Reserve in Reverse

Fallen Emperor?

 

With almost two thirds of global equity markets represented by the US, the fall in the dollar so far this year is quite dramatic, and for many investments, more important than the underlying asset.

UK retail investors are especially exposed to this, as although Jeremy Hunt (UK Chancellor) may not notice it, the US is where most UK investors went, when his party’s policies ensured the twenty-year stagnation in UK equity prices.

While Sunak continues to pump up wage inflation, which he claims, “won’t cause inflation, raise taxes or increase borrowings” Has he ever sounded more transparently daft? Sterling, knowing bare faced lies well enough, then simply drifts higher. Markets know such folly in wage negotiation can only lead to inflation and higher interest rates.

We noted back in the spring, in our reference to “dollar danger” that this trade (sell dollar, buy sterling) had started to matter, and we began looking for those hedged options, and to reduce dollar exposure. To a  degree this turned out to be the right call, but in reality, the rate of climb of the NASDAQ, far exceeded the rate of the fall in the dollar.

While sadly the other way round, a lot of resource and energy positions fell because of weaker demand and the extra supply and stockpile drawdowns, which high prices will always produce. But that decline was then amplified by the falling dollar, as most commodities are priced in dollars. So, a lot of ‘safe’ havens (with high yields) turn out to have been unsafe again.

The impact of currency on inflation

Currency also has inflation impacts. Traditionally if the pound strengthens by 20%, then UK input prices fall 20%. The latest twelve-month range is from USD1.03 to USD1.31 now, a 28% rise in sterling.

In a lot of the inflation data, this is amplified by a similar 30% fall in energy, from $116 to $74 a barrel for crude over a year. In short, a massive reversal in the double price shock of last year. In fairness this is what Sunak had been banking on, and why the ‘greedflation’ meme is able to spread. But while that effect is indeed there, other policy errors clearly override and mask it.

 

A Barrier to the Fed.

In the US we expect the converse, rising inflation from the falling currency, maybe that is creeping through, but not identified as such, just yet, as price falls from supply chains clearing lead the way, but it is in there.

Finally, of course, this time, the dire performance of the FTSE is probably related to the same FX effect on overseas earnings assumptions. Plus, the odd mix of forecast data and historic numbers that we see increasingly and idiosyncratically used just in the UK. If the banks forecast a recession, regardless of that recession’s absence, they will raise loan loss reserves, and cut profits, even if the reserves never get used.

Meanwhile, UK property companies are now doing the same, valuing collapsing asset values on the basis of the expected recession, and not on actual trades. So, if you have an index with heavy exposures to stocks, that half look back, half reflect forward fears, it will usually be cheaper than the one based on reality.

 

Why so Insipid?

OK, so why is the dollar weak? Well, if we knew that, we would be FX traders. But funk and the Fed’s ‘front foot’ posture are the best answers we have, and both seem likely to be transient too.

If the world is saying don’t buy dollars, either from fear of the pandemic or Russian tank attacks or bank failures, that’s the funk. As confidence resumes and US equity valuations look more grotesque, the sheep venture further up the hill and out to sea. To buy in Europe or Japan, they must sell dollars.

The VIX, in case you were not watching, has Smaug like, resumed its long-tailed slumber, amidst a pile of lucre.

a graph showing market volatility

From Yahoo Finance CBOE Volatility Index

 

So as the four horsemen head back to the stables, the dollar suffers a loss.

The Fed was also into inflation fighting early; it revived the moribund bond markets, enticed European savers with positive nominal rates, (a pretty low-down trick, to grab market share) and announced the end of collective regal garment denial policies. But having started and then had muscular policies, it must end sooner, and perhaps at a lower level. So that too leads to a sell off in the dollar.

 

Where do we go instead?

So where do investors go instead?

In general, it is either to corporate debt, or other sovereigns. Japan is not playing, the Euro maybe fun, but not so much if Germany is getting back to normal sanity and balancing the books again. So, the cluster of highly indebted Western European issuers are next.

Sterling now ticks those boxes, plenty of debt, liquid market, no fear of rate cuts for a while, irresponsible borrowing, what is not to like?

 

For How Long

When does that end? Well, the funk has ended. You can see how the SVB failure caused a dip in the spring, but now the curve looks upward again. Although fear can come back at any time, as could some good news for the UK on inflation.  However even the sharp drop the energy/exchange rate effects will cause soon, leave UK base rates well south of UK inflation rates.

So, every bit of good news for the Fed, is bad news if you hold US stocks here.

How high and how fast does sterling go?

Well, it has a bit of a tailwind, moves like any other market in fits and starts, but could well go a bit more in our view. Oddly the FTSE would be a hedge (of sorts).

 

 


a cartoon of a startled bear, with a dog rushing towards it happily, and a bowl of food in between these two

FEEDING FIDO

International interest rates - what a dog’s 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 Fed’s 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 Powell’s 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 – so it typically pays more to borrow. The markets just needed the signal.

From : this site’s 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 (Bailey’s last top job) created the foible of pensions being forced to hold loads of so called “risk free” 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 “4&4” view on interest rates and inflation, (so higher for longer) but other investors and markets clearly have. You can’t 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 builders’ merchants all say ‘yes’. 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 won’t 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 won’t 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 isn’t it, how so many clever people failed to read the memo?


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


Investment, Politics and Economic cycles

An intriguing current question is which cycle are we in now? Is it the 2000 to 2022 one, or the 2008 to 2022 version? We look at the arguments, and the politics behind it all. And who exactly are energy sanctions designed to hurt?

Hopefully, everyone has now understood it is not the 2020 + rate cycle. Why should it matter? Well, the implications for interest rates are startling. And indeed, for buying on the dip.

Interest rate cycles

If you consider that interest rates should be about 2% above inflation, to induce savers to defer their consumption, then this cycle really extends from 2000 onwards. The excess credit of that era, led firstly to the GFC in 2008. This in turn led to sudden a lack of credit, but ultimately exactly the same problem of excess debt has reappeared in 2022. The efforts to dampen cycles, seem to just exaggerate them. As does using the same remedy for two very different problems.

Here’s the US picture from the late 1990’s to 2017

In a similar way UK Base Rates in January 2000 were 5.5%, as they were in December 2007, before a long descent to 0.25% in August 2016 which largely held (with a few bumps) all the way to December 2021, when they were still 0.25%! That was before the recent rather modest rises. So, by our “inflation plus 2%” measure of sanity, October 2008 was the last time base rates were sensible.

Ref: this stats article

In other words, this crisis was foretold. SPACs were an early indicator which we mentioned back in 2020. So, if the GFC was caused by too much credit in the US sub-prime housing market, will the hallmark of this one be excess speculation in meme stocks and crypto currency? Clearly, we have now learnt that these “assets” are all distinctly well correlated with each other.

In which case, banking regulation was only half the answer to these vicious moves, because the regulatory perimeter is always too tight. The vandals will inevitably camp just outside the walls - wherever they are built.

Will inflation auto-correct?

It also raises the question of whether the “cure” to moderate this economic cycle is going to be a continuation of the same lax monetary policy. A rather fuzzy consensus has formed around the 3.5% level for interest rates to top out, falling back down in time.  

We accept that is roughly the market belief, but feel it needs big assumptions about the auto-correction of inflation, which is presently just a fervent hope. In the real world (as distinct from asset bubbles) interest rates are too still low to matter, and we still have negative real rates on an exceptional scale. If Central Banks are really hoping to correct the laxity of 2007 to 2022, they will not stop at the current levels, but will go far beyond and cause a proper recession. But if they just want to re-establish the post 2008 consensus, they will go easy. They are talking about the former, acting like the latter with all their foot dragging and funny fixes. Is Euro fragmentation sorted? We doubt it. But if it is, they are not telling us, or really even defining what it is.

The ECB and our energy pricing policies

That partly is why markets are jittery, and why the ECB seeming to move from the cheap money forever camp (leaving Japan all alone there) to the appearance of being serious about inflation was so traumatic. We still don’t think they will tame inflation with interest rates alone, as by definition to do so breaks the Euro. This is because Italian debt in particular can’t be funded at any credible real interest rate. So, they too are just hoping for the best.

We also remain baffled by the West’s energy pricing policy that has created this sudden existential crisis. It was interesting to hear Boris telling a startled world, from Kigali, that not everyone feels creating a global food crisis is a rational approach to the Ukraine invasion. As if that was news, although it clearly was to him.

The politics behind it all

But there too we sense two underlying agendas.

Just as it is possible these interest rate rises are really to mop up the GFC policy errors, so also, a large part of the left is desperate for high energy prices.  This includes the more thoughtful contingent hoping demand destruction will help sustainability goals (we ourselves have long advocated £2 per litre petrol, but gradually building to that over the last decade, not overnight), but also the more zealous, who are keen to exploit the crisis to render renewables competitive, that much sooner.

There are some big distortions  in energy prices too, much of it created by the modern obsession with competition at all costs.

If this is so, then Russia is just a convenient excuse to ramp up carbon prices, blaming Putin for the resulting misery and achieving long-term goals. Certainly, Biden is acting that way, albeit, as ever talking the opposite way. Or rather his clever minders are.

There is a hint too that Boris is in the same deranged camp.

Oddly the EU led by Germany and Austria, with talk of restarting coal plants seem a little more pragmatic. Meanwhile the great beneficiary is Russia and the ever-stronger Rouble. They too have used the crisis to consolidate long term aims, not just in the war-torn rubble of Ukraine.

In short you either have inflation, or a credible short term means to create energy to replace Russian supplies, or high interest rates.

It is odd to think you would want to select just the first and last of that trio….unless your motivation was to correct another perceived policy error.


this is a photograph of a desert road, with the words written above : never reaching the end?

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 that’s 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 “normal” 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.

Extracted from the UK Office of National Statistics (ONS) June update.

And with inflation we will again see plenty of “top line beats” 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. 

Data taken from the June update of the Office of National Statistics UK.

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. 

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 can’t 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 don’t 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 don’t 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 that’s 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 I’VE 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 “Cameron light” 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 ‘wrong type’ 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 “activists”, who are anything but, but do bend their MP’s ears. They just want to dislike Boris and his lack of scruples, but also like the gifts he brings them.

They don’t want local trouble, so enough of those MPs voted against him, to keep their local associations happy. If that “terrible man” stays in office, they can at least claim they did their bit, but ‘others’ then let the side down.     

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, it’s just we really can’t 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.