Reflections & Predictions
This year wonât be last year, that much we know. Nor indeed will it be the inverse, which is inconvenient. So, starting this year as last year, but simply turned face down on the desk, is a trap.Read more
Tripod
We take a look at three things that move markets: macro, politics, and mood.
We have an inexplicable market rally to explain. On bonds we remain wary and we also take a look at the Keynesian attitude to inflation.
The obvious explanation for the market rally is Santa Claus, or perhaps in more mundane terms mood. The markets (in both bonds and equities) have had a beating, the shorts were satiated, the cash piles vast, and markets had simply had enough.
So, back up like a bungee it went, the heaviest fallers often bouncing back the highest.
Inflation (still)
We can talk endlessly about peaks and plateaus for interest rates, but we still donât see any measures likely to get inflation back to 2%, for several years. But it seems that doesnât matter now. The so-called base effects, the softness in commodity prices, the excess inventory (rather than prior shortages) all mean inflation will fall, and for most, for now, thatâs enough. Regardless of how far or how long it takes.
Indeed, there is some realisation that if prices are really rising at 10%, it is best to buy now, not wait for higher prices.
And for a lot of service-based firms, capacity is indeed short, and they feel free to ram through price rises, to open up their gross margins, assuming (rightly) that if everyone else is doing it, and no one really knows their true cost bases, they are winners. As they are.
And as we long predicted, the elimination of competitors, and monetary tightening, leaves big firms free to expand into a void. After all they have faced flat prices for a long time, so the chance to move prices up is most welcome.
Seeing it like Keynes
So, it is perhaps useful to remind ourselves of the Keynesian view that inflation is âa method of taxationâ which is used by the Government to âsecure the command over real resourcesâ in the same way as ordinary taxation. So, he was really not a fan.
How then do we explain the UK Treasury (all notional Keynesians) using abundant deficit financing to sustain already overheated demand?
Well in short, we donât, it is just politics. By raising pensions and welfare in line with inflation, the UK Government is acting as if they need to secure the economy against high unemployment and a recession. The classic ills Keynes addressed.
Although (so far) neither of those disasters is evident anywhere, except in their own predictions. Older hires are rising which is generally a sign of overheated labour markets, looking for marginal supply.
Which is quite neat, as if those evils donât arrive, the policy clearly worked and if they do, well our politicians tried their best. Given the shambolic recent failures of Treasury predictions, that they have any ongoing credibility is really quite remarkable.
But that process also embeds the long desired extra taxation, resulting from the inflation they are not quelling. There being no limit to how much Governments want to spend, there is equally no limit to their appetite for tax.
All of which nicely pings the pinball back to the Bank of England, which was so very unhelpful in the early autumn, so letâs see how they do now? Will they truly show the steel of the Americans or the Micawberism of the Europeans?
And interest rates (still)
The interest rate (beyond the short-term market rally) is therefore still the big decision. If inflation is here to stay, it all depends (once more) on the US, and on what reason the Federal Reserve has to stop tightening, even with high inflation. We canât see one. Albeit we are very reluctant to guess there is none, with such strong markets. And it maybe they just had an arbitrary target, which they have now reached.
From this page on the Vanguard website
However, that gives us a trio of reasons (apart from the roguesâ gallery above) to still avoid bonds.
- If inflation stays elevated, bonds are a rip off, as they have a negative real return.
- If the Fed stays strong, bonds are a rip off, because base rates are still rising.
- And if the Fed wins, but others fail, then bonds are a rip off, because the dollar keeps rising (and hence other currencies fall).
In summary the only bonds that look attractive to us are still short-dated US ones. Which is not really new, nor does it make long term sense, with strongly negative real rates still. Bonds by definition can only have a real return when rates exceed inflation, either due to falling inflation or rising rates. And we donât see that crossover for a while.
A THREE-LEGGED STOOL
So, we return to that trio: macro, politics, mood. Political uncertainty is much lower (for the next two years) in both the UK and US, and perhaps is not that unstable in Europe either, although the Ukraine war could still change that significantly.
Even China seems a little less keen on confrontation.
Macroeconomic factors really do not yet feel encouraging. It is way too early to declare victory over inflation.
Paradoxically when inflation is clearly beaten, earnings declines will then set in, as pricing power recedes. The failure to see that decline, will indicate inflation remains a threat.
And finally, mood - yes, the mood feels good, for now, although how long that remains is as much psychology as anything else. But if bonds do start to slip, donât expect the party to keep going for long. Nor will recent dollar weakness persist.
The overall view seems to be that the handbrake turn has been completed, we may slide a bit more, but we wonât spin again.
But that assumes we know a lot about the track and conditions - do we?
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?