The Glass Bead Game
We look today at a domestic version of a complex, rulebound meaningless pursuit that too many of our brightest and best waste their lives pursuing, and whose twists and spirals ultimately signify nothing. Â I mean the UK Office of Budget Responsibility (OBR), of which I took a tour this week. Almost nothing there is as it seems.
Meanwhile markets reprise 2023, with tech or bust once more. Although tech and bust is the market fear, as fiscal stimulus and services inflation hold rates too high for some to survive.
UK OBR
The OBR was an explicitly political creation of the coalition government in 2010, with a remit to somehow restrain the ever-increasing debt governments take on, to bribe electors. They were also keeping half an eye on the much older âdebt ceilingâ style US legislation. It failed; so now the OBR just thrives on telling the government how much more it can spend or not collect, with spurious accuracy; purportedly managing public money.
It doesnât forecast anything as a forecast is an expected outturn. All it does is crank the handle on the old, discredited Treasury model, creating projections. A projection is 1) a âwhat ifâ assuming all other things are equal and 2) only as good as its underlying model.
One clear flaw is the requirement to take government spending plans as viable when they are usually not. They also have no idea where public sector productivity is heading. It has no remit to look at how productivity might be helped and no capacity to look back at how wrong its old âforecastsâ were. That is the job of the National Audit Office, it seems.
It also wonât talk to the Bank of England, as that organization has executive powers (to raise or lower rates) and the OBR apparently must just be a commentator: more glass bead rules.
So, it fiddles with the model and its six hundred inputs and countless equations to give precise answers to pointless questions, because each answer sits in its own vacuum.
Thereâs a heavy focus too on tax revenue, but with quite a thin staff, this results in excessive reliance on HMRC, who can be hopelessly wrong (and typically over optimistic on tax yields). But again, if the tax bods claim some complex, job destroying, arcane nonsense will raise income, in it goes. The side effects of such decisions must also be ignored.
It has no remit to assess how taxes impact productivity, which partly explains many of Huntâs blatantly anti-growth measures. As a result, the economy is locked into low productivity, getting steadily worse.
From the ONS flash report here
For all that the financial press will be full of the OBR cogitations on the forthcoming budget (March 6th). One little bit of power they do have involves a requirement for the Chancellor to give ten daysâ notice of the budget contents (hence no doubt the usual leakage levels) and for two months before that, they sift through proposals and indicate how each, in isolation, would work. The economy is an interconnected entity, they know, yet there is no attempt to give us an overall view.
THE LOST RALLY
I have few rational reasons why anyone would lend the UK Government at under 4% for ten years, were it not for some foolish faith in the OBR projections, without reading the small print.
Which brings us to markets: back in November the UK ten-year gilt yielded 4.5%, by about Christmas falling to 3.5%, and now it is back over 4% and headed higher.
Chart from this website
Quite a spin in ten weeks for a ten-year duration instrument. This is why that Christmas rally in value stocks was ignited, and indeed started to push out into Real Estate, various Alternatives and certain smaller stocks.
Although it didnât move those stocks most sensitive to the credit markets, who will need to rollover/refinance current debt. This affects for example, the renewables, private equity, and office property. The problem there is of both rates and availability. With the scale of asset mark downs, whether interest is 6% or 8% is not the issue; there is no funding appetite even at 20%.
The year-end rally moved a wide group of stocks, from extremely cheap to still very cheap. We then realized that it was not yet safe to go back in, so buyers evaporated, and prices faded. With state debt at 4%, against persistent inflation, fixed income is also oddly unenticing. So, the market default has been to pile back into the biggest, most liquid, US tech stocks and similar easy-in/easy-out momentum trades, like bitcoin.
There is little sign of deflation in services, no evidence of it in housing, where supply issues dominate, and little in financial services; indeed, all the supply side mess of COVID and excess regulation, is simply getting worse. Public sector pay inflation is also high and going higher (donât tell the OBR).
This does not dent the 2024 story of cutting rates and hence higher stock markets, but it may require some patience, and that delay may itself create more pain.
The Glass Bead Game and the âlost marblesâ qualification for office
Our games of self deception are not to be confused with lost marbles of course; it turns out that the onset of senility is now a bar to being prosecuted for storing secret state papers and also, somehow, a recommendation for re-election for four more years, to the most powerful post in the world.
If that ends up giving us Trump again, by default, presumably he will at least have a defense in future years, against those same crimes? He does not have the âBiden defenseâ available at present, perhaps thankfully.
As the OBR shows, very clever institutions can come up with very silly solutions.
Into Broad, Sunlit Uplands?
This week has included a major but baffling fixed interest event in London. And we include some thoughts on the novelty of a conservative prime minister for the Conservative party - but first, the shape of the coming recession.
Who Survives in the Coming Recession?
It may help to see this recession, as just the reversal of the COVID boom, paid for with debt and deeply inflationary; in which case what should it look like? The ultimate aim will be to unlock labour markets, where we said (in our newsletter of 20-3-21) that COVID would do most harm.
Unlike traded goods or commodities or liquid assets, there is no simple snap back available without pain, because labour pricing is inflexible downwards. Indeed organised labour has worked hard to embed that inflexibility, notably in minimum wage laws, and the crippling of the hated gig economy.
Certain capital assets too are stranded and inflexible, but probably not most commercial (or residential) rents. Large single purpose buildings may be vulnerable and we feel, so is quite a lot of owner occupied residential property, whereby recent unearned gains will now need reversing.
Labour costs have two available paths. Either the 40% of working age adults who have now withdrawn from the labour market must (in some measure) return. It is their ongoing withdrawal post COVID that has hurt most. While COVID has also created (mainly in the public sector) a lot of extra staffing that is hard to step back from, especially in healthcare, which further depletes the available labour pool, and must also be reversed. Reducing labour taxes also helps.
Possible business failures
If not, there may instead need to be widespread private sector business failures. The third option, a speeding up of capital investment to substitute for labour, has somehow failed to be either fast enough or effective enough. It seems just too hard for businesses to predict demand paths, to commit to such expenditure. Cap ex is all about confidence, which is absent.
How then to measure if this labour reset finally happens? Well it looks as if job creation will need to go into reverse, with a net two quarters (at least) of contraction. There are plenty of businesses to fail, speculative and derivative loss making tech for a start, retailers of goods who over extended in the supply chain inspired boom, service sector spaces, where the current surge has drawn in capacity well in excess of long run demand, will all get hit.
As will everyday businesses, that have net margins that canât withstand the double figure interest rates demanded of sub prime (i.e. now most SME) borrowers.
Paint that template over where the most savage equity falls have already happened, it fits quite well. But it is by no means universal, if IP, not labour matters, or labour can be off-shored, it is in a better place.
Although as jobs disappear, so the strain reaches further into total consumption and demand.
Fixed or Floating.
What of fixed income? Well we took the view early this year that you canât stand in the way of an avalanche, unless you hope to surf it. So we kept clear, and still are.
Source : this page
It was a very well attended fixed income conference in London this week, so credit is clearly back into portfolios, big time. My worry was the Table Mountain (or Brecon Beacons or Grand Canyon) graphs. All of which were steep sided, but flat topped, and on all of which, just now, is the exact point when lungs bursting, you climb the last butte, to see a vast sunlight upland.
Really? Why? No idea, but somehow the collective belief is rates top out circa 4% and then fall.
Certainly not if they mirror the inflation path (see above), that gap is now vast twixt interest rates and inflation; it will close - it has to. However we see more rises, not a near term peak and also far slower falls, than the market does. Reason? It is labour inflation that now drives it, and it wonât roll over soon.
Unless that is, the rate rises so far have done real damage and rates are then cut to mitigate a severe recession. If thatâs the expectation (and it may be) you really donât want equities at all, not even energy, the yearâs bright spot.
So the question is, are high yield bonds now cheap?
Well yes, and quite attractive; defaults at the rate now implied, are unheard of. But if that odd plateau graph of rates is wrong, everything has yet to get even cheaper. Thatâs the rub. And that is why, for now, bar floating rate, secured, we are still not going into credit. And also because global interest rates must eventually align, so the dollarâs ongoing strength is a bad sign, as that will have to reverse too. This makes dollar assets themselves now dangerous.
The same dilemma is true for equities, yes, high quality, mid-size companies look cheap, the FTSE 250 is down some 20% in a year, almost as bad as the NASDAQ, whereas the FTSE 100 is modestly up (a distinction shared only with the Nifty 50). But again, we thought that value was emerging in the summer, but sadly not so; the market still sees a viscous earnings contraction ahead.
Which brings us back to employment, either it must fall, or participation must rise, and I fear we expect a fall, which seems more likely. This cycle, in the all important labour markets, still feels a long way from done.
New Broom
As for Truss, well talk of growth at the inept and hidebound Treasury is a nice change. As is that of getting the country working (spot on). This is core free market stuff. Has she the votes? Pretty sure she has, it was odd for the left wing of the party to eject Boris, who his actions showed was one of theirs. To unseat another leader would guarantee oblivion, so they must back her.
Worrying about fiscal rectitude, for a two year government, seems oddly implausible too. Yet she still fell prey to the old belief that governments (and higher tax) solve everything with her energy package, least of all can that solve demand based inflation. That is for Central Banks to do, and as ever, they are getting no help from the rest of government.
Does this suggest a big US rate hike this week? Not sure, we are much more seeing the end point as rather higher, than faster near term rises. We kind of think the Fed has made their point already.
Seeking an end to the turmoil
This market turmoil feels interminable, as asset markets stumble to find a firm footing and churn relentlessly. Instinct says thatâs a time to buy. But there is so much happening, as this multi-year trauma unwinds, it is quite hard to know what.
Although we try to segment it, the key problem is the terrible dishonesty of politicians, who have bullied their citizens into an unthinking reliance on institutionalised theft on a grand scale and a belief that nothing really matters, as long as you have a press release to deflect it.
IT IS ALL STILL COVID
So, working through piles of annual accounts, as a pleasant distraction, (I have always enjoyed history), the one repeated theme, is of shrinkage, under investment, caution. This, in a way, is natural because COVID reset two years of global production, and indeed destroyed large areas of output and services. Which also makes it terribly hard to understand what ânormalâ is now.
Not helped by the piteous vagaries of those craving spurious accuracy. Big banks and resource companies seem overall just to want to carry on shrinking, which is odd as their results seem very good. But they are not. All that has happened is they took big write offs and reserves in 2020 (which were not needed) and that then reversed in 2021. However, the underlying business volumes fell, the trend to more disposals than acquisitions was unremitting; these are shrinking businesses.
To the populists who believe higher taxation lowers inflation (are they mad?) and indeed, to market commentators, this looks good, but it is really not, productive employment is shrinking too, workforce participation is not roaring back.
And with inflation we will again see plenty of âtop line beatsâ or rising revenue, but that too is an illusion. And indeed, raised dividends. For example, Shell now proudly offers a 4% dividend rise, as if that is generous; last decade it was, but not now.
That is now a real dividend cut.Â
As we struggle with a badly damaged global economy, government policy is unremittingly wrong-headed: you wonder what we could do worse than the vast debt fuelled bubble after COVID?
But then we stumble on the idea of doubling or trebling domestic fuel prices. We do this to punish big energy exporters like Saudi Arabia and Russia. Only a simple clown could believe that will help us, and only a child-like vandal, that it will halt Russian armies. We take our own possessions out and smash them on the street, like voodoo dolls, because we are hurting and want others to hurt too. Nuts - it is tearing our own clothes in blind anger, but we ourselves are not the enemy.Â
Meanwhile, underneath all this noise, is the game up?
Is the expansion we have seen for two decades based on cheap Asian product imports, and low interest rates fuelling inflation in non-traded goods now done? The non-traded category is everything that canât be shipped in. Land, services and the like that must be consumed, where they are provided. Although with that went quite a lot of imported labour consumption too, of course.
I keep wanting to write positively on China, but I simply donât know. Is their COVID winter politically sustainable? Is it a massive pivot back to a closed state? Was the aberration their great expansion, and they are now reverting to being a hermit kingdom? Instinct again says no, who would reverse the greatest success story of our time? But evidence the other way just slowly piles up. Another giant nation seems slowly to be sliding towards belligerent stagnation.
And so much went crazy with the toxic mix of low interest rates, and excess liquidity. We may at last have learnt that if you have a blocked pipe, spraying it with gold is not a remedy. The pipe stays blocked, but everyone gets flecks of gold on them. Better (and cheaper) to hire a plumber.
WHAT WILL BE THE THIRD POLICY ERROR?
We certainly donât see the recent bubble implosion reversing, for all the bluster, crypto, and concept stocks, feel to us like a long term drag on the indices, remorsesly lower.
The turn feels to be more likely in bonds. The fight is between a shrinking set of outputs, but rising prices and apparently rising consumption. As long as policy blunders persist, and they show no sign of ending; then the upward pressure on rates will also persist.
But we doubt that any conceivable interest rate rise can solve this inflation. In short, the fire must burn itself out or at least no longer be stoked up.
In which case posturing about a long run 2% 3%, or 5% rate is really guesswork. But thatâs the big question. If it is 3%, we are already there, but there is no great market conviction on that. At least the belated but long inevitable addition of the Europeans to rate rises, should take some heat off exchange rates.
LETTERS IâVE WRITTEN
What about Boris? I was quite surprised at the swift and co-ordinated move to a no confidence vote. The Tory party is rubbish at a lot, but plotting it does do rather well. And also surprised at the vote itself. The rebels can not win, without a candidate that both factions like, that is the real Tory party and this odd âCameron lightâ lot in Downing Street. Of course, Boris himself is already largely that candidate, talks right, acts left. Which means all sides hate him, but neither can replace him, for fear of the âwrong typeâ of fake instead. Just what you want to be, you will be in the end.
There was also a fair bit of bile, stirred up by the media, and rather infecting what are loosely called the âactivistsâ, who are anything but, but do bend their MPâs ears. They just want to dislike Boris and his lack of scruples, but also like the gifts he brings them.
They donât want local trouble, so enough of those MPs voted against him, to keep their local associations happy. If that âterrible manâ stays in office, they can at least claim they did their bit, but âothersâ then let the side down. Â Â Â Â
Will Boris last up to the election?
Our core belief remains Boris stays in power long enough to hand over to Keir and Nicola. But perhaps we have rather less conviction than last week. We thought Keir was more likely to be in trouble, but perhaps the Tory plotters could be desperate enough to finally agree on a candidate? Either way this is now a lame duck UK government.
But then like markets, outside events may rescue it, itâs just we really canât see how at present.
As for where to consider investing? Our MonograM momentum model loves the dollar, for sterling investors and for USD ones, increasingly just cash, and decreasingly the S&P, so long the global refuge.
But that is in no way a recommendation, just an observation; more detail on our performance page.
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 heâs not, and he wonât, 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 heâs 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 canât 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.
Heâs 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 âutterly clearâ 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 âsurpriseâ 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 canât 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 âdot plotâ 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 canât 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
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. Â
Are we really seeing a labour shortage? The UK truck driversâ 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 donât 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.
Truckersâ 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, itâs 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 wonât 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 wonât 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 1970âs.
There are a number of other supply factors at play too, but while some will recur, most are temporary. Â Â
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 donât 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. Â
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 donât 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