There's a storm coming
Finding refuge won't be easy.
It has been one of those “interesting” days, as the Bank of England raises interest rates and Meta Platforms (Facebook, to you and me) looks set to lose more market capitalisation in one trading session than any company in history.
After two years during which Western nations crippled their economies with unprecedented lockdown measures, and after 15 years of extreme monetary policies, the inflationary chickens are coming home to roost.
I’ve been expecting this for a long time - though as the saying goes, there is no difference between being early and being wrong.
For a while now, my position in gold-related derivatives has been larger than any of my positions in individual companies.
The gold price has been steady, but the hands at the Bank of England are not.
What’s most astonishing about the decision announced today is that four of the committee members wanted to increase rates by 50 basis points in one fell swoop.
At its meeting ending on 2 February 2022, the MPC voted by a majority of 5-4 to increase Bank Rate by 0.25 percentage points, to 0.5%. Those members in the minority preferred to increase Bank Rate by 0.5 percentage points, to 0.75%.
Here’s a reminder of what this rate has done since 2007:
As you can see, savers enjoyed only the mildest relief from 2018 until the arrival of Covid-19, when rates sat at 0.75%. That is the rate we should return to very soon.
Has stagflation finally arrived? This is what the BoE thinks (I’ve added the bold):
Beyond the near term, UK GDP growth is expected to slow to subdued rates. The main reason for that is the adverse impact of higher global energy and tradable goods prices on UK real aggregate income and spending. As a result, the unemployment rate is expected to rise to 5%…
Inflation is expected to increase further in coming months, to close to 6% in February and March, before peaking at around 7¼% in April. This projected peak is around 2 percentage points higher than expected in the November Report. The projected overshoot of inflation relative to the 2% target mainly reflects global energy and tradable goods prices.
Seems pretty clear to me! The above paragraphs could almost be used as a definition of stagflation.
Like trying to put ketchup back in its bottle, the BoE suggests that inflation will return to “a little above the 2% target” in just two years. But how could they know this?
They suggest CPI will fall “as global energy prices are assumed to remain constant after six months, and as global bottlenecks ease and tradable goods prices fall back a little”. Again, how can they know this?
Let’s remind ourselves of the trajectory of the UK’s M2 money supply:
All of this having been said, it would be unfair to suggest that the UK is going to suffer worse than most of Europe and North America.
Indeed, the ECB’s interest rate and money supply policies are far more extreme.
The ECB’s M2 money supply:
You may disagree with me when it comes to the inflationary scenarios implied by these statistics.
But even if you disagree with me, I think it’s wise to have a mindset that is ready for the scenario that I envisage.
If UK inflation is already going to hit 7% officially (an important distinction), then is it really so hard to imagine it hitting 10%?
In a US context, inflation has also hit 7%, according to the official numbers, the highest since 1982.
Is it so outlandish to think that real inflation - absent any tinkering by government statisticians - is already in double digits?
Are predictions of 15% inflation to be scorned, or taken seriously?
Equity markets face a reckoning
At this stage, I’m blue in the face from talking about the longest bull market in financial history.
But shares in Meta Platforms (FB) are down by 26% in after-hours trading.
That alone is going to soften the cough of many perma-bulls.
It’s a one-day drop of over $200 billion in market cap, in a single stock.
And remember: this is a company whose conventional financial metrics did not even look so expensive! Before the drop, it had a P/E multiple of ~23x.
In a world of zero interest rates, an earnings yield of around 4% (or a P/E multiple in the range of 25x) is perfectly attractive.
Unfortunately, many investors may be about to find out that zero interest rates were a mirage.
It was a false utopia, where interest rates and inflation could both be held near zero indefinitely. Where bond yields only went in one direction, and stock prices always went up and to the right.
But the inflation genie is out now. Western central banks are facing the Hobson’s Choice that is so often faced by their counterparts in the developing world: to raise rates and risk crashing the prices of many assets, or to do nothing and to let inflation cause uncontrolled chaos.
It’s not a real choice, in my view. In the end, interest rates will rise and asset prices will reflect reality.
When that happens, it will be critical for investors to own those companies which generate real, lasting value for shareholders.
The bubble stocks, while fun to hold during the boom, will then be seen as the financial equivalent of nuclear waste.
I’m looking forward to travelling this journey with you!