11th January 2013
That would place a significant amount of pressure on the current policies surrounding quantitative easing. Mott calls this the greatest financial experiment in history and questions many aspects including whether US policies on QE and interest rates are the way to meet its 6.5 per cent unemployment target. Mott obviously has a way with words, but he earned his fund manager's stripes in the technology boom where he held firm to the view that it was an unsustainable bubble. If he's correct this time it could have huge implications for the current policy trajectory and indeed our recovery from this flat-lining economy in the UK. Rather than chop it up into the most interesting bits, we are going to publish Mr Mott's inflation and QE ideas below in full.
“The Greatest Financial Experiment in History” – the big picture
Like any team of Fund Managers, we spend many hours discussing the ‘Big Picture’ for the economy and the stockmarket. However much we debate it, we keep coming back to the view that we are living in the greatest financial experiment in history.
The global financial crisis brought debt-fuelled consumption to an end and left advanced economies facing the prospect of deflation as excessive debt levels start to be paid down. Governments, which have taken on much of the bad debt within the banking system, are now constrained by their own deficits and are unable to spend their way out of the crisis. So we are led into the politics of austerity and the grim possibility of a depression.
But the Central Banks have been so fearful of this outcome of a potential depression that they have unleashed unprecedented policies, such as record low interest rates and money-printing, in an attempt to provide a counter-balancing force to austerity and to try to keep the world afloat.
The net result of these two opposing forces, of deflationary deleveraging versus inflationary central bank policies, has enabled economies to “muddle through”. We describe this muddling through as “the tightrope walk”. Our central case, to which we previously ascribed a 60 per cent probability, was that the UK and indeed the world’s economies could cling onto this tightrope. But we think that the risk of falling off is real. In our last strategy note , “Clinging to the Tightrope” written in mid-October 2012, we gave a 15 per cent chance to falling off to the left into deflation (“we’re all Japan now”) and a 25 per cent chance that we fall off to the right and the “inflation genie” would get out of the bottle. Our challenge as Fund managers has been to create a blend of holdings for the PSigma Income Fund that would do well in this range of three possible outcomes.
New PSigma ‘Scores on the Doors’
However, we now think that the Central Banks are going too far. The risk of policy error not just keeping us on the tightrope, but pushing us off to the right, towards inflation, has increased.
We now see a 55 per cent chance that we can continue to muddle through, down from 60 per cent. That’s a reduction from where we were, but still just about our central case. We now see only a 10 per cent chance of deflation leading ultimately to a depression, but an increased 35 per cent chance of inflation. And, sadly, still a 0% chance of synchronised non-inflationary global growth. To summarise:
– 55% Muddle Through
– 35% Inflation
– 10% Deflation / Depression
Why worry about inflation?
We think we may be approaching an inflection point where the markets start to worry more about inflation. Why are we more worried about inflation now than we were three months ago? The short answer is that policy has become more and more extreme. So let’s look at 5 reasons why.
(1) Quantitative Easing is now unlimited. Quantitative Easing (aka ‘money printing’) in the USA is now open-ended, so potentially unlimited. The Federal Reserve is buying $40bn of Mortgage Backed Securities and $45bn of Treasuries per month. At an annualised rate, this amounts to a suspiciously handy 90 per cent of the 2012 Federal deficit.
(2) Ultra Low Interest Rate Policy is being misdirected. The US Federal Reserve has explicitly said that they will keep interest rates near zero until unemployment falls to 6.5 per cent. Even if this is a sensible target, interest rates are, in our view, the wrong tool to achieve it. What about supply side conditions? What if more than 6.5 per cent of the American workforce is in practice unemployable in a higher value-added economy? This opens the prospect of interest rates staying too low for too long.
(3) Everyone is trying to kill their currency. The US is not alone in engaging in wide-scale QE. Most of the major currencies have Central Banks that are looking to print money to, amongst other things, reduce the relative value of their currencies in an attempt to promote exports. Japan has just redoubled its efforts. This beggar-thy-neighbour approach may work for one country, but if everyone is at it, it is doomed to failure. But it does reduce the value of paper money compared to physical goods and services. This is inflation.
(4) The Bank of England potentially giving up on inflation targeting. The successor to Mervyn King as Governor of the Bank of England, Mark Carney, has raised the prospect of replacing the current inflation targeting regime with a framework that aims at a nominal GDP number. We see this as a smoke screen to allow higher inflation in a low growth world.
(5) Imported disinflation is over. Western consumers (and Central Banks) have benefited enormously from the shift in manufacturing to the emerging markets and, in particular, to China. Buying ever cheaper imported finished goods, from socks to televisions, has had a massively dampening impact on western inflation. The benefits of this are now largely played out. Anything that could be ‘off-shored’ already has been. And more importantly, emerging markets are now seeing significant wage increases which will result in higher prices for the end consumers.
This will hurt, but a lot less than the alternative
Inflation erodes spending power and, as consumers, we will all feel w
orse off. This is particularly true because inflation is likely to exceed wage growth, so real disposable incomes will continue to be squeezed. We do not see a return to 1970’s style wage inflation: the historic power of the unions has been diluted and job security is weak, so employers hold most of the cards. This will be a deflationary inflation.
However, a sustained period of steady inflation is the least painful way to erode the debt. Demands for repayment in the future fall in real terms. This is hugely helpful for all debtors, be it the mortgaged householder or Her Majesty’s Government. Obviously, the burden falls on savers and it is sad to say that we will see the prudent pay for the follies of the reckless.
However the scale of debt is so large that earning our way out is not a realistic option without serious public and social unrest. Even getting total debt as a percentage of GDP down by a couple of percent is to inflict widespread pain, as we have seen in Greece and Portugal. It is hard to see how the entitled populations of the UK and America would be prepared to wear the necessary pain. Much easier all round to inflate the debt away.
ARE WE THERE ALREADY?
To some extent, inflation is already with us. The Bank of England has exceeded the middle of its target inflation range for 38 months in a row. What is remarkable is that despite this persistent inflation, the UK gilt market is trading at such low yields. Real interest rates on bonds have been negative for some time. Are low gilt yields telling us that the bond markets are relaxed about the inflation numbers? Or is it rather that the same target-busting Bank of England has been the most enormous buyer of gilts and has successfully subverted all price signals? The Bank of England now owns about one-third of the entire stock of gilts. Also pension funds, insurance companies and commercial banks have all been forced buyers of gilts, largely irrespective of price.
The outlook fot gilts must be poor
It is not clear to us, or quite possibly anyone, how the Bank of England is going to be able to unwind its massive position in UK gilts. It is also not clear to us why any uncompelled buyer would buy gilts at these current levels. Whilst we are not predicting a rout, the likelihood must be that gilts are a poor investment from here.
This is a mixed blessing for equities. On the positive side, the income availability in the UK equity market is fantastic. The PSigma Income Fund holds many great quality, powerful, companies that yield twice or three time the yield available on UK gilts. Historically this tends to be a great buying signal for equities. However the risk may be that with rising gilt yields, the bond and the equity markets meet in the middle.