Sterling trouble

The world remains in very unfamiliar economic territory. The central bank fight with inflation continues to escalate, with interest rates at most maturities across the world continuing to soar. This is an essential fight unfortunately, as we’ve pointed out many times before – it is vital that this inflationary episode is not allowed to turn into a saga. Turkey is the contemporary poster child for what happens when central bank policy is decided by populism – unplayable macro-economic conditions characterised by runaway inflation. Central bankers are not forced to face the electorate for a reason – this is necessarily unpopular work, often prioritising medium-term financial health over incoming.

For investors, these rising (real) interest rates have destroyed a very comfortable consensus of the last few decades. Many had become too assured of the idea that the ever lower real interest rates of the last few decades could be extrapolated deep into the future. The longer it went on, the more it became linked to other apparently inexorable forces. The value of certain types of cash flows, coupons, and investments soared as a result. It may be that we head back to that more comfortable world for investors. Growth stocks, gold, even certain crypto currencies may again prosper. Government bonds could return to providing both stock-like returns and a measure of shelter in the bad times (certainly yields are already looking a lot more attractive than they did at the beginning of this year). However, those holding out for a return to that reality should not hold their breath on the evidence of this week.

There may also be some more durable effects to think about too. If we assume that investment returns are a function of a complex web of incentives providing investors with a sliding scale of returns depending on their capacity to absorb risk, then our assessment of the inherent risk in some of these investments may change. We have been reminded that government bonds do not always provide insurance when the economic backdrop turns sour, and that gold can be an unreliable ally in inflationary times.[1] If the perceived risks are greater, and enough investors agree, then we may find the required compensation rises too.

This is all part of what diversification is about of course. Shelter has been found this year in areas that would have been considered highly unlikely investor allies only very recently (Figure 1).

What to do about the UK economy… A new team operates the levers of power with, in the eyes of some, a barrage of fresh ideas to jolt the UK economy out of its economic slumber. The timing is of course difficult, as suggested above. The economy needs to slow to bring inflationary pressures to heel – the latest data from the labour market, characterised by falling participation, rising wages amidst the lowest level of unemployment since the 1970s is illustrative. However, the slowdown the Bank of England continues to try and engineer does not mesh easily with a government motivated by public sentiment.

Tax policy is obviously a highly sensitive area. Strong views abound. Highly selective views of history, recent and distant, are marshalled by both sides to prove their points. From our perspective, we can point out that there is now decent evidence to show that there is no meaningful relationship between the level of taxes and growth.[2] The idea that the tax rate or indeed the size of the state in a particular economy should be definitive in the growth rate that ensues is likely reductive.

Growth, of which productivity is the dominant force, is driven by myriad forces. Innovation does not only come from the private sector. In fact, there is good evidence to show that the state has a vital role to play here, doing the often thankless (and highly risky) work of base innovation across a broader range of areas than the private sector would be able to tolerate. DARPA in the US is the oft-cited example of the role the state has here, allowing the private sector to kick down already open doors and profit.[3] The success of targeted industrial policies in Taiwan and Korea in the last half century has helped upend many previously held truths regarding productivity and development too.

This does not mean that all is lost for the UK. We are certainly at a perilous moment in our times. The poorest households remain under terrible strain, with the blows of the last few years having already fallen unequally. Brexit is not going to plan[4] and there is potential for more turbulence on this front yet if Article 16 is triggered. However, this remains a country with much envied institutions, several important areas of likely enduring comparative advantage,[5] a capital city that remains around the top of the top table globally and universities that will continue to attract high quality students from around the world if allowed. These are enviable strengths to build on for the future.

The productivity slump of this last period is certainly perplexing and there are surely no easy answers (otherwise it would have surely been solved already!). For the role of the state, it is likely not the size, but its role in the economy that matters. More technological breakthroughs are coming, the advances in Artificial Intelligence is just one of the areas that will see to that. The main message of the past here is that the state has to work hard to redistribute opportunity in such periods of change. Luck, or the lack of it, should play as small a role as possible in the lives of the citizens in your fold.?

[1] Antti Ilmanen (2022) Investing Amid Low Expected Returns – making the most when markets offer the least - Wiley

[2] William G Gale & Andrew Samwick (Sept 2014) – Effects of Income tax changes on economic growth – Brookings and NBER & https://www.lse.ac.uk/News/Latest-news-from-LSE/2020/L-December/Tax-cuts-for-the-rich

[3] Mariana Mazzucato (2013) – The entrepreneurial state – debunking public vs private sector myths – penguin

[4] https://cepr.org/voxeu/columns/trade-migration-and-brexit

[5] https://blogs.lse.ac.uk/businessreview/2022/09/02/sunak-truss-what-should-the-next-uk-prime-minister-do/

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