What caught my eye this week.

Very interesting news this week from Belgium is not a phrase that has grown stale from overuse.

But as the world gropes towards a better post-pandemic work-life balance I read:

…workers in Belgium will soon be able to choose a four-day week under a series of labour market reforms announced on Tuesday.

The reform package agreed by the country’s multi-party coalition government will also give workers the right to turn off work devices and ignore work-related messages after hours without fear of reprisal.

“We have experienced two difficult years. With this agreement, we set a beacon for an economy that is more innovative, sustainable and digital. The aim is to be able to make people and businesses stronger,” Belgian prime minister Alexander de Croo told a press conference.

Ten years ago you sought financial independence to get out of a stifling office culture. It was about finding a better balance between making ends meet and the freedom to control what you did and when.

But now everything from hybrid working to four-day week trials to more calls for a universal basic income shows the system may be adapting, too.

Capitalism co-opts and exploits – one big reason it’s so successful. What was rebellious in the 1960s was mainstream youth culture by the 1990s, for example.

4% for all

While it’s hardly a serious prospect, some have wondered: what would happen to economic growth if FIRE ¹ went mainstream?

They’ve even couched the less productive population that might result as morally irresponsible.

But while it’s an equally unlikely prospect, I wonder: what would happen if it was the other way around, and the mainstream went FIRE?

Could more of us end up – whisper it – happy at work?

[continue reading…]

1. Financial Independence Retire Early.[↩]

And you thought the pandemic kept you up at night. A wave of high inflation is engulfing the UK economy, with January’s 5.5% CPI inflation measure the highest for 30 years.

Few will sleep easily as the cost of living soars.

It’s enough to send you back into social isolation to avoid paying higher prices:

Of course, an irony of high inflation is it can make it rational to spend now rather than battening down the hatches and saving for the future:

• If the prices of furniture or cars are going up so quickly, can you afford to put off a purchase?

• If the real terms spending power of your cash in the bank is getting eroded faster than a prince’s credibility, why save?

These are questions we haven’t had to think about for years.

At Monevator we believe you should still try to live within your means and pay yourself first. Investing in a range of assets is the best way to protect yourself against inflation in the long run.

But that’s not to downplay things – nor to forget that poorer households have few real assets and little option but to suck up higher prices on daily essentials, or go without.

Moreover in the UK things are nailed-on to get worse before they get better.

Energy bills will soon spike with the 54% increase in the regulatory price cap in April.

And while an imminent National Insurance increase won’t itself feed into inflation (and may even dampen spending) it all adds to the squeeze on our spending power.

Two factors behind high inflation

There’s a big debate as to why inflation is so high after decades mostly in the doldrums.

I skimped on it in my earlier quantitative tightening post, in the interests of time and space. (Yours and that article’s, not Albert Einstein’s…)

But let’s now get into it.

Beyond causing you to wince every time you reach the supermarket tills, high inflation is roiling the bond and stock markets.

Traders have scrambled to anticipate how and when Central Banks will raise rates in response.

This is hardly a no-brainer. Central Banks must try to choke off high inflation without strangling the post-Covid recovery.

And how they can best achieve that depends on what exactly is causing prices to rise so quickly.

There are two main theories:

• One side sees a supply shock. The pandemic plunged us in and out of lockdowns. Our shopping habits changed more than a five-year-old’s wishlist to Santa. Factories and distributors couldn’t cope. The result? Surges and gluts that have screwed the price of everything, from oil and lumber to used cars and gym equipment.

• The other side says it’s all about demand. Consumers have too much money. Their wallets were bloated by overly-generous government aid to offset Covid. Savings were fattened by all that time we were Zoom-ing in our undies instead of going out spending. Very low rates (and booming stock markets) have given everyone too much financial firepower.

For what it’s worth I’m mostly in the supply shock camp. (Though I must admit it’s getting lonelier.)

I expected huge disruptions from lockdowns, so I was not surprised by them. Listening to firms reporting their earnings, I’ve been hearing about problems up and down the supply chain. But these will be solved. And I see no reason why secular deflationary forces have gone away, longer-term.

To give just one illustration, the online furniture retailer Made saw its key Vietnamese suppliers shutdown when Covid overwhelmed that country last year. Made is now carrying tens of millions of pounds worth of deferred revenue on its books – and it’s a sure bet some would-be Made customers went elsewhere. Yet rivals faced the same issue. And some of their customers went to Made.

The net result is whatever stock retailers did have in could command a higher price. Especially as it has become very expensive to ship in replacement goods from Asia, with container rates increasing by as much as 800% last year. Discounting was reduced. Sales grew, but margins were crimped by higher costs.

This to me is all indicative of a supply kerfuffle.

Admittedly, some select companies are boasting of straight-up sky-high demand.

Disney is one. US customers seem willing to hurl money at the House of Mouse after two years cooped up with their kids. On a recent earnings call, its execs all but boasted of their ability to charge higher prices at Disney’s theme parks.

So I do see both forces at work.

In addition, demand shock advocates also note how the US government sent out money in the mail. They see a housing boom in the US, the UK, and elsewhere. They point to meme stock and crypto bubbles in the midst of the pandemic as indications of money to burn.

And then they wonder what us supply-siders are smoking?

Unusually abundant money has probably thrown fuel on the fire. But I’m not convinced it’s the cause of high inflation.

For one thing, the widely-fingered form of fiscal Covid support deployed in the US – universal stimulus cheques – wasn’t really done so much in Europe. But we’ve still got the high inflation.

As for easy money, near-zero interest rates didn’t cause high inflation before Covid – nor in Japan for many years before that.

So why now?

And the key forces that kept price rises low before Covid haven’t gone away either.

To return to my Made example, that company will continue to source from numerous global suppliers and undercut slower legacy businesses like John Lewis. Brexit has introduced more friction into UK trade, but it hasn’t turned off globalization.

Similarly, Made’s technology platform should continue to drive higher sales from a relatively smaller base of staff and premises than older firms can achieve. Some of this efficiency will be passed on to consumers as lower prices.

These wider trends (and others) have helped keep lid on inflation for decades. They are beyond the authorities’ control.

Why does it matter what’s causing high inflation?

If high inflation is mainly due too much money sloshing around – from interest rates kept too low for too long or from government super-spending – then rate rises are just the thing we need.

By raising interest rates, central bankers make it more expensive to borrow and more appealing to save. This pours cold water on the animal spirits of companies and households, taking some heat out of the economy.

Expansion looks riskier, so less of it happens. Interest charges on debt go up, meaning less money to spend on everything from factories (companies) to stuff (consumers).

But what if high inflation is mostly a supply chain issue, as I suspect?

In that case raising rates might not be so helpful.

Sure, rate rises will slow the economy, and reduce demand for what money can buy. That will mean less pressure on stretched supply chains, and less scope for companies to jack-up prices.

However higher interest rates don’t magically make supply chain problems go away. In fact they could inhibit some solutions – expansion at ports, say, or hiring more workers.

Thus raising rates could slow the economy without curbing inflation, at least for a while.

Which raises the spectre of stagflation – a stagnant economy in a death pact with high inflation.

Again we haven’t seen that for more than 40 years. And as 1970s revivals go, you’d rather get a mullet.

Higher wages could embed high inflation

Regardless of what caused this high inflation, the key issue will be whether central bankers can head off a wage spiral.

If workers expect prices to keep rising and are able to demand higher salaries, they will spend their extra earnings bidding up prices even more.

This is the stuff of nightmares for central bankers. I suspect it’s why the Fed is talking tougher than economic conditions really warrant. (I believe US growth will probably slow quite quickly from here).

The governor of the Bank of England got a kicking earlier this month for urging wage restraint. But we should understand where he’s coming from.

I’d be all for fat cat wages rising slowly and everyday workers’ earnings rising more quickly – in real terms – in a sustainable way over several decades.

But wages that quickly spiral to chase ever-escalating prices are no good to anyone. Again see the 1970s.

You can’t blame workers for wanting more money. High inflation means that even with eye-catching nominal wage rises, real (after-inflation) wages are falling:

Source: FT

The trouble is once wages go up they seldom go down. They are ‘sticky’, in the jargon.

Don’t believe me?

Imagine Apple cut the cost of iPhones by 20%.

That’d just be a Black Friday sale.

But what if Apple chopped salaries by the same amount?

It’d surely make global headlines.

Take a look at this graph from the Office for National Statistics:

Source: ONS

As you can see, worker incomes have grown at a positive – albeit slowing – clip for, well, ever.

Individual firms might go through retrenchments that give them more bargaining power with staff for a time. And there can be shenanigans at the margin (e.g. more part-time staff or fewer better-paid staff and more contractors). But salaries in aggregate go up and stay up, adding to the cost base and fueling higher prices, as companies try to maintain their margins.

People become accustomed to a certain lifestyle and they are loathe to give it up. If employers try to cut their wages, they’ll try find another job.

Very low unemployment makes that much easier.

Curb your enthusiasm

Twitter abounds with armchair economists screaming that central bankers should raise interest rates yesterday – as if the mandarins at the Bank of England and the US Federal Reserve haven’t noticed that inflation is running at twice their target rate.

These bankers know high inflation could well prove a blip – provided wages remain restrained.

Besides supply bottlenecks getting sorted out, there are technical reasons to expect inflation to calm down. Prices can leap, but provided they stop leaping they stop contributing to inflation. An oil price approaching $100 a barrel will continue to be painful, for instance, but it won’t keep boosting inflation year-over-year unless it goes above $100 and beyond.

Bankers also know that hiking rates will take a while to have any impact. We might only know they’ve raised them too much when the impact is felt alongside a slowing economy.

Finally, the cure for high prices is always high prices. Capitalism sorts out inflation by finding new sources of supply or by promoting substitute goods for profit, which curbs further price rises.

Many people will tell you it’s obvious how this will play out. They will point to current market forecasts of inflation expectations and rates, which imply this high inflation is transient and that interest rates will indeed rise for a bit, but should then will start falling in a few years.

I think that’s likely, but I don’t think it’s a slam-dunk.

Market forecasts always look highly rational at the time. But those curves weren’t predicting today’s inflation at 5.5% – nor markedly higher interest rates – a couple of years ago.

Far from it.

Great expectations

How this all shakes out is anyway highly relevant to us, both as consumers and as investors.

High inflation can increase the correlation of shares and bonds in the near-term. It’s bad for both, as they fall until they find a new level appropriate to the more inflationary environment.

That would leave the safety cushion element of a typical 60/40 portfolio looking rather deflated.

Longer-term, shares can benefit (high inflation can boost sales and profits, if only in nominal terms, bringing down those frothy valuations) but it won’t be such a smooth ride.

As always we everyday investors probably shouldn’t be making heroic bets in an attempt to outwit the multi-trillion dollar markets.

As I’ll discuss in my next post, a diversified portfolio is more not less important at times like these.

We may be in a new regime for inflation and rates, compared to the past 30 years.

But I see it as more as the equivalent of a new government than of a radical overnight coup.

What is quantitative tightening? Why are bond funds falling? Should you alter your portfolio before the Bank of England further raises rates and soaring inflation sends you to the soup kitchen?

All good questions that we’re hearing from Monevator readers every day.

So let’s have a primer on what’s going on with central banks, rates, inflation, and the market.

Setting expectations

With most things in investing, every answer leads to two more questions.

Such exponential growth is great for compounding your wealth. But it’s bad for your patience and my fingertips.

So rather than go down every rabbit hole, I’ll include plenty of links to other articles. ¹

And we’ll put off considering what (if any) action you should take until next week.

When we’re done you still won’t like it if your portfolio falls when a central banker opens their mouth. But at least you’ll know why you’re down!

Note: there will be much talk of the US. That’s because as the engine of global markets, changes in US monetary policy typically affect everything.

What is quantitative tightening?

Quantitative tightening (QT) is a contractionary monetary policy. It’s the opposite of quantitative easing (QE).

In fact QT potentially reverses QE.

Still with me?

Okay but (a) what the flipping Henry is a ‘contractionary monetary policy’? And (b) as many of us never really understood QE, reversing it doesn’t simplify much.

So, briefly, QE involves experiments operations by central banks to lower interest rates. They do this to support economic growth and soothe stress in the financial system. The bankers’ aim is to hit their inflation target and any other policy goals.

Traditionally central banks exerted their influence by changing the base interest rate that commercial banks are charged for holding money with them.

However in the ruinous crater-strewn landscape that followed the financial crisis, central banks went unconventional.

The bankers wanted to support asset prices, tempt money into riskier securities, and encourage economic growth to ward off deflation. They’d try to do this by keeping market rates lower than they otherwise would be.

Led by the US Federal Reserve (the Fed), central banks purchased higher-yielding assets from commercial banks in exchange for more liquid shorter-term paper. (Read Cullen Roche’s QE series for the mechanics.)

The net result was higher prices for safer assets and lower yields across the spectrum.

For example, the graphic below shows the decline in the all-important ten-year bond yield in the heyday of pre-pandemic QE.

Most economists (though not all) would agree this descent was at least partly due to QE:

Source: Vanguard

Other mooted impacts of QE – such as egging on reckless speculation or juicing the money supply – are more hotly debated.

For instance the Bank of England found no evidence QE boosted lending in the real economy. (Although some might say: “it would say that wouldn’t it.”)

The consequences of quantitative tightening

Quantitative tightening should be the opposite of QE. Central banks will wind down their purchases of assets (and eventually maybe sell them). They will also raise their base rate.

This should reduce demand for assets like government bonds compared to cash and short-term paper, and hence increase yields as bonds are sold off. (When bond prices fall, yields rise).

You’d expect this to happen until bond yields reach a level that tempts enough buyers back into them.

And indeed this dance has already happened. Without the US Federal Reserve yet raising interest rates or halting asset purchases, yields have been shifting across the curve in anticipation:

Source: GuruFocus

Expectations are everything in financial markets. Yields have risen as traders try to anticipate where rates and inflation will be in one or two years from now and beyond. It’s happened in all major markets.

That is why your bond funds are down.

Markets now expect slightly more than half-a-dozen US rate rises in this cycle, starting in March.

Meanwhile in the UK bank rate is expected to be above 1% by the end of 2022, peaking in 2023 at around 1.5%.

Why do quantitative tightening?

Okay, but if QE made money cheap and it supported economic growth, why stop? Who doesn’t like free money and a booming economy?

Well, central bankers for a start. History suggests too much of a good thing can cause the economy to overheat.

At best that could stoke even higher inflation, which would then have to be choked off with more rate rises – and perhaps a deeper recession – compared to if central bankers had acted earlier

At worst too much cheap money could lead to dumb investment decisions, credit bubbles, and another financial crisis.

(Actually, history again reminds us of worse still. Folks who end up moving their near-worthless savings around in wheelbarrows get politically uppity. Think gunshots in the streets uppity.)

Central bankers would therefore like to return conditions to normal in their noble pursuit of price stability. (And to avoid a revolution).

Once conditions are ‘normalized’, they can go back to simply raising base rates – and their eyebrows – to influence the economy.

(They’d also probably like to get back some of their firepower so they have more ammunition to respond in the next crisis.)

Some doubt complete normalization is achievable anytime soon, due to the sheer scale of QE. But it’s the aspiration.

However there’s an even bigger reason to start quantitative tightening ASAP – which is that inflation is missing its target by about the same margin as I missed out on playing for Man United.

Inflation is running at 6-8% in the US and Europe. And unemployment is very low.

It’s hard to justify rock-bottom rates when inflation is going through the roof.

Quantitative tightening and your bond funds

With all this going on, it’s clear why the mere talk of quantitative tightening has roiled markets – and your portfolio.

Higher rates across the yield curve come about from falling bond prices, as investors reshuffle their holdings according to their expectations for central bank interest rate hikes and any reversal of asset purchases, as well as their forecasts for inflation.

• At the ‘short end’, those government bonds that will mature over the next year or two have sold off mostly in anticipation of imminent central bank rate rises.

• The further out you go towards the ‘long end’, however, the more inflation expectations and the prospects for economic growth drive bond prices/yields (by influencing the much more uncertain expectations for interest rate levels that will prevail many years hence).

Short-dated US Treasuries have seen their yields rise faster than long-dated bonds. Short-dated bonds compete with cash in the bank, where traders are very sure interest rates will soon be much higher.

In addition, traders might be betting that the more central banks tighten now, the greater the long-term impact on market interest rates and inflation.

Hence expectations for more rate rises – and sooner – that have emerged in 2022 (driven by higher than expected inflation and arguably lower unemployment) may imply a need for fewer rate rises further out.

Or maybe the market fears a policy error?

This is all a balancing act for central bankers. If they go too heavy too soon with quantitative tightening, they could cause a recession.

Expectations of a recession may be signaled by the yield curve inverting – a situation where long-dated bonds yield less than short-dated ones. (Unusual, due to the additional term premium that’s normally demanded by investors in longer-term bonds).

The curve is already flattening, as short-term yields have risen by more than long-term yields:

Source: Mish Talk

We may well discover a recession is an inevitable price to pay for the easy money conditions (and asset price rises) of the past decade.

But I don’t think it’s a policy goal.

Higher rates and inflation affect equity valuations

Broadly speaking, equity valuations also turn on the cost of money (interest rates) and inflation.

• With higher inflation, the value of future earnings in terms of today’s money is lower.

• With higher rates, investors see safer returns from cash and bonds as more attractive than before. So again, they’ll value uncertain future earnings less highly.

We can expect quantitative tightening to depress valuations for pretty much all asset classes.

However some investments (such as miners and energy shares right now) may enjoy an off-setting boost, as high inflation makes their near-term high earnings more attractive.

With a lot of fits, starts, bumps, and reversals, the same repricing and reshuffling shenanigans we’re seeing in bonds will therefore play out across the risk/reward spectrum of all assets.

Investors are now re-evaluating equities, property, and even the likes of gold.

As I noted, companies’ shares are mostly valued on their future earnings power – discounted by expectations for interest rates and inflation.

The more that a company’s earnings will come in the far future, the more higher yields and inflation expectations will impact – in theory – its present value.

When interest rates are at zero and inflation is low, the value put on future earnings can be very high indeed. Cash is trash (in that it earns you nothing) and low inflation expectations means distant earnings will still be very attractive in terms of today’s money.

All that changes with quantitative tightening and with higher inflation, however.

Investors aren’t willing to pay so much for a company that won’t be profitable until 2030 if they think that by then the spending power of cash will have fallen 25% in real terms and they might have earned 3% a year in the bank on the way.

Hence the ‘multiple’ investors put on the company’s earnings will go down.

Played out across all companies, this re-rating can cause a market decline.

The ups and downs of go-go stocks

In practice so-called growth shares have been hit much more than value shares.

Investors had slapped very high multiples on growth companies’ future earnings – and then ratcheted them even higher on the back of temporary stay-at-home economics. They’ve now reined that in.

Of course shares represent businesses, and their individual fortunes will depend mostly on the success of their operations.

But tightening monetary conditions can have a direct impact here, too.

For example, banks may reduce lending, making it harder to (re)finance and to borrow to grow.

Or consumers may decide to save more and so reduce their spending, hurting sales.

It’s all connected

A big shift in the outlook for rates and inflation ultimately changes the relative attractiveness of all assets.

Investors now even view something like gold – which has no earnings – differently.

When your cash earns you nothing in the bank, why not own gold?

Conversely when cash is paying say 2%, why pay to hold gold that earns nothing?

Remember: a goal of QE was to push money to accept riskier returns.

All things being equal, we can therefore expect quantitative tightening to do the opposite. Investors will retrench. More investors will eventually see attractive returns available again from bonds, thanks to higher yields following price declines. Some money that shifted into shares in a desperate hunt for yield will go back to fixed income.

This is all why – besides their eternal effort to sound sexier than accountants – City types call the shift to quantitative tightening a regime change.

Thankfully the CIA need topple no banana republics to get us to this new financial world order.

But if the 40-year decline in interest rates really is over, we can still expect some fireworks.

The turning of the screw

We now know what quantitative tightening is, and why it’s happening.

But to return to where we started, what does it mean for your portfolio?

Well, it sure looks like a recipe for more volatility, lower stock markets than otherwise, and – gasp – falling bond prices.

But before you sell everything and cower in a cash savings account (where you’ll be losing 6% a year in real terms) I have a menagerie of caveats.

We’ll get into those next week.

1. Fewer people seem to follow links nowadays. What a waste of hypertext![↩]