“He who understands it, earns it; he who doesn’t, pays for it.” Albert Einstein’s famous trope on the concept of compound interest, what he called the Eighth Wonder of the World. Only he reckoned without the UK Department of Transport and the captive audience of the daily rail commuter to disprove his theorem: even if commuters understand compound interest perfectly, nevertheless they pay for it in spades because, other than by not travelling at all, there is no alternative. 

Less wonderful, more a menace when applied to railway economics 

Worried about the significant decline in post-Covid passenger numbers, this week Transport Minister Grant Schapps announced a six-week, one million half-price, off-peak ticket ‘bonanza’ (terms and conditions apply) as he bids to get the Great British public back on the rails again. Eye-catching, certainly, particularly with the May local elections in the middle (perish the thought of bribing the electorate with cheap train trips) but reports suggest that if one million tickets sounds a huge number, in fact it only represents 1% of the total number of passenger journeys in the comparable period before the pandemic.

 

Let us delve into micro world of railway economics for a moment and investigate. By way of illustration given the commonality of the experience among the broader commuter population, three of us on the Jupiter Merlin team live in the East Midlands and commute regularly from Grantham into London. When travelling more than two days a week season tickets are the only viable option, particularly given the need to travel at peak time and to have the flexibility to change schedules without penalty (the full fat, anytime, open day return in Standard Class is £145; roughly 66 pence per mile). The Standard weekly season ticket based on five days currently costs £247; season tickets are clearly heavily discounted in return for which the franchisee or Train Operating Company (TOC) knowing the predictability of the commuter’s behaviour, also benefits from the certainty of revenues paid up-front whether the passenger travels or not. That discount notwithstanding, the annual financial outlay is still not insignificant; a ‘big ticket’ item in the annual household budget by any measure.

 

Because of its predictable habits and the total number of daily commuters involved (in 2019 40% of all rail fare revenues were from the regulated sector), that commuter cohort forms the backbone of railway economics. So as not to be taken for a ride financially, season ticket holders are nominally a protected species: annual fare increases are not at the TOC’s discretion, they are regulated by the government based on a formula of RPI+1. The author’s Barclaycard records show that, neatly, in 2010, the weekly cost was exactly £100 lower at £147. 

An unsustainable model 

Over the past 12 years both CPI (consumer price index) and RPI (retail price index) have played in relatively narrow bands when measured in year-on-year changes: before starting to run away at the end of last year, over the period in question UK CPI experienced brief deflation (2016) and momentarily nudged 3% in 2017, but the mean rate was 1.8%; for RPI, a low of 2.0% and a high of 4.0% and a mean of 2.5%. In absolute terms, since 2010, like-for-like consumer prices have risen by 31% and retail prices by 49% (the principal difference between the two indices is the inclusion of housing and mortgage costs in RPI).

 

In comparison, and with the additional innocuous sounding ‘+1’ kicker, consider Einstein’s point and look at the insidious and pernicious effect of compounding: in absolute terms, over that same period, the rail passenger’s regulated fare has risen by 68%, a compound increase of 4.4% pa. By the very definition of RPI+1 and the strategic objective of ‘real terms fare increases’ set out in the TOCs’ operational frameworks, fares are explicitly designed to outstrip inflation. The real issue is by how much in the context of what is affordable. If the cost has risen inevitably and inexorably faster than the official inflation rate, has the ability to fund the purchase kept pace? The answer is ‘not by a long chalk’. The Office for National Statistics tells us that between 2010 and today, average nominal UK wages have risen by 36%, a compound growth rate of 2.6%. Regulated fare price rises have far outstripped average earnings. 

Deferred pain 

Arguably the worst is still to come. The pricing formula says that the RPI+1 figure published for July is the one used to set the regulated fares for the following calendar year (i.e. the current fare was based on last July’s RPI figure of 3.8%; in context the March 2022 RPI rate has just reached 9% and will be unlikely to have fallen appreciably in three months’ time when next year’s fare is settled). There is nothing immediately transitory about this particular element of real-world inflation.

 

Leaving aside that as a result of the pandemic and the perceptible shift in societal expectations of the work-life balance and the ease and accessibility of working from home (whether it is good for sustaining competitive businesses, let alone building and developing them, is doubtful), our back-of-the-envelope analysis of the UK’s current rail model suggests it has a greater need of fundamental surgery than merely the superficially seductive sticking plaster of six-weeks’ worth of cut-price, off-peak tickets. It does not need an O-Level in Economics to figure out that raising fares (even ‘protected’ ones) faster than your customers’ ability to keep pace being able to afford them, is an unsustainable business model. To maintain a viable network, the taxpayer ends up paying the balance but that is no long-term solution either. 

Bond markets read the inflation tea leaves

The analysis above is relevant because such operating models rely on long-term predictions of trends. Prices are an elemental component, and the derivation of future pricing policy is based upon economic forecasts and markets’ assessments for inflation and risk.

 

Staying with inflation but moving from micro to macroeconomics and at the risk of being nerdy and technical, the US 10 Year real yield, or the yield the Treasury bond pays after adjusting for inflation, turning positive (i.e., exceeding inflation expectations) has been causing excitement this week.

 

Government bond yields discount the trajectory of future interest rates. The current Fed Funds rate was only raised above zero in March and through the differential, known as the breakeven point, between the nominal 10 Year bond yield and its Treasury Inflation Protected Security (TIPS) equivalent, at their current respective yields they point to an average inflation rate of 2.97% over the next decade. Those real yields turning from negative to positive indicate interest rates rising by two points in the foreseeable future as being likely. That is consistent with the kite-flying exercises we have described in recent columns by various members of the Federal Reserve (Fed) to lead the witness that the Fed should be acting aggressively to raise interest rates from here, notwithstanding that this week, the International Monetary Fund (IMF) lowered its 2022 global GDP forecast again, now down to 3.6% against 4.4% in January and 4.9% last October.

 

But how good an inflation predictor is the 10-year break even? The chart below shows the history of the 10-year break even and, overlaying it, the actual reported inflation 10 years later to date (i.e., to be accurate, the break even predicts average inflation over a 10-year time series rather than a forecast at a point 10 years hence). ‘Forecasting’ suggests a degree of scientific certainty about the future; the reality is that beyond about two years, forecasting is little more than extrapolating current trends and applying some educated guesswork with the risk that the further into the future, the more likely your prediction is to be wrong (far more useful than the predicted outcome itself is understanding the sensitivity of the variability of that result to changes in key inputs; that analysis gives you much to work with).

Predicted inflation vs actual inflation
Predicted inflation vs actual inflation

Source: Blomberg as at 22/04/2022 

If it has not been accurate with millimetric precision, nor has it been a bad trend predictor, especially given that with the advent of quantitative easing (QE) and zero interest rate policy by central banks in the aftermath of the Global Financial Crisis it was pricing future inflation in the context of an entirely new and very unorthodox monetary experiment. Remember too that the Fed’s mandate is to manage the US economy with an average inflation target of 2% which, until the pandemic, it had done reasonably successfully. Where the model potentially comes unstuck is with exogenous shocks of which we have had two in as many years. The model is a reasonable extrapolator, but it is not the Delphic Oracle.

 

But as we mentioned above, today’s 10-year breakeven is discounting an average inflation rate approaching 3% over the next decade, a point higher than the Fed’s target. Given the current rate of US inflation at 8.5% and the IMF seeing it being higher for longer than anticipated, nevertheless markets are assuming that the Fed will bring it back under control.

 

Leaving aside the current circumstances of war and disease, and whatever else of an exogenous nature might be thrown at us, with all their pernicious effects in the way we behave and react, the future ‘known-knowns’ are challenging enough. Consider the big, powerful, long-term macro forces at work, potentially pulling in opposite directions: on the deflationary side, the ongoing digital revolution, and declining demographics across the western democracies and China; likely to be inflationary, the nascent but rapidly accelerating climate change revolution and the race to decarbonise societies and the economy, and the current inclination towards Keynesian economic policies (‘tax and spend’) among most western governments. Which will have the upper hand over the next decade, or whether they neatly cancel each other out, remains to be seen. Then tip into the mix the effect of reversing twelve years’ worth of QE; at its inception QE adding to the money supply was thought to be economically inflationary—in fact the opposite has been true: while it caused significant asset inflation, the easy access to cheap credit has created surplus economic capacity, reducing productivity and contributing to the erosion in real earnings; the Zombie Economy.

 

As to the debate about whether the current rate of inflation is transitory or enduring and embedded, that is being driven as much by geopolitical events as anything. The pertinent question is less where and when inflation peaks, than at what rate does it eventually settle, particularly in the context of central banks’ mandate targets of 2% and taking in to account the political need to balance prices and wages. We know what the markets think.

 

But exogenous shocks can always derail an otherwise relatively smooth journey. Just ask any commuting season ticket holder.

 

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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