Sunday Supplement – A historical moment? Or Much Ado About Nothing?

Aug 7, 2022



“You are thought here to the most senseless and fit man for the job” – Dogberry (William Shakespeare) (from Much Ado About Nothing)

The Bank of England, the Price Cap, and 160% inflation

Welcome to the supplement by Adam Lawrence as we process another very interesting week in the UK – the leadership contest develops yet further wrinkles with things getting personal, and looking somewhat petty and pathetic at times. The Bank of England met and acted decisively, offering some strong guidance and what, at times, felt like a eulogy for the next couple of years. Crude meanwhile dipped under $90 a barrel, offering some relief at the petrol pumps within the next 6 years (sorry, I mean couple of weeks, of course – a weak gag at how slow the distributors are to put the prices down, but how fast they are to put them up), but natural gas continues on a tear up leading ultimately to ofgem predictions of the next price cap increase (that’s now January, so that the companies don’t have to wait 6 months to make even bigger profits – sorry, I mean so that the prices can come down more quickly when everything is back to normal – I must be in a particularly cynical mood this week……) to be around £4,200 with October predictions now at over £3,600 – at a simple level in December and January, notoriously tight months for a large percentage of UK households – bills a couple of years ago might have been expected to be £200, they are now £500 for an average house. Energy inflation, isolated simply by household bills, is 160% (that is very clearly hyperinflation levels). Inflation is at 9.4% – that’s CPI, RPI was 11.8% for June.


Let’s clear something up straight away. The Bank’s delivery of the committee notes – spoiler alert – gave the very strongest indication of a guaranteed recession next year, starting in Q4 of this year, that I can ever remember. A recession predicted to be a year long in all major possible worlds that they see (they did not say this specifically, but this includes a world, unlikely in my view, where the Russia/Ukraine conflict comes to a swift conclusion from here). None of their models see a situation where a recession is avoided.


What do we all do about it?

The best way to deal with this is NOT going to ground. Sitting back and waiting is simply a silly idea. Why? Because by the time something does happen – and indeed, the timescale does look particularly predictable now, the writing does appear to be on the wall – you will be warming up old relationships, starting afresh with no pipelines of deals – you will be yesterday’s news. Just this week I saw what looks like a good deal and could well be a great deal, once all the DD is in. It would be the largest deal I’ve been involved in to date. I’d love to get it into the portfolio. Does it mean I shouldn’t deploy cash reserves I’ve been building up, preparing for this recession that I’ve considered guaranteed for many months now? Absolutely not. This deal alone could mean if I didn’t transact next year at all, I wouldn’t be sorry.


So, prices are going down then?

Also – does recession mean a guaranteed drop in house prices? Nothing is guaranteed. The faster release indices – Nationwide, Halifax – told a different story, but admittedly at the margin. Nationwide saw prices up 0.1% in July – Halifax said 0.1% down. It’s fair to say the market has flattened a little. August will need some seasonal adjustment as the most “traditional” August for 3 years – people are back to holidaying, although in smaller numbers as many fear what’s to come and grapple with the price of keeping cars on the road, but it could easily be a flat or down month. We wait months for the ONS data that only looks backwards by definition – nonetheless, consumer confidence is already on the floor and that has not yet led to a market screeching to a halt. The predictions are that this year will end up 5% or so – despite the “guaranteed” Q4 recession I’d still be tempted to be 0.5-1% higher than that, even.


I’ve said it a number of times recently, but nominal prices don’t need to go down for houses to adjust in price, in real terms. Wages are up 5% in the private sector – 7% including bonuses – and the forecast is that they will move up around 6% more over the next year, and the unemployment rate will go down before it goes up. Unemployment now, however, is predicted to be above 6% in 2025 as this recession has a predicted long shadow. If prices stayed the same and we were in August 2023, and the market is up 0%, but wages are up 6%, houses are (in simplistic terms) 6% more affordable. Deposits will still be hard to save. 


What else is going on? Well, the Bank of England is divesting bonds, so quantitative tightening is a thing. The plan is that it happens at a pace that doesn’t affect anything too much. However, the astute will be asking at least one question here…….so, we have a guaranteed recession coming, according to the bank, but the past 15 years of pumping money into the system when we have an issue is being reversed, even when we have the biggest sustained downturn since 2008-9 coming down the pipe? Eh? Perhaps, instead, they are trying to dribble back some of the massive “temporary” QE measures before they need to go back to the well in the face of what happens as the recession unfolds, instead? Seems viable. The boring bit is that they expect to divest around £80bn of bonds over the next 12 months, to take the bill down from £864bn (high point was £895bn) to a mere £784bn or so.  


I’m confused…….is the Bank confused too?

This should be deflationary, or at least not inflationary, but potentially deflationary for asset prices. Alongside increasing interest rates, we really should expect more asset price deflation. Two massive factors here though – one, global energy and further geopolitical disturbance or a longer conflict in Ukraine than is still expected. Two – the persistence of inflation. The language used by the Bank simply could not have been any stronger this week – and remember, this is an organisation that takes its use of language very, very seriously.


This paragraph from the minutes I thought was worth replicating in its entirety to illustrate this:


“The MPC will take the actions necessary to return inflation to the 2% target sustainably in the medium term, in line with its remit. Policy is not on a pre-set path. The Committee will, as always, consider and decide the appropriate level of Bank Rate at each meeting. The scale, pace and timing of any further changes in Bank Rate will reflect the Committee’s assessment of the economic outlook and inflationary pressures. The Committee will be particularly alert to indications of more persistent inflationary pressures, and will if necessary act forcefully in response.”


What are they saying here? Well, firstly, it is hard to predict things at the moment – so it is important to reiterate that they will react when they have to. The reaction in September – and beyond – is not pre-set. The next part says that, in my view, rates can go down as well as up, and that will always be on the table if (and when) rates do go above where the long-term equilibrium is expected to be. We have the clearest steer yet that the bank don’t wholeheartedly disagree with a longer-term base rate at 2.25-2.5%, in “normal” times (remember those?).


What next? Yet more assurance that they will react to what’s coming next for the economy and also inflation, and then yet one more reiteration that inflation is the priority, and then the money shot – “if necessary act forcefully in response”. This sort of language is only supposed to mean one thing – we are on top of things, and will not hesitate to act and do whatever is necessary.


Big speak – but will it translate into reality?

This needs to be drilled down into however. The market now believes the base rate may not quite hit 3% in getting this inflation under control. They are seeing October 2022 as the peak in inflation – CPI at a little over 13%, now the price cap has risen quite so much – and this is very possible. Going into recession, all else equal, WILL calm inflation. This isn’t, interestingly, the time to stop raising rates necessarily, as they need proof that inflation has calmed down before stopping the raising of rates.


This is where the Bank, and the majority of the economic commentators out there, and I, part company. I believe that core inflation (stripping out the noise from these energy markets) at 6.5% inflation or thereabouts, is a significant problem which takes at least 2 years to fix, and I think more like 3-4. This is still on the rise. Private sector wages at 6% basic rise plus there will be further bonuses while the labour market remains tight, sees the average wage rise at about 8%. This simply has to filter through into prices and, commodities aside, the price of inputs in business is likely to be “sticky” upwards, just like the price of petrol and diesel at the pump. Wages VERY rarely come down in nominal terms – that would take some recession – so prices have to reflect that, otherwise companies go bust as the market works its magic.


The best cure for high prices is high prices. Think about that for a moment. A nasty concept as we talk about heat banks because of the price of heating a home effectively this winter, but an economic reality. If prices are too high, demand comes down because of both affordability, and willingness to pay. The market speaks. Capitalism and efficient allocation of resources at its best – sometimes with horrific consequences, but those are the rules of the game. If cheap flights are no longer cheap, relative to other alternatives, fewer people will go abroad – and on the flip side, the domestic tourism market will grow. Airlines, airports and associated industries will suffer and that suffering could carry on for years – this may well have been the analysis of Berkshire Hathaway when the legend that is Buffett dumped his airline stock positions in 2020 at what looked like relatively low prices at the time.


What will the new PM do?

This same logic, of course, works for rents just as it works for house prices. House prices are more complex – because the availability and price of credit are drivers, alongside wages. Rents are a little more simplistic – because wages are the driver. Next month we will learn what will happen to minimum wage and benefits next year, and that is an incredibly important announcement. It may be one of the first ones of (likely) Truss’ chancellor, and it will really set a stake in the ground for ongoing negotiations, public sector pay and strikes, and the overall approach – austerity? Boosterism and more Boris, Borrow Borrow Borrow to Build Build Build – I can’t see the party dropping the “levelling up” soundbite because it seems to go down so well. 


Indeed, it might be the case that massive borrowing to turn the pandemic into a 100-year debt a la War bonds, or the Marshall Plan, could paper over the cracks of a broken energy market over this winter and pave the way for an early election in Spring 2024 – not impossible if Labour still look relatively benign and unexciting in comparison. Better than waiting for a recession to really bite, which surely is a guaranteed loss, or at the very least a loss of a majority government and we will lurch towards coalitions, minority governments and/or hung parliaments. We will see.


The survival tips

Either way, the pieces of advice that do make sense are: build your warchests. Now is not the time to do marginal deals, and NEVER is it the time to be a motivated buyer. Look out for the “tipping point” – at the moment this is an orderly recession prediction, and it looks highly unlikely that government-led fiscal policy can avoid it. Usually, it isn’t like that – there’s a trigger event. Natural gas prices doubling again from here – for example. That may well be the trigger already, of course. Credit gets withdrawn. A major event involving the EU or other geopolitical risks being realised. Etc. etc. 


Keep your gearing robust, and fix debt. Now is not the time to bear upside risk. If it doesn’t work on the fixed rate, it doesn’t work – assets held for trophy reasons, or for the long term, or because “London never goes down” are not assets to be holding right now in my view. If it doesn’t cashflow, then take the capital you’ve made so far and reinvest it into something that does. Sharpish.


And then that last piece of advice. The one time when even Uncle Warren can sound a little predatory. Be greedy when others are fearful. That will very likely be a mantra to channel more than once over the coming 18 months. I’m still seeking to grow much more than I am to divest – I’m simply trimming off some assets which have outperformed, in areas that I am less bullish about going forwards, and using the proceeds to add some to the cash pile and swapping them for better structured, better cashflowing buildings or businesses. This never sounds like a bad idea – I know – but this is an example of being more strategically and tactically smarter than in a market that will simply carry everyone. What’s coming won’t, and those zombies who have been well looked after by microscopic base rates since March 2009 will see what’s coming surprise them like a slap around the face – this means opportunity, and you need to be in shape to make the most of those opportunities. 


As I said at the beginning, that doesn’t mean doing nothing. Far from it. That’s the worst thing to do. But have sensible criteria – be choosy – bid low – sure. And then follow up, follow up and follow up. Fallthroughs are likely to rise and a good percentage of people will already be very nervy, and likely make bad choices when they look to divest. Opportunity knocks at times like these – be ready, be bold and be the best you can be! Until next week……

inflation forecast