Market Insights

25 October 2022 | Simon King

Thoughts on 2022: Road to Nowhere

We have started writing this piece at least four times in the last two weeks, assuming on each occasion, that the most recent tumultuous political or economic event was the last. How wrong we were.

The current phase of instability in the UK is unsettling, unnecessary and unprecedented. We hope that the 1985 words of Talking Heads do not prove prophetic, but changes must be made to ensure that short term issues do not leave permanent scarring. Mervyn King, ex-Governor of the Bank of England, has eloquently described the situation that we are in and the fact that we must face up to the difficult decisions and implications we must now take, in an honest and non-partisan fashion. King warned about the most difficult decisions to come, including austerity and possibly ‘significantly higher taxes’ to fund public services, both to get the books in order but also to avoid passing on a staggering bill to future generations.

We do not spend all our time analysing UK markets and politics, the rest of the world is actually more important, but the vast majority of our clients live and/or work in the UK, therefore we cannot avoid giving our thoughts on an extraordinary period of macroeconomic turmoil. We will not provide a blow-by-blow account, since effectively we are back to where we started, with one or two rather serious longer-term implications. Our summation is that after a long period of ‘kicking the can down the road’ and then a very brief flirtation with fantasy economics, the UK is finally facing up to the poor position it is really in.

Where to start the timeline for a conversation on the state of the UK economy is a difficult enough decision in itself but suffice to say, many of the current issues we face have their roots in decisions and policies enacted several decades ago. Governments of all political hues have repeatedly eschewed the concept of industrial policies and strategies and have failed to successfully implement the majority of the dwindling number that they have adopted. A period of strong growth after the year 2000, followed by a phase of low interest rates and inflation from 2010 to 2020, have masked a total absence of credible long-term plans in Health, Defence, Power, Social Care, Education and Transport. First Covid-19 and now global geopolitics have exposed this void in a rapid and harsh manner. The UK is not the only country facing these issues, but it is probably the most developed of the bunch.

We try to avoid expressing any political views in our thought pieces but given recent events, we feel obliged to comment on why we believed that the “Trussonomics” was and is a flawed concept. Underlying our critique is our belief that global GDP growth will be lower going forward than it has been previously ie the world will grow more slowly in the future than it has in the past. We have commented on why this is the case in previous commentaries, but it is fundamentally down to an ageing population and a lack of productivity growth. These longer-term trends have been exacerbated in the short-term by a pandemic, heightened geopolitical tension and deglobalisation. It varies on whose forecast you take, but GDP is predicted to grow globally at less than 2% pa for the next decade. The doomed Truss/Kwarteng school of virtual economics sought to average 2.5% with no side effects. In our view this would be very difficult, even with a strong starting position and impossible given the long-term failings discussed earlier. Attempting such a policy may be successful for a year or two but will inevitably create inflation, leading to higher interest rates and/or recession.

If we are right about a very low level of underlying growth, then the only way to achieve any sort of prosperity is to keep interest rates low, which is what has happened since 2009. Unfortunately, to get re-elected, governments also want to keep inflation low, have full employment and minimise government debt. Nirvana is never achievable and at best you can achieve two of the three. At present, the UK is achieving only one: employment, and is also witnessing very high interest rates. The decision taken three weeks ago to essentially borrow to achieve growth, cannot be successful. Markets looked at the plan and said, ‘we don’t like it; you’re borrowing too much.’ Certain politicians retorted, ‘we don’t care about the markets’ but unfortunately, they have to. As a country, we rely on the ‘kindness of strangers’ ie foreigners to buy our government debt, but put simply: they don’t have to. The pound is not a reserve currency or a safe haven in times of trouble. As such, international investors have stated ‘if you want us to buy all the debt (gilts) you need to fund power subsidies, tax cuts and your daily deficit, we will require a very high interest rate’. This means the government itself has higher interest payments to make on its debt and it must, therefore borrow more money to do so.

So, where does the UK go from here? The new Chancellor has completely dismantled the growth strategy of his predecessor but is left facing a slew of short- and long-term issues. He has bought himself some time and will also be aided by the fact that, as the UK fades from the spotlight, its performance and prospects will merge with the rest of the world. In the meantime, the Chancellor will focus on taxation, spending, borrowing and growth. Each of those in their own right is complex and in totality, very daunting. On taxation he will seek to reduce the overall tax take and spread it on a more equitable basis. As the French finance minister Colbert stated in the 1670s “the art of taxation is to pluck the goose so as to obtain the largest number of feathers with the least hissing”. On spending, he will have to renege on previous promises, which will cause disquiet in many parts, but is to the heart of what Mervyn King was talking about. He should not try to disguise real cuts with nominal rises ie budgets will go up but much less than inflation. On borrowing, he will most likely get rates down but will still be left with more elevated rates than was anticipated a month ago, part of the scarring that events of the last month have created. On growth, he has to come up with a lot more than the anaemic supply side reforms of the mini budget. It needs to be a joined-up strategy, with focus on reforms and initiatives that can actually be delivered and not a series of headline grabbing soundbites.

Top of the short-term in-tray is inflation. An alignment of strategy between the Government and the Bank of England will help immediately but cannot deal with the root causes. Indeed there is very little that can be done, and we will simply have to wait for it to run its natural course and suffer the reductions in living standards it will produce. Inflation is a global phenomenon, and its sources are too diverse and deep-seated for any single country to deal with. We stressed our concerns on letting the inflation genie out of the bottle some time ago, but even we have been surprised at how high it has risen and for how long it is likely to persist. It has thrown up a wide range of opportunities in all asset classes. Most interesting for us at present, is fixed income and more specifically, government debt. We have generally avoided this area but are now starting to see some compelling valuations. Although there is still a good chance of further poor performance if interest rates go higher than the market is anticipating, the upside/downside risk is now more balanced. The main factor to be cautious of, is that although inflation rates are similar within the developed world, they are the result of differing catalysts and may move very differently in the future. US inflation comes from an overheating in demand, whereas European inflation is mainly due to supply problems ie with energy. The UK is an unfortunate mix of both, made worse by the impact of Brexit.

We have focussed on the UK in this piece for obvious reasons, but there is a lot going on in the rest of the world that is unfortunately, putting downward pressure on markets. Europe is struggling with energy costs in the short-term and the need to establish effective common policies to cement the advantages of the economic union in the longer term. At present, Europe’s structural issues are being highlighted by the economic turmoil. The situation in Ukraine is worsening in our view and there is a danger that, as it slips down the news agenda, markets forget that it could have a severe impact, both politically and economically, if there were to be another major escalation in hostilities.

The level of tension between the US and China continues to rumble along with the US intent on playing a high stakes game of antagonism, particularly in the semiconductor market. The US economy itself has remained remarkably robust and is certainly enjoying the benefits of Biden’s generous Covid handouts. These looked foolish at the time, and certainly stoked inflation, but at least gives consumers a savings buffer and buys the Government some time (probably deferring outright recession until mid-2023). For different reasons the Chinese economy is holding up relatively well, but investors are more interested in when the zero Covid policy will be lifted. Japan remains our biggest conundrum, performing well as an economy with low inflation, but low interest rates resulting in a weak currency.

In summary, we are witnessing a truly remarkable phase in economic history. With most major monetary authorities hellbent on taming inflation and raising interest rates into weakening economic conditions, we see recession as inevitable. Our hope is that it is a shallow one with less outright unemployment than usual, but painful nonetheless as real wages and living standards decrease over a long period of time. There are currently no hiding places in investment terms, everything went up together and now it is coming down together. However, markets are now discounting much of the current and future turmoil and certain areas are starting to look very interesting. Change always brings new opportunities, which we continue to seek out for our clients. If we can have the difficult debate, and more importantly take the difficult decisions we have discussed, then we can start to make progress. At the end of the day markets prefer to go up.

 

 

 

 

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