Historians generally disparage ‘what if’ narratives – but it makes fun reading and, more importantly, challenges accepted wisdom.
Anyone wanting an insight into alternative outcomes from great historical events may want to browse Niall Ferguson’s Virtual History, a collection of counterfactual essays. Ferguson is one of the outstanding historians of the recent years, making complicated issues, particularly financial ones, understandable.
So, I was intrigued by analysis reported last week that 900,000 years ago the human race almost died out and that there were fewer than 2,000 people of reproductive age in the whole world. The dinosaurs were long gone, and it is not clear what would have evolved. Perhaps Homo Sapiens (Wise Man) would not be around and given the harsh conditions at that time, a species more suited to the cold conditions would have become dominant. More Neanderthal less Einstein. I am no expert, but my hunch is that the conclusion of a near Extinction Event is overstated. But it is fun to speculate what financial institutions would look like if a different path had been taken.
Can inflation rise?
Let’s do a bit of crystal ball gazing – not counterfactual but challenging the prevailing consensus. What happens if inflation, rather than falling, starts to rise again. In recent weeks we have seen oil prices move up, from $67 a barrel in May to nearly $90. This has been put down to Saudi Arabia extending the timeframe of its output reduction. Let’s further assume that my economic analysis is wrong and despite the tightening in monetary policy and the squeeze on disposable incomes, global growth accelerates – perhaps due to reflationary policies in China, a tech-based productivity spurt or consumer and businesses acclimatising to the new higher interest rates. In effect, animal spirits start re-appearing.
One answer seems pretty clear: interest rates will go higher. Governments could try to restrain growth through tighter fiscal policies but that is never popular. So, I think it falls on central banks to do the work. One lesson I have taken away from the last few years is that companies are alive to any opportunity to raise prices. Under the guise of the energy price surge and heightened confusion about drivers of inflation, companies have not been slow to blame factors outside their control – ‘nothing to do with us – honestly’. Wage settlements can be accommodated because consumers, used to low inflation, have lost an important yardstick by which to judge corporate behaviours. These traits would be re-enforced by a reversal in current disinflation trends, so say nothing about higher inflation expectations that would be embedded.
If we take the UK as an example, we saw interest rate expectations hit 6.5% in July. In an environment of stronger growth and higher commodities, I could envisage base rate pricing in the 7-8% area. In the US and euro area, I would be looking at rate expectations moving higher by a similar amount. Some reading this may think – that does not sound wildly different from the scenario we were looking at two months ago when slow disinflation was the consensus. And this is my problem. I find it really difficult to envisage UK base rates in this territory – let alone higher – for the simple reason that such tightening of policy will lead not to a shallow recession, which has been my call in recent months, but to a much worse outcome. A challenge could be that I am looking in nominal terms and that we should focus on real rates; I am not convinced. Basically, my view is that a global tightening, taking rates in most areas 2% above present pricing, would tip the major western economies into recession and probably produce a financial crisis.
Government bond markets were mixed last week. Ten-year US treasury yields moved back above 4.25%, although there was little change in real yields, with the twenty-year rate staying around 2.1%. In the UK, ten-year yields hovered around 4.4%, a slight fall over the week. Investors are beginning to price out a move to 5.75% in UK base rate, as reflected in three-year yields, now at 4.8% compared to 5.5% in early July. German government yields edged higher, the ten-year ending the week at 2.6%.
On the credit side there was little change. Sterling corporate spreads moved wider by 2 basis points (bps), with on-going supply of bank debt. However, as HSBC proved, an attractively priced issue will attract significant demand. A new seven-year senior bond, issued at 230bps over gilt yields, ended the week the best part of 20bps tighter. Similarly, high yield markets saw a marginal widening but spreads still remain near their year lows.
Base rates at 8%? I don’t think so. But it is usually wise to ask, ‘what if?’.
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