a map of russian oil pipelines with pictures of pipes super imposed on it - in house collage - illustration for an article by charles gillams - he who pays the piper

He who pays the piper

A very strange quarter: the FTSE100 was up, in sterling terms the S&P 500 was up, and the Russian Rouble ended where it was just before the Russian invasion. Short term dollar interest rates are nicely positive at last.

So where is the problem?

UK policy changes – could we finally be leading in economic policy?

Well, at long last the UK Chancellor has finally realised that just throwing money at inflation has one clear outcome: more inflation. This is tough lesson learnt back in the 1970’s and seemingly since forgotten.

If true it is a turning point and we predicted that it must always come sooner for the UK, if it persists in staying out of the Euro, than for bulkier continental currencies. Sunak also seems miraculously to be finally tackling some long overdue, multi-parliament, structural taxation issues, a rare sign of political maturity.

Whether he can hold the line against an increasingly dimwitted set of MPs and a media who constantly bay for more fuel to be added to the inflationary fire is unclear, but at least he has had the courage to step out into the unknown night, not cower by his warming bonfire of magic myths.

Nor is it clear whether he has the clout to unpick the cosy mess created by Theresa May and her childlike energy price fixing, or the ensuing nonsense from Ofgen. This fine-tuned capacity to the point of absurdity, guaranteeing a massive breakdown in the generating buffers, which had been painstakingly installed under a series of Labour governments.

Inflation policy is being taken seriously

But Rishi is trying; to cool inflation you simply must have demand destruction, there is no choice. This type of deep-seated widespread inflation will be hard to quell in any other way. True, areas of it can be contained, but it is hard to hold it all.

He is lucky to be helped by a Bank of England that seems to be serious about its brief, not regard it like Lagarde and Powell, as some kind of political inconvenience, to be wished away in double talk and evasion.

But he’s unlucky in other ways; we noted a while back that China no longer seemed to care about headlong export led growth, or more broadly about access to hard currency. It feels it can invest with and gain from its own currency and avoid importing the monetary excesses of the West. That in turn means it cares less about the endless flows of cheap goods to Europe and the US, and conversely about soaking up those surpluses in luxury goods and services. None of this is good for our inflation.

Meanwhile by eliminating the oddly divergent starting points for the two income taxes, National Insurance and Income Tax, Sunak has opened the way to many benefits. It continues to drop taxpayers out of the system, despite desperate measures by HMRC to suck more in. A key step, and a sign of, for once, a more liberal, more efficient government. Many more steps are needed to unshackle wealth creation, but it is a start. It makes much of the Universal Credit complexity around thresholds also fall away. Most of all it is a step closer to combining the two income taxes.

Politically this is highly desirable, as it strips away the pretence of a low starting rate of taxes on income.

It perhaps even gives an excuse for the otherwise inexplicable step of introducing National Insurance on employees passed retirement age. Given so much of current inflation is due to the mass withdrawal of older workers, another step in that direction looks remarkably stupid, but perhaps it has a higher purpose. It is good to see that the “Amazon” tax as Business Rates should be called, as it gives Amazon such a massive earnings boost, is also clearly still under long term review.

Why has the rouble recovered?

Source : this page on tradingeconomics.

The recovery of the rouble is of course not a market step alone, doubling interest rates, exchange controls and the mass withdrawal of exports to Russia from the West, are part of the story too. But it also shows a turning point. At first the West was so shaken by Russian military attacks, it was prepared to follow its own scorched earth policy, regardless of the harm caused to our own people and employers.

But at some point, the realisation that Ukraine’s army would hold, that Putin’s army was not that good after all, especially up against modern weapons and we start to understand that the further blowing up of our own bridges just raised the ultimate bill. Here are the sanctions we've imposed.

So, it seems it is no longer true that any price is worth paying to help Ukraine or hinder Russia. Clearly, we don’t have to jettison all our principles in dealing with other tyrants, nor one hopes do we need to alienate every piece of remaining goodwill with the rest of the world, by panicked grandstanding.

The mob is still rampant, goaded by an American president for whom no European economic sacrifice is too great.

But maybe it is also time to tell Ukraine that no NATO also means no imminent EU: Brussels has its hands full with its own struggling ex-Soviet states.      

And what about Powell and his policy?

Well, we don’t expect him to hold inflation down with his trivial rate rises, nor politically can he do more than tinker. It seems too that Lagarde at the very least has to get Macron back in, before telling the bitter truth about rates.

So, we feel the bond market has rates where the market would like them to be, in the US, not where they will be set by the Fed anytime soon. And the Euro is now in a very odd place, still with monetary stimulus being applied and with an unstable gap to US interest rates.

So, we may look to be where we were late last year, but in most cases the cracks are now alarmingly wide.

Europe, quite urgently, but the US as well needs a sharp jolt upwards in rates to halt inflation.

Oddly only the UK looks to have spotted the danger, stopped the false COVID ‘economic expansion’, tightened fiscal policy, reformed taxes and raised base rates steadily, towards where they need to be. How unusual.

Long may PartyGate continue if this is the end result.

We will take a break for Easter now, and resume on the 23rd.

If the first quarter is a guide, by then everything will have changed again.


This is a collage image - the left hand side says no sanity claus, and the right hand side is a photograph of a tree wrapped in a quilt. It is an illustration of the article on investments written by Charles Gillams called 'there is no Sanity Clause'

THERE IS NO SANITY CLAUSE

Three big topics this week from three central banks, all of whom look to be in a muddle, with their knitting all jumbled up and highly implausible. Entirely predictable inflation meanwhile threatens to sweep them off their path, as they tinker with micro adjustments to interest rates.

Boris is diverting, but we doubt if it all matters; pre-Christmas entertainment. If he were logical or even vaguely numerate, he would change, but he’s not, and he won’t, but nor does he need to.

The Lib Dems win a by-election, that Labour fails to contest, but it makes no difference in Parliament, and it lets Boris look contrite mid-term. He will survive this with ease.

Which is not to say he should, or that he’s not making a hash of COVID, the sequel. In keeping the NHS in its current format, Boris fails to ask, as many have before him, whether it is still fit for purpose. This remains an urgent question. It can’t simply collapse every year.

Bailey - Bank Governor and historian

But perhaps Andrew Bailey, Governor of the Bank of England, understands the extraordinary risks Boris poses to the economy, and has hiked rates to show that. A Cambridge (Queens) historian, with a doctorate on the impact of the Napoleonic Wars on the cotton industry of Lancashire, he will know full well the impact of a French orchestrated trade war backed up by a dodgy pan European monetary system.

A consummate insider, via the LSE, he moved on to the ascending ladder of the Bank, which did include a slightly unfortunate move into the FCA. This turned out to have rather more real villains than he was used to. Married to the head of the Department of Government at the LSE, he will be very well aware of the political game and the current mood in Whitehall.

He’s seen enough inflation and has decided the Bank must pretend to act. Not only is the rate rise trivial, but it also coincides with a continuation of Government bond buying (QE), an odd call. That the last thing the economy needed was still more liquidity, has surely been obvious for eighteen months now.

Christine Lagarde and Jerome Powell

In Europe the same mishmash exists. We have been hearing Christine Lagarde explain why the ECB is now accelerating one asset buy back (APP) while ending another one (PEPP). She was winging it with the phrase “utterly clear” in answer to a pertinent question, when it was clearly anything but. Still, she did seem to have her ear rather closer to the ground on wage inflation, at least compared to Jerome Powell.

He by contrast has been caught with his pants on fire, trying to weasel his way out of the Fed failing to spot inflation, by saying that most market commentators agreed. Remind me, which is the canine, and which the wagging appendage?

Basic economics - why inflation arises

We called it on inflation as soon as that stock market rally took off, and for the simplest of economic reasons: the pandemic had reduced global productive capacity, so absent a change in price levels, the economy was less productive, profits were therefore lower, competition would therefore be less (unless prices rose), and total production must fall. Less output, same demand will always mean inflation.

Forget the energy issue, forget supply chains, less capacity, more demand always means trouble. True based on that one schoolboy error, the dopey measures to reduce capacity further by more regulation, hiking the minimum wage, paying people not to work and so on, plus embarking on accelerated decarbonization and a few new trade wars, was not going to help much either. But please no more “surprise” inflation, it was baked in. (See extract from my book, Smoke on the Water, blog dated July 2020, title re-appearing shortly on Amazon)

After the interest rate rise

However, we have also long felt that interest rates can’t rise enough to stop inflation, but that as governments have to back off fiscal stimulus, as they are already overborrowed, the lower productive capacity will itself shrink demand, and in the end cause inflation to fall. But we see that as taking years, not months.

Why are interest rates not rising to combat inflation? No political will for a start, and any one country that gets too far out of line will find currency appreciation itself addresses the problem. So, do we believe the US “dot plot” suggesting three rate rises in 2022, while the Euro zone does nothing? We struggle to.

Powell is still clinging to the lower workforce participation rate (which matters) as a signal to defer rate rises and not the unemployment rate (which is more closely related to vacancies) and hence of less fundamental relevance. While employment is great, it will still be unattractive if inflation (and fiscal drag) takes off, thereby holding the participation rate low.   

This is a graph showing US labour participation during November 2020-21.
See the Statista page from which this is extracted for more detailed information

This does still suggest dollar strength, while sterling like other smaller currencies always needs to be wary of getting too far out of line with US rates. But also, a need to fathom out the new look economy. To us, it does not seem service industries that rely on cheap labour are operating in the same world they grew up in. Certainly not if it is onshore.

There is a forced change in government consumption patterns (and hence employment), and this will also be telling. We are heading into quite a different market, when all this shakes down.

Sitting on high cash levels over Christmas, as we are, is pretty cowardly, but if you can’t see the way ahead, slow speeds are usually safer.

We do also rather agree with Chico Marx, this year at least.

Charles Gillams

Monogram Capital Management Ltd


River Deep, Mountain High

Welcome back Mr. Powell - so what is a good response to impending inflation?

After nine months or more the newly reappointed Fed Chair conceded the blindingly obvious: we have an inflation issue, along with the equally transparent need to tighten monetary conditions to quell it. At least he’s fronted up to that, unlike the position in Europe.

What diverts us is what the right response is. Some things are perhaps obvious: gold at least in sterling terms now has positive momentum again. But there is a tremendous volume of liquidity to soak up still, while stimulus will keep being pumped in for a long time. But fixed interest just looks hopeless, credit quality is plummeting, rates are rising, and returns are poor, even in high yield.

Are we clear of COVID effects?

Nor are we really clear of COVID effects. We are yet to pass beyond all the “emergency measures”. So here in the UK, VAT is still reduced, commercial evictions banned, and government departments are still showing that odd mix of budget destroying costs and below normal productivity. So, spending pressure will stay elevated for a good while. Tax rises on corporate profits and on labour through National Insurance hikes, will therefore start to bite, well before the last variant has caused another pfennigabsatze-panik. (spike/trough related panic)

Markets have also been jittery. In general, the buying opportunities just after Thanksgiving have held, which is a good sign. The subsequent gyrations have (so far) indicated a good weight of money ready to buy the dips. But there is little doubt cash is fleeing the overhyped stocks, which are far more prevalent in the US, than in the UK. The shift out of basic commodities is also apparent. So, I would still expect enormous cash balances to build up into the year end in the banking sector, albeit maybe not always in the right places. Any Santa Claus rally will be strictly retail elf driven; the old man is self-isolating this year.

Characteristics of this inflation

Our view remains that the expected high inflation is systemic, simply because of the structural damage and inefficiency inflicted by COVID. So, it maybe transient, but multi-year transient. In this case while the seasonal moves down in energy prices will be a welcome relief, assuming Northern Hemisphere temperatures stay around seasonal norms (and that’s what mid-range forecasts are indicating) - it is not a solution to the inflationary pressures.

Nor do we see the any unwinding of the inventory super cycle caused by the holiday season and the ending of lockdowns, all at once, as having much beneficial impact on price levels.

Businesses all want inventory and will keep rebuilding it across their full ranges for a while. After all, right now holding stock has little financial cost attached.

See this article published by Markit.

Most corporates are at heart squirrels; it won’t be easy to break a new habit. 

So how should we play this?

The bigger issue is how to play this - the received wisdom is pile into the US, probably the NASDAQ, while having a side bet on bitcoin or some less disreputable alternatives.

That’s where most investors knowingly or otherwise have their funds.

NASDAQ may churn as dealers try to create some volatility, but the overall (and in our view inflated) levels will most likely remain.

This Omicron variant episode at least has halted the IPO madness, and the whole SPAC nonsense is washed up. Sadly, not a big surprise to see portly old London has just tried to catch a train that left the station last year.

The longer view

But it is a bubble we think - our icf economics monthly looks in more depth at how these played out the last couple of times. Not pleasant, but oddly familiar.

NASDAQ and Bitcoin may yet scale new peaks, but the river below is very deep. Perhaps that old affection for base gold is not just nostalgia?

Time for some year end reflection.

Charles Gillams

Monogram Capital Management


three pots - with the middle one lidded - denoting the investment pots of monogram capital management ltd

All kinds of everything

We move towards the end of the year with a great deal of challenging uncertainty and big calls to make, on inflation, China, US Politics, whether interest rates are pegged, and a few political issues. The temptation to sit it out and come back after Burns Night, is intense.

A lot of things will be clear then: the severity of the winter, and hence fuel prices, also of the EU COVID spike, the nerve of some Central Banks and who leads the largest one, and how the Beijing Olympics will go. All are potentially significant matters for investors.

Few of these issues are surprises, which is good, indeed we see advanced economies as being in fairly stable shape, but badly damaged by populist politicians, who can’t face telling voters that ‘nothing comes from nothing, nothing ever could’.

Inflation

So, on inflation, we took some flak back in the Spring for talking about 5% inflation, but we regard that as pretty conservative now.

From the OECD data here.

We see it as structural too, not related solely to excess demand, supply chains or energy prices. All of these matter, but the last two are indeed transient, and excess demand is within the power of the fiscal and monetary authorities to affect. The real trouble is both the lingering and severe harm COVID is causing to productivity, especially in the service sector and in a public sector still too reliant on overmanning and allied with that, the curse of politicians trying to exploit the pandemic to pay off their chums.

Our conclusion is that we will have higher prices at least for the next two quarters and possibly all of next year. Critically Central Banks will most likely be powerless to prevent or reduce that, without bringing the house down. 

Broken China?

One cannot but be envious of the performance turned in, yet again, by Scottish Mortgage. The half year gains are massively from one stock, Moderna, and then a broad raft of e-commerce and big data plays. So, really, they just continue to surf the NASDAQ run. By contrast their big cap China positions generally damaged performance but have not yet been visibly trimmed. Although China does drop from 24% to 17% of their NAV, which is significant, with North America rising from 50% to 57%. (I should also mention we don’t hold a position in this stock and have not had one this year.)

So, NASDAQ strength allows them to survive what for most fund managers has been the poison of owning anything in China this year. A decision we took, guided by our momentum models, very early.

We also note the manager’s viewpoint, which broadly aligns with a view that what Beijing is doing, is what the West should do as well, in attacking and controlling big tech platforms and their associated excesses. Telling the biggest companies to also do more to reduce inequality and cure social problems hurts profits; but they still see both as not unreasonable requests and they claim big Chinese companies are already willingly complying.

Yet for all the apparently cold rationality of the Scottish Mortgage viewpoint, we do understand it, and do see China trashing their participation in areas of global commerce and capital markets as an odd piece of self-harm, if it is really their aim, not just an ill-thought-out consequence of domestic actions.

So, we see the set back so far in China stock prices, as based on the possibility of the area being uninvestable, like Russia, but not yet on that certainty - see the how strong the trade figures are even with India, a so-called political antagonist. But tipping over to uninvestable would be a market shock and again we inch closer to that, with each diplomatic spat.

United States - and the Fed Chairman

The big US call, and again we signaled this as critical a while back, and actually well before the US Presidential Election, is about Powell. My sense is removing a competent Fed Chair for purely partisan reasons would be damaging to markets and the dollar. But the pressure on the ailing Biden to do just that feels intense, and I am struggling to see who in the White House will have the maturity to stop it, if Biden caves in.

Would a new Chair do things differently? Might markets push harder still for a rate rise and the dollar, short term at least, suffer? For now, re-appointment is still expected, but the odds on a shock are shortening.

Interest rates

The Bank of England is also, quietly in the midst of a storm, it is not actually independent however hard it claims otherwise, it relies too much on Whitehall just to survive, and, in a way, can’t do anything meaningful on inflation anyway. Still a rate rise, even a notional one, would show it is still awake. It makes little sense just now, but as a symbol might yet happen. To us it simply adds emphasis to the political chaos overtaking Johnson and the ongoing shift towards an institutional alignment with a Starmer government.

Material interest rate rises (so returning us to positive real rates) during 2022 therefore still feel impossible. Indeed, German rates have once more flirted with changing the nominal sign, only to collapse back into negative territory.

To sum up - where does that leave us?

Well curiously, mildly bullish. We may not much like the position, but who cares about that, our task is to make money for investors. We also have had a think about what rescued investors from the COVID slump, on the basis that a future sharp inflexion in interest rates could look much the same.

What we see is the power of real growth, not the flotsam of cash hungry concept companies that can never pay a dividend, but fast-growing, broad-based technology – following that has been the winner for a decade. We do want to call time on that, partly for the nonsense and scams it tugs along behind it, but we still struggle to see the turn. 

Charles Gillams

Monogram Capital Management Ltd   


two part photograph to accompany newsletter by charles gillams, showing a winding hilly road and a graph with a downward plunging line

Caution: Bumpy Road ahead

Puzzle: World markets have whipsawed in the last few weeks, from high anxiety to an almost beatific calm. The VIX volatility index has dropped to pretty well a post-pandemic low. Which should mean we all agree, but on what exactly?  Rising inflation, yes, but how durable, and caused by what?

And that, we all accept, will make interest rates rise, yes, but how high for how long? Markets we feel are, to say the least, fragile.

At the turn, we know that moves can be dramatic both ways, for markets.  

Are we really seeing a labour shortage? The UK truck drivers’ situation

What we see now is not a labour shortage, and hence political talk of stemming migration and higher wages is well off target. What it is, in part at least, is a failure of the routine operations of an incompetent government, something politicians typically don’t want to discuss.

The government has insinuated itself into so many areas, with its complex regulations, that the market economy now lies ensnared in myriad interlocking regulations, backed up by a deeply entrenched blame culture (and its friend the compensation economy).

To take one example, there is no shortage of truck drivers, but there is a shortage of qualified, approved, signed off and regulated truck drivers, because as part of the destructive lockdown, the government just halted the conveyor belt of required testing and approvals.

Truckers’ wages have for long been too low, of course, especially for the owner drivers in the spot market. What we have is not a labour shortage, it’s a paperwork shortage. The difference is vital for how enduring inflation is. A new driver will take a couple of decades to grow, but clearing a paperwork jam, a few months. One is enduring, the other transient.

Withdrawal of older workers from the labour market

Work after all is something of a habit: once it is lost, it can be hard to understand why it existed. So, we see a marked increase in older workers in the UK who have just withdrawn from the market (Some thirty million fewer hours worked - see figure below). That too is not a labour shortage as such, they all still exist.

But if work was of marginal benefit to the worker, and the costs to resume work (actual or psychological) are high, disruption will cause the fringe or marginal job to be unfilled. Yet again more in the transient column than permanent.

Someone will waive the rules, or the government will notice, well before all drivers get paid high enough wages to cause embedded inflation. In any event articulated fuel tanker drivers tend to work for big employers, with good conditions, and are well organized. They have to be, after all they drive mobile bombs. The spot operator on a rigid rig is in a different market.

Inflation will most likely be transient

So, if it is not an actual labour shortage, it won’t cause wage inflation, and will be transient. Some other areas reliant on highly skilled older workers will continue to see standards fall, but generally younger workers will over time fill those slots and gradually acquire those skills.  And it won’t be a long time.

Our view from way back was of 5% plus inflation and labour markets that struggle to clear this year. We were wrong to not foresee the failure of regulatory processes to keep up. However we still do see a permanently higher post COVID cost base and therefore in certain sectors, a large amount of marginal productive capacity are likely to be withdrawn from the market.

With a banking system that still struggles to offer commercial finance to the SME sector, because of excessive regulatory caution, there are swathes of jobs that have simply gone. So that labour will in time be redeployed. The current concern is that many of these workers show no desire, or ability under current conditions, to return to the market. But when they do, the capacity that has been destroyed will slowly return, and once more drive down prices.

Nor should we forget just how much the Exchequer loves inflation, as fiscal drag, their beloved tax on higher prices, smooths away so many budgetary blemishes. They will let it go, if they possibly can.

Commodity prices

On the input side we do still see commodity price rises as transitory, at least within the energy market. As others have noted much of that too is regulatory failure on a grand scale, not a true shortage. Price fixing by the state is a notoriously foolish concept, as we learnt in the 1970’s.

There are a number of other supply factors at play too, but while some will recur, most are temporary.   

How long do we think the inflation spike will last?

So yes, inflation will spike, and yes it will stay elevated for much of next year, but no, we don’t see it as necessarily durable, once COVID restrictions and related behavioural changes vanish.

We are still pretty certain that the political costs of aggressive interest rate rises will outweigh any perceived price control benefit. As long as some Central Banks hold off rises, it will be very hard for others to do so, without sharp currency moves or bringing in formal exchange controls. That would in turn spook markets far more than rate rises.  

The next phase of markets

All of this says to us that a major market dislocation, despite the benign signals, lies ahead in the next six months.

Markets shifting rapidly are more a sign of uncertainty than of a new degree of confidence, and we simply don’t trust it. We see inflation as apparently out of control, but no significant interest rate rise response is feasible. That can feel like stock nirvana, but also like investor purgatory, as you have no idea what is or is not a sustainable profit.

Charles Gillams

Monogram Capital Management Ltd