News, Reflections and Ideas

Introduction

We are facing a summer of discontent with many workers striking for better pay and conditions. Some of the press are arguing that it is irresponsible of the unions to be striking (look at the invective being thrown at the RMT over the rail strikes) but we take a very different view here. The attempt of the workforce to fight against further serious dents in their living conditions is a natural response to 15 years of upside-down financial policies that have benefited the wealthy and have cost the working man and poor quite a lot.

We believe the strikes will not subside until there is some form of accommodation – it will be difficult to accept a 3% pay rise when inflation is predicted to exceed 10% in the coming months, and this is following on years of real wage erosion – with some sectors having seen a 20% reduction in real wages over the past decade and a half.

Again, we will break with our normal structure because this is quite a complex argument that is best delivered by a series of short sub-sections.

The 2007/08 Crash and the Start of the Long-Term Issues

While there are quite a few explanations of the Global Financial Crisis, the base cause was over easy lending to individuals that should not have been borrowing so much money to buy assets they could not afford. The risk of the sub-prime lending was masked because the individual loans were chopped up and reconfigured and sold off to institutions with the offer of high returns. When the defaults started to occur, the whole House of Cards came tumbling down and govts had to bail out the financial sector with quantitative easing (pumping money into the system) and extremely low-interest rates.

Such actions were needed in the short-term but the long-term use of cheap and easily available money has turned systems and individuals into ‘easy money’ addicts. Govts and central banks have been fearful of turning off the taps because of the likely withdrawal symptoms of the addicts. However, this long period of easy money has had a number of negative consequences that we will continue to plague normal activities until we move back to more normal economic conditions.

The natural way of things in market economies is the importance of incentives and signals. The incentive for working hard is to be able to buy the things you want, you can save a bit and earn a reasonable rate of interest and save up to buy larger assets. The benefit of the savings is that they can be released into investments at higher interest rates. The cost of borrowing ensures only ‘sensible’ investments are undertaken and money is not frittered away. With the hard work of individuals and the solid investments of companies, the economy prospers for all concerned. In addition, because there is a real cost to borrowing money, those businesses that are not really viable, close, and the resources are re-allocated to more productive uses. This is the picture of a healthy economy where incentives, signals and a ‘normally’ functioning financial system come together to create wealth.

Once we throw away the incentives and signals of a normally working financial system we have all kinds of perverse consequences. First, when asset classes are being inflated through excess cheap money, the incentive to produce is lessened. Second, savings are not rewarded and borrowing is encouraged, and given asset class inflation, the incentives to take excess risks are amplified. Third, monies are not directed towards productive investments, instead they chase the easy returns of inflating asset classes. Fourth, zombie companies are allowed to remain in existence, with clear consequences for asset mis-allocation. Fifth, the signalling power of prices and returns are distorted, and the power of markets to direct activities are diluted. Sixth, governments are encouraged to borrow at the low interest rates and this again distorts the working of the economy. With the govt borrowing and spending, and pretending that it can solve most ills, the private sector is crowded out in both the financial markets and the economy, with obvious consequence for dynamism and creativity. Finally, if the UK persists with these kind of policies longer than its competitors, there will be a run on Sterling with consequences for inflation and the UK will become a less promising place to invest for overseas’ investors.

The Amplification Effects of the Response to Covid

Pre Covid the UK was not in the greatest of economic health and inflation was starting to raise its ugly head. However, the UK lockdown response to Covid has just amplified all of the issues that were building pre the pandemic.

While some will argue that the lockdowns were inevitable, we tend to disagree – though there is some argument for the first lockdown. The problem with the lockdowns is that we had no real analysis of their overall costs and benefits – they were essentially driven by giving primacy to minimising ‘Covid deaths’ over all other considerations. Countries like Sweden took a more measured and reflective approach and seem to have avoided most of the other consequences while not being out of line in terms of the proportion of Covid deaths.

There is now an acceptance that the lockdowns have had serious consequences for the health of the nation (e.g. record number of cancelled operations, missed cancer referrals, etc.), education (school children and students have been treated appallingly) and the general chaos that results from broken supply chains, WFH, poor customer service, etc. While lockdowns may have been a godsend to the middle classes who could adjust their work-life balances and benefit from the asset price rises, the working classes have often had to keep working in the workplace, have not benefited from asset price rises and are now suffering from the cost of living crisis.

What went wrong is that the ‘establishment economists’ have little understanding of how economies really work. Economies are fragile entities that depend critically on the proper incentive structures and a working price system that signals how resources and monies are to be allocated. The Austrian economists (e.g. Hayek) understood how market systems could be blown off course when parties, such as govts, become overly involved and distort price signals and incentives. To put an economy into a form of hibernation for two years, to pay millions to do nothing, to further borrow 15% of GDP was bound to lead to negative consequences. Effectively, the view taken of the economy was that it could be put to sleep and woken up with no real consequences. Sadly, individuals have now taken a different view of the workplace, their rights vis-à-vis employers, what they want from life, etc.

If all of that is not bad enough, govt has become further entrenched in how the economy runs and taxes have been raised to pay for its activities – and please accept, govts are normally very wasteful with the monies of its citizens – just consider the spending during Covid and the further waste that will be committed by the NHS. But there is a more insidious side to this increased govt involvement – it now sees itself as a solver of problems way beyond its normal remit and it is the deadhand that is throttling the life out of the nation. It is too early tell whether Brexit will be a success but the opportunities to liberalise activities are being squandered by a govt interfering in all aspects of every day life. For example, how long the population will wear the costs of a rush to net-zero is anyone’s guess.

Is the Age of Financial Madness Really coming to an End?

The above sections have argued that we have suffered from 15 years of upside down price signals and incentives, and such a way of running economies has to come to an end at some point – how painful will be the tilt back to more normal times is open to question. The U.S. Fed seems more willing to push up interest rates and reverse quantitative easing, the BoE has been far more timid and there is a general acceptance that it is behind the curve of dealing with inflation expectations.

What kind of price we will have to pay for a return to normal conditions has at least two views. First, there are those who see high inflation continuing, interest rates rising at quite a rate, discontent in the labour markets and a bear market for equities. Second, there is the more sanguine view that supply problems will retreat, inflation will subside and interest rates will not have to rise too much. Equities will have a volatile time over the next year but normal service will be resumed before we know it. Essentially, we are living through a temporary blip – this was very much the view of the BoE. Part of this second argument is that the labour market is nowhere near as well organised as it used to be and wage demands will not become entrenched. There is some truth in this but what we do see is a level of general sympathy for the plight of the workforce – years of sub inflation pay rises and now having to deal with the prospect of double digit inflation. In essence, wages will have to rise to accommodate a disgruntled workforce and interest rates will have to rise to squeeze out a wage/price spiral. The subsequent recession will dampen wage demands and eventually inflation. ‘Boom and bust’ has not been eradicated (see Gordon Brown’s gaffe) and we need them to restore some form of sense to our markets.

Idea –Risk on, risk off, what goes around comes around.

Much of the above is a matter of opinion. Economists seeing the same set of statistics can have a different interpretation - not least, through their own political leanings. Therefore, it is hard to claim what is true in the reality through the data, let alone forecast the future given the complexity of the interactions among the players. From an investment point of view, these are all parts of the unknown quantity that some see as risk (slightly more quantifiable) and the rest uncertainty (the unknown of the unknown, which is much harder to quantify). The immediate concern is about inflation and how it may affect one’s investment. In our earlier blog on this topic, we demonstrated a simple timing strategy to help improve the odds (see Investwithstyle.org - Inflation NRI-2022-05-12).

Another relevant lesson to investment is the temptation of riding a bubble when it seems to be backed by some macro force (cheap money and promises of ‘whatever it takes’). Sooner or later the party will be over and all these need to be paid for. Timing the market to ride the asset inflation bubble is dangerous. However, it is very difficult to warn of the danger of riding the bubble to those who are chasing the hot asset and seeing their ‘investment’ generating significant returns in the short term.

We demonstrate the change of sentiments in two simple graphs illustrating the price path of three assets: bitcoin, S&P 500 and FTSE100 indexes. The first one is taking from January to July in 2020 a period when the Covid-19 outbreak and government responses dominated the world, including financial markets. With cheap money and time at hand due to lockdown, many investors ‘enjoyed’ playing the financial markets and going for risk. A simple observation confirms that the riskier asset (i.e bitcoin, the blue line) leading the way of ‘recovery’ after a series of government injections of liquidity into the market in late March 2020.