Tears were shed in the last week.
They were tears of laughter rolling down the cheeks of the Bank of England, the IMF, the Federal Reserve, and the ECB. They represent the old guard who dug the deep financial hole over the last 10 years, the one from which extraction can be nothing less than painful. Then in one day of stupidity from Cwazy Kwarteng, a decade of errors by central bankers were forgotten. Oh they laughed. At a stroke, the central bankers were off the naughty step – for now.
But it is important to see the context, not be either too parochial or short-termist, and see what we can learn.
The last month has been a news rollercoaster, and it ended on Friday with the UK’s mini-Budget, as a result of which one journalist was heard saying that the UK stock market is plummeting and the economy is being destroyed. There is lots to unravel in today’s update, which ends with conclusions on financial markets.
The big news in the UK was undoubtedly the sad death of Queen Elizabeth. As the world was spinning towards Great Depression III in 2008, the Queen confronted the big financial brains by asking “why did no one see this coming?”. Again, in 2012, she prodded the UK regulators and asked if complacency added to the 2008 crisis. Nothing was done.
The Queen probably didn’t think that such an obviously avoidable mess would be repeated in her lifetime. It was clear that something had to change, but nothing did and prior complacency, of politicians and central banks and regulators, was soon re-established. As we entered 2022, the vulnerability of financial markets and the economy (UK and global) was much greater than in 2008.
Much needed doing, and still needs doing. But by who?
I have often referred to the central banks as having an impressive track record of failure, whether the Bank of England, the US Federal Reserve or otherwise, and recently asked “If you can’t trust the actions and forecasts of central bankers, what about politicians?”. The evidence of last week is, at best, mixed.
But let’s start with the US.
On 14th August the US announced that their core inflation, the stickier inflation, unexpectedly accelerated to 6.3%. Some of the most balanced analysts, previously cautious optimists, had the optimism shaken out of them.
The US Federal Reserve was left with no choice but to push rates up by another 0.75% and is clearly in no mood to back off dealing with inflation. It isn’t just that they need to rebuild their credibility – though that is an issue. They also get that the wage-price spiral must be stopped fast.
Higher interest rates will cause considerable short-term pain in the economy. But rather that than leaving the problem unsolved, and having much higher interest rates, unnecessarily, for many years to come, and rolling economic chaos.
Bank of England Underperformed Again
This is not a lesson which the Bank of England has yet taken on board, and they underperformed again last week, on Thursday, with a rate rise of just 0.5%, to 2.25%.
If you are determined to get inflation under control, the guideline is that interest rates must be higher than inflation, and core inflation in the UK is 6.3% - much higher than 2.25%. Unless core inflation comes down fast, and soon, the implication is interest rates are heading towards 7%. [Back in July we suggested 6% interest rates lay ahead, it wasn’t a difficult calculation. As of last Friday’s mini-Budget, the media reported: “shock” that “markets” now expect 6%, which has “come out of the blue”! Not really.]
As I said in May, and on various occasions in the last 3-4 years, “a couple of generations used to low inflation and low interest rates are about to get a rude shock”.
The Bank of England also suggested that the UK might already be in recession. Hardly a revelation. A recession began in April when people were told their energy bills had gone up by 50%. A recession occurs when a broad cross-section of people and businesses begin to change their behaviour, and that was from April when even those who could afford to pay began to behave differently – you only needed to ask friends and family.
That change of mood also impacts the stock market – lack of confidence hits our investing habits as well as spending habits – more on that in a moment.
Mini Budget, Major Chaos
With the mini-Budget last Friday the new Conservative government was left with a balancing act. The UK and much of the developed world are suffering from stagflation – stagnation or recession combined with inflation. This is a nasty and rare economic phenomenon, for which the cure is painful.
The priority is the cure for inflation, because if that is not quelled, higher inflation and lower growth will persist for many years. That cure has to be applied by the central bank raising interest rates, and staying focused on doing so until it is clear that inflation is heading back to 2%.
In parallel, the government has to decide how to deal with the stagnation. Should they help those suffering the inevitable recession? If so, who and to what extent? And what can be afforded? Whatever that action, they need to be sure not to stoke the inflation problem. That is the balance which should be struck.
It was obvious that the proposed tax increases of the previous (also Conservative) government would be reversed. Beyond that a bit of signalling was required about new policies for growth e.g. rebuilding Victorian infrastructure, reducing student debt, overhauling the care system, incentivising a “greening” of housing stock, a bonfire of regulations, encouraging investment, particularly in technology… The list is a long one because nothing had been done for a decade and more – politicians ducked when there had been a need for leadership.
What we got was an incredibly bizarre collection of tax cuts, certain to instantly undermine the credibility of the new Chancellor, because the risk is that they will stoke inflation, which would not have been the case if tax cuts, even temporary ones, had been focused on those most in need. Were those individuals paying 45% tax, and earning over £150,000, in need of a pick-me-up? Bankers’ bonuses to be uncapped? A PR disaster.
It was worse than just a PR disaster. It wasn’t that the sums didn’t add up. There were no sums!
The reaction of the media was predictably hysterical. One Guardian journalist proclaimed that the stock market had plummeted and the economy was being destroyed. The latter was a silly thing to say. The former was just made up. On Friday the UK stock market closed down 1.97% - the same as Germany, and less than France, down 2.28%. The US stock market also ended down by 1.72%.
It was currencies which caught the headlines on Friday and created hype and hysteria. The currency rate of a country measures the confidence of overseas investors for sure, but it is also a macho indicator – weak currency, weak country. This feeds headlines, and the headlines feed the febrile mood which means that currency dealers can make a killing.
The currency hysteria is overdone. Sterling has fallen just over 20% since the beginning of the year versus the US dollar. That isn’t too terrible relative to other currencies versus a very strong dollar. The euro is down 22%, and the yen down 40%.
Today, a week later, sterling is back to where it was before the mini-Budget.
It was bond markets which reacted in the most worrying fashion, but bonds aren’t sexy and tend not to create headlines.
Bonds have been heading south around the globe for some time. But the UK government bond market came under specific pressure in recent days, “disorderly” in the parlance, forcing the Bank of England to intervene on Wednesday (28th September).
It emerged on Wednesday that the UK government bond market had become illiquid. Doubtless, more details will emerge on this in the coming days, but we have been talking about the coming liquidity problem for years. Liquidity can be defined as “who will buy when I want to sell?”.
Worryingly, government bonds are the most liquid financial market – so if they have liquidity problems, there really is a major problem. This will more obviously be seen as a global bond market problem in the coming months, and will likely also be replicated in stock markets.
There are already rumblings in the US about their government bonds, but they don’t get much coverage in our parochial press. The US government bond market is the most liquid in the world, yet has been hit “with its most severe bout of turbulence… underscoring how big swings in bonds and currencies and jitters over US rate rises have spooked investors” (FT yesterday).
How about Japan? There was massive action last week by the Bank of Japan to fend off hedge funds betting $7 billion against the yen.
There is more. But it suffices to say that there is a serious, multi-faceted, global crisis unfolding, probably only in its early stages. So let’s not be too parochial.
By the end of the year, we should hear about much more constructive, and better thought-through, UK policy initiatives. Fingers crossed. But this is a minor matter in the context of unfolding events in global financial markets and economies.
The point is that we must not become obsessed by domestic headlines. The proximate cause of the growing problems is central bank errors over the last 10 years, creating an investor mania and market valuation bubble, and a vulnerability and sensitivity which is now coming into focus.
Getting out of this hole was always going to be painful, and not just for investors. Even before interest rates get close to their peak, there is a global cost-of-living crisis, aided and abetted by the pandemic and the Russian invasion of Ukraine.
Tread carefully. If you can preserve capital now, when this “adjustment” for markets is over there will be some of the best opportunities of your lifetime – but for now we need to remain cautious and patient.