What a difference four weeks and a war makes. When it comes to the pricing of risk, fixed income markets are learning to join the dots as the broader implications of a second major exogenous shock, in the shape of a global conflict whose epicentre is Europe, complicates the ramifications of its immediate predecessor, the Covid-19 pandemic. Incidentally, this week marked the second anniversary of the UK being ordered into full lockdown, as was said at the time by Boris, “for three weeks”; what a pious hope that was!
Tighten your belts
UK inflation data for February saw the Consumer Prices Index (CPI) rise to 6.2% year-on-year, up from 5.5% in January; the Retail Prices Index (still used in the inflation adjustment for many regulated goods and services) hit 8.2%. The Office for Budget Responsibility (OBR), the UK government’s independent economic forecast unit, indicated that CPI would exceed 7% for the remainder of 2022, forecasting that the peak could reach 8.7% over the year-end before subsiding, all other things being equal. In context, last October the OBR forecast a peak inflation rate of 5%.
At the risk of being pernickety, but to point out the patently obvious given the very dynamic circumstances, this in a world in which very little currently can be taken for granted or treated as equal with confidence. By way of illustration, the Jupiter Merlin team has been on its half-yearly UK roadshow since March 8th: in the less than three weeks since, during which time oil sanctions have been announced against Russia and hopes of Saudi Arabia and others making up the potential shortfall of 4% to global supply have been raised and dashed, the aggregate change in global oil prices, both up and down, has totalled around $90 per barrel. Ninety dollars of volatility in three weeks on a price currently sitting at $117!
Simultaneously, the OBR reduced its expectations for economic recovery this year, lowering its official economic growth forecast from 6% to 3.8% as the corrosive effects of inflation combined with not insignificant tax rises (surely a government own-goal despite Rishi Sunak’s deeply cynical pledge to remove a penny from the basic rate of income tax in 2024 immediately before the general election) and falling real wages conspire to weigh on consumer confidence.
In the United States, following the 0.25% rise in interest rates seen last week, further news from the Federal Reserve (Fed) supported the stance that it intends to act aggressively to stem US inflation, where CPI was already at 7.9% in February. If only a couple of weeks ago markets were implying a desire to see the Fed easing back on the brakes in the second half of this year, the Fed seems determined to scotch any such thought.
The bond markets reflect the see-saw in sentiment as fixed income investors reassess the effects and direction of these powerful macroeconomic and geopolitical forces. The US 10-Year government bond (the accepted proxy for the global “risk-free” rate of return) stood at a yield of 1.17% on 8th August 2021, the most recent low-point; by March 4th this year, a week in to the war, 1.73%. Today, after the Fed’s statements of intent to tackle inflation against the backdrop of a slowing economy (it is usually counter-intuitive to be raising interest rates when growth is already potentially decelerating, but these are extraordinary times), it stands at 2.45%.
Similarly, in Europe, in August last year the German 10-Year government bond had a yield of minus 0.50%; as recently as the beginning of March, the yield was still negative; today it is plus 0.56% (and the European Central Bank is at least nine months behind the Federal Reserve in even getting to first base raising the eurozone deposit rate from its current level of minus 0.5%; it is the last major western central bank still to be smoked out of its entrenched position that the real enemy is deflation rather than inflation). As a reminder, bond prices move inversely to their yield and these rising yields reflect significant falls in bond prices, down around 8% on average year-to-date.
Another way to understand the seismic shifts in bond markets is this: in December 2020, before global immunisation programmes had begun (successful Covid vaccine trials had only been revealed 6 weeks before), lockdowns had been reimposed across most western democracies as a second (or was it a third?) wave of Covid roiled around the world and economic conditions were dire; at that point $18.4 trillion of global government bonds, estimated at around 30% of the total in issue, traded on a negative yield. $18.4 trillion has reduced to $3 trillion today that still carries a negative yield, almost all the reduction being due to the re-pricing of existing debt rather than the nominal sum actually shrinking to any significant degree.
Masters of the Universe?
As we have said in these columns before, as recently as mid-2021, it was the explicit intention of the US Federal Reserve to maintain stable monetary policy (i.e. using quantitative easing and keeping interest rates at zero) until at least the end of 2023, even in to 2024. Reflected in Churchill’s observation as he shifted political ground, and not for the first time, “when the facts change, I change my mind. What do you do, madam?”, central banks have been forced to adapt to rapidly changing circumstances. Common sense dictates that they should. However, common sense also dictates that in trying to condition markets and maintain an even keel, central banks should avoid being dogmatic.
Alongside the Bank of England and the European Central Bank, the Fed painted itself into a corner from which it was difficult to extract itself with dignity and credibility. Someone once wryly suggested that central bankers are the modern ‘masters of the universe’. Let us disabuse anyone of that notion; they most certainly are not. They are as susceptible to events as the rest of us. Maintaining the confidence of markets is critical; being prescriptive long into the future leaves central banks at the risk of having to back-peddle furiously when events over which they have no control threaten to overtake them.
Biden and von der Leyen broker a gas deal
As we go to press, terms have been agreed as to how the US can help the EU wean itself off its reliance on Russian gas supplies. The US will deliver 15bn cubic metres of liquefied natural gas to Europe this year, with the intention of increasing that volume to 50bn cubic metres a year when sufficient port infrastructure has been built to handle and store the shipments. The support will continue until 2030. It is an important development in the EU’s energy policy, so long in hock to Moscow and Putin. Just as significantly, it represents a significant thaw in US/EU relations, not least in the context of the simmering tensions over European foreign policy and its defence policy within NATO. If the EU’s axis had been to break the hegemon of US defence influence in Europe, its new dependence on US energy gives Washington significant political leverage in determining what happens next. In turn, Russia will be forced to seek new markets for oil and gas, almost certainly looking eastwards towards China and India. More twists and turns in the game of geopolitics in which many plates are already spinning like mad.
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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