Thoughts through the cycle: W3 August ’20

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  • In times past, August was known as the ‘silly season’ in the British press. With the heavy-hitting journalists off on holiday, newspaper copy had to survive on meagre rations – sensational stories about escaped ‘panthers’ stalking the fields of Surrey accompanied by grainy, long-range snaps of what appears quite clearly to be the neighbour’s cat and such like. For newspapers, public examination results in mid-August provided welcome relief, allowing reportage of beaming teens contemplating leaving the parental home for university and their first taste of the fruits of adulthood.
  • Inevitably, as 2020 wends its miserable way from summer to autumn, even the A-level result ritual has been marred by controversy. With Covid-19 having led to exams being cancelled, pupils were to be graded on their predicted results. As an additional novelty, the British government decided to amend these predicted grades using an algorithm, with the entirely predictable result of outrage from those pupils whose grades fell below expectations. One only needed to spend half an hour or so listening to a talk-radio station such as LBC to feel the burning sense of anger and injustice that then forced a government U-turn which in effect has simply shifted a problem further downstream with universities now struggling as some courses may now be oversubscribed if all offers have to be honoured. Perhaps university and education might be a good topic to use in a general discussion about where the UK and its government finds itself at this juncture.
  • The starting point as ever is debt and its gradual intrusion into all areas of society. The UK is relatively new to education-related debt. The first student loans were introduced in 1990. Tuition fees were introduced in 1998. The Conservative/ Liberal Democrat coalition of 2010 oversaw a sharp increase in tuition fees, and consequently a large increase in the amount of debt with which students graduated.
  • In terms of the ethics of debt and schooling, it is quite clear that borrowing for tertiary education is not itself a problem as anyone can do so, and university attendance involves over 40% of each year cohort. As a paradigm for the role debt plays in society, paradoxically it is in fact the inability to borrow which causes the problem. While any undergraduate in the UK can borrow to fund their degree, the same is not true of secondary education where private schooling has to be funded by parents (or often grandparents) without any direct recourse to debt. This is the element which causes most angst with respect to inequality and privilege given the perceived advantage gained by privately-educated pupils.
  • What is most interesting though is the premium on houses which lie in the catchment area of top non fee-paying state schools. While there are no fees, higher house prices (and therefore implicitly higher levels of mortgage debt) show that where it is possible to borrow for secondary education, parents are willing to do so, albeit indirectly. A recent article in the Daily Telegraph shows this to be true even at primary school level, with parents in some cases paying premium of up to £37,000 for properties in the right catchment area (‘Pay for private education or buy a property near an ‘outstanding’ state school – which saves you most money?’ Daily Telegraph, 16/01/2020).
  • Debt therefore seems to be the answer for almost everything – at least for now. It has certainly been the answer for governments around the world with respect to the questions raised by Covid-19 and how best to deal with it. In June this year, UK government debt-to-GDP exceeded 100% for the first time since 1963. There are hints though that the UK Treasury senses a snake in the debt garden of Eden. Chancellor Rishi Sunak has declared that the highly expensive pandemic furlough scheme is coming to an end in October, even as France has extended its support until the end of 2021 and the normally frugal Germans are considering prolonging theirs for another 24 months. One wonders whether the imminence of Brexit and the likely burden that could place on the public finances is playing a part in Treasury thinking.
  • In 1963, the UK was paying down its war debt. The last tranche of this was repaid in December 2006, just over 60 years after hostilities came to an end. This provides a salutary reminder of what the duration in debt really means, and quite how long it takes to pay it off. The most extraordinary part of the British Government’s foray into A-level grade allocation is not that for the second time in a year they went all-in on allowing policy to be decided entirely by an algorithm, or that those involved in the decision making didn’t see that such intervention would tee the government up for an almost inevitable barrage of complaint. What is most striking is that the government was involved in deciding pupils’ A-Level results at all. This is the really radical departure, and the one which requires the most thought.
  • Casting one’s mind back to Autumn last year and the pending UK election, there was much fright at the prospect of an interventionist Labour government under the leadership of Jeremy Corbyn and the havoc it would wreak on the UK economy. Even those who recall the 1980s excesses of the ‘loony left’ Labour councils led by Derek Hatton et al would not have imagined that a Corbyn government would pay for large parts of the workforce just to stay at home, or that it would be government policy to subsidise people’s lunches in an ‘eat-out-to-help-out’ policy. That a Tory government is implementing such policies is perhaps nothing more than a sign of the times. The political denomination of the government is not the issue at hand – government intervention is itself the thing demanding focus.
  • Much has been made of global central bank policy in the face of the pandemic and its aftermath. Not only have there been rate cuts, but in the developed world, central banks have intervened with unconventional monetary policy on an unprecedented scale, particularly using quantitative easing (QE). In the UK, the Bank of England’s current QE programme totals £745b, and the amount executed so far mirrors almost perfectly the increase in the Government’s primary deficit. While Governor Andrew Bailey is at pains to uphold the independence of the Bank of England, it is clear to even the most casual observer that there is at least a rhythm to the central bank’s purchases and the government’s deficit.
  • In history, periods of unprecedented crisis have often led to emergency government powers being implemented which, while temporary at inception, become through habit permanent features of the political landscape. The UK’s income tax policy was for example first implemented by William Pitt the Younger in 1799 to raise revenue for the war against Napoleon and has remained ever since. With respect to the Bank of England’s independence, it is worth noting that Treasuries ‘Ways and Means’ fund was once again enabled in April this year. While limited to £0.4b at present, it nonetheless theoretically allows the government to borrow directly from the Bank of England without recourse to the bond market. Were this ever to be used in earnest, the Ways and Means fund ought to be considered direct monetisation of the UK deficit, with all the immediate inflationary implications that involves. [The peculiar name of the fund is linked to the Ways and Means Act of 1694 which brought the Bank of England into existence.]
  • While financial markets are currently obsessed with central bank support, they should perhaps be thinking more about how central banks are becoming or might become subordinated to the wishes of government. The surge in government debt and the deflationary impact of this has forced government bond yields lower. Albeit somewhat indirectly, central bank policy is being dictated by government fiscal policy. When Bank of England Monetary Policy Committee (MPC) members talk about negative interest rates as a policy option or a possible ‘tool in the box’, it is unclear whether they are being disingenuous or just desperate to avoid admitting the obvious.
  • The graph below shows the current UK Gilt curve in bright green with the that of August 2019 in yellow (dotted). The Bank of England’s 2020 rate cuts are visible at the short end of the curve (the bar chart at the bottom of graph shows YoY change), but it also shows that the UK nominal yields are now negative out to seven years. This being the case, MPC members ought perhaps to drop the engineer with the toolbox analogy for that of playing the rear-end of a pantomime horse the front of which is being manned by Boris Johnson’s increasingly gaff-prone and spendthrift government.

Source: Bloomberg, 17th August 2020

  • Government deficit spending demands Bank of England QE to keep rates low. Low rates themselves have a knock-on effect on other parts of the economy, not least the pension industry. As detailed in the Financial Times, the UK’s largest private sector pension fund, the 400,000-strong University Superannuation Scheme (USS) has recently declared that is now in deficit to the tune of £12.9b versus a £5.4b deficit in 2019 (‘UK universities pension fund deficit rises to £13bn’, FT, 29/07/2020).
  • This is no small matter – academics have already been on strike following increased contributions last year. The scheme is now just 84% funded, down from 93% and, “The material reduction in the funding ratio reflects reductions in interest rates over the year and the devastating impact of coronavirus on global markets in the final quarter”. It is unclear what the funds target return is and therefore how great the funding deficit really is if one assumes that the recovery from current economic malaise is more U- or swoosh- than V-shaped.
  • This problem brings together a number of the themes mentioned earlier. Heavily indebted economies tend to grow and recover more slowly, and this is reflected in low or negative nominal rates. While central bank policy may help government fund deficits in the short term, it does not help savers in the long term. With bond yields so low, there is a question about how much lower they can go – and it is clear the Bank of England fears negative rates due to the adverse effect it has on bank profitability (look at the Eurozone as your example). It is also clear that if bond yields are around the lows, especially when equity valuations are at or around the highs (in the US at least), then the knock-on effect on pension funding is due to become far more important. When the implications of pension funding (the lack thereof) becomes more apparent, the furore over A-level results will seem in retrospect to have been a storm in a teacup.
  • The recent pandemic and the government reaction to it may well mark a turning point for the investment industry. Increasingly there are questions being asked of the efficacy of the traditional 60/40 equity/bond portfolio given that bond yields are so low and equity valuations so high. That which has worked in the past may not do so in the future, but that does not mean all is lost. One can in fact take one’s lead from the culprits themselves – governments. The growing focus on deficit financing differentiates the current crisis from that of 2007-2009. The latter was deflationary. In the age of populism, modern monetary theory, and people’s QE, it seems increasingly probable that we are eventually going to be due a period of inflation or stagflation. Investors would be wise to start preparing their portfolios accordingly.

Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as at 20th August 2020

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