Sunday Supplement – Is the Smoke Clearing?

Nov 13, 2022

“Having been forced into being the only game in town, they (Central banks) now find that their destiny is no longer entirely or even mostly theirs to control. The legacy of their exceptional period of hyper policy experimentation is now in the hands of governments and their political bosses” – Mohamed El-Erian, The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse


Welcome to the supplement – shall I start telling you yet how many there will be before Christmas? Too early? It was for me when earlier this week I was in the car with my wife and a Christmas song starting pinging out through the speakers……


Swaps heading in the right direction

We’ve had another week of international action and happily have seen a couple of important milestones passed. Firstly and most relevantly, the 5-year SONIA swap (the market upon which a decent amount of the mortgage lending in the UK is based) went under 4%, touching 3.80 one day; in the height of the Truss crisis, it was over 5%, so this is a big move in the right direction. Remember this is the most influential metric in setting the pricing of 5-year fixed rate mortgages of all kinds – all the packaged lenders can lend at the 5-year swap, plus operating costs, plus a margin. The markets have confidence in the team currently in place, despite the enormity of the task which they face (although how could you have less confidence in the previous team!?).


US Midterms

The US election has in the meantime spooked markets because the much-publicised “Red Wave” did not materialise in a meaningful way, which is a fair surprise although the pollsters seem to have missed, in their predictions, exactly what the woman-on-the-street’s reaction would be to the repealing of Roe vs Wade by the Republican-controlled supreme court. The democrats have retained control of the senate, regardless of the runoff election in Georgia which involves one of those “only-in-America” situations where a former NFL star, who fairly clearly espouses “do-as-I-say-not-as-I-do”, is running for election to the Senate. The runoff isn’t until early December, but the Nevada result has cemented it for the Dems. The “Red Ripple”, as it has turned out to be, currently sees the Republicans better off by 6 seats net (in the House, where there are 435 voting officials). Always makes you chuckle somewhat that there are more elected officials in the UK parliament despite the size of the population and the country!


Crypto Meltdown

Even bigger news in a smaller bubble in the US this week has been the seeming undoing of crypto billionaire Sam Bankman-Fried (or Sam Bankrupt-Fried perhaps) and his exchange FTX, which has proven too toxic for any of the major exchanges to try and save. This reminds me of a similar event back in my days heading up a betting syndicate – the rival exchange to Betfair (now a public company), Sporting Options, was declared insolvent and Betfair came in to bail out all customers facing losses, because the cost of doing that was far lower than the cost in shaking confidence in the betting exchange product. That paid off. Betfair was so much larger than Sporting Options that this was not a major issue, and Betfair did not bail out everyone but offered a commission rebate structure for balances of over £1,000. Clever, and good business – Binance or one of the other exchanges could take a lesson from that, I think. Interestingly, the story was nearly exactly the same – it appears that in order to create liquidity, a connected company was providing liquidity – it looks like that connected company has around $10bn in losses, because the market makers were not as smart as the market takers – but where did the $10bn come from in the first place? From the exchange of course, which was never going to use the funds that people had deposited in order to trade on the exchange of course – because of this fantastic transparency, and the lack of “horrific” government intervention and regulation – and unsurprisingly, with scant oversight and regulation, that’s exactly what has happened.


When people are facing significant losses, I’ve written before about how I dislike those who revel in the situation. Now is not the time – now is the time to reach out to those who have lost money and support them, mentally if not financially. Crypto is, was and always has been a form of gambling – I’ve said it many times over the years – and the number of risks people are taking that they just don’t understand at all are their undoing. Security risks. Counterparty risks. Extreme volatility. That’s before we even start on how hard it is to be a good trader. I was sickened – then, on reflection, I was only surprised that I was surprised – when I heard how many ex-gambling addicts who had got their lives back on track, had then descended into a Crypto bloodbath because it was not being looked upon as gambling, when in fact that’s exactly what it always was and always is (and stocks and shares, if trading in and out on any kind of regular basis, are not much different). 


Still, the wider relevance for the majority who are not involved in Crypto is the risk of contagion into other markets. Consumers are already extremely bearish, and earnings forecasts are being revised down at a rate of knots. Amazon have already cut Q4 revenue forecasts from $155bn (analysts) to $140-$148bn and tech has been taking a big bath, although there’s no sector more likely to lose your job in than tech, this week, it seems, with Meta shedding 11,000 staff and Musk taking the sword to Twitter since his utterly unnecessary flight-of-fancy takeover of the company some weeks ago. How one person can be such a genius and such an idiot at the same time is almost unexplainable! Having said that, the volatility has again been extreme thanks to some positive (all relative, prices still rising) inflation news in the US.


Consumer confidence on the floor – but bond yields falling. Recessions being discussed are only a question of how deep, and how long. Auction properties selling at one of the record-lowest percentage conversion rates in history since the data began. It looks terribly bleak, doesn’t it?


Remember the essentials

Not necessarily. Not for those of us that remember that we are in a low-risk, slow-moving, utterly essential sector of the economy. For some of us, me included – that’s why they are in property from an investment point of view. Over a decade ago, I saw a rental market that was poorly served, with terrible product (the quality of which has increased so much in the past decade, although never mentioned in the press of course), and a real need for housing from the customer/problem-solving point of view – with the backdrop of a price adjustment after 2008, and a low cost of borrowing.


Rent growth looks irresistible – bad news for the tenant of course, and the reality is that the increases are not making up for the squeeze in the margins right now – so barely good news for the landlords. Affordability is an issue, although there is still headroom in much of the market (geographically)  and the expectations for wage growth are still healthy for next year, simply because of the tightness of the labour market and the cost of living situation – although there is a careful tightrope to walk to ensure we don’t see the sort of wage/price spirals from the 1970s that truly took the situation out of control.


The end of the rises?

It does seem though that we’ve seen the short sharp shock and potentially seen the ceiling in the bond markets for the moment or even, dare I say it, for this particular cycle. It might not feel like it for those on base-rate tracker style products, but we could – I emphasise COULD – be over the worst of it and near the intended high, at least as far as the central bank is concerned.


This is a big statement and my own needle has been moved significantly this week by my attendance at the local Bank of England breakfast briefing. The meeting last week, and resultant webinar, was mentioned last week but the briefing this week brought me greater insight.


Strong Guidance from the Bank

For regular readers you will recall my conversation from the last breakfast briefing, where I got the naughty schoolboy treatment for asking the rep whether the stress test at base of 6% was sufficient (given that the market at the time had a base rate of above 6% as the peak rate for 2023). I asked the regular rep (who was not in attendance last time) about this question and where the Bank really felt they were on this issue, one to one. I got a much more substantial answer – the most direction I’ve ever received from the Bank on the interest rate issue as it stands. The rep simply said to me – I have got some extensive information in the presentation about the base rate, and I will put some extra colour around it in order to answer your question – and if you feel I don’t answer it, then please email me. A vastly improved answer compared to my metaphorical slap on the wrist!


The presentation then ensued and contained multiple hints that the Bank feels that the current base rate at 3% is sufficient at this time. The rep openly said, a number of times, that the market has got it wrong (still expecting base rate to peak at 4.75% or so in 2023) – much more definitely than he has in the past (although this narrative has been a commonplace occurrence this year, constantly stating that the market expectations were too high). They even went as far as to plot out what the expected recession looks like based on the market’s expected interest rate – that was the one that made all the miserable headlines, 8-quarter recession, on a par with 2008 or thereabouts; then plotted out what the recession would look like if they hold base at 3% throughout that period – much shorter, much shallower.


This felt to me like I was eavesdropping on a conversation between the Bank and the Treasury/HM Government. Effectively, the Bank is saying “Don’t make us raise rates any more. Please. Let’s sort the rest out with fiscal policy?”


US inflation over the peak? Too early to say

The flip side is that the government doesn’t want a recession at all, of course; certainly not before the next election. All of this looks like great news, and then we had another piece of good news on Thursday, as US inflation data was 0.2% lower than expectations. This is the miss that we’ve been waiting for – but we do need to remember that one swallow doesn’t make a summer. The stock market rocketed up – and it MIGHT be the turn of the corner for the US (although I doubt the path will be this smooth) – but the US are miles ahead of the UK in terms of this cycle. This news sent the UK gilt yields sharply downwards as the 5 year UK gilt hit 3.25% on the downside on Thursday. This represents another saving of perhaps 0.25% on fixed mortgage rates, although likely a couple of weeks to see this filtering through; everything going in the right direction.


Recession guaranteed?

A couple of major caveats here of course. Firstly – it has been this sort of year. The markets are still too wedded to the lower rates of interest, in my view, that we’ve been enjoying as borrowers for the past 13 years or so. Good news and reactions downwards – then bad news and yields surging back upwards. This was almost immediately proven to be correct because on Friday we had the news that the initial GDP estimate (there will be revisions, plural) is that GDP contracted by 0.2% in the third quarter. This 0.2% was the amount the economy had grown in the second quarter. Rather than focus on the basis points for a moment – what this does show is that the economy has effectively ground to a halt in real terms – or, more accurately and perhaps what represents what we really feel in the pocket – AFTER inflation adjustments, there has been no growth. 


A closer inspection of Q3 does explain this really quite quickly, however. The Queen’s passing in September was truly a momentous event, for many reasons. September alone saw a GDP drop of 0.6%, mostly explained by the period of national mourning including an extra bank holiday. Without this – or, alternatively phrased if the passing had not happened until Q4, which has looked economically tough all year and is usually a tough quarter – the headlines wouldn’t have cranked into gear around recessions, just yet. 


Energy, specifically Natural Gas

The other caveat – and perhaps more bearish (sorry). The futures prices on energy. The current calculations being done by the Bank of England are based around the Government still providing a level of protection, particularly to the most vulnerable households, on energy prices after 31st March 2023 when the “cap of the cap” is lifted. Prices looked very bad when Truss announced her policy to cap the energy costs to both households and businesses. They’ve moved upwards significantly since then, particularly natural gas. The average price of 200p a therm or thereabouts for 2022 thus far, is now the LOWEST price that the futures go back to by the end of 2025. In the next 18 months or so, the average price looks like 350p a therm or a 75% increase from where we are today. This is crippling, and the Governmental bailout bill is spiralling upwards, which, with the fiscally prudent Hunt in charge with reminders of what it would mean if he were NOT fiscally prudent, means deeper cuts and higher taxes than ever planned before. 


Futures could of course keep going the wrong way, as well. There has been a massive bump in the curve since August, although the Russian withdrawal from Kherson may well make an impact when markets open tomorrow. It would be naive to pin the world’s energy problems all on Ukraine and Russia however; even in a time of calm, IF that comes relatively quickly in the war, there are still major issues as energy demands keep going up (as the world’s population nears 8 billion) while energy supply is trending downwards, both naturally and artificially thanks to the actions of Russia, OPEC+, and also environmental pressures. 


Just Stop Protesting

On that subject – “Just Stop Oil” must be the most intergalactically stupid name for an organisation that anyone has ever conceptualised. The complete opposite of “Black Lives Matter” – one is self-evidently true (regardless of the political machinations behind the name), the other is self-evidently completely idiotic. The number of deaths if we “Just Stopped Oil” would make climate change look an awful lot MORE attractive, and I have become sick of hearing spokespeople on the radio saying “Ask the economists” – if you ask this one, he will tell you what you might not want to hear – the balance is a fine one, and get the withdrawal of fossil fuels/the transition to clean/renewable wrong and you will face quite literally billions of deaths worldwide, in short order. Everyone is on board with the cause when it comes to carbon neutrality, I think, these days. The HOW is the problematic part and such brute force suggestions and solutions are not solutions at all. 


The Budget

This coming Thursday sees the Autumn Statement and the smart money is backing £35bn or so of Government spending cuts, and £20bn in extra tax revenue. Freezing the tax allowances (as has been planned until 2026) is already going to raise a significant amount of revenue as inflation hurts all earners who are involved in those thresholds, and the suggestion is that the 45% band, “abolished” less than 2 months ago, will instead have its threshold moved down to £125,000. It might be a good time to put things into context and remind those who are near the political centre and retain some balance that there has been a gigantic wealth transfer from the Government to the households since 2020 – over a trillion pounds – and nearly all of that is explained by two things – increases in land and property values, and increases in stock markets which have benefited pension schemes of the defined benefit kind, of which very few people under 45 or so will have much exposure to at all. 


What happened to Build, Build, Build? It feels like Tax, Tax, Tax

These are not the same people that pay income tax at the highest rate, unfortunately – so the fairness of the tax system will be legitimately called into question once again. However, if the Government is to continue supporting households through the energy crisis (and not to do so is fairly unthinkable, and fears of the 1970s three-day-week are clearly fresh in the mind), some fairly drastic fiscal action is to be needed to save the Bank of England from cranking up the rates yet higher.

After this week we have one more big week of news this year on the economic front, although I’m sure the announcement of the UK’s CPI/RPI for October will also move markets (and I’m still expecting us to miss to the upside, as well) – current figures are 10.1 for CPI and 12.6 for RPI, consensus forecasts are 10.6 and 13.4, and I expect nearer to 11 and north of 13.5, personally. If we overshoot by 0.2% or more, the yields will take another walk to the upside, as the message will be the opposite of that in the US, and Wednesday is the big day. The big day left is the final Bank of England policy meeting in December on 16th – and the likely outcome there looks like 0.25% upwards, to me, when inflation news disappoints again this week. There will be one or two votes not to put the rate up any more though, of course, and you can sympathise with the Bank needing to reiterate to the markets that they will continue the inflation battle until inflation is extinguished, or at least is heading downwards. Even the Bank’s forecast sees inflation at or above 11% by the end of this year/in early 2023, and I’m afraid I think it will be slightly above that (perhaps 11.5, hopefully not 12). 


So that’s a mega macro wrap this week, but this is the first week that I really started to see a path away from eternal interest rate rises, a break in the clouds; if that is the case, base might well find a level at around 3.5%. Q1 has 2 meetings in 2023 for the Bank – 2nd February and 23rd March. I would expect economic doldrums to be hit by the time of the first meeting, simply because the temperatures will have seen the UK gas go on in a big way, and the lack of storage means that we only have enough for half a cold month before being at the mercy of the spot markets, which are highly volatile. 


Hard yards ahead, but a plan

Our path forwards as investors remains both difficult and clear; we need to structure our assets defensively in this period, ensuring tight management and concentrating on income and cash-producing assets and businesses, including the business of selling our own time and effort or human capital as economists prefer to call it – the fixed rates that have trended near to 7% are on a path, although somewhat volatile still, downwards at this time, especially when the Bank’s intentions for the December meeting become more clear. There will be a feeling that the volatility bump caused by Truss might be a good thing in the end if we’ve seen the top of the yields, and we are moving much more quickly back towards something that looks like the monetary policy of the early 2000s, which was accommodative – this will only hold up if rents keep increasing at the rate they are, however, in order to return some yield to the rental market. Pressure looks incredible on the Treasury to lift benefits by inflation and this will be gigantic for the housing market going forwards – there have been mixed messages here and I myself have very mixed feelings on the subject, so I will refrain from further comment until we know the answer after Thursday.


Rates also heading in the right direction

We have seen some 5.69% earlier this week on 5-year limited company fixes and the 5-year residential rate (which I watch as the single most influential rate in the market) has taken a significant move to the downside in the past few weeks, happily – to under the stress rate from the past 10 years, the 5.5%, which is absolutely key for a functional housing lending market. There are still significant challenges (and I expect a solution to the help-to-buy withdrawal this week; if there isn’t one, expect housebuilding shares to take a serious bath), and the 5-6 weeks left of the housing market before Xmas shutdown will be interesting. 


Darling you got to let me know……should I buy or should I wait?

For the buyers, there will be significant opportunity coming – no need to wait, it is already there in the auction market, particularly in unsold lots and those that were not even offered in recent auctions due to lack of interest but were listed/lotted – work to be done, offers to be made. For the first time in many months I’ve felt like we might know enough to have seen the worst of the rates, but without anywhere near the whole picture of the incidence of the rate rises on the wider market, just yet.


You know what comes next…..keep calm……carry on……more next week!