October 17, 2022: Andrew Hilton’s weekly rant

For almost 30 years, I ran the CSFI, which used to bill itself as the ‘City’s pre-eminent think-tank’ - which was fine and true, except that, when we started, we were the only game in town. Unfortunately, even a good idea has a finite life. Six months after I packed my bags, the CSFI is being folded into a better-funded body. If it reappears, it will, I am sure, be a rather different animal. That leaves me with two options: go quietly into the night, or rage against the dying of the light. I would prefer the latter – hence this newsletter, which is, in some sense, a throwback to the days when I ran a group of slightly sleazy economic and financial tip-sheets in New York that the Financial Times had bought in an early (and bizarre) bid to crack the US market.

I’ll try to cover what I see as the major economic, financial and geopolitical developments that affect all our lives. I don’t think I was ever accused of excessive politeness in my years at the CSFI; but let me see if I can turn the dial up a bit…

Where to start?

Well, let me begin by laying out my prejudices.

First, I am by nature a conservative – not exactly a horny-handed son of toil, but Northern, lower middle-class, grammar school/Oxford, aspirational. Which means that I am acutely (excessively?) aware of social issues, but don’t trust the Left to solve them. I want to find right-wing answers to left-wing problems. It also means I am deeply suspicious of all change.

Second, I am a bit deracinated. I am half-Polish; I have spent a fair chunk of my life in odd countries – mostly the US, but also Greece and Nigeria. But, at the same time, thanks to Northern roots (and buckets of cynicism about the English class system and the dominance of the Southeast), I was always mildly supportive of Brexit – even though it was pretty clear that there would be a hefty economic price to pay for poking one’s finger in the eye of the metropolitan elite. I will try to view the UK, not as the centre of the universe, but as a G7 country that punches well above its weight and is often the canary in the coalmine as far as new ways to screw things up are concerned. (That is extra-true today; Truss is a pathfinder for political incompetence.)

Third, although I am (I guess) an economist, I am an economist with a strong background in international relations, development and political science. (FWIW, my doctoral dissertation was on foreign investment in Nigeria.)  Dynamic stochastic equilibrium growth theory was never really my bag, and, while I am in awe of people who can read equations like music (and, indeed, of those who can read music), I am inclined to think that obsession with models just leads to tears.

That’s it.

So, what are the big economic issues of the day? And where do I stand on them?

Although there is a temptation to start with our little domestic brouhaha in the Westminster bubble, there is really no doubt about what the big international issues are  – though one can argue forever about what caused what, how they are related, and which can/should be addressed first. They are:

• The fact that we are almost all facing a global surge of inflation into double digits, the like of which we haven’t seen since the 1970s; and

• The real danger that, faced with inflation running at five times their target rate, central banks will tighten monetary policy so far and so fast that they will precipitate a global recession on the scale of the 1930s.

Behind these are two other issues – ‘meta’-issues, as Mr Zuckerberg might say.

The first is, obviously, the legacy of the Covid crisis. (I know it still lingers on in Xi Jinping’s quixotic pursuit of a ‘zero Covid’ strategy; but, for most of us, it is firmly ‘in the past’.)  Governments are now being blamed for pumping far too much liquidity into the system in an attempt to make sure the global economy didn’t actually grind to a halt. We, in the UK, were in the forefront, with the BoE’s QE strategy resulting in a bloated bond portfolio of £865 billion that hangs like a dead weight on the British economy – and that will have to be worked down before we can see sustained growth on any scale. Mutatis mutandis, other governments are in the same boat – and all are being subjected to pretty bitter attack by economists of all stripes.

The problem is that, at the time, almost all those same economists (including those at the FT who are now so critical) supported unlimited fiscal spending and monetary suppression on the grounds that the lesson from the Great Financial Crisis (only a decade before) was clear: Better Safe Than Sorry – spend, spend, spend, don’t bother about the inevitable skull-duggery, and worry about cleaning up the mess later. It is naughty of them now to discover their inner Mr Micawber, and to say that governments should have realised that the global economy didn’t really need support on the scale that was provided.

I should also add that economists ( I include myself) also supported the idea that, post-Covid, we should shift from a ‘Just-in-Time’ global economy to a ‘Just-in-Case’ economy – one in which we would forego the efficiencies of tight supply chains with very limited redundancy in favour of rebuilding stocks and reducing dependency on single suppliers. Even though that would inevitably mean higher costs, and therefore, higher inflation, we all thought it was a Good Thing – and we still do. Indeed, we Europeans now go round beating up on ourselves for not diversifying away from oligopsonistic dependence on Russian oil and gas.

Here, however, I want to offer a heretical thought.

When the Soviet Union fell, Washington neo-cons wanted to rub the Russkis’ noses in their own failure, by reducing them to the economic and political irrelevance of, say, Albania. Instead, sanity prevailed, and a consensus emerged that we in the West should do what we could to incorporate post-Communist Russia into the West, both politically and economically. That meant encouraging foreign investment, currency convertibility, foreign trade and free travel. It made sense. It also made sense to tie in Russia, as a major energy exporter, with Western Europe, as a major energy importer – and, indeed, for decades Russia was an exemplary supplier, far more reliable (for instance) than Holland, which closed the Groningen gas field on the say-so of a bunch of local eco-nuts.

I think that consensus was right. Sure, there was a risk that Russia might revert to rogue nation status. But that seemed unlikely, and was a price worth paying.

And then something happened. Something snapped – and, after 30 years of inching closer to the West, Russia did indeed revert. Why? Well, mostly (I guess) because we grossly misunderstood what drove Putin, and his almost mystical conception of Mother Russia. But also because we made mistakes. I well remember (because I was deeply involved with an annual Seminar in Athens that included some very senior figures from newly-democratic Russia), that, from the earliest days of Gorbachev and Yeltsin, there was a belief that Bush and Baker had explicitly promised that the US would not mess with Russia’s ‘near abroad’, that it would not park short range nuclear weapons anywhere near Russia’s border, and that it would not expand NATO to include the former Soviet Republics.

Instead, we messed – and that fed a paranoid streak in the Russian leadership that has led us to a situation in which, for the first time since 1945, we have seriously to consider that we may be about to see the use of nuclear weapons on the battlefield. 

That prospect doesn’t faze lots of armchair warriors. And others dismiss Putin’s threats as nothing more than bluster. Still others insist that Russia’s military commanders will never let him press the button. We will see. But I – like Henry Kissinger, like Pat Buchanan, like US academics of the ‘realist’ school – figure that a one percent chance of Armageddon (and I would say it is quite a bit more than that) is not a chance I really want to take. So, in the words of Kissinger, give Putin an off-ramp. Give him something that he can show to the Kremlin that enables him to present his ‘special operation’ in Ukraine as something less that the total, abject, overwhelming defeat that the resurgent neo-cons in Washington and London are insisting on.

Tough, maybe, for Zelenskiy – whose demands now appear to include the return of Crimea (which was never part of Ukraine until 1957). But he can be rewarded. I would hate to see NATO membership being dangled as a sweetener, but accelerated admission to the EU would be a real prize for every Ukrainian citizen – with far more immediate economic benefits.

And, I should add, there would be a bonus for the UK. If Ukraine were to be given an accelerated route to EU membership, the one thing that we could be pretty certain about is that it would block other potential members since the cost of absorbing Ukraine would be massive over a very long period. Only last week, for instance, Zelenskiy put the price of civilian reconstruction at US$57 billion – and counting. No chance, therefore, of an independent Scotland jumping the queue – something that even the most woolly-headed Nationalist would have to accept.

So, where does that leave us?

Well, I think the first thing to remember is that Russia is not the only game in town – and, if a range of gurus from the NYT’s Tom Friedman to NYU’s Nouriel Roubini (who has a new book on ‘megathreats’ out) are right, it is not even the most important. 

That accolade goes to China – where the Communist Party’s 20th Congress opened over the weekend. It is expected to rubber-stamp Xi’s almost godlike status by giving him an unprecedented third Presidential term, though he may not get things all his own way. After all, he is presiding over a very sharp economic slowdown, a dangerous rise in urban joblessness (with youth unemployment now estimated at around 16%), and a ‘zero-Covid’ strategy that even his closest associates must see is doing far more damage than it is worth. The key will probably be who gets Premier Li Keqiang’s job. Li (who is notionally in change of the economy) is stepping down, and there appear to be candidates to replace him from different Politburo factions.  It may be an opportunity to put a safety brake on the new President-for-Life.

Still, Xi’s opening speech was full of tough rhetoric on economic self-sufficiency (he is not an economist) and on ‘re-unifying’ the mainland with Taiwan. (Historically, Taiwan has actually only been part of China for less than a century.) Dangerous territory – particularly given last week’s highly protectionist trade bill in the US, which forbids US companies (as well as companies in South Korea and Taiwan that do business with the US) from providing Beijing with latest-generation silicon chip technology. Friedman regards this as a US ‘declaration of war’ on China’s tech sector, and it is bound to have major repercussions when the Chinese leadership refocuses from the Party Congress back to the economy.

What might those repercussions be? More pressure on Taiwan? Certainly. (Remember Quemoy and Matsu?) A step-up in ties with Russia through bodies like the Shanghai Cooperation Organisation? Probably There are lots of ways for Beijing to retaliate.

But that’s for later.

A brief digression on the UK…

I don’t know what one can say about the political omnishambles we have in the UK. It is my belief that Truss and Kwarteng could have got the bulk of their tax-cutting/pro-growth agenda through without upsetting either the markets or Martin Wolf,  if only they had not included the abolition of the top rate of income tax and the cap on bankers’ bonuses – both of which were (almost deliberately) inflammatory, while being pretty marginal in economic terms. Overall, Britain’s debt/GDP ratio is not particularly high - in particular it is much lower than the US (90% to 130%). And the markets were pretty much primed for the roll-back on both NI and corporation tax. Moreover, other countries (notably Germany) have spent even more than we are proposing on emergency energy price relief – and most of it unfunded. But the damage is done. As James Carville said, you can’t buck the bond market – and it spoke loud and clear.

Maybe it will again this week – though my guess is that an emollient Chancellor and a deeply chastened PM, who is willing to abandon any principle she might have had, should be enough to keep the vultures at bay. Particularly if she sacrifices the penny cut in income tax and makes a few marginal spending cuts. But how long will she stay – and who will replace her?

On the first, much depends on Graham Brady. My guess is that, at any stage, he will be able to produce enough letters and emails to the 1922 Committee from disaffected MPs to justify changing the rules and pushing Ms Truss down the oubliette of history without the say-so of the Tory Party membership. And I think he must be minded to do so – quickly. 

Who replaces her? Well, I note that the press seems still besotted with Sunak – perhaps in an uneasy partnership with the (allegedly very difficult) Penny Mordaunt. But that seems unlikely to me, given: (a) all the issues around Rishi’s money, wife and tax status; and (b) the fact that he was the principal reason BoJo got the chop. I also note the swelling support for Ben Wallace – but, really? A former Army Captain who I am sure is brave, but who has zero knowledge of economics and finance?  Which leaves Jeremy Hunt – who has the big advantage of being, effectively, the PM already (since he is pretty much unsackable). He is also plausible, well-connected (father an Admiral), rich-but-not-too-rich (£13 million from selling his educational training company), sufficiently pro-European to keep the FT happy, and deeply ambitious. Sure, junior doctors loathe him, but he doesn’t scare the horses. And (allegedly) he speaks Japanese. Oh, and he is pretty much non-ideological. True, he used to support a zero corporate tax rate, but as Henri IV used to say, ‘Paris is worth a mass’.

Of course, becoming the UK’s PM at this stage could be a fate worse than death. I am less apocalyptic than some about the British economy. (Never forget that the IMF’s MD is Bulgarian and its Chief Economist French – both quite convinced that Brexit was a disaster for Britain, and determined to prove it.) But Northern Ireland and Scotland are going to loom large, and are deeply intractable problems. Good luck.

But let me turn to the global economy.

Last week saw the Annual Meetings of the IMF and World Bank in Washington.

Unusually, the Bank was barely visible – even though the poorest countries are much worse affected by inflation (food, fuel and fertilizer - the three Fs) and recession. Perhaps the reason it kept such a low profile was that its President, David Malpass (a rather unimpressive Wall St economist who got lucky when Trump appointed him to one of the best jobs in the world) was facing a rebellion over his allegedly climate-sceptical views. Whatever the focus was on the Fund – and the three key reports that it published: its World Economic Outlook, its Global Financial Stability Report and its Global Fiscal Monitor.

Distilling the various messages is not easy. But, as far as growth is concerned, the Fund has left its forecast for the global economy this year unchanged from its Spring forecast at 3.2% - down from 6.0% last year. That is a pretty desperate drop. But next year looks even worse – just 2.7%, with US GDP slated to grow just 1.0%, the Eurozone 0.5% and the UK just 0.3%. That has got all the Brexit-bashers in the British press in a tizz – but it is worth noting that the Fund’s forecast for Germany next year is even lower,  -0.3%. We are by no means the worst in Europe.

However, if the Fund is to be believed, we will be the worst amongst the major economies next year (albeit not the worst in Europe, with Slovakia and Estonia both pipping us) as far as inflation is concerned.

This year, our average inflation rate is set to be 9.1%, compared with 8.1% for the US, 8.5% for Germany and 8.3% for the Eurozone as a whole. (Frankly, given different definitions and the usual margin for error, they are all much of a muchness – but journalists love to focus on small differences.) The problem comes next year, when the Fund assumes (rather heroically, IMO) that inflation drops dramatically in almost all countries – except in the UK, where it is projected to be stuck at 9.0%.

Well, I rather doubt it. The argument is that unfunded tax cuts will come home to roost. But, if so, it is not clear to me why the UK will do so much worse than Germany – where inflation is set to be 7.2%.  And we could come in lower if (as everyone expects) Truss’s tax cuts are now little more than an airy-fairly aspiration.

In any case, the UK was not the only (or even the main) issue on the Fund’s agenda last week. It was also deeply concerned about:

• ‘liquidity issues’ – particularly what it sees as a serious deterioration in the ease and speed with which assets can be traded at a given price;

• A ‘faltering’ property sector, which could easily morph into a banking crisis;

• The continuing volatility of commodity markets; and

• A pretty hefty increase in US Federal, state and local government debt, which is only sustainable as long as international funds continue to flow into the US in search of a ‘safe harbour’.

All of that, taken together, means there is at least a fair chance that inflationary expectations will become ‘unanchored’ – which is what all we economists are really worried about.

And then, of course, there is the market – or rather the markets, since bond, equity and FX markets don’t exactly move in lockstep.

Take equities first… 

Last week saw intraday swings in (primarily but not exclusively) US equity prices that were described by Bloomberg as ‘for the ages’ and by the WSJ as ‘head-spinning’. One day, for instance, saw the Dow off over 500 points at one stage, only to close up almost 830 points. Week-on-week, the numbers don’t look that impressive. The Dow  was up 1.2%, the S&P500 was down 1.6% and the tech-heavy Nasdaq was off 3.1%. In Europe, the Dax was up 1.3%, but our own FTSE100 was down 1.9%.  Still, year-to-date, we are either in or very close to bear market territory – and chartists I know are still looking for another 20% drop.

Bond markets have also been bit hard. 

Last week, for instance, the yield on the US Treasury’s 10-year benchmark began at 3.89% and closed on Friday at 4.02%. Although it has eased to 3.95% in early trade today, that is still up from 1.60% at the beginning of the year. As for Europe, the 10-year Germany bund yield ended last week at 2.35%, and is now around 2.30% - up from effectively zero at the beginning of the year. Fortunately (at least for Truss and Hunt), initial signs are that the UK gilt market is recovering. Last week, the yield on the 10-year gilt rose from 4.20% to above 4.5%, before easing to 3.98%. At that point, buyer’s remorse seems to have set in and yields backed up again. By the close on Friday, the 10-year yield was 4.39%. However, Hunt’s charms and an apparent meeting of minds with Andrew Bailey seem to have done the trick – at least for now. In mid-day trade, today the yield has fallen back to 4.04% - which, it is worth noting, is still 300 bp more than it was at the beginning of the year. (And, of course, there is no guarantee that, in this febrile atmosphere, yields will stay down.)

As for FX markets, there is a narrative in the UK media that focuses almost entirely on sterling – ignoring the fact that what we face is not a sterling crisis as much as a dollar crisis. 

Even after a sterling sell-off last week, that saw the pound fall 1.1% against the dollar, to close on Friday at US$1.121/£, it has not fared much worse than the euro – and it has done significantly better this year than the Japanese yen. Year-to-date, sterling is down 17.1% against the dollar, the euro is down 14.3% and the yen is off 29%. On a trade-weighted basis, the dollar is up 17.8%. President Biden may view this as a sign of strength (and it certainly helps keep the cost of imported goods down, which is important ahead of the November 8 mid-terms), but it is likely to be devastating longer-term for US competitiveness.

That prompts a word on the US mid-terms…

Up until very recently, the received wisdom was that the Democrats would lose control of both Houses of Congress to the Republicans. After all, the Senate is effectively tied, and their majority in the House (where every seat is up for grabs) is tiny. With gasoline prices close to US$4/US gallon and inflation close to double digits, the Democrats ought not to have had a chance – even though the US labour market is very tight. However, they had (and have) two big things going for them which make the outcome a toss-up (and, IMO, make it more likely than less that the Democrats will hang on to both Houses:

• First is Trump. The Democrats have kept him, his family and his legal troubles front-and-centre – and the Donald has obliged them by  reinforcing every clumsy stereotype about himself. The point is (and it applies in spades to the 2024 Presidential election)  that, for every Republican who thinks Trump walks on water, there is another Republican who hates him almost as much as the Democrats do. So, while Trump-supported candidates may clean up in primaries (where you have to be registered to vote, where MAGA Republicans have a solid edge), they simply cannot win at a general election. The arithmetic is absolute.

• Second is the Supreme Court – or specifically, the Court’s action in striking down Roe vs Wade. Personally, I think there is a lot to be said for giving socially divisive issues like abortion back to the states, but – thanks to the stupidity of the GOP leadership – this isn’t being looked at as a states’ rights issue, as much as an attack by (old white) men on women. And Sen McConnell’s talk about a Federal ban on abortion just compounds the Republicans’ reputation as ‘the stupid Party’. How dumb can you get?

So, as of now, I would say the Democrats will hang on to both Houses – though I concede that the latest polls probably still give the GOP an edge in the House of Representatives.

What of recent economic releases?

In the US, there were two important economic releases last week:

• The FOMC minutes for September,  which suggested that Committee members are most afraid of doing ‘too little too late’ on inflation – and, hence, are prepared to push the Fed funds rate  up to at least 4 ½%, even at the risk of provoking a recession; and

• The September inflation data, which came in substantially worse than expected, with headline inflation easing less than expected, to 8.2%, and ‘core’ inflation unexpectedly rising from 6.3% to a 40-year high of 6.6%.

The combination undoubtedly spooked the markets since it has effectively ruled out any chance of a Fed ‘pivot’ on interest rates.

Given that other US economic releases last week (the NFIB and TIPP optimism indices, first-time jobless claims etc) were generally disappointing, that does tend to reinforce a fairly pervasive economic gloom.

As for Europe, however, there was a bit of good news in that industrial production was up 1.5% in August. However, as in the US, inflation data can bring an optimist down to earth quite quickly. In Germany, for instance, the harmonised CPI for September really hurt – jumping from 8.8% to 10.9% (why does no one at the FT focus on that?) , with the wholesale price index also jumping from 19.8% to 19.9%. It is a mixed bag in the Eurozone (France, for instance, is doing better), but Germany is a real problem.

Turning to the UK economy, data released last week was also mixed.

On the positive side, the BRC retail sales monitor came in substantially better than expected last month, while the unemployment rate fell from an already near-record low 3.6% to just 3.5%, with average earnings rising from 5.5% year-on-year to 6.0%. On the other hand, however, the trade deficit worsened appreciably, from £5.4 billion in July to £7.1 billion in August – and that has got a lot of economists with long memories worrying about a BoP crisis. And both industrial production and manufacturing took a hit in August.

Plus, and this is probably more important, overall UK GDP  (which we, almost alone, calculate on a monthly basis) turned down, falling 0.3% in August, after a rise of 0.1% in July – leaving it up just 2% for the year. That doesn’t bode well for the next few months.

What else?  Well, I think it is worth flagging the row that has erupted in Washington (at both ends of Pennsylvania Ave, rather than at the Bank or Fund) over the decision by OPEC+ to cut oil production by 2 million b/d. 

Never mind that (because several member states were not producing anywhere near their quota) the effective fall in output will be no more than 600,000 b/d. Never mind, either, that the international oil price continues to fall, with front-month WTI down 8.2% last week (to US$85.55/barrel) and Brent down 7.1% (to US$91.44)  This is a chance for long-time Saudi-haters in both Houses of Congress to try to push through restrictions on arms sales, threats to withdraw US troops from the Gulf and all sorts of measures that terrify both the White House and Foggy Bottom. Of most concern perhaps, is the so-called NOPEC Bill, which would permit the US Justice Department to file anti-trust charges against OPEC – and, more broadly, against all state-owned oil companies. It won’t pass (partly because it is fiercely opposed by the US arms industry, for whom Saudi Arabia is the No1 export market), but it is sure as eggs-is-eggs going to make an improvement in relations between Biden’s Washington and MbS’s Riyadh harder to achieve.

Meanwhile, in one of those ironies of contemporary politics, Biden is considering easing sanctions on Maduro’s Venezuela so as to allow Chevron (the only US major in the country) to restart oil exports. Better that, the White House apparently feels, than doing anything to boost domestic oil production.

As for this week...

The focus ought to be on China. In addition to the Party Congress, there is a full slate of economic releases including third quarter GDP and fixed asset investment. Elsewhere, we, Japan and several EU member states are due to release inflation data, and, in the US, markets are likely to focus on the Fed’s Beige Book survey of regional business conditions and on the Philadelphia Fed’s October survey. 

Elsewhere, watch out for the October ZEW business survey in Germany. It could be nasty.

If you got this far, thanks for bearing with me. I’ll try to put out a second edition next week – but a lot shorter, and focusing more on the data. That is, of course, unless politics (domestic or geo) take over – as I fear they might.

Andrew Hilton

Andrew@economic-evaluation.com