The Nightmare Before Christmas (but mostly after)
By Martyn Page, Investment Director at Worldwide Financial Planning
December 16, 2022
This month we focus on inflation and how central banks are intent on choking it by using higher interest rates to weaken tight labour markets and what this might mean for investors.
The type of inflation that central bankers, savers and pensioners don’t like is persistent inflation. Higher prices arising from corporate opportunism alongside the strong desire of households to spend savings accumulated during lockdown mixed with a lack of supply due to Covid restrictions drove last months spike. For example, last year, second-hand Sanderos (the best-value small car) were selling for more than the list price of new ones – because there was a 4-6 month wait for these.
This high inflation (currently around 11%) is straining household budgets and in many cases imposing significant hardship. Unsurprisingly, strikes are becoming widespread as workers seek to be compensated for the dramatic contraction of the real value of their wages at a time of severe labour shortages. This is the crux of the risk central banks face right now because wage settlements in line with current inflation carry the risk of baking-in inflation – because companies then increase their prices to pass on higher labour costs and potentially create a devastating wage-price spiral. In the long-term an economy that does not work for anyone makes everyone worse off. Unfortunately, the traditional cure for persistent inflation is an economic slowdown which reduces demand and increases unemployment.
Like it or not, equity markets in the UK and Europe largely depend on US stock markets. In turn, these depend on expectations for US company profits’ growth and expectations about where US interest rates are likely heading. So, let’s start there.
US: Major investment bank Goldman Sachs expects the top 500 US companies to collectively deliver flat profits growth in 2023. Previously it had expected 3% growth in aggregate. (The energy sector is currently exempt as high oil prices and lower capex keep margins at record levels.) Unlike most UK companies who only report twice a year, US companies report quarterly. GS said the net profit margins of US companies had shrunk a lot more than expected in the third quarter of this year – indeed it was the first contraction since the height of the Covid-19 pandemic, hence the downgrading of profits forecasts for 2023.
Our view: we have said that one of the big contributors to inflation has been companies taking advantage of the cost-of-living crisis to push through price increases. We said we hoped that central banks would try to engineer a squeeze on fat profit margins to contain inflation rather than the traditional heavy-handed approach of deliberately creating unemployment to contain wage costs. We said there were a number of ways to encourage consumers to shop less – for example using policy to push equity markets lower in order to reduce the wealth effect which encourages people to spend more, higher credit costs, higher taxes and fear-mongering. All of these are designed to rein in ‘animal spirits’. Thus, the unexpectedly large margin squeeze in the top 500 US companies suggests this might now be happening. There is also a lot of anecdotal evidence – major tech corporations have been laying off large numbers of staff. In Ireland, Intel has offered three months unpaid leave in Q1 2023 to thousands of staff in a bid to manage costs while retaining skilled labour.
We remind readers that US analysts’ forecasts for company earnings almost always start each calendar year being overly optimistic - only to be gradually lowered as they come into contact with the reality of actual quarterly results. By the end of next Spring, a year of flat profits might look optimistic in hindsight.
Set against this, we must remind ourselves that an American consumer armed with a credit card is a force of nature. A shopping superhero. From Thanksgiving Day to Cyber Monday a record 196.7 million shoppers flocked to stores in search of discounted stuff, compared to 179 million last year. Online sales hit a record high too, up 2.3% (that’s mostly inflation), with almost half of purchases made by mobile phone.
What about interest rates? After obsessively pushing up interest rates without pausing for breath like a fitness freak in a gym, Jay Powell, head of the US central bank, finally said at the end of November that it might be time to moderate the pace of rate increases. At last he – or his speechwriters – acknowledged that the effects of the rapid tightening (the fastest on record) have yet to be felt. The big question is how much higher must US interest rates go in order to bring inflation back to target and keep it there. This is what the Fed is feeling its way towards.
Here, Powell talked about how this meant ensuring the US economy grew more slowly to allow supply to catch up with demand, how wages make up a large part of inflation and how the labour market was still tight. I’ll explain. Well, US unemployment is near 50-year lows and there are 1.7 job openings for every person looking for work. When demand for workers far exceeds their supply it is not surprising that wage growth remains strong, too strong in fact to be consistent with the Fed’s two per cent inflation target.
Why is the labour market tight? Powell said the current labour force is shy some 3.5 million workers. True, many people were too ill to work after Covid but they, apparently, have mostly recovered. Around 1.5 million of the missing workers is due to a plunge in net immigration and a rise in deaths during the pandemic. The remaining two million it seems are due to a rise in the number of early retirements. Some of these older workers may have covid-related health concerns and fear returning to the workplace are suffering from long-Covid or have just had the stuffing knocked out of them. For some, a higher stock market and higher house prices might have enabled them to retire a couple of years earlier than originally intended. Powell says these former workers don’t look like they are coming back and that this is causing him a problem.
Our view: In 1968 there was a particularly naff comedy film called ‘Don’t Raise the Bridge, Lower the River’. The obvious way for the Fed to strangle excessive wage growth is to deliberately engineer a recession. Indeed, the shape of the US yield curve currently indicates that the US is on course for a recession in 2023. However, given that the labour market is unusually tight, interest rates might have to go up an awful lot to achieve this. And that would create a lot of damage. Powell does not want to be like the surgeon who proclaimed ‘the operation was a success but the patient died’.
An alternative might be to lower the river, i.e. somehow engineer a reduction in the number of new job openings. In turn this could reduce pay pressures keeping the economy ticking along and avoiding a particularly deep, damaging recession. If the front loading of US rate rises comes to squeeze US consumers, just as headline inflation starts to come down, then that may result in a further narrowing of companies profit margins back towards more usual levels as they adjust the prices of goods and services. This scenario is what economists call ‘a soft landing’. They are rare. Powell also suggested that another way to lower the river would be for legislation to encourage retirees back to work.
Is there room for the US stock market to fall further? Yes, there is. Why? Because company profits in 2023 might turn out to be quite a bit lower than are currently pencilled into estimates and thus share prices. Would it be a disaster? Probably not. Economies regularly go through cycles and then recover. This is just the current one. We would also remind long-term investors that when the fundamental news is bad, the investment news is often good because you can buy the future for less. And America is where they test drive the future.
UK: We said above that short of engineering a nasty recession there are a number of other ways of encouraging consumers to spend less – these included higher taxes and fear-mongering. In November we got both, thanks to Chancellor Hunt’s Autumn Statement. The higher taxes come sneakily by freezing personal allowances until at least April 2028 – a bit like having an increasing number of neighbours stealing your wifi signal. By continuing the freeze on personal allowances and tax bands, more of people’s pay rises will be clawed back in tax. This drives historically large falls in real disposable incomes, which drop by a cumulative 7 per cent over the two financial years to 2023-24, wiping out the last 8 years of improvements.
The fear came, as usual, from the media who also amplified the OBR’s confirmation that the UK was already in a recession which could last more than a year. A large part of the problem is that economic growth has been much weaker than in the past as a direct consequence of Brexit. On a more positive note, the labour market remained tight, with employers having to offer higher pay to fill vacancies. Like the US, the number of available workers is fewer because of the pandemic and also because many European workers have gone home.
Interest rates: The Bank of England raised interest rates to 3 per cent and its chief economist said that rates will have to go up higher, albeit not as high as the 5.25 per cent recently priced in by bond markets. And, as in America, the Bank is concerned about second-round effects where pay demands rise to counter higher inflation. With a large number of strikes about to happen it may take some time before we are able to see what at level pay settlements are agreed. The Bank will obviously take these into account when deciding upon where to set interest rates.
Mortgages: What happens to mortgage rates is slightly different. Yes, the Bank sets the short-term deposit rate but longer-term fixed rate mortgages (say five years) are priced off the market, where long-term yields have been falling. For example, on 27th September, just a few days after the UK’s disastrous mini-budget, the yield on five-year gilts shot up to 4.8%. But, by the 30th November they had fallen to 3.1%. That’s actually a tad lower than the yield on two-year gilts! In our view, there is clearly financial space for banks to further reduce the price of their fixed-term mortgages – assuming they feel the need to. To anyone whose current fixed-rate mortgage is set to expire in the next six or seven months, we would say, please do not panic. There are various structural options which can help mitigate any potential short-term pain and the price of mortgage deals continues to change rapidly. Please do not simply accept whatever your high street bank offers you. A mortgage broker should be able to find you a better deal while a good independent broker will also be able to give you valuable advice on your own personal situation.
Household Spending: At the risk of stating the obvious, households face a choice between spending more money to buy the same things they did before, or cutting back on some purchases. The extent to which households cut consumption will be an important determinant of how much the UK economy slows down and how shallow or deep the recession will be.
The public is reacting to the cost-of-living squeeze in different ways, according to a Bank survey. Households that have spent more money have generally funded this extra cost by saving less. Over half who spent more put aside fewer savings from their income each month while a quarter drew on existing savings. About one in 12 households said that a pay rise has helped them to fund higher expenditure, while around 5 per cent of households stated that they have increased borrowing to spend more.
Evidence of consumers’ propensity to spend is not always as clear cut as we might imagine. For example, early in November, Ryanair said forward bookings (both traffic and fares) remained strong over the October school half-terms and into the peak Christmas travel period. Michael O’Leary, chief executive of the low-cost carrier said ‘We’re seeing very strong forward bookings, which is unusual given the nervousness. There’s no evidence in our forward bookings of the nervousness about recession.’ We would add a caveat to this. Mr O’Leary is no stranger to talking up his book. It might be that the strong forward bookings reported are simply the result of some people switching to the lower-cost airline, rather than an indication of consumer health.
UK Equities: A brief word on the UK stock market. Cheap. But please distinguish between the blue-chip FTSE-100 market and the Mid-250/ smaller companies’ arena.
The former contains many commodity-related oil, gas and mining companies alongside drug companies whose profits are global and linked to the US dollar and Euro. The strength of the dollar over the past year, because of rising interest rates over there, has been the main reason why the UK stock market has held up so well as the earnings when repatriated to a weak sterling look better than they are. But the US dollar is not likely to stay so strong forever.
The latter – the mid and small caps – are much more domestic and have been shunned by international investors since Brexit. It looks cheap on many measures. Going into 2023 if you start to read about companies being acquired, then take this as a confirmation. As we said above, when the fundamental news is bad, the investment news is often good because you can buy the future for less.
Europe: For the eurozone area, headline inflation in November fell for the first time in 17 months, albeit only down to 10%. Core inflation (which strips out volatile food and energy prices) remained unchanged at 5 per cent. Within the eurozone inflation rates vary widely: for France, Luxembourg and Malta inflation is around 7 per cent whereas the Baltic states have inflation of 21 per cent. Some are more exposed to the energy shock than others.
Preliminary estimates for inflation in Germany and Spain were both lower than expected, and suggest that eurozone inflation may have peaked. If so, it could fall quite quickly. For example, inflation in Spain has fallen from 10.7 per cent in July down to 6.6 per cent in November. The sharp fall reflects a moderation in consumer spending and a weakening of corporate pricing power. Inflation in Germany, at around 11 per cent has fallen much less because of its greater reliance on imported gas. As you would expect, it is the wholesale price of energy that drives inflation; supply chain bottlenecks continue to ease.
To give you an idea of where the inflation is in the eurozone, for November annual inflation in services was 4 per cent, for non-energy industrial goods 5 per cent, for food, tobacco & alcohol it was just over 13 per cent while Energy was almost 35 percent. In October it was 41.5 per cent. If we strip out Energy from the inflation basket then eurozone inflation was 5 per cent – half the headline figure for November.
What does the European Central Bank think? Well, we don’t really know as it doesn’t publish the minutes of its meetings. What we do get are lots of speeches by its president, Christine Lagarde. Recently she told MEPs that she didn’t think inflation had peaked in October and that with the unemployment rate at a historically low 6.5 per cent ‘we have to stop stimulating demand’ (demand here being the rebound in spending after lockdown) before adding that the bank was in ‘highly accommodative territory’. By this she means today’s level of interest rates is considered economically stimulatory and – since this is currently seen as a bad thing – interest rates must go higher. It is central banker speak for ‘the beatings will continue until morale improves’.
Spain 6 Germany 0. Since the World Cup is underway, we can’t let November slip by without mentioning that relative oasis of tolerance in the Middle East known as Qatar. One reason Germany has such high energy costs is that it said nein danke to nuclear power and coal while making itself worryingly reliant on gas piped in from Russia. This month Germany signed a 15-year deal with Qatar to buy liquified natural gas (LNG). Deliveries start in December 2026 and so are not being made by Amazon. However, the deliveries will be coming via the US because Germany currently has no LNG import terminals. By comparison, Ireland has two and Spain has six. Germany intends to build four. So, by New Year 2027 the LNG will be shipped into the US and then out again to Germany’s newly-built terminals. That’s a mere four years away. In Europe, Ukraine ranks second for gas reserves.
In our view: financial markets always look ahead – but they do so according to narratives. For example, if inflation looks like it might have peaked, the markets will expect ECB interest rates to rise less than previously pencilled in. This then makes them think the peak in interest rates is coming that bit sooner. An assumption is then made that after a peak comes a series of interest rate cuts. These are typically supportive of share and bond prices. Of course, the ECB might simply hold rates at a higher plateau. That said, the eurozone economy is particularly sensitive to interest rates, so if inflation appears to be rapidly falling back to the target of close to but under 2 per cent, the central bank might well start to cut rates – particularly if there is uncertainty about the severity of an economic recession. Markets might begin to price in such an eventuality even as the news headlines report the next increase in eurozone interest rates on the 15th of December. It helps to think of markets as being like the guilty suspect in a crime drama -they work out a story and stick to it until it becomes so obviously full of holes that they have to quickly make up another story. That’s their nature.
Europe contains a truly wide range of quoted companies in which to invest. But for most people the actual choice will typically come down to funds which: a) invest in companies with domestically-generated profits, b) companies which are truly global businesses that happen to be European in origin, c) smaller company funds which are more volatile but offer the prospect of growth significantly above and beyond the broad economy in which they operate. All require patience.
With eurozone interest rates still low in nominal terms, European bond funds currently do not appear attractive. That said, there are investment companies which do offer higher yields. Some are specialist property companies, but these are highly sensitive to moves in interest rates (if rates go up more than expected, their shares go down more than expected and vice versa). Others invest in various aspects of renewable energy (wind, solar, battery storage). These can also be sensitive to changes in regulations, government subsidies and indeed the variable assumptions made in estimating their worth. Such businesses may also be easy targets for windfall taxes – but rational governments ought not to want to harm businesses they need to reach their net zero targets. A decade ago, many such investment opportunities were simply not available to investors.
Russia: Anyone with an interest in what it felt like to live through the collapses of communism and democracy in the USSR (and who has seven hours to spare) might enjoy Russia 1985-1999: TraumaZone on BBC iPlayer. Using only stock footage from BBC news teams, the montages depict the madness of centralised planning, oligarchs use of perestroika to seize state assets, the rise and fall of Boris Yeltsin, his deliberate use of war to distract from problems at home and how Putin came to be where he is. Be warned, it is not a John Lewis Christmas advert.
China: November began with Hong Kong’s stock market up on rumours that China intended to slightly relax its strict zero Covid-19 policies – which ought to boost flagging global growth. China’s government immediately denied the rumours. ‘Relaxation’ turned out to mean reducing quarantine periods by two days for close contacts of infected people and for inbound travellers, and removing a penalty for airlines for bringing in too many cases.
Most of Beijing’s 21 million inhabitants continued to endure lockdown and near-daily testing. Life is similar in Shanghai, the country’s main business hub. Different regions have different rules adding to the frustration. In Guangzhou University Town, construction cranes were used to deliver food to students locked in multi-story dorms. You can see how tensions might rise. By month end, protests across at least 18 cities against the zero-Covid policy had escalated to levels not seen since Tiananmen Square in 1989 where state suppression included tanks crushing students sleeping in their tents.
In our view: China is unlikely to be preparing for an imminent re-opening. Right now, the authorities no doubt realise they risk losing control of public patience or control of the virus. Or both. That suggests China could be in for a volatile six months with policy errors more than likely. We think that while it would be logical for equity markets there to rise with any indication of lockdown easing – because stock markets typically focus on the headline news – the Chinese economy continues to face serious problems in its banking and property sectors. As such, our view has not changed – China remains an unattractive place to invest directly. One ‘safer’ way to access growth there might be via funds invested in European branded luxury goods companies – where investors also have the benefit of better corporate governance.
And finally: Princess Martha Louise of Norway, whose boyfriend says he is a shaman, relinquished her royal duties to focus on her alternative medicine business. Does anyone else sense a possible spin off series from The Crown or perhaps a Netflix special?