Blain’s Morning Porridge 29 June 2022: The UK should lead by spending more on Defence – we can!
“What a day, what a day, what a blo*dy great day, what a blo*dy great day to go sailing…”
This morning – Inflation is increasing the burden of the UK’s debt, but it’s been well managed and should not impact as heavily as it might in other highly indebted nations. We can probably afford to spend more – especially in Defence, the primary duty of any state.
Apologies for the lack of comment yesterday, but I was invited to sail a beautiful 1938 American Classic Ketch, Tomahawk, in Cowes’ Classic Sailing Regatta. (I won’t be around Friday either as I’m going back to do another day on the boat!) Politics and markets will just have to wait..
Sailing… is important! It’s also educational… My job on board was to trim the Mizzen. Its the small sail set at the back of the boat on the second mast. Although it looks small and insignificant, its critical to performance on a classic yacht. If it’s “sheeted” too tight the boat will become un-steerable. If it’s too soft, it’s just flapping drag. Downwind it’s a witch (positive), upwind its hard work.
Sailing is all about equilibrium – balancing the yacht perfectly based on all the variable inputs acting upon it. I trim the Mizzen Sail to react to every puff of wind, every wave hitting the hull, while staying in synch with the Jib (the sail at the front) and the Main. I need to be aligned with the crew trimming these other sails, the helmsman, the navigator and what the wind and sea is doing. The result is the sheet (rope to you landlubberly types) controlling the sail is in constant motion as I watch and feel everything! (And, yes.. good sailors can see the wind and read the water…….)
Naturally – and to justify the amount of sailing I try to pass off as “doing my job” – it’s exactly what I do in markets every day! Trying to spot the rocks or long term dangers to the economy is critical. The reality of sneaking a day off is lots of work to catch up on, and that’s why this Morning’s Porridge is more of a late brunch..
But there is an analogy between racing yachts, playing markets and predicting economies. Lots of moving parts, incredible complexity and unpredictability, and a constant hint of danger as we try to navigate our way through it… Yacht racing is one of the most complex sports in the world. It can turn chaotic in a heart-beat. Just like markets..
My gut feel on markets? More on that tomorrow… I’ve been involved in a conference on supply chains, and spending time with our US stock market research guys in London.. and it strikes me… there is trouble ahead..
But this morning… or this afternoon I should say… I’m more intrigued as to why the UK government seems to be backtracking on defence spending, when security should be front and centre on our list of concerns. As we hear of Nato warships taking on full war loads, and the risks of conflict spreading, it seems strange UK Defence Secretary Ben Wallace now denies he wanted a 2.5% of GDP commitment. My sources tell me he still does. But, Boris, and boy-wonder Chancellor Rishi Sunak want to hold back on spending.
Seldom have the markets looked this difficult to read – but they could get worse. 20% up one day, 20% down the next is exhausting. Central banks could exacerbate the current uncertainty with policy mistakes, or further exogenous shocks could further undermine sentiment.
But the area that worried me most is political stability and political mistakes – especially in front of a Europe already divided by Ukraine and the cost of Russian sanctions. Many of my clients are worried about national debt – they worry the UK can’t sustain 100% debt GDP, and somethings got to give. But few would argue the government needs to cut spending on defence at this time. Its at times like this we need to think big, and send strong signals to Europe. Defence spending should be top of the list – as should many other things like the NHS and Education… But defence is “the immediate clear and present danger”!
Boris and Sunak have blinked… and you have to wonder why. Do they understand the reality?
Last week the UK’s Office for National Statistics released its monthly report on Public Sector Finances last week. The May report highlighted £14 billion of borrowing in May, £3.7 billion more than earlier forecast by the Office for Budget Responsibility. Buried in the small print of the report was a £5 billion rise in the costs of servicing interest on index-linked Gilts (“linkers”) – which comprise 24 per cent of UK government debt. The cost of servicing linker debt has risen in line with the dramatic increase in the Retail Price Index.
Inflation bites! No Sh*t Sherlock.
But its not the end of the world. May’s interest cost increase made it the most costly month in terms of interest servicing in nearly 30 years. It clearly riled Tory politicians. They know there is nothing suggesting inflation will suddenly moderate, or be “transitory”. It strongly suggests rising inflation will impose a long-term and increasing drag on UK government finances.
Naturally, Boris and Rishi are concerned. They should be. Inflation crushes savers – who vote their jobs! The only good news is inflation diminishes liabilities. It means if the government borrows £100 today at 5 per cent inflation, the £100 it pays back in 10-years time will have declined to £61.39 at today’s values. Good news for the borrower, bad for the investor – who are mostly UK pension savers!
Conventional economic wisdom says the only way to fight inflation is to stem demand by raising interest rates. But that won’t immediately calm inflation – which is forecast to hit 11 per cent in Q3 2022. Nor will it address the triggers of inflation – pandemic supply chain dislocation and the energy shock of the Ukraine war. Or you can fight inflation by diminishing demand by cutting income – famously by lessening job security.
In reality there is actually little to worry about in the medium term. The good news is the bulk of the UK’s £2.3 trillion debt borrowings (which stands around 96.5 per cent of GDP) is funded by the issue of fixed rate gilts, most of which have been issued with low long-term rates. That rate won’t rise till the debt has to be refinanced. Their average maturity is around 14 years – meaning the UK will be paying minimal interest rates on the bulk of its debt for many years. On a relative basis, the UK’s debt position isn’t that bad.
The UK Treasury, which issues Gilts through the Debt Management Office, will have to pay more to issue around £150 billion of new debt through 2022, raising the amount of money government will need to service that debt. The yield on the ten-year Gilt has risen from 1.5 per cent in March this year to touch 2.6 per cent last week – and yields will probably go higher still! Effectively the UK can expect to pay one third more in interest payments on new conventional debt.
That’s probably a cost worth paying to ensure the Navy can keep the sea lanes to US resupply open with new patrol aircraft, the Airforce has missiles, and the Army gets vehicles they can use if push comes to shove in the Baltics. They more they look able to, the less likely they will need to fight. Cutting spending sends a completely different signal to Moscow.
All around the Europe we are seeing similar problems. Nations are struggling with inflation, rising interest rates, higher debt service costs on borrowing, rising bond yields, currency weakness, and how to address multiple vectors of financial instability as they try to hold their economies together. There is a serious threat the economic challenges and Energy cost crisis presented by the Ukraine invasion could end up crushing hopes of European rearmament – which is likely to be the most powerful deterrent to Putin embarking on further sabre-rattling.
The UK is a good example of what might go wrong. If confidence wobbles in the government’s ability to handle the multiple economic crises now upon us, the UK’s currency and bond markets could come under massive pressure. Investors would want a higher interest rate to account for the increasing risk of the UK, while the currency could tumble as investors sell gilts to buy less vulnerable more stable nations.
Currency is a key part of the equation. Since January, sterling has crashed over 10 per cent against the dollar. Why? It’s part of the Virtuous Sovereign Trinity, a simple way to explain how Confidence in a country, the value of its Currency and the Stability of its bond market are closely linked. When they are strong, they can be very strong. But, if any one of the Trinity’s legs were to fracture, then the whole edifice could come tumbling down.
Clearly the UK has some current confidence “issues” regarding the incumbent political leadership. Such fears magnify internationally held concerns. These are all perceived as reasons for sterling weakness, and are another reason bond yields are rising.
While the UK’s debt quantum should be manageable – Italy is somewhat different. As part of the Euro, Italy is no longer financially sovereign. It has rules on Debt/GDP to observe (and ignore). But effectively Italy borrows in a collective currency it has no real control over. It has to plead with the ECB for the right to borrow money, and relies on the ECB to announce special measures to make sure its debt costs don’t turn astronomical. Without the ECB, Italy would be heading straight for a debt crisis. So things could be far worse.
The bottom line is rising interest rates and higher inflation will all contribute to the weakness now apparent in many countries. If it weren’t for the additional problems of political instability and rising concerns about the UK to address Brexit, then the UK would look stronger than most in terms of the Virtuous Sovereign Trinity.
But if Britain, Europe’s strongest Military Power, is seen to wobble on defence spending.. then don’t be surprised if it becomes another nail in Ukraine as Europe also dithers and pulls back on the basis their economic challenges are even larger.
No time for five things this morning/ afternoon…
Out of time and back to the day job…
Strategist – Shard Capital