Asymmetric Markets – but it’s still all about inflation, which we are addressing wrong!

Blain’s Morning Porridge Aug 7 2023: Asymmetric Markets – but it’s still all about inflation, which we are addressing wrong!

“Hammersmith Palais, the Bolshoi Ballet, Jump back in the alley and nanny goats..”

Lots of conflicting signals in markets, but what does it all mean? It largely boils down to inflation – to understand it we have to think beyond conventional economics and address the causes and reality, rather than punishing the economy!

But first – Holiday Time!

Regular readers will know my passion is sailing… In between the gusts and showers, I spent the weekend boat-bimbling… getting our sailing yacht ready for a short summer cruise. It took a couple of hours to get the barnacles off our rubber-dinghy – I’d left it in the water for a couple of weeks, but the warmest water on record has encouraged a proliferation of marine life such as I’ve never seen before. On the yacht the water intake for the engine was nearly blocked by baby oysters looking to get on the marine property ladder.

The train of depressions that soaked and flattened the UK through July finally shows signs of moderating. Changing weather patterns and the warm-water powered up storms that saw the UK get up to 300% more rain than average in July. It led to one of the roughest Fastnet Races (695 miles to the tip of Ireland and back) in recent decades – with nearly 1/3 of the competing boats retiring. My chums who did the Cowes-Week Regatta last week came back exhausted by the conditions. But finally, the Jet Stream has moved up. Although there are still storms coming through, they are looking less frequent. They winds might still be stronger. At the moment it feels August might just improve. We could even be on for three-or-four days of light winds and blueish skies.

Hence, She-who-is-Mrs-Blain and I are going to grab the opportunity to take a couple of weeks half-off work and sail down to the West Country – available for working-from-boat. Wednesday looks a good weather window. Our adolescent dog has been reminded how to use his Astro-turfed mat. The bilges are full of wine.

The Morning Porridge will remain “On Watch”, but articles will be weather and internet dependent! If we make it to the Scillies, then you likely won’t be hearing from me. If we get holed up in Falmouth, Salcombe, Fowey, Plymouth or elsewhere and it’s raining, then I’ll probably fire up the laptop! (Any readers on the South-West Coast, let me know if you are around..)

Meanwhile, back in the markets…

Last week I listed as many of the issues making markets uncertain, nervous and unstable as I could think of. It was a long list of Reasons to be Fearful, Part 2. 0. “Sing-along-with-Smokey” does not appear anywhere on the current agenda. (You need to be a certain age to get that particular reference. Anyone who does wins a prize..) Of course; other opinions are available – more than a few folk see opportunity in these markets! (They are right!)

These are definitionally asymmetric markets: where multiple competing and opposing perspectives are competing for air-time. Take your pick from the following broad themes:

Underlying growth conditions are excellent as recession will be avoided, a strong recovery will justify higher stock multiples, while stock price upside and value is well supported by interest rates unlikely to head much higher.
There are a host of “exciting” investment themes fuelling investor enthusiasm: AI, healthcare, room-temp superconductors, and now, apparently a US team has achieved “ignition”, a fusion reactor that created more power than was put in.. (Or as one cynic put it: enough power to heat up a domestic iron for nearly an hour…) The reality is we remain decades away from unlimited power, and it won’t be free… but in the meantime, no one want’s to miss out! (FOMO)
Upside from the Magnificent Seven tech stocks and the attention given to new tech is obscuring the painful reality of corporate defaults, rising bankruptcies, declining consumer discretionary spending and other bad news. (Everyone thinks Uber is suddenly magic because it posted a tiny profit…. It was nothing compared to the gazillions its being haemorrhaging for years… and it’s just a taxi-firm!)
Inflation isn’t beaten yet. Global markets remain vulnerable to a crash landing while central banks juggle volatile inflation (likely to be triggered by rising energy/food/supply chains costs) by keeping rates high, fuelling increasingly fraxious wage demands and social instabilities.
There are the wall-of-worriers seeing too much negative news in market to keep sentiment strong: from a looming house price sentiment crash to sovereign debt concerns as rising interest rates impose massive refinancing costs on already over-levered nations like the UK and US, and China’s post covid recovery.
There are plenty of nay-sayers: “stocks are too euphoric”, “bond prices have further to fall”, etc..
Long-term issues such as reconciling climate change and net-zero ambitions with policy when there is a dearth of finance available to fund infrastructure maintenance and repair (forget building new stuff because of Nimby broken planning) seems to be taking a back seat.
Political threat levels are rising ahead of the 2024 electoral cycle. Its looking brutal in terms of polarisation and fake news. The temptation for struggling parties, like the Tories in the UK, to sacrifice long-term climate goals to engineer a quick economic boost ahead of an election looks pretty cynical – but ultimately we have to balance growth with climate.

As always lots of decisions for the invisible hand of markets and the machinations of politicians to muck up. As always.. the answer lies somewhere in-between: “Things are never as bad as we fear, but seldom as good as we hope.” What’s the middle path?

The big number last week was Friday’s US employment report, which stayed resolutely in line with the steady numbers this year: not strong, but not weak either. … demand for labour remains resolute, but less than “hot”. The economy needs workers, wages are still rising strongly, but the pace of new job creation is easing. The mixed number pushed down bond yields and stocks on perceived signs a slow-down is coming. That’s hardly a surprise… job strength, in this case, is a lagging number when central banks are trying to push it down by raising rates.

That’s the big issue for central banks – their only policy lever, interest rates to fight inflation, is a long-term control. It’s not like dropping carbon control rods into a nuclear reactor to immediately dampen the chain-reaction. It’s a similar lag on most effects triggered by rising rates – it takes time to shift expectations and prices by hiking rates… creating imbalances across the economy. For instance, sentiment plunges immediately as house prices fall when mortgage rates rise quickly, but it can take months for inflation to start to fall in which time sentiment has been spanked.

The issue is: maybe the underlying premise on fighting inflation has been wrong? Perhaps the broad brush of inflation hikes via interest hikes is just wrong. Maybe we should seek to address the direct causes of inflation. All the other inputs also lag – particularly energy costs in this inflationary event. Nearly every single of the market themes listed above (except for the new tech coming through) is related to inflation.

The traditional approach to inflation is that everywhere and anywhere it is a monetary phenomenon –all the money the govt unleashed thru QE, Covid Funds, Bailouts, Furloughs, recovery loans and QE squared triggered is now blamed for the current inflation. It is now traditional inflation: pushing up goods costs fuelled by wage demands. The reason it took so long (QE began in 2010) was because that monetary inflation was balanced by deflation from Chinese exports and gains from supply chains feeding into the global economy. That deflationary phase is not going to happen again – great article in WSJ explains how labour is now longer cheap in Asia.

When the current inflation crisis came it was multiple. The first leg of the inflation spike was Covid and the damage it did to supply chains, labour supply and building up spending forgone cash balances in households. The second was rising geopolitical square-offs between the West and East.

But, the event that triggered the inflation outbreak was the spike in energy costs when Russia invaded Ukraine.

The reality is traditional monetary inflation has been embedded in economy – into financial assets – since 2010 when QE and easy money took hold. The response to inflation has been traditional – calm an overheated economy and wage demands with the blunt object of rate hikes to create unemployment and a slowdown – endogenous inflation.

However, the root causes of inflation, ie energy costs and now food inflation remain exogenous – determined by events in the Russia, the Black Sea and elsewhere – not by UK and US workers demanding higher wages, their productivity or such.

Trying to solve inflation by putting workers into austerity in fear of their homes and livelihoods is having precisely zero effect – inflation is falling because energy prices are falling! Doh! Although supply chains have contributed to inflation as more money chases fewer goods, cutting wages with tax-hikes and austerity spending has achieved little except make people more miserable.

What we should be focusing on is stable energy costs. Maybe that’s what central banks should have been telling governments? Don’t fight inflation with a bludgeon, but with a rapier aimed at the specific causes.

I’m coming to a conclusion that higher interest rates will achieve little except embed wage inflation, raise inequality and thus unrest. (Normalised interest rates are another matter to consider.) Inflation will remain stubbornly persistent because of energy costs: OPEC and Winter coming for European Gas again. Food prices look vulnerable on Russia/Ukraine and the developing El Nino and global weather pushing up agri-commodities via drought and flood.

Five Things To Read This Morning:

FT Hedge funds lose $6 bln betting against cruise lines and hotels

BBerg China or India? How to Invest in the Coming Asia Boom?

WSJ The Era of Ultracheap Stuff Is Under Threat

FT Missing Ice and bleached coral: the sudden warming of the oceans

WSJ Investors Bet High Rates Will Linger

Out of time, back to the day job..

Bill Blain

Strategist – Shard Capital