It was Ronald Reagan who, on August 12 1986, made the following shrewd observation in a speech: ‘the nine most dangerous words in the English language are “I’m from the government and I’m here to help”’. An intuitive free-marketeer and monetarist to his fingertips, across the Pond singing from the identical ideological hymn sheet as Mrs Thatcher in the UK, ‘Reaganomics’ and ‘Thatcherism’ were at their potent peak in the mid-1980s. Fast forward four decades and several political generations to today and those familiar with the Merlin webcasts or among the audiences on our recent UK Roadshow will have heard us say many times that monetarism of the type practised by those long-past Anglo-Saxon administrations is now dead and buried; whatever the political colour governments across the western world purport to be, even those which are hypothetically rightward-leaning, all are practising communicants at the altar of Keynesian economics, addicted not only to massive state intervention but state expansion at the expense of the private sector. Such thinking was well-entrenched before the pandemic; the economic collapse resulting from Covid has only exacerbated it.

 

While somewhat unconvincingly trying to keep the relatively small but vocal Thatcherite wing of the Tory party at bay with promises eventually to reduce the size of the state (“our moral mission”), Chancellor Rishi Sunak’s budget this week was lifted straight from the left-of-centre Keynesian tax-and-spend playbook: an average 3.3% real terms uplift in government spending with local authorities, health and transport being the major percentage increase winners and defence again the only real-terms loser; state spending is forecast to rise to 41.6% of GDP in 2026/7 against 39.8% in 2019/20, pre-pandemic; with frozen personal allowances, rising National Insurance rates and a hike in Corporation Tax in 2023, over that same four year period the tax burden as a percentage of GDP will have risen an estimated three percentage points to 36.9% of GDP. These are numbers not experienced since the 1970s. The Office for Budget Responsibility (OBR) sees marginally better growth prospects than a year ago, though less rosy than six months ago, but reserves its greatest misgivings about the inflation outlook reckoning that the risk to its 4.4% estimate for 2022 is on the upside (in context, the Bank of England has raised its CPI estimate to 5% and the IMF forecasts 6% for the UK next year, bearing in mind the Bank’s mandated nominal inflation target is 2%). One immediate effect on the Gilt market leading to a 0.2 percentage point drop in yields (i.e. a rise in prices) was Sunak forecasting that in 2022 he would need to raise £58bn less than anticipated through new government debt issuance; in context this was the biggest one-day move in Gilt yields since March 2021.

Investment or expenditure? The two are not the same

Our reference to Reagan above is important in the context of UK long-term growth prospects. At heart is the fundamental difference in opinion between monetarists who believe that beyond the minimum required for necessary state services (defence, education, law & order, minimum social safety net etc), long-term national growth and a thriving, competitive economy are best met by the private sector: allocation of private capital is the most efficient means, producing not only the greatest returns but also offering the best environment for sustainable growth with strong productivity, durable earnings and rising nominal tax receipts. Keynesians on the other hand subscribe to the thesis that maximum tax income derives from high taxation rates and that the state itself is the most productive allocator of capital for universal benefit. When we look at many of this week’s budget proposals, the key question is whether the cash involved is a genuine investment producing a return which can itself be re-invested in a virtuous cycle, or is it in fact merely expenditure producing minimal or zero return, far from a virtuous cycle, more an economic vortex? The most sensitive and divisive area is health which now consumes more than 40% of all UK government expenditure (the NHS is not only the biggest employer in the UK, it is the biggest employer in Europe, and even more bewildering, the seventh biggest employer in the world, yet its appetite for cash is voracious, insatiable, and as a system it remains perpetually unstable, lurching from winter crisis to winter crisis even without a pandemic to deal with); the unchecked and unchallengeable gravitational pull of the NHS is so strong it is the economic and societal sun around which all the rest of the UK’s national planets orbit.

 

In essence, are Sunak’s initiatives in the longer term going to lead to sustainable, above average inflation-adjusted growth of say 2%+ thanks to the theoretical multiplier effect, or do we return to the pre-pandemic average of between 1.5-1.75% because the frictional resistances embedded in what economists call the transmission mechanism are so great that every marginal pound spent is squandered? Time will tell.

Bank of England briefing and counter-briefing ahead of the next MPC meeting

But it is against a backdrop of incipient inflation and stuttering global recovery that the Bank of England Monetary Policy Committee meets on November 4th having been reminded by the Chancellor in his speech that controlling inflation is the Bank’s top priority. Last week’s annual UK inflation numbers were not in themselves worrying at 3.1%, down from 3.2% a month ago. But with those new IMF and Bank of England forecasts, Governor Andrew Bailey said he might have to act sooner rather than later to deal with incipient inflation, possibly even as soon as November. Speaking from America, former MPC member Danny Blanchflower two days later went off on a long and impassioned tirade as to why Bailey was talking rot, that now was absolutely the wrong time to be raising interest rates; if you’re worried about a stuttering economy then ratcheting rates up will be a guarantee of bringing it to a grinding halt, possibly even throwing the engine in to reverse. A current MPC member, Silvana Tenreyro, joined in the briefing/counter briefing melee, siding with Blanchflower.

‘Stagflation’: testing monetary policy to destruction

The fear is of the UK economy entering a period of ‘stagflation’. The ingredients are there but the usual recipe is inflationary pressures but stagnant growth thanks to stagnant demand; what we have currently is inflation thanks to above average demand but clogged-up supply creating the economic drag. If inflation is the disease we’re trying to ward off, what is the cause of the problem for which higher interest rates are the analgesic, bearing in mind that empirically interest rate changes take an average of 18 months to have a measurable impact?

 

Interest rates are used to change consumer behaviour, i.e. controlling the demand side of the economy; what they palpably do not do is un-bung the mechanism of sclerotic supply-side plumbing. No number of interest rate rises is magically going to procure more HGV drivers or shift goods off a dockside in Singapore or empty a ship in Los Angeles, any more than they will stop the Russians or the French weaponizing energy supplies.

 

But as we make the point often, economics is not a science with predictable outcomes; it is simply the sum of all human interactions and transactions measured in pound notes, dollars, euros, yen and any other denomination of currency. Patterns and relationships may emerge to support extrapolated conclusions but the inputs remain as fickle as the wretched humans responsible for them. There is the risk that we talk ourselves into a recession and what was a supply-side problem does indeed become a demand-side issue. If inflationary pressures persist thanks to higher wage expectations becoming embedded, then you have proper stagflation. But that in turn throws up a new set of problems, particularly regarding the neutral rate (the rate of interest that has zero effect on the economy, neither applying the brakes nor gunning the engine). If growth is zero the temptation is to lower rates to crank up economic activity, but that could then feed the inflation beast and all that happens is a widening gap of negative real interest rates. If the interest rate is already zero (as now), do you go negative, a treadmill which once you’re on it seems remarkably difficult to get off again (the ECB opened its own copious can of worms with that one back in 2015)? Or do you try and tackle the negative real rate and inflation problem with a higher interest rate which runs the risk of driving the economy in to recession? Or do you do nothing and merely hope the problem sorts itself out.

“In the land of the blind, the one-eyed man is king” (Desiderius Erasmus, 1500)

In the game of bluff between the central banks and the markets, who’s going to blink first? The problem for the central banks is that if it’s them, all that fine forward guidance, holding the line, trying to exude an air of confidence that all is well, counts for little; it’ll simply show that the policy-makers know no more than the rest of us.

 

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:

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