Jupiter Merlin Weekly: Governor to Chancellor, an Imaginary Letter

Weekly Market Review

The Jupiter Merlin team imagine what the Bank of England Governor might say to the Chancellor, then assess who’s ahead in the net zero arms race?

Governor to Chancellor: an imaginary letter

“Dear Jeremy, First the good news: inflation is back to single digits (yay! Result!). The bad news is that it refuses to play the game and conform to the outputs of our immensely sophisticated spreadsheets’ forecasts. I’m stumped as to why but the likelihood of it being back to 2% in the foreseeable future (I apply the word ‘foreseeable’ to a limited horizon bearing in mind our inability to foresee what is right in front of our noses, let alone anything beyond) I’d rate at no greater than a snowflake’s chance in Hades. It pains me to say it, but we don’t really have much idea what’s going on here. Heigh ho. Yours sincerely, Andrew. PS If we’re not much good at this, your own Treasury’s propensity to fiscal incontinence isn’t exactly helping. A”.

The letter the Governor of the Bank of England did not write to the Chancellor of the Exchequer to explain (again) why inflation exceeds the Bank’s mandated target of 2%. Deep in the Bank’s bunker, with neither natural daylight nor visibility on to the world outside its imposing façade, Threadneedle Street’s finest are trying to fathom why, almost exactly 12 months after global commodity and wholesale energy prices peaked and most have tumbled since, UK inflation remains not only frustratingly high, but core inflation (excluding food and energy) is still rising.

Investors are resigned. With more UK interest rate rises a certainty (will 5.5% be the peak? We have had many a false summit on this momentous inflationary journey over the past two years: whether in the form of a peak or plateau, base rates will eventually go no higher; it is simply a case of how high and by when), Gilt yields are rising in sympathy. The two-year Gilt yield at 4.55% (the one most often used as the basis for pricing fixed rate mortgages and car purchase schemes) at the time of writing is a mere 0.2% points off the level of the so-called “idiot premium” attained at maximum panic during the Kwasi Kwarteng budget debacle last October. Looking to longer-term government financing, the 10-year yield is 4.32% and the 30-year, 4.63%. Compared with the period since 2007, it is an expensive outlook.

Net-zero arms race: Biden lights the touchpaper

And this rising cost of debt presents a significant problem, and not just the obvious one related to the cost-of-living crisis.

Significantly catalysed and turbocharged by Joe Biden’s Inflation Reduction Act and the extensive protectionist economic incentives deployed to encourage US households and industry to ‘go green’, it is clear that a global arms race has been unleashed on the path to the seemingly immutable Holy Grail of carbon net-zero by 2050. If that date is fixed and enshrined in law, the way to it is littered with many arbitrary and politically susceptible mileposts, e.g. for installing domestic insulation; the banning of the sale of new combustion-engine vehicles etc. We have referred in these columns before that the decarbonisation of global society and the economy is dressed up by a combination of alarmism on the one hand and on the other the warm, fluffy language of being at one with nature, a sense of the shared common purpose and of environmental kumbaya.

The harsh reality is that beneath the overarching ‘green’ sentiment, every country has its elbows out and its big boots on jockeying for competitive advantage. This new industrial revolution including the control of scarce physical resources will be instrumental in defining the new economic world order, who are the winners and who are the losers. Nobody wants to be left out (it’s a relative game); the question is how much does a country need to spend to win or at the very least, to avoid losing; can it afford it and who is going to pay?

This week has seen the arguments progress. Andy Haldane, former chief economist at the Bank of England and now CEO of the Royal Society of Arts was interviewed on the Today Programme on Radio 4. Referring to the notion of in his own words ‘arbitrary government debt limits’ in the context of GDP, without directly saying it, he was implying that they should be abandoned in the pursuit of making sure that the UK is one of the winners in the net-zero race. The contention was that the government should be prepared to pay now through increased borrowings for the deferred economic benefit at some indeterminate future date. The alternative is to accept permanent relative decline. His other contention, this time more explicitly, is to hire more foreign labour (if increasing debt is the sticking plaster to financial ills, then arguably hiring more overseas labour is no less a sticking plaster for employment markets when currently 11% of all UK government spending is on working-age social security payments and, according to the Centre for Social Justice, 3.7 million of the 5.2 million people in the UK claiming out-of-work benefits have been given dispensation not to seek work).

State vs Private sector and the optimal allocation of capital

Haldane’s thesis is not mad; all capital asset pricing models are based on assumptions of the future rewards from an investment today, the calculation of the theoretical payback period and the required rate of return against the cost of capital for a given discount rate and risk assumptions. But it only works in a fully rational, well-planned economic system.

The transition from a society powered by hydrocarbons for three centuries into one powered by alternative fuels in less than three decades requires immensely complex strategic and operational planning on a grand scale. However, politicians’ fortunes in democracies are governed by the short-term electoral cycle. Their energies are focused on staying in power. Most have no experience in detailed policy planning; many have attention spans that would make a goldfish seem a paragon of concentration; the excitement and distraction of political trivia (partygate, speed awareness courses to name but two) is more absorbing than the tedium of close attention to strategic policy detail. The fiscal backdrop is one in which the tax burden is the highest on record but public services are demonstrably struggling to keep up with demand and hard choices about public spending are regularly fudged; annual government budget deficits are embedded; the UK is already 100% geared in terms of debt/GDP. Ask yourself: is the government the best and most efficient allocator of capital? Or should it be left to the private sector to come up with the implementation of solutions under an overarching framework defined by the state?

Show us the money! But whose?

Which brings us to the second point: who pays? In Haldane’s world, it is ‘the government’. But should that funding be predominantly from borrowings, with all the attendant risks aggravated today by the significantly increased cost of servicing the debt? Having had a decade-and-a-half of ultra lax monetary policy, as discussed above we know that the funding environment can change dramatically and potentially for a prolonged period when economic circumstances change; that increased funding has a real financial cost, the more so when applied to a rising level of debt. Or should it be raised through taxation? Labour is formulating its election strategy; planning a splurge of green projects, Shadow Chancellor Rachel Reeves has flown kites before about not only increasing both borrowings and taxation rates to fund it but also extending the sources of taxation to include a direct tax on owned assets etc. President Macron of France with the same ambition but faced with the same funding dilemma, is also reported to be considering similar tax raid measures on France’s journey to net-zero (as if he did not have enough difficulty already raising the pension age from 62 to 64!).

If it is the private sector which does the heavy lifting, how should it be incentivised actively to take the lead? The attractions diminish with every additional level of central regulatory intervention. What form should incentives take? Should it be through tax breaks to encourage consistent capital expenditure commitments? This week’s announcement of the new electric vehicle battery giga plant to be developed by Tata on behalf of Jaguar Land Rover suggests the preferred route is through one-off subsidies: in this case energy discounts and helping meet the costs of decarbonising Tata’s other industrial installations, all tied to employment and emissions conditions in the UK (the total subsidy could be as much as £800m on this one plant alone). Are private sector companies and their equity and bond investors sufficiently prepared to underwrite long-term risks, or are they becoming conditioned only to undertake such projects if back-stopped by central government. Which ultimately means the taxpayer.

This journey is only beginning. Huge open-ended questions remain. Can all this be done in time? Can it be done at all? Where is the plan? What is the vision? Is it realistic? Who pays? Is it the greatest growth and investment opportunity in centuries? Or will it be ruinously expensive and we all sink under the weight of our own debt and expectations? Time will tell but in an intensely competitive world, the stakes are rising.

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.

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