PICTURES OF MATCHSTICK MEN
I noted at the end of our last bulletin, that markets are feeling strangely bullish, for a few reasons, which I share. Although only in some places. I still find little attractive in most debt markets. They are cheap, but given losses this year, are they good value?
And UK politics is becoming boring, which is no bad thing.
So, were we right to predict that interest rates alone cannot tame inflation?
Our original thesis for this year, that interest rates could not tame inflation alone, maybe is right. The level needed would cause too much damage. But that is applicable (we now see) to the UK, but not as yet to the US. And oddly perhaps not as yet to the EU either, although Lagarde midweek, perhaps had the same tilt. But German profligacy may wreck that.
The logic is the same for them all. You canât tame this beast by rate rises alone, as double figure inflation needs double figure interest rates and that is just not happening.
The UK is certainly not prepared for that level of rates and fiscal restraint is therefore now required. Fiscal drag will do some of the heavy lifting, and energy price declines a fair bit more.
Some commodity market statistics were released by the World Bank, this quarter. The above graph is extracted from their statistical report
But tax rises and government spending cuts will still be needed to cool the UK labour market. In particular the public sector must be reined in, or service cuts made.
Earnings will fall, taxes rise, growth stall, discontent rise. But still no collapse in housing (secondary) markets or in employment.
Nor do I therefore see much rise in loan defaults. This makes the recent round of forward-looking bank provisions unusually daft. You canât audit the future, so how can you include it in historic accounts? A weird hybrid. Best to ignore all that and focus on now, and now is still not terrible. With a pretty hefty valuation discount in situ.
(Data downloaded from the Office of National Statistics for this in house graph).
The US political situation
In the US, The Federal Reserve have effectively said if there is no fiscal restraint, they will ramp up rates till there is, or inflation falls. That is scary, but it looks as if the Mid Terms will hobble Biden and stop some of his fiscally reckless measures. He thought the wave that toppled Kwasi missed him, but it was the same ocean, and likely will give him a rough ride too.
Bidenâs approach felt good, overindulgence often does, but the pain of the untethered dollar is now starting to hurt US earnings, and in time US jobs, however much they dream of legislating against that. The impact of rate rises is also probably less than it sounds in the media, partly because most reporters are likely to have mortgages, whereas a growing number of investors donât.
Overall US government policy remains to force up inflation and challenge the Fed to sort it out. Hence all the Fed threats are directed not at the market (which cares) but at The White House (that does not). Mid Terms (on the current path) will therefore be a big boost to US markets, as it means Congress at least, will start to work with, not against the Fed. As with Kwasi, a reckless budget will not pass unchallenged again this time. Those extremes belong to the COVID era, that is now over.
Comparison with the UK position â and where Europe maybe is headed
With that battle already won in the UK, both sterling and to a degree UK rates are reverting to the status quo ante. And as sterling rises so the FTSE falls; that link also remains. If the UK is neither chasing interest rates up, nor letting the pound fall, it gives Europe some cover to do likewise.
In truth although sounding dramatic, in the real world it is inflation that really counts not (as yet) interest rates which are still absurdly low.
The Tory Party â what can we discern?
Talking of status quo, thatâs where the Tory party is now headed. Cameron drifted too far left, Boris dithered, Truss drifted right, and now the new government is a hybrid, although colloquial English perhaps has a stronger word for it.
I sense that spending decisions may correctly be back with a powerful Chancellor. There is a seeming party truce till the next election, when half the current Cabinet seats will vanish anyway, and then who knows?
Or if this coup and enforced hybridisation fails, we really will know the party is split, and a General Election could follow. Unlikely, though.
Why bullish then?
US earnings except for highly indebted outfits, will probably stay surprisingly strong for a while yet. And likewise, the dollar pivot point is being pushed further out, as no one else in the developed world is going for rates quite that high (or that fast).
There are also two market forces to look out for, rising rates and slowing growth is one, but the simultaneous loss of liquidity is another. The former will cause a patchwork of changes, both good and bad, but the latter the ending of a multi-year bubble.
It all remains cyclical â a transition, not a bounce
The difference is key, rates are possibly a two-year cycle, a bubble a ten-year one. The bubble in non-revenue companies, and in absurd multiples for even profitable tech, will take longer to deflate, be slower to re-inflate and be muddied further by all that spare capital accelerating technological change. This is still not an area we either feel confident in, or trust their valuations.
If we really are back to the status quo in the UK, about to be in the US, why would markets be going down, down, deeper and down?
Lend me your fears
I come not to praise Kwasi, but to bury him. This is an explainable, predictable but probably futile coup in the UK Tory Party, along with more King Canute from Bailey of the Bank.
But in markets there is abundant good value, but with few clues on how, or at what cost, inflation is to be tamed. Or indeed what may escape this time.
Political Manoeuvres
We have long noticed the Tory partyâs splits and factions, broadly between the left and the right wing. This was a chasm Boris was uniquely able to bridge, by talking right, and acting left. The puzzle, as we noted, was why the left would bring him down to replace him with a right talking right acting Prime Minister. The preference was for a Blairite Conservative, low tax, high spending, but a steady reformer, with a lethal penchant for foreign wars and illogical hatred of the Euro. After Kwartengâs departure, the Tories now have the doomed high tax big state faction back in charge again.
Hence the need for a pretext to overrule the party members and threaten Truss with the ever-gleaming sword of Damocles, held by the 1922 committee - we are back where the plotters wanted to be after Cameron â with the neutral Hunt playing the safe stooge to hold the fort.
Unlikely to win the next election
It foretells the inevitable party split â but we had never seen another Tory term as possible, regardless of the leader. Nor have we ever seen Keir Starmer as needing to do anything but sit tight and keep a grip on his party. If he is also spared the crippling cost of a really tight General Election, he can now face down the Trade Union money men as well.
As for Kwasi, if he stays the course, his troops will yet triumph at Philippi, he is by far the best the Tories have just now and looks to be the future. He has understood that if you fail to free the supply side, in a new productivity revolution, the current national decay will just go on, as it has for twenty years or more. But he has also not torched his future, Miliband style, in the wrong leadership move.
Will any of this stem the attacks by market traders? I doubt it. Will any of this forestall the inevitable sharp rise in interest rates, I doubt it. Or indeed stop ongoing sterling losses. To quell inflation requires interest rates above inflation, you canât bear down from below. It remains daft to think UK interest rates can be effective whilst remaining underneath US ones either, as we said in our previous post.Â
Both clipped from this site, and set out side by side. The core data as is cited below are from the Federal Reserve and the Bank of England respectively.
So, what is the shape of this next recession?
I think we are now starting to see it. Not that much unemployment, the current tight labour market, without addressing increased workforce participation, is going nowhere. Nor is a secondary residential property crash certain. That is so last century, both areas are now far more heavily fortified sectors than they were last time. And both are now designed (and legislated) to be fiercely inflexible downwards. That is what the current labour market (and our dire productivity performance) is telling us.
House prices are propped up by a very generous market backdrop, ongoing vice like planning, high land taxation, tons of liquidity and a deep political fear of the consequences of a collapse. For all the moaning, borrowers are still able to load up at negative real rates, with a highly competitive mortgage market and generous fixed term offers.
But do expect a general slaughter of small businesses (or rather the current collapse will go on despite the various support packages). Expect weak margins for UK based firms, ever more exposed to competition, from far more generous and protectionist states.Â
WTO rules really are in tatters now and routinely ignored by powerful countries like the US and Germany. Expect a resulting fall in quality both in goods and services, again a continuation of current trends, as globalisation retreats.
But remember too, that so far, we do have inflation, but not a recession. The current dislocation is caused by a resource switch towards savers, who at all levels have had slim returns for a while, and we will now instead punish borrowers, who have had an absurdly easy, subsidised, inflationary decade.
The big picture, overall
Meanwhile in the energy world, a resource transfer is taking place from energy users to energy producers, who have likewise had a thin time of it. That those energy producers are places like the US, Russia, Saudi Arabia, Iran, Nigeria, Brazil, is a remarkable own goal for Europe.
But it is neutral for the world.
Indeed, much of those surplus funds will now be collected as various direct and indirect tax revenues, or to pay down debt, or as new investable funds, or distributed as dividend payments, but very little of that vast energy price transfer leaves the known universe.
For Europe, however the decline happens with the slow loss of productivity, plus the demographic torque. Meanwhile borrowing our way out, is suddenly becoming far more painful.
The political turmoil is ultimately from this change, and the longer states borrow more and pretend nothing has changed, the less effective will be their remedies. And indeed, the more the big efficient producers, like China, the US and Saudi Arabia will thrive. Neither more debt, nor protectionism will solve this, nor indeed will more global military adventurism.
Confidence is understandably damaged
Given that backdrop the mood music is damaged just now. Markets are trying to spark rallies, but with no real confidence yet.
Investors sense there is value, but with too little data to know where.
But whisper it quietly, Santa Claus is due, and the market mood is not quite as bleak as events suggest it should be.
FEEDING FIDO
International interest rates - what a dogâs dinner! But perhaps also a wake-up call: this is real life - governing for your social media feed does not work. We take a glance, too at the property market.
MARKET EVENT OR MACRO?
Our view has long been that we need rates at 5% to make a dent in labour inflation, both in the UK and US. It looks like the Fed (to our surprise) finally agreed. But with that comes a risk of overshoot, driven by the timing of the US mid-term elections. Powell, perhaps rather more attuned to politics than his banker colleagues, was keen to drop the bombshell early, rather than on 2nd November, right on top of the mid-term elections. So, I think the Fedâs now done with giant rises. Future rises may be less and spaced out, and quite possibly not that many.
One of the most chilling sections in Powellâs press conference was when asked about the global implications: yes, he assured us, he quite often takes tea with international colleagues. That was it. This time round the US is happy to crash through the global economy without a care in the world.
Encouraging short sellers
It seems Bailey of the Bank failed to get the memo, because oblivious to the soaring dollar, he stuck to plodding domestic rate rises, as if Leviathan was not bursting forth from the deep. Lifting rates by 0.5% when the dollar lifted 0.75% the day before felt like a joke. And if Bailey could not see that, the markets could: UK two-year gilts abruptly repriced to US rates.
But sterling is still hobbled by UK rates at 2.25% - too low. By trying to be clever on the rate rise, Bailey has simply let the short sellers in. As the chart below shows, having already hit the renminbi and the yen, it was obvious who was next. Sterling is a small but liquid currency block, with no allies â so it typically pays more to borrow. The markets just needed the signal.
From : this siteâs fine moving graphs
I doubt all that volatility really makes much difference to the real economy. Indeed, the Bank has now braced sterling nicely. As for the pension schemes, the FCA (Baileyâs last top job) created the foible of pensions being forced to hold loads of so called ârisk freeâ assets to prop up UK government borrowing. A most amusing idea, always going to blow up one day.
Not that sure even 4.5% rates will slow wage inflation up. But we will know soon enough, after all the destination was to us never in doubt, just the arrival time. I still see the strain of rates rising to (say) 8% as too much for the electorate in either the US (the leader) or the UK (who follow).
Recession fears?
Nor do I consider either the US or UK end rates to be high enough to cause a severe recession, although clearly, they will have an impact on asset prices, and in the end, labour markets.
So, I conclude this is more a market event than an economic one. And surprisingly it is all in bonds (and therefore currencies).
Investors will hang back until they see those settle down and that could take the rest of the year. So, although everything is perhaps cheap, the VIX will keep many on the side-lines.
The UK at least feels at bargain levels, but buying dollar stocks still feels somewhat pricey.
BRICKS AND MORTAR
So, to property. Well, we got this one wrong. Partly we failed to see Ukraine becoming a big war, but one with no quick winner. This triggered European (in particular) energy inflation. Partly we therefore saw interest rate rises staying in single figures, which is not what some REIT prices imply.
Not that we have changed our longer term â4&4â view on interest rates and inflation, (so higher for longer) but other investors and markets clearly have. You canât fight the tape.
In general, outside the warehouse sector, real estate companies (unlike say Private Equity) had already taken the hit to values, their balance sheets showed the new world, backed by real deals. So, adding a second discount does seem odd.
Gearing levels are not high, and debt maturities well extended, and interest (still) well covered. Maybe private markets are worse, but it is not clear why that contagion spreads into quoted ones. If there is a blow up, it is not obviously in public markets or mainstream lending.
But if quoted markets are right, what of residential markets?
Well logically as they are still going up, do residential prices now have a big drop built in, which is yet to happen? The price of mortgage banks, home builders and buildersâ merchants all say âyesâ. But how will it happen? It is not a big sector in UK public markets, but the odd couple that do exist (Mountview, Grainger) have also taken a hammering. They have some debt and are rental specialists (of various types).
So, markets say yes, house prices will also collapse.
Do I believe that? Anymore than talk of imminent dollar sterling parity and 8% base rates? Frankly no. Stagnate, chop around, go sideways, blow the froth off. Sure. Collapse; is wishful thinking.
After Armageddon I fully expect to see a plucky estate agent emerge from the ruins, justifying an offer above the asking price for the debris, with potential (but may need planning consents).
So, if true, that means despite a hair-raising ride, those mortgage banks and residential owners will in time emerge resilient.
Sadly, for many, that also suggests, without forced sellers from the buy to let market (where there will be a few), the stock of housing units wonât change and therefore nor will rents. Housing stock is very lagged and current moves will only close the pipeline two years out. Only mass unemployment hits rents, and if this is a market event, not an economic one, it wonât change, because structural unemployment is not the issue. Indeed, we are at record low unemployment levels.
In summary
A market tremor created in Washington, was transmitted to the UK, and is now rippling round the world; either currencies hold their interest rate differential with the dollar, or get crushed.
Old news; it is odd isnât it, how so many clever people failed to read the memo?
Into Broad, Sunlit Uplands?
This week has included a major but baffling fixed interest event in London. And we include some thoughts on the novelty of a conservative prime minister for the Conservative party - but first, the shape of the coming recession.
Who Survives in the Coming Recession?
It may help to see this recession, as just the reversal of the COVID boom, paid for with debt and deeply inflationary; in which case what should it look like? The ultimate aim will be to unlock labour markets, where we said (in our newsletter of 20-3-21) that COVID would do most harm.
Unlike traded goods or commodities or liquid assets, there is no simple snap back available without pain, because labour pricing is inflexible downwards. Indeed organised labour has worked hard to embed that inflexibility, notably in minimum wage laws, and the crippling of the hated gig economy.
Certain capital assets too are stranded and inflexible, but probably not most commercial (or residential) rents. Large single purpose buildings may be vulnerable and we feel, so is quite a lot of owner occupied residential property, whereby recent unearned gains will now need reversing.
Labour costs have two available paths. Either the 40% of working age adults who have now withdrawn from the labour market must (in some measure) return. It is their ongoing withdrawal post COVID that has hurt most. While COVID has also created (mainly in the public sector) a lot of extra staffing that is hard to step back from, especially in healthcare, which further depletes the available labour pool, and must also be reversed. Reducing labour taxes also helps.
Possible business failures
If not, there may instead need to be widespread private sector business failures. The third option, a speeding up of capital investment to substitute for labour, has somehow failed to be either fast enough or effective enough. It seems just too hard for businesses to predict demand paths, to commit to such expenditure. Cap ex is all about confidence, which is absent.
How then to measure if this labour reset finally happens? Well it looks as if job creation will need to go into reverse, with a net two quarters (at least) of contraction. There are plenty of businesses to fail, speculative and derivative loss making tech for a start, retailers of goods who over extended in the supply chain inspired boom, service sector spaces, where the current surge has drawn in capacity well in excess of long run demand, will all get hit.
As will everyday businesses, that have net margins that canât withstand the double figure interest rates demanded of sub prime (i.e. now most SME) borrowers.
Paint that template over where the most savage equity falls have already happened, it fits quite well. But it is by no means universal, if IP, not labour matters, or labour can be off-shored, it is in a better place.
Although as jobs disappear, so the strain reaches further into total consumption and demand.
Fixed or Floating.
What of fixed income? Well we took the view early this year that you canât stand in the way of an avalanche, unless you hope to surf it. So we kept clear, and still are.
Source : this page
It was a very well attended fixed income conference in London this week, so credit is clearly back into portfolios, big time. My worry was the Table Mountain (or Brecon Beacons or Grand Canyon) graphs. All of which were steep sided, but flat topped, and on all of which, just now, is the exact point when lungs bursting, you climb the last butte, to see a vast sunlight upland.
Really? Why? No idea, but somehow the collective belief is rates top out circa 4% and then fall.
Certainly not if they mirror the inflation path (see above), that gap is now vast twixt interest rates and inflation; it will close - it has to. However we see more rises, not a near term peak and also far slower falls, than the market does. Reason? It is labour inflation that now drives it, and it wonât roll over soon.
Unless that is, the rate rises so far have done real damage and rates are then cut to mitigate a severe recession. If thatâs the expectation (and it may be) you really donât want equities at all, not even energy, the yearâs bright spot.
So the question is, are high yield bonds now cheap?
Well yes, and quite attractive; defaults at the rate now implied, are unheard of. But if that odd plateau graph of rates is wrong, everything has yet to get even cheaper. Thatâs the rub. And that is why, for now, bar floating rate, secured, we are still not going into credit. And also because global interest rates must eventually align, so the dollarâs ongoing strength is a bad sign, as that will have to reverse too. This makes dollar assets themselves now dangerous.
The same dilemma is true for equities, yes, high quality, mid-size companies look cheap, the FTSE 250 is down some 20% in a year, almost as bad as the NASDAQ, whereas the FTSE 100 is modestly up (a distinction shared only with the Nifty 50). But again, we thought that value was emerging in the summer, but sadly not so; the market still sees a viscous earnings contraction ahead.
Which brings us back to employment, either it must fall, or participation must rise, and I fear we expect a fall, which seems more likely. This cycle, in the all important labour markets, still feels a long way from done.
New Broom
As for Truss, well talk of growth at the inept and hidebound Treasury is a nice change. As is that of getting the country working (spot on). This is core free market stuff. Has she the votes? Pretty sure she has, it was odd for the left wing of the party to eject Boris, who his actions showed was one of theirs. To unseat another leader would guarantee oblivion, so they must back her.
Worrying about fiscal rectitude, for a two year government, seems oddly implausible too. Yet she still fell prey to the old belief that governments (and higher tax) solve everything with her energy package, least of all can that solve demand based inflation. That is for Central Banks to do, and as ever, they are getting no help from the rest of government.
Does this suggest a big US rate hike this week? Not sure, we are much more seeing the end point as rather higher, than faster near term rises. We kind of think the Fed has made their point already.
The Turn of the Screw
So, we have Truss now. The continuity candidate, not the dull man who would take away our sweeties. But also, the same old Fed, keen to do just that. And its time we took a look at Starmer, the other continuity candidate and an excellent book on him; required reading for serious investors.
Otherwise, it is always a good summer when nothing changes. Markets swoop and soar vainly trying to catch our attention, but the reality remains that rates have to rise enough to destroy the excess demand that causes inflation. And they have to rise to equal or surpass that level, eye-watering as that prospect is. It will not be over until the US jobs report goes negative, and stays negative; anything less is prolonging the pain. Â
Presentation over substance
But this is a time of intensely political Central Banks, headed up by people without a grounding in economics, but a lot of âpresentation skillsâ. They will be dragged kicking and screaming and smiling to do what they should have done last year, hoping vainly for some supply side reform or windfall to help out. But largely still facing the exact opposite, populists who think subsidies âcureâ or ameliorate inflation.
Markets are oddly buoyant; they get like this at times, but we see that as a mix of delusion, the self-reinforcing strength of the dollar (be very careful of that one, it is a new bubble) and the spluttering remnants of buying on the dip.
But be under no illusion, Central Banks trying to guess where the economy is going is like fly fishing with a jar of marmite. Entertaining, but highly unlikely to catch anything.
Truss: Issues and options
Truss meanwhile looks like a re-run of Boris; it wonât be quite that simple, but it looks like more style over substance, a different set of lobbyists, but nothing really changing. The idea either she or the EU can afford a bust up with the UK, just shows how silly markets can get.
Some of her programme may make sense, both the NI (tax) rises, and the corporation tax increases were badly timed and should be reversed, given inflation is doing the hard work already through fiscal drag (or frozen tax thresholds).
The rises were proposed when we were exiting the COVID crisis, but before we understood the energy one. We said so the last time we wrote to you.
Ditching a few Treasury backed white elephants (HS2, Freeports, the crazy fiddling fetish on capital allowances) would do no harm either, but overall, the marketâs verdict is clear: fiscal responsibility is still a long way out. We can all see how sterling has collapsed against the dollar; it is less clear why it has fallen against the Indian Rupee or the Chinese Yuan.
Source: See this website for all the daily data.
A book to read for all investors
So to Starmer, the likely next UK prime minister, where we need to pay more attention. Both on his mindset and on why the Labour Party hates him so much. Which in turn explains why (and with the Tories fatal ideological split heading them into Opposition), he is so fixated on party control.
Oliver Eagleton writes very well. His recent book The Starmer Project looks at four episodes, his left wing legal start, his transformation into a Tory enforcer with a penchant for exporting judicial expertise to the colonies (donât laugh), his alleged machinations to back the Peopleâs Vote nonsense to bring Corbyn down (pretty dense stuff, even now) and his use as the Blairite stalking horse to put a stop to Corbynâs chiliastic tendencies, (which also gives you a trigger warning about a light dusting of Marxist ideological claptrap).
So Starmer is all about what works, which would make a nice change.
Weâre looking at a very global mindset, apparently quite a strong Atlanticist outlook, keen to work with European authorities, but aware that the Brexit boat has sailed. An interest in devolving power down, but keenly alert to the risk of anarchy that entails. Indecisive, a Labour Party outsider (on his first election in 2015, apparently his nomination had to be held back to ensure he had the minimum length of prior party membership). Starmer is not exactly collegiate, but he has run a Whitehall department (as Director of Public Prosecutions) so not a loose cannon.
Very London too, Southwark, Reigate, Guildhall School of Music (sic), Oxford for post grad law, Leeds as an undergraduate. So should at least know where the Red Wall was. But lest you relax too much, a total ignorance of economics or business, let alone how to create growth. It wonât be easy.
And what about Markets?
Well for a UK (or non US) investor you only had one question this year. If you ditched the local currency you made money, and if you held onto sterling you got hit. Our GBP MonograM model is doing fine, it got that one big call right: kind of all you need. If you are a dollar investor, outside of energy your best place was cash. And our USD model took longer to spot that shift. As for active investing, sadly pretty much the same, the dollar is the story, or dollar assets. All of which perhaps makes dollar earners in the UK look cheap still.
But for now we see the story as a currency one, and at heart that is just about the timing of tightening interest rate spreads. The widening of those spreads has caused the recent havoc.
So when (finally) the European and UK Central Banks abandon futile incrementalism and get the big stick out, that will call the turning point.
Charles Gillams