Time for investors to learn a new game
The times are very out of sync. This is evident from the recent turmoil in UK government bonds markets and the sterling gyrations.
These febrile events were triggered by Chancellor Kwasi Kwarteng’s shock “mini Budget and its uncosted approach towards the public finances. 25 per cent in the face of looming double-figure inflation. Despite the rising cost of consumer goods, the Bank has retreated from its proposal for quantitative tightening to return 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 took action in response to a danger squeeze on pension funds, which were short of collateral to support their investment strategies. This was to match their liabilities, which 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. It is obvious that Liz Truss, the prime minister, has lost confidence 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 the Bank of England’s mandate for financial stability has overtaken its obligation to control inflation.
The Bank is committed to stop supporting the gilt market by October 14. If the Bank feels the need to continue after that date, a recession — likely a necessary cure of the current excess labour demand — could be deferred at the cost of much higher inflation.
Investors need to realize that most Britons will become poorer, despite the Bank of England’s rescue mission. Inflation is eroding living standard. The mini budget’s tax cuts have not offset the fact that mortgage holders and businesses are facing steeply rising borrowing costs.
Markets expect the base rate will peak at between 5-6 per cent.
When investors consider how to adapt their portfolios and personal finances in these rapidly changing circumstances, they need to look beyond the pension funds fiasco. They need to ask themselves what kind of world they live 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. These reserves now amount to well over $3tn in China’s case. These reserves, which reflect the countries’ surplus of savings, over domestic investment, helped to depress the risk-free rate in global government bond market while fuelling debt-dependent growth within 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 due to a huge supply shock. The introduction of cheap labour from eastern Europe and Asia into the world economy shifted the balance of power in favour of the capital owners and against the workers. The cheapening of labour relative capital led to lower investment and weaker demand, not only in Britain but also in other advanced countries. Other factors were also pushing in the same direction.
Pascal Blanque is the chair of Amundi Institute. The research arm of Amundi’s investment group, Amundi, argues that investors’ desire for high returns on equity and a low cost capital led to underinvestment in many sectors of the “old economy”. This was in tandem with investors’ implicit preference for high-dividend policies and share buybacks, as well as mergers and acquisitions at a cost of capital expenditure and wages. Blanque adds that an artificially low cost capital means that the discount factor used for calculating the net present value assets’ income streams pushes up the value, diverting capital flows away from productive tangible assets within essential industries and into leveraging current assets. This helps to explain why, with the pandemic in Ukraine and the war in Ukraine the war in Ukraine, inflationary pressures and shortages are affecting more than just the food and energy sectors. The tech sector has also seen a rise in market values due to low discount rates. Blanque’s underinvestment thesis suggests that inflation will fall more slowly than the 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. The most striking aspect is the complete reversal of fiscal and monetary policies. Covid was countered by governments spending liberally, while central bankers responded late to rising inflation with more aggressive interest rate hikes.
Reserve accumulation is at an all-time high in the developing world. 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. This will reduce the current account surplus, and curb outflows to the US Treasury market. The rise in geopolitical tension between Washington, Beijing and Washington also points to a world where China will financially decouple from the US. Opec oil producers may also stop converting petrodollars into US Treasuries. This would increase long-term interest rates, particularly in the US, and spread quickly to other countries, including Britain.
The labour markets are at their tightest in years. The UK strikes on the railways , for waste collection and the postal services show that the balance of power is shifting in favour of labor relative to capital. The same trend is evident in the USA. The days of low interest rates are gone and central banks will have to work harder to keep inflation within their target ranges. A major demographic shift is also adding to the problem. 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 battle in which older people who tend to vote more than young try to recoup income via the ballot box. Globalization, which has weakened union power, and contributed to the low-interest rate regime, is on the decline. 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 abandoning the free market ideology of Reagan-Thatcher and rediscovering industrial policies. They encourage multinationals to reshore, and promote domestic industries that are strategically important in areas like microchips. Defence spending is rising due to geopolitical pressure. The state will likely play a greater role in decarbonisation.
Industrialists are building resilience into their business portfolios after pursuing economic efficiency in cross-border investments. The Truss government is swimming against the global tide, with its small state and low tax, liberalizing instincts.
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’s and the eurozone’s recessions look inevitable. A deep global recession is unlikely, however, as China and Japan, the two largest economies in the world, are both easing their monetary policies while others tighten. The retreat from quantitative easing in West means that systematic mispricing and misallocations of capital have ceased since the financial crisis. Markets are being re-empowered as we saw in the bond market pension fund brouhaha. 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 world is shifting from a deflationary environment to one with higher inflation. This will create financial instability. As perceptions of recession and soft landing fade, markets will be volatile, while worries about monetary excesses, especially in the US and other countries, come and go.
What now for investors?
With stagflation, bonds cannot provide a hedge against recession and against volatility in equities. Diversification can be difficult to achieve. The bond bear market appears set to continue. Profits will be under pressure due to the reversal in the very liberal trade-investment regime that existed before the pandemic and Ukraine. There is also the need to overhaul global industry and infrastructure to ensure low carbon transition. The corporate share of national income will also decline. This is not good news 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. The storm ravaged real assets.
Dario perkins from research house TS Lombard argues investors should now look for exposure to real economic sectors, particularly those that stand to benefit most from deglobalisation and green transition, as well as higher public investment. He believes that tangible assets like commodities, real estate, and value stocks will thrive in a world where the rise of intangibles such as tech giants, will end. Subdued inflation and low rates of interest favor intangible assets. However, this advantage disappears in a relationary environment. This is not because intangible assets are more durable.
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 is that boring is back.
The transition to low carbon will still bring new growth opportunities. Professional investors believe that climate change risk cannot be efficiently priced in the markets. This is good news for active fund managers as well as for savvy private investors.
Inflation is a politically unregulated transfer of value from creditors and debtors. This makes it difficult for would-be debtors to enter the housing market.
Older people will find that working longer is the best way to address the cost of living crisis. We can only hope that politicians, central bankers, and others will find a way to lower inflation without too much recessionary pain. The inauspicious start of the Truss government in the UK suggests that the omens are not positive.
The author of 5 books, 3 of which are New York Times bestsellers. I’ve been published in more than 100 newspapers and magazines and am a frequent commentator on NPR.