Merlin Weekly Macro: Are markets too obsessed with inflation?
Merlin Weekly Macro: Are markets too obsessed with inflation?
The Jupiter Merlin team discuss whether markets, in their obsession with tracking inflation trends, are not paying enough attention to key structural issues.
Falling inflation: bond markets reckon it’s all over…
US and UK inflation in October once more moved in the right direction and this time in unison. Interestingly, the last four months of US CPI data is a perfectly symmetrical distribution: 3.2%; 3.7%; 3.7%; 3.2%; the headline number is yet to break out of the bottom end of the 3%-4% range in which it has been stuck since June when it fell to 3.0% from 4.1% in May.
Nevertheless fixed income markets took great cheer from this sideways trend, even though the magic 2% target remains elusive so far and progress towards it is grindingly slow. It gave fresh impetus to falling bond yields, the corollary of which is rising prices (from a recent peak of 5.07% on 19 October, today the yield on the US 10 Year Treasury is more than a half point lower at 4.44%). What we now have is a new Mexican stand-off between the markets who provide capital and the principal central banks which, through the official interest rate, set the benchmark price of it. It is virtually the reverse of where we were in mid-2021: then, investors were pushing up yields as the perceived inflationary risk grew while the central banks denied there was a problem and refused to raise interest rates from rock bottom; now, investors are driving yields down while central banks are reluctant to reduce interest rates from current highs. In effect markets are telling them, and the Federal Reserve in particular, that if they were not cautious enough two years ago, they are being far too conservative now.
Nevertheless fixed income markets took great cheer from this sideways trend, even though the magic 2% target remains elusive so far and progress towards it is grindingly slow. It gave fresh impetus to falling bond yields, the corollary of which is rising prices (from a recent peak of 5.07% on 19 October, today the yield on the US 10 Year Treasury is more than a half point lower at 4.44%). What we now have is a new Mexican stand-off between the markets who provide capital and the principal central banks which, through the official interest rate, set the benchmark price of it. It is virtually the reverse of where we were in mid-2021: then, investors were pushing up yields as the perceived inflationary risk grew while the central banks denied there was a problem and refused to raise interest rates from rock bottom; now, investors are driving yields down while central banks are reluctant to reduce interest rates from current highs. In effect markets are telling them, and the Federal Reserve in particular, that if they were not cautious enough two years ago, they are being far too conservative now.
…bar the shouting
While cheered and entirely absorbed by the inflation data, investors are either sanguine about or completely ignoring some important structural issues.
In the United States, the House of Representatives has yet again kicked the can down the road as it once more fails to meet a substantive agreement about US government spending in relation to the burgeoning debt pile. As a reminder the government breached its agreed debt ceiling in October for the second time this year; government debt exceeded the $31.4 trillion limit in January and, despite a new agreement in June applying moderation, is now approaching £34 trillion with a debt/GDP ratio well in excess of 130%. Placed in special measures again, the fixed legally-binding 45-day guillotine was due to expire at midnight on 17th November beyond which, if Congress had not agreed a new funding plan, all government services would be suspended precipitating either a public sector shutdown or failure to honour its bonds.
The House has failed to reach agreement but at least by a large majority Representatives did agree that talks should continue rather than the guillotine be triggered. It was signed into law by Biden on Wednesday night that until January 19th, spending is protected at current levels on ‘priorities’, including military construction, veterans’ affairs, public transport, housing and energy; any other government expenditure (health, law & order etc) remains funded until February 2nd. The critical issues which prompted the latest imposition of special financial measures in the first place, the incremental spending on the war effort in Ukraine and financial aid for Israel, are no nearer a conclusion or a solution than a month ago.
What an indictment of the world’s biggest economy that this is how it conducts its domestic business. A year ago after the mid-term elections when Biden lost the House but retained the Senate, it was assumed that for the remainder of his Presidency he would be able to do little and therefore do no harm. In fact, in a hung Congress and despite a lame duck President, the political stalemate in Washington is a significant impediment to achieving meaningful progress to break the financial deadlock that Biden’s profligacy has created. But currently markets appear completely relaxed about this significant structural fault-line at the heart of the US economy.
In the United States, the House of Representatives has yet again kicked the can down the road as it once more fails to meet a substantive agreement about US government spending in relation to the burgeoning debt pile. As a reminder the government breached its agreed debt ceiling in October for the second time this year; government debt exceeded the $31.4 trillion limit in January and, despite a new agreement in June applying moderation, is now approaching £34 trillion with a debt/GDP ratio well in excess of 130%. Placed in special measures again, the fixed legally-binding 45-day guillotine was due to expire at midnight on 17th November beyond which, if Congress had not agreed a new funding plan, all government services would be suspended precipitating either a public sector shutdown or failure to honour its bonds.
The House has failed to reach agreement but at least by a large majority Representatives did agree that talks should continue rather than the guillotine be triggered. It was signed into law by Biden on Wednesday night that until January 19th, spending is protected at current levels on ‘priorities’, including military construction, veterans’ affairs, public transport, housing and energy; any other government expenditure (health, law & order etc) remains funded until February 2nd. The critical issues which prompted the latest imposition of special financial measures in the first place, the incremental spending on the war effort in Ukraine and financial aid for Israel, are no nearer a conclusion or a solution than a month ago.
What an indictment of the world’s biggest economy that this is how it conducts its domestic business. A year ago after the mid-term elections when Biden lost the House but retained the Senate, it was assumed that for the remainder of his Presidency he would be able to do little and therefore do no harm. In fact, in a hung Congress and despite a lame duck President, the political stalemate in Washington is a significant impediment to achieving meaningful progress to break the financial deadlock that Biden’s profligacy has created. But currently markets appear completely relaxed about this significant structural fault-line at the heart of the US economy.
Germany: another bastion of safety?
Germany’s government bond yields have been backtracking too, coat-tailing US Treasuries, also losing close to half a point at 2.55% (and again, prices heading in the opposite direction). A few short weeks ago in a Jupiter Merlin Macro article (27 October) when fixed income markets were still climbing their wall of worry rather than straining at the leash to be off to the races, we described the perceived financial risk to Italy as measured by the spread between its government bond yield and that of Germany; that spread has since narrowed slightly, away from the danger zone (that’s not to say the underlying problem of Italy’s enduring economic difficulties has gone away; it most surely has not).
But the implicit assumption in the risk calculation is the flakiness of the numerator and the stability and solidity of the denominator. Events in Berlin this week show that Germany has significant problems of its own. A court has ruled that the Traffic Light Coalition budget plan to transfer €60bn of unspent pandemic recovery funds towards green industry development is a breach of Germany’s strict debt break laws (in which the Government is forbidden by law to present a budget with more than a 0.35% deficit/GDP ratio). The budget also includes a pledge to double the commitment to Ukraine to €8bn. A means will almost certainly be found to present a legally compliant budget by December 1st but significant compromises will have to be made on other areas of public spending in an economy which is as near as makes no difference to being in recession.
The risk here is not so much financial, as it is in the US, as political. Olaf Scholtz’s coalition comprising his own Social Democrats, the Green Party and the centre right Free Democrats (who have responsibility for the finance ministry) varies between fragile at best and riven with division at worst. His is the weakest, least effective chancellorship in generations and deeply unpopular. The budget row reveals the significant ideological tensions, particularly between the Greens and the FDP. Whether the coalition holds together or fails on irreconcilable points of principle, as did Mark Rutte’s in Holland in the summer about immigration, remains to be seen.
But this must be viewed through the lens of rapid polarisation in the German political system. Notably the significant momentum of the far right AfD, regularly polling over 20% nationally and now making demonstrable inroads in West Germany having broken out of its traditional heartland in the East. Also making waves is Sarah Wagenknecht, dubbed Die Unfassbare-the incredible one, a political phenomenon on the hard left. She is an ideological Marxist but committed German nationalist; she is described by many German political commentators as being as xenophobic as those on the far right, the very constituency to whom she is appealing. Not shy in nailing her colours to her personal mast, she is setting up her own eponymous party. It is another two years before the next Federal election but these are febrile times in German politics at the centre of which are four key issues: the stagnant economy; immigration; Germany’s path to carbon net-zero; and the consequences of the war in Ukraine. In a couple of weeks we will be approaching the first anniversary of the planned but failed right wing, military-led coup d’état in which the aim last December was to storm the Bundestag. That it was successfully foiled was not the point; that it was even a possibility is much more absorbing. Yet investors, preoccupied with things they can count and their universal tunnel vision approach to inflation, still use Germany as the benchmark of stability and the definition of a “safe haven asset” when seas get rough. One to ponder.
But the implicit assumption in the risk calculation is the flakiness of the numerator and the stability and solidity of the denominator. Events in Berlin this week show that Germany has significant problems of its own. A court has ruled that the Traffic Light Coalition budget plan to transfer €60bn of unspent pandemic recovery funds towards green industry development is a breach of Germany’s strict debt break laws (in which the Government is forbidden by law to present a budget with more than a 0.35% deficit/GDP ratio). The budget also includes a pledge to double the commitment to Ukraine to €8bn. A means will almost certainly be found to present a legally compliant budget by December 1st but significant compromises will have to be made on other areas of public spending in an economy which is as near as makes no difference to being in recession.
The risk here is not so much financial, as it is in the US, as political. Olaf Scholtz’s coalition comprising his own Social Democrats, the Green Party and the centre right Free Democrats (who have responsibility for the finance ministry) varies between fragile at best and riven with division at worst. His is the weakest, least effective chancellorship in generations and deeply unpopular. The budget row reveals the significant ideological tensions, particularly between the Greens and the FDP. Whether the coalition holds together or fails on irreconcilable points of principle, as did Mark Rutte’s in Holland in the summer about immigration, remains to be seen.
But this must be viewed through the lens of rapid polarisation in the German political system. Notably the significant momentum of the far right AfD, regularly polling over 20% nationally and now making demonstrable inroads in West Germany having broken out of its traditional heartland in the East. Also making waves is Sarah Wagenknecht, dubbed Die Unfassbare-the incredible one, a political phenomenon on the hard left. She is an ideological Marxist but committed German nationalist; she is described by many German political commentators as being as xenophobic as those on the far right, the very constituency to whom she is appealing. Not shy in nailing her colours to her personal mast, she is setting up her own eponymous party. It is another two years before the next Federal election but these are febrile times in German politics at the centre of which are four key issues: the stagnant economy; immigration; Germany’s path to carbon net-zero; and the consequences of the war in Ukraine. In a couple of weeks we will be approaching the first anniversary of the planned but failed right wing, military-led coup d’état in which the aim last December was to storm the Bundestag. That it was successfully foiled was not the point; that it was even a possibility is much more absorbing. Yet investors, preoccupied with things they can count and their universal tunnel vision approach to inflation, still use Germany as the benchmark of stability and the definition of a “safe haven asset” when seas get rough. One to ponder.
Halving inflation: Rishi’s claimed success
Here in the UK, irreverently re-named Rishi ‘Sunk’ by his opponents and the satirical press after his travails this week dealing with a recalcitrant (now former) Home Secretary and all the collateral fallout including having to resort to the appointment of a 7-year expired MP and failed Prime Minister as Foreign Secretary, and being humiliated by the Supreme Court throwing out his immigrants-to-Rwanda policy again, this has been a difficult week for Mr Sunak. But at least inflation falling to 4.6% allowed him to claim one small victory, however unjustified. In his struggle to meet his Five Pledges laid out in his first keynote speech as Prime Minister on January 4th, 2023, he can claim to have ‘halved inflation’ by the end of the year from the 10.5% recorded in December last year. Nos 10 and 11 may be adjacent addresses in the Downing Street terrace but it is not clear their respective occupants talk to each other or listen to what the other says. While Sunk, sorry, Sunak, was pledging an implied target of 5% inflation this year, only a month before, Chancellor Jeremy Hunt had set an explicit target of 3% by the end of 2023. It will be January before we know whether he too has succeeded.
While Sunak will of course claim victory on inflation, the fact remains that even if it has more than halved from its peak of 11.1% recorded last year, it needs to more than halve again to reach the 2% level beyond which the Governor of the Bank of England no longer needs to write an official letter to the Chancellor explaining why the Bank has missed its mandated target. And the reality is that neither the Prime Minister nor the Chancellor played any material role in the reversal of inflation; that has been much more to do with the cycle of global commodity prices moving in their favour (including gas), and the simultaneous mathematical tailwind of the comparative time series advancing a month at a time. But in difficult times when at risk of drowning, politicians grab what little logs of luck float past them and hang on tight. Who wouldn’t?
As for Sunak’s remaining four 2023 Pledges: to grow the economy, to slash NHS waiting lists, to cut the debt, and to stop the boats, given it is already mid-November and there are only six weeks left of the year, it seems a fairly confident prediction that there is a greater chance of Hell freezing over than any of these being meaningfully achieved if at all. But that is a political problem for another day.
While Sunak will of course claim victory on inflation, the fact remains that even if it has more than halved from its peak of 11.1% recorded last year, it needs to more than halve again to reach the 2% level beyond which the Governor of the Bank of England no longer needs to write an official letter to the Chancellor explaining why the Bank has missed its mandated target. And the reality is that neither the Prime Minister nor the Chancellor played any material role in the reversal of inflation; that has been much more to do with the cycle of global commodity prices moving in their favour (including gas), and the simultaneous mathematical tailwind of the comparative time series advancing a month at a time. But in difficult times when at risk of drowning, politicians grab what little logs of luck float past them and hang on tight. Who wouldn’t?
As for Sunak’s remaining four 2023 Pledges: to grow the economy, to slash NHS waiting lists, to cut the debt, and to stop the boats, given it is already mid-November and there are only six weeks left of the year, it seems a fairly confident prediction that there is a greater chance of Hell freezing over than any of these being meaningfully achieved if at all. But that is a political problem for another day.
“Mod Rap”
Investors, and those in fixed income in particular having had a notably difficult time for the past two years, are understandably keen to get going again. There is a risk that in charging head-down, they lose sight that there are still conditional risks, such as those we have outlined above. As the author’s mother-in-law is fond of saying, “Mod Rap, darling”, her shorthand for ‘modified rapture’. It seems an appropriately pragmatic assessment.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
Authors
Investment Manager & ESG Investment Director, Independent Funds/Merlin
Investment Manager, Jupiter Independent Funds/Merlin
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