I have been meaning to write this blog for the last few weeks, however, I’ve been caught with sick kids and a very busy office! It is fortunate however, that I haven’t got to it, as a lot has happened in the last few weeks!
The financial world is turbulent at the moment with rate hikes globally, an energy war in Europe, the near collapse of the pension funds in the UK, collapse of the pound, record levels of inflation, exceptional volatility in the stock markets, continued collapse of crypto currencies, house price instability and exceptional strength of the US dollar. Overlay on top of this the death of a Monarch, local elections, political instability in the US and the threat of nuclear war, it is pretty tough to figure out what to do! I try my best below to sift through some of the above and figure out what it all might mean for NZ.
The state of inflation
Firstly, I thought I would address inflation and the cost of debt (rate hikes). As I have written about plenty before, the most traditional tool to combat inflation is the raising of interest rates. The school of thought is that as debt becomes more expensive, people are encouraged to save and slow expenditure. The important thing, however, is that the cost of debt has to be in excess of the rate of inflation. If inflation is higher than the cost of debt, theory suggests that people will continue to spend and prices will continue to lift as money is losing value quicker than goods.
The problem with this, is that inflation is currently running hot globally and whilst we have seen significant hikes in rates, we are not yet close to inflation figures. NZ’s most recent inflation figure was 7.30%, the US had it at 8.30%, Australia at 6.1%, UK at 9.9% (and forecast to chase down 20%!!), Italy at 8.90%, Germany at 10% and Canada at 7%. This isn’t to mention the likes of Argentina (78.5%) or Turkey (83.45%).
If we follow theory and lift the cost of funds above the rate of inflation the OCR should theoretically climb another ~4.5% (it is currently 3%). Paul Volcker is perhaps the most famous combatant of inflation in charge of the Fed from ‘79 – ’87, he had to lift interest rates a full 700 basis points (7%) above the rate of inflation to kill it! That would imply rates of >10% in NZ not to mention what it would mean globally.
The impact of rising rates
Whether we get there or not, I am not so sure, that kind of lift on rates would be catastrophic on a number of levels. We have already seen that the RBNZ is losing ~$150M+ per month (which taxpayers are covering) at the current levels of rates. This isn’t to mention the hardship on mortgagors and businesses in NZ as people would need to seriously tighten their belts (or worse) to get through.
Offshore, the US government has USD$31 Trillion of debt (publicly declared), their ability to cope with serious hikes in the Fed rate are even slimmer than ours. Approximately 30% of the US public debt rolls over in the next 12 months, which means it will be moving from the initial rates (near 0%) to >3% being a significant drag on tax revenues.
Private and corporate debt adds another ~$60 trillion to this figure. This isn’t a problem unique to NZ and the US, however, with most western nations holding significant levels of debt. Lifts in the interest expense of such a magnitude of the above could be seriously impactful on the economic security of most western nations.
Despite this and the recent hikes, however, there is still a reasonable perceived amount of economic security. NZ’s most recent released GDP figures put paid to the idea of there currently being a recession. The US wasn’t so lucky with two consecutive quarters of negative growth (the general definition of a recession), however, they have publicly declared they are not in a recession. On top of this, employment remains strong and default rates don’t seem to have spiked. This is giving confidence to the RBNZ and Fed (and others) to continue to lift rates and take the battle to inflation. Recent forecasts now see the OCR climbing above 4.5%.
The US Dollar
The strength of the US dollar is also driving the need for rate hikes globally. This is a very interesting market to follow at the moment, not least for the reasons I mentioned above (US debt etc.). For a long period of time, the USD has been seen as a safe harbour for investment and that has been very apparent recently with the turmoil in Europe and the UK.
As the economic hardship has taken grip and Powell has made commitments to lifting the Fed rate, demand has spiked for the USD with it at it’s strongest in a long time. To encourage investment and demand in other currencies, their central banks have taken to following the US and lifting interest rates (capital typically flows to where it can achieve the best risk free return). Because of this, other Reserve Banks are almost forced into following the Fed in a bid to prop up their currencies and prevent the importation of inflation (falling currency value increasing the cost of goods).
This is important to consider as right now it could be considered that the Fed is really holding the key to interest rates. Inflation will be a determining figure, however, it is unlikely any Reserve Bank will pivot without the support of the Fed doing so themselves. Anyone except perhaps the UK.
The fall of the Pound
The UK recently announced tax cuts (albeit reversed as at today) which caused real turmoil in their markets. Globally this was seen as an inflationary act and caused a real run on the Pound. The fall in the pound resulted in a corresponding collapse in their treasury prices forcing many pension funds in the UK to liquidate their treasuries.
This began a vicious circle with the UK Exchequer needing to step in as a buyer for the pension funds in fear of their collapse. For context, UK pension funds account for approx. 40% of the UK institutional asset management market i.e. a collapse in the pension funds would be catastrophic for the nation. This precipitated a massive collapse in the UK pound with it falling to it’s lowest levels in recorded history.
This was a brief reminder of the tightrope that governments are currently walking, and why most reserve banks will be hesitant to move against the Fed.
The energy war in Europe
The last piece to the puzzle, globally at the least, is the Ukranian war and subsequent energy war that Russia is waging with Western Europe. As has been reported, Russia is cutting off access to hydrocarbons to the West in an effort to ease their sanctions on Russia and turn a tide in the war. This has seen energy prices lift > 8x their 10 year average, and governments looking to respond with subsidies and incentives to reduce energy consumption.
Stories of no hot water in a German winter and business closures have caused real global concern amongst economists and citizens. Whilst the direct effect of this will be felt by European nations, the corresponding inflationary effect and reduction of supply and wealth will have global impacts. Similar to the recent battle over reliance on microchips in Taiwan, there are items produced in Europe which will either climb significantly in cost or fall in production causing corresponding supply shortages and inflationary pressures.
Arcelor Mittal, Europes largest steel maker, is idling blast furnaces in Germany. Alcoa, the global aluminium producer, is cutting a third of production at its smelter in Norway. In the Netherlands, Nyrstar, the world’s largest zinc producer is pausing output until further notice. Perhaps the most concerning could be Hakle, one of the largest manufacturers of toilet paper in Germany, has tipped into insolvency due to the energy costs.
So what does all the above mean?
Our thoughts at Lateral Partners remain similar. Inflation is going to persist to be a global issue for the foreseeable future. Whilst the reserve banks are tentatively pursuing it at the moment, global economic pressures will begin to tell and we expect there to be a pivot from these institutions in the near / medium term future. Originally, we had expected that this year, however with recent economic data remaining as buoyant as it has, we now think it will be early in the new year before we see the moves.
The pivots will be buoyant for asset prices and borrowers, releasing some of the pressure on borrowing costs and thus providing a boon for asset prices. It will, however, not resolve the inflationary issues and we could see some spikes on inflation next year.
A recession may slow the increase in inflation, however, the global pressures on energy, currencies and negative real rates will continue to provide a platform for it to remain high. Until we see true unemployment, and only if we see a meaningful lift in interest rates will inflation fall significantly, but we don’t expect that in the near future.
Brace for inflation, ride out the hurt on rates and be prepared for some more rough and tumble in the next 6 months.
As always, if you are looking for some advice don't hesitate to reach out.
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