We began the year with an episode of panic. We end it with something of a Santa Rally. And in the meantime a couple of western governments have fallen at the hands of “populism” and the US has elected her first ever president to have served neither in politics nor the military. Can 2017 sustain this level of interest? Here are some thoughts on themes to watch in the New Year.
First of all: interest rates. The trend in “safe haven” government bond markets has already reversed. The Fed shocked some this week by indicating a forward path for monetary tightening which is not quite as glacially slow as had become customary. So this theme is already underway.
Monetary tightening is an unfamiliar concept these days, however, and its effects are unpredictable. Some key details to watch will be the impact of higher rates, if any, on corporate margins (including for private equity) and mortgage borrowers. The possible influence of higher bond yields on fiscal arithmetic could demand attention, especially here in the UK. Higher yields in the US could have all sorts of side effects on emerging market capital flows, credit spreads and equity pricing, and then there is the possible spillover for the dollar.
Volatility, then, is to be expected. And it is (worryingly?) easy to identify disaster scenarios from this source. A central bank, for instance, which balks at tightening policy too fast and decides to leaven the blow with some cosmetic unwinding of its QE program, panicking risk markets in the process. Or a bank which decides to take a risk on supposedly short term price behaviour and holds back on hiking rates . . .
. . . Fuelling inflation. Now this dog hasn’t barked for years and, to stretch the metaphor, has been blocked in its kennel by barrels of cheap oil since late 2014. Will prices take off, especially in Britain and the US? By how much? How will this compare to expectations? What will the impact be on real wage growth? And fiscal arithmetic? And profit margins? Again, disasters on some or all of these fronts are easy to conjure up. And again, inflation is a rather unfamiliar animal nowadays. Here in Britain it hasn’t even reached the Bank of England’s 2% target for three years.
The consensus for a while has been that equities are a good inflation hedge. This might turn out to be true (though it wasn’t at the time of the major price shocks of the 1970s). But earnings reports will bear close scrutiny next year. Equity markets have been filling themselves with cheer a long, long time before the run up to Christmas. If EPS do not catch up with prices then the latter could prove more vulnerable to an unpleasant surprise.
Political risk looks set to continue as we approach the New Year. Europe is an obvious place to focus on with elections in France having drawn a lot of media attention – though the Dutch will get there first (15 March plays 23 April for the first round of the Le Pen-athon). Geert Wilders is likely to win the most seats but will there be some kind of “grand coalition” to stop him becoming PM? Then there are the usual tensions to consider, as well as the overhanging threat of terrorist barbarity in many parts of the world.
Looking at this little list – interest rates, inflation, earnings and politics – it is easy to contemplate next year with a sense of foreboding. But we should not be too gloomy. President Trump’s policies could prove expansionary for the US economy and positive for Wall Street. After all, its reaction to his election on 8 November has seen the S&P 500 rally by 6% since then. Putting Brexit to one side the rest of the EU could well muddle through the possible electoral upsets of 2017 with Brussels and the euro very much intact. They survived the sovereign debt crisis. Will this be any harder? Note, too, that the Dutch referendum to veto an EU agreement with Ukraine (6 April) has been sidestepped with a certain amount of Eurofudge and a newly minted trade deal, with no explicit possibility of accession, has been agreed only this week. PM Rutte is to put it before the Dutch parliament soon.
Manageable inflation and modest rate rises might not trouble markets unduly. Yes, weak EPS could be the straw that breaks the equity market’s back in the right circumstances. Equally, strong earnings growth could be the icing on the cake. Either way, these are some of the key moving parts to keep our eyes on as the calendar turns over another page. The only advice this blog can give is general, and not really susceptible to the calendar at all: where investors have views on these things they should position for them, with careful thought, and ongoing vigilance.
“Mr Speaker, I am abolishing the Autumn Statement.”
2016 has already delivered much in the way of political upheaval. But no one was expecting this! Granted, there was much laughter as the new Chancellor told MPs that, having done away with the traditional spring Budget and Autumn Statement, he would be moving to an autumn Budget and a Spring Statement. (He had to clarify that this really was a significant change because the Spring Statement wouldn’t actually say much.)
Thus concluded the only truly dependable projection from HM Treasury. What did the rest of this, the last ever Autumn Statement, have to tell us?
Reports of the event were dominated by the forecast effects of Brexit. Of course, nobody knows what these will actually be. The Office for Budget Responsibility plumped for lower growth, higher inflation and more borrowing than before. Its guesses are worth no more than the Bank of England’s – though they were, interestingly, very different. The Bank, in its Inflation Report out earlier this month, had GDP for 2018 and 2019 coming in at +1.5% and +1.6%. The OBR thinks the answer will be +1.7% and +2.1%. Counter-intuitively the OBR is also forecasting lower CPI inflation (2.5% and 2.1% as against 2.7% and 2.5% over on Threadneedle Street). It is likely mere coincidence that higher growth and lower inflation will have combined to produce a less alarming debt forecast. In any event, the inconsistency serves to demonstrate nicely the speculative nature of all these kinds of exercise.
Regular readers will know how important the level of gilt yields is too. They have fallen since the Budget and this has delivered a projected bonanza of £24bn over the course of the next five years. That is the impact of a fall in gilt yields of all of 0.3%. (So long as they don’t go up again, the nation’s finances are safe. Well, safeish.)
The Chancellor briefly alluded to longevity and suggested that the next Parliament consider doing something about it. This is a good idea: the state pension bill is forecast to reach £101.9bn in fiscal 2020-21, up from £91.5bn this year. And that represents a compound annual increase of only 2.7%. More aggressive inflation, or a higher rate of earnings growth would push the cost higher.
We have no idea what growth and inflation will be over the next few years. Nor does the Treasury have much, if any, control over interest rates. There are, however, material numbers over which it does have some say. And in this febrile political environment, with Brexit on the horizon (or possibly not), public debt already forecast to reach 90% of GDP soon and no medium-term prospect of balancing the books, what is the expected net impact of the Chancellor’s policy decisions? Why, to widen the budget deficit by £4bn next year, £6bn in 2018-19 and £8bn the year after that! And those numbers are predicated on the basis of 43 discrete policy changes covering everything from tax reliefs available to museums to the exemptions regime for social sector rent downrating. Taxes up, borrowing up and the tax code as complex as ever. The ghost of Gordon Brown still hovers over the building whose magnificent remodelling he instigated all those years ago.
But – as many have felt, at times, this year – enough of politics. Despite the mainly Brexit-related fuss it caused the Autumn Statement contained nothing to suggest that the management of the country’s economy is to undergo change. The UK’s national debt remains problematic, and the Treasury seemingly content to be at the mercy of future events. That, from a pure investment perspective, is the key message from the last Autumn Statement in history.
The election of Donald Trump to the US presidency apparently “wiped out more than $1 trillion across global bond markets“, as reported by Reuters earlier in the week. The inflationary nature of his policies has not, after all, gone unnoticed. Bond markets have digested new information and responded rationally, by falling in price so as to offer investors the prospect of higher real returns. Yes, the politics have tinged the reporting – as with the economic consequences of the UK’s decision to leave the EU. But surely the picture is clear: an event has occurred, markets have responded efficiently and their response is cause for concern.
As in the case of Brexit, however, the political element seems to have cost some observers their perspective. Starting with the obvious: only part of that $1trn comes from the US itself. And bond markets have been weakening for some time: Mr Trump’s election only accelerated the process. Referring to the BofA Merrill Lynch US Treasury Index, the full market value of US government bonds climbed to a peak of $9,729bn on the 8th of July, when the ten year bond yield reached a record low of 1.36%. By 8 November, before there was any indication of the surprise election result, this value had already fallen to $9,507bn. As of yesterday, the number was $9,296bn. So most of the fall since the summer preceded the new president entirely.
More broadly the invocation of a “Trump thump” is a symptom of the behavioural concept known as anchoring. We had become very used to both the recent level of bond yields and the pace of their rise before the election, so the sudden change shocked us into thinking that something anomalous had occurred: in this case, a dramatic change in policy direction arising from the victory of a candidate from left field.
This is at best a partially misleading analysis. Inflationary pressure has been mounting – and disinflationary forces have been receding – for some time. Look at the prices of base metals and freight and global activity seems to have been picking up over the second half of this year too. What is strange – perhaps – is that bond yields remained at record lows for such a long time. Putting it unkindly, bond markets have often seemed to care much more about the last ten weeks than the next ten years. There is a case to be made that the so-called “thump” was no more than a catalyst to their ongoing recovery from inertia.
Time for some more context. Yes, the US 30-year yield has risen by its fastest pace since at least 2009, putting on 40bp in four trading sessions starting last Wednesday week. But it has since spent the whole of this week hovering around the 3% mark. The initial spike was unusually volatile, but taking a slightly longer view the 30-year yield has now risen by about 1% in total since its July low – and did exactly the same thing over a similar period in H1 2015.
Look at current pricing in absolute terms and 3% is not even a high number. Trump has only managed to thump the 30-year Treasury yield back up to where it ended last year. It is almost exactly in line with its five-year average. And this is still miles below the 5.3% it posted on the cusp of the credit crunch (21 July 2007).
From another angle, a 3% return for thirty years looks plausible in real terms if we focus on the most recent American CPI data (last in at +1.6%). But long run expectations according to the University of Michigan survey are closer to +3%, and the 21st-century average prior to the Great Recession was +2.8%. On that basis the election result has only delivered US investors a prospective 30-year real return of 0.0-0.2%. In fact if one really wanted to get bearish on bonds one might observe that these levels of inflation would, not so very long ago, have been regarded as unachievably benign in any kind of growth-positive environment for the US economy. That is why the bond market has been able to rally to new highs year, after year, after year since inflation peaked at 15% in 1980.
So from a politically detached perspective, perhaps we should forget about Mr Trump’s impact on the US bond market. Fundamentally speaking he has taken the stage as accomplice, not assassin.
What we oughtn’t to do, of course, is forget about the possible impact of bond markets . . .
Well that clinches it, surely. Today’s US data showed the unemployment rate down again to 4.9%. Payroll growth continued at a strong pace, with non-farm jobs up by 161,000 last month. Both these prints came out in line with expectations – but wage growth beat every estimate going, hitting a new post-recession high of +2.8% on the year. Purchasing manager surveys out over the last couple of months suggest that the rate of job creation will accelerate into the end of this year if anything. The American labour market is showing clear signs of warmth. Surely, a Fed hike next month is certain.
This chimes with the consensus view. Of the 66 forecasts currently made available to Bloomberg, 15 expect no change and all the rest are for a 25bp hike. The interest rate markets also expect the Fed to see out 2016 with a target rate of 0.75%, then go on to hike again around the middle of next year.
So far, so uncontentious. Indeed it is reassuring from an investor’s perspective that the market reaction to somewhat firmer expectations for interest rates has, thus far, been sanguine. Halfway through this year a December hike had yet to be priced in; by the autumn the eurodollar futures market had become unequivocal on the subject – Treasuries sold off too – but the S&P 500 still rallied, turning in its strongest quarterly performance of the year so far.
The key word there is: “somewhat”. In the US as in Britain there is now a real risk that tightening occurs more quickly than people think.
That +2.8% wage growth is part of the reason why. A connected reason is that the energy sector has recovered some of its strength this year, taking away a recent source of downward pressure on activity and employment. Then there are import prices: stable oil and a stable dollar have now closed off that source of deflation. Core CPI has already been running at its strongest sustained level this year since the Great Recession. Both the headline CPI measure and the consumption deflator used to calculate chain-weighted GDP have been catching up. Finally, unreliable indicator as it is and completely unfashionable as it has become, broad (M2) money supply growth is running at its fastest pace for nearly four years.
The question to which nobody knows the answer is: will the labour market start really overheating and, in the circumstances, contribute to an uncomfortable level of inflation? At the moment, US policymakers are split on the subject, but the Fed’s actual monetary response to date, together with the interest rate markets’ pricing, implies a near-total lack of concern.
Another wild card is our old friend political risk. At present, polling at the national level and in some of America’s “battleground states” suggests that Secretary Clinton is on course for a narrow victory. If Mr Trump were to pull off a surprise win, however, it is not just the market response but the economic consequences which could be significant. There has already been extensive coverage of the effect that the candidates’ fiscal policies might have on the national debt, but consider some of the Republican candidate’s other measures: the expulsion of migrant labour, swingeing tariffs on imports, less accommodative trade agreements (as well as big tax cuts for businesses and households). All of these would be inflationary.
It would be imprudent to expect a crisis. But the possibility of a problem is clear and what matters to us as investors is that this is not recognised – indeed, quite the reverse. Bond markets think that inflation over the next ten years will run at an average of 1.7%, below the 2.1% they have priced in on that horizon over the last 15 years. Consumer expectations for near term inflation, as measured by the University of Michigan survey, are below average too, and for long term price behaviour are at their lowest ever level.
So there could well be a surprise or two in store. And whatever its scale, this ought to have consequences for portfolio construction.
Followers of the UK’s business media will have noticed coverage of an unfamiliar subject this week. On Tuesday we discovered that the annual rate of CPI inflation had rocketed up to 1%. Last week this blog opined that it was actually input prices which would merit close attention; this did not happen so detail on those shortly. First, however, let us deal very quickly with the headline rates.
1% on the CPI is indeed “the highest rate of inflation for nearly two years”. But that is not saying terribly much for two reasons:
- Over the longer term 1% is an insignificant number. Before the recent period of energy-driven disinflation CPI hadn’t fallen as low as 1% since September 2002, when the world was still recovering from the collapse of the TMT bubble. Its average over the past 20 years has been 1.9%. Exactly five years ago it peaked at 5.2%. So it ought to be difficult to become too excited by the print on Tuesday (which was broadly in line with expectations anyway).
- The “core” CPI measure, which cuts out energy, food, alcohol and tobacco, had already hit a level of +1.5% this March. What we observed this week was the continued closure of the gap between core CPI and the headline rate. In other words, the pickup in headline inflation tells us more about the dwindling influence of cheap oil than it does about, say, the weakness of sterling.
This is not to dismiss the significance of the CPI data entirely. But if we are looking for the fingerprints of the pound we will not find them here.
And so to PPI: producer price inflation.
There has been a little more drama here. Input prices were again up by more than 7% on the prior year – not at quite as high a rate as for August but nonetheless, this measure is showing more heat now than at any other time since 2011. And this time we know sterling has something to do with it since the core measure of input price inflation, which strips out oil among other things, has also reached levels not matched in almost five years. We should expect this to be the case: with the pound down by over 20% on a trade weighted basis in the past year it is a matter of the “basic laws of economics”, as one of the better comment pieces had it this week (it always a pleasure to find that one has friends in common with people).
That piece also carried a forecast from Lord Haskins, former scion and chairman of Northern Foods, that food price inflation in particular is on track to hit about +5% in a year or so. Again, those “basic laws” do tend to repeat themselves. The last time we had a comparable fall in sterling was during the years 2007-8 when the trade weighted index shed nearly 30%. By mid-2008 that input price inflation had peaked not at +7% but at +35%. Back then the food component of the CPI hit a ceiling only at +14.5% making Lord Haskins’ prediction seem quite mild.
Of course in 2008 this didn’t last. The currency found a level and input price inflation fell away again. The domestic economy was contracting, and output would not fully recover until Q3 2013. Unemployment had already started to rise – though it would take three years to reach its peak of 8.5%. And the housing market was in a state of freefall. (It was not until mid-2014 that the average UK price would recover its 2007 high.)
Back to the present.
Should sterling hold its current level the inflationary impact on producer prices will persist, to a greater or lesser extent, into the summer of next year. And nowadays the position of the economy could hardly be more different.
GDP growth of +2.1% is precisely in line with its 20-year average rate and though such estimates are fertile grounds for analytical controversy is likely to be near or at its trend rate. Similarly unemployment of 4.9% could well be regarded as “full employment” and nationwide house price inflation is still running at over 8%.
Given that Britain’s circumstances are so very different today, what is curious is that the policy response to all this is exactly the same as it was in 2008: interest rate cuts and QE from the Bank of England, and if he can get away with it in next month’s Autumn Statement, fiscal largesse from the Chancellor (gilt yields suggest he might be able to fiddle his way to justifying it despite the lousy borrowing numbers out this morning).
Something about this is not quite right. Perhaps the Bank’s expectations that Brexit will see labour market slack and falling output will be met. But even the Bank acknowledges those Basic Laws. And in only a few months’ time, the clear signs of price inflation simmering away at the bottom of the pot could very easily have erupted into a vigorous boil.
At midnight last Thursday, the pound fell by more than 6% against the dollar. Its intraday (intranight?) low was 1.1841. Since then, cable has stabilized somewhat. It currently prices at about 1.22, up from a closing low of 1.2123 reached on Tuesday. So what does the pound’s latest “31-year low” – or even “168-year low” – signify, if anything?
First let us consider the very straightforward economic consequences, which are twofold.
On the positive side, the cost of buying British goods and services from abroad, from JCBs to tour bus tickets, falls. This is growth positive. It is also why currency devaluation is one of the most obvious and best understood forms of monetary easing.
On the negative side, the cost of buying foreign goods and services in Britain, from rice to Ritalin, increases. This is growth negative since it compresses margins for importers and makes consumers poorer. This is also why currency devaluation is a risky and unpredictable means of monetary easing.
One key question for the British economy is: which of these two effects will predominate? That depends purely on the inflationary impact. If this is relatively modest then devaluation will increase growth without hitting people’s pockets, or firms’ margins, too forcefully. If it is significant, however, then the devaluation will depress overall economic activity since domestic demand accounts for a far more substantial part of output than exports (62% versus 30% on Q2 GDP data).
It is hazardous to speculate as to which outcome Britain will face. On the one hand, supranationalist media sources are sure the export benefits will be slight and the inflationary impact severe. On the other, Brexiteering sources seem not to have considered the inflation question at all.
One thing we can do is examine the scale of the pound’s recent fall with some detached perspective.
Cable has fallen by 29% since the high of 1.7166 it reached in early July 2014. Its all-time closing low was posted on 26 February 1985 at 1.0520. However the pound has not yet broken through its December 2008 low against the euro (€1.025) or its more recent (2011) low against the yen. Looking at the Bank of England’s trade weighted index, which pits the pound against a basket of other currencies, this week’s low was barely through the previous record level reached in 2008 (73.3 versus 73.4 back then).
It is understandable that the focus of the media should be on the sterling exchange rate which has moved the most dramatically. However, again with some detachment we ought to observe that cable’s recent history has been affected by dollar strength as well as sterling weakness. The Federal Reserve’s trade weighted dollar index has risen by more than 21% since its 2014 low. Indeed, while the pound has fallen by 29% against the greenback the euro has not been far behind, dropping 21% since its own 2014 high point (from $1.39 to $1.10 today). Without wishing to overdo the point about press coverage one does not see headlines in The Economist about “votes of confidence” in the single currency.
Some sources have taken things further, with Bloomberg claiming that the pound has become an emerging market currency: “the new Mexican peso”. Now at the time of the “tequila crisis” back in 1994 the peso more than halved in value against the dollar in under three months. More recently, the Brazilian real almost halved in value as commodity markets collapsed in 2014-15. Again, a little more perspective would be nice.
This is not to downplay the risks arising from imported inflation. The UK’s next CPI and RPI prints will come out on Tuesday. PPI input prices in particular will merit close attention. Year on year they have already rocketed up from -15% to +8% in the space of 12 months. That inflation has to go somewhere: again, either into shrunken margins or consumer’s pockets (and if it persists, most likely both). Back in 2007, RPI inflation rose at around 4-5% and food prices were making tabloid headlines. Inflation also means higher pensions, higher gilt yields and higher public sector wages, all of which is bad news for Britain’s strained fiscal arithmetic.
Furthermore, Mark Carney today confirmed the Bank of England’s insouciant attitude to inflation at a “public roundtable”, saying that while he appreciated that it could cause problems he was willing to see the Bank miss its target to protect against the supposed loss of jobs into next year. (Readers of this blog will know that the MPC officially abandoned its founding mandate back in August). Markets are less complacent: expectations for a further cut in the base rate have evaporated, and the ten year gilt yield has risen to 1.1% from the record low of 0.52% it established only a couple of months ago.
Now price increases were back in the tabloids again just this week. If imported inflation does cause problems, and the Bank does nothing to stop it, then the ugly devaluation scenario may well end up playing out. Looking at the bigger picture for sterling, and not just the cable rate, we ought not perhaps to panic overmuch. But even at a princely 1.1% the gilt market is not remotely priced either for an uncomfortable patch of price behaviour or the policy normalization required to deal with it. There could be some interesting developments ahead.
It was obvious at the start of this year that the behaviour of the oil price would be one of the key economic variables of 2016. We saw sharp falls early on, with lows below $30 repeatedly tested. (Had these persisted the disinflationary impact of cheaper energy would have continued into the winter.) Then there was a convincing recovery, along with risk assets, into the spring. And over the past few months the price has stabilised convincingly for the first time since the initial fall in 2014, holding a range of about $45-50 since the middle of April.
This week’s OPEC meeting might be expected to reinforce that stability. The decision was announced on Wednesday to reduce the cartel’s crude output by about 0.25m-0.75m barrels per day. (Details of individual production quotas are to be agreed at the next meeting in two months’ time.) There are the usual question marks over the credibility of the OPEC system – diplomatic tensions between its members, doubts as to their adherence to quotas in the first place and so on. Crude has fallen back a bit today on profit taking and on fears that the deal, modest as it is, might yet fall through.
But the announcement was significant. It is the first cut agreed since 2008. Should November’s meeting prove fruitful the group’s quotas will have changed for the first time in five years. It has encouraged Russia to start talking about a production freeze again. It hints, in short, at the firming of the bottom end of the range we have seen oil prices occupy over the last five months.
This is doubly true when we look at recent changes in the balance between crude supply and demand. Over the course of 2014, the six-monthly average global production level increased by 2.8m bpd as against a 1.1m bpd increase in demand. Albeit on a much lesser scale the reverse has happened since: six-monthly average global demand has risen by 2.3m bpd versus a 2.0m bpd increase in supply. In fact the production surplus as of August, again using the six-monthly average, had fallen to 443k bpd down from a high of over 1.5m bpd in mid-2015. So the OPEC cut, especially if accompanied by a Russian cap on output, would bring supply consistently below the level of aggregate demand for the first time in over two years.
Looking at this from the other end, rising prices would come under pressure from increased production from other sources, notably US shale. Cost efficiencies have already seen the oil rig count rise by 32% from the low it reached back in May – and it remains way off the mid-2014 highs. The current range for crude, then, would appear to be secure both from persistent falls and persistent increases. It could be a case of 2012-2013 all over again, just at the $50ish per barrel mark rather than $110.
There we must add a note of caution. For some producers, $50 per barrel is too low. OPEC granddaddy Saudi Arabia has just had to funnel billions of dollars worth of state support into its banking system. Its reserve assets peaked at $731bn back in 2014 (about 100% of GDP – quite a cushion). Since then they have fallen by almost a quarter to $553bn. That’s a sharper fall than Russia has seen over the same period (-15%. Indeed, Russian reserves have been climbing steadily for more than a year). At the extreme end of the spectrum, there is the bitter human tragedy unfolding amid the ruin of Venezuela. The fall in crude has not killed off shale, but it has put several economies under varying degrees of strain. If there is a real challenge to the OPEC deal this blog suspects that it will come about from economic imperatives rather than political disagreement.
Deal or no deal, oil seems to have found its level more securely than ever now. Regular readers will know what this means for inflation, and, depending on the reaction function of the central banks concerned, monetary policy in due course.