Bank of England confirms sticky inflation and reflation, and the big lesson from the Ukraine war.

Blain’s Morning Porridge – May 18th, 2023: Bank of England confirms sticky inflation and reflation, and the big lesson from the Ukraine war.

“The Thin Red Line wavered but held, then drove them from the field.”

 This morning:  Two parts this morning: What the Bank of England actually said, and The Big Lesson from the Ukraine War is simple: “Things are seldom as bad as we fear, but never as good as we hope.” Global geopolitics and markets have taken a knock, but will coalesce around whatever new global links emerge.

Part 1 – What the Papers’ Headlines miss

This morning I am a bit confused. The headline in the Financial Times says: “Bank of England governor admits UK economy suffering from wage-price spiral”. The Thunderer (The Times of London) proclaims “Inflation set for sharp fall, says Andrew Bailey”, and the Torygraph (the journal of the conservative party (note small c) leads with essentially the same as FT: “Andrew Bailey admits Britain is suffering a wage-price spiral.”

I went to the Bank of England’s website this morning and read the speech “getting inflation back to the 2% target.”  It is eminently sensible, describes what happened and says:

• “We do have good reasons to expect inflation to fall sharply over the coming months, beginning with the April number to be released on 24 May.”
• “Even as headline inflation is coming down, the MPC pays particular attention to indicators of inflation persistence, including labour market tightness and wage growth, and services price inflation.”
• “The Committee continues to judge that the risks to inflation are skewed significantly to the upside, primarily reflecting the possibility of more persistence in domestic wage and price setting
• The MPC will adjust Bank Rate as necessary to return inflation to target sustainably in the medium term, in line with its remit. If there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required.
• Our commitment to the 2% inflation target is unwavering.

That seems pretty clear:

• Inflation is coming down, but will remain sticky.
• The economy is recovery.
• Expect some reflationary expansion.
• Keep a close eye on wages.
• The Bank will hike rates further if required.

Tuesday’s morning porridge on a Thursday: I missed sending out a comment on Tuesday because of an IT problem. What follows is that comment, with some minor revisions..

Part 2 – Things are seldom as bad as you fear, but never as good as you hope.

The above line is one of my key market mantras. Last year we feared the complete implosion of global energy markets, geopolitical crisis and new battlelines, and crashing economic doom and gloom. Step back. Breathe. Relax.

In February 2022 markets universally expected Russia would complete the invasion of Ukraine in just a few days. The smart money played technical games by initially shorting Russia, intending to pile back in after the inevitable new sanctions and anti-Russian rhetoric caused the rouble and bonds to crash, before, equally inevitably, the defacto annexation of a sovereign nation by a hostile power was pushed down the agenda and anger was replaced by practical acceptance, thus Russian assets would recover.

Didn’t happen quite that way.

Putin’s invasion spluttered, but the energy shock that accompanied the invasion became the next fear. It triggered a global inflationary impulse, and looked certain to plunge already fraxious European economies into full depression. There was panic about gas shortages and pensioners freezing. Household bills went through the roof. Yet, economic energy catastrophe remains curiously absent. The Germans put in place infrastructure to import Gas from the States within months. Again, the downside was vastly over-estimated.

Around the globe there remain a huge number of largely right-wingers blaming hated “liberal elites” for causing the war. Some sincerely believe Nato pushed Russia too far. Others saw it as an opportunity to espouse political themes around real and imagined political misdemeanours. They confidently predicted Ukraine would fall. Despite being wrong in every respect, many are so invested in the cause they remain Russia Shills.

I am confidently informed the Russian economy is in great shape, its income rising from exporting billions of dollars/renminbi of Oil to China and India instead of Europe, leaving an economic cash glut to pay for the armaments it is using to crush the Ukrainian terrorists. Yet, this morning the Russian finance minister Anton Siluanov is widely cited around global media, admitting oil output is falling, and revenues are dropping. That is hardly a surprise since Russia’s only markets are now India and China paying deeply discounted prices.

It doesn’t take a genius to work out Russian claims of economic perfection are nonsense. Corruption has been endemic since 1917. The Soviets lost the last Economic war in 1989 because the inefficiencies of the communist system were crushed by simple market forces. Any nation that sends its forces into action with tyres made of Chinese cardboard (as was found on broken down Russian trucks abandoned near Kyiv) remains corrupt to the core. It may be resource rich, but the outlook for the kleptocratic Russian economy is to become little more than a cheap oil bazar for anyone willing to risk the consequences. (Think Afghanistan, but more menacing..)

The invasion triggered also a global geopolitical reordering. Many nations behaved opportunistically. Some claimed to be neutral, but acted against the West – not least the South Africans who’ve apparently been supplying Putin with arms. (There will be a reckoning – but quietly.) The Gulf flexed independence, declared neutrality and welcomed Russian money. They expected a global re-ordering around a diminished NATO, a declining dollar, new markets, and bet they would become the money men for a new economy fuelled by China with Russia providing the muscle. It isn’t happening. Their domestic security without American cover is now dependent on the good graces of China keeping the Iranians in line – good luck with that.

Russian’s failure in Ukraine changes the game. No sensible economy wishes its future economic prosperity based around the improbability Russia can still win. They are changing tack. The dollar is not about to vanish – there is simply no alternative. New geopolitical accommodations will be found.

China looks embarrassed. It will have to think long and hard about the recovery of the lost province (it never actually owned) of Taiwan. It can’t afford the strategic embarrassment of not succeeding, but it’s a tactical toss-up whether they would win or not. (Wargames show the US would win, but at enormous cost to both sides.) The People’s Army follows the same tactical doctrines as the now broken Red Army, and its humiliation is something Xi can’t contemplate. China hasn’t actually fought a war in 50 years.

Xi also knows China’s supposed economic dominance is something of a bluff. The economic numbers suggest the Chinese economic miracle has peaked. It is unlikely to surpass America for years, and per capita GDP is unlikely to ever catch up as it struggles with demographic headwinds and slows in coming decades. It’s entirely possible the current lacklustre performance of the economy, reopening far less strongly than expected, may confirm China’s period in the economic spotlight proved briefer than Xi worst fears. The US banks are all quietly scaling back their Chinese presence.

China’s choice is simple. Invade Taiwan with enormous risks and negative economic consequences, or re-engage with the West and build new economic ties to enhance growth, wealth and prosperity. Bit of a no-brainer.

Back on the battlefield, the Shills remind us of the enormous capacity of the Red Army for sacrifice and suffering, citing the 20 million plus that died against the Nazis. Given time the Russian steamroller is apparently unstoppable. Except the steamroller is a demographic nightmare, a fraction the size of Europe, and essentially already broken. The shills forget that until Hitler invaded in 1941, Soviet Russia was just as culpable for the breakup and partition of Poland and atrocities against the free peoples as the very fascists they claim to now oppose.

The reality is the Russian military record has ever been less than brilliant – 300 years of underperformance and copious losses with little to show for it. In 1917 it was the catastrophic collapse and desertion of Russian armies, followed by capitulation to Germany, that enabled the Bolsheviks.

Russia’s problems on the field may get worse. Earlier this week UK Premier Rishi Sunak promised Ukraine’s Zelensky more missiles and medium range attack drones. It is only a matter of time before the Ukrainians get the F-16’s they want. Zelensky is adapt at pressing all the right buttons. I suspect the RAF will throw in some older Typhoons – which I informed Ukrainians pilots are already being taught to fly.

Who knows what will happen in Ukraine? Why would Nato pull support now? Will a peace still be enforced upon the invaded state? It looks less likely. Maybe Ukraine will still provide the surprise markets are waiting for – the expected Ukraine spring offensive pushing the Russians out and opening the door to negotiations loaded in their favour? Or maybe not.

Only one man really wants a Ukraine war, but there is simply too much at stake for the Ukrainians to demand anything else less than total Russian withdrawal. It could yet prove stalemate… but ultimately the West has already won by exploding the myth of Russian martial prowess and forcing them to exhaust their war stocks.

As so often happens in markets, The War in Ukraine has turned out far less negative than we feared. The West did not collapse on the back of an Energy crisis. Ukraine has suffered greatly, but has gone from Europe’s most corrupt state to its darling. Its people have become confident and independent. The war has given them character, purpose and a sense of self. Ukraine has held out – with copious western supplies, but on the back of sacrifice by its better motivated and trained forces.

In contrast, it’s increasingly clear the war has “not necessarily played to Russia’s advantage”.  The illusion of Soviet military might has been comprehensively shattered. Trying to bully the West into energy submission has proved bluff and bluster. The news flow emerging from the Russian side of lines – supply issues, a broken relationship between Putin’s Chef (the Wagner mercs) and the Army command, unexplained aircraft losses, and increasing troop unrest may all be propaganda and fake news, but it increasingly looks like Russia is no longer focused on winning the war… but on how not to lose it.  No one knows how Putin will pull Russia out the strategic quagmire he’s created.

One route, perhaps the only one realistically left, for Russia is to try and break NATO and the West politically by driving wedges between it. That may be in Turkey – by persuading a re-elected Erdogan to play along, or it may be fake news and interference with the US elections to further polarise Democrat/Republican polarisation and support the re-election of Trump with a view to him cancelling aid to Ukraine and disengaging the US from Nato. It’s entirely possible the prospect of a second Trump term will cause European leaders to push for a negotiated peace at any cost.

It’s a space worth watching.

Meanwhile… something historical to think about…

Tuesday night was the 80^th Anniversary of the Dambusters Raid on the German Rhur when highly trained and motivated RAF fliers took out the great dams of the Rhur. Apres moi le Deluge is the apt motto of 617 Squadron – probably the most famous aviation unit in history.

(I sat and watched the film recently – it is a considered work framed by stiff-upper-lip 1950’s attitudes, but it’s still a damn fine and moving movie. The final words say it all: “I have some letters to write.” The film has been hit by Woke. The code word for success was famously the name of raid leader Guy Gibson’s black Labrador, but now the dog’s moniker has been redubbed to “Trigger” rather than the original name deemed too offensive for the sensibilities of modern audiences.)

Millennial Millies watching it today will no doubt complain at the “overwhelming whiteness” of the crews – but the historical facts are 133 young men from around the British Empire (plus a Yank) boarded 19 Lancasters to bomb Germany in 1943. 53 of them died. 3 were captured. That’s a 42% casualty rate on a single operation. Few survived the war, and those that did have all now passed into memory.

Was it worth it?

The economic effects of the raid on the German war effort are still debated. RAF Commander Bomber Harris thought the Dams Raid a waste of resources.

What is undoubtedly true is the raid’s stunning PR value – even to this day – enhancing Britain’s reputation for derring-do, as resourceful, inventive, and able to deliver a significant blow to German industry with pin-point accuracy delivered by highly skilled professional warriors. Only 11 of the 19 bombers actually dropped their bombs on target, but incredibly they delivered greater damage and inflicted more casualties than any previous RAF raid – including the first 1000 bomber raid in 1942! It was only later in 1943 Bomber Command began to inflict the 5 digit casualty numbers that characterised raids in the latter years of the war. As Churchill said: Germany reaped the whirlwind.

Today the bombing of infrastructure like dams to create civilian casualties would be considered a war crime. Then, civilian morale was a justifiable target – as was taking out the power supply feeding the German war machine, while wrecking rail yards and factories.

What’s the relevance of the Dambusters today?

Some nations are dangerous. Some are hollow. The ability to project power and achieve strategic objectives is dependent on more than size and resources, but also on spirit, moral and unity of purpose. Economic factors are important: capitalist systems have their problems but produce richer, wealthier nations. Autocracies? well they lost all the major wars of the last century. Looks the same way today.

Five Things to Read This Morning

FT                     Rishi Sunak’s lack of Industrial strategy attacked by former business secretaries.

BBerg               Steve Cohen is “Pretty Bullish” on Markets thanks to AI

WSJ                  Russia Sows Far-Reaching Chaos Using Crimea as a Base

Guardian          Rishi Sunak’s upbeat view on economy stocks claim he is out of touch

Businessweek   Tales from the CryptoWinter

Out of time, and back to the day job..

Bill Blain

Strategist – Shard Capital