Supplement 070523 – God Save the Economy

May 6, 2023

“It follows that the goal of forecasting is not to see what’s coming. It is to advance the interests of the forecaster and the forecaster’s tribe.” – Philip Tetlock, Superforecasting: The Art and Science of Prediction.


Happy Coronation Sunday, and God Save the King regardless of the impact on the meek GDP of our great nation with his extra Bank Holiday. One thing the banks really can’t do at the moment – particularly in the US – is go on holiday, as further wobbles appear in the regional banking sector. My Rodcast investment mastermind pick for the quarter looks in trouble (or, in my opinion, worth doubling down on) – I chose buying the index for US regional banks if you missed that episode.


The logic behind my pick was simple – firstly, it is contrarian to buy when everyone else is selling. There is an argument that profits in the sector are in major trouble in the US – but I’m not buying it. The banks found ways to get through the post-2008 era in the UK and still make a fat wedge – this will, in my opinion, be the same. When JP Morgan announced the “rescue”/cheap purchase of First Republic this week, my other logic looked even more sound – there is consolidation afoot in that sector, whether the regulators want to avoid it or not – they have limited choice, in my view. 


In a throwback to the 1980s, PacWest also lurched into trouble losing a gigantic slice of its market cap in a smooth stroke – and all I could think of was Pacman, but Pacman being JP (or their compadres) gobbling up the small regional banks as if they were the pills that kept the yellow machine moving around that board. The question that remains, of course, is who are the ghosts?


Most of the bigger news this week has been very US-focused, because of the data release times; we have our own Central Bank meeting next week, of course, and at the risk of spoiling the surprise, the rates are going up 0.25% with a nod towards another 0.25% next time round. In my view. There’s still a lot of consensus that rates MUST drop soon – particularly in the US – and the yield curves for both countries are as inverted as they’ve been in this current cycle.


This means that immediate/short-term government debt provides stronger returns than longer dated debt. However, the US and the UK look quite different – the US has an extremely steep curve; for those familiar with the yield curve, you might well have seen the 2y/10y used as the recession indicator – but the 3m/10y has a far better track record. The more inverted it is, the more convinced the market is of a recession. In the US the difference was nearly 200 basis points on Thursday, after the Fed chairman laboured over his Q&A, showing some difficulty in explaining his plan and also understanding of the current situation. The US raised their base rate another 0.25% for those who missed it. 


The UK curve is inverted in the short term – in terms of 6m/10y (we don’t have a 3 month gilt by name, although at many points there are of course gilts with 3 months to maturity). 93 basis points is another surefire indicator of a recession, according to the market. 


There’s one mistake still being made though. The market is thinking that recession means rate cut – in the UK with inflation still at 10%, and core still well out of control at over 6%, there is no chance this is right. This is just how the problem has been dealt with in recent times. The central bank will, in my view, remain strong and keep raising rates to 5%+ if they need to, even in the event of recession. Their unspoken “hard stop” is not until 5.5% – 5.75% in my view, which I’ve pieced together from the Bank of England webinars, comments and Q and As, alongside the Bank’s MPC minutes.


In the US this is arguably even MORE true, but the funds rate is already at 5-5.25%, and this causes the US more problems because their debt as a percentage of their income is just so much higher. Their hard stop is a little short of that, I think, and that’s one reason why they hinted at a pause this week.


Let’s be clear – recession DOES mean rate cut, but it doesn’t mean immediate rate cut, and that’s the problem. Luckily for those of us that rely quite a lot on the 5-year bond yield, the UK curve does some really funny things – dropping to 3.6% or so for the 5-year (which puts cost of BTL debt at 5.5%+, a sensible range to plan for is 5.5%-7% depending on what sort of loan you might need/how quirky the building is), then coming right back up to nearly 4.2% on the 30-year yield (I’ll be honest, if I was a pension fund trustee or institutional asset manager, I would be absolutely smashing into that right now).


Why does the curve do that? The story is (according to the curve) – recession imminent, a cut in rates to stimulate the economy out of that recession, but then higher rates for the longer term because inflation will be endemic. That’s the story I read, anyway! I agree with parts of it; I’m not so sure the 5 year bond yield will stay this low, so let me make a statement I wish I’d been clearer about over the past few months:



There’s a live chance of 5%+ base right now, and a lot depends on the progress of the economy. We are in a perverse situation where we almost want a recession, although we are feeling the same consequences anyway in many ways. Everyone is poorer – like it or not – in purchasing power terms, unless you’ve managed a 25%+ pay/compensation increase in the past 18 months or so. Businesses sell less at higher prices and may see increases of earnings – generally – but those increases do not keep pace with inflation either. 


The chance of that base rate hinges on other economic performances, and if we look back to the US who release inflation figures next week, they released job data last week. The figure, which came back at over 250,000 new jobs created, continued to confound forecasters who thought that there had been a significant slowdown. Unemployment ticked back to only 3.4% in the US, and this means that rate rises are more likely in the short term, not less. 


The US also indicated a pause in their rate rises – which the market, desperate for the cut or the “Fed pivot” as it has come to be known over the past decade, interpreted as a sign that this cut was coming soon. As above, I disagree – the UK will play out in a similar way, I believe, but our cycle is a few months or even 6 months behind. Our core growth is also a lot weaker, but GDP doesn’t win elections. The economy is important of course, but that manifests itself at the moment in two main ways – the price of everything but particularly food, and the negotiations with the unions to strike pay deals. The latter is going better, in spite of the strong inflationary environment, with the NHS deal done (ex-doctors) and the doctors also making positive noises. The back of this is broken – once the teachers are sorted, and the offer seems to be getting much more broad and does even sound like the government is listening to the union, with concessions on workload as well as pay – the public support will wane to the extreme when we are left with the bones of Mick Lynch and the RMT, who the public have not supported in their majority in spite of enjoying Mr Lynch sticking it up the establishment with considerable skill.


The inflation promise is one of Rishi’s big problems. His support from the OBR, normally reliable, has been weak on this one. He saw forecasts of inflation down to 3% or below, and thought that halving it – which, being generous, would be 5.5% or under by the end of the year, was nailed on. It still is likely, but if April’s figures go as I expect and are still over 10%, it will soon be odds-against. All this pushes an election further away, in my view, particularly after the complete kicking the incumbents have taken in the local elections this week.


Labour is the largest party in local government since 2002, but nowhere near the dominance they had before the 1997 election, which was a landslide for Blair in case you missed it! It still is very close, even if the Conservatives met their most bearish predictions and lost over 1000 seats. This trend, if extrapolated, would mean a hung parliament in a general election – it will all be about momentum (Not Momentum, the far left group) from here!


The gap looks narrow. Let’s see what happens. Either way I see limited room for manoeuvre. In many ways it does remind me a bit of ‘97, because the likelihood is that there won’t be much money to spend and this is why Labour introduced the notorious PFI contract into healthcare and local and central government spending. The private finance initiative saw returns for investors underwritten by local authorities, in a time of fairly high interest rates. Some of those contracts pay out for 50 years and beyond, but it means using “off-balance sheet” debt in order to cook the books, to an extent. It is shadow banking at the very top level. As usual, if you were to try this your lenders would not be happy with you – but it is OK for the government to do so with our money rather than theirs.

I’m not entirely against PFI – there have been times to do it, which, of course, being a government decision, is exactly when they HAVEN’T done it. It is a bit like the gigantic opportunity Sunak missed in early 2021 to issue a significant amount of recovery bond debt and invest it in infrastructure or similar; it would have taken big vision, but with effectively zero servicing costs it was a simple commercial decision because even a 1% return annually on any money invested would have beaten the cost of that capital. Those same decisions now cost 4%, rather than 0.1%, and thus become very expensive indeed or easily unviable.


Otherwise, the money has to come from taxation, and something that looks like the “tech turnover tax” or Digital Services Tax to give it its correct name. In 2020-21 this little talked-about tax (because it comes from the companies everyone loves to hate on a tax front, but still use relentlessly) raised £358 million, and there is scope to increase this significantly. It is also a dangerous precedent, taxing on turnover, and is the main problem with Section 24, which has had a very clear negative impact on rental supply at this stage and is continuing to do so.


It’s interesting to study this tax just for a second – because this is just typical of how new taxes work. When VAT was introduced, it was introduced as a simple tax – it now has a manual just short of 1000 pages long. This could well expand its brief and it is easy to see why. From minutes in parliament:


In its first year, 2020–21, HMRC received £358 million in Digital Services Tax receipts. Altogether, 18 business groups paid Digital Services Tax. Around 90% of HMRC’s receipts for 2020–21 were provided by five business groups.Fourteen businesses paid more than expected (nine of those were not expected to pay anything). Four paid something but less than expected. Eleven who were expected to contribute paid nothing. In most cases, those who paid less than expected or nothing did so because of the impact of COVID-19. Thirteen of the 18 payers paid more in Digital Services Tax than in Corporation Tax. In September 2022, 46 business groups were still being assessed for their liability to pay the tax for 2020–21, so the total amount of tax payable for 2020–21 is still not finalised


Bearing in mind this is supposed to be a temporary tax (yeah right), phased out in 2024-25, I see no doubt this will be kept on because of the sentence I’ve highlighted. Yes, they got something rather than nothing, and it won’t take too much intelligence to guess who those 5 business groups are that paid 90% of the tax (with there being some fairly famous acronyms describing them, FAANG or MANGA if you prefer).


It’s clear that there will need to be planning for a change in administration, as the results of the local government elections kick in. Rishi’s five pledges are looking tough to deliver on time, but this government has pulled it out of the bag before, and is by far the best incarnation of the party from an economic perspective for years. I will write more extensively in the coming months about the pros and cons of a Labour government (or a coalition, which will be hotly denied, but Lib-Lab looks much more likely than anything else).


To me, the higher interest rate environment got even more entrenched this week. Many still feel that I’m missing something; I’m sure I am, I always am – but I have considered the argument the other way quite considerably. While we remain under 5.5% pay rate for resi mortgages, we just don’t have to cut – in spite of the fact that this is sending many businesses with variable rate debt down, or into significant cutbacks. That’s probably healthy as well – the system where no-one goes broke is the dangerous one, and equity and bondholders absolutely need to lose money sometimes. The failure to accept this in the EU debt crisis is why that will once again loom its head as the ECB continues to raise rates, and Varoufakis, the former Greek finance minister, will rise from the flames and continue to tell everyone about how right he was, and is. 


I wanted to share one aside before I sign out for this week to go and continue to pledge allegiance to the flag – or not – you decide? I had a number of very interesting phone calls this week about sizeable deals, which is a surefire sign things are moving and people are divesting – and I expect more next week when the Bank of England do the inevitable on Thursday. One was about the collapse of a group who were spearheaded by a former bankrupt who didn’t have his financial house in order and had overleveraged the assets of the group, on floating rate debt. 


The investor money – unsecured – in this situation – numbered an 8 figure sum. This is the second one of these since the high-profile JVIP bust some months ago, at an even more eye-watering sum. Full recovery has no hope at all, and avoiding complete loss will be a result. The likely returns are double figure pennies on the pound rather than single, although the person left in the mire perhaps has not accepted that just yet. There’s a couple of lessons from really good lenders that I know that I thought I’d share on the back of this story, for any active, or prospective, lenders out there who read the Supplement:

  • Underwrite the deal AND the person, AND their team. There’s no OR here, note. 100% of everything is needed. 
  • Don’t put your life savings into one investment. It shouldn’t be done. Diversify – not to get bigger returns – accept LESS, but in things that don’t correlate and have independent ways of making money
  • Face reality and take fast action when things go wrong. It’s property. Things DO go wrong. Sometimes accepting a small loss is absolutely the right thing to do. You won’t get double digit returns without breaking eggs. The entire financial world expects 4-5% returns annually in a pension with an eye on preserving capital. As soon as you go north of 5%, you are introducing bigger risks.
  • Don’t take risks you don’t get paid for. ‘Nuff said on that one!
  • Understand the price of debt and the capital stack. I can’t emphasise this one enough. Every 0.1% of LTV has a different price – I will write in future about this at a greater length, but understanding Senior Debt (and Stretched Senior), Mezzanine, Preference Shares and Ordinary Shares would be a good start!
  • Return OF investment before return ON investment. Well worth remembering Uncle Warren’s rule here.


Lending your money is one more shiny penny. You MUST remember rule 6 above all others. It’s hard to do, NOT easy. There’s stress and risk. Please don’t risk your life savings with one individual who speaks well. I met the person in question in 2016 and said one thing after I had done so to the person I attended that meeting with. “He’s been bankrupt before, and with his attitude, he will be bankrupt again”. And so it came to pass. 


With all that in mind – Keep Calm and Carry On, until next week!