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 ā 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 1970ās 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 heās 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 āAmazonā 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 Ukraineās army would hold, that Putinās 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 donāt 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. Ā Ā Ā Ā
And what about Powell and his policy?
Well, we donāt 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 āeconomic expansionā, 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.
DETONATION OR ROTATION
Two big market forces are at work just now, one is rotation out of the low interest rate winners, to wherever we go next, the other might be something more spectacular.
Enough of the market still sits in the ādonāt knowā category, to make everyone uneasy. The VIX is high.
So, what would cause the more explosive outcome? Traditionally higher rates divert more of the profits of indebted companies to banks and bondholders, so the theory goes, reducing dividends. Or at the more extreme level, this also makes refinancing debt harder.
This comes with a āsecond orderā impact, in that consumers or buyers also shovel more towards the banks, less towards the producers.
But none of this seems remotely likely yet, the world is awash with cash, and savings levels and interest rates have barely stirred from their COVID slumber.
Markets seem to be just talking about normalising, not slamming the brakes on.
Will we grow regardless of inflation?
The other big risk would be a failure of non-inflationary growth, which also seems unlikely. There are few practical signs of governments enacting the type of supply side restraint needed, we know. We still look for some self-restraint on how much governments seize in taxation; with high inflation taxes should be being cut, or thresholds systematically raised, but thatās also not happening.
The āidiot populaceā as curated by the media, constantly wants more supply side restrictions, greater consumption and lower prices, as if this was all somehow available; it is not. The worry here is that governments having messed up the big issues, give way to yet more populist demands for the impossible. At the same time, markets are also getting a little less keen to finance such nonsense or, being markets, raising the price at which they do so.
Well, all that is possibly true and has been happening for a while, but the old theory was that innovation was too fleet footed for any of that stuff to matter much. This is getting a bit tired, but broadly still seems to hold.
What if Ukraine does erupt?
So, the third detonator is in Vladās hands. Is a reverse Barbarossa coming down an autobahn near you? Well letās assume yes, because heās finally lost it. It is still fairly clear that if he steps onto NATO territory his army is in trouble, US and NATO airpower will rapidly outgun him. So, I discount that. But perhaps Ukraine does indeed end up like Belarus. China will support Putin, so the UN is irrelevant.Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā
Then what? Well, a nation the size of Spain gets locked out of European commerce. Not important. Defence spend goes up? Well, some would say āabout timeā. Germany can decide to burn coal or nuclear or freeze, see previous answer. Come to that, so can we.
Given Russian gas must go somewhere, a bit like Iranian oil, it probably goes to China, which then trades it or cuts back its own Far East imports. Gas as we all know, canāt be stored for any useful length of time. Russia needs the earnings from it, so it will emerge on the market somewhere, at pretty much the current price.
It will be messy, it will create hard choices, but Russia is well on its way to autarky already, it can certainly live without dollars. Is this really a detonator? On its own, I doubt it.
Where is the rotation?
So, we still conclude all this market reaction is rotation, and it is out of overpriced US equities, where Biden created the biggest inflation bubble by far, and where interest rates are rising faster than elsewhere in the OECD. Hence, we see the hazard as mainly still on Wall Street, and to a lesser degree to the US economy. Weāre looking at rising rates, a strong dollar, increased detachment from the global economy, and none of it helps earnings, but nothing is catastrophic either. The US (unlike the UK) wisely seized the chance to be energy independent.
But even so, we are not yet that concerned, valuations in the US are still extreme, as many sets of earnings seem to show, once the market looks at forward guidance, it shudders, and prices fall. A lot of built-in growth is needed to get price earnings ratios back down to earth, and thatās whatās being hit just now. To use a forty or fifty times earnings multiple, needs a lot of confidence about the future. That stretched temporal certainty is now lacking.
This is not that unusual for a rotation, but in that case, markets will bounce, and that will suddenly move a lot of funds off the side lines and back in. Where is that process now? Well going back to the Jan 27th low is causing some excitement. But we are not sure even thatās a disaster. Overall, the taking out of that and the October 2021 S&P low, wonāt be fun, but the market still had a heck of a run up last year.
Have a look at where our MonograM investment model allocates funds based on momentum, over the last three decades, the US is absent for significant stretches. We rebalance monthly, the next one will be most interesting.
And inevitably, we do feel cautious too, but it is about levels, not wipe outs. Rotation not detonation.
Charles A R Gillams
Monogram Capital Management Ltd
First Principles
Principles may be lacking in certain quarters, but we will start with the economics of inflation rather than Boris.
How much inflation and for how long?
Inflation is simply too much demand for the available supply, nothing more complex than that. So, you tame it by either less demand or more supply. So, unlike it seems most Central Bank economists, who it turns out are just statisticians, for ever looking back, we must project forward.
That tells us quite clearly that the inflationary imbalance will persist as long as demand stays artificially high and supply is artificially constrained. It is that simple. Forget the rest.
So as long as governments have fiscal laxity, along with negative real interest rates, they are pushing up demand. As long as workers wonāt or canāt work, it will reduce supply, as long as economic activity is made less efficient by government action and diktat, it will reduce supply; end of.
So, at the very least Central Bank balance sheets must start reducing, which is not happening, stimulus must be fully withdrawn, which is not happening, and the old workers and their old ways of working must resume, which is not happening. Fresh capital can certainly change some of that, but it takes time.
Putin, Oil, and Geopolitics
What about oil?
This is the one item that alone might distort the picture. Which is positive, as we see oil prices falling in the summer. We also donāt see the West has really grasped what Putin is up to; in all the cold war style hysteria, he is possibly just after what he says. This is for the West to stop fomenting rebellion in Russiaās sphere of influence, and to be clear about NATO expansion plans, where there are indeed none in existence. He might have higher hopes, perhaps of a deal on Crimea in exchange for the Donbas, but we doubt it (or his chances of getting it are low). As might we, less interference in our politics would be nice; but see previous answer.
Nor is it that clear he is actually rationing energy; it is telling that Russia is reported as not able to meet its OPEC + quota, which at these prices is crazy. His oil industry will have been hit by sanctions, and the loss of Western expertise, and the Russian economy will also have suffered under COVID. A loosening of sanctions would really help him, for all his bravado.
If that reading is correct, as the situation winds down and OPEC+ winds up production, oil prices will fall, I would expect quite substantially. Much of the energy spike is self-inflicted, with nuclear plant closing or offline in France and Germany, and reckless price controls, having made using UK gas storage unattractive. All of these things can be sorted out.
Any possible good outcomes on inflation?
So, to inflation, well it wonāt care much about the pinpricks inflicted by the likely interest rate rises now under discussion, especially if they creep up so slowly no one notices. It needs a unified 1% OECD jump to cool this lot down, and the ending of stimulus. Neither is likely. Closing the US printing presses, were it to happen, does also have interesting global impacts, as Andrew Hunt notes.
We see it all turning rather glacially, with a bigger slump in inflation, if energy prices fall, but then being generally persistent in the 3% area for the rest of the year. We expect to have both higher rates and inflation for a while.
All of this is mighty tricky for investors, but I donāt sense that just bailing out is right, nor that the actual interest rate rise will cause an enduring slump in all asset prices. Investors have to own something, or they will sit and be mauled by inflation.
And what of Johnson?
It is easy to read the current level of confusion from either sideās viewpoint. Yet to me, I see the normal factional infighting, the usual media exaggeration, some political mischief making, but still no reason to depose a Prime Minister with a very clear mandate and a large majority. Like any large party the Tories have the embittered and passed over, the Remainers and fans of state intervention and a volatile and raw body of new recruits in seats no one ever expected to win. Plus, no doubt a few opportunists who sense that the heavy lifting on COVID and BREXIT is done, and they can now seize all the prizes.
The Tories do need a reset; it would be nice if Downing Street left Ministers to govern and simply acted as a cheerleader. Not that I see that happening, leaders and their hangers on always lust after more and more centralization, more control. But until a compelling, unifying, plausible Tory opponent appears, I foresee no change.
And in a way with reform all but dead, with Goveās last hurrah on āLevelling Upā a damp squib, it may not matter who leads the Tories, they have very little real power.
It is quite odd how big majorities do so little good, and how poor party discipline is, when they have them.
Charles Gillams
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 āfar offā 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 didnāt 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 āthat is not my dogā.
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 ājust a blipā 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 winterās 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 ācompetitionā and could ācapā prices of a global commodity, get moved on (or better out).
It is still next winterās 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 heās 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.Ā
At this stage of tightening, we donāt 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 Ministerās 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 Mayās 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)
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 heās not, and he wonāt, 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 heās 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 canāt 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.
Heās 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 āutterly clearā 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 āsurpriseā 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 canāt 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 ādot plotā 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 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 canāt 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