November 25, 2021
“If inflation was measured the same way as the 1970s, 2021 inflation would be as high as back then.”
This quote from an esteemed financial market observer is very key. And while we can’t calculate what 2021 inflation would look like under the 1970s methodology, we do know it would be north of 12%. Yet the Federal Reserve still claims that it is transient.
Could the Fed be significantly behind the curve? Probably, but does it matter? At the end of the day, even if inflation does drop back to “acceptable” levels in 2022, then every dollar holder is still out of the chunk of purchasing power they lost this year. So yes, it does.
Historically Central Banks tend to towards doing “too much too late” in my observation, so I guess it’s no surprise, but I do wonder at what point they overreact. We know the base effects in the inflation numbers could see the headline figures look elevated until around the middle of next year, so this suggests a nervous 6-8 months for the front ends of the fixed income curves.
The other recent interesting development has been the change of attitude in China: It has been clear for some time that President Xi was favouring a “Lone Wolf Warrior” stance, but this has changed (for now) with the sudden re-engagement with the World via the statement issued at COP26 and now the extended summit with President Biden. The cynical amongst you will feel this is linked to slowing growth at home and the upcoming Olympic Winter Games in China… I would struggle to disagree.
China does remain a significant concern globally, but while any overflight of Taiwan was making headlines a couple of months ago, the press are now basically ignoring the ongoing sabre-rattling. It is hard to see how the world would be able to do much if China decided to invade beyond sanctions and given the events of the last couple of weeks it suggests that the Chinese have understood that they need to be economically engaged with the Rest of the World which probably lessons the likelihood of military action for now.
The same cannot be said of Russia. With troops massing on the Ukrainian border once again and the testing of a “satellite killer” missile this week that forced the occupants of the International Space Station to “duck and cover”, Mr Putin’s belligerent attitude is being helped by the perceived weakness of the West and in particular, the incumbent US President post the disastrous withdrawal from Afghanistan. The dependence on Russia for 60% of Germany’s energy supplies is the issue that many predicted it would be, so with the US warning an invasion could be imminent and, in the game favoured by bond traders everywhere, we should play “What if” and consider what an annexing of Ukraine would mean for the markets who seem to be dangerously complacent:
Firstly of course we’ve seen the soaring gas prices as traders speculated that Russia was holding back supplies to put pressure on the West (up from 100 pence per Therm in late Summer to touch 300 pence by October) so this gives us a good clue where the pain will lie if it all “kicks-off”.
Europe is not starting from a position of strength: starting the winter season with the lowest stockpiles of gas in decades and the German regulators have just suspended the certification of the Nordstream 2 operator meaning it will likely be February at the earliest before gas can flow there.
Simply put, it will be impossible for gas supply from Russia to continue in the event of an invasion: either they will cut off the supplies or sanctions will be imposed to stop imports. Yet there is simply not enough oil and gas available elsewhere to make up the deficit, so prices will multiply in panic buying and then there will need to be major efforts to conserve energy, almost certainly resulting in Germany seeing factories and offices closed. Anyone old enough to recall the UK’s “Winter of Discontent” when a 4-day week was imposed on industry (which was still 2 more days a week than the car industry worked though!) with electricity only available for 1 hour each evening in homes will know that the only good thing to come out of it was the Baby Boom! It won’t be great for charging your electric car though.
The Euro is also likely to take a massive hit: after all this conflict would be right on its borders and the damage to the European economy with the lack of energy will hit hard as well. Plus, Germany and friends will have to re-arm, which given the extremely low levels of investment in defence (for example in Germany) over the past decade will be very expensive, which will, in turn, require more money printing to pay for that and any support for businesses hit by the lack of energy supplies.
The damage won’t all be in Western Europe though but even a plunging Rouble and Moscow Bourse will spell trouble for banks with loans and other exposure in Russia.
But the good news is the markets are telling us it’s all unlikely to happen. Which means if it should occur, we could see some very violent moves indeed.
Time to “Duck and cover” your portfolio into the Pactum Corporate Capital Fund? As we discussed last time, equities are a mixed bag but with short-dated fixed income highly vulnerable to sudden moves from the Central Banks if and when they wake up to the inflation threat, a return close to 3% in Swiss Francs with no rate or equity exposure has to be a very sensible alternative at this time.
Text written by Rick Pearson, CIO