By Victor Hill
14 mins. to read
Weather versus climate
We are so accustomed to the term “climate change” in the discussion about how anthropogenic carbon emissions are leading to higher temperatures across the planet that we have become inured to its significance. We often confuse weather with climate.
Weather is about what is happening today and next week. Climate is about how much it tends to rain or how much the sun shines over the course of a typical year (where, statistically, typical is the mode of a significant range of data such as rainfall and temperatures). Sometimes these two things are conflated.
When temperatures hit 40 degrees Celsius in some parts of southern England on 20 July this year we rightly spoke about exceptionally hot weather. And some cited this as evidence for climate change. Now there is much evidence for medium-term climate change – the glaciers are melting and ambient temperatures have been rising over a long period, and so forth – but one very hot day is not proof of climate change, which can only be observed over a protracted period.
From an economic perspective, at least in so far as the advanced economies of North America and western Europe are concerned, we have been living in a climate of near-zero interest rates since the financial crisis of 2008-09 when, briefly, the entire banking system faced collapse. Lehman Brothers went under 14 years ago last week: but, in economic terms, 14 years is an era – and one that is now ending.
After the financial crisis, central banks across the West became just as important as ministries of finance in the determination of national economic policy. Their principal gambits were to hold interest rates at unprecedentedly low levels and to boost the money supply (the stock of money in the economy) through bond purchases – an exercise that came to be known as quantitative easing (QE).
In the first instance, the main objective of the central banks was to maintain liquidity in the financial markets to forestall systemic bank failure. The amount of new money created by QE was inferior to the amount of money withdrawn from the world economy by the drastic shrinkage of bank balance sheets, so the risk of precipitating inflation (“too much money chasing too few goods”) was small.
In time, however, those who run the mutually connected network of western central banks, came to regard QE not just as a means of ensuring financial liquidity but as a means of preventing threatened recession by stimulating the economy. In essence, the central banks got into the business of demand management – something that had only been attempted hitherto by finance ministries through fiscal policy. The inflation they generated did not show up in the retail price index but rather in asset prices – mainly of property and equities.
By using near-zero rates and QE to stimulate economic activity indefinitely, the central banks caused the economies of advanced nations to become dangerously dependent on monetary intervention – until some major event made further near-zero interest rates and QE undesirable or impossible.
In fact, there were two events. First, the lockdowns during the coronavirus pandemic created severe supply-chain bottlenecks and labour shortages which were inflationary. Thus, a wave of cost-push inflation was gathering force even before Vladimir Putin started to manipulate gas prices by engineering supply interruptions in the autumn of last year. Then, secondly, Putin’s war began, and gas prices soared to extraordinary levels. The inflationary juggernaut was unbound.
Why UK rates will inevitably rise further
Catherine Mann, an external member of the Bank of England’s (BoE’s) Monetary Policy Committee (MPC), warned last week that a “gradualist, tiptoe strategy” on raising rates could do more harm than good. This may have been aimed at Andrew Bailey, the Bank’s governor, who has consistently resisted pressure to raise rates for fear that this would unbalance the economy. Mann voted for a 75 basis-point rise in the base rate at the last MPC meeting on 22 September, while the consensus was for 50 basis points. She fears that the government’s subsidising energy bills could finance a consumer boom which would push inflation higher.
Another concern is that sterling is still looking weak against the mighty dollar. The main reason for dollar dominance is that the Federal Reserve (Fed) has been ahead of the curve in raising rates to counter inflation, while the BoE and the European Central Bank (ECB) have been laggards. A second reason is that, at a time of sky-high hydrocarbon prices, the US is self-sufficient in energy. In contrast, the UK and Europe must import hydrocarbons denominated in dollars. A third reason is that in times of dire geopolitical stress such as now, the dollar is regarded as a ‘safe haven’. The BoE will have to raise rates further in step with the Fed if it is to protect the pound.
Just to put the plight of the pound into international perspective, last week the Chinese yuan fell to an all-time low against the dollar. We are not alone.
The MPC is expected to raise rates by at least 75 basis points in November – and possibly by one percent. According to the ONS, the UK is not actually in recession as previously thought. The fear is that further rises in rates will reduce consumer spending and that recession might result after all.
The gilts wobble
On Wednesday, 28 September we experienced a foretaste of how changes in interest-rate expectations can spook even the deepest and most liquid markets.
As I reported last week, institutional investors were forced to liquidate some of their gilt positions in order to raise cash to meet margin calls on holdings of futures contracts after gilt prices began to tumble. Such futures contracts reside on the balance sheets of so-called liability-driven investment (LDI) funds which institutional investors use to hedge themselves against adverse movements in rates and to match assets with liabilities.
That sent gilt yields soaring − at one point to over five percent − before the BoE intervened. The Bank, which had previously announced its intention to sell down its stock of gilts as part of its new regime of monetary tightening, pledged to buy long-dated gilts in the open market to the tune of over £50bn a day for two weeks up to 14 October. That brought the yield on the 10-year gilt down to just over four percent. Since then, the gilts market has stabilised. When the market opened this morning, the 10-year gilt was yielding 4.167 percent.
In fact, the programme of gilts purchases proved to be in excess of what was needed. On Monday (3 October), the BoE bought a paltry £22.1m of gilts: £1.89bn of gilts were offered to the Bank and declined. Meanwhile, the Fed has been watching the bond markets in the UK with trepidation, fearing that the London gilts market could be the ‘canary in the coal mine’. As for the ECB – it has been too busy buying up Italian government bonds to comment.
This week the House of Commons Work and Pensions Committee confirmed that it would be writing to the Pensions Regulator over “issues raised by the Bank of England’s intervention”. The Pensions Regulator oversees more than 5,000 corporate pension schemes which collectively have more than 10 million stakeholders. Such schemes are heavily exposed to UK gilts. The economic and political implications of the collapse of a major pension provider would be incalculable.
Simon (Lord) Wolfson, chief executive of Next PLC, said last week that his finance director wrote to the BoE five years ago to warn that LDIs were a “time bomb”. The fear is that in times of market stress, as occurred on 28 September, LDIs might amplify volatility. It also emerged that Legal & General (L&G) has been earning an estimated £77m annually by offering LDI funds to clients in recent years. L&G’s investment-management arm (LGIM) claims to have a 42 percent share of the UK LDI market. Other important providers of LDI structures include BlackRock and Columbia Threadneedle.
Shares in pension giants L&G, Aviva, Phoenix and M&G were all well down last week.
Lessons from the travails of Credit Suisse
Credit Suisse, the 166-year-old Swiss lender, has experienced a series of catastrophes over the last two years, including charges of money laundering and tax evasion, as well as huge losses accrued from exposures to the collapsed Archegos Capital private hedge fund and to the ill-fated Greensill Capital. Last year, the bank was fined almost £350m in a loan scandal in Mozambique known as the “tuna bonds” affair. Then there are the as yet unquantified losses relating to the failed takeover of the American tech firm Citrix. Credit Suisse has lost about CHF4bn in the last three quarters alone, with the result that its funding costs have soared.
The bank employs 45,000 staff worldwide, including around 6,000 people in the City of London and manages almost £1.4trn in assets. It is regarded as a systemic component of the international financial system.
In tandem with the precipitous fall in Credit Suisse’s share price, its credit default swaps (CDSs) have been showing signs of stress. Like LDIs in the pension sector, these provide a hedge or insurance policy against the risk that the counterparty cannot honour a liability. The buyer of a CDS receives reduced default risk, while the seller of the CDS is paid a premium until the underlying liability matures. The seller must provide collateral to ensure that the buyer will be paid in the event of default.
Last Friday, Credit Suisse put out a statement on its future which had the opposite effect to the one intended. Spreads on its CDSs widened to levels not seen since the financial crisis – up to 300 basis points or more compared with 55 at the beginning of the year − suggesting that the markets think that the risk of Credit Suisse defaulting on its obligations is 23 percent within the next five years. Ulrich Körner, the bank’s chief executive, is due to unveil restructuring plans on 27 October. But at CHF4.22 this morning, the bank’s shares are trading at a massive discount to net asset value per share. Either the markets know something the accountants don’t know, or the shares are bargain-basement cheap.
The real point of this sorry tale is that in normal market conditions investors and counterparties would have given Credit Suisse the benefit of the doubt, given its solid capital base and decent liquidity buffers. But since Kwasi Kwarteng’s “kamikaze” mini budget on 23 September, and the international reaction to it, negative newsflow, reinforced by rumours circulated on social media, is being greeted with near neurosis by the market. We can expect more febrile markets in this charged environment.
The politics of economic climate change
The period over which the Tories have been in power in the UK coincides exactly with the weird years of near-zero interest rates. The Tory-Liberal Democrat coalition government arose in 2010 from the ashes of the Labour government, which had been shaken by the near collapse of the entire financial system. The coalition, and its all-Tory successors from 2015, were able to assuage the negative fallout of the crisis and its aftermath by borrowing heavily in the knowledge that the interest cost would be bearable. As a percentage of GDP, national debt has grown from about 48 percent to around 100 percent now. So much for Tory “austerity” and “fiscal responsibility”. As I have said before, the cost of servicing the national debt will become the major theme of the Truss premiership.
The most drastic impact of rising interest rates in the short term will be felt by mortgage holders. Rises in mortgage rates are not unique to the UK – US mortgage rates recently hit six percent, their highest level since 2008. And, according to Moneyfacts.co.uk, the average rate offered on a two-year fixed-rate mortgage in the UK is now 6.07 percent.
By the time that the BoE base rate hits six percent – which could be as early as next May – many mortgages in the UK will have become unaffordable, with the result that some homeowners will be obliged to put their houses on the market and either downsize or move to rented accommodation. That is likely to depress house prices, though there is no consensus on how severely.
The problem for the Tories is that their core supporters are homeowners, particularly the aspirational variety who see themselves on a journey up the housing ladder. The cuts in stamp duty announced in the “fiscal event” of 23 September will be as nothing compared to the impact on the disposable incomes of mortgage holders. Homeowners now have larger mortgages in absolute terms and relative to their incomes than when interest rates last turned north. That is because house prices are a larger multiple of average incomes.
This situation is reflected in the opinion polls of voting intentions which put Labour ahead of the Tories by a wide margin. Liz Truss has another two years before she will be obliged to call a general election, but with her party so divided on economic and social policy it is doubtful that her government will last that long. Rising rates could well signal the end of Tory rule. My best guess is that Truss would bequeath Sir Keir Starmer a fundamentally healthy economy just as John Major left Tony Blair a growing economy in 1997.
The plus side
Near-zero or very low interest rates have distorted investment decision-making for over a decade, leading to suboptimal capital-allocation decisions. If the discount rate applied to investment projects does not accurately reflect the cost of capital – which should reflect relative risk – then good and bad investment programmes will carry fundamentally similar internal rates of return (IRR). Indeed, if the discount rate is zero, then the IRR becomes infinite – which in the real world of business beyond the economic textbooks is patently absurd.
Therefore, if we can regress to a historically more “normal” level of base interest rates (five-six percent will do just fine) then better investment decisions will be made as the wheat can more easily be separated from the chaff. I strongly suspect that the flatlining in productivity levels experienced across the G-20 countries over the last decade or more is a function of artificially low interest rates. Better investment decisions will lead to greater productivity and greater productivity will drive stronger economic growth.
It is doubtful that an infrastructure project such as HS2 would have been given the go-ahead if interest rates had been at six percent. The benefit of saving commuters 20 minutes’ travelling time on the journey from London to Birmingham is marginal when compared to the massive cost of the project, especially if environmental degradation is priced in (which is best practice, these days).
In the era of near-zero rates, investors have been drawn to some quite marginal technologies in the desperate search for yield. People like technology journalist Andrew Orlowski believe that one such dead-end technology is plant-based meat (not to be confused with lab-cultivated meat, which is another proposition). Sales of mushroom sausages and the like spiked before the pandemic and then declined. Shares in California-based Beyond Meat soared to $234 after flotation but are now languishing at around $16 – a miserable investment. McDonald’s doesn’t even sell its “McPlant” burger in the US any more due to declining uptake.
Another marginal technology in my estimation could be virtual reality, widescale demand for which is still unproven. If I am right about that, then Meta, which has ‘bet the farm’ on humans retreating into alternative universes, could be in trouble. Meta has already shed about 60 percent of its market capitalisation so far this year – another disastrous investment for anyone who piled in during the pandemic.
It is significant that SoftBank, which has a track record of investing in marginal technologies, has announced that it will lay off about one third of the staff in its flagship Vision Fund.
The transition back to interest rates which correspond to the long-term historic average was always going to happen – the question was when.
The change in the economic climate will entail a change of culture. I foresee several defined trends in a world of higher, or as I would prefer to say, normal interest rates. First: a new appetite for authenticity. Out with the fake, bring back the real. Second: forget the fads. Things that last are more worth having. Third: the solid is preferable to the nebulous. Forget crypto, non-fungible tokens (NFT) and NFT-based art. Go for land, gold and tangible assets that generate cashflow. My colleague, Nick Sudbury, presented an excellent way to get exposure to farmland recently − and I shall have more to add to that soon.
People tend to suppose that the prevailing conditions in which they find themselves will endure indefinitely, when in fact everything is temporary. The global climate has always been in flux, whether due to human activity or not: about 15,000 years ago temperatures started to rise and the glaciers which covered much of northern Europe slowly melted away, resulting in a massive rise in sea levels. Our ancestors adapted by scrambling to higher ground. Similarly, investors, businesses, individuals and governments will just have to adapt to much higher interest rates – though some will do so more successfully than others.
Listed entities cited in this article:
- Credit Suisse (Zurich:CSGN)
- Beyond Meat (NASDAQ:BYND)
- Meta Inc. (NASDAQ:META)
- SoftBank Group Corp. (LON:OR15)
- Legal & General (LON:LGEN)
- Aviva (LON:AV)
- Phoenix Group Holdings (LON:PHNX)
- M&G Group (LON:MNG)
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