Dear Jeremy………!

Whilst ever inflation remains above 3% or below 1% the Governor of the Bank of England is duty bound to write to the Chancellor, to try and explain:

  • why its above or below target,
  • what the Bank’s outlook for inflation is,
  • and what if anything the Bank is doing about it.

The letters are published on the Bank of England website, should you care to read them and refer mostly to discussions at the Bank’s Monetary Policy Committee (MPC).

I did not go back through the whole history but I suspect whilst there may have been some good reads in 2008 to 2010, since c2012 they have been pretty occasional and pretty dull.

For example in May 2021, CPI has dropped below 1%

Andrew Bailey (AB) writes to Rishi; ‘overall, the Committee judges that inflation expectations remain well anchored and consistent with inflation close to the 2% target’.

Base rates are at generationally low levels set at 0.1% and we are all trying to put our lives back together after the lock downs.

Again in September 2021, four months later, CPI has popped above 3%

AB writes to Rishi: ‘In the central projection, conditioned on the market path for interest rates, inflation returned to around 2% in the medium term. The Committee’s central expectation continues to be that current elevated global cost pressures will prove transitory.’

Nothing to worry about, a few price rises, but it is all going to be over quickly, no changes to base rates.

These two letters looked pretty similar and there was quite a bit of what we call in the trade ‘cut and paste’. Fast forward 8 letters, inflation hit 11%, is subsiding much slower than expected and with base rates lifted to 5% the tone in the June 2023 letter is somewhat different.

Extracting a number of statements by AB to Jeremy with my comments/explanations:

‘Headline CPI inflation is expected to fall significantly further during the course of the year, in the main reflecting developments in energy prices.’

But, and it’s a big and long but…

‘In the MPC’s latest projection, presented in the May Monetary Policy Report and conditioned on market interest rates prevailing at the time, an increasing degree of economic slack, combined with declining external pressures, meant that CPI inflation was expected to fall significantly below the 2% target in the medium term. However, the Committee judged that the risks around that modal inflation projection were skewed significantly to the upside, reflecting the possibility that the second-round effects of external cost shocks on inflation in wages and domestic prices may take longer to unwind than they did to emerge. ‘

We got this wrong as recently as May this year and have been underestimating how high inflation will be and how long it will stay. AB goes on:

‘Since the May Report, there has been material news in a number of UK economic data outturns, including those that the Committee has noted it will be monitoring closely as indicators of persistent inflationary pressures – in particular wage growth and service inflation – against the background of a tight labour market and continued resilience in demand.’

And, what’s more:

‘At the time of the previous MPC meeting and May Monetary Policy Report, the market-implied path for Bank Rate averaged just over 4% over the next three years. Since then, gilt yields have risen materially, particularly at shorter maturities, now suggesting a path for Bank Rate which averages around 5½%.’

Everyone else now thinks we are going to have to keep base rates above 5% for at least a couple of years. Then trying to explain why base rate rises might not be working:

‘Mortgage rates have also risen notably. The Committee is continuing to monitor closely the impact of the significant increases in Bank Rate so far. As set out in the May Report, the greater share of fixed-rate mortgages means that the full impact of the increase in Bank Rate to date will not be felt for some time.’

For now there is not much AB can do about this. A few people are getting hurt as they roll off fixed rates to variable rates at the new levels, but more people own their own homes outright than ever before, more have fixed rates that insulate them for another few years, and more still don’t even own a home, or borrow any money.

This is not just a 2023 problem. Future inflation rates are extremely hard to predict and simply raising interest rates has always been a blunt instrument for tackling inflation, especially when it’s being caused in part by external pressures outside the UK.

I found this great chart on Schroders’ website this morning which highlights:

  • Just how extreme and unsual near zero base rates from 2010 through 2021 were
  • That historically, following bouts of high inflation, base rates have had to be held higher than inflation for some time to force it down.

Please note that this chart is a few months old and inflation is now heading down even in the UK. 

Reading these letters and looking at this chart makes me think that UK base interest rates may now be higher and for longer than we all thought even just a few months ago and I’m not alone in these thoughts. It looks like AB will be writing to Jeremy for some time!

My favourite 20 year Gilt yield chart has just popped up again: 

Source: Marketwatch 07/07/23

From hovering around the 4% mark at the start of the year, to 4.5% in the last month, this week it has moved up to 4.8%. The inverted yield curve is flattening off, but not because the shorter dated end is falling, it is still rising, but the longer dated yields all the way out to 30 years are rising faster now.

Source: Marketwatch 07/07/23

The Blackrock i-shares UK Gilt ETF is down 2.5% since Wednesday and 6.7% year to date. Our decision not to jump into quite tempting longer dated bond yields earlier in the year has been a good one and helped protect capital in portfolios. Our two short-dated bond funds have made 2% in the first half of this year compared to the losses on Gilts. Annuity prices are still falling and will be similarly impacted, expect them to be 2-3% cheaper in the next few days.

The rise in rates globally is also holding back equity markets as we all price in the new value of money and the return on cash deposits. The rise in UK rates, now at a faster pace than the US and Europe is making Sterling stronger. Dollars are just over 5% cheaper for us to buy today than a year ago.

The FTSE 100 is down about 4% year to date and so too is the wider US Dow Jones index after adjusting for the movement in currency exchange rates. The more focused S&P 500, which we own in portfolios is the only bright spot, up about 10% in sterling terms and driven by the rise in a small number of big companies exposed to the AI fest.

Should we be selling everything and going to cash? We don’t think so.

Firstly, our bond investments should do better than cash and we can earn 6-8% without having to buy into longer dated bonds so we can protect against further rises in those longer dated gilt yields.

Secondly, for our equities it would be easy to sell now and miss out on some fantastic returns over the coming months. Technically both the Dow Jones and the FTSE 100 are all still higher than their October 2022 low points. Whilst it might not feel like it, we do have a recovery still underway from that point. We can’t guarantee of course that we might see markets go lower again, but as time passes, as markets go sideways, companies are really getting cheaper.

If you take the view that long term on average shares make inflation plus 5%, in the last 18 months since the December 2021 peak that’s probably about 18% given the inflation we have had. The S&P 500 and the Dow Jones are both down c7% in nominal terms. So, after inflation, and typical year on year growth they are c25% cheaper. This can often be the way equity markets behave. There isn’t enough fear to create a big drop in price, but enough to stop prices rising until at some point its clear they are attractive again.

Such a rally could come after good earnings later this month, or a surprise resolution to the Russia/Ukraine crisis, we don’t know. We do know with higher inflation you want to own real assets that generate returns over and above inflation and for our liquid investing process that is equity markets.

Nick, is on a well earned break this week. Our trainee analyst Costa, has this morning produced some competitor analysis which I can share looking at portfolio services comparable to Multi Asset Moderate portfolio. Blue and green are good, yellow and red are bad:

Source: Tideway internal research 07/07/23

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