Time for investors to learn a new game
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The times are seriously out of joint. That much is clear from the recent turmoil in the market for UK government bonds and the gyrations of sterling.
These febrile events followed Chancellor Kwasi Kwarteng’s shock “mini” Budget with its uncosted approach to the public finances, along with the Bank of England’s minuscule 0.5 per cent increase in the base rate to 2.25 per cent in the face of looming double-figure inflation.
Despite the ballooning increase in consumer prices, the Bank has now retreated from its proposed quantitative tightening back to quantitative easing.
This means a shift from promising to unload government bonds — known as gilts — acquired in the period since the financial crisis of 2007-09 and to start buying again. The Bank acted in response to a dangerous squeeze on pension funds that were short of collateral to support the investment strategies they were using to match their liabilities, that is payments to pensioners.
Officials were no doubt worried that a disorderly gilts market, among the world’s supposedly safest assets, could expose vulnerabilities in systemically-important banks and other financial institutions that were counterparties of stretched pension funds.
What is inescapable is that the government under prime minister Liz Truss has lost the confidence of many in the markets. Its borrowing costs are now greater than those of Greece or Italy, despite having a much lower ratio of debt to gross domestic product — 86 per cent compared with 157 per cent and 122 per cent for these two countries respectively.
For retail investors, one conclusion is that the Bank of England’s mandate to ensure financial stability has trumped its obligation to control inflation.
The Bank is committed to stop supporting the gilt market by October 14. If it feels a need to continue beyond that date a recession — probably a necessary cure for the current excess demand for labour — would be potentially deferred at the price of much higher inflation.
Investors should also realise that most Britons will be poorer because, notwithstanding the Bank of England’s rescue mission, inflation is eroding living standards. Borrowing costs are rising steeply for mortgage holders and businesses, offsetting the benefit of the mini budget’s tax cuts.
Markets now expect the base rate to peak at between 5 and 6 per cent.
In considering how to tailor their portfolios and personal finances to these fast-changing circumstances, investors need to look beyond the pension fund fiasco. They must ask what kind of world we are in.
A changing world
The world we have come from is one where the interest rate regime was heavily influenced by savings behaviour in China and other emerging markets.
By maintaining undervalued currencies for much of the past 30 years or so to support export-led growth, Beijing and other Asian capitals racked up large current account surpluses and created an astonishing accumulation of foreign exchange reserves. In China’s case these now stand at well over $3tn.
Such reserves, which reflected these countries’ surplus of savings over domestic investment, helped depress the risk-free interest rate in global government bond markets while fuelling debt-dependent growth in advanced countries — including the UK.
In the wake of the 2008-09 financial crisis, governments ran tight fiscal policies while central bankers adopted ultra-loose monetary policy, with low or negative nominal rates of interest.
Inflation remained subdued partly thanks to a huge supply side shock whereby the introduction of Asian and eastern European cheap labour into the world economy ensured that the balance of power between capital and labour in the developed world was tilted firmly in favour of the owners of capital — and against workers.
The cheapening of labour relative to capital resulted in lower investment and weaker demand in advanced countries, not least Britain. Meanwhile, other factors were pushing in the same direction.
Pascal Blanqué, chair of the Amundi Institute, the research arm of the Amundi investment group, argues that investors’ demand for excessive returns on equity combined with an artificially low cost of capital contributed to under-investment in most sectors of the “old” economy. This went hand in hand with an implicit preference by investors for high-dividend policies, share buybacks and mergers and acquisitions at the expense of capital expenditure and wages.
An artificially low cost of capital, adds Blanqué, means that the discount factor used to calculate the net present value of assets’ income streams pushes the value upwards, diverting capital and cash flows away from productive tangible assets in essential industries and into leveraging existing assets.
That helps explain why, with the pandemic and the war in Ukraine, shortages and inflationary pressures are being felt way beyond the energy and food sectors. Low discount rates have likewise pumped up market values in the tech sector. If Blanqué’s under-investment thesis is right, it means that inflation will come down more slowly than markets currently expect.
The coming recession
As has so often happened in history, a pandemic and war have imposed a dramatic change of economic direction. Many features of the low-interest paradigm have gone into reverse, not least because of Covid-19 and the war in Ukraine. Most strikingly, the balance between fiscal and monetary policy has been turned on its head. To counter Covid, governments spent liberally while central bankers responded belatedly to soaring inflation with increasingly aggressive interest rate hikes.
Reserve accumulation in the developing world is past its peak. And while China’s renminbi last week reached its lowest level against the dollar since 2008, Beijing is actually reorientating policy from export-led growth to increased consumption at home. That will reduce the current account surplus and curb outflows into the US Treasury market.
The heightening of geopolitical tension between Washington and Beijing also points to a world in which China will financially decouple to some degree from the US. Opec oil producers might likewise stop recycling petrodollars into US Treasuries. That would put upward pressure on long-term interest rates, notably in the US and spreading quickly elsewhere, including Britain.
As for labour markets they are at their tightest for years. UK strikes on the railways, in waste collection and the postal service tell us that the balance of power has tilted back in favour of labour relative to capital. The trend is equally apparent in the US. So the days of ultra-low interest rates are over and central banks will find it much more difficult to keep inflation within their target ranges.
Adding to that difficulty is a big demographic shift. As Charles Goodhart and Manoj Pradhan have argued in a recent book, The Great Demographic Reversal, ageing populations in the developed world will shrink the workforce and thus help re-empower workers.
This is fuelling a distributional struggle in which older people, who tend to vote more than the young, try to recoup income from the workers via the ballot box.
At the same time, globalisation, which weakened union power and contributed to the low interest rate regime, is in retreat. Complex cross-border supply chains established by companies over the past 20 years have been disrupted by geopolitical friction between the US and China along with the Russian invasion of Ukraine.
In this new climate, governments are retreating from the free market ideology of the Reagan-Thatcher era and rediscovering industrial policy. They are encouraging multinationals to reshore and trying to promote strategically important domestic industries in areas such as microchips. Geopolitical pressure is bumping up defence spending. And the state will probably play an increasingly important role in decarbonisation.
For their part, industrialists, having single-mindedly pursued economic efficiency in their cross-border investments, are now building resilience into their business portfolios. Against this background the Truss government, with its small state, low tax, liberalising instincts, is swimming against a powerful global tide.
While central bankers would like to secure a soft landing for their economies, they have realised, as inflation has surged beyond their expectations, that a key lesson of the 1970s stagflation was that a mild recession today is a price worth paying to avoid worse inflation and a bigger recession later on.
In North America, the UK and the eurozone recession looks inevitable. But a really deep global recession looks unlikely because both China and Japan, two of the world’s largest economies, are easing monetary policy while others tighten.
The retreat from quantitative easing in the West means that the systematic mispricing of risk and misallocation of capital since the financial crisis is now unwinding. Markets are being re-empowered, as we saw in the gilt market pension fund brouhaha before the Bank of England intervened. With public deficits and debt at sky-high levels, the bond vigilantes who staged buying strikes in the bond markets in the late 1970s and the 1980s will be back.
The stage is set for financial instability as the world shifts from a disinflationary climate to a higher inflation environment. Markets will be volatile as perceptions about recession versus a soft landing wax and wane while worries about monetary overkill, especially in the US, come and go.
What now for investors?
With stagflation, bonds cannot provide a hedge against recession and against volatility in equities. Diversification is hard to achieve. The bond bear market looks set to continue. The reversal of the very liberal trade and investment regime that prevailed before the pandemic and Ukraine, the need for a substantial overhaul of global industry and infrastructure to secure the transition to low carbon, and a much tighter labour market all mean that profits will be under pressure with the corporate share of national income set to decline. This is not great for equities.
The best historical guide to how asset prices might respond to this newly inflationary, lower-profit environment is the great inflation of 1965-82 when central banks lost control of the money supply and the world had to cope with the oil price shocks that followed the Yom Kippur war of 1973-74 and the Iranian revolution of 1978-79.
According to fund manager PGIM, US inflation and unemployment went from 1 per cent and 5 per cent respectively in 1964 to nearly 14.5 per cent and 7.5 per cent by summer 1980.
The experience in the UK was far worse, with inflation peaking on the retail price index at close to 27 per cent in the mid-1970s while unemployment reached double figures by the early 1980s. Gold surged phenomenally but collapsed after 1979, whereas commodities, which showed a comparable surge, lost less of their value in the 1980s. Commercial and residential property bubbles in the UK burst in the mid-1970s but prices then recovered. Real assets proved to be bolt holes in the storm.
Dario Perkins of research house TS Lombard argues that investors now need to look for exposure to the real economy, especially those sectors that stand to benefit from deglobalisation, the green transition and higher public investment. This is a world, he thinks, where tangible assets such as commodities, real estate and value stocks will do well, ending the dominance of companies based on intangibles, such as the tech giants.
Subdued inflation and low interest rates, he adds, favoured intangible assets, but this advantage disappears in a reflationary environment and not just because intangible assets have longer duration.
There is now a scarcity premium on physical assets, increased uncertainty about future returns and disincentives for the various forms of financial engineering that boosted intangible valuations during the 2010s. The scalability of intangible businesses meant that they benefited disproportionately from globalisation, an advantage that is now diminishing.
One message for investors, then, is that boring is back.
Still, the transition to low carbon means there will be new growth opportunities. The view among professional investors is that climate change risk is not efficiently priced in markets, which is good for active fund managers and astute private investors.
That said, inflation involves a politically unsanctioned transfer of value from creditors to debtors, while making life harder for would-be debtors seeking to enter the housing market.
For older people, working longer will be the best way of addressing the cost of living crisis. We must all hope that politicians and central bankers will find their way through to a lower-inflation environment without too much recessionary pain. In the UK, the Truss government’s inauspicious start suggests the omens are not good.