Bond Markets Unconvinced
Solicitor-Advocate (In-House Company Solicitor)
Market Update to close of markets Friday 1 July 2022.
This week we learned that the end is nigh, or at least the era of rock bottom interest rates and sub-2% inflation. The dignitaries gathered at the ECB’s forum on central banking took turns to spell out how determined they are to tackle inflation. As well as trying to signal to markets that they are willing to do whatever is necessary to get a handle on inflation, this also served as a warning that economies and households will be shouldering the burden. Markets appeared only partly convinced. Fear of recession caused more volatility for equities again this week and, oddly, the yield on Treasuries and Gilts fell – not the typical reaction if interest rates are expected to stay high.
Bank of England governor Andrew Bailey used his turn on the microphone to warn that the UK’s economy will weaken before other developed countries as inflation will be more keenly felt. Along with other central banks, the Bank of England has been slow to tackle inflation and it is still struggling to get ahead of the curve, but Bailey has been keeping an eye on the data as GDP and retail sales are already falling. Find out more on how to secure your assets here.
PRIVATE OFFICE ASSET MANAGEMENT’S THOUGHTS ON INFLATION AND INTEREST RATES
It is clear that the central banks are aiming to burden the working and middle / upper middle classes with the task of bearing the brunt of the hurt in getting inflation under control by the use of their bluntest monetary instrument available to them – that of raising interest rates and thereby raising the borrowing costs for households who are already overstretched and living from pay cheque to pay cheque with the largest amount of both mortgage and non-mortgage debt in history. Because let’s be honest, the rich, (and “rich” has reached a different level nowadays with the ‘out-of-sight rich (you know who they are) influencing governments, influencing stock market movements with merely a single tweet etc. – their spending is not going to be affected because of interest rate rises of 0.75% per annum, – the only people interest rate rises seriously adversely affect are the working and middle classes.
The rationale of using interest rates to fight inflation is to curb spending and therefore demand, and thus bring prices down and with them inflation. Essentially then if the ordinary household consumers have even less money in their pockets, they will not be able to afford the non-essentials because their mortgage payments and their non-mortgage debt payments will go up (unless already secured on fixed rates) with the result that household budgets will be further squeezed and thus they will not be able to afford to spend on those non-essential items. This distorted thinking appears to blame the ordinary consumer [and their over-spending] for the present surging global inflation problems, so let’s start there.
Is the household consumer and small business owner (those most adversely affected with raising interest rates) to blame for the present 30 to 40-year high global inflation rates through their assumed overspending creating too much demand? Of course not. Have they been in the past? – well yes, but decades ago way before the financial crisis in 2008 / 2009 when the greed of the few almost plunged capitalism and the global economy into almost irreversible peril, – before Gordon Brown sold off the UK’s Gold Reserves at a fraction of its value, before Pension funds were raided of £billions in New Labour’s first budget with the abolition of Advanced Corporation Tax Relief, and before Quantitative Easing (QE).
Since the financial crisis 13 years ago, the USA’s debt mountain has increased from US$9.4Trillion (2009) to approximately US$27Trillion today (it was at more than US$30Trillion just a couple of years ago before the second round of QE – which is nothing more than the US Federal Reserve printing money to pay off some of its out-of-control debt mountain). Between 2009 and 2015 the Federal Reserve printed US$3.5Trillion to buy back some of their issued Treasury Bonds with this artificial money (artificial inasmuch that it should never have been in circulation in the first place). It is probably true to say that since 2015 the number has doubled. So, the USA has reduced its debt by printing money to pay off their debt, and then they re-issue the debt to raise more money. It’s the same as a household having their very own household mint in the back garden, so no matter how badly they run their household finances if they get into trouble the homeowners can simply go out back to print as much money as they wish to clear their mortgages and their non-mortgage debts. This is akin to what QE is for central banks and their governments. The risks and absolute inevitable consequences of QE is that it will lead to an increase in inflation which is what we are seeing now.
The central banks and the economists speak about trillions as if it’s just an accepted and understood number, but it’s not an ordinary number and most people couldn’t even write it down numerically because it just doesn’t figure in 99% of people’s minds and real worlds. One Trillion is one million x one million. Think that through, their debt level is at US$27,000,000,000,000 (US$27million x US$1million). And this additional quite unfathomable amount of debt has been amassed during what we are led to believe have been boom times for economies, bull markets where the US economy has ‘prospered’, during a time when the Internal Revenue Service (“IRS”), has tentacles reaching into every US citizen’s pocket worldwide with such burdensome local responsibilities to the host countries of ex-pat US citizens to ensure they all pay their highest dues to Uncle Sam – that US citizens are now virtually impossible to deal with from a professional financial services perspective.
So it is fair to assume that US tax revenues over the past 13 years have been at record highs since the financial crisis, along with record low unemployment in the US during the period. And yet the result is that the USA have increased their national debt levels by more than 200% since 2009! And 2009’s debt levels were record highs by 100’s of percent in 2009 compared to 13 years earlier to that (and just to give one tongue-in-cheek pause for thought let us consider this – the US War of Independence from Britain in 1776 was all because Britain wanted to reach out for a little bit of tax from their new colony across the other side of the Atlantic, – and the war was fought, and won, because this new colony was heralded as “the land of the free”, the American dream, where taxes would no longer apply and ordinary people could start anew and not have to be burdened with government tax and intervention and unwanted or unpopular laws! How is that ideal working out?).
So, if the present rampant surge in global inflation is not due to the spending excesses of the household consumer, what is the cause? We firstly have to look at the obvious, and that is energy. As at 25th May 2002 the wholesale price of gas had increased by 335% over the 12 month period, including a 82% rise from November 2021 to January 2022. Crude oil’s average closing price in 2020 was US$39.68 per barrel, and its year high closing so far in 2022 was US$123.70 – that is an increase of +211.75%. Is this anything to do with households overspending? No of course it isn’t. Wheat was priced at USd/Bu 607.64 in January 2021, and it hit a high of USd/Bu 1,289.30 on 17th May 2022 which is an increase of +112.18%. Is this increase in one of the top 3 (with rice and corn) of the most important food grains in the world and is the vital ingredient for many food items including bread, cakes, pastas and noodles anything to do with the average household overspending? Again, no of course not. We are hearing that many households are struggling so badly that they are literally having to choose between turning on their energy supply for heat and buying food.
Energy by itself over the past 12 months accounted on average for around half the total headline inflation. This particular inflation (as most of the world is a net importer of energy, is referred to as “imported inflation” – in other words it is inflation over which monetary policy has no control. The huge price rise in wheat and other food stuffs can also be put in the same bracket and so monetary policy i.e., interest rate rises will do nothing to control food price inflation. These are essentials, and consumers cannot stop buying these even if they wanted to, and so these interest rate hikes further hurt the household consumer whilst doing nothing to bring down inflation.
What else, on top of the exorbitant energy and food price rises which account for probably 65% of the headline inflation rate has contributed to the rampant surge in global inflation? I mentioned the financial crisis above, and the US Federal debt numbers that are difficult to comprehend. Let us provide those debt numbers with some sort of benchmark so that we can get some perspective of them. I would refer to an article that I wrote several months ago about the US debt mountain when I suggested amongst other things that, just as cosmologists created the term “light year” to better describe the vast, incomprehendible distances across the universe, perhaps economists should create another unit of measure for the astronomical numbers when describing the worlds (allegedly richest) nations’ debt mountains. I would like to outline once again the scale of the situation we are dealing with here and how these debt mountains (and the governments formula to cure to the global economy following the global financial crisis of 2008/2009) also affect inflation because frankly their actions laid a ticking inflation time-bomb which has now come home to roost.
Allow me introduce you to Alpha Centauri on the left, the triple star system located 25 trillion miles from our earth and sun, the nearest star in its system to our solar system being “Proxima Centauri”. Because of the vast distances across space, cosmologists do not refer to the distance in miles because 25 trillion miles is difficult to comprehend. Instead, they use the term light years – 1 light year being the amount of distance that light travels in one year. So, with light travelling at 187,000 miles per second, which is approximately 1 million miles every 5 seconds, it takes light 4.3 light years to travel between our solar system and Alpha Centauri. To further put that into perspective, it would take the Saturn V Rocket, the most powerful rocket ever built by man, 100,000 (one hundred thousand) years to travel between our solar system and Alpha Centauri at full pelt with no gravitational or wind resistance in the vacuum of space.
So how is this relevant? Well, the national debt of the US Government is currently at US$27Trillion+ which has been reduced substantially by the Federal Reserve printing around US$6.5Trillion since 2009 and injecting this enormous amount of money into the economy through its bond purchasing scheme known as Quantitative easing (“QE”) (clearing that amount off of its debt effectively, and the US debt mountain has further been reduced in real terms by the inevitable inflation its QE policy caused because with inflation now at around 10%, – the actual value of that debt is reduced accordingly because the US$ is now only worth 90 cents compared to this time last year.
If we apply that to their debt mountain US$27trillion – in real terms the debt reduces by US$2.7trillion with 10% inflation to US$24.3Trillion. So, governments do want some inflation in the system to decrease the actual value of their ridiculous amounts of debt amassed (in boom times!). They also need low central bank interest rates because when they issue their debt to the market to raise additional US$trillions to fund the gap between their committed spending plans versus the tax revenue projected to be raised in any given year, – they must compete with “risk-free rates” which is the interest rates of the central banks, its own Federal Reserve. Because if interest rates (risk free rates) are at 10% then they would have to offer, say, 12%+ for investors to be tempted to buy their debt issues (to give their money to the government like a mortgage in reverse to receive interest payments for a number of years and then hopefully the return of their invested capital at the end of the agreed term – on the assumption that the government doesn’t default on its debt issue/s).
Back to Alpha Centauri and the relevance of its distance from us. It would take light 4.3 years to travel to Alpha Centauri at 187,000 miles per second or 1 million miles every 5 seconds. It would take man’s fastest and most powerful rocket 100,000 years to get there. This is the key point, and this to a lesser but comparable degree is true of all of the world’s “richest” nations – the US debt mountain is so huge that as light travels between earth and Alpha Centaur, – if it had just the US Federal debt in tow, – it could drop a US1Dollar note of its debt each and every single mile of its journey of around four and a half years at 1Million miles every 5 seconds, and still have enough USDollars of debt in tow to travel back to earth dropping a single US$1 Dollar bill every mile for 4 months of its return journey – which but for QE would have perhaps been 30% of its return journey. The enormity of the QE of not just the US but also in Japan, the EU, the UK and other nations, whose own debt mountains have also risen to previously unimaginable numbers, – and their individual and combined actions with their bond purchasing schemes (QE) has contributed to the current global inflation problems. Hardly at all is the ordinary household responsible for inflation this time around.
The definition of Inflation is, in the literal sense, the action of inflating something or the condition of being inflated. In economic terms it is a general increase in prices and the fall in the purchasing value of money. If you take a balloon out of its packet and you blow into it, you obviously inflate it. If you take an already inflated balloon and blow into it you will cause it to inflate further. If you keep inflating it further, eventually the balloon reaches its limits after which it will explode and that will be the end of the balloon.
The global economy with all of its laws, rules and regulations has (or had) an arguably finite amount of money circulating around it, with the same money continuing to circulate. QE introduces additional money, huge amounts of money into the government’s coffers via their central banks printing these vast amounts of additional money via their mint. There is only so much additional money that can be introduced to inflate the global economy without causing too much inflation, and this is where we are now, – the inflation hasn’t been caused by the everyday consumer, – the vast majority of it has been caused by global energy price inflation, global food price inflation and we must add to that “Quantitative Easing” (don’t always believe the words on the tin – “easing” is probably not the right word!).
Government’s actually do require inflation if they have huge debt mountains to manage, as it serves to reduce the real value of their debt. They also desire low interest rates in order for them to be able to issue their debt to investors at manageable [interest] repayment rates. Let us be clear, using the US and the UK as just 2 examples, – they will never clear their debt, they can only hope to manage the interest payments on their debt and inflation is a very effective tool for reducing the real value of their debt mountains. They need to keep interest rates comparatively low so that they can get their debt issues off at the lowest rates and best possible terms for them, and they also need to juggle the rhetoric to keep taxing society and its workers as much as they can get away with to generate as much tax revenue as possible – on incomes, capital gains, inheritance tax / death duties, VAT, state taxes and the list goes on and on.
If the scenario unfolds whereby governments and central banks fail to keep a lid on inflation, and government debt levels continue to rise where they do become unmanageable, then this is where some less conventional commentators and conspiracy theorists suggest that the world is heading for a “reset” – where the powerful press the button and we start off back at zero including whatever ramifications that might mean for all of us. That scenario would be when our anecdotal balloon explodes! Whilst we do not concur with those views at all, these national debt mountains and government interference with markets to the degree they have influenced them over the past few years cannot go on at infinitum without some form of alternative corrective measures having to be sought and implemented.
Here at Private Office Asset Management we have not been surprised at all with the significant corrections that the major markets have seen since the beginning of this year, including the losses over the past few weeks. We have predicted this many times as early as last Autumn. Having de-risked considerably towards the end of 2021, we sold 100% of our allocation to the Nasdaq in March, when we also reduced our already significantly underweight position across the equity markets by a further 75% leaving just 9% invested across the major equity markets which we subsequently reduced to zero at our May Investment Committee meeting for two thirds of our clients – and so much of the losses that the markets have suffered have not directly impacted our clients very much at all. Key to our strategy is to maintain portfolios with a very low volatility (inherent risk) during such times and we have achieved that not only compared to the markets but more importantly compared to the toughest multi-asset industry risk-rated benchmarks.
Whilst the above weekly updates on the markets across some of the major indices, bond markets and commodities are useful, – it is probably worth putting these numbers into context since the beginning of this year and since we de-risked significantly further in March:
Major Equity Markets – their losses since March 2022 and since the beginning of January 2022 respectively:
Market Indices: Losses since March 2022: Losses since January 2022:
- FTSE-100 -7.21% -7.30%
- FTSE-250 -13.15% -21.91%
- S&P-500 -18.29% -21.01%
- Nasdaq -24.56% -30.35%
- German DAX: -13.47% -21.09%
- EuroSTOXX 50: -13.71% -21.41%
- Nikkei 225: -9.94% -13.31%
In January 2022 the Nasdaq-100 reached a combined market capitalisation (value of its constituent companies listed on it) of circa US$26trillion. It has since dropped 30%, wiping off US$7.89trillion from the combined values of the 102 constituent companies listed in the Nasdaq-100. Whilst we have predicted market corrections due to the many well documented challenges including inflation, the ending of QE which served to support the markets, interest rate hikes, the Russian invasion of Ukraine and the resulting negative news flow about the state of the global economy and the fears of recession, – there comes a time where the markets look to be fair value. We would say at this stage that although the challenges do remain, some of these markets at the present levels look fair to good value notwithstanding the challenges still prevalent.
Our view, as outlined repeatedly since the start of this year, is that we should seek to “make-and-take” small profits where we can. To achieve this requires us to be active, – this is not the time for passive investing. Because we look after a relatively small book of client families by design, we are able to be active and work closely with all of our clients. The first priority this year was to reduce volatility (risk) across all of our client portfolios – even those with a high appetite for risk. Our job is firstly to limit losses and to protect capital. It is clearly impossible to protect 100% of capital with markets plummeting by the levels detailed above, but we have been successful in protecting our client’s capital on a relative basis against the toughest multi asset risk-rated benchmarks by working continually to reduce inherent portfolio volatility. Presently the average volatility within our client portfolios is around just one third to half of the multi asset risk-rated benchmark’s volatility.
The other obvious objective is try to make some gains. There is little point in riding the indices up, retaining the holdings and seeing all of the gains lost and then moving into serious negative territory as the markets continue to fall – this is what many investment managers have to do because the mechanics and processes they have in place simply does not allow them to divest in a meaningful manner. Our strategy includes studying the news flow and market data across each of the indices we are interested in and to identify which we feel are now fair to good value and then to make a decision at what level it makes sense to go back in and invest. To be able to properly capitalise on our bold advice to de-risk which saw us sell out of the equity markets and avoid these major losses on the downside, we do need to find the level that we are happy at to advise our clients to buy back in at so that we can take advantage of the upside as the markets bounce back.
We feel that we are now at that stage where the values are sensible enough to start buying back in. However, we do expect the markets to trade within a range and we therefore do not believe that ‘buy and hold’ is the strategy to pursue. We will be endeavouring to identify the buy-in levels to move back into the markets at the lower end of their trading range, and then to aim to bank some short-term net profits once the markets have moved upwards to a level we are happy with before they reach the level where we feel they might fall back again.
For those clients who authorised us to do so in our most recent portfolio rebalancing recommendations, – whilst simultaneously holding around 50% in cash, and 20%+ in defensive alternative / total return strategies, we did purchase oil at the level we waited around 6 weeks for it to drop back to, and then we sold it to bank between 1% net profit and 5.3% net profit on that allocation to oil depending when each specific client provided us with their authority to proceed. We are now looking to implement a similarly careful and well thought through strategy with some of the indices noted above since we have already benefitted by having divested entirely of them or reducing allocation by 75% compared to benchmark during which time the markets declined by up to 30% as detailed. We believe that now these significant losses have occurred, as widely predicted by us since the end of last year, they represent fair to good value and we are now prepared to consider buying in at these significantly reduced levels – and to then manage the risk by understanding the predicted short term trading range high and low from our own research and decades of experience.
It is worth noting that in December 1999 the FTSE-100 reached just over 7,000 before closing at 6,950 on 30th December 1999. Today it stands at 7,168. Thus, in its first 16 years from inception on 3rd January 1984 at 1,000 it grew by 695% in 16 years to December 1999. However, since December 1999 in the ensuing 22 and half years, it has advanced just 218 points which is a capital return of just 3.13% in 22 and a half years. This translates to a capital appreciation of just 0.139% per annum – around one seventh of one percent per annum. However, the market has gone up and down in the meantime trading during the last 5 years between its high of 7,778 in May 2018 to its low of 5,190 in March 2020. We do not need linear growth to earn worthwhile profits, we can make-and-take profits by being active and buying at its lower levels and selling at the targeted higher level within the identified trading range.
We do not live in an era like we lived through between 1984 and 1999 where the markets advanced unfettered by over-regulation, without the influence of the insanely wealthy power-people, free from government manipulation and interference by the policies of their “independent” central banks. We now live in an era which is altogether more challenging which does require careful strategies to avoid the losses as well as to make the gains. As stated, passive investing will just not do in these challenging times, we need to be active, and the beauty of our highly personalised bespoke advisory service is that we are able to work with all of our clients and do just that because we choose to work with a fairly small book of clients so that the quality of our advice and services is not diluted.
GLOBAL: ERA OF LOW RATES OVER
The Bank of England joined the European Central Bank and the US Federal Reserve to declare an end to the era of low interest rates and low inflation. The heads of the three central banks confirmed that they may take more drastic action to prevent high inflation becoming persistent. This followed a warning from the Bank of International Settlements (“BIS”) that developed economies risk being caught in a high inflation world if wages rise steeply and feed further inflation. So, in other words, wage rises are being advised against so that interest rate hikes can hurt the households as much as possible. The BIS wants more aggressive action now, saying any short-term pain is preferable to dealing with high inflation if it becomes entrenched. The combined effects of flooding economies with cheap money (Quantitative Easing), the effect of shutting down many supply chains due to the Covid restrictions, and the now the war in Ukraine have all conspired to create a very gloomy economic picture.
Boris Johnson’s assertion that workers asking for wage increases will make inflation worse is almost beyond comment. Yes, of course it might, but households are struggling to pay for energy and food and are living uncomfortably from one pay day to the next as it is. With inflation at a 30-year high, energy and the cost of petrol through the roof and food inflation at a 13-year high. Shamefully, Britain is among the worst in the world for wage rises over the last 20 years. As has been reported the current squeeze on households marks the biggest hit to incomes since records began, and now data from the Organisation for Economic Co-operation and Development (OECD) has shown that, despite the worsening crisis, Britain has followed a pattern over two decades which leaves Britain as one of the least favourable places in the world today for wage increases.
German consumer inflation data was one bright spot among new economic data out this week. CPI in Germany unexpectedly fell in May as the German government cut fuel duty and reduced rail and bus fares to ease the cost of living. This suggests governments, not central banks, are better able to tackle inflation in the very short term. Bond markets were unmoved by central banks’ statements as yields on Gilts and US Treasuries fell this week. The UK government is under pressure to do the same but the Treasury is resisting such measures – one suspects this is to recoup some of the excessive spending of the last two years resulting from furlough, business grants and loans, vaccine and PPE contracts, because tax receipts, particularly VAT, have benefitted from the surge in prices.
UK: ECONOMIC WEAKENING
Bank of England governor Andrew Bailey warned that the UK is already suffering more from inflation and the economy is likely to weaken more than other developed countries due. Despite the deteriorating outlook he also raised the possibility of a 0.5% interest rate hike if necessary to tackle inflation, but we have detailed our thoughts on that policy above. Rising prices are continuing to squeeze consumers as household disposable income fell by 0.2% in the first quarter of 2022 when adjusted for inflation. The figure excludes the impact of the recent rise in energy costs and tax rises that were introduced in April.
The British Retail Consortium reported that food inflation hit 5.6% in May – the highest rate since 2009 – and retailers are passing on costs to consumers at the fastest rate in 14 years. Rising costs saw retail sales fall by 0.5% in May and consumer confidence has fallen to a fresh all-time low. Meanwhile, the UK’s current account deficit grew to a record 8.3% of GDP in the first quarter, driven mainly by increased imports of manufactured goods and oil.
UK: AIRLINE WOES CONTINUE
The travel industry is still trying to recover from the coronavirus lockdowns as it struggles to cope with resurgent demand as staff shortages continue to cause disruption. Heathrow updated its passenger forecast to 54.4m passengers this year, 67% of pre-Covid levels. However, its chief executive warned that it would take up to 18 months for the industry to fully recover. The industry has also warned that rising inflation may erode demand and that a resurgence of Covid also remains a risk.
The government and aviation regulator have ordered airlines to ensure advertised flights go ahead and to avoid any disruptions similar to those seen during the June half-term. BA, EasyJet and Wizz Air have all cancelled thousands of flights while Gatwick recently cancelled hundreds of flights to avoid further disruption this summer. Cancellations mean revenues and profits remain far below 2019 levels. Heathrow received a further blow this week when it was told to partially reverse the increase of its landing fees.
Please note that nothing written here by the author should be construed as giving advice, it merely outlines our thinking. Any advice will be discussed and proposed on an individual basis with each client when any advice that is given should be fully discussed with us before proceeding with any proposals made.
If you enjoy reading this weekly update, albeit quite a long update this week, please feel free to share it with your friends and / or family who may also find the contents of interest, and do not hesitate to contact us if you need any help, information or advice yourself about any of the areas covered this week.
Yours sincerely, Phil Simmonds