First Principles
Principles may be lacking in certain quarters, but we will start with the economics of inflation rather than Boris.
How much inflation and for how long?
Inflation is simply too much demand for the available supply, nothing more complex than that. So, you tame it by either less demand or more supply. So, unlike it seems most Central Bank economists, who it turns out are just statisticians, for ever looking back, we must project forward.
That tells us quite clearly that the inflationary imbalance will persist as long as demand stays artificially high and supply is artificially constrained. It is that simple. Forget the rest.
So as long as governments have fiscal laxity, along with negative real interest rates, they are pushing up demand. As long as workers wonāt or canāt work, it will reduce supply, as long as economic activity is made less efficient by government action and diktat, it will reduce supply; end of.
So, at the very least Central Bank balance sheets must start reducing, which is not happening, stimulus must be fully withdrawn, which is not happening, and the old workers and their old ways of working must resume, which is not happening. Fresh capital can certainly change some of that, but it takes time.
Putin, Oil, and Geopolitics
What about oil?
This is the one item that alone might distort the picture. Which is positive, as we see oil prices falling in the summer. We also donāt see the West has really grasped what Putin is up to; in all the cold war style hysteria, he is possibly just after what he says. This is for the West to stop fomenting rebellion in Russiaās sphere of influence, and to be clear about NATO expansion plans, where there are indeed none in existence. He might have higher hopes, perhaps of a deal on Crimea in exchange for the Donbas, but we doubt it (or his chances of getting it are low). As might we, less interference in our politics would be nice; but see previous answer.
Nor is it that clear he is actually rationing energy; it is telling that Russia is reported as not able to meet its OPEC + quota, which at these prices is crazy. His oil industry will have been hit by sanctions, and the loss of Western expertise, and the Russian economy will also have suffered under COVID. A loosening of sanctions would really help him, for all his bravado.
If that reading is correct, as the situation winds down and OPEC+ winds up production, oil prices will fall, I would expect quite substantially. Much of the energy spike is self-inflicted, with nuclear plant closing or offline in France and Germany, and reckless price controls, having made using UK gas storage unattractive. All of these things can be sorted out.
Any possible good outcomes on inflation?
So, to inflation, well it wonāt care much about the pinpricks inflicted by the likely interest rate rises now under discussion, especially if they creep up so slowly no one notices. It needs a unified 1% OECD jump to cool this lot down, and the ending of stimulus. Neither is likely. Closing the US printing presses, were it to happen, does also have interesting global impacts, as Andrew Hunt notes.
We see it all turning rather glacially, with a bigger slump in inflation, if energy prices fall, but then being generally persistent in the 3% area for the rest of the year. We expect to have both higher rates and inflation for a while.
All of this is mighty tricky for investors, but I donāt sense that just bailing out is right, nor that the actual interest rate rise will cause an enduring slump in all asset prices. Investors have to own something, or they will sit and be mauled by inflation.
And what of Johnson?
It is easy to read the current level of confusion from either sideās viewpoint. Yet to me, I see the normal factional infighting, the usual media exaggeration, some political mischief making, but still no reason to depose a Prime Minister with a very clear mandate and a large majority. Like any large party the Tories have the embittered and passed over, the Remainers and fans of state intervention and a volatile and raw body of new recruits in seats no one ever expected to win. Plus, no doubt a few opportunists who sense that the heavy lifting on COVID and BREXIT is done, and they can now seize all the prizes.
The Tories do need a reset; it would be nice if Downing Street left Ministers to govern and simply acted as a cheerleader. Not that I see that happening, leaders and their hangers on always lust after more and more centralization, more control. But until a compelling, unifying, plausible Tory opponent appears, I foresee no change.
And in a way with reform all but dead, with Goveās last hurrah on āLevelling Upā a damp squib, it may not matter who leads the Tories, they have very little real power.
It is quite odd how big majorities do so little good, and how poor party discipline is, when they have them.
Charles Gillams
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 heās not, and he wonāt, 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 heās 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 canāt 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.
Heās 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 āutterly clearā 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 āsurpriseā 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 canāt 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 ādot plotā 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 canāt 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. Ā
Are we really seeing a labour shortage? The UK truck driversā 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 donāt 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.
Truckersā 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, itās 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 wonāt 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.Ā And it wonāt 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 1970ās.
There are a number of other supply factors at play too, but while some will recur, most are temporary. Ā Ā
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 donāt 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.Ā Ā
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 donāt 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