“Everyone has a plan until they get punched in the mouth” – Mike Tyson
Welcome to the supplement – delayed release this week for Father’s day! Happy Father’s day to all the dads out there. Week ending 19th June 2022 will, when the tale of the tape is put together about the post-covid era, be right in the thick of it, one way or another. The beginning of the end, or perhaps the end of the beginning; or, as looks increasingly less likely, the bottom for stocks and bond markets as a soft landing was skilfully executed by the respective central banks of the major powers in the Western World, including the UK.
The last one looks less likely for a number of reasons, but one is the divergence in tactics from the central banks. We’ve seen 3 tactics this week – one, in the UK, from the Bank of England; a prolonged rise with a very clear steer that the next meeting will see rates go up 0.25% again. The score on the monetary policy committee was an exact mirror of the score from last month’s meeting – 6-3 in favour of a 0.25% rate rise, with the minority all asking for a 0.5% rate rise. This time, the power of the governor shone through and “held hard” in the face of what has gone on in the other, larger central banks in the West. With each 6-weekly meeting of the MPC that passes, we get a clearer picture – we are now on 5 rises in a row and as I say, are short odds for a 6th rise at August’s meeting (set for Thursday 4th, for those who want to know when their floating rates will be going up again).
The messaging behind this is clear. Don’t be concerned – we’ve got this under control – and stronger action is not needed because the chief driver of this inflation here is not going to be quelled by rate rises. The economy needs brakes however, so that the inflation that has been caused by commodity price spikes, energy, and pandemic-induced stimulus does not become even more entrenched in the economy, fuelling a wage rise, price rise spiral.
The European central bank has gone down a different path. They’ve had a different concern. One of the many problems the ECB has is setting an appropriate base rate to suit the majority of its members. That doesn’t mean “one country, one vote” because, as is blindingly obvious, some members are more powerful and important than others (and have larger economies). The other nuance that is relevant here is that individual member states still have their own national government bonds, and those with good memories will remember back in the last decade when all the talk was of the PIGS (Portugal-Italy-Greece-Spain) and their entrenched indebtedness – and particularly the David vs Goliath battle fought by Yanis Varoufakis and the Greeks against the might of the whole EU.
They decided they needed an unscheduled meeting this week. These are normally reserved for really significant events – in the past decade, the unscheduled meetings of the Bank of England have been reserved for a surprise referendum result some 6 years ago, and around times of Covid lockdowns (in their first iteration in the UK) – looking back further, financial crises and major terrorist attacks have provided other reasons, as have wars.
The astute will have noticed that none of those have happened this week. However, the worst kept secret in the world is that the PIGS did not have their problems solved when this came to a head in the last decade. Austerity and tightening conditions were attempted to be imposed – and, as often bemoaned in those who have less than warm feelings to the EU, not always enforced. Think targets rather than quotas (just as OPEC+ do, these days, regarding the production of oil).
There’s a lot of debt, and not enough economic activity moving in the right direction in the countries in question to realistically pay for it. With negative interest rates on the deposit facility, and rates at zero for the main refinancing operations, since 2016, this is a slow and drawn out way of attempting to redress some of this balance and, effectively, ensure that capital is preserved for bondholders rather than allowing the weaker economies to default on their debts.
The emergency meetings are meant to do a number of things, but one is to calm the markets. What’s happened recently is a surge in bond yields – i.e., bond prices have come down, offering a better yield versus their face value. Italian 10-year bond yields passed 4% this week. This is very, very significant in the face of the low-rate environment we’ve been living in for much of the past decade – in February 2021 it was as low as 0.45%, although in the early part of the 2010s when the Eurozone debt crisis was raging, it was nearly at 7% – so we aren’t quite there yet!
Bond yields go up – borrowing to replace expiring debt becomes more expensive. People want more of a risk premium because the probability of a default becomes much more “live” again. Still a very low probability – but with all the extra covid debt around, there is much more risk, of course! A greater percentage of the government revenues (tax receipts, primarily) will go on servicing this debt, having a drag effect on what can be spent by the government, or worse, causing them to borrow more to pay more.
The meeting resulted in the announcement of a new tool to prevent divergence (the spread between the Italian bond yields and the German bond yields is watched very closely, and was widening at an alarming rate – seen as a gauge of the fear factor when it comes to the Euro bond markets), but was received in a relatively lukewarm fashion. There’s been a pledge to direct cash towards the most indebted/Southern European states. This seems strange, when you think about it – almost rewarding bad behaviour, and I can’t imagine it being particularly well received in Germany. As often, project EU takes precedence over individual nations, however, and with war in Europe, the value of the EU is, from a security perspective, as high as it has been this millennium, I’d venture.
It is difficult to write about central banks without using the phrase “kicking the can down the road”, but of course these “temporary measures” like Quantitative Easing have formed more of a permanent part of the central bank arsenal since the financial crisis (of course, Japan have been doing it since their crisis over 30 years ago, but likewise have done nothing in terms of growth since then, in real terms).
The US Federal reserve instead decided to kick more of a field goal – on the back of the surprise that didn’t surprise too many people who have been watching US inflation and the economy closely for the past couple of years – the expectation was the same number as April, 8.3% – instead the achieved number was 8.6%. The largest for over 40 years (a familiar headline when it comes to inflation these days). The number itself is problematic, but the direction of travel is more problematic, because this upside risk is where concerns really, really start and why you hear lots of analogies about getting genies back into bottles when it comes to inflation, and horses and stable doors, and the like. The Fed raised rates 0.75% in one go in a characteristically American, bullish fashion.
Until the inflation forecast is at least as many points over, compared to the achieved number, as it was under this month, the markets will not calm down. The pattern of the past decade and a little over – the markets rout, the Fed comes to the rescue – has not been played out in an environment where rates are 7% below the rate of inflation. Real rates of return are absolutely crippling and pension funds and the like lose serious money in real terms, which has a knock on effect to the people that those pension funds support – if Queen Victoria was here, I can assure you she would not be amused.
The real danger of a recession with rising yields is dawning upon the world. Recession, but inflation too high because it is not demand-related enough. The supply shocks need to calm down, to sort this out – this would be stagflation on steroids, or what is known as slumpflation. An economic slump (significant/sustained drop in output) in a time of inflation and rising unemployment. I’ve even seen skimpflation now mentioned – similar circumstances, addressed via a drop in quality (rather than shrinkflation – the shrinking of the size of products, as seen in chocolate bars over recent years). Enough ‘flation.
This is the final missing ingredient in whichever one of these horrendous terms you want to pick as a proxy for these tricky times. Employment. The job market is still very, very robust in the UK and the US. It is, of course, backed by consumer confidence but whilst that is very low at the moment, we have not seen those effects filter through just yet (they take some time, and are faster in the US than the UK, but the leading indicator is the number of job vacancies, which at the moment is still reaching record highs as the figures roll in, month on month).
Some of the consumption that is going on is also still underpinned by the household savings balances that exist – the governments and the central banks have little control over these, and limited ideas as to how long they can go on subsidising the higher cost of living – and this is a classic unknown, that can have unintended consequences, go on longer than expected, or end very suddenly, resulting in an output drop.
The end of free testing in the UK resulted in a 0.3% GDP drop (or, more accurately, was the given reason for this drop) in April. March was already a 0.1% drop. What’s often forgotten is that when we talk about GDP we are talking about real, i.e. inflation adjusted GDP. We do that VERY sparingly in terms of other statistics. To grow an economy when inflation is 9%, in real terms, we must grow a shade over 10% just to show a 1% real number. This shows you the enormity of the task, when you realise just how aggressive inflation is at the moment, and when you realise that the Bank of England have upped the Q4 2022 forecast to 11% annual inflation at its peak (and with energy crises still having upside risk, I am closer to 12-13% now over that period).
There are huge implications to rail strikes and union-driven industrial action in the upcoming weeks and months – as predicted some months back, social unrest is also, usually, not far behind in these situations. Anecdotally, most I’ve spoken to, and listened to on the temperature-taker that is radio phone-in shows, there is limited sympathy with the rail workers who are already well paid compared to the average salary, or compared to a nurse which is a favourite benchmark (of course, there’s folly in comparing one worker to another who is known and accepted by the vast majority of the population to be underpaid, but there you go) – those better informed understand that the shift to hybrid work has broken the railway business model and that we are still, as taxpayers, via the government, shovelling money into the rail franchises on a monthly basis.
The next strikes though, of course, won’t be rail workers. It will be something else. The negotiations are so important, and will be being watched in a hawk-like fashion – but I cannot imagine the operators, with the government breathing down their necks, having a lot of room to concede much in a loss-making environment. It also provides a perfect opportunity for a fall guy to explain why GDP falls further, because the country is “paralysed” by rail strikes (a lot less paralysed than it was whenever it happened before the pandemic, of course, thanks to 50% of jobs being able to be done remotely when necessary).
So where does all this leave us? In uncertainty, of course. What do you want in times of uncertainty? Workable cash reserves. Businesses trading with less than 6 months cost base in the bank are overtrading, right now. Working capital availability is key. Fixing rates wherever possible – yes, I bang that drum weekly at the moment, but it isn’t too late and these short-term rises are not going away. We may yet crash back down to zero – but not with inflation at 11%+, so prepare for rain.
Plan for the worst, hope for the best – those two outcomes are very, very far apart at the moment. If there was a time to hunker down – and I know, 2020-21 were very hard for everyone and there was lots of enforced hunkering down, and life is short and it is there for living – but big risks at this time are not sensible. Cashing in on some profit, especially if you are carrying a lot of fixed term debt, and it expires within the next 3 years, might be a sensible strategy and it is one where I’m practising what I preach!
Until next week – when I want to comment on the renters’ reform bill, amongst other things, but we are still at white paper stage of course – stay calm, at least until the next central bank meeting……