Jupiter Merlin Weekly: The central bank policy porridge
Jupiter Merlin Weekly: The central bank policy porridge
The Jupiter Merlin team discuss the attempts of central banks to navigate between recession and inflation, with mixed results that risk being either too hot or too cold.
Investment Manager, Jupiter Independent Funds/Merlin
Investment Manager & ESG Investment Director, Independent Funds/Merlin
Chicken feed. Once synonymous with something worthless, now it is in reality very expensive. As UK wheat for May delivery reaches £345 per tonne, double the price less than 13 months ago, alongside soaring electricity costs to power the incubators, so UK egg producers are finding themselves in a real bind: the cost of producing eggs now exceeds the price UK supermarkets are willing to pay for them.
What should chicken farmers do? Save money by stopping production but risk having no business? Grin and bear it in the hope of eventually passing on the increased cost to retailers who themselves are labouring under wafer-thin, low single-digit operating margins and their own business cost pressures? Innovate? How many more uses for an egg are there that have not been found already? Diversify, with all the associated risk?
What should chicken farmers do? Save money by stopping production but risk having no business? Grin and bear it in the hope of eventually passing on the increased cost to retailers who themselves are labouring under wafer-thin, low single-digit operating margins and their own business cost pressures? Innovate? How many more uses for an egg are there that have not been found already? Diversify, with all the associated risk?
Inflation: complex and contradictory moving parts
Inflation dominates the headlines, the ubiquitous “cost of living crisis!” debated daily in the media. If egg producers are a simple microcosm of the problem, the real picture is inevitably much more complex. While the war in Ukraine and the sanctions regime against Russia are pushing up the international wholesale prices of gasoline, diesel, wheat, sunflower and fertiliser to near all-time highs, the knock-on effect of General Secretary Xi’s Covid lockdown policy as China grapples with its zero tolerance of the virus has caused the price of copper, iron ore, lumber and nickel to fall from the March peaks, quite sharply in the case of copper, a bellwether of economic health.
The US inflation rate for April was reported at 8.3%, marginally down from 8.5% in March but down by far less than analysts had been expecting, particularly with the sharp reduction in the price of crude oil over the past month since the hiatus when the UK and the US announced oil sanctions against Russia. Markets are still grappling with the possibility that inflation may prove more enduring and embedded than anticipated. As much as anything, it will be wages which are likely to be the factor which determines that duration; raw materials and energy prices are cyclical and volatile (which by implication means they go down as well as up, as illustrated above), while nominal wages tend not to fall, albeit P&O found a blunt and not very successful solution to that problem when it fired 800 seagoing staff and tried to replace them with workers on lower wages.
The US inflation rate for April was reported at 8.3%, marginally down from 8.5% in March but down by far less than analysts had been expecting, particularly with the sharp reduction in the price of crude oil over the past month since the hiatus when the UK and the US announced oil sanctions against Russia. Markets are still grappling with the possibility that inflation may prove more enduring and embedded than anticipated. As much as anything, it will be wages which are likely to be the factor which determines that duration; raw materials and energy prices are cyclical and volatile (which by implication means they go down as well as up, as illustrated above), while nominal wages tend not to fall, albeit P&O found a blunt and not very successful solution to that problem when it fired 800 seagoing staff and tried to replace them with workers on lower wages.
Fed policy for Quantitative Tightening: meat on the bones
Last week, the US Federal Reserve announced an increase of a half percentage point in the Fed Funds target rate of interest taking the rate to 0.75%-1.0% against 0%-0.25% two months ago. While it has shied away from adding three quarters of a point at the next policy meeting in June, it has already laid the path for at least two further half-point increases in the next two meetings. Chairman Jerome Powell still expects the rate to top out at 3%, what he expects to be the ‘neutral’ rate (i.e. the point at which the rate of interest is neither slowing nor accelerating the economy; given the economy is dynamic, particularly in today’s extraordinary circumstances, only the foolhardy would take that projection as being cast in stone) during 2023.
On the liquidity front, effective 1st June and for three months the Fed will allow maturing bonds to roll off its balance sheet without being refinanced (that projected run-rate is $47.5bn a month, $30bn of which is government bonds and the rest are mortgage-backed securities); from September it will begin proper quantitative tightening (QT), meaning it will actively sell securities back to the markets. The monthly sums will be capped at $60bn per month for government bonds and $35bn for mortgage-backed securities. In context, the total Federal Reserve balance sheet is still just shy of $9 trillion, having been $4 trillion immediately before the pandemic, and a mere $400 billion before the Global Financial Crisis when quantitative easing (QE) was but a twinkle in its creator’s eye. \
On the liquidity front, effective 1st June and for three months the Fed will allow maturing bonds to roll off its balance sheet without being refinanced (that projected run-rate is $47.5bn a month, $30bn of which is government bonds and the rest are mortgage-backed securities); from September it will begin proper quantitative tightening (QT), meaning it will actively sell securities back to the markets. The monthly sums will be capped at $60bn per month for government bonds and $35bn for mortgage-backed securities. In context, the total Federal Reserve balance sheet is still just shy of $9 trillion, having been $4 trillion immediately before the pandemic, and a mere $400 billion before the Global Financial Crisis when quantitative easing (QE) was but a twinkle in its creator’s eye. \
Policy porridge: how hot do you like your QT?
Meanwhile the Bank of England, facing many of the same issues, opted for a quarter-point rise, (the fourth in succession since December), taking the UK base interest rate to 1%. Governor Bailey pointed towards the risks of taking too aggressive a stance being likely to add to the risk of a recession for an economy already demonstrably slowing.
We have said before that the European Central Bank (ECB) remains the one to be smoked out of its bunker, a long way behind the policy curve of its UK and US colleagues. But even Christine Lagarde has finally capitulated and announced that ECB interest rates will probably rise in July, having already twice retreated from indefensible positions when her target dates of the end of the year and the third quarter were successively routed. But if all are roughly now on the same page on the path from QE to QT, it’s a ‘Goldilocks and the three bears’ menu of policy porridge: the US response is hot, the UK warm-ish and the eurozone distinctly tepid, perhaps not surprising when hosting a major war on its doorstep. After over a decade of central banks being the markets’ friends, investors have now been cut adrift, left to sink or swim according to their own devices.
We have said before that the European Central Bank (ECB) remains the one to be smoked out of its bunker, a long way behind the policy curve of its UK and US colleagues. But even Christine Lagarde has finally capitulated and announced that ECB interest rates will probably rise in July, having already twice retreated from indefensible positions when her target dates of the end of the year and the third quarter were successively routed. But if all are roughly now on the same page on the path from QE to QT, it’s a ‘Goldilocks and the three bears’ menu of policy porridge: the US response is hot, the UK warm-ish and the eurozone distinctly tepid, perhaps not surprising when hosting a major war on its doorstep. After over a decade of central banks being the markets’ friends, investors have now been cut adrift, left to sink or swim according to their own devices.
Markets: clutching at straws or catching a falling knife?
And what have investors been making of all this? Judging by the recent extreme volatility in government bond yields, the answer appears to be everyone clutching at straws. The US 10 Year government bond having been nudging 3% at the beginning of May, hit 3.2% on May 9th and is back at 2.88% at the time of writing; likewise, the German 10 Year government bond yield sailed through 1% to peak at 1.2%, again to subside back to 0.89% at the time of writing (in context it was still a negative yield as recently as 4th March).
Markets are inherently forward-looking, constantly scanning the horizon for factors which change the outlook rather than being preoccupied with what is already regarded as ancient history, however recent it might be (although reported data is an important sense-check on the journey).
In that respect, while the headlines focus on inflation, investors are already divining from the chicken’s entrails that with global growth slowing, the future risk is less about inflation itself and more about whether in tackling it, the central banks tip the economy over the edge. In the minutes of its recent policy meeting, the Federal Reserve referred to recessionary risk but that it hoped to engineer a “soft landing”. Such an ambition is neither delusional, nor is it deliverable on demand: if that were the case, given major Western economies are supposed to be managed to a target inflation rate of 2%, we would not be sitting with current inflation at four times the mandated rate. Central banks can influence outcomes, but they certainly do not control them.
There are empirical pointers supporting market opinions that the threat (rather than the reality) of a prolonged dose of policy medicine is already working. The US autos market has outstanding finance liabilities at a record high of $1.3 trillion, while in the past quarter the volume of new car sales has plummeted year-on-year by 15% for used cars and 16% for new ones, the latter exacerbated by the chronic shortage of components, semi-conductors in particular. With unsupportable gratuitous price inflation for vehicles and rapidly escalating financing costs, those sliding volumes suggest the steam is coming out of the market. In housing, the new 30-year mortgage rate is offered at 5.4% compared with 3.1% a year ago which most see as causing a slowdown in new house sales.
Markets are inherently forward-looking, constantly scanning the horizon for factors which change the outlook rather than being preoccupied with what is already regarded as ancient history, however recent it might be (although reported data is an important sense-check on the journey).
In that respect, while the headlines focus on inflation, investors are already divining from the chicken’s entrails that with global growth slowing, the future risk is less about inflation itself and more about whether in tackling it, the central banks tip the economy over the edge. In the minutes of its recent policy meeting, the Federal Reserve referred to recessionary risk but that it hoped to engineer a “soft landing”. Such an ambition is neither delusional, nor is it deliverable on demand: if that were the case, given major Western economies are supposed to be managed to a target inflation rate of 2%, we would not be sitting with current inflation at four times the mandated rate. Central banks can influence outcomes, but they certainly do not control them.
There are empirical pointers supporting market opinions that the threat (rather than the reality) of a prolonged dose of policy medicine is already working. The US autos market has outstanding finance liabilities at a record high of $1.3 trillion, while in the past quarter the volume of new car sales has plummeted year-on-year by 15% for used cars and 16% for new ones, the latter exacerbated by the chronic shortage of components, semi-conductors in particular. With unsupportable gratuitous price inflation for vehicles and rapidly escalating financing costs, those sliding volumes suggest the steam is coming out of the market. In housing, the new 30-year mortgage rate is offered at 5.4% compared with 3.1% a year ago which most see as causing a slowdown in new house sales.
The Zombie Economy: the chickens heading home to roost
We have talked often in these musings of the ‘Zombie Economy’, one in which badly run companies which should have gone bust under Darwinian economics were allowed to persist over a long period without any great incentive to improve, thanks to easy access to cheap finance arising from lax post-global financial crisis central bank policy. Those companies are now likely to find themselves in great difficulty, particularly if they are still carrying high levels of financial leverage (i.e. they have over-borrowed). Indeed, they face the perfect storm: a slowing economy with commensurately slower demand for goods and services; rising input costs; high debt levels on which the interest burden is rising by multiples rather than percentage points; and, finally, limited or no access to refinance their balance sheets. It is no surprise that spreads in high yield credit and credit default swap premiums (the protection premium paid by bondholders in the event the company defaults on its loans) have ballooned as investors reassess the price of risk in toughening conditions.
These are very unusual times: war; pestilence; simultaneous dislocation to the supply side of the economy and headwinds for the consumer; stagflation; upside-down policy with central banks tightening monetary conditions as global growth slows. Uncharted waters in which treacherous reefs and shoals abound for the unwary or the gung-ho. There are no hard and fast answers here to complex questions. In what has occasionally been a febrile environment, we believe it pays to keep an open, diversified and flexible approach to investments.
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.
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