Inflation, Interest Rates, Pandemics and Crypto – 23/01/2022

Jan 23, 2022


Welcome to another Sunday supplement, unbelievably already number 4 of the year. We’ve blown past “blue monday” and there’s barely been time, in our operation, to catch your breath. We’ve got considerations which we are going to have to discuss because I am seeing the chatter and the direction of travel, and expectations will help to shape this just as much as reality. 2022 feels very risky indeed, already, and that requires agility, common sense, a cool head in the face of change, and, if navigated correctly, will mean opportunity. (not sure I’ve ever used so many commas in one short sentence!)

I want to start with house prices for 2022. We tend to talk nominally – let’s get that out of the way up front. The consensus viewpoint from a number of reliable sources is around the 4% mark for the year. A lot of the forecasters just see others’ forecasts and do the same – I’m absolutely convinced of that. I’ve gone on record as saying 5-6%, but have fallen into that same conformist nominal trap. What would be more interesting, and useful, albeit more difficult to understand, would be to discuss house price rises in the context of inflation (i.e. in real terms), wage increases, and with the backdrop of interest rates being considered.

Rates will have an impact on house prices. The blocker remains as deposits, for people looking to get on the ladder – that much is well documented. However, there’s been a 40 year trend downwards in the overall rates, that many believe has contributed to house price growth (and it has, because the availability and the price of credit are both important factors). That trend is over, as I’ve discussed earlier this year – although this doesn’t mean hikes are going to be savage, it just means it isn’t trending downwards any more. You can visualise very long low interest rates – the best example of this in action is the Japanese economy since 1989. Our own 50-year bond yield which I’ve referred to in the past is 1.05% (and our 30-years are 1.3% versus around 2.1% in the US right now). The 10-years – the one to watch if you were going to pick one – is 1.17% in the UK and 1.77% in the US.

Now, you can’t hang all of your hats on this one. The bond market looks stubborn to any sensible commentator and there is a feeling that it “must” break at some point. These yields SHOULD be higher! There’s a transitory element to inflation, but an absolute ton of forces that are more permanent. Minimum wage is up 6.6% in April. Energy prices are still going mad and likely to push up, and the Bank of England this week estimated that upon the release of the 5.4% inflation figure, 1.5% of that was solely down to energy price increases. (the problem there is that fixing our energy problem is a 20-year strategy, and we have made bad move after bad move on that front since the 1980s, if not before!).

However, in my traditional style of trying to add some balance to the argument, this is a good time to revise the “widowmaker” trade of all bond traders – JGBs. JGBs are Japanese Government Bonds. The urban myth goes that all bond traders, when they start out, for the past 30 years, have thought it a good idea to short JGBs. They are priced incorrectly. However, the central bank in Japan has stubbornly owned these to a massive degree for decades, and the rest are owned by extremely risk-averse organisations (almost solely based in Japan). Patriotic almost in their defence of the JGB. It is called the widowmaker because that price move just hasn’t happened in 30 years. There’s an element of one of my favourite phrases there – “the market can remain irrational longer than you can stay solvent” – and it is the sheer size of the balance sheet that no-one, not even George Soros (or similar swashbuckling hedgie/trader) can make a meaningful dent in it with a series of short positions. The Japanese central bank has owned up to 70%, of all of these JGBs, over the years. The current number is closer to 50% with only 7% owned by entities outside of Japan (20% by insurance companies, 15% by banks, as it goes – both of which can handle negative real returns, out of interest, because they are effectively following an arbitrage model or a very low-risk long-term strategy around borrowing and lending).

When you see the percentages laid out like that, it all feels a bit false. And you’d be forgiven for thinking that, because on the face of it, it is. This is part of the “ponzi” that the enthusiasts refer to (just before they convince you of the merits of the crypto system, which, in reality, is only full of speculators, preppers and tax evaders…..which has a heavy dose of irony to it). What happens when the system is put under stress – well, we’ve seen that over the past 2 years. It has passed the test at the time – and, if you’ve missed the sensible commentary, the pandemic is over (more on that later, and a touch more on crypto too) – but now it is time to deal with the consequences, and the fallout, and that will take some time to play out.

Applying that back to the UK and the US, as the two markets of most concern, where in the UK the central bank owns around 38% of the debt, and in the US the percentage is far lower, more like 18%. The very fact that the US is far keener on repaying this, faster, than the UK (and certainly Japan) tells you something about the long-term position that we are in (and how much headroom there might just be, in the face of another crisis). US investors own more like one third of the US national debt which is interesting because there is a far bigger culture of private provision of pensions etc. which the UK has trended towards in recent years with the introduction of mandatory private pension schemes contributed to by employers, and employees if they don’t opt out. In the States the 60-40 Bond/Equity mix is commonplace (this would be an entire raft of supplements on its own, regarding the future of that mix) – I will leave that here, but this says quite a lot about where there are real structural differences between the US and the UK.

The US just isn’t ready for the comparative “ponzi” feeling described above, whereas the UK are far more long-term-entrenched in it, with the Japanese as their mentors in this department! Either way, collapse is not around the corner, but there is still a lot of sense and prudence in fixing the roof when the sun is shining, something we’ve failed to do in the past (and something that politics usually gets in the way of). The question that arises from that is, is the sun shining, for real? Or are we in this cost of living crisis that the media want us to believe…..
As usual the truth is somewhere in the middle. The real suffering of the inflation situation is to be felt by those reliant on the benefits system. The ideology of the current administration would never allow them to make life easier for those on benefits – indeed, there is a reasonable argument that life was too good on benefits running up to 2010, and then the austerity angle was used as a stick to beat “them” with. The fact that a good majority of the problem, intergenerationally, was caused by the very same ideology in the 1980s while busy “fixing” the figures to look good politically is very rarely discussed – not that I approve of dwelling in the past anyway.

I have had two interesting conversations this week which have touched on this and the energy price situation. One where we agreed that, in reality, we are in a financial position to double our own energy bills (in our own domestic properties) and not feel marginal pain from it – because our energy bills are a small % of our net income. However, another conversation with a friend of mine revealed that because he is in an old, energy efficient (and large) property, that his energy bills are now 10% of his net salary every month – which is a massive number. What rings in the back of my head in all these conversations as well is that it really hasn’t been that cold a winter thus far. What if 22-23 really IS a cold winter?

This is where inflationary situations get confusing. There are some that have (comparatively) benefited massively from the recent situation. HGV drivers – after years of getting paid less and less in real terms, and being treated very poorly – are one example. Those involved in goods, one way or another, including manufacturing, food and FMCG have been large beneficiaries of pay rises that run towards the 10% level (again, recognising that this is from a relatively low base). This 10% is being passed on up the chain of course, and is putting significantly large inflationary pressures on food, supermarkets etc. This is exactly how inflation spirals upwards, something I have been writing about for over a year now – now we are living it – and where does it stop?

Now – for those loyal readers of the supplement and their own investment needs – this is where it gets interesting and yet again more difficult to understand. Many property investors are notoriously asset rich and cash poor – and that’s because so much of the reward is back-end loaded (of course, don’t cry for me, Argentina – you can always re-gear upwards and withdraw money without tax implications, necessarily – and take that money from the future in the now by doing that. That’s not a recommendation, by the way!). So, they may well feel that inflationary squeeze.

However, there’s never been a better case AND a worse case for putting rents up! Voids are easy – the market will set the price, you should be heavily involved in that decision every time, and also decide if you have a great product that will push the boundaries, or are letting something a little tired that needs help and encouragement and needs reflecting in the price. Some landlords are giving a bit back at the moment – lower rents do get better tenants, sometimes, because they are better at budgeting and don’t need to fall over themselves to take whatever is out there. It is a tough decision.

However, existing rents are a different matter. Many investors are simply not in the habit of reviewing them and putting them up. This is utter folly, of course – the only way is little and often. Don’t sit and moan when compliance costs go up if you don’t run your business properly! There needs to be an expectation that rents will rise, each year, to reflect inflation and increased costs of asset ownership. This is not about squeezing the tenants, this is about proper commercial decisions.

So – that’s the “for”. What about the against? Well, we’ve already done it – wages rising in lower paid jobs, but all other costs potentially rising faster. I think we will see 7% inflation this year in the UK now, at some points. We get these soundbytes such as “highest inflation since x” but those aren’t helpful – we need to look at likely spikes, troughs, and just how sustained this will all be. If I’m right and we do hit 7, whilst it will start to ebb back a little, we could be in August or so before that happens in any meaningful way, because of “base year effects” apart from anything else. If you recall, inflation was completely dead during the pandemic, and it was August ‘21 before it really started to gather pace/go above target. As importantly as the 5.4% figure this week, the forecast was 5.2% and exceeding forecast means faster action needed.

So, there’s a risk here that the notoriously calm and staid central bankers will just ebb towards “very concerned” and that means more rate rises. A series of fast rate rises is problematic, for several reasons:
i) we have not experienced it for many years, decades indeed
ii) we have a serious amount of debt, 20% more than we had 2 years ago – so it costs more to service
iii) it takes time for these to have an impact. IF the central bank puts rates up twice more before the end of May (not impossible by any stretch), we won’t see how clever or not that is before December or so.

Of course the rate can go down as well as up, and indeed we saw that in the US in 2018 (we were still reeling from the uncertainty of the referendum result, so we never got anywhere near that party). They went to 2.5% and then right back down, before the pandemic even registered. We could easily see base rates at 1, this year, and that might well be too much too soon and have impacts in 2023 and beyond.

The central banks as a rule don’t tend to like ups and downs; and the MPC is packed with smart people, of course, so I’m sure they can see all this coming – at least I hope so. Where the 10-year bond yield will be is anyone’s guess. What we can say is that the gap between the UK 10-year and the US 10-year is a likely consequence of the UK’s “comfort” with just how much of the gilts that the Bank of England own whereas the US wants to dump the majority of its US treasuries as fast as possible, and the price for that is higher rates.

So – capital values can easily be dragged up this year by inflation. Rents are likely to rise as well (new rents especially). This is positive inflation for asset owners, whilst it stays “relatively” under control (and duration is absolutely as important as just how high it spikes). There are LOTS of things that can calm down central bankers and households – for example, the point around inflation being near-zero for a year or so and quite flat before that. On average over 2 years, 5 years, etc. – it doesn’t look so bad. And that works while everyone believes the narrative that the duration will be short, or relatively short. It doesn’t take a genius to predict that that duration will be longer than expected (or that the central bank SAYS that it expects, more correctly), but when and how does it calm down as then wage pressures are still very high in a tight labour market, with inflation to cope with (as most households see a real-term decline in their incomes, and certainly in their disposable income – especially if the tax rises go ahead as planned!)

The fiscal and monetary policy puzzle is about as difficult as it has been over the past 15 years, in my view. This is not GFC-level stuff and the banking system near collapse – that’s much bigger. But it needs careful stewardship and a leader that the overall system believes in. That’s the best case I could make for Boris keeping his job – we need Sunak in charge here, the majority of his team’s decision making during the pandemic was spectacular, we need more of the same and that leadership. Many are worried about who the next PM might be – I am much more worried about the next chancellor……

So – if your head is still attached to your shoulders after all of that – there are further topics that must be covered this week. Firstly I wanted to share that there does seem to be an uptick in stock available at reasonable prices via the auction markets. We’ve put the work in this month and are hoping to reap the rewards in the next couple of weeks. This could well filter through into the open market over the next several months, although we need the narrative “the pandemic is over” to sink in.

And let’s get into that. I shared a Tomas Pueyo article this week on my socials which had that as the headline. “Coronavirus: Game Over”. I’ve loved his work throughout and his “Hammer and the Dance” article will be stuff of future legend, I have no doubt. He’s landed as a world class analyst and great thinker who was unknown pre-pandemic. However, the headline on this one is not his best work.

To be clear – I totally agree. I identified in early December the material probability that Omicron was mild, and would potentially end the pandemic per se. Let’s remember what the world actually means and the etymology of it – pan = all, demos = people (local people, technically). All the world. The disease then becomes endemic – one more pathogen to deal with. I’ve discussed the mental turmoil some have gone through who seem unwilling to accept there is a new risk in the world. What this really means is that it is officially time to “live with it”.

Depending on how that message is communicated, and how much a scrabbling, struggling “leader” needs to use that to his own political advantage/to save his own (snake) skin, this could and should unlock the door to housing stock. And we may see that see-saw I’ve talked about for 12+ months now – prices are up so much, of course, and time to cash in? But demand has ebbed back slightly, and will continue to do so…….will that mean a crash? Unlikely, because the bubble has not had its time to inflate. Will it mean a wobble, though? Very likely. If 2-2.5% was to come off the top of the market over the course of say 2 months (perfectly possible later this year) that could mean an awful lot of opportunity as the doom mongers start to create the clickbait headlines around “housing price crashes” etc. – only for it to stabilise. Perfectly possible and in the realms of pandemic inspired volatility. Thank me later! (and time any disposals well, would be my advice).

What we need is some stock analysis – and I’ve not left room for that this week, but I will get that in next week. A refresh and just how much difference the January effect and the new year makes will feature, and I expect some meaningful differences since our last update.

My post-script for the week is crypto-related. I wrote last year of a very fascinating consultancy session that I had with a well-placed investor and mortgage broker. It was the best conversation I’ve had regarding crypto, because he asked for my opinion on it, mostly because he was so realistic and well-informed about bubbles and hype in general, but had managed to trade through it and do very well. He was convinced of a crash in January, and he was right! Of course, this stopped boring old methodical me from getting involved back in October/November even if I had been tempted!

Pair that with seeing some of the social “proof” this week – a large trader publishing a one-day loss of $1.2m on his socials, bitcoin down 45% from its last peak as I write this, and headlines of $1tn being wiped off crypto on Bloomberg. Bitcoin down 17%, Ether down 25% – only a few weeks ago when asked to predict crypto, which I am definitely not qualified to do, for 2022, I said that I thought there would be a crash leading to a flight to Bitcoin and Ether over the course of this year – how long that would take to play out, I don’t know. I still don’t know. But there’s usually survivors here – check Amazon’s stock price during the dotcom boom and bust – and they are the likely ones in my view. This will be ugly – then there will be consolidation – and then gains, for those who have real trading talent.

I was saddened as well this week to read about an investor’s loss to hackers, in the 6-figure region. I must say this is the other factor that’s kept me out of it – as someone who has experienced counterparty risk in a massive way in a previous life, and lost similar sums of money because of it – I am these days 100% worried first about where the money and assets are held and the old “return of investment before return on investment” than I am the actual returns. Although in a period of inflation like this, can I afford that mindset……luckily my hard real (boring) assets are keeping pace or indeed outstripping it, at the moment anyway.

As you can tell, this week, I could go on – tune in at 10am on Piotr’s timeline or my own, or YouTube for the Property Sisters, for our weekly chat which will be sure to be full of further explanation on these events and yet more again! Until next week, stay safe and ideally un-inflated…….