Sunday Supplement – “Older men declare war. But it is youth that must fight and die” – Herbert Hoover.

by Feb 27, 2022

“Older men declare war. But it is youth that must fight and die” – Herbert Hoover.
The events of this week mean that the supplement takes a bit of a pivot this week. From a macro perspective, what does the invasion of Ukraine mean, and where are the geopolitics likely to go? From a micro perspective, what does this mean for the UK, who are geographically relatively isolated (you could have said the same about Poland in 1939, of course), but have meaningful ties on a number of levels with both Ukraine and Russia?
There’s also an interesting observation that I’ve seen more strongly reflected over all recent news stories – part of the Covid shadow that will last for many years. In last week’s news, long since forgotten apart from those of us mending fences all week (physically, not metaphorically), the Met Office had issued two red weather warnings on the same day. This is a rare event and the obvious parallels around climate change don’t even seem to be mentioned any more, primarily because of its place on the agenda. The warnings ended up being justified with 4 losing their lives – but I heard more than one call into talk radio questioning the authority, accuracy and indeed the motives of the Met Office.
This isn’t worth significant airtime as a theory – in my view – but it is an observation that some are a) feeling that “distrust everything that comes from a government organisation” is the way to go and b) are motivated enough by that feeling to call up a national radio show and share the latest “storm conspiracy” and their piece on why the Met Office might do this. That’s where we’ve got to, and the government has to shoulder a significant amount of the blame for that due to the communications and behavioural strategies employed during the pandemic phase of Covid-19. Like almost everything this is likely to be a continuous feeling on a scale – a few are at this far end of the spectrum, but many, many more are likely to be feeling at least some of this distrust.
A further observation, and some of this is very valid in the post-brexit world, and I have limited memory of it before the 2016 referendum, is the confluence of the far right and the far left around the Russia/Ukraine situation. This isn’t the first time – recently seen in anti-lockdown protests before they became particularly large in number – that people from the opposite ends of the spectrum have been shoulder to shoulder. For those fortunate enough not to have looked into it yet, basically on one side it is all our fault because we weren’t friendly enough to Russia and Clinton should have let them join Nato in the 90s, on the other side it is the abject weakness of the West that is allowing Russia to pursue its long term goal to restore the USSR (or, perhaps more accurately, the Russian empire if you dissect Putin’s 90 minute monologue on the matter).
There are definitely some points that are worthy of consideration without signing up to the extremes of either ideology. It seems fair to conclude that Russia doesn’t want a democracy on its border and Ukraine was the most likely of the former republics to be invaded. It also seems from a strategic perspective that Russia would see advantages in occupying Ukraine – 40% of the world’s grain comes from Ukraine, then there are the significant natural gas reserves to consider of course. There are also broad borders and a further move west that are offered by the geographical positioning.
The Russian army is currently moving faster than the already-named “allies” – but let us stick with NATO as the primary defence force. The Ukraine forces are putting up a robust defence but are in a very difficult place from a sheer weight of numbers perspective. Friday saw Ukraine outperform based on the Russian expectations, who may have been too bullish here – but one of many questions that arises is how does a Putin-style character retreat from this situation – there has been a large commitment here and reverberations are likely for decades.
One remaining pin to fall on the sanctions side is the removal of Russia from the SWIFT system – thus reducing their ability to move money. Anyone doing business with Russia will be hurt by this, of course, and there are some direct issues causing some hesitation on this front. There is a need (and an irony, given that the UK system still remains the most active in terms of tax-avoidance on the planet, with its network of various crown dependencies and offshore havens, which has inevitable money laundering consequences) to squeeze Russia and indeed Putin from a personal perspective, and Sergey Lavrov (Russia’s foreign minister) – which is underway and thought of as the only way to make a meaningful difference to Putin. His estimated fortune of hundreds of billions (depending what you read and how much you believe of course) provides a significant target if it can be located. It’s also the case that you’d expect him to have made meaningful preparations for these assets to be frozen.
There are other consequences here of course – India see this as an opportunity to welcome Russia via their own payments system, and very little is in the Western media of the role of China in this whole conflict – a China who no doubt looks on and wonders whether it is a good time to bring Taiwan back under its mighty wings. War news is pushed to the back of the Chinese media broadcasts with Putin’s narrative given a better billing, and it seems clear to commentators that Russia will enjoy China’s support throughout here. This looks problematic for the USA and the West in general – Russia are not a particular threat on their own, but if my enemy’s enemy is indeed my friend, Russia and China together are a force that will not be challenged by the current administration.
There are many national considerations here that are slowing down the EU response; Germany gets half of its coal and natural gas from Russia, and a third of its oil. These amounts are not replaceable in short order. Then there is the impact on pricing in general.
Oil prices are volatile, of course, and there has been a roughly 10% gain in February so far. Prices have fallen back from $100 for the moment, but the direction of travel since the lows of the pandemic already looked fairly clear this year. The resistance to break the $100 level will in itself be interesting, but this adds to inflation of course which is already a massive consideration in the UK and the USA.
Then there are the energy price shocks on top of a shock. There was a huge spike upwards in the later part of the week, although prices had come back by a fair amount at the end of the week. This is just the sort of event that I detailed during the early days of the pandemic – an issue on top of an existing issue, and this is where problems really originate from. Some rushed-out research yesterday was suggesting that the average energy bill for a UK household could move to £3000 per year in October, from low £1300s before last October’s energy price cap increase. This would be around 130% in just over a year, which is not just inflationary on its own, but of course these prices impact absolutely everything produced in goods terms.
Electricity in factories, all the way through to the cost of logistics in getting goods from A to B, will suffer yet more. This pushes inflation expectations upwards yet further, by a number of basis points. Less than half a percent, but we are approaching the time at which we truly begin to appreciate the longer-term nature of the current inflation situation; a few more days of data is needed but the emergence of 5% in the inflation expectations from the market in 2 years time has happened this week on the back of the conflict.
This is really significant. Expectations for at least a year have been around 3.5% – 3.75% as the markets could see the writing on the wall post-Covid. There was a time when this looked like a partial balancing out of extremely low inflation during the darkest days of the pandemic, when economic activity had slowed so very much. A move to 5% and above in 2 years time means ever more likelihood of further base rate rises – despite them being against the wishes and the wants of the Central Bank as discussed at length last week. I maintained that an “accidental” or longer-term rate around 3-4% would be a governmental dream due to the amount of debt taken on – and the Bank in the most recent briefings seemed relatively comfortable with understanding that this inflation would work itself out within the next 2-3 years (despite the squeeze this would put on people, of course – although in fairness that is not within their remit).
Here’s the rub – most of these roads end up with a similar situation. We need to borrow some money. The primary issue here is that everyone has done that in such significant quantity since 2020 (and indeed, before that, I hear you say!). If inflation expectations do truly start to manifest in a meaningful way (and they haven’t as yet) – i.e., if people start to ramp up consumption in the expectation of constantly rising prices – then this is when rates do meaningfully need to come up to cool down the economy and consumer spending.
Why hasn’t this been happening so far? After all, the writing has been on the wall around this inflation for at least a year now? Well, the pandemic has had a significant impact. The shadow on consumption behaviour left by Covid is not something that will pass quickly – I would liken it to a tree – its roots are as wide as it is tall. Two years of uncertainty, behavioural manipulation and outright fear are likely to take as long to shake off – people just don’t wake up one day and forget all about it. Visual cues, whether they be in shops, restaurants, or on public transport, will still be in many people’s minds on a daily basis for months to come even with the withdrawal of mandates in England.
So we come back to the current paradox. With rate rises not needed to cool consumption, and with inflation roaring due to cost-push issues and supply side issues, exacerbated by the Russian invasion of Ukraine, the Bank of England does not want to raise rates. It has to, however, because it still has to be seen to be doing the right thing. The danger of not raising rates while inflation expectations continue to go up is an issue for international credit ratings, aside from anything else.
We also hear an immuted amount of slack in the forecast here. The Bank’s choice of language is “inflation working its way through in two to three years”. You can make your own mind up as to whether this is transitory, but we have seen above-target inflation since September 2021 now. “Two to three years” from February 2022 gives a near-pass to inflation beyond the next election, Feb 2025, at which point an extra 6, 12, 18, 24 months will no doubt be understood. That would be 5.5 years above target, if that does happen – and there is a material probability of that absolutely being what plays out. So much for transitory, eh?
What do we do with the information though? This is a strange situation. I send my mind back to 2011 when I’d decided to make a meaningful effort to build a property portfolio. Rates looked cheap and, indeed, inflation was raging at the time (around 5%, although that was a very temporary situation). The difference was that property also looked comparatively cheap. We need to go a bit deeper here however.
Property was cheap in 2011 if you used your benchmark year as 2007. However, after-inflation i.e. real returns in the 10s, as a decade, were negative for more than half of the households in the country. That is – if you adjusted them for inflation, despite inflation not being particularly significant apart from in early 2011 and then after the Brexit referendum, houses had actually got cheaper in real terms. I have referred to this before, several times, as one of the most unreported facts in property. Of course, it doesn’t make headlines (“Houses more affordable in real terms”). Then you need to consider, certainly if you worked in the public sector, in the 2010s you also had a pay cut in real terms, after inflation – so that also needs to be factored in.
Overall that means a lower standard of living. However, the continued deflationary impact of technology may not have made it feel like that. The other phenomenon that is often forgotten when looking at this sort of analysis is that a person earning the average wage in 2010 is unlikely to be earning the average wage in 2020 – they are likely to progress through their career, get promoted, find more financially rewarding work; or, they are likely to have retired/removed themselves from the labour force altogether. Either way, they don’t conform to the average. The real comparable is between person A in 2010 and person B in 2020, the same age as the 2010 person. The impersonal nature of this, and the fact you don’t feel this at the sharp end on a personal level, means that it can quickly become a paper exercise and is about “macro” level inequality rather than personal inequality.
What was also different? Rental growth had already happened because of demand stimulated by the great financial crisis. However it had slowed, and indeed moved at between 1.5 and 3% per year based on ONS figures in the decade that followed. The ONS is currently measuring rent growth at around 2%, although this is existing tenancies primarily – whereas growth in new rents is being measured by other indices at closer to 10%, either side of it depending on which index you read.
What should you do about it? In times of inflation, holding debt is a sensible strategy that should build wealth. Ideally that debt will be at a fixed rate, and there is still a very unique situation here with inflation at over 5% on official figures and heading to 7 and higher (I’ll be very surprised if we are not over 8% in a few months time), and significant debt available at 3% or even lower if you own property in your personal name. There is an inevitable move upwards in the price of everything, including wages (despite the Bank of England telling people not to ask for pay rises), which means that rents will keep moving upwards with debt payments on fixed mortgages moving sideways, and inflation will create a large nominal wealth effect.
Does this guarantee a continually rising market? No, it doesn’t. It is an arbitrage situation to take advantage of, even if the property prices don’t go up in real terms because inflation is so high for a period of time. The more that prices do move up in nominal terms, taking into account the cost of credit but also the moves upwards in wages, the more a bubble starts to inflate – so we would rather in the long term this ebbs away, but whilst it continues it will remain difficult to buy, profitable and sensible to refinance, and a time to sweat assets and improve the existing to protect yourself from the dangers of significantly rising energy prices amongst other things.
While stock remains short, it may also be a good time to assess every asset particularly as it becomes empty. Look at the situation – finance, what you can actually realise if you sell the asset after tax and frictional costs, current rent – and make a sensible decision. I can easily see a situation where selling in 2022 might yield a better price than selling in 2026, for example. Two reasons for that – selling in a market like this could yield 10%+ more than the market value is one, the other is that when the see-saw does turn, it becomes much harder to sell at the market value and indeed you might be more like 10% below the market value if you do need to sell in 2026 (why am I picking on 2026 particularly? I’m not predicting that to be “the year” but there are clear ongoing economic problems that will not be worked through until the next recession.)
Timing the market is hard and not recommended! The issue will be what you do with that money in the interim – inflation-beating investments are hard to find at the moment and frictional costs of buying and selling might make holding the better strategy. It may well be, just as with previous pandemics, that all capital holders and investors feel some of the pain over the course of a number of years to come.
At the moment, sometimes, it feels like the answer is that there is no one answer. This is the nature of uncertainty and volatility, I’m afraid. We had better get used to it for the moment, and the moment could easily be another 2 or 3 years. Be smart, don’t overextend yourself, if you are buying ensure to buy well, if you are selling also ensure to sell well. Opportunities are out there as people reassess their life goals apart from anything else – that’s a very natural thing to do after a pandemic – and never forget that your reality is not the same as everyone else’s! Until next week………