a faded picture of annie lennox, with the words of a song starting 'sweet dreams'

Sweet Dreams

Here we talk about the delights of the Conservative Party Conference in rainy Manchester, the failure of the in-built two-year time horizon in inflation models, and what may happen to interest rates.

 

FANTASY IN BLUE

At times in Manchester, it felt like everyone was looking for something. As government steps up spending initiatives, and empowers regional governance, and drives big spending on not achieving net zero, the chorus of demands for more taxpayers’ cash grew deafening.

There was utter silence on efficiency or capital allocation; it was all just “a good thing” to spend more.

And oddly too, with so much lip service to the long term and reducing debt and halving inflation, the ‘how’ of those was also ignored. Surely halving inflation is not even a government task? It was devolved to Bailey of the Bank - yet we heard not a word of criticism. If ever an eight-year commitment to a disastrously run project needed cancelling, his appointment looks to be just that.

This would spare him (and us) those endless letters on why he’s failing to control inflation.

For all that Conference was oddly cheerful - quite a bit of steel on show, from Suella of course, the only natural politician involved - some guts from Steve Barclay at Health, and Stride, a little less convincingly, at work and pensions - else, all rather wooden and on autocue. Although you could not help but notice that Farage still charms the fringe crowds.

 

COMPETENT DELIVERY?

The abiding issue remains competent delivery. It was odd to hear the government on HS2 arguing for accountability by sacking their own Euston delivery team. As if the failure of HS2 is not theirs, and theirs alone.

Instead of penny packet incrementalism, government needs a holistic delivery view - perhaps why France can build a TGV, and we simply cannot.

 

From this report of the Institute for Government

The Maude/Osborne “reforms” destroyed half our domestic contractors, by a short-term focus and ceaselessly moving the goalposts. As a result, home grown firms are in the minority on the HS2 contractor list, and giant multinationals with more lawyers than bulldozers were the main bidders.

They want top dollar to take on the risk of a lazy, indecisive government machine - no wonder.

 

THE CHANGE PRIME MINISTER?

 

We have been very clear since 2019, that the Tories can’t win another term, none of that changes, but the scale and composition of the anti-Tory majority next year is rather less clear.

In many ways, the best case for a Labour defeat, at the next election, is that the Tories have done it all already. They have blown the bank on out-of-control spending, splurged on unaffordable welfare, and raised taxes to unsustainable levels.

From this website

This government also crashed the pound, let inflation loose, let rhetoric overtake sense and has gone in hock to foreign debtors. I suppose they have yet to invade a sovereign country without a UN mandate, but they are working on that too.

So? Well oddly Starmer is still slightly boxed in, and in terms of polling data, not really getting much help from the weak Lib Dems, in those critical three-way marginals in the South. While Scotland clearly has had enough of the SNP running Scotland, it is less clear that they don’t want the cause of independence to be heard in London. The Rutherglen by-election could be sending both messages, but in a general election voters only send one. I would not assume that genie is back in the bottle just yet.

 

JITTERBUG BLUES

 

We continue to see US rates above inflation, which is very different from UK rates which are still below.

So exactly what Powell (and Bailey) are doing with selling down the Central Banks balance sheets at a time of maximum new issuance, is not clear; it solidifies vast paper losses, creates new losses on the rest, so seems to be quite a pricey warning shot to politicians. But it is a plausible reason (along with super high levels of new issuance) for current bond market nerves.

We have always felt the Central Bank models, where whatever the question the answer is “it will be fine in two years” are a fiction. The awareness that rates and inflation are staying high, is long overdue. But we have been in no doubt about it, for two years, nor have we ever flinched in our aversion to bonds, we were never being paid enough for the risk.

The jitters in the bond market feel more like a turning point, the sudden chop as the tide turns. The dollar has risen; people want to be there; if there is enough demand, that will lower bond yields again. So, I am not looking at US rates rising, so much as at the battle switching back to fiscal policy. Although in the end if Biden really wants 7% rates, I guess he can try to have them.

The UK and Europe are less contested, the labour market in Europe at least is not that tight, although still at record low unemployment levels, but with a lot of surplus workers in France, Spain, and Italy, and especially amongst the young. Euro interest rates are also really quite low still and are not yet looking restrictive.

So, it looks like another round of softening currencies, stagnant inflation and rate rise pressure. Central Banks still hope they have done enough. Even so it is quite odd that UK long rates are only just touching the level of a year ago, logically they should be two points higher. As for oil, we have seen this autumnal spike as a little surprising but transient, and as ever at this time of year, the short-term path is weather related.

Overall if the start is any guide, October yet again could be rough for markets, but longer term still looks brighter.

 


The Long Recessional

English local elections, and US regional banks

The English local elections saw the Tories lose 1,058 seats, dropping to 2,299 in the wards contested on Thursday, Labour gained 536 rising to 2,674, while the minor parties saw the Liberal Democrats rise by 405 to 1,626, Independents dropped by 104 to 962, Greens rose by 241 to 481.

What does all that mean for next year? Well, we called the next General Election for Labour the day after the results of the last one, and nothing has changed that view. Nor do we believe talk of falling short of an absolute majority is anything but wishful thinking by bored commentators. Rishi is largely in office, but not in government: a fairly weak cipher for the mandarins behind the throne. When they tell him to abandon core Tory principles, he obeys. This divides his party even further.

So, investors really should focus on the ‘what’; not the ‘if’. The Tories as we noted last time, had most to lose, and will take some heart at the spread of their defeats amongst the opposition parties. Although given the locations contested, both official Labour, and the Corbynite rump voting Green, did well.

This was an anti-Tory vote, rather than pro anything in particular.

We will still see a solid Labour governing majority next year. The Lib Dems will likely be back over fifty seats; as ever un-representative of their larger vote share.

So, what of Starmer?

 

His big offer is that he will stop party infighting and provide stable competent government. It will be Blair redux. The core five aims are currently crime, education, NHS, climate change and growth. Who would have guessed. No doubt apple pie is next.

The method it seems is Blairite targeting, with a bit of management mumbo-jumbo about breaking down silos, overarching aims etc. With the one area of large-scale Soviet style planning in the energy sector, with a state-run organisation, with what sounds like loads of money, but in truth (for the task) is not. Anyway, the big issue is not power generation but transmission.

I guess we do know from Wes Streeting, (the next health minister) that Labour knows the real problem is the public sector unions, part of why Starmer was so keen not to rely on their funding or support. But while ‘silo breaking’ is neat code for curing chronic demarcation fights, again, how does he propose to tackle it? Breaking ossified crusts needs steel. We know soft soap and water won’t do it.

But to tackle that, means splitting up some giant empires and even if Labour wanted to, I doubt if it has the means. At the same time public sector reform requires exiting vast areas where mission creep has expanded a thin film of under-funded interference and sub-par delivery. True Blair did cut loose Scotland and Wales, to wreck their own patches, raise their own taxes, maybe we will see more of that?

So, we should not hope for too much, we will get another well-meaning ambitious left-wing lawyer, but he is not Blair, and Blair despite fond memories, still gave us the GFC and Iraq.

We fear that the hostility to business and enterprise shown by Sunak will persist, it is probably embedded in the Treasury and Whitehall.

The slew of rate rises, and the slow sacrifice of the US Regional Banks

Somehow Wall Street keeps looking for rate cuts, and collapsing inflation, when it is simply not visible in the data. They are so hidebound by their models, that they see inflation as a pile of bricks. You count the bricks; you know what inflation is. But it has never been that, it is like the water table, it is a level, not discrete pieces, and like water it spreads, dampness pervades all. Sure, you can remove bricks, even big pieces of wall, but the water table needs everything to dry up for it to subside.

 

Taken from this article by IMF staff writers, Agarwal and Kimball in 2022.

You can see the flaws, factors 1, 2 and 5 look like classic bricks, or transitory bricks we should call them now. As for 4 that has been entrenched by regulations, especially on minimum wages, by tax hikes, health fears and support payments, which leaves 3 as the real solvable problem, and it endures. True they rightly noticed it, but by relying too much on the bricks falling, institutional economics just keeps getting it wrong.

You can’t lower the level, while demand remains too strong to be drained away. While the idea you can disperse inflation while piping liquidity in to offset the cost-of-living crisis, is simply daft. Until excess fiscal stimulus stops, inflation will quietly shift, steam away, reform, and then drip back on us; clammy and damp as an English spring.

It helps a bit that vacancies per job seeker are falling in the US, but it is all pretty glacial, the job market is still very tight and wage inflation still embedded. We are awfully short of swallows to be declaring summer’s arrival.

Yet, we do accept Central Banks have largely given up on rate rises, we think too soon, and their main mechanism will now be leaving rates elevated for longer. Along with quantitative tightening, which as few politicians really understand it, they can get away with. Well, it may slowly work.

Looking ahead

We (still) see inflation as higher for longer, rates likewise, and over time the big users of debt, mortgage borrowers and national Treasuries, are going to get used to paying more for it.

Although expect some other fiddle to try to stop this too, which will, naturally, embed inflation and stagnate productivity.

Markets? Well, with plenty of liquidity still and indeed (unjustified) rate cut optimism and many cash flow yields staying attractive, they remain skittish, but with no panic.

So, we are not that gloomy. Although perhaps a sideways summer is ahead.

If your base case is rapid rate cuts and mean reversion, we still have our doubts.

 

Charles Gillams

Monogram Capital Management Ltd

The Recessional is a great poem by Rudyard Kipling. And the Long Recessional, the title of David Gilmour’s book on RK.

While Shonibare’s trademark mannequins rely on implausible inflation to prevent disaster too.


A winter picture - there is snow on the ground and some trees with orange leaves, in a wood, in Luxembourg

Wood for the trees

We have all been obsessed with rates and inflation, but we seem to be in danger of missing what looks like a widespread bull market running broadly from last October. This is widely applicable outside the main US markets, including in gold. There is a similar and at times masking trend of dollar weakness.

What are the implications of this?

We also look at the unending tragedy of the various remnants of the Tory party.

Still Rising?

With markets still fixated on the next crash, we can sometimes overlook the long momentum swings. Although the US banking crisis matters, it is of little relevance to the far more concentrated and tightly controlled Basel III banks in Europe. Many would say to excess, but they are clearly tighter rules. The few assets not marked to market are a footnote in Europe; in the Wild West of US regionals, they can be the whole story.

On a one-year basis, the France CAC 40 is up 14%, the German DAX by 12%, with both the UK large cap and Japan’s Nikkei also positive, so equity markets have been strong, almost regardless of rate rises. The US is the main home of negative twelve month returns, but the gap between the S&P and the NASDAQ declines over that period, is now quite small, after the spring bounce back in the latter.

What does that mean?

For all the media love of the disaffected trashing their own communes, doing the right thing on pensions (they were very out of step) apparently helps France.

While the splitting of power in the US Congress and the meanderings of a senile President, has perhaps hurt the US, with everything from banking regulation to the debt ceiling made into a political game.

Brazil is down too, but India and Russia are up.

Well perhaps I go too far, but maybe there is a pattern? Markets like stability.

Relative values

While comparisons are complex where accounting systems diverge, the UK still looks like the lowest rated with the highest yield, and conversely the NASDAQ still has (by some way) the highest rating and lowest yield. US earnings are it seems still much more valuable.

The savagely anti-business stance of the UK, including a brutal rise in corporation tax maybe part of it, it will create a fall in earnings (and likely dividends) next year.

While the less visible, but still onerous onslaught in the US, including  a minimum tax take, won’t be good.

So, does inflation matter?

The UK perhaps is also seen as the one major European market that looks to have dithered too long on controlling inflation (which could explain sterling strength). However, I see no real appetite for more austerity in the UK, so I find that assumption slightly puzzling. Having the FX market convinced UK rates are going a lot higher (because of policy failures) is hardly comfortable, but feels a little like re-living last year now.

Oddly too, controlling inflation the US way, has hurt equity markets more, it seems, than letting it burn out in the European style. Heresy to many of us, but that’s what the numbers imply.

All the theory, all the historic data says we now must get a sharp recession, but then grandpa, pray where is your beloved recession? Still looking, since mid February. It seems we must appease the inverted yield curve and believe base rates matter, but a bit more evidence would certainly help.

And rate cuts will be a powerful tonic, when they come. The bears are now reliant on widespread recessions, and soon.

Perhaps the best of this little bull market has gone, but there is a lot of liquidity still about and being out of the market with high inflation, is not great.

A multitude of sins – local elections coming up

And what of the UK Tory “Party”, if such a mess can be called that. The assumption for a while has been that the imminent local elections will be bad for them. However, they are a curious mix of voting locations this time, not London, not all of the Home Counties, none of the Celtic fringe, but a good chunk (but again not all) of the Red Wall seats. See map below.

This is a map showing all the political parties in a regional map of the UK just prior to local elections in 2023

Map from Wikipedia page on 2023 local elections

But really it is heavily biased to the Tory heartland, vast swathes of Labour free wards, where they are not even bothering with candidates, so it will not tell us that much. The Lib Dems will do well, but significant conquests in many areas will now require quite substantial swings.

The assumption is also that Dominic Raab was cut down by Sunak, who has yet to learn that throwing competent colleagues under the bus may feel good, but it thins the ranks of effective ministers, and builds up the malcontents. He has handled these badly, and forgets the real target is not his ministers, but his own position.

Tory strategy

Seemingly the Tory party has run just one electoral strategy for years, based on old victories; just trash the opponent. In a two-party state, voters must then decide who they dislike least. And both Labour (and the SNP) have reliably offered something so vile, that a simple victory follows.

But no longer, Labour (despite their recent rather crude posters) still seem innocuous.

The Lib Dems are sticking to their amateur politics, which can also look strangely alluring, if the other two parties look mysterious or inept. The Tories (like the SNP) are now in danger of being judged by results, not by fear or hatred of the alternative.

The score card on that basis looks pretty bad, and Sunak’s pledges are so far, going the wrong way.

 


this is a picture to illustrate the shakespeare quote - friends romans countrymen - here Charles Gillams uses it to discuss the aftermath of a modern political coup

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 party’s 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 Kwarteng’s 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 – with the neutral Hunt playing the safe stooge to hold the fort.

Unlikely to win the next election

It foretells the inevitable party split – 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 can’t 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. 

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. 

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.     


The Turn of the Screw

So, we have Truss now. The continuity candidate, not the dull man who would take away our sweeties. But also, the same old Fed, keen to do just that. And its time we took a look at Starmer, the other continuity candidate and an excellent book on him; required reading for serious investors.

Otherwise, it is always a good summer when nothing changes. Markets swoop and soar vainly trying to catch our attention, but the reality remains that rates have to rise enough to destroy the excess demand that causes inflation. And they have to rise to equal or surpass that level, eye-watering as that prospect is. It will not be over until the US jobs report goes negative, and stays negative; anything less is prolonging the pain.   

Presentation over substance

But this is a time of intensely political Central Banks, headed up by people without a grounding in economics, but a lot of “presentation skills”. They will be dragged kicking and screaming and smiling to do what they should have done last year, hoping vainly for some supply side reform or windfall to help out. But largely still facing the exact opposite, populists who think subsidies “cure” or ameliorate inflation.

Markets are oddly buoyant; they get like this at times, but we see that as a mix of delusion, the self-reinforcing strength of the dollar (be very careful of that one, it is a new bubble) and the spluttering remnants of buying on the dip.

But be under no illusion, Central Banks trying to guess where the economy is going is like fly fishing with a jar of marmite. Entertaining, but highly unlikely to catch anything.

Truss: Issues and options

Truss meanwhile looks like a re-run of Boris; it won’t be quite that simple, but it looks like more style over substance, a different set of lobbyists, but nothing really changing. The idea either she or the EU can afford a bust up with the UK, just shows how silly markets can get.

Some of her programme may make sense, both the NI (tax) rises, and the corporation tax increases were badly timed and should be reversed, given inflation is doing the hard work already through fiscal drag (or frozen tax thresholds).

The rises were proposed when we were exiting the COVID crisis, but before we understood the energy one. We said so the last time we wrote to you.

Ditching a few Treasury backed white elephants (HS2, Freeports, the crazy fiddling fetish on capital allowances) would do no harm either, but overall, the market’s verdict is clear: fiscal responsibility is still a long way out. We can all see how sterling has collapsed against the dollar; it is less clear why it has fallen against the Indian Rupee or the Chinese Yuan.

Source: See this website for all the daily data.

A book to read for all investors

So to Starmer, the likely next UK prime minister, where we need to pay more attention. Both on his  mindset and on why the Labour Party hates him so much. Which in turn explains why (and with the Tories fatal ideological split heading them into Opposition), he is so fixated on party control.

Oliver Eagleton writes very well. His recent book The Starmer Project looks at four episodes, his left wing legal start, his transformation into a Tory enforcer with a penchant for exporting judicial expertise to the colonies (don’t laugh), his alleged machinations to back the People’s Vote nonsense to bring Corbyn down (pretty dense stuff, even now) and his use as the Blairite stalking horse to put a stop to Corbyn’s chiliastic tendencies, (which also gives you a trigger warning about a light dusting of Marxist ideological claptrap).

So Starmer is all about what works, which would make a nice change.

We’re looking at a very global mindset, apparently quite a strong Atlanticist outlook, keen to work with European authorities, but aware that the Brexit boat has sailed. An interest in devolving power down, but keenly alert to the risk of anarchy that entails. Indecisive, a Labour Party outsider (on his first election in 2015, apparently his nomination had to be held back to ensure he had the minimum length of prior party membership). Starmer is not exactly collegiate, but he has run a Whitehall department (as Director of Public Prosecutions) so not a loose cannon.

Very London too, Southwark, Reigate, Guildhall School of Music (sic), Oxford for post grad law, Leeds as an undergraduate. So should at least know where the Red Wall was. But lest you relax too much, a total ignorance of economics or business, let alone how to create growth. It won’t be easy.

And what about Markets?

Well for a UK (or non US) investor you only had one question this year. If you ditched the local currency you made money, and if you held onto sterling you got hit. Our GBP MonograM model is doing fine, it got that one big call right: kind of all you need. If you are a dollar investor, outside of energy your best place was cash. And our USD model took longer to spot that shift. As for active investing, sadly pretty much the same, the dollar is the story, or dollar assets. All of which perhaps makes dollar earners in the UK look cheap still.

But for now we see the story as a currency one, and at heart that is just about the timing of tightening interest rate spreads. The widening of those spreads has caused the recent havoc.

So when (finally) the European and UK Central Banks abandon futile incrementalism and get the big stick out, that will call the turning point.

Charles Gillams