the UK in 2005 but nonetheless suggested that job gains outweigh job losses without clearly specifying the mechanism (possibly inward investment). It further suggested that companies who offshore generally experience an increase in average productivity gains and also associated offshoring with an increase in company turnover. The report acknowledged that average service sector wages decline with more offshoring but postulated that average manufacturing wages stay broadly the same.

A more current 2015 report from the CEPR (Centre for Economic Policy Research) probed further into the impact of offshoring on British jobs. It took a far closer look at the geographical and industry sector impacts and is a far better reference point for explaining how and why some regions and industries have been particularly badly hit while others have seen enormous benefits. By delving into the detail we can start to understand why deprived areas of the country are rebelling and perhaps glean insights into the reasons for anti-EU and anti-globalisation sentiment.

The report divided the UK employment market into ‘routine’ and ‘non-routine’ jobs. It basically suggested that the UK jobs market has become increasingly polarised into these two categories ‘with labour market disadvantages increasingly concentrated in specific occupational categories.’ Routine occupations have rapidly declined in recent years while non-routine jobs have shown a slight increase. A finding of the study indicated that routine jobs were ‘overrepresented in some parts of the UK, mainly in the midlands, the north and the northwest, Wales, and parts of Scotland. By contrast, non-routine activities were overwhelming concentrated in London and the southeast, with spikes in cities such as Aberdeen, Edinburgh, Harrogate, Manchester, and Bristol.’

The report found that ‘the impact of offshoring in places more exposed to such trends as a consequence of their pre-existing industry specialisation was significantly negative on routine occupations.’ It further noted that ‘the consequences of offshoring are likely to be particularly severe in the short and medium term in specific areas with a high initial specialisation in routine activities.’ In other words the areas where routine jobs are ‘overrepresented’ have and will continue to experience the predominantly negative effects of globalisation in the short term and will have to wait much longer for the positive effects of offshoring to work their way through the system: ‘In addition, compensation effects of job creation in non-routine occupations were strengthened in the long term, once efficiency gains linked to the geographical rationalisation of production had been capitalised.’

So we have the outline of an explanation for the changes that are taking place in the political world and perhaps can now rationalise what we can all see with some economic data. Parts of the UK are very unhappy with their lack of prosperity and are likely to continue to express this dissatisfaction in the ballot box until the economic benefits of globalisation start to spread across the UK.

At the micro level we have to be cognitive of this dynamic and as change managers need to factor-in the potential changes to regulation and taxation in our evaluation of offshoring propositions. The UK is far less likely to introduce anything near a 35% levy on imported goods and services than the US but there will no doubt be some taxation implications for states seen to be unfairly trading with the UK or pursuing predatory pricing. Offshoring should perhaps no longer be seen as the automatic answer to many cost reduction challenges, and even if it is still seen as a viable option the location of an offshoring proposal will require even deeper consideration. Strategic views of national politics and trade practices are likely to become an increasingly integral part of the offshoring decision. An offshoring decision barely features on the corporate social responsibility agenda at the moment but we cannot be certain that this will sustain. The electorate is now watching and the political class have become much more aware of the relationship between corporate decisions and any potential impacts on voter intentions. Stripping a pension fund of hundreds of millions of pounds may be attracting the opprobrium of the public today but a few years from now it is not beyond the realms of possibility that an announcement to offshore hundreds of jobs from an economically deprived area will attract the similar amount of voter (and therefore customer) revulsion.

With or without a Donald Trump presidency we need to be far more careful about those offshoring decisions in the coming years.