Investment Comment
23rd September 2022
Zugzwang
Zugzwang is the German word for a situation in chess (and life) in which a move must be made, but each possible one will make the situation worse. With a toxic combination of lingering inflation and slowing growth, welcome to the world of central banking.
While high inflation would seem to demand that central banks tighten policy through raising interest rates, this will likely negatively impact economic growth, which is already slowing as a result of the surge in commodity prices caused by the ongoing conflict in Ukraine. Therefore, there is a high chance that the actions of central banks could help drive already weakening economies into recession. Nevertheless, they are determined to act.
This week saw a number of central banks globally raising interest rates. The US, UK, Switzerland, Hong Kong, Indonesia, Norway and South Africa all moved, highlighting the co-ordinated tightening of policy we are seeing across the world.
Starting with the US, last month, Fed Chairman Jerome Powell, rocked complacent markets with his hawkish statement at Jackson Hole, and yesterday he reiterated those sentiments whilst also announcing another 75bps rate rise. “The chances of a soft landing are likely to diminish” because monetary policy needs to be “more restrictive or restrictive for longer”, Powell warned during a press conference following the rate rise announcement. He also pointedly refused to rule out a recession. Echoing the language he used at Jackson Hole, Powell said “we will keep at it until we’re confident the job is done”, the “job” of course bringing inflation under control. The Fed also unveiled a new “dot plot” of Fed official’s interest rate projections that reinforced their commitment to a “higher for longer” approach. Whereas in June (when last published), officials predicted the Fed rate would reach a peak of 3.8% in 2023, that has now risen to 4.6%, albeit there is a wide divergence of views. This continued ratcheting up of interest rate expectations has seen bond yields rise to new highs, which is negative for bond prices/returns and equity market valuations. It also supports the US Dollar, which has been exceptionally strong this year, up over 15% versus Sterling.
In the UK, the Bank of England “only” raised rates by another 50bps bringing interest rates up to 2.25%, despite warning that the UK may already be in recession. A larger move had been predicted but it is likely that the Bank was waiting to see what came out of the much anticipated “mini-budget” from the new Chancellor, which we discuss below.
Economic policy tug-of-war
Earlier today the UK Chancellor, Kwasi Kwarteng, announced a series of tax cuts and economic measures. While this was not a formal budget, only a “fiscal event”, it’s the biggest tax-cutting event since 1972. The planned rise in corporation tax was scrapped, the recently introduced increase in national insurance was reversed, stamp-duty thresholds have risen, the basic rate of income tax will be cut from April 2023 and the 45% top rate of income tax has been abolished. In total, there was over £30bn of tax cuts on top of the £150bn estimated cost of holding down gas and electricity bills. The Treasury is also budgeting more than £20bn a year for additional debt servicing costs to fund a significant increase in borrowing.
The combination of a massive fiscal loosening with low unemployment, high inflation and a weak exchange rate creates significant macroeconomic risks. While the introduction of a price cap on energy prices will lower inflation in the short-term, the fiscal splurge announced today will work in the opposite direction, boosting demand and increasing inflationary pressures in the economy. It seems likely that the Bank of England will consider that this boost to demand will offset the gain from lower headline inflation and adopt higher interest rates than would otherwise have been the case. This heralds a period of disjointed economic policy with a “tug-of-war” between the government and the Bank of England over the direction of policy.
Gareth Thomas Head of Investment Management
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