Merlin Weekly Macro: Labour paralysed as economic faultlines widen

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War has been declared but hostilities are on hold. Stand by your beds and form an orderly queue while the seatless Andy Burnham secures a parliamentary perch from which to launch a leadership challenge.

Enigma-less Variations

As the vultures circle over the hapless, grievously wounded Keir Starmer in the aftermath of the local and national assembly elections, his mantra remains “I get it”. Given he had already re-set his government at least twice in its short life and offered the same plea every time, clearly he doesn’t “get it” at all. More importantly, seemingly none of those who might replace him has any greater clue either. Tinkering at the edges, the centrist/compromise candidates (Wes Streeting, John Healey, Shabana Mahmood, Al Carnes among the declared, intending or touted riders) would be more of the same testing Einstein’s Parable of Quantum Insanity that repetitive head-banging somehow produces a different result; the seductively but wholly mislabelled “soft left” (Angela Rayner, Andy Burnham, Ed Miliband etc) would offer more extreme Left wing versions of what has already failed.

Not one of them has a plan which addresses the deep structural faultlines and flaws which pervade the UK economy. On the contrary, included in the King’s Speech, Ed Miliband’s proposed Energy Independence Bill is both the opposite of what is advertised and a deliberate act of gross national self-harm. Economic reform will not happen this side of the next general election, due in 2029. In the meantime, pressure from the Left for even greater social spending to see off the threat from the Greens points to a growing demand to abandon (or at least to dilute) Labour’s current borrowing constraints.

Eyes wide shut into the EU’s elephant trap

Bereft of ideas, all the above and particularly Starmer himself and the current Chancellor favour the panacea of closer alignment with the EU as though it will make all our problems go away. The equivalent of a shipwrecked mariner reaching out to a sinking lifeboat, this surely cannot be the answer. A quarter-baked political project with incomplete monetary union, zero fiscal union, structural governance pillars grounded in sand, the EU is incapable of fundamental and logical development in the absence of full political union. And political union across 27 disparate member states is as likely as finding a pink unicorn at the bottom of the garden. The EU is a truculent teenage orphan whose parents died years ago and who has lost its bearings; in the meantime stuck in perpetuity between childhood and being an adult, its path to maturity has stalled yet it still wants to be among the grown-ups. Why an attachment to this is an advantage is difficult to fathom.

In the face of Red Wall opposition, neither Starmer nor any of the potential Labour leadership candidates has the political guts to propose reapplying for full EU membership. Being fully in is justifiable, so too is wholly out; “dynamic alignment”, however, in which the UK is a self-imposed rule-taker but not a rule-setter, is simply crass. It is no more than an unconditional surrender of sovereignty with little tangible benefit in return. It is a position that is as stupid as it is unprincipled; it is certainly not one that should be adopted by choice. Compounding his error, Starmer would seriously contemplate bypassing Parliament to ram through such a realignment; he would incorporate binding EU regulations extending the authority of the European Court of Justice across a spectrum of domestic policy areas. Such a course betrays both political weakness in the face of Reform Brexiteer opposition, and a cynical contempt for the democratic principles he claims to uphold. The EU must be rubbing its hands with glee. Far from putting us at the “heart of Europe”, the UK would be precisely where the EU wants us: peripheral, compliant, footing the bill and in no position to argue.

Bond barometers

Bond market yields are barometers of risk. Relatively simple in concept but technically complex instruments, bonds tend only to become mainstream news when the rising political or economic mercury impinges obviously on the national finances or upsets the mortgage market in an extraordinary or uncomfortable way. The short but brutal budgetary chaos arising from the misjudged implementation of Liz Truss’s fiscal policy in the autumn of 2022 was the most obvious example. Then, hitting 4.5% at peak panic in the Liability Driven Investment crisis in the pensions insurance sector, the UK 10-Year Gilt yield was a two-and-a-quarter percentage point premium to the prevailing Bank of England Base Rate (in fact it was double the interest rate); today, amid political chaos as the Labour Party indulges in internecine warfare between its various factions and seriously considers its first ever defenestration of a Labour sitting prime minister, at 5.05% that 10-Year yield is a 1.3 percentage point premium to the current Bank rate of 3.75%. As a borrower, whether it is the higher nominal level in 2026 or the greater premium of 2022 which is more painful is a moot point.

As a rate of interest on government debt, much is made of the today’s 10-Year Gilt yield being the highest nominal level since 2008, the time of the Global Financial Crisis when interest rates were falling to mitigate the systemic financial fallout. Of far greater significance is that today with the risk to interest rates being on the upside from their already elevated levels thanks to the inflationary effect of the war with Iran, that same rate of UK government interest is being charged to a level of debt almost 100% of GDP. Two decades ago, before the bank bailouts, government borrowings were less than half the size of the economy. The OBR reckons that in 2025/26 government interest costs at £111 billion will have accounted for 3.7% of GDP, or 8.3% of total public spending; in 2008 the comparable debt interest figure was £30 billion or 5% of total managed public expenditure and 2.1% of GDP. It is obvious that our national financial resilience is much lower now than nearly a generation ago.

Bond Vigilantes

Bond markets are being publicly hailed as “vigilantes”, allegedly replacing politicians as fiscal policemen. They mark the government’s economic homework and define the boundaries of how much it can borrow before the investment risk arising from the debt burden becomes so great that the authorities simply run out of road and can go no further. The reality is not as simple as that:  firstly, while they fund it with capital, bond markets do not make policy; secondly, a great big game of bluff is playing out between the markets and the government.

Governments need a constant source of finance to fund public operational and capital expenditure; bond cohorts facing expiry need refinancing; on the other hand,  counterparty governments engaging with us in trade need to hold our own government’s bonds and currency as collateral in the resulting balance of trade, while institutions such as pension funds and insurance companies have strict regulatory requirements to hold bonds for risk management and liquidity needs. The government knows that only in the direst of circumstances would the markets instigate a bond purchasing strike and risk economic and financial collapse; the UK last tested this in 1976 under Chancellor Dennis Healey, when the IMF had to step in with an emergency funding line. Reflecting the risk that the government might default, markets demand a higher rate of interest in mitigation, fully understanding that as bond yields rise, the prices and therefore the capital values of the bonds they already own fall as a result. But in a fiat system underpinned by trust, everyone understands that it is in nobody’s interest, not the markets, not the government, not our trade counterparties, not the public or business, to test the system to destruction; but equally, there should be no blank cheque which may cause that tipping-point to be reached. The other source of revenue, the electorate, also has finite patience.

Rachel Reeves’s so-called “Securonomics” fiscal rules agreed with the OBR at the outset of this ill-fated administration prescribed current spending being met from tax receipts while capital requirements could be met through loans raised through the bond markets; that is entirely sensible and rational. However, she is a hostage to fortune when her financial calculations are wrong, or factors beyond her control are against her, or her party refuses to play ball with social and economic policy changes which underpin her fiscal assumptions (or worse, as is self-evident, when all three—the persistent shortfalls in revenues against expenditures exacerbated by higher borrowing costs, the exogenous economic hit from the Iranian war and the self-inflicted political pratfalls over disability benefit reform and the winter fuel allowance--blow up in her face simultaneously).

Government bond yields anticipate the inflation outlook and the monetary policies adopted to manage inflation to the mandated 2% target. Allowing for duration, the premium or discount reflected in the differential between the bond yield and the central bank interest rate is the perceived risk of other factors which might cause default either to the interim interest payments or the failure to repay the principal loan on time and in full. These are troubled and unstable times; the UK is not alone in seeing government bonds test or reach generationally high yields; the same applies to the US, the eurozone and Japan.

It is worth stepping back and considering the significant repricing of risk in the past six years: in May 2020 during peak Covid lock-down, the US 10-Year Treasury carried a yield of 0.5%; when Putin marched into Ukraine in February 2022, it was 1.75%; today the yield is 4.5%. Significantly, taking the difference between the cash bond and its inflation-adjusted equivalent, the implied average long-term US inflation rate has remained remarkably constant at around 2.3%.

More than half a point higher than the US but with a similar central bank interest rate, the equivalent UK yield reflects both the relative insignificance of the UK economy compared with the US and our heightened political instability.

Blind Vigilantes

Lest the markets become too self-absorbed polishing their haloes as the self-appointed pragmatic arbiters of fiscal probity, they might remember that such vigilance and care were entirely absent in the prolonged period of central bank Quantitative Easing. They were falling over themselves to lend money to governments, almost at any cost. Peak madness was reached in 2020/21 when a third of all government debt globally was accorded a negative yield (i.e. “investors” were effectively paying governments to borrow and every marginal pound/dollar/euro lent to a central treasury incurred an incremental total cost to the lender).

When the yield is negative the only way bond investors make money is by selling bonds at a higher price than they bought them which in turn depresses the yield further; known as the Law of the Greater Fool it requires sequential investors to suspend belief and behave irrationally buying more and more expensive stock, in this case at a greater and greater total cost. At its extreme, in 2021, even the German 30-Year government bond was priced as such, implying less than zero chance of any risk of a problem over the subsequent three decades—it was therefore ironic that within months a potential Right-wing military coup was uncovered to storm the German Bundestag and to oust the government (that it failed is not the point!). But in self-justification, fund managers managed to convince themselves that if held to maturity, the certainty of a precisely calculated loss 30 years in the future was an invaluable anchor-point in portfolio construction and therefore of value. All this author knows for certain is that in 30 years he will either be 93 or dead; that really is an anchor-point.

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.