Jupiter: Jupiter Merlin Weekly: Welcome to cold turkey

That was the week that was! We recently wrote of the 30th anniversary of the UK’s ejection from the European Exchange Rate Mechanism in 1992. This week shared some of those febrile sensations though not quite with the same level of heightened drama. And now the blame game is under way.

And she hasn’t even been Prime Minister a month

Clearly fingered is Chancellor Kwasi Kwarteng, the author of the ill-fated mini budget (now referred to euphemistically as a ‘fiscal event’). Prime Minister Liz Truss cannot escape the pillory too: it was her ideology of ‘Trussnomics’ and the emphasis on low taxes repeated ad nauseam on the Tory leadership campaign trail which Kwarteng subsequently turned in to policy. Whatever the arguments of the economic and ideological rights and wrongs of that policy, its political naivety and its deeply flawed execution are significantly politically damaging, possibly fatally. “Black Wednesday” sealed the fate of John Major and led to the Tories’ electoral evisceration in 1997, not because the UK did not directly benefit from our ejection (it benefited enormously), but because the fact of it happening at all was put down to incompetence. Already dubbed “Dis-Trusst” and “KamiKwasi Kwarteng” by detractors, those derogatory, stinging nicknames will endure until the election in 2024 as a badge of mismanagement and incompetence. It is interesting to make the comparison: in all the ‘Partygate’ shenanigans precipitating Boris Johnson’s eviction from No 10, he was still universally ‘Boris’, at worst ‘Johnson’, even to his political enemies and those who hated him personally.

Blaming it all on UK tax cuts misses the fundamental and much bigger point

But if last week’s budget and its tax cuts in particular were the lightning rod for a flash crash requiring the Bank of England to step in to avert a systemic crisis in the pensions market but with the ripple effect spreading much wider, the fact is that the storm clouds had been brewing globally for years. All that was needed was a catalyst to discharge the tension which had built in the economic and financial system going all the way back to the financial crisis of 2007-10.

For the uncomfortable truth is that however much the finger is being pointed at the hapless Kwarteng and ‘it’s all his fault’, his was merely the straw which broke the camel’s back. For more than a decade-and-a-half, western economies have been in the grip of lazy, left-of-centre Keynesian economic groupthink. It has been too easy, too convenient to maintain the status quo. We have all been complicit in propagating and taking advantage of it: governments, central banks, investment banks and the financial community, companies, individuals as consumers, and investors.

QE defibrillator: apply terminals! Stand clear! Now! Bang!

The Global Financial Crisis was a seminal moment in financial history; the period, especially in September 2009 and the Lehman crash, when the entire Western financial fabric faced the very real prospect of total melt-down. Quantitative easing (QE), the mechanical process of buying government bonds in bulk to inject immediate mass liquidity into the financial system was born. It was designed as a financial defibrillator, to shock the banking system back to life again, to stabilise and restore its natural rhythm. Its simultaneous effect was to drive bond prices up and yields down to bring those yields more in to line with interest rates which had been reduced earlier in the crisis to zero. The ultimate position was reached on March 23, 2020, when confronting the pandemic crisis the Federal Reserve declared its support for the high yield sector, formerly known as Junk: the dangerous inference was that investment was a riskless exercise. It is not.

Instead, QE became an addiction, embedded in the economic and financial fabric

If QE was designed as a quick financial fix, what it was never originally intended to be was a long-term economic crutch. What it became, and remained so until this year, was less a defibrillator and more an addictive drug. In the drug addict analogy, QE is the delivery mechanism, the syringe; but the drug itself, the economic heroin, is liquidity in the form of debt. And if the debt is essentially free, it’s even better because it costs nothing to add more.

‘Cold turkey’ on the withdrawal path was evident on several occasions as the Fed in particular tried to unwind QE, slowing the bond purchases with the intention eventually of stopping altogether. 2013 was the first adverse reaction, one of several which followed, dubbed ‘taper tantrums’. Bond investors saw the major supporting agency, the central bank, habitually buying bonds from them and helping keep bond prices rising, casting them adrift. The natural reaction? Get rid of your own bonds and book the profit before prices go down. Everyone else follows suit. Result? A collapsing market. How do we restore order (the prime function of a central bank is the maintenance of orderly markets)? Get the central bank to engage reverse gear and buy bonds again.

But it was the Bank of Japan (BoJ) and the European Central Bank (ECB) which began to use QE in a very different way, not as a financial prop but as an instrument of economic policy to try and stimulate inflation and economic growth too by accelerating QE to the point that the excess liquidity added to the money supply would trickle down to the real economy and the consumer. Everyone would benefit – in both jurisdictions, but particularly in Japan, there was determination that the strong deflationary pressures facing both economic regions were the real danger, leading to long-term economic decline; their brand of QE was designed at least to temper those forces. The BoJ extended QE to include not only government bonds but lower strata of fixed income, and eventually equities too. In 2015, the ECB started buying bonds issued by national eurozone governments, not equal in quantity to their issuance but in multiples of it; the inevitable result was a persistent rise in bond prices and a significant drop in bond yields to the point they became negative, consistent with the ECB’s negative deposit rate of -0.5%.

As is well documented, QE produced rising bond prices but caused other assets to correlate too, in particular equities and property, as investors (and in this equation, the ones that matter are the pension funds and the life companies) sought less expensive sources of cash income to meet their liabilities as bonds became increasingly poor value. Investors had no reason to see the end of QE if the result was the prop supporting markets being pulled away.

As inflation stayed mostly within the limits of the common target of 2% inflation shared by the principal central banks (the Fed, the Bank of England, the ECB and the BoJ), so there was little incentive to shift policy despite universal negative real rates of interest giving zero incentive for governments, companies and individuals to save cash and every incentive to borrow more.

Cheap or free debt released government purse strings: bingeing on debt

Governments, benefiting from ultra-low bond yields (i.e., the cost of borrowing) were seduced by being able to spend greater sums ostensibly safe in the knowledge that every marginal pound, dollar, yen, euro added to the national balance sheet was at little or no cost (indeed in Europe, with negative yields, investors were paying to lend money to governments! Just to drive the point home, governments were being paid to borrow. How weird was that? But it happened!). While in the aftermath of the global financial crisis (GFC), governments made some efforts to contain their deficits and to try and restore balance sheet strength (here it was labelled “austerity”) by cutting public spending, the political choices were difficult, often too difficult. “Austerity” was cancelled in the UK by Theresa May in 2017, a word never to be uttered in front of the electorate again, so politically loaded was it.

Indeed, the fiscal policy landscape had changed considerably. A decade of anaemic growth and low productivity with falling real earnings was to be met with stimulus. Governments of all political persuasions would spend on a grand scale: infrastructure; welfare; the accelerating shift to carbon net-zero. Deficits were the norm, the need to reduce debt shelved. Fiscal stimulus aided and abetted by loose monetary policy is the breeding ground of inflationary pressures.

The one notable and honourable exception was Germany where post-GFC policy makes it illegal for the government to budget a deficit of anything but the smallest proportion.

Debt has become all-pervading

“Prudence” was the term coined by Gordon Brown in 1997. She and her prim skirts were long ago confined to history, indeed by Brown himself. By the end of 2019, most major western economies had government debt in excess of their GDP and growth was dragging at below long-term historic trend rates. But companies too had changed behaviour. If up to the early 2000s in the Anglo-Saxon world equity financing had been popular, debt was rapidly taking over as the principal source of capital. It was cheap, accessible and readily available, it could be rolled over with little difficulty even by companies who should not have been lent it in the first place. Investors were complicit, encouraging companies to change their financial structure and lower their weighted average cost of capital to increase returns by taking on more and more cheap debt. What might potentially happen to the cost of funding that debt was conveniently forgotten, to be dealt with some other time.

And then the pandemic hit, followed swiftly this year by Putin’s invasion of Ukraine and what is in effect World War Three by proxy. The fiscal and monetary response, the sanctions regimes and Putin’s reactions and their inflationary effect are well documented and will not be repeated here. We have discussed them many times.

The IMF goes public. Unwisely.

However, some of this week’s events need to be dealt with head on. The International Monetary Fund’s (IMF) intervention in UK government policy was both unhelpful and unwarranted. A spokesman said ours are not ‘conventional policies’ of a ‘responsible G7 country’, more those of an ‘emerging economy’. What he really means is that it is economically heretical in his view to break with the conformity of groupthink, to do something different, to break the status quo. The counter to that is that only time will tell whether ‘Trussnomics’ will succeed or not (and there are plenty of monetarists who argue that given time and opportunity—both admittedly in short supply– it will); but what is equally clear is the truth in Einstein’s theory of insanity: that everyone doing the same thing repeatedly will somehow produce a different result; we’ve tried that already and it didn’t. But as damaging, and irresponsible, in allowing the inference that the UK is a banana republic he is telling international investors that the UK’s creditworthiness is suspect. If the bond ratings agencies downgrade UK debt, investors will demand a higher rate of return to compensate for the perceived greater risk. Funding costs rise further which is immediately inflationary and debilitating economically in the longer-term. The IMF’s could be a self-fulfilling prophesy.

While the domestic media focus has inevitably been very much on the UK, leaving aside our Chancellor’s successful attempt casually to shoot himself in the foot, to a greater or lesser extent most western governments are all making heavy weather of dealing with the near-universal cost-of-living crisis. One government, Italy’s, has already fallen directly as a result. It is unlikely to be the last.

The UK has undoubtedly produced its own pratfalls but the essential truth of what confronts investors is that across the western world, previously complacent central banks are now going flat-out using monetary levers to try and contain inflation which ran away from them, while governments’ fiscal policies are still fully pedal to the floor spending money and increasing their national debts. They are pulling in opposite directions. That is the definition of irrational economics, something on which the IMF remains surprisingly mute (nor curiously did it feel necessary to wade in in July when the ECB had to announce emergency measures to prevent exploding Italian and Greek bond yields presenting a systemic risk to the eurozone, deploying tactics which are not only irrational and illiterate but quite possibly illegal; perhaps because Christine Lagarde the current head of the ECB was previously Managing Director of the IMF and her successor at the IMF, Kristalina Georgieva, is a former European Commissioner? Perish the thought!). The cost of funding that debt is rising not by percentage points but in multiples, and very quickly, and not just in the UK. It is a toxic brew, manifest in the extreme volatility seen in global bond prices, currencies and, so far to a lesser extent in equities.

We’ve enjoyed the high. Now endure cold turkey

But further, it is the dawning reality that as the central banks reverse tack from a decade-and-a-half of ultra-loose monetary policy and being supportive of markets particularly through their erstwhile bond purchasing programmes, that drug of QE, to the opposite and quantitative tightening and them actively selling bonds, they have removed that monetary crutch which markets have come to take for granted for so long. Welcome to cold turkey. As investors adjust to having to assess risk without that central bank back-stop but in an increasingly uncertain economic environment with a recession looming exacerbated by President Putin’s malign influence on global inflation, increased volatility must be expected.

Debt!

But the one thing we all need to get a grip on is debt: governments, central banks, companies, investors, us as consumers. It is not free and should not be so. The cost is variable, something we had forgotten. And it is someone else’s money; while it is easy to kick the liability can endlessly down the road, eventually they do want and expect it back!

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