“The iron rule of nature is: You get what you reward for. If you want ants to come, you put sugar on the floor.” – Charlie Munger RIP, legendary American Investor.
Before we begin – this is one more shoutout for the Propenomix Advent Calendar – if you listen on a podcast platform, it is worth checking out the Propenomix YouTube for the daily posts I’m doing throughout December to celebrate getting to 500 subscribers! Thanks to all the regular readers and listeners who have subscribed……if you haven’t yet, what are you waiting for!? Please can you recommend me to a friend who you think would be interested? I’m loving the commentary, feedback and interaction that I get on there, and am still at the stage where I can reply to the comments.
Welcome to the penultimate Supplement for 2023 everyone. Yes, imagine my distress when I realised I could have referred to last week’s as the antepenultimate Supplement – still, that’s sorted that one out now. 1 more sleep until Xmas. Don’t worry, there’s also one Supplement left before the calendar ticks over to 2024!
I’m looking at the viability of producing daily content on the YouTube channel next year – it might only be 60 seconds worth – warning in advance – but the “shorts” part of the advent calendar has been far better received than I thought it would be. It will really encourage me to sharpen up my skills when it comes to brevity – something I definitely need to do, let’s face it.
So – WHAT a fortnight for the bond yields eh? Let’s start there, in case you’ve been living in a cavernous structure for the past fortnight. All the news (aside from the split of the Bank of England vote) has been pointing yields in one direction – DOWN. Global and US yields – DOWN. Federal reserve now discussing rate cuts – DOWN. Inflation under 4% – DOWN. GDP contraction in Q3 2023 rather than “break-even” – DOWN. Recession incoming (quite a big chance now, it will be tight – although it is a complete technicality at the moment) – bond yields DOWN.
Why does this happen? For two reasons, broadly. Firstly, the interest rate is deemed to be above the natural rate, under which the economy would neither grow nor shrink on the back of monetary policy – so it is perfectly legitimate to expect that the next move could be a cut. Secondly, because the base rate is now well above the CPI rate of inflation and even above Core Inflation for the first time in a LONG time, a cut becomes a legitimate tool in the Bank of England’s armoury.
Remember there’s really a minimum period of 6 months for rate rises to take effect, and often up to 2 years – so the entirety of the rise has not yet played itself out. There’s likely to be more grinding to a halt in the relatively near future.
In recessions (or something that looks like them) – the central bank’s broader brief to ensure financial stability kicks in, and they would rather be stimulating than choking off any economic growth.
So – it’s all good, right? Why the long face? Well, don’t get me wrong – I’m celebrating the move from 4% on 11th December (5 year gilt) down to 3.3% on 23rd December as much as anyone. That’s nearly 3-quarters of a percent that can come off 5-year mortgages. In the past month, the swap rate is actually down a little more than this, and the 3.35% 5-year swaps from 23rd December mean that rates around 5.4% with NO FEE could be viable in the new year (or, 4.4% with a 5% fee – or somewhere in between). Massive news while this holds up.
“But it’s crashing!” I hear you say – why fix now? Well, remember, you can switch down rates while the application is ongoing, or hold your rate if rates go back up. This is a VERY RARE example of a one-way bet in favour of the consumer, or the individual, versus the organisation. WHY can you do this? Because volatility like this is very rare, and because the lenders broadly allow it at the moment, then if a lender broke from the crowd and said that this WASN’T OK, they would have a significant amount of dissatisfied customers.
Plus, this week’s title will have given you a quick hat-tip as to what is coming today. I haven’t got the bunting out just yet. Fill your boots just now, but if you are going to get carried away like the rest of the world with the fact that “inflation is over” and “we’re going back to the old days” – then I’m about to do something to your chips that isn’t very christmassy. But before I do, let’s just round up the macro picture in its entirety in terms of what has changed this week.
CPI was the first “biggie” of the week – and, as mentioned, under 4% – 3.9% was the print. This was the second month in a row of a big miss to the downside – consensus was 4.4%, and the psychology of going under 4% is at least as big as the psychology of going under 5% last month. A really orderly fall in the past couple of months, although some see a trend of concern. I’m not so sure – 2 data points can’t constitute a trend, and the flash PMIs discussed last week don’t look recessionary right now, so that is of some comfort.
Month-on-month for both CPI and Core we had deflation – -0.2% and -0.3% accordingly. Black Friday perhaps plays a little part there – but so did the dying off of the spikes in energy and oil after the October 7th incursion in the Middle East, which did not turn into the commodity meltup that was predicted at some points. Some volatility just playing out, I think. I’ve chosen at points this year to calculate the 3-month-to-year figures as more of an up-to-date prediction – so, it takes the last 3 months’ figures and then compounds them 4 times to come up with an annual rate, in case that isn’t clear.
Core comes out at 2.01%, which would be fantastic – CPI comes out at 1.2%. Perfectly possible, and not far off my original predictions back at the beginning of 2021 to take around 4 years to get back down to target. Currently, looks like I might have been a bit bearish – IF you follow these arguments and agree with the mainstream. Luckily, I don’t.
Remember – if the facts change, I change my mind. As you would hope. Let’s just stick with what the facts are, though. The little-spoken-of (despite making up 47% of CPI, as discussed many times this year) services inflation was a bit of an outlier. This did NOT crash, and instead hit 6.3% (down from 6.6%). For reasons beyond my ken, there is no consensus forecast on services inflation – but with services expanding according to the flash PMIs, and wage pressure increases next year – does 6.3% annualised strike you as safe territory? Or does it strike you as 2.96% contribution to the 3.9% CPI print (6.3%*47%)?
RPI hit 5.3% (forecast was 5.7%) so continued on the way downwards, but still not crazy-time territory yet.
Still, this was enough for another bath on the bond yields on Wednesday. Thursday was largely uneventful – the UK borrowed slightly less than expected last month, which is better than borrowing more than expected – but Friday brought more news that sent yields down again. GDP figures revised for both Q2 and Q3 2023 – Q2 revised down to zero, and Q3 revised down to -0.1% (a contraction). With the -0.3% GDP growth in October alone, it starts to look very recessionary – although this could easily be one of the most technical recessions of all time.
GDP for Q4 looks like it will print either -0.1% or 0%. If it is the former, we have a “recession”. The likelihood is that the economy will grow in Q1 2024, and so it would be over before it has even officially started, really. This is the textbook definition of the RINO – recession in name only. We’d rather not have one – of course – and it does impact confidence particularly in corporates (one thing Boris did get right is that he was always invoking Boosterism – he could be incredibly positive at a funeral, that one). However, if we swallow a quick RINO it does improve the relative position of everything for 2024, which will help the Tories tracing-paper plan to keep Labour at bay at the next election – the dark days are over and here comes improvement! (It won’t work, it didn’t work in ‘97 – but also, Starmer isn’t Blair, and McSweeney and Gray aren’t Campbell and Mandelson either.
The rest of Friday’s macro metrics of note were annual GDP growth now revised down to 0.3%, business investment down 3.2% quarter-on-quarter (ropey, but forecasts were -4.2%), and retail sales year on year limping upwards in a tiny fashion (although, again, ahead of forecasts). Retailers have basically swallowed inflation this year – tiny growth in sales, but that’s all nominal, so they are (on current figures) 3.9% worse off year on year at 0% growth. There’s points over the past 12 months where they’ve looked much worse off than that, and my personal feeling is that there’s a much larger consumption wave coming next year on the back of the wage and benefits rises, as I’ve alluded to.
So – where does that leave me and my position? I’m difficult, dispassionate and, always, divided. It is impossible to look at the yield movement this week and be unhappy – however, extrapolating this into multiple rate cuts and everything going smoothly next year just doesn’t work, for me.
I’m more bullish on the economic performance – already writing off any technical recession that does occur – bearing in mind where we are now. I DO think wage rises next year cause some more permanent structural unemployment in the economy, but given we still sit at 4.2% unemployment today, that isn’t so bad. Productivity would actually improve – or could. However, the fact that more tax cuts are coming (Sunak has said as much) and people at the lower end of the pay scale will have more money in their pocket in real terms – these are both inflationary factors. There’s a lot more pointing to disinflation right now, but two sizeable monthly drops don’t guarantee inflation down below target in the shortest order. In January, energy prices go up again before going down in April on the current forecast. LOTS goes up in April, at a percentage based on last year’s inflation, not today’s inflation.
One of the biggest errors is looking back at the last 15 years and using that interest rate as a benchmark. I still think that data wants to be thrown out.
One of the other mistakes and traps I’ve definitely fallen into as well is not looking at the timing of the incidence of these rate rises. Let me explain in a bit more detail what I mean there.
When rates were zero, the world was easy. Massive corporations borrow at 1.5-2%, investors borrow at 3%, housing associations borrow at 0.5%. Money is nearly free. Any money in the bank is solely there for rainy days and to manage cashflow – there’s no investment case for holding it.
When rates move up very quickly, in a space of under 2 years but really with the majority of the yield moves upwards concentrated into more like a 12-18 month space – with the amount of tipping off that was out there (I’ve referred a number of times to just how many large companies fixed debt for an inordinately long time, starting in Jan 2022, when they saw the rises coming) – debt servicing costs didn’t go up too much. Indeed – the landlords stuck on base rate trackers have swallowed the whole of this, and been hit the hardest – many others (especially those who read the Supplement) fixed large quantities of debt for 5 years, which was the best that most of us mere mortals can do (large companies averaged 17-year fixes in 2022, the lucky beasts).
So, those on base rate trackers represent about 20% of the entire market, if the relatively thin and non-transparent data on the subject that is available from corporate reports can be believed. 80% were NOT hit as hard with their existing stock. Then, let’s get on the other side of the fence.
Let’s look at the different sort of investment decisions that have been made in the past few years:
2020 – “Should I take this loan at 2.5%, with one year of no payments whatsoever?” (genuinely no brains required here)
2021 – “Should I try and buy this property and get an element of return, with this incredibly cheap mortgage to set against it?” (Early 2021 – yum yum, later 2021 the water started to get very warm indeed and it was hard to buy of course). Harder decision and hard to execute even if decision made
2022 – “Should I sell this property in this incredible market? Or break my mortgage and fix for 5 years? Should I put the rent up?” – still not much else to do with the money, until late 2022. Again, not easy to execute in, but relatively easy decision making.
2023 – “Why should I get out of bed and put all this effort in, when I can get 5-6% in a short dated government gilt at no tax, or a fixed-rate account with FSCS protection for 5+ years at 5.5% (at certain points)? Have I got enough property anyway?” (a totally different set of choices and outcomes). “Am I getting a better return in property in 2023 than a bank?” (Of course, property is for life, not just for Xmas, and I’ve written extensively about reinvestment risk before).
What’s 2024 holding? “Do I want to invest more when a Labour government brings uncertainty to the PRS? How hostile will they be?”. “I’ve missed the 5.5%, but maybe 4% is still OK, especially now inflation is back down?”. “It sure was less effort”. Then throw in a sprinkle of those who still think property prices will fall next year (the dolts).
You see the pretty incredible evolution. You couldn’t really do that over another 5 year period in the past 15 and have such stark shifts in mindset, decisions and legitimate questions to ask yourself. Sure, you can always be afraid of your own shadow – that’s your prerogative – but these have I believe been genuine points and concerns and have meant more volatility in the supply in the PRS than we’ve ever seen before.
But – what’s the kicker that’s been missed here? Well, it’s actually the net gain of this new interest rate landscape for those with money. Pension fund deficits? What deficits? Sorted. Cash-rich companies? Well, at the moment we are getting 5.5% in the bank/bonds, so we actually don’t need too many new projects. We are throwing off cash, and have that long fixed debt at 2-3%, so actually, we are OK thanks. Cash-rich individuals – even with borrowing – as long as it is fixed at the “old money” rates – same goes. The return to savers kicks in much faster than the impact of the higher rates for borrowing, which just swallows up around 125k mortgage holders each month who drop off. However now they might well be dropping off 2.5% average rates to go onto 4% average rates – a LOT less punitive than suggested in the middle of this year.
This has some complex elements to it. Rent-seeking in general – just sitting and taking interest on the money – doesn’t drive productivity, innovation, long-term growth and research and development. In the past 15 years, pension funds (and others!) have had to work very hard for the money, or take fairly big risks for modest returns. Not so much as at today – and the “new” risk-free rate, even with 0.75% being shaved off it this fortnight alone, still looks very attractive, set against nearly 15 years of pain for savers of any kind.
Also – the big gains here for the savers have already been seen and are ebbing back, whereas the pain for those dropping off fixed rates just piles up month on month, of course. The pendulum swings back, and the data isn’t clear on when and how hard that will happen. We have the advantage of being a bit slow, and the disadvantage of our core inflation still being 5.1% compared to a US 4% core now (Euro area 3.6%).
We can’t cut as quickly as the others can. We are behind the curve, still. The market now believes that around May is time for the first cut – remember, we still need that first meeting where the hawks don’t vote to RAISE the rates again as they just did. I can’t see a lot more dropping out of the 5-year bonds just yet – we’ve “crossed the Rubicon” for the first time in a couple of years this week, and the figures 12 months ago on the yield curve are actually higher than they are today – long may that last. It isn’t necessarily permanent though.
There’s still inflation in this system, and I maintain there IS a secular element to the post-covid inflation landscape. Yes, there was some transitory – and yes, it has largely gone but its spectre on wages and benefits next year remains, as I’ve said a few times (but it bears repeating – remember this around April/May 2024 time, because I sure will).
OK – the Grinch is satiated. I actually wanted to end with a deeper look at the ONS figures that everyone and their dog has got obsessed with, with our -0.1% growth rate last quarter. OK – that’s 2.5 billion quid – no small beer, but in today’s parlance – not a fat lot in terms of Government spending. Often missed or never reported, really, at the end of the ONS quarterly national accounts publications – two points:
- The household saving ratio is estimated at 10.1% in the latest quarter, up from 9.5% in Quarter 2 2023 because of an increase in income outweighing a slight increase in expenditure.
- Real households’ disposable income (RHDI) is estimated to have grown by 0.4% following growth of 2.3% in Quarter 2 2023.
The savings ratio was down to 5.3% in 2019 – so is riding still at nearly DOUBLE what it was pre-pandemic (although 5.3% was historically a pretty low print). Conclusion – people are still saving more thanks to uncertainty, volatility and inflation – and of course, rates are a bit higher than they were in 2019 so the incentive is higher – but, in reality, most of this is driven by expectation and need – rather than rate attraction.
RHDI – the best metric, really, for households because it takes into account taxation and inflation and income – has performed in the following way, quarterly, since Q1 2020 (this week’s image):
If you indexed those percentages, starting from 100, you’d end up now at 101.3 as at the most recent quarter (Q3 2023). Or – put another way – this is a MASSIVE improvement from the several percentage points off that has been claimed this year in several articles. The average household, in real, after-inflation terms, is now better off than they were at the end of 2019. Or to put it one more way – RHDI after a lot of fuss earlier this year is now HIGHER than it has ever been. On paper at least – and at the average, which as discussed many times is a dangerous place to be – the cost of living crisis is absolutely OVER.
The likely path in Q2 2024 is a monster increase – even if inflation holds up at 3.5%, and most forecasters have it well below that now based on recent trends, then average wage rises at 5-6% say (with minimum at 9.8%) will see a massive boost to RHDI. Cut taxes (and let’s face it, it will be another cut to benefit basic rate taxpayers, to try and win votes) and that improves RHDI the other way. People will be feeling a lot better off…….because they actually WILL be better off, in spite of all the negative chatter around inflation.
So – in conclusion, before signing off for Xmas – I’m not convinced this inflation bus has driven its last journey just yet. That would mean stickier rates (if I am right), and these yields look about as low as they can get, for me, until confirmation of rate cuts from the central bank. It does now feel like the next MPC committee vote is 8-1 (8 to hold, 1 to cut) – although there’s plenty of time yet before the next meeting.
I expect rates can hold up at this rate and an independent central bank will want to be nice and slow on the way down, just as they were on the way up. A better way (in my view) would be to follow a “cut, pause, cut, pause” strategy but that would need real confidence in forecasts (which, as noted over the past few years, have been anything but brilliant in recent years from the BoE, the OBR, or a whole bunch of other large organisations).
Lots disagree with me and are calling swap rates under 3% soon – it’s worth noting that early February 2023 saw the 5 year yield at 2.83%, so it is about possible, but is a serious departure from a base rate of 5.25%. The yield curve is still DEEPLY inverted at the front end, and although this is a long time to have been carrying an inverted yield curve, it isn’t long enough to write off the inverted yield curve as a pretty good indicator of a recession. Just not yet. If we do hit a -0.1 -0.1 +0.2 (Q3, Q4, Q1 ‘24) – perfectly possible now – we really shouldn’t give it too much thought. Q2 ‘24 could print a really healthy number if inflation DOES go as low as some now think, because of the boosts that the extra consumption will bring to the economy. The recession the yield curve has predicted isn’t this technical one, if that is happening right now.
I would take the money now, personally, rather than hanging around for more drops – I still believe the one-way bet referred to above is the way to go. This is not financial advice and you should ALWAYS do your own thing, of course – but I don’t see a simple, nice, sweet unwinding next year to 1% inflation and 2.5% growth, sorry to say. The soft landing is not even halfway through, if indeed it is happening – and I still think it is odds against to happen.
With that cheery thought – around which I will put plenty more meat on the bones over the coming weeks and months – there’s only a bit more to say…….
Well done for getting to the end, as always – one more nudge for the Propenomix Advent Calendar – (with a release each day, one 60-second explainer and one longer-form but under 10 minutes). Subscribers are very, very welcome, and here are the links – for the channel: https://www.youtube.com/channel/UCpNyNRdTJF87K3rUXEV3s-Q and here to the Propenomix website: https://propenomix.com/ – thanks for supporting me spreading the word, more subscribers will lead to more and better content. For the penultimate time – Keep Calm and Carry On!