Watch the Bond Market – that’s where the line will break!

Blain’s Morning Porridge 3^rd Jan 2023: Watch the Bond Market – that’s where the line will break!

“It’s often not the detail, but the blindingly obvious hidden in plain sight we miss…”

This morning: Watch the Bond Markets. In bonds there is truth. Brutal, uncompromising, painful truth. When the crisis comes, it will hit bond markets first. 

Let me start by offering everyone the traditional Scot’s New Year Toast: Lang May Yet Lum Reek.

(A lum is a chimney, and reek is smoke – a roaring fire and smoke billowing out the roof is a sign of prosperity, although not so much of climate awareness..)

Welcome to 2023.

The new year opened with the IMF warning how the coming recession is set to leave the global economy fundamentally damaged – expect a modest recession in the US, a deeper slowdown in Europe and something almost terminal in the UK! Even China could see sub-par growth on the back of a Covid shock, perhaps triggering a global mini-supply chain crisis. Whatever happens next there will be consequences reverberating around the globe.

Investment banks are split – many still think the US will avoid recession completely – although I suspect they are overly optimistic.  No one has anything hopeful to say about the UK.

The outlook for the UK appears shocking. A quick perusal of the headlines this morning would depress the most determined optimist. Rising inflation, crashing consumer spending, tumbling productivity, a contracting economy, cost-of-living crisis, housing collapse, higher rates and higher inflation, a general strike… you name it and someone expects it. (There was one small voice of hope predicting rates may start to fall by year end, but that particular economist was struck by a rogue No 139 bus midway through his explanation….)

2022 was an extraordinary year – but we should have seen it coming.

Everything that happened was an inevitable consequence of what had gone before – how overly easy money, QE and the implicit assumption Central Banks exist to bailout and smooth markets, changed the way markets behaved. The lessons we’ve learnt since 2008 were to follow central banks’ money, to assume financial asset prices can only ever go up and cheap money was the new, new normal. Guess what. It is not.

It all came to a head when the shock of the Ukraine war highlighted the dangers of energy insecurity and the economic damage an energy price shock can massively and suddenly inflict, while triggering run-away inflation. Who knew? (US Readers: Sarcasm Alert.) Quite properly, rates, inflation and currencies now dominate macro thinking.

The pace at which we are being forced to relearn the downright bleeding obvious about the way markets work, and how foolish the new assumptions were, was quite educational through 2022 – and will become more so this year. More than a few home truths have been absorbed about our capacity for financial stupidity and the suspension of financial common sense in the face of speculative lunacy.

The underlying sense Bond and Stock markets can only go up unravelled through 2022 – but many market observers are still looking at the ’22 crash as if last year’s ructions, and fundamental reassessment of markets was nothing more than a modest correction, a mere re-ordering of some out of line financial asset price relationships, a reaction to Covid, supply chains, energy, etc, etc… which simply won’t be repeated a second year in a row.

Doh… this has only just started. At the end, the global economy and markets will emerge in strong shape. The questions are how long, how painful and how to survive the change.

Markets have a curious belief that bad years are always followed by better years – some folk have not been reading their bibles about Pharaoh’s 7 bad year dream. At one stage last year US bonds were posting a negative 20% return on the year – prices brought down by the iron maths of yield and duration, and the fact rising inflation meant real yields were actually falling as bond prices fell.. For anyone not following bonds – that’s a double whammy and pretty bad.

However, the trick to being a successful market strategist is not to tell you what happened last year, but what’s going to happen next.

My big theme for the year: Watch the Bond Markets. In bonds there is truth. Brutal, uncompromising, painful truth. Ouch.

We’ll start with the corporate bond market – credit. Although many companies were able to raise substantial cash and strengthen balance sheets through the easy money years, now money is properly costly, and in a falling bond market, credit fundamentals are back at the fore of investment thinking. Companies that borrowed money to buyback stock instead of making capital investments will be in trouble as debts come due.

Corporate earnings will be pressured by crashing consumer spending and rising credit spreads – there will be an increasing sense of crisis as it becomes clearer higher rates, persistent inflation, declining earnings and falling real incomes are long-term. Some sectors, like retail and autos are obvious weak links, but consequences will ripple out over the economy and the whole credit market.

One vector of credit crisis will be liquidity. As we’ve seen many times in the past, when bond markets crash, they crash quickly and liquidity – the ability to sell or buy a bond – diminishes with extraordinary alacrity. Markets go offered-only very fast, and its highly contagious. When, not if, it happens, I shall be putting on my bond broker hat once more and scooping up bargains.

I am far more worried about coming crisis in the Sovereign Bond markets…

It won’t just be the UK, but 2022 provided a textbook case of the collapse of a nations long established Virtuous Sovereign Trinity: a stable currency, a sustainable bond market and political competency. When the Truss/Kwarteng ill-considered and unadvised mini-budget confirmed political competency was out-the-window, the result was a sterling crash and a near meltdown in Gilts. Although there are now adults in the room, it’s not sorted.

Over holiday I woke up shaken by the ultimate bond nightmare. (OK, I admit it was after a particularly hearty consumption of very good Cheese and Red Wine…)

In my dream, I found myself in a crisis meeting with the UK government, various ministries, the Bank of England, the Treasury, The Debt Management Office, the Office for Budget Responsibility and the Prime Minister – although he didn’t say much:

• It was panic. Government ideologues were demanding deeper cuts to spending and more austerity, ministers were arguing further cuts would crash the economy, the ministry of defence was warning its personnel could not fill the jobs of every striking government worker, the Treasury was warning of a looming spending crisis as tax receipts tumbled and emergency energy borrowing widened the deficit, the DMO was concerned at gilt liquidity and how much more it could fund to cover energy bills, while the very clever economist from the OBR was warning the sums simply didn’t add up.
• For some reason the Prime Minister asked me what I thought. I replied: “Sir, you face an imminent financial crisis where collapsing confidence in government and the economy is causing a buyer strike as foreign buyers exit, resulting in a gilts crash, panic in markets and pensions, a sterling crisis and the need for higher rates despite this recession becoming an economic catastrophe. Your only solution is for the Bank of England to resume QE [buying gilts] to stabilise the bond market, but sterling remains at risk.    

At that point I woke up in a sweat… Resuming QE? Is that the only way out of this mess?

How would the market react?

• Would they smell the panic and exit the UK?

Or,

• Would they simply follow the QE money and buy UK assets (thus stabilising sterling) in the knowledge the Bank of England buying is an opportunity for easy gains?

Which Central Bank is going to crack first and reopen the QE programmes to avoid economic meltdown… answers on a postcard…

On that happy note… what’s in the News?

FIVE THINGS TO READ THIS MORNING

FT                    UK Faces worst and longest recession in G7, say economists

BBerg              China’s Economy Ends Year in Slump as Covid Infections Surge

WSJ                 Tesla Comes Up Short of 2022 Delivery Target as Growth Slows

BBerg              Markets Pray for a Goldilocks Economy in 2023

Thunderer       What’s in store this year for the economy?

Out of time and back to the day job…

Bill Blain

Strategist – Shard Capital