Blain’s Morning Porridge – Jan 20th 2023: Forget inflation – its interest rates that will set markets and drive new growth.
“Being a hippy was the most natural thing in the world to me..”
This morning: Around the globe everyone thinks inflation is beaten. It may well be, but the consequences will persist. Interest rates may not “pivot” the way market optimists hope, with profound implications for equities and bonds. We are into a new market cycle of normalised rates and corporate fundamentals. All-in-all, that’s a good thing for growth!
Yesterday was a fun day in the office – or in my case not in the office. I was working from home again because Southampton and all-points south-west of London have apparently been ceded to Brittany by NotWork Rail and government indifference about Britain’s unstable infrastructure. A landslip on the mainline south from Waterloo is going to take weeks to fix. So much for levelling up when they can’t even level the tracks.
The Russian airforce bombs the stuffing out Ukraine in the morning, and everything is fixed by tea-team. Here in the UK it rains a bit, and the country gives up for a month. The considered advice is just don’t travel to London anymore – which is a problem when I have meetings and clients to entertain. I shall simply take up residence in my club next week…. Good news for the club. Very bad news for my liver.
Back in planet market..
If you want an olive tree to thrive – you don’t mollycoddle it. You cut it back with gusto. If there is one thing we learn in the QE years 2009-2022 its cutting interest rates to zero did very little to create real growth – just loads of distortion and inflated financial asset prices.
Yesterday’s office debate – which you can hear later today – on the Shard Lite-Bite Podcast was about inflation, rates, stocks and bonds under the headline: Is there going to be a recession next year?
Some folk think recession very unlikely…. They see US consumers as strongly capitalised with high savings, a labour shortage (strong employment), and everything pointing to a very thin recession, but more likely long-term growth following a brief slowdown as the world completes a readjustment to the end of the Pandemic/Ukraine Energy Shock/Supply Train destabilisation. I argue US consumers are not the only ones who matter – that slowing consumption as the cost-of-living crisis threatens to hollow-out Europe and the UK is going to hurt. Globally.
And that’s without factoring in the looming possibility that political gridlock as the Trumpanistas of the Republicans Looney-Right decide they should destroy the US’ Financial Credibility in order to save it… by triggering a debt ceiling default. I am assured more reasonable US Republicans will vote with Democrats – don’t bet on it. Any GOP member who votes against will be voted out their seat by the Alt-right. When Kevin McCarthy says he’s got it covered, pick 15 votes and reasons why he’s not.
But enough worrying about US politics – why worry today about something we’re only going to have to worry about tomorrow? I’ve been watching how the Equity Market has convinced itself there is massive upside potential in the current market. Overpriced growth stocks have corrected. Its all priced in.. they say.
We’ve seen undervalued European markets catch up with overvalued US prices. The magical word behind all this is “Pivot”…. That grossly overused expression now meaning the point at which central bank tightening becomes renewed easing. Equity markets are pricing in an economic soft-landing, falling inflation, and a swift return to lower rates – basically expecting a boom on the continuation of the last 15 years of ZIRP easy money QE asset inflation of the 2010s.
That is simply not going to happen.
As I always say when confronted by unrealistic euphoric expectations: “a quarter ounce of whatever they are smoking please.” I don’t think we’re poised on the edge of complete market meltdown either. It’s going to be one of these classic market years: “Things are not as bad as we feared, but not as good as we hoped.”
My crystal ball (powered by common sense – the rarest element in financial markets), now tells me 2023 is going to be the start of something trending towards recovery rather than recession – but I don’t rule out further economic pain, especially in Europe. Fingers crossed, but we are leaving the bad news behind. The inflation spike triggered by energy costs will ease. We’re likely to see the global economy driven by China reopening – and I know my Commodities guru at Shard Capital, Ashley Boolell, is predicting record raw materials prices this year. (We’ll be talking about that next week.)
However, the real issue is growth and rates. Growth is the future. Without growth forget addressing climate change or geopolitical threats. Growth won the cold war. Growth will fix the planet. But, growth depends on productivity gains and consumption. As long as these are broadly aligned the economy grows. When they are not – the economy stalls, and inflation is the usual result. The negative effects of inflation were hidden for much of the last 15 years. Interest rates were kept deliberately low – so were worker wages. Inflation in the real economy died – aided by importing deflation from China as it became the centre of cheapest-to-produce manufacturing.
However, ultralow interest rates impacted financial asset prices. Equities became massively inflated by cheap money. Bond yields tumbled – triggering all kinds of consequences. The most important is that productivity growth stalled. Why spend capital building new plant and machinery to boost production and profits, when the easiest way to boost the stock price was to raise debt to fund stock buy backs?
The consequence of 15 years of over-easy interest rates, financial asset inflation, and then the energy shock was a collapse in productivity alongside a massive rise in income inequality. Workers wages stagnated the whole period. Their ability to consume was then crushed by the inflation generated by the Ukraine energy shock. If consumption is going to resume, wages have to rise.
That’s why its unlikely central banks really anticipate a return to low interest rates. Headline inflation will fall, but wage-inflation as consumption plays economic catch-up will remain stubborn, keeping inflation above the target 2%. That will have significant consequences in terms of how quickly the economy can reset and how resilient it will be to a new, new normal of 4-5% interest rates. Normalisation will make Central Bank’s role much easier.
My expectation is real inflation and higher for longer interest rates will trigger a second correction across the equity and debt markets – it will be a winnowing of the chaff. Many of the high-growth tech stocks of the great bubble economy funded themselves with debt – they simply aren’t making the returns to repay that borrowing. They will default. The private equity business has invested an extraordinary amount of money into second rate companies, and levered them up to the hilt during the easy money good times. Junk bonds are just that. The PE managers got their money out, and don’t particularly care these companies are now likely to default on debt.
Rising defaults from higher for longer interest rates, and declining corporate earnings from crashing consumption? Not a good look. Zombie corporates than only survived on low rates will be crushed by normalisation.
On the other hand, I do expect a new new normal economy to have its winners – companies with sustainable balance sheets, low elasticity of demand products, decent profit margins and solid business fundamentals to thrive – looking attractive from both an earnings and debt capacity basis. Basically…. Good companies will thrive. Bad ones will make way. Unrealistic companies, like Britishvolt, which failed earlier this week, will die. Sad, but inevitable.
There is recession-like pain to come, we will have to get used to higher interest rates. and change our company/investment models accordingly, and we will need to get used to defaults.
As I’ve written before; the greatest strength of the capitalist system is the God-given right of companies to fail. Dead companies leave market niches for nimbler new competitors to spawn new growth. Although there is probably a 50/50 chance of recession this year, it’s going to be worth a good dose of creative corporate destruction in order to stimulate new growth in its wake..
Final thoughts this morning: Jacinda Ardern stepping down as NZ premier? Respect. A politician admitting the role has worn them out is a good thing. She may not have been everyone’s cup of tea – but she is honest. Respect and admiration.
Five Things To Read This Morning
BBerg – Oaktree’s Marks Sees End to Junk-Bond Rally With Defaults Rising
FT – Treasury begins taking “extraordinary measures” as US hits debt ceiling
FT – 300 nuclear missiles are headed your way. You must respond. What now?
WSJ – China’s Property Bust Compounds Economic Pain
BBerg – BOE Governor Says “Corner has been turned” on UK Inflation
Out of time, and have a great weekend..
Strategist – Shard Capital
Thanks Bill, as most days the above makes an awful lot of sense.
So, a cheeky question if I may?
Picking up on “a new normal economy to have its winners – companies with sustainable balance sheets, low elasticity of demand products, decent profit margins and solid business fundamentals to thrive – looking attractive from both an earnings and debt capacity basis”.
Without asking you to name names could you possibly offer a suggestion of certain ratios (and relevant levels and their combination) to look for when picking out such winners? By that I mean for example “dividend yield > x as long as dividend coverage > y” or “net debt / EBITDA < z" or…
Thank you in advance.
Yours in anticipation
Always a breath of fresh air – cheers.
Ardern respected? how closely did you follow her. she endorsed and acted out the most repressive Covid compliance strategies outside China. the word democracy and her dont belong in same sentence. my kiwi friends tell me she faced ignominious defeat if she stayed in the race. plenty of video clips on U tube for those doubting my assessment. Good riddance.
One man’s Covid Nazi is another person’s Prime Minister who presided over the lowest death rate in the West.
She had many talents… empathy not least.
Donald Trump had many talents… but don’t expect me to praise him for his skill in cutting his tax bill.
I heard Martin Armstrong say that because of negative interest rates coupled with laws that they must buy government debt ,european pension funds are broke. Can this be true?
Not entirely… but the structure of European Govt Debt is … complex and its not same as Treasuries, Gilts or JGBs..
Pension funds buy govies for very good reasons – and they are not busted by them.
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