Altitude sickness
Do âhigher rates for longerâ matter? Is China doing anything different? Has the UK election become a one-horse race?
So far, both the markets and Central Banks have acted as if rate rises matter far more than they do, in real life. High interest rates are simply a pot stirring device, they donât take any money out, they just shift it from borrowers to savers at a higher speed. The net effect is that they donât matter to the totality of an economy as such, although the government takes a slice (as ever), and the exchange rate may shift.
It can also change investment decisions, affect confidence, restrain borrowers. But these are generally quite gradual influences. And the pile up in saversâ cash offsets them. It is a change of content, not of quantum. Meanwhile, in order not to move the âconfidenceâ needle, governments get spooked and start giving more handouts in compensation.
Investment decisions focus as much on corporate tax rates, costs and technology as on interest rates. While the evidence of resulting restraint by borrowers, where the dominant one is actually the government, appears a bit thin and is longer duration. Even the UK mortgage market has perked up.
Where rate rises may matter more, is if the winners (savers) donât spend, and the losers (borrowers) default, creating value destruction, rather than simply price movements. Not much of that is evident yet, as loan underwriting has (generally) been good, and neither the level of rates, nor their duration, has eaten far into the big credit buffers still in place.
Defaults on bank loans, set against the greatly increased rate differentialâs impact on earnings, have been minor. Bank provisions for purely economic reasons are not rising fast.
Overall, given the dominance of the âvote buyersâ in most markets, I am not that worried by consumption, and judging by London theatre prices, the high end is not showing much restraint either. While all those second order effects donât matter much this year.
It is no surprise to us that the world has now drifted back to ânot many rate cutsâ nor is it clearly a disaster, for all the sudden market noise. The political imperative for a rate cut to throw before the electorate (justified or not) still leaves June in play.
It is fairly clear where the froth is, where any nosebleeds are due; also that this market response is all sentiment, unrelated to actual economic forces.
A SECOND LOOK AT CHINA
What of China? For a while in the un-investable box, and I think still largely so for the mainland indices. Reasons? political risk, both internally and externally, growing sanctions, unequal treatment of overseas investors, disappearances etc â same as ever. So why look again? Well in part if globally the UK looks cheap, China looks even cheaper, right at the bottom of the pile.
The mists seem to be clearing on their economic strategy : manufacturing is still at the heart of it, which implies so is exporting and hence some engagement with the wider world. Not just high-volume low-cost production, although recent trade statistics do show falling value on rising volume. But a clearly and often stated desire to move up the value chain, seems to be coming off.
Chinaâs factories have a lot going for them, they are still building coal power plants (306, yes three hundred plus, currently in the works) and nuclear, (150 plants planned over the next decade) at high speed, plus plenty of renewables, providing abundant cheap energy.
From this site
Labour laws are to them just an amusing Western concern. Also noticeable is that Chinese universities still study real science, based on academic merit â they are the world leaders in many areas â just ask your university professor buddies.
Plus, they have no interest in electoral cycles.
If China wants to stay at the core of global manufacturing, it can. A flat rate 10% tariff seems to barely touch the existing and growing price advantage. There is also a point at which consumers will baulk at the price of domestic protected production, even in the US.
So, if China is simply the old ill tempered, paranoid, Communist dictatorship, flooding the world with cheap goods, stealing intellectual property and manipulating currency, then the problem is at least familiar.
In that case, it is not throwing its lot in with Russia and going back to Stone Age military adventures as yet.
So, when fund managers hang on to well researched individual stocks, knowing all that background, I am inclined to at least listen. Trade needs cash, wants cash, uses cash, needs investment and therefore some global engagement.
INTO THE ABYSS
We have long predicted the loss of the Tory Red Wall seats, one term rookies as we called them. Under 200 Tory seats left in six months, seems well-nigh inevitable as well. So yes, it is a one-horse race. And is Starmer really going to say anything substantial (and in truth there are quite a lot of plans and approaches on the table already)? I doubt it, he has no need to.
It is just the older and far tougher problem of working out how to pay for it all, without raising taxes so high no one wants to work, invest in the country or indeed live here. Given the record of the last century or so, expecting things to change now, is delightfully naĂŻve. They wonât.
It needs radical reform of regulation, entitlements and cost bases. No more salami slicing, no more buying off vested interests. There is some of that from Wes Streeting, but a lot more would be needed, the new ministers must do more with less, not less with more.
Looking at how the UK and US markets have performed this year, tells you a lot about those expecting such a grown-up approach. A backstop approach is to plan for the change.
Where many people choose to live and work, will be decided within this year.
Jerome K Wiley?
We do think Powell is running off a cliff, just not the one the market assumes. As we endured the wettest February since (at least) 1836, when William Lamb was prime minister, and the wettest Tory government since records began, is there any chance of dryer times?
But first the tiresome tango of rate rises, the market swept to and fro, nation by nation, until the firm stamp of a well-heeled bond whips the whole mass back round again.
Bailey of the BoE, and Powell of the Fed
So, this week it is to be Bailey first out the gate, FTSE up, bond yields down, next week who knows? That rates will fall this year is the only certainty and the big US markets have built a near vertical climb out of that snippet. But you will note, not in rate sensitive stocks, the Russell (small cap) is still pretty flat, weighed down by the regional banks that dominate it.
And Powell, heâs guessing or as he calls it is âdata dependentâ, but for all that he is pretty happy projecting those guesses forward. So, he has moved from three rate cuts this year, to a new position of ? Well - three rate cuts this year. Not much data dependency there.
Before long he will run out of âthis yearâ, because the inflation numbers are not behaving, nor critically is the oil price. Â Like Bailey in the UK, he is desperate to cut and under heavy political pressure to do so, both have said 2% inflation is not now needed, just moves in the right direction.
I feel the only thing that can get us there is a sudden (and indeed overdue) drop in the energy price, which we do expect in the summer, but who knows? It has held up rather well so far.
So, at the moment, Powell is perhaps  running on thin air. Protectionism and vote buying fiscal measures mean he canât get there without some other help.
Markets are supercharged â is it sustainable though?
And if rate cuts are what has supercharged markets in the US, I donât see that as sustainable right through the year. It might instead be the possibility of a more market friendly, fiscally prudent, Trump, which would be more logical, in some ways; but that still feels implausible.
Nor do I see, as yet, many other markets joining in. Partly, why own anything else but the NASDAQ? Some markets have moved (Germany, Japan) but you could also argue that was after being oversold for too long. While the Swiss have cut rates, it is in part (as ever) to restrain their currency, I am less sure others will want to move ahead of the US.
They may be forced to, but there again their scope before European and UK elections looks limited. And some parts of the market, like UK smaller companies and many REITs (and some renewables) are not signalling anything but yet more damage and destruction, from suspect refinancing at high rates and over optimism on revenue.
Air Cushions
It was notable too how keen Powell is to slow the tightening imposed by reducing the Federal Reserve bond holdings, which has to date been done at a fairly brisk pace. He now talks of stabilising holdings, (in other words resuming bond buying, stopping the runoff of expired holdings) at what seems a high level, for fear of taking too much liquidity out of the system.
From this explanatory article on the process by the Richmond Fed.
For a while rates and reserve sales were working as one against inflation, but not for much longer it seems. Which should be good for bitcoin and other liquidity consuming monsters, if nothing else.
Who is Next in the UK?
The interesting Tory battle is between the Official wing, now entrenched in power, and showing no sign of intelligent life, beyond wanting to âmake a good fist of itâ in the inevitable electoral defeat. Then there is the Rebel wing, keen to cause trouble, break things, get popular support, or be nasty, if it gets them attention. Although the Official wing regards this as disloyal, it follows an old pattern. It is not just about this particular bunch: see this paper.
Faced with a like quandary under Blair, the Tory party swung left, towards the centre and power, just as Gordon Brown started the decade long Labour march to irrelevance. The Official assumption is that will work again, although the alternative scenario is that Starmer settles down in the centre for the long haul, and the Rebel wing, kept securely away from power, withers for lack of a structure.
But all ruling parties were, by definition, rebels once.
Back in 1836, William Lamb was an unsuccessful politician, wrapped around by Peel, sent to the House of Lords, then brought back as a centrist Prime Minister, and being generally useless, was turfed out again, after naming an Australian city, en route. One must hope for no repeats from history.
William Lamb, Lord Melbourne â from this site
It does not feel time for compromise candidates, nor will a âsafe pair of handsâ do. Rishi is in a fight.
Meanwhile the fields here feel like salt marshes, dark water lurking in deep cracks, the lips of which slide into clay and suck at the soles of your feet. We certainly could do with some heat.
I do expect this run in markets to go on, but the upside in the big US indices looks more limited and broader participation elsewhere will await those rate cuts. Both their size and speed have a capacity to disappoint, especially when they are so hotly anticipated.
The politics, a long time coming, may become more influential. It could get choppy.
We will take an Easter break, after what feels like a long spring.
And return with the sun (we hope) on 14th April.
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.
Skipped - what will 2024 look like?
May I say we told you so? In "Skipping Along" before the summer break we called the end to rate rises, and by the November Fed meeting, we were well on board for a "rip your face off" rally. Feeling ripped? Anyone coming to the equity party in December, has just not been paying attention.
And our powerful MomentuM model had investors buying Japan and European Indices LAST December, so they have milked that entire rally. It also signaled buying back into the NASDAQ from May, arguably a bit late, but still very effective.
Jerome Powell said nothing new this week, and the New Year still looks bright for the beaten-up stocks, regions and sectors, as rates decline. I suspect prospects for the perennial winners to keep on winning are not too bad. Although economic growth will suffer (and so will earnings), but valuations still have some space to catch up amongst a lot of this year's losers, as discount rates keep swinging lower and bond yields dwindle.
A RED CHRISTMAS â Looking forward a year.
A year ahead, politics looks more interesting: so, what will the newly elected British House of Commons do next Christmas? What are the choices and likely outcomes?
The new Labour prime minister will care relatively little about political opponents, and quite a lot about holding party discipline.
Nor, we are told, will he seek early solutions to some of the more intractable constitutional problems (Second Chamber, Proportional Representation, Party Funding etc.), as based on his predecessor's experience, that just wastes precious time.
For all that, when it comes, his manifesto will (at last you may say) be festooned in clear deliverables, a plan to govern, at least for the next year. Â Â While Rachel Reeves is influential, the drive will be legislative, not economic. But as ever The Chancellor will have to then deliver the possible.
A DOLLOP OF BORROWING
So, more debt, extra tax, spending cuts are the options facing her, to fund that manifesto along with a cursory fig leaf for growth. The latter is needed (like the absurd Tory public spending targets) to get the Office for Budget Responsibility on side. Albeit responsibility is what you take, whereas the OBR offer simply a comptometer's sign off on specious forecasts.
For all that the Treasury thinks Gilt markets pay attention to the OBR, although I doubt it. So very early on, the rather too stringent self-imposed spending and funding restraints the Tories have adopted, will be quietly reconfigured. The rise again of a few PFI like schemes to keep stuff off the books is likely; Labour does not do fiscal hawks.
Falling interest rates and lower indexation provide small windfalls, and binning the 'irresponsible' Tory promises of tax cuts, won't hurt the numbers either. So yes, more debt, low tens of billions at least will be used.
A SPLASH OF TAX
What of tax? Can the pips be made to squeak. Yes, again, I am sure they will be, although not really on income tax, and I think for employed staff not on NI either. Labour has no love of the entrepreneur, who is too poor to hire lobbyists or to make donations. So, a bit more squeezed there off the self-employed and small business owners.
I expect a big hike in fuel tax, especially petrol and aviation fuel, under a green cloak, generating another ÂŁ10 billion. Consumption taxes remain rewarding: VAT rates, thresholds, and exemptions are all likely targets. And if they are inflationary, just adjust them away in your numbers. Nothing new â claiming them to be a 'one off' (of course).
UK property taxes are low in the South East, due to a long-standing failure to re-rate, so there is some scope there. With more housing coming, this will likely be punitive. But there are other enduring loopholes, that make little sense: REITs, Limited Liability Partnerships, a lot of EIS, VCT, Freeport stuff, albeit none of that is big ticket. I guess some simple populist tariffs may arrive as well. Labour is at heart protectionist.
All in all, I expect Labour to get enough from extra debt and taxation to provide a budget to tackle (rather than just top up deficits in the funding of) some long-standing reforms. I'd also expect seizures of assets. The Treasury seems to have a taste for balancing the books illegally, and there is little judicial protection.
PRESENTS FOR SOME
I don't expect infrastructure or defense budgets to be much loved â that's some of the cuts. The undoubted green spend will likely benefit (or keep on benefiting) China's manufacturers, more than the UK, but do still expect energy prices to go on up. They are the modern sin tax.
But higher tax, debt and spending can be pretty good for the economy, as Biden has shown, it all depends on how long you can get others to fund you for, and at what price.
Much as I am sure Labour don't want to crash the pound, they normally eventually find a way to do so, and for all my glib assumptions, they will be starting far closer to the edge than most new governments, for some while.
THE HANGOVER
How useful is that analysis? Well don't expect the FTSE to collapse, this will be a spending regime, but do expect stock specific damage, although arguably a lot of that is in the price of impacted sectors, or indeed the long standing (and ongoing) flight from UK equities overall.
The FTSE is mired in a twenty-year stagnation, from 7,000 in 2000 to well, 7,000 now, although not to altogether discount the medium-term Tory inspired rally. Note what Labour, even Blairite Labour, gives you.
On the other hand, sitting, duck-like, waiting to be hit, or worse buying into vulnerable areas, feels quite high risk.
The election outcome is (and has been for a while) clear. Nor is this a safe European coalition of the sane and less sane. Â It will be red through and through.
Given so many other options, and that some of the pain will be direct on pensions and property, it seems a good time to start planning on the investment side.
The MP's pension fund invests only 1.7% in UK listed equity. Do they know something?
Have a magnificent Christmas and thank you for reading.
We will be back on January 14th.
Charles Gillams
17-12-2023
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 taxpayersâ cash grew deafening.
There was utter silence on efficiency or capital allocation; it was all just âa good thingâ to spend more.
And oddly too, with so much lip service to the long term and reducing debt and halving inflation, the âhowâ 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 heâs 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 âreformsâ 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 canât 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 donât 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 âit will be fine in two yearsâ 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.