“….in the November Inflation Report, the projections for inflation were the highest ever published by the Bank, while the forecasts for output growth were the lowest ever published.”
(Andy Haldane, Chief Economist of the Bank of England, 2nd December 2016)
The calm before the coming inflation storm has spanned 25 years. It has created an unprecedented bull market in government and high grade corporate bonds, which are now breathtakingly over-priced.
The first 18 years of this bond bull market were the result of increasing productivity in developed markets, fast capacity growth in emerging markets and a glut of world savings pushing up the price of safe haven securities, such as gilts (securities issued by the UK government). Post the 2008 global financial crisis, central bank QE (quantitative easing), which involves buying-up government debt, switched on the turbos and rocketed bond prices into the stratosphere.
The Bank of England’s objective with QE is to hold down interest rates and encourage borrowing at normal levels so that the money supply doesn’t collapse (as it did in America after the 1929 Wall Street crash with disastrous consequences). As there was no major depression after the 2008 crisis, most economists argue that QE worked.
I agree, but monetary policy can only alleviate the pain of a struggling economy for a short period, and the way in which QE works has unfortunate side-effects. One of these is that lower interest rates increase the value of existing assets. That is good news for the wealthy, but not good news for the less well-off, particularly if they are in low paid jobs, and especially if lower interest rates do not promote investment in the economy.
The economic recovery of the last 8 years has been shallow with virtually no improvement in productivity because businesses are just not investing in new capacity. Instead, companies have been taking on more employees, probably because they can sack workers if demand diminishes, whereas newly purchased machines simply stand dormant. This has been good for the bottom-line rate of UK unemployment, which is down to 4.8%, but as lots of the new jobs have been lower paid, productivity growth has been non-existent for nearly 9 years.
It gets worse. The average UK working household has seen a deterioration in net disposable income over the last 10 years. During the same period, their retired parents have seen an increase. Young working families don’t do any better when it comes to their net wealth. The under 45s have seen savings dwindle whilst their parents have seen theirs rise.
This explains why the country, given the opportunity to vote for change in the June EU referendum, did so. Which brings me around nicely to my main point, which is that vast numbers of voters in western democracies are unhappy with their lot. They used the power of the ballot box to kick out David Cameron in June, dash Hillary Clinton’s dreams in November and send Italy’s young prime minister, Matteo Renzi, to a humiliating defeat in December.
The change in mood will not be lost on our politicians. Theresa May promised that her government will now work tirelessly to support the “JAMs” (Just About Managing Families). You can expect similar language and promises from France’s Republican presidential candidate, Françoise Fillon, as he seeks to stop Marine Le Pen from taking power. Angela Merkel, having announced that she will stand for a fourth term, and having already refreshed Germany’s dwindling workforce by admitting one million young ambitious refugees, is now changing her language to recapture the ten percentage points of popularity that she lost as a result of her unpopular stance on immigration.
Monetary policy may have avoided a catastrophic collapse of the money supply, but it hasn’t created increases in standards of living for average working families. The only course now open to governments, which comprise politicians wanting to get re-elected, is to revert to fiscal policy, ie., public sector spending to boost demand. This is why there has been a lot of talk, both sides of the Atlantic, of investing in infrastructure. But can we afford it?
At the end of 2015, UK government debt was around 86% of GDP (see chart below). This may seem high, especially as it has shot up from the low levels reached in the mid-80s (in March 2008 UK government debt to GDP was just 35%). You may find it surprising to learn that in the UK this is still lower than the average rate of debt over the last 315 years, which is 95% of GDP. There is scope for governments to increase borrowing. Long-term interest rates are still very low (which makes the debt comfortably serviceable, at least in the short-term) and politicians won’t get re-elected unless they make working class people better off. It is for these reasons that western governments will return to more aggressive fiscal policies. When they do, the public sector will start employing more resources, boost demand and promote an upward movement in prices. That is good old fashioned demand-pull inflation, and it’s just around the corner.
On 2nd December, Andy Haldane, Chief Economist of the Bank of England, said “….in the November Inflation Report, the projections for inflation were the highest ever published by the Bank, while the forecasts for output growth were the lowest ever published”. Central banks may be able to hold base rates low for a little longer, but the market will discount future increases, pushing down the value of longer-term bonds. Some predict an orderly correction to the bond bubble, but there is rarely such a thing in financial markets, which means a collapse of bond prices is a real possibility. This is why, as we move into the New Year, we have already slashed our allocation to long-dated bonds.
2016 was, on the whole, a very good year for COURTIERS investors. We managed to navigate the political problems well and our strong position in US dollars helped enormously. 2017 will be trickier. We have already cut our risk to long-dated bonds and, as always, we will be on the look-out for other risks whilst seeking to deliver reasonable returns. I would like to finish by thanking everyone that entrusted us with the care of their assets over the last year. We are very grateful for your confidence. I wish all our readers a very merry Christmas and a prosperous and peaceful New Year.
From Monetary Policy to Fiscal Policy
There’s a huge difference between monetary and fiscal policy. Monetary policy is where the government or the central bank tries to stimulate the economy by reducing interest rates. It makes the cost of borrowing less, it makes the cost of serving existing mortgages less, and therefore, theoretically, it puts more money in people’s pockets. But, what it also does, is it makes assets more valuable because things that pay a decent dividend yield, when the base rate is very low, are worth more to somebody else to buy. So, Q.E. (Quantitative Easing) is very good for those that hold large amounts of existing assets. The problem with monetary policy is that if it doesn’t work then what happens is the extra spending that is in people’s pockets, because they are paying less that interest rates, is simply saved, so it’s what Keynes would call “a very high liquidity preference”, and if people just save their windfall it has no effect on demand within the economy.
Fiscal policy works by cutting taxes to put more money into consumers’ pockets in the hope that they will spend it. However, unless they believe the tax cut is permanent, they won’t necessarily spend it and they will then save it for the rainy day that they think is coming down the line. If all that fails, the final way which absolutely guarantees additional demand in the economy, which Keynes would always advocate when you’ve got to give the economy a shock to get it going, is that the government steps in and does something. That type of fiscal policy is when the government starts spending on things and governments both sides of the Atlantic are about to start doing that. That’s why Teresa May’s government has been talking a lot about infrastructure spending in recent weeks because with infrastructure spending you guarantee that you will increase demand in the economy.
Fiscal Policy: Effects
Fiscal policy may be effective – the infrastructure spending may be effective – at pushing up demand, but if the economy is already running pretty full-on it’s going to create lots of strains within the economy itself. Bearing in mind that the International Monetary Fund reckons there’s not massive amounts of spare capacity in the UK economy, in other words we are almost consuming as much as we possibly can produce, and unemployment is now below 5% (it’s at 4.8%), because of that, there’s not loads of additional workers around to throw at the new infrastructure projects. So, when the infrastructure kicks in in earnest, and the government starts creating more jobs, and using more resources, and buying more services because roads will need to be planned and built, you’ll need architects, lawyers and accountants. When the government starts doing that, if the economy is already near peak, then prices will go up because there will be an inadequate supply to meet demand and that’s where inflation starts to come in.
Politics and Leadership
The reason we have a high degree of certainty that fiscal policy will be rediscovered by politicians in 2017 is because the lesson of 2016 is that there are lots of ordinary working class families in Europe, the UK, and the US, who are thoroughly dissatisfied with their lot and they’ve taken the opportunities given to them to give the traditional politicians a bloody nose. David Cameron lost the EU referendum mainly because lots of families have seen no increase in their net standard of living over the last 10 years and so a change for them was as good as anything. It’s the same in the US, with Trump becoming the president-elect, and the same with Matteo Renzi, Italy’s young prime minister, who put his political future on the line with a referendum on reform and fifty-nine per cent of the voters voted against him - it was a landslide victory for the opposition. A lot of other politicians who will be up for re-election in Europe next year in Holland, in France, and Angela Merkel then in Germany in the autumn, would have been watching this. They cannot get re-elected if the average working class family feels that they’ve got, and will continue to get, a raw deal. Unless these politicians can find some way of making those families feel better off and feeling part of a recovery that they’ve played very little part in then those politicians will not get elected. A politician can only execute their policies if they’re in power. Those lessons of 2016 and what happened to Cameron and Clinton and Renzi will not be missed amongst Europe’s existing politicians.
2016 Market Performance
We were really quite pleased with the calls we made through 2016. It’s been a very good year for our investors. The feedback we’ve had has been good and we’ve managed to steer our way through the storms of the political upheaval that we’ve been going through. We stayed away from long-dated bonds, which have been very weak recently, and we will be staying away from those going into 2017. The reason for that is that if fiscal policy is reintroduced and inflation comes back into the system then interest rates will go up. If you are holding bonds with the UK government at a yield of around 1.5% and the base rate starts to climb quickly, that’s going to look like the lousiest investment in town and your price will drop like a stone. For that reason, we are very concerned about bonds into next year.
The risks in 2016 were all political. I said earlier that I think we steered our way through those well. I don’t think my predictions and what was going to happen with the EU referendum in the UK or the Clinton v Trump were right – I thought we would remain and the American people would put Hillary Clinton into the White House – I was wrong on both counts. Fortunately, the risks that we had identified we covered off, and we actually made quite good money for investors, certainly during the EU referendum. That’s because we got very long the dollar because we thought it was really a one-way bet. That’s a good indication of what asset management is all about. You can have your views on something but you don’t necessarily need to back on those views, you’ve got to assess where the risk and return trade-off is. Going into 2017, it’s going to be politics again. We think it’s going to be a type of risk coming through, as I’ve said with inflation, because governments are being encouraged to spend a lot. Despite what the average man in the street thinks, UK borrowing to GDP at the end of 2015 was about 86%. That is still 9% below the 315 year average. You get a lot of commentators saying “there’s loads of debt, there’s loads of debt”, it may seem like that compared to the level of debt that was around in the summer of 2008, which is about 36% of GDP, but compared to what it’s been historically, when in 1821 the government owed 211% of GDP to fund the Napoleonic wars, 86% doesn’t seem that bad. That lesson will not have been missed on any politician, so we will be looking very, very, carefully at bond risk in the market because we think this 25-year bond bubble has just burst.
COURTIERS Christmas close
So, what will I be doing over Christmas? I’ll be looking at my screens, you know I spend my life looking at screens! Four screens on my desk, I can look at my iPhone, my iPad, Instant Bloomberg, looking at all COURTIERS’ assets bobbing around live on feeds, I can trade if I want to, if I really felt like it – that’s modern technology. And, before anybody thinks I’m asking for them to get their violins out for me at Christmas, I’m not, I’m extraordinarily lucky, I love economics, I like markets, I like maths, I spend my time doing it and earning a very good living as well. So, if any youngsters are watching this, the tip I’d give them is find out what you can do in life and what you’re good at and make money doing it and that’s not a bad thing to do.
The team will get a break, I’ll spend time with my family and friends, as lots of other people will. Fortunately, markets have a tendency to be calmer over Christmas because lots of people take a bit of time out and it’s quite a relaxing period. In terms of a message to clients, I’d say “enjoy it!”, you’ve worked really hard for the money you’ve got, you work really hard to have that comfort, and what is the point if you don’t actually enjoy it. So, when you look at clips like these and you read our articles, we’re always talking about the next problem around the corner.
Just think of a story a friend of mine told me when he was working for the Ministry of Agriculture, Fisheries and Food years back, he said to me you can find a wealthy farmer, you can find a happy farmer but you won’t find a wealthy, happy farmer. The point he was making is that very good farmers are obsessed with risk and what’s going to happen with their crops and their livestock and I think that translates into asset management. Clients pay us to do the worrying so it’s pointless them doing it too, so I suggest they let us get on with the worrying and they have a thoroughly good time.
The last thing I would say to everybody is thanks very much all our investors for supporting us in 2016, thanks for your very nice comments – it was great to catch up with loads of people at the recent investment seminar – I wish everybody a very, very, happy Christmas and a prosperous, and let’s hope the politicians give us, a peaceful as possible 2017.
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