“Sometimes I wonder if the world is being run by smart people who are putting us on or by imbeciles who really mean it.”
-- Mark Twain
Hindsight really is 20-20. Everyone crushes it as a Monday morning quarterback. That said, some of the decisions our leaders make do really erode confidence. The recent turmoil in the UK under the new Truss government is just the latest example. Like all nations, Britain has been fighting inflation this year through higher interest rates designed to curb demand and cool off the economy. Last month the new Truss government announced a “mini” budget of unfunded tax cuts that would have stimulated demand and was completely incongruent with the Bank of England’s goal. It didn’t take long for markets to weigh in on the matter, forcing the British currency to all-time lows against the US$ and their bond yields sharply higher. A first year economics student would have known better.
Another example of poor planning is Europe’s overwhelming dependency on Russian energy which seems so obviously shortsighted now. How could the leaders of Europe tie their industrial production capabilities and the very means to survive winter to just one country and have that supply be from Russia? Diversification is rule 1, 2 and 3 in risk management so how was this dependency allowed to happen? And watching President Biden beg Saudi Arabia and Venezuela for more oil after cancelling the XL pipeline was the height of hypocrisy. And closer to home, Canada finds itself lacking in energy infrastructure so that we cannot play a bigger part of the global energy solution when it is desperately needed. Years of “not in my backyard” squabbling and lack of Federal leadership leaves us still without direct export capabilities for our natural gas liquids and oil.
While it is easy to criticize our many global leaders, I want to focus my attention on the most powerful government institutions these days. Since the Great Financial Crisis of 2008, our global central banks have exerted more influence than at any other time in history. These institutions are independent from the elected governing bodies and have proven to be more powerful with seemingly limitless resources that can be called upon in times of need. When the global pandemic arrived, all central banks met the challenge head on by cutting interest rates aggressively and cranking up their money printing presses. These actions were needed when the global economy was put into a coma to allow for scientists to play catch up. However, it now seems obvious to all that central banks kept their monetary spigots wide open for far too long resulting in an historic growth in the money supply. They did this thinking that inflation was transitory and largely due to fractured supply chains. With the benefit of hindsight there can be no debate that they were completely wrong and we are paying the price for it now.
The good news is we know how to fight inflation. It is simple but not easy and certainly not without some angst. Raising borrowing costs always dampens demand eventually. But this tool is a blunt instrument that beats everything into submission but it does take time to work. The first rate hike happened in March and the pace of increases has been unrelenting since. Meanwhile, the impact of that first rate hike has yet to be fully digested and we keep piling them on. To put some perspective on this tightening cycle, in January of this year a 1 year Canada bond was yielding less than 1% and it now yields over 4%. A 5 year mortgage was offered at about 3% at the start of the year and is now well over 6%. The 30 year bond yields on both sides of the border have doubled this year. The absolute level is not the issue, it is the pace of the rate increases that has the market on a knife’s edge. These are dramatic moves and are causing a lot of ripples and stress in all markets. While stock indices are down 12% in Canada (20-30% in the US), bond indices are down double digits and are having their worst year in many decades. A typical portfolio (60% stock, 40% bonds) is apparently having its worst year since 1926!
Anyone who has driven on an icy road appreciates the oversteering analogy that seems overused but still descriptive in my mind. You turn into a slide hoping to correct the slide just enough but you end up overcorrecting. This forces another bigger overcorrection in the opposite direction as you desperately try to avoid driving into the ditch. To complete the analogy imagine doing all of this with a foggy windshield and having to use only the rearview mirror to guide you. This is essentially what central banks are doing these days. As interest rate changes take up to a year or more to impact spending and economic decision making, central banks are looking at stale dated inflation data. They are very afraid of making another sequential policy error and are desperate to regain lost credibility. But it is very likely that they are overcorrecting yet again.
I am in the camp that the central banks are now oversteering and run the real risk of driving the global economy into the ditch to get inflation under control. In economic circles, this is called a hard landing where a recession is the eventual outcome. Contrast this to what we all want which is a soft landing where inflation eases sufficiently as the economy slows just enough without actually contracting into a recession. The first scenario has passengers screaming and the second has everyone clapping on a gentle touchdown!
In my last letter I talked about the risks building and the biggest risk in my mind continues to be the unrelenting surge in the USD against all other currencies. The USD as measured by the trade weighted index is up 18% YTD. As the USD is the world’s reserve currency, this means many countries denominate their debts in USD, and those debts have just grown by 18% just in currency terms. On top of that many of those loans are getting much more expensive to service as interest rates climb. The strong USD has been equivalent to a wrecking ball for many economies. The tightening cycle has to end soon or bad things will start happening and then central banks will have to reverse course quickly to prevent worse things from happening. I know that sounds ominous but it just tells me we are closer to the end of this rate tightening cycle.
Unlike economics, math is much more certain. The US Federal government now has total debt outstanding of around $31 Trillion and as of September 30th, the average interest rate was 2.07%. Each month that interest rates stay elevated, this average interest rate will climb. At the moment, nobody is too concerned but imagine if rates stay elevated or keep climbing? At what point will the service costs for the USA and every other government become a real concern? With so much debt in the world, there are mathematical limits to where interest rates can go before gravity kicks in. The consensus is that we have another 1 or 2 more rate increases by year end and then likely a “pause and assess” to let the higher rates filter through the economy. By then, inflation should begin to tilt lower but getting back to the 2% target will some time. But if we start going in the right direction, markets can start looking forward to the other side of this tightening cycle. And if they have oversteered (which is a real likelihood in my mind) rate cuts will start at some point next year and the reflation trade will be back on. The next year will most likely be very different from this year. The US mid-term elections are just a few weeks away and this opens the door for a traditionally strong period for the stock markets until spring. We just need some confirmation that inflation and with it, interest rates have peaked for this cycle. Until then, we are continuing to maintain a fairly defensive posture.
Derrick