As politicians in virtually all democracies face down the cost-of-living crisis with ever more creative state interventions, the ideological chasm dividing monetarist conservatives, currently having to suspend belief, and Keynesian fiscal liberals, grows ever wider. Both sides recognise the need to “Do Something!”; the question is what? And having decided ‘what’, how much of it.
Flush from the leadership election stump brandishing her credentials as the rightful heir to Thatcher, Liz Truss has immediately embarked on the biggest welfare spending plan in history. At £130bn, the cost of the 2-year freeze on domestic electricity bills is roughly equivalent in size to Gordon Brown’s great bank bail-out in the Global Financial Crisis. Tip in the estimated £45bn to help businesses weather the storm, and that represents more than half the cost of the pandemic furlough scheme. The additional burden this time, particularly against the pandemic fiscal lifeboats launched two years ago, is that funding costs borne through the addition to the national debt, and as measured by the 10-Year Gilt, are (at the time of writing) at 3.2%, far higher than in 2020 when they were all but zero.
The energy price cap plan throws the spotlight on the palpable political and economic tensions inherent in three important policy areas: money supply and the debt burden; the pratfalls of imposing regulated domestic prices in a market subject to the global pressures of highly volatile and completely unregulated input costs; and, finally, energy security and the national strategic electricity generating capacity shortfall. Let us consider each in turn.
Alice-in-Wonderland economics. Essential state aid or Helicopter Money?
On the monetary policy side of the equation, the major central banks are now fully focused and gung-ho attempting to return the malign inflation genie back to its bottle. Interest rates are rising at every policy meeting; quarter and even half-percentage point increments are for wimps (there has just been a three-quarter percentage point rise from the European Central Bank). Shrinking their balance sheets to contain financial stress, the central banks are also reversing their earlier loose, stimulatory stance of sovereign bond purchases in favour of tightening policy, actively selling those bonds back to the markets and in the process trying to force bond prices down (the corollary of which is rising yields, consistent with rising interest rates).
On the other hand, despite the inflation problem, governments are showing little in the way of coordinated fiscal thinking with their central banks. With almost every government in the western world in the grip of liberal Keynesian ideology, the pedal is still largely to the floor when it comes to spending state cash on health, welfare and big infrastructure, in particular on the path to carbon net-zero. With the notable exception of Germany at 69%, most major western economies are currently more than 100% geared in terms of its national debt to GDP: the US 137%; Japan 266%; France 113%; Italy 151%; Canada 118%. Here in the UK, ours is 96% but if the economy shrinks in the way the Bank of England forecasts, and we are about to add the equivalent of 8% of GDP to the national debt through the electricity bill relief programme, we too will be more than 100% again soon. In every country listed here, except for Japan, interest rates on that debt are rising. Fast.
But if inflation is fuelled by imbalances between supply and demand, demand behaviour is conditioned by the supply of money and its ‘velocity’ (crudely, how much is available and how quickly is it spent). And with policies such as Truss’s here is the rub: Keynesians will argue that it is a relief package, by capping electricity prices it will take the steam out of household bills and reduce the rate of underlying inflation (some economists are estimating by as much as three percentage points, potentially); on the other hand, monetarists argue that the reality is that the programme is simply £175bn being added to the money supply over two years and that, notwithstanding that it relieves short-term nominal inflation rates, the long-term effect is just the opposite. Look at it this way: for those deep in genuine fuel poverty, the £400 direct relief payment added to scrapping the 8% green subsidies levy charged to one’s electricity bill, for the average consumer worth about £153pa, this is a life-line; for those households under less pressure, or the many not needing help at all, this is a windfall cash bonus available to be spent on discretionary items (what economists term “luxuries”) rather than necessities.
In a similar vein, in the US, as we discussed in this column on 19th August, President Biden’s new Inflation Reduction Act (his $738bn 10-year climate change incentive and welfare programme) may prove to be inflationary, just the opposite of what is intended. But more recently and by Presidential Decree (i.e. without the approval of Congress), he has just eradicated $10,000 of debt from every remaining student loan, and for those on welfare Pell Grants, the relief is $20,000. The total estimated cost to the Treasury is $300bn. This package is on top of the $1,400 (known as “Stimmy Checks”) paid to every US adult last year as part of the Covid recovery plan, amounting to $380bn. If Stimmy Checks were nakedly stimulatory, the debt forgiveness is billed as a relief package; yet without doubt both are incontrovertibly additions to the money supply, and inflationary in effect, and yet Biden professes to be driven by the need to contain inflation! These are strange, topsy-turvy times indeed.
Definition of a camel: a horse designed by committee
In these columns last autumn, we argued strongly that the concept of the energy price cap was fundamentally flawed. From an investment standpoint, in an industry whose capital structure is rooted in the private sector, when selling prices are effectively nationalised (not only capped but fixed by the government) but electricity suppliers are subject to the maelstrom of volatile global input costs entirely beyond their control, investors in those companies have an immediate asymmetric risk placed upon them.
The new policy outlined by Truss relieves the immediate tension for the consumer but that tension simply moves elsewhere: freezing prices for two years even rather than reviewing sequentially quarter by quarter in the outgoing regime, places an immense strain further up the supply chain. If input costs continue to rise and the wholesale cost of electricity goes up with it, but through the artificial freeze to the consumer and amortising the difference over ‘n’ number of years to be recouped in future bills (one way or another, you will still pay), energy suppliers face a significant potential short-to-medium-term cash flow crisis. Some are equating the potential liquidity crunch for the sector as being as significant an event as Lehman was for banking when it went bankrupt in the Global Financial Crisis. Time will tell if that is over-egging the pudding in terms of severity. The Treasury solution is that companies should resort to emergency funding lines from their bankers, backed as a last resort by government guarantees. But however this plays out, investors are in an invidious position.
Of course, there must be a level of protection for consumers against the risk of profiteering in a completely unregulated market, particularly one as essential as energy. But the proposed UK solution to the problem of escalating prices creates a systemic risk, one where the elastic band is stretched so far it potentially snaps. It has already happened in Germany: Uniper, the country’s biggest gas supplier, had to be bailed out in the summer by the German government as it teetered on the brink of insolvency.
None of which addresses our electricity generating capacity
We are throwing £175bn at bill relief. Truss is also proposing the granting of new gas drilling licences in the North Sea and lifting the ban on onshore fracking to help reduce the reliance on imports. But neither of these measures addresses the fundamental strategic problem that we have in the UK: our domestic demand for electricity uncomfortably exceeds our capacity to produce it. In 2021, of the 644 Terawatt Hours (TWH) consumed, 51% was parasitically absorbed in the production loop itself to ‘create’ that electricity in the first place, including the frictional losses incurred along long-distance power transmission lines. Nearly 8% of our electricity was imported, half of those imports from France and the rest from Norway and Belgium.
Over the past two decades we have seen the demise of (reliable) coal being replaced by (as reliable) gas and the rise of (unreliable) renewables in our generating capacity. Much of our existing nuclear is coming to the end of its service life. Yet within the next two decades we are going to see an exponential rise in demand for electricity as we shift from combustion-engine vehicles to those most likely to be electric powered (unless there is a significant development in hydrogen technology as a viable alternative fuel for transportation). This is an entirely foreseeable problem as yet with no sustainable solution.
But consider the following back-of-the-envelope calculation: we theoretically have 75 Giga Watts (GW) of installed electricity generating capacity in the UK (‘theoretically’ because yields on solar panels and wind turbines are significantly affected by available sunlight hours and the quality of that light, and whether the wind is blowing or not; we also have to account for that parasitic loss described above of electricity used in its own production). The new Rolls Royce nuclear Small Modular Reactors are rated at 470 Mega Watts per unit (0.47GW) and are priced currently at £1.75bn each. Simple maths says that conveniently we can buy 100 units for the same total cost as Truss’s energy bill relief package, and in the process add 47GW of capacity to the system. Two units could be installed in each county in the UK, thus reducing transmission costs too. Heavens, with Gilts at 3%, the funding cost alone on £175bn would buy another three units! As a letter writer to the Daily Telegraph might say “Sir, Am I alone in thinking we might be missing a trick here?”.
As a parting shot on energy security, it seems to have slipped under the radar, but the French electricity giant EDF is being fully nationalised (it was already 85% state owned). EDF owns British-located generating assets (mainly nuclear) accounting for 20% of UK capacity, now entirely under the control of the French government. We are only too familiar with Putin weaponizing gas to gain geopolitical leverage, but it was only last year that President Macron was threatening to use electricity supplies to the UK as a political lever in the post-Brexit fights over the Northern Ireland Protocol and fishing rights in the Channel, neither of which is yet resolved. Make of that what you will.
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.
The value of active minds – independent thinking
A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.
Fund specific risks
The NURS Key Investor Information Document, Supplementary Information Document and Scheme Particulars are available from Jupiter on request. The Jupiter Merlin Conservative Portfolio can invest more than 35% of its value in securities issued or guaranteed by an EEA state. The Jupiter Merlin Income, Jupiter Merlin Balanced and Jupiter Merlin Conservative Portfolios’ expenses are charged to capital, which can reduce the potential for capital growth.