Bonds and Bullwhips
What are bonds for? Not always what you think. And the whiplash of the economy, (the bullwhip effect on all markets) makes recession both inevitable and meaningless.
Corporate bonds vs government bonds
So, to compare bonds - a corporate bond is issued to fund a project to produce a return greater than the interest and principal, and then pay the lender back. Much of the value lies in the assessment of how reliable that redemption is. Some of it is also whether the bond is cheaper or more expensive than a similar one, some of it is who is allowed to hold that bond.
But value lies in redemption, especially at the shorter end.
So, on that basis, what are government bonds? Well, they are there to achieve other objectives, seldom involving either redemption or a cash positive lifetime. It is largely accepted that they are a funding device to load debt upon future taxpayers, who luckily can’t vote. And the price of the bond is just what investors will pay for it.
Market rigging
Governments will therefore try to directly rig the market, to avoid paying too much interest, by for instance, mandating all investors and especially pension funds should hold gilts, their debts, on the gloriously fake grounds that they are “safe”. Well, just remember this year’s disastrous collapse, down by a quarter at the long end, with plenty of volatility too, ‘safe’ they are not. But the regulators and professional bodies still peddle versions of the old homily about the percentage of bonds in a portfolio should equal your age.
They can also apparently use the rate of bond interest to control inflation (so they say), so raising it (and devaluing bonds) if inflation rises, albeit the causes of inflation have little to do with the bonds (or bond investors). Then most marvellous of all, they can rig the price by easing and tightening their ‘quantitatives’ at will. Although no one is quite sure what a quantitative is, or indeed where it lives.
So, the government bond market turns out to be pretty much whatever you want it to be. To be contrasted with the weird and feckless equity, whose value can be, pretty much whatever you want it to be. Or indeed bitcoin, whose value….
A difference of degree granted, but less clearly one of substance. Rigged markets in any asset, make us nervous, and all markets are increasingly manipulated, to some degree.
What of bullwhips and earthquakes?
Well, both show a declining sinusoidal wave, that ripples prettily along and disappears. Whether it is the globe scratching its toe itch in Tierra del Fuego, or an irritated ear in Reykjavik, it is very jumpy. Where you stand now can be higher or lower than yesterday; it is erratic, chock full of faults, and crucially, not smooth and cyclical.
So, measuring whether you are higher or lower than last week’s datum matters little, if your fields have vanished into the sea, or indeed your sea has become a field.
So it is with recessions, after the shock we have had, being up or down two quarters in a row is trivial. Indeed, as that slick whipping wave races by, we will certainly be both.
Do changes in the Government bond markets matter?
And trying to decide whether the gyrations in the government bond market have any relevance to the level of the economy when the whole structure is bucking around, is slightly crazy. Nor are yesterday’s maps going to be of any use.
That is even assuming that the price of bonds has any relationship to anything except how little governments want to pay for their exorbitant debts. While I have not even mentioned the wealthy autocracies involved in the same game.
And that’s the market muddle we are in. The US Central Bank is playing old style economics, using the interest rate to control inflation - hang the cost of debt, that’s a problem for Congress.
But the UK and European Central Banks are playing new style, because they fear that the usual medicine will be disastrous for their rather sickly patients.
And US stock markets are using that funny old, discredited, yield curve to predict a recession that is by their definition (two down quarters in a row) inevitable, but ignoring the COVID earthquake which has upended all our old data and assumptions, simply because we have never had one like that before. The curse of econometrics is that we can only predict the future if it resembles the past.
EU stock markets
Meanwhile European stock markets have understood rates are not going up much more, because the EU would prefer to rig the market, so investors think they must have avoided a recession, which is equally a delusion.
And underneath all that is the great big chunk of molten sludge at the core, the vast irredeemable mass of government debt, where real yields are apparently staying submerged everywhere.
So wise men can select from all of that to predict that markets in debt and equity are going to go up a lot or down a lot, really as you wish. And they may all be right, at least somewhere on the globe.
Our own choices
But we still see no point in holding state debt, nor much in holding cash for too long. Corporate debt and equities, especially equities with a real value that you can figure out, maybe. We look at ones without state interference rigging the price, and with an ability to raise prices to hold margins, and which have a dividend yield. Those, we think, may still be attractive.
And we are not alone, many markets and stock prices bottomed out in October and are steadily inching up. Our own MonograM momentum models (both in the USD and GBP versions, a rarity this year) have triggered a re-entry into equites, and for once in a while, not US ones.
Something is shifting under our feet. So next year at least, is very unlikely to be like this year.
When we next write the calendar will have changed and no doubt many rate rises will have happened. But we doubt if the big themes will change much.
In the meantime, Seasons Greetings and a prosperous New Year, to all our readers.
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 can’t 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 can’t 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 won’t 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 that’s the expectation (and it may be) you really don’t want equities at all, not even energy, the year’s 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. That’s 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 dollar’s 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.
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.
LOCATING THE ELUSIVE BASE
the investment impact of recent events
CRANES
I spent last Sunday in the elusive pursuit of grus grus, in the upper Marne basin, East of Paris. For some reason the Common Crane had already left in a bid to cross Central Europe, heading for the Artic, weeks earlier than in most seasons. Clearly, they knew something about the airspace ahead of them.
While the largely empty Lac du Der, also had lessons on levelling up; here was a vast and disruptive engineering scheme, it seemed executed without too much controversy, operating well and with the surrounding villages wealthy, quietly prosperous and largely content. Or so it looked in the February sunshine. It was all in pretty harmonious concord with nature too.
THE FRENCH MODEL
It seems the French can see the grand scope of government, the need to provide top class infrastructure. Here is their France Relance plan up to 2030. Up to 3-4 billion Euro is likely to be spent in 2022 alone.
The issue is perhaps not just politics, but the unspeakably low quality and lack of vision of the UK governing class. The French cities have retained their great buildings, the administration is a high profile and visible force, not something to park in the burbs, having ejected them from city centres to grab their assets for still more rentier housing. Nor does the state foolishly aim to do everything, the peage (and TGV) enable high class fast communication, but certainly not always for the lowest price. Nor is health care completely and absurdly free, irrespective of demand. But it is effective.
Power is cheap and plentiful, no hysteria about nuclear there, and the military proud and visible, even the transport police are packing heat. So, watch that off peak ticket schedule.
Of course, not all is rosy. COVID hysteria still ruled, masks and vaccine passes were required for everyone, for everything.
Yet if any UK government is serious about leveling up, (as in the recent White Paper) here is both a lesson, and an indication that Gove’s piffling attempts are a mockery; he needs more like £48 billion to start it, not £4.8 billion.
You feel they just picked up the easy option from the choices their tired civil servants had suggested. Perhaps it was the one that said, “No real impact, but sounds OK for now”.
UKRAINE - Did Putin miscalculate the West’s indifference?
Ukraine? Not a lot to add to that. We were wrong that Putin was not stupid enough to do it. Wrong too that it would be over in hours. So, treat our topical ignorance with care. Also, wrong that the West would shilly-shally over piecemeal sanctions. Whether we are wrong yet again in assuming that without a quick win, the sanctions will now damage the global economy quite badly, remains to be seen. I also suspect seizing Central Bank assets can only be done once and once done, global finance and investment will become far more fractured, forever.
But in truth, it was going that way already.
However, this blind market panic seems absurd. I really doubt if Putin, at this point, wants to line his battalions up on a border to provoke NATO, who are I suspect closer to an aerial counter strike than he thinks, and would indeed now love the excuse of any incursion on NATO soil.
He has made it into a popular potential war for the West, the most dangerous sort.
War Tactics
It looks to me as if Russia wants a pincer movement, to isolate Ukraine’s forces in the Donbass, plus a threat to Kiev to topple the government, but has he the muscle to take and hold all of the vast country? Even if he does, that does not suggest he will go further than Ukraine, just now.
While his aims are so blatantly false, success can be easily claimed for almost any outcome. So, a collapse in currencies, and stock markets across Eastern Europe, looks an exaggerated response. True, this is Germany’s worst nightmare come true, no competent military and a gun-shy US, so they must now realign fast, and where Germany goes, so goes the EU. It is not going to fold or fissure in the face of this explicit threat. Although Germany at heart is much more like the UK than France; rapid execution will not be quite as easy as simple announcements. Remember the farce over moving Tempelhof airport?
As yet, the final step of directly locking in Russian energy supplies, large parts of which go to German consumers, has not been taken, but that would, in the short term, be very costly.
Although high taxes on energy give governments a great incentive to let prices rip, (and demand destruction is great for the climate lobby too), but they are rather less popular at the ballot box.
Interest Rates
Meanwhile Powell remains determined to stay behind the curve on rate rises, it is as if the received wisdom on rates, indeed on Central Bank power, has been quietly ditched, and instead he is hoping inflation burns itself out through demand destruction/supply creation. Well, an interesting experiment, but if that’s the game, as we have predicted for a while, inflation will remain gently smouldering, but rate rises will still be very gradual.
The Fed should have turned off the monetary stimulus and reset to ‘normal’ six months ago, by the time they finally move, it will be a full twelve months late. Real rates are deeply negative, levels not seen in decades, and moving fast, this is really not quarter point stuff.
All of the above implies on-going nominal economic growth, ongoing share price appreciation (at least in nominal terms) and an ongoing reward for borrowing to excess.
But despite the rush to safety currently supporting the US dollar (and US assets) the danger to markets is not just from the noisy, tragic, East but also from experimental monetary policy in the US.
NO NEWS?
Staying on the sidelines till Burns Night still remains rather attractive. Christmas as ever brings thin trading, a lot of speculation and some brutal repression or natural disaster, in a far-off land. Although these days ‘far off’ could include Lille or Llandudno, both pleasantly calm and now even sounding a bit exotic.
But for all the noise, has the investing world really shifted? We did kind of have a Santa Claus rally, but with COVID about, he got shoved back up the chimney pretty fast. Meanwhile Powell was transformed into Scrooge with the terrifying thought that in a massive boom, with high inflation, perhaps he didn’t need to be reinvesting maturing state-owned bonds?
What we see is confusing data, a fair bit of economic damage from Omicron, some people not wanting to be ill, but mostly from a Pavlovian reaction to the very idea of COVID the Sequel. Fortunately like most sequels it was a pale imitation, we knew the cast, guessed the plot, will leave the show early.
Inflation - where have we got to?
Peter Sellers in The Pink Panther films asks an innkeeper if his dog bites; having been assured it did not, the dog snarled and bit him. On remonstrating he was kindly informed “that is not my dog”.
Well clearly Powell, Biden and a few other innumerate players wish to tell us the same about inflation.
Sadly, and transparently, it is their dog, and equally clearly it will bite.
There is an econometrics game of saying there is no inflation (except in; used cars, housing, fuel, take your pick really). That is like selecting the first brick to burst in a failing dam, and saying that the structure was fine, except for this one defective brick.
Therefore, the first sign that (finally) the ‘just a blip’ inflation nonsense has been retired must be good news. This comes along with some evidence that sensible Democrats (well at least one) have spotted that more money for less work in order to buy fewer goods, is probably not actually helping poor American families.
The energy question
We will sort out energy prices, if governments are sensible. So, if, like President Xi, we do bring back a bit of stand by coal capacity, for next winter’s peak. There is plenty of coal around. We have not been too short of wind around here either, of late, the UK also has a good number of salt caverns, which we can (as we used to) stuff with gas, rather than believe the idiots in the Government who felt it was too expensive to have cheap summer gas on stand buy. While at 80 USD even the Saudis will pump more, the Permian certainly will.
So that just needs a bit more planning, a bit less spurious forecasting to within three decimal places, a bit more building in a margin for error, whilst hopefully all the Whitehall types who claimed they were fostering ‘competition’ and could ‘cap’ prices of a global commodity, get moved on (or better out).
It is still next winter’s answer, none of this will help this year much. Most capacity for the next two months is sold.
So, what will Powell do next?
All of this leaves us with massive liquidity, poor labour market participation, excess demand and the normal reaction to all that: inflation picking up and negative real yields slowly being eradicated. What is not to like? Demand plus capacity usually equals growth.
While Powell may have failed to grasp the intricacies of inflation, I am not expecting him to suddenly declare his job done on minority employment rates, with such a poor participation level. So, I expect he will keep trying on that. Which suggests he’s not going to over-indulge in rate rises. Hence the idea the Fed will look at other ways to soak up liquidity, is quite logical.
At this stage of tightening, we don’t find most bonds attractive, but recent history suggests that if the US 10-year bond gets closer to 2%, it attracts foreign money, unless Euro base rates also rise, which still seems unlikely. More buyers will of course push the yield back down.
While China is both cutting rates and provoking some hefty defaults, which is not a great background for foreign investment, especially as they seem to be targeting offshore investors. Without knowing whether the US interest rate tops out at 2% or 4%, emerging market debt (like their equities) could be either cheap or expensive; just now it is very hard to gauge.
So cautiously we plough on - funds must be invested, the (as of now) attractive alternatives, all look pretty expensive or rather risky, while if rates really do start to rise, the dollar will itself become desirable. So, we expect something, some asset, will suddenly catch a bid and soar away. Outside the US mega cap tech stocks, value already abounds.
Overall, a return to normality. With rather fewer gifts from Lapland to be had just for asking; all of this should be quite encouraging.
While it looks like sterling has strengthened for now, the various tin pot media storms have led to the Prime Minister’s critics looking into the abyss and not liking the view very much.
It may look bad to bend some rules, but dropping a Prime Minister for disliking Theresa May’s taste in wallpaper, or treating staff like human beings, or because Liz Truss is ambitious? Not really.
MCM had a good 2021, in our global lower volatility space. The CityWire link to our subsector is here.
Charles Gillams
Monogram Capital Management Ltd
9th January 2022
(article illustration by Martin Speed, creator of the Woofle bears)