Blain’s Morning Porridge – 6^th October, 2023: Normalisation means Tough Times Ahead – especially for Rishi Sunak.

“If you’re hanging onto a rising balloon, you’re presented with a difficult decision. Let go before it’s too late or hang on and keep getting higher, posing the question: how long can you keep a grip on the rope?” 

The Tough Times will pass – how do you then create an economy that balances Growth and Prosperity, Politics and Justice, the Environment and Business, Wealth and Equality. Could it be as simple as setting the right interest rate?

The brutal truth is markets are unsustainable at current levels. Simple as. A correction this way comes.

• As bond yields rise, equity valuations need to reflect higher rates with lower multiples. Simple as.
• As Saudi and Russia conspire to push up oil prices and fire up inflation, realisation will mean something will give. Simple as.
• Rising interest rates are creating enormous strains across commerce and banking – that are only now becoming apparent. Simple as.

It will be stocks that crack – as bond yields reset at higher levels, prices will fall to “normalised” relative values: ie dividend yields on stocks need to rise to match rising rates! That means overpriced equities will hurt. There will be a wobble, correction (call it whatever it is), then there will be recovery and in a short time we will forget everything we’ve learnt from this up/down cycle. (Next time… wonder if I will still be writing the Porridge?)

Signs and portents abound… like the travails of the UK challenger Metro Bank – trying to raise capital when they need it (rather than when they could have!). It is a terminal banking mistake, and highlights how tumbling bond prices has eaten away notional bank equity – the same factor that sank US banks earlier this year. There is a scrabble underway for Metro’s mortgage book. It will be gone by next week.

Who will be next?

If you are looking for investment ideas: I suggest principal protection and returns. I suggest sell froth and speculative tosh to buy real assets that provide clear, mitigated real returns – for instance, I’ve an aviation deal giving a 10%+ return from a diversified pool of assets to minimise metal and credit risks. That’s better than hoping some AI hopeful or EV maker can sustain a 30 times stock multiple when rates hit 6% later this month.

(Crashing Dis-chordant Major Chords…)

The good news is markets are long-term self-correcting. What we’re seeing today is a scrabble to catch up with higher rates. It’s all kind of predictable if you’ve been following the last 15 years of interest-rate insanity.

We’re experiencing the consequences of distorted low interest rates. The effect was to warp the functioning of markets, and the behaviours of investors, financiers, management, entrepreneurs and even the legions of retail sucked into myths like crypto, meme-stocks and NFTs. When money is too cheap it had all kinds of pernicious effects – which are becoming increasingly obvious. Hindsight is a wonderful thing.

I suspect the cure is analogous to a junky going cold turkey. It’s going to take time for normalised interest rates to reinforce normal behaviour from market participants. The cure is simple – normalise interest rates to enforce market and economic sanity. Its happening. It will hurt. Things will then get better.

Meanwhile, back on a small island on the unfashionable end of Yoorp..

There are times when you just have to laugh out loud. Yesterday was one of these moments. I was chatting with a client about potential positive investment theses into the UK. He suggested – with a smile – investing in potential contractor firms able to build basic railway and transport infrastructure on the Western Shores of the Island of Britain might be a sound idea?

Bollchocks I said. Was he aware there will be an election next year, meaning all promises made this year will be noisily forgotten?

I cited him an article from the Torygraph – the in-house-journal-of-record of the Conservative Party. (It’s the first thing I read every morning – so I know what the enemy is thinking!) When the Tories start laughing at themselves –they really are stepping up to the gallows of public opinion.

“After more warm-ups than a poorly defrosted sausage roll, Rishi eventually came on stage to music that sounded a bit like the Big Brother theme tune. Making a joke here about the likelihood of being “voted out” would be, of course, in poor taste.

He talked a lot about Westminster being “a broken system”, about the problems of vested interests and inertia, and – worst of all – “empty rhetorical promises”. There seemed to be real steel in the PM’s voice. Boy, I’d hate to be there when he gets his hands on whoever it is that’s been running the country for the past 13 years.

There was also the much-vaunted televised mercy killing of HS2, along with a promise to reinvest “every single penny” into transport infrastructure. “Sorry darling, the vet had to kill Tiddles with a bolt gun, but here’s a handwritten promissory note for a unicorn.”

Regular readers might be surprised I’m not going to seize the opportunity to verbally rip Rishi Sunak’s throat out for his abject betrayal of the North by abandoning the HS2 railway to Winterfell/ Manchester. Well done. The Government is building a fast railway to somewhere that already has plenty of railway instead of where one might be useful.

The optics about government planning and decision making are derisory, but any decent railway engineer would tell you a properly planned and costed rebuild and renewal of existing track (new digital signalling to replace Victorian wiring, electrification, relaying permanent-way, major infrastructure replacement, regular track maintenance, plus the empowerment of NotWork Rail to actually run the system) could have achieved major gains in speed and capacity for less money across the whole network.

Neither can I fault Sunak for rowing back on Green Policies a few weeks back… even though it clearly damages the UK’s soft-power and reputation as a leading green nation. It’s not very green to delay, but it’s financially pragmatic, just like firing up mothballed coal-powered electric plants is. Let’s conveniently ignore record September temperatures around the globe.

The thing is Sunak’s a politician about to lose an election, so of course he’s going to lie, cheat, deceive and be opportunistic as he clings to the sinking raft of his shattered destiny.

That’s what politicians do. I could go on about how awful the Tories have been… but what’s the point? Deep in their hearts, even Petty, Penny, Jacob, Boris, Theresa, Michael, Cruella, Sue and the other forgettables know what they have done. I doubt Liz does. (I wonder if Gordon Brown felt that way? Watching him since he lost in 2010, his dignity stands in marked contrast to the current crop of failed PMs.)

After 13 years running the country, the Tories are finally admitting mistakes – not actually ‘fessing up”. Sunak was whittering away about the last “30 years of broken politics”, which I suppose means it’s a much Tony Blair’s failings as his own.

Yeah, whateva…

What is actually wrong with the UK economy? Why does the outlook across all Western Economies feel so bleak? There are multiple problems including, political instability, polarisation and factionalisation, decaying infrastructure, utilities and services, weakening growth and productivity, ageing demographics, rising inequality, and growing sense it’s all unsustainable.

We tend to see these problems in terms of political mistakes – why has the UK achieved the square root of Didley-Squat over the past 13 years? Why were priorities not clearly set? Why are decisions that could have been made in 2010 only being made now? Who should we blame them for the lack of planning around railway infrastructure – years ago a full analysis by a former BA chairman concluded HS2 would be a waste of effort.

The problems aren’t actually political – they are about the economy and the way it functions. And one-factor around the functioning of any economy is set by the cost of money – the very same point I was making at the start of this morning’s missive.

There are two extremes of political economy:

• It can be a smothering, socialist economy where the welfare state consumes all resources and nothing really works, and it collapses into wokery, or
• It can be brutal capitalism, where greed ensures the wealth of the few and the serfdom of the many, nothing really works, and it collapses in revolution.

The UK has achieved something unique – combining some of the very worst aspects of socialism – a welfare systems that is expensive and doesn’t work (plus a Stockholm-syndrome cult around the NHS), and privately owned utilities that make their owners exceedingly wealthy by providing minimal services.

There is a third factor – an extraordinary degree of general incompetence. No one knows how to manage anything any more. A sure fire sign of an economy is crisis is when hiring a consulting firm to oversee change management is considered a smart and valid business solution.

In our hearts we know the UK will continue to fail to rebuilt our ailing infrastructure, re-invent the NHS, make Education fir for purpose, give the armed forces weapons that work, or do anything much more than keep missing because corporate and political behaviours and culture are driven by the cost of money:

• Engineers are managed by accountants.
• CEOs are told what to do by CFOs.
• Middle Management are incentivised to make their bosses look good – rather than manage.
• Staff are trained to complete forms – not to solve problems – to save paying them.

As a result we live in a treacle economy where everything hs become just too difficult. (Try it: try to change your mobile phone plan on-line or over the phone. You will fail.)

How do we fix it?. Set the right interest rate – might be a good start.

You will be amazed what happens. The right rate will force CEOs to make competent investment decisions on what to invest in or not. It will force CFOs to properly calculate risks and returns. It will force companies to economise and force middle management to do their jobs of managing the firm and its evolution – rather than spending billions on a cut’n’past powerpoint presented by a business consultant who never worked a day in a real job. It will force companies to pay staff properly in a growing economy. It will force Governments to look carefully at the economy and work out priorities. It will force politicians to properly balance tax and borrowing – when money is tight and every vote matters then a smart government will introduce marginal taxation to ensure the Wealthy pay.

Give it time, but the right cost of capital could yet surprise us all..

Anyway… I’m off to watch Scotland vs Ireland at the Rugby World Cup in Paris. I have a feeling I might be quite low come Monday morning…

Five Things to Read This Morning

Times                          Investors are asking if this dog has had its day.

WSJ                            Is The Economy Hot or Cold? What to Watch For in September Jobs Report

FT                               Bond market gyrations are yanking us into uncharted territory

FT                               Who feels the pain from the bond sell-off?

BBerg                          The 5% Bond Market Means Pain Is Heading Everyone’s Way

Out of time and back to the day job, and have a great weekend…

Bill Blain

Strategist – Shard Capital