Jupiter Merlin Weekly: UK inflation defies the script
Jupiter Merlin Weekly: UK inflation defies the script
The Jupiter Merlin team discuss the stubbornly high inflation rate in the UK, the Bank of England’s latest interest rate rise, and the painful impact on mortgages.
Investment Manager & ESG Investment Director, Independent Funds/Merlin
Investment Manager, Jupiter Independent Funds/Merlin
UK inflation defies the script
Made in January, Rishi Sunak’s pledge to “halve inflation by the end of the year” has run into distinctly heavy weather. At the time, when the headline rate of CPI was 10.1%, his ambition was to see inflation back down to 5%. By the end of May, it was stuck for a second successive month at 8.7%. Worse, after excluding inconveniently volatile food, fuel, tobacco and alcohol prices, core inflation rose to a new high of 7.1%, up from 6.8% in April, spurred on by companies in the services sector in particular passing on cost increases in accelerating prices to customers and consumers. This was not in the script: the Bank of England’s own economists expected the May CPI print to be a fall to 8.3%. Sunak may yet have his wish for CPI to be 5% by Christmas time, still more than double the Bank of England’s mandated target of 2%, but bearing in mind we are already past the Summer Solstice (as the author’s Granny used to say without fail on June 22nd as she drew the curtains in the evening, “the nights are drawing in now”; believe it or not, she was a cheerful soul) every month that goes by which frustrates the progression in turn closes the window a little further on the likelihood of it being achieved.
Mortgages: the latest political hot potato
Given the inflation rate confounded the Bank’s brightest by almost half a percentage point, the Monetary Policy Committee had no option but to endorse yet another interest rate rise: this time a return to half-a-point at one sitting, now to 5%. Inevitably the political argument has moved on to one of whether it is right to support those most immediately in the firing line: homeowners with mortgages. An estimated 1.4m households have already or are due to come off fixed rate mortgages this year; another 1.2m are in the same position next year, all facing the prospect of significantly higher mortgage interest costs. It would seem perverse for the government actively to be trying to limit house price inflation on one hand by constantly jacking up stamp duty rates while on the other bailing out financially over-extended householders.
As it is, despite protests from back benchers, rather than use tax-payers’ money to soften the blow (for those of us with mortgage memories extending back to the pre-historic era of 1988 when it was abolished, the return of MIRAS, Mortgage Interest Relief At Source had been suggested) both the government and Labour want to push the burden onto lenders. Those providing mortgages should be more accommodating with their debtors by exploring all options with enforced foreclosure only a last resort. Clearly there are ramifications for financial institutions and their balance sheets as well as for those borrowing to buy a house.
Schemes such as temporary interest payment holidays or extending mortgage duration terms are being discussed, including one example of a lender already being willing to extend a 30-year mortgage to 35 years or even 40. These ‘solutions’ ease the short-term pain but the debt and the obligation remain, simply back-end loaded and made bigger; think of a 30-year old who has taken out a 30 year mortgage: in this scenario, instead of completing repaying the principal sum by the age of 60, the borrower will still be liable until the age of 70, which includes an extra 10 years of capitalised interest upon which interest is being charged again. The compounding effect will be significant (the underlying assumption is that over time, the borrower’s financial circumstances will improve, easing the real effect). There is no silver bullet here. What seems bizarre is that this April saw the return of the 100% mortgage being available, albeit in limited circumstances and with a collar-and-cap on the interest payments, but still with the real possibility of negative equity; presumably the regulator had no objections.
As it is, despite protests from back benchers, rather than use tax-payers’ money to soften the blow (for those of us with mortgage memories extending back to the pre-historic era of 1988 when it was abolished, the return of MIRAS, Mortgage Interest Relief At Source had been suggested) both the government and Labour want to push the burden onto lenders. Those providing mortgages should be more accommodating with their debtors by exploring all options with enforced foreclosure only a last resort. Clearly there are ramifications for financial institutions and their balance sheets as well as for those borrowing to buy a house.
Schemes such as temporary interest payment holidays or extending mortgage duration terms are being discussed, including one example of a lender already being willing to extend a 30-year mortgage to 35 years or even 40. These ‘solutions’ ease the short-term pain but the debt and the obligation remain, simply back-end loaded and made bigger; think of a 30-year old who has taken out a 30 year mortgage: in this scenario, instead of completing repaying the principal sum by the age of 60, the borrower will still be liable until the age of 70, which includes an extra 10 years of capitalised interest upon which interest is being charged again. The compounding effect will be significant (the underlying assumption is that over time, the borrower’s financial circumstances will improve, easing the real effect). There is no silver bullet here. What seems bizarre is that this April saw the return of the 100% mortgage being available, albeit in limited circumstances and with a collar-and-cap on the interest payments, but still with the real possibility of negative equity; presumably the regulator had no objections.
Inflation’s stickiness: the Bank of England as much the problem as the solution
Why is our inflation proving stickier and more enduring than that of our competitors? There are many complex factors at work, but as we have pointed out before, inflation is not a homogenous force automatically common among all countries at the same time and to the same degree. But one factor, particularly in comparison with the US Federal Reserve is that while it took the Fed three months longer than the Bank to begin implementing interest rate rises (the UK began monetary tightening in December 2021 while the Fed began in March 2022, followed reluctantly by the ECB in July), the Fed was far more robust than the Bank when it came firmly to grasping the policy nettle, quickly jettisoning the usual quarter point increments in favour of half points, and finally and with the Banks and the European Central Bank (ECB) forced to do the same, by three-quarters of a point at one go in November.
Another central bank, albeit of a relatively minor economy, was even more aggressive. Being wary of over-generalising and making blanket assumptions about the similarities of national inflation drivers, we note that Canada was among the early adopters of reversing quantitative easing and immediately introducing quantitative tightening (QT). It began QT in March 2022 with a quarter point rise to 0.5%, followed successively by two half point increments and in July a full point at one sitting (the Canadian base rate is now 4.75%). One wonders whether there is any coincidence that having taken much more aggressive action much earlier in the rate-rising cycle, the Canadian inflation rate peaked at a lower level (8.1 % last June) than ours and has subsequently fallen much faster now to 4.3% (though even it ticked up a little recently).
Another central bank, albeit of a relatively minor economy, was even more aggressive. Being wary of over-generalising and making blanket assumptions about the similarities of national inflation drivers, we note that Canada was among the early adopters of reversing quantitative easing and immediately introducing quantitative tightening (QT). It began QT in March 2022 with a quarter point rise to 0.5%, followed successively by two half point increments and in July a full point at one sitting (the Canadian base rate is now 4.75%). One wonders whether there is any coincidence that having taken much more aggressive action much earlier in the rate-rising cycle, the Canadian inflation rate peaked at a lower level (8.1 % last June) than ours and has subsequently fallen much faster now to 4.3% (though even it ticked up a little recently).
Regulated energy prices: the worm that turned
Looking at other factors, while commodity prices tend to be global in their effect, making their presence felt more-or-less universally, labour markets have their own national constructs and idiosyncrasies: we all have different employment markets, pensions, income tax and welfare regimes etc. Therefore the dynamics of wages, an important part of the inflation make-up, behave according to local and national conditions, leading to a likely level of divergence.
But leaving aside that 7.6% UK private sector wage inflation is undoubtedly a powerful vector particularly behind the core inflation rate (but even at that level, still falling in real terms against CPI), a further national structural factor peculiar to UK inflation is that we find ourselves on the wrong end of well-meaning but fundamentally flawed government policy on energy costs. Pinched straight from Labour’s Ed Miliband playbook of socialist pricing policy ahead of the 2015 election and implemented as Conservative policy under Theresa May in 2019 (long before the 2021 gas price crisis and last year’s big spike in electricity costs), the UK’s energy price cap mechanism to fix the price of gas and electricity has now come back to bite the government. Adjusted last year to shield consumers from the worst of the storm as wholesale electricity prices rapidly increased to a peak of £580/MWh, the mechanism reacts very slowly in reverse. Despite the electricity wholesale price tumbling 83% to £106/MWh since last September, UK consumers are stuck paying relatively high retail prices compared with other jurisdictions. Much the same applies to domestic gas.
While there is undoubtedly a political imperative to address the underlying drivers of the cost-of-living crisis (and other governments faced exactly the same clamours to “DO something!” to help alleviate the pressures on hard-pressed household budgets), it remains largely the case that when politicians intervene directly in domestic market pricing mechanisms, they become hostages to fortune. Electricity and gas are both traded internationally, so while the government might regulate the cost to consumers, it does not control the market price. Pricing differentials arising out of conflicting mechanisms (one with prices set by the regulator, the other set by the markets) only provide opportunities for speculators to arbitrage the difference; and it ill-behoves a regulated pricing regime to keep changing the regulations to suit market conditions when that regime is designed to provide a level of stability and certainty. All too often, what seemed a good idea at the time to its creators and implementors (but very definitely not to us, as we documented our disapproval at the time in these musings) in practice turns out to be a monster.
But leaving aside that 7.6% UK private sector wage inflation is undoubtedly a powerful vector particularly behind the core inflation rate (but even at that level, still falling in real terms against CPI), a further national structural factor peculiar to UK inflation is that we find ourselves on the wrong end of well-meaning but fundamentally flawed government policy on energy costs. Pinched straight from Labour’s Ed Miliband playbook of socialist pricing policy ahead of the 2015 election and implemented as Conservative policy under Theresa May in 2019 (long before the 2021 gas price crisis and last year’s big spike in electricity costs), the UK’s energy price cap mechanism to fix the price of gas and electricity has now come back to bite the government. Adjusted last year to shield consumers from the worst of the storm as wholesale electricity prices rapidly increased to a peak of £580/MWh, the mechanism reacts very slowly in reverse. Despite the electricity wholesale price tumbling 83% to £106/MWh since last September, UK consumers are stuck paying relatively high retail prices compared with other jurisdictions. Much the same applies to domestic gas.
While there is undoubtedly a political imperative to address the underlying drivers of the cost-of-living crisis (and other governments faced exactly the same clamours to “DO something!” to help alleviate the pressures on hard-pressed household budgets), it remains largely the case that when politicians intervene directly in domestic market pricing mechanisms, they become hostages to fortune. Electricity and gas are both traded internationally, so while the government might regulate the cost to consumers, it does not control the market price. Pricing differentials arising out of conflicting mechanisms (one with prices set by the regulator, the other set by the markets) only provide opportunities for speculators to arbitrage the difference; and it ill-behoves a regulated pricing regime to keep changing the regulations to suit market conditions when that regime is designed to provide a level of stability and certainty. All too often, what seemed a good idea at the time to its creators and implementors (but very definitely not to us, as we documented our disapproval at the time in these musings) in practice turns out to be a monster.
Price regulation: a catching habit
As with energy, the notion of fixing markets is creeping insidiously. The Scottish government has already done it in the private and public sector domestic rental market, capping rents and making evictions difficult if not impossible. While the final details are still to be worked out, in England and Wales a similar regime is being planned by Michael Gove. These policies are not just economic but social; they are intended to change behaviours and market dynamics.
But it was with a mounting sense of incredulity to us that Rishi Sunak, our Prime Minister and former Chancellor of the Exchequer, really thought it was a good idea to try and regulate the price of basic foodstuffs. When we say ‘regulate’, what he actually had in mind was a voluntary price cap regime. But had food price inflation carried on rising at a high teens rate, what would have happened in practice is that the media and politicians would have been quick to name and shame those food retailers who chose not to play the game (it was not difficult to foresee that had the production and wholesale cost of eggs, flour, butter, milk, bread etc continued to rise, but retailers’ selling prices were capped, either they would have seen their margins quickly eroded or, more likely and pragmatically, they would simply have stopped selling loss-making lines which would have created panic buying and hoarding among consumers and the risk of insolvencies among producers). This hare-brained scheme was only abandoned a few days ago, not on principle that Sunak saw it was wrong, but simply because enough retailers and some on-the-ball cabinet ministers urged him that for all practical purposes it was completely unworkable and potentially disastrous.
But it was with a mounting sense of incredulity to us that Rishi Sunak, our Prime Minister and former Chancellor of the Exchequer, really thought it was a good idea to try and regulate the price of basic foodstuffs. When we say ‘regulate’, what he actually had in mind was a voluntary price cap regime. But had food price inflation carried on rising at a high teens rate, what would have happened in practice is that the media and politicians would have been quick to name and shame those food retailers who chose not to play the game (it was not difficult to foresee that had the production and wholesale cost of eggs, flour, butter, milk, bread etc continued to rise, but retailers’ selling prices were capped, either they would have seen their margins quickly eroded or, more likely and pragmatically, they would simply have stopped selling loss-making lines which would have created panic buying and hoarding among consumers and the risk of insolvencies among producers). This hare-brained scheme was only abandoned a few days ago, not on principle that Sunak saw it was wrong, but simply because enough retailers and some on-the-ball cabinet ministers urged him that for all practical purposes it was completely unworkable and potentially disastrous.
The looming spectre of Ted Heath
But it raises a fundamental question. What, pray, persuaded Rishi Sunak that it was a runner in the first place? This is the man who, in his leadership hustings, professed to be a free-market Tory in the mould of Margaret Thatcher (all the candidates tried to catch her ghost’s coat-tails, most having zero understanding of what The Lady was really about) and later claimed to have a portrait of his economic hero, the late Chancellor Nigel Lawson, hanging on his office wall. He must be confused: Lawson was a committed radical of the monetarist school. Instead of thinking it to be Nigel Lawson peering down from on high, perhaps Sunak was in fact holding a candle to Ted Heath, an unreconstructed paternalistic Tory who felt compelled in 1972 to pursue national wages and pricing policies to try and curb inflation. History says that didn’t end so well. History has a habit of repeating itself. QED.
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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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