Market Update 11th February 2022
This week the inflation melodrama continued, with US inflation numbers reaching record levels. This set off another round of speculation over interest rates with talk of an emergency rate hike being needed over the weekend. That wild over-reaction has died down, but even some cooler heads in the market are revising up their estimates of how aggressively this issue will need to be tackled. It’s a fine line for the Federal Reserve to hold. On the one hand fear of further rates hikes can do quite a lot to damp down the pressures driving inflation and so reduce the need for future actual rate hikes. On the other, if the markets get too carried away and the actual policy ends up being a surprise that can have negative consequences too. Either way, we are ready to respond and where possible to pre-empt by applying some common sense to the issue.
HIGHER INFLATION & AND LOW INTEREST RATES: HAVE GOVERNMENTS ENGINEERED THIS? IF SO, WHY?
Let’s be perfectly honest and clear about this, and revisit what we at Private Office Asset Management have been saying for an awfully long time now. We live in times of, not so much free market capitalism, but where governments and central banks, and the insanely rich household name investors and CEO’s exert a significant degree of intermittent market distortion and manipulation. QE is one example, Elon Musk dumping his own stock being another, and higher inflation with lower risk free central banking rates also play a significant role in all of this madness.
I had my thesis accepted by Kingston University for my DBA (Doctorate) where I intended to tackle the issue of the US, UK and European Government debt crises and to conclude as to whether their totally out of control debt mountains (which have in the main been amassed during times of great prosperity to add further intrigue and wonderment to any normal and right thinking person) can ever be repaid, or even controlled with the interest payments even remaining close to affordable. Remember that the cogs of the US governmental institutions have ground to a halt more than once, which required emergency agreement between Congress and the Senate to authorise yet further raisings of the US Government debt ceiling in order to unblock the impasse, – and all this with the US allegedly being the richest nation on the planet!
Governments have their spending plans to fund. They do this of course by a mixture of tax revenue and then issuing debt for the shortfall. Governments need central bank interest rates to be low so that they do not have to compete with high risk free interest rates when getting their debt away. If the central bank interest rate was 5% then even the strongest and most reliable AAA Nations would have to offer the market 6.5%+ to attract purchasers of their various debt issues. So very low interest rates are very much in the interests of the major nations governments. But the Treasury and the Bank of England are independent of Government aren’t they? Yeah, course they are – hardly a mutual influence between them!
Now we consider inflation, – and of course it is painfully obvious that the current 7% inflation rate means that the purchasing power of the $ or £ is devalued by 7% over the 12 month period. This is also true of any existing debt. Thus, to state the obvious and to keep it to numbers that we can actually relate to let’s assume you have £1Million sat on deposit earning nothing. In one year at an inflation rate of 7% the real value of your £1M will have reduced to £930,000. It is arguable that with the national debt of the major nations being so large, – they might be tempted to come up with an alternative to the number itself, much like cosmic distances which are measured in light years because the actual number of miles is simply unfathomable. Light travels at 187,000 miles per second, and the nearest interstellar star system to earth is Alpha Centauri and Alpha Proxima at 4.37 light years – so 1 light year being the distance that light travels in 1 full year at 187,000 miles per second. In miles it looks like this: 25,600,000,000,000 (£25.6Trillion miles) The debt mountain of the US is now US$30,001,677,931,519 – more dollars in debt than the earth is miles away from Alpha Centauri. Staggering isn’t it?
So, – might an inflation rate of 7% be a good thing for the US government – or at least as high an inflation rate as possible without it affecting the economy so badly that GDP output slows significantly and there is political unrest with the governing party? Consider this: If 7% was knocked off the real value of the US$30Trillion debt mountain by the annual inflation rate of 7% – this effectively reduces the US debt mountain in real terms by US$2,100,000,000,000 (US$2.1Trillion). Two or three years like this might be very handy as it might reduce the real value of the debt mountain by 25% (US$7.5Trillion).
If we then throw in the QE (where the US Treasury over the past couple of years with the pandemic and not including the massive QE programme post financial crisis in 2009) has been printing money and buying back their debt at a rate of US$2.1Billion per month – then over 2 just years at that rate the US government has bought back (reduced) its debt by US$50,400,000,000. So inflation reducing the actual monetary value of the government debt by huge percentages, QE literally allowing governments to print their own money and pay off their debt artificially, and low interest rates meaning they can raise money by selling their debt to the market at historically low interest (coupon) rates, – one might be forgiven for believing that much of this has all been contrived. Certainly it hasn’t done the real reduction in the debt mountains any harm and so clearly higher inflation and prolonged lower interest rates is one way of efficiently tackling the debt.
In conclusion we are fully aware of these artificial market forces, and we pay equal attention to them as we do the PMI numbers, the VIX index and the more traditional measures by which any good investment adviser / manager might look to value markets and predict as much as possible over the short term in order to navigate the best possible outcome for clients across all risk profiles.
Elsewhere the UK posted record growth figures confirming that shutting half the country down and then opening up it again does have an effect. With economic activity now almost back to pre-pandemic levels, the real test will be whether growth can be maintained.
GLOBAL: MARKET CONCERNS OVER FUTURE RATE HIKES
Government bond yields continued to rise and peripheral European countries like Spain and Italy saw some of the sharpest moves as investors’ expectations of a rate rise from the European Central Bank increased. Although ECB President Christine Lagarde tried to ease back expectations about a rate increase, several members of the ECB said they expect the bank to tighten interest rates this year.
In the US, consumer price inflation increased at the fastest rate in 40 years as it hit 7.5% in January. This surprised markets once more and caused the yield on 10-year Treasuries to rise to the highest level since mid-2019. Equity markets have also had a bumpy ride. US tech stocks experienced elevated volatility again but most developed markets are positive for the week. Several of the major contributors to core inflation are already slowing and with energy prices unlikely to keep rising as fast the general expectation is for inflation to fall in the second half of the year regardless of interest rates.
As far as we are concerned the largely positive week for equities continues to support our timing to invest further into the markets from the beginning of last week, having reduced equity exposure during the third and fourth quarters of 2021 which protected us against the pullbacks. Our well stated theme of “make and take” in our endeavour to keep pace with inflation, if possible, across all risk profiles this year is working out perfectly so far for 2022 and we have seen some very positive portfolio gains over the past 2 weeks especially in our growth portfolios. Even if the markets pull back a bit when trading opens on Monday we have quite a lot of positive margin having predicted the pullbacks and the recent gains (and positioned for both to reduce drawdown then to take advantage of uplift), and we have robust strategies in place inherent within our client portfolios to deal with volatility.
Our correct predictions during the Q3 and Q4 2021 and Q1 2022 has not been anything ground-breaking, but simply applying common sense to the trading ranges we feel are reasonable given the current macro. We do not hide behind benchmarks by tracking them, we are benchmark aware but we are independent of them and make decisions in the best interests of our individual clients and not for “the masses” which we don’t have and have no desire to have. We are near to the gains that we wanted to achieve and we expect to be speaking with our clients to discuss consolidating some of these gains in the short term to “make and take” and then re-evaluate the markets to pin-point buy-back-in levels as and when we do consolidate some of the recent gains.
UK ECONOMY: NORMALITY RETURNING AFTER PANDEMIC
UK GDP recovered in the fourth quarter despite the impact of Omicron. GDP fell 0.2% in December as Covid restrictions curbed some activity but, overall, GDP increased by 1% in the three months to the end of December. This reversed a 1% decline in the previous quarter. The stronger-than-expected final quarter saw GDP growth for 2021 hit 7.5%. Annual growth compares well to other developed economies as France recorded annual growth of 7% and growth in the US was 5.7% in 2021.
The recovery in international trade has helped fuel the UK’s recovery. Overall, trade volumes picked up with imports and exports both rising by around £6bn in the final three months of the year. Over the course of 2021 imports of goods rose by 8.4% and exports increased by 4.9% – although these remain below the level seen in 2018. Global trade looks set to recover further in 2022 as global shipping firm Maersk this week predicted most supply chain disruption will have cleared by the second half of the year.
UK EQUITIES: HOUSEBUILDERS BOOSTED BY INFLATION EXPECTATIONS
The robust UK housing market continues to benefit construction companies. Although house price growth appeared to slow in January, affordability is a potential headwind for builders as the average house price has increased by almost 10% over the last 12 months to £276,759. However, house builders say rising prices, the end of the Covid stamp duty holiday and the phasing out of the Help to Buy scheme have all so far failed to dent demand.
Barratt Development, Bellway and Redrow all reported half year results this week and said that rising house prices are more than offsetting the rising costs they are facing. Redrow’s half year profits were up 16% as rising house prices push up the profit margin on each completed unit. Barratt reported a slight rise in profits and pointed to very strong orders for this year. Share prices are recovering from a poor start to 2021 as increasing profits will help offset the costs of a new government levy to pay for the removal of flammable cladding.
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Philip A. Simmonds LL.B(Hons), MBA, FPFS, Chartered MCSI
Chief Executive Officer | Solicitor-Advocate (non-practising)
Chartered Wealth Manager | Chartered Financial Planner