Stocks are rallying on hopes that Jerome Powell and the Fed will stop increasing interest rates this fall, pivot, and start reducing them next year. For fear of missing out on the next great bull run, many investors are blindly buying into this new Powell pivot narrative.
What these investors fail to realize is the Fed has a problem. Inflation is raging, the likes of which the Fed hasn’t dealt with since Jerome Powell earned his law degree from Georgetown University in 1979.
Despite inflation, markets seem to assume that today’s Fed has the same mindset as the 1990-2021 Fed. The old Fed would have stopped raising rates when stocks fell 20% and certainly on the second consecutive negative GDP print. The current Fed seems to want to keep raising rates and reducing its balance sheet (QT).
The market-friendly Fed we grew accustomed to over the last few decades may not be driving the ship anymore. Yesterday’s investment strategies may prove flawed if a new inflation-minded Fed is at the wheel.
Of course, you can ignore the realities of today’s high inflation and take Jim Cramer’s ever-bullish advice.
When the Fed gets out of the way, you have a real window and you’ve got to jump through it. … When a recession comes, the Fed has the good sense to stop raising rates,” the “Mad Money” host said. “And that pause means you’ve got to buy stocks.
Shifting Market Expectations
On June 10, 2022, the Fed Funds Futures markets implied the Fed would raise the Fed Funds rate to 3.20% in January 2023 and to 3.65% by July 2023. Such suggests the Fed would raise rates by almost 50bps between January and July.
Now the market implies Fed Funds will be 3.59% in January, up .40% in the last two months. However, the market implies July Fed Funds will be 3.52%, or .13% less than its January expectations. The market is pricing in a rate reduction between January and July.
The graph below highlights the recent shift in market expectations over the last two months.
The graph below from the Daily Shot shows compares the market’s implied expectations for Fed Funds (black) versus the Fed’s expectations. Each blue dot represents where each Fed member thinks Fed Funds will be at each year-end. The market underestimates the Fed’s resolve to increase interest rates by about 1%.
Short Term Inflation Projections
The biggest flaw with pricing in predicting a stall and Powell pivot in the near term is the possible trajectory of inflation. The graph below shows annual CPI rates based on three conservative monthly inflation data assumptions.
If monthly inflation is zero for the remainder of 2022, which is highly unlikely, CPI will only fall to 5.43%. Yes, that is much better than today’s 9.1%, but it is still well above the Fed’s 2.0% target. The other more likely scenarios are too high to allow the Fed to halt its fight against inflation.
Inflation on its own, even in a rosy scenario, is not likely to get Powell to pivot. However, economic weakness, deteriorating labor markets, or financial instability could change his mind.
Recession, Labor, and Financial Instability
GDP just printed two negative quarters in a row. Some economists call that a recession. The NBER, the official determiner of recessions, also considers the health of the labor markets in their recession decision-making.
The graph below shows the unemployment rate (blue), recessions (gray), and the number of months the unemployment rate troughed (red) before each recession. Since 1950 there have been eleven recessions. On average, the unemployment rate bottoms 2.5 months before an official recession declaration by the NBER. In seven of the eleven instances, the unemployment rate started rising one or two months before a recession.
The unemployment rate may start ticking up shortly, but consider it is presently at a historically low level. At 3.5%, it is well below the 6.2% average of the last 50 years. Of the 630 monthly jobs reports since 1970, there are only three other instances where the unemployment rate dipped to 3.5%. There are zero instances since 1970 below 3.5%!
Despite some recent signs of weakness, the labor market is historically tight. For example, job openings slipped from 11.85 million in March to 10.70 in June. However, as we show below, it remains well above historical norms.
A tight labor market that can lead to higher inflation via a price-wage spiral is of concern for the Fed. Such fear gives the Fed ample reason to keep tightening rates even if the labor markets weaken. For more on price-wage spirals, please read our article Persistent Inflation Scares the Fed.
Besides economic deterioration or labor market troubles, financial instability might cause Jerome Powell to pivot. While there were some growing signs of financial instability in the spring, those warnings have dissipated.
For example, the Fed pays close attention to the yield spread between corporate bonds and Treasury bonds (OAS) for signs of instability. They pay particular attention to yield spreads of junk-rated corporate debt as they are more volatile than investment-grade paper and often are the first assets to show signs of problems.
The graph below plots the daily intersections of investment grade (BBB) OAS and junk (BB) OAS since 1996. As shown, the OAS on junk-rated debt is almost 3% below what should be expected based on the robust correlation between the two yield spreads. Corporate debt markets are showing no signs of instability!
Stocks, on the other hand, are lower this year. The S&P 500 is down about 15% year to date. However, it is still up about 25% since the pandemic started. More importantly, valuations have fallen but are still well above historical averages. So, while stock prices are down, there are few signs of equity market instability. In fact, the recent rally is starting to elicit FOMO behaviors so often seen in speculative bullish runs.
Declining yields, tightening yield spreads, and rising asset prices are inflationary. If anything, recent market stability gives the Fed a reason to keep raising rates. Ex-New York Fed President Bill Dudley recently commented that market speculation about a Fed pivot is overdone and counterproductive to the Fed’s efforts to bring down inflation.
What Does the Fed Think?
The following quotes and headlines have all come out since the late July 2022 Fed meeting. They all point to a Fed with no intent to stall or pivot despite its effect on jobs and the economy.
- *KASHKARI: 2023 RATE CUTS SEEM LIKE `VERY UNLIKELY SCENARIO’
- Fed’s Kashkari: concerning inflation is spreading; we need to act with urgency
- *BOWMAN: SEES RISK FOMC ACTIONS TO SLOW JOB GAINS, EVEN CUT JOBS
- *DALY: MARKETS ARE AHEAD OF THEMSELVES ON FED CUTTING RATES
- St. Louis Fed President James Bullard says he favors a strategy of “front-loading” big interest-rate hikes, repeating that he wants to end the year at 3.75% to 4% – Bloomberg
- FED’S BULLARD: TO GET INFLATION COMING DOWN IN A CONVINCING WAY, WE’LL HAVE TO BE HIGHER FOR LONGER.
- “If you have to cut off the tail of a dog, don’t do it one inch at a time.”- Fed President Bullard
- “There is a path to getting inflation under control,” Barkin said, “but a recession could happen in the process” – MarketWatch
- The Fed is “nowhere near” being done in its fight against inflation, said Mary Daly, the San Francisco Federal Reserve Bank president, in a CNBC interview Tuesday. –MarketWatch
- “We think it’s necessary to have growth slow down,” Powell said last week. “We actually think we need a period of growth below potential, to create some slack so that the supply side can catch up. We also think that there will be, in all likelihood, some softening in labor market conditions. And those are things that we expect…to get inflation back down on the path to 2 percent.”
We are highly doubtful that Powell will pivot anytime soon. Supporting our view is the recent action of the Bank of England. On August 4th they raised interest rates by 50bps despite forecasting a recession starting this year and lasting through 2023. Central bankers understand this inflation outbreak is unique and are caught off guard by its persistence.
The economy and markets may test their resolve, but the threat of a long-lasting price-wage spiral will keep the Fed and other banks from taking their foot off the brakes too soon.
We close by reminding you that inflation will start falling in the months ahead, but it hasn’t even officially peaked yet.recession unemployment pandemic treasury bonds bonds corporate bonds sp 500 stocks fomc fed federal reserve spread recession gdp interest rates unemployment
Three Infrastructure Investments to Buy as War and Inflation Rage
Three infrastructure investments to buy as war and inflation rage offer ways to overcome ongoing economic risks in pursuit of precious profits. The three…
Three infrastructure investments to buy as war and inflation rage offer ways to overcome ongoing economic risks in pursuit of precious profits.
The three infrastructure investments to buy as war rains terror and destruction, inflation rampages and the Fed raises rates feature companies that appear well-positioned to succeed amid market mayhem. Stocks have advanced in the past couple of trading days, but the economic and geopolitical risks still leave many prognosticators warning that a new 2022 market bottom may yet lie ahead.
One of the three infrastructure investments to buy showcases a company whose unmanned drones have proven their value in Ukraine as the nation’s outnumbered defenders recently have begun to push back a Russian invasion of more than 120,000 troops that began Feb. 26. Another company on the list of three infrastructure investments to buy includes a producer of solar panels that could help alleviate a war-related energy shortfall in Europe due to Russia cutting its supply of gas to nations opposing its attack of Ukraine.
Three Infrastructure Investments to Buy Look to Evade Financial Fallout
“Stocks have been beset with no shortage of problems in recent weeks,” wrote Mark Skousen, PhD, to subscribers of his weekly Home Run Trader advisory service. “The primary negative, of course, is that the Federal Reserve is determined to slow the economy, reduce demand, and thereby bring down inflation.”
Mark Skousen, Forecasts & Strategies chief and Ben Franklin scion, meets Paul Dykewicz.
However, too much tightening, too fast, risks pushing the United States into a recession, continued Skousen, an economist who uses his analysis of inflation, interest rates and monetary policy in recommending stocks and options to buy. Economic statistics are showing a slowdown in the economy, if not a recession, he added.
“Even though real gross domestic product (GDP) is slightly negative, second-quarter gross output (GO) — which measures total spending in the economy — grew by 1.7% in real terms,” Skousen stated. “GO includes the supply chain, which is still catching up from the lockdown-induced shortages.”
Three Infrastructure Investments to Buy Face ‘Super-Strong’ Dollar
Additional concerns include a “super-strong dollar,” sliding consumer confidence and a cooling residential real estate market, Skousen counseled.
Investors can consider an exchange-traded fund that offers broad exposure to companies providing automation infrastructure, said Bob Carlson, a pension fund manager who also leads the Retirement Watch investment newsletter.
Bob Carlson, investment guru of Retirement Watch, talks to Paul Dykewicz.
Carlson suggested Robo Global Robotics and Automation (ROBO), a fund that seeks to follow an index that is concentrated in robotics-related or automation-oriented companies. The fund had decent performance until 2022 when it plunged. The fund became caught in the downdraft that befell technology and industrial companies.
Both sectors have done poorly as interest rates rose in 2022, Carlson commented. The fund is down nearly 40% in 2022, while its three-year return is just shy of an annualized 6%.
The fund owns 81 stocks and has 17% of the fund in the 10 largest positions. ROBO’s top holdings recently consisted of Cognex (NASDAQ: CGNX), Intuitive Surgical (NASDAQ: ISRG) and IPG Photonics (NASDAQ: IPGP).
Chart courtesy of www.stockcharts.com
Three Infrastructure Investments to Buy Buoyed by Unmanned Drone Stock
“Additive manufacturing technologies are at an inflection point in their ability to solve challenges faced by manufacturing companies, particularly with recent labor shortages and supply chain disruptions,” according to Chicago-based investment firm William Blair & Co. “Historically, additive manufacturing applications have been limited by productivity capabilities and lack of industrial strength materials.”
Executives of AeroVironment, Inc., (NASDAQ: AVAV), an Arlington, Virginia-based maker of unmanned drones and other multi-domain robotic systems, recently gave a presentation to William Blair analysts about how software from its Plank and Progeny acquisitions provided a key competitive advantage. Indeed, the success of AeroVironment’s “kamikaze drones” in Ukraine may extend into Asia.
AeroVironment officials compared the Ukraine War-related Switchblade media coverage to “100 SuperBowl ads worth of press.” Before the war, AeroVironment was not even authorized to export the Switchblade.
“It was used in the Middle East for over a decade, but it was viewed as a niche offering,” William Blair analysts wrote. “Ukraine is providing a testing ground that proves the Switchblade 300 is incredibly valuable. Now it has U.S. State Department permission to sell to more than 20 countries. In mid-September, it was reported that Japan is evaluating purchasing several hundred kamikaze drones and is evaluating AeroVironment’s Switchblade.”
A recent Switchblade 600 contract for Ukraine valued at $2.2 million may be a tipping point. On Sept. 15, almost six months after an initial report that a contract was in the works, it came to fruition.
While Javelin, Stinger and TOW traditional missile systems have a three-mile maximum range, the Switchblade 600 has a 20-mile top range with similar effects. The Switchblade 600 has the same size warhead and can be launched without a visual lock on the target, William Blair analysts wrote in a recent research note.
AeroVironment Stands out Among Three Infrastructure Investments to Buy
William Blair rated AeroVironment to “outperform” the market and indicated it appears to be the favorite to win the Army $1 billion/10-year FTUAS program, but an executive at the robotics company estimated that the U.S. Navy addressable market may be larger than the potential market for the Army. Software from Planck, acquired by AeroVironment, enables the JUMP-20 military battlefield drone to perform vision-based autonomous landings onto moving platforms, such as maritime vessels.
The JUMP-20 is a vertical takeoff and landing (VTOL), fixed-wing unmanned aircraft used to provide advanced multi-sensor intelligence, surveillance and reconnaissance (ISR) services. AeroVironment’s systems “flourished” during Navy IMX 2022 exercises earlier this year, according to William Blair.
Regarded as the largest unmanned exercises in the world, IMX 2022 showed how AeroVironment’s LEAP software received feeds from manned aircraft, unmanned aircraft, manned vessels and unmanned vessels. At IMX 2022, AeroVironment’s LEAP software was not supposed to be the hub, but when other software “was not executing.” AeroVironment’s LEAP software assumed the hub role on an ad hoc basis.
“We expect AeroVironment’s success at IMX 2022 to lead to contracts for its JUMP-20, Puma and Switchblade aircraft down the road,” the William Blair analysts wrote.
Chart courtesy of www.stockcharts.com
Three Infrastructure Investments to Buy Include Standex International
Standex International Corporation (NYSE: SXI), a multinational manufacturer of food service equipment, engravings, engineering technologies, electronics and hydraulics headquartered in Salem, New Hampshire, has many growth paths ahead of it. Rated by William Blair to “outperform” the market, Standex International could materially accelerate organic growth to 10% or more during the next two to three years, excluding its commercial solar panel production volumes for an innovative Gr3n joint venture with Italy’s Enel (OTCMKTS: ENLAY).
That partnership with a multinational manufacturer and distributor of electricity and gas has gained importance due to the suspected sabotage of both under water pipelines of the Nord Stream 1 from Russia to Western Europe, along with one line of Nord Stream 2. Seismologists in Denmark and Sweden suggest that sizeable explosions on the order of 100 kilograms of TNT occurred in both incidents.
With Russia’s President Vladimir Putin facing unexpected battlefield setbacks more than six months after he ordered a Feb. 26 invasion of neighboring Ukraine that the former KGB agent euphemistically called a “special military operation,” the pipeline sabotage seems targeted to hurt European nations as winter nears. Since Putin ordered troops into Ukraine in February, Russia has cut supplies of natural gas to Europe to heat homes, generate electricity and fuel factories.
European Leaders Complain of ‘Energy Blackmail’ by Putin
European leaders have accused Putin of using “energy blackmail” to weaken their support for Ukraine as the country seeks to repel Russia’s aggression.
Without presenting any evidence, Russian officials are attempting to blame the United States for the apparent sabotage, even though the affected nations are among America’s closest allies. President Biden countered the accusations were the latest in a continuing Russian campaign of “disinformation and lies.”
Biden also described the explosions of the Nordstream pipelines as acts of “sabotage” and discussed sending divers to examine the pipelines to find evidence that could be brought to light. Russia’s audacious move to “annex” Ukrainian territory in a Putin-led ceremony last Friday, Sept. 30, was declared illegal by Ukraine, the United Nations, the United States and many other Western allies who said it violated Ukrainian and international law.
Solar Panel Design Aids One of Three Infrastructure Investments to Buy
Standex further plans to benefit from significantly higher research and development (R&D) investments for new product development to “materially increase organic sales growth,” William Blair opined. New product launches are expected across all five of Standex’s businesses in fiscal 2023, including high growth end-markets such as renewable energy, electric vehicles, human health, commercialization of space and sustainable products.
Standex’s Gr3n joint venture could attain full commercialization by mid-decade, potentially becoming Standex’s sixth business segment. The result could boost Standex’s “organic sales growth” to the low teens in the next three to five years, the William Blair analysts wrote.
The joint venture has developed and tested a prototype for a highly innovative, extremely efficient and 100% recyclable new solar panel design that is 30-35% more efficient and weighs 38% less than traditional glass solar panels. With interest in solar panels rising as the European Union (EU) scrambles to replace the 40% of its energy previously sourced from Russia, Standex is expanding electronics’ production capacity in Germany, China and India, the investment firm reported.
“If the new recyclable, highly efficient solar panel can be cost-effectively produced, it could become the largest new product in Standex’s history,” according to the William Blair analysts.
Chart courtesy of www.stockcharts.com
U.S. CDC Halts Its Country-by-Country Travel Notices
The U.S. Centers for Disease Control and Prevention (CDC) dropped its country-by-country COVID-19 travel health notices on Monday, Oct. 3. Those warnings began early in the pandemic as COVID-19 cases and deaths climbed.
COVID risks affect supply and demand for infrastructure stocks, but not as much as cyclical companies whose share prices can soar when economic conditions are favorable but fall fast when inflation, a potential recession and Fed interest rate hikes imperil stock prospects. Savvy investors monitor COVID-19 outbreaks and lockdowns to forecast how certain stocks and sectors, such as infrastructure, are affected.
Another encouraging sign occurred when Canada announced on Sept. 26 that it would remove all remaining COVID-19 entry restrictions, such as testing, quarantine and isolation requirements. That development could boost trade and tourism between that country and the United States.
China’s strict zero-tolerance COVID policy continues to be controversial and recently sparked a rare protest in its technology hub of Shenzhen, social media video showed. The dissent came after government officials ordered a sudden lockdown due to 10 new infections on Sept. 27 in the city of more than 18 million people. Officials ordered residents in three districts there to stay home.
China has locked down more than 70 cities fully or partially to preserve its zero-tolerance policy of COVID. However, 27 people were killed and 20 more were injured when a quarantine bus overturned on a mountain road on Sept. 20.
U.S. COVID-19 deaths ticked up by nearly 4,000, up about 1,000 compared to roughly 3,000 the previous week. Cases in the country totaled 96,481,081, as of early Oct. 5, while deaths jumped to 1,060,408, according to Johns Hopkins University. America stands out dubiously as the nation with the most COVID-19 deaths and cases.
Worldwide COVID-19 deaths in the past week rose by more than 11,000, up about 2,000 from the prior week. The number of deaths totaled 6,550,203, as of Oct. 5, according to Johns Hopkins. Global COVID-19 cases reached 619,211,562.
Roughly 79.5% of the U.S. population, or 264,112,767, have received at least one dose of a COVID-19 vaccine, as of Oct. 5, the CDC reported. Fully vaccinated people total 225,284,115, or 67.9%, of the U.S. population, according to the CDC. The United States also has given at least one COVID-19 booster vaccine to almost 110 million people.
The three infrastructure investments to buy can be repurchased at reduced prices after a rough 2022 market wide. Despite high inflation, Russia’s continuing war in Ukraine and recession risk after 0.75% rate hikes by the Fed in June, July and Sept. 21, the three infrastructure investments to buy offer some insulation compared to cyclical stocks with government budgets less economically sensitive than the private sector.
Paul Dykewicz, www.pauldykewicz.com, is an accomplished, award-winning journalist who has written for Dow Jones, the Wall Street Journal, Investor’s Business Daily, USA Today, the Journal of Commerce, Seeking Alpha, Guru Focus and other publications and websites. Paul, who can be followed on Twitter @PaulDykewicz, is the editor of StockInvestor.com and DividendInvestor.com, a writer for both websites and a columnist. He further is editorial director of Eagle Financial Publications in Washington, D.C., where he edits monthly investment newsletters, time-sensitive trading alerts, free e-letters and other investment reports. Paul previously served as business editor of Baltimore’s Daily Record newspaper. Paul also is the author of an inspirational book, “Holy Smokes! Golden Guidance from Notre Dame’s Championship Chaplain,” with a foreword by former national championship-winning football coach Lou Holtz. The book is great as a gift and is endorsed by Joe Montana, Joe Theismann, Ara Parseghian, “Rocket” Ismail, Reggie Brooks, Dick Vitale and many others. Call 202-677-4457 for multiple-book pricing.
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What’s next for ancient DNA studies after Nobel Prize honors groundbreaking field of paleogenomics
Thousands of ancient genomes have been sequenced to date. A Nobel Prize highlights tremendous opportunities for aDNA, as well as challenges related to…
For the first time, a Nobel Prize recognized the field of anthropology, the study of humanity. Svante Pääbo, a pioneer in the study of ancient DNA, or aDNA, was awarded the 2022 prize in physiology or medicine for his breathtaking achievements sequencing DNA extracted from ancient skeletal remains and reconstructing early humans’ genomes – that is, all the genetic information contained in one organism.
His accomplishment was once only the stuff of Jurassic Park-style science fiction. But Pääbo and many colleagues, working in large multidisciplinary teams, pieced together the genomes of our distant cousins, the famous Neanderthals and the more elusive Denisovans, whose existence was not even known until their DNA was sequenced from a tiny pinky bone of a child buried in a cave in Siberia. Thanks to interbreeding with and among these early humans, their genetic traces live on in many of us today, shaping our bodies and our disease vulnerabilities – for example, to COVID-19.
The world has learned a startling amount about our human origins in the last dozen years since Pääbo and teammates’ groundbreaking discoveries. And the field of paleogenomics has rapidly expanded. Scientists have now sequenced mammoths that lived a million years ago. Ancient DNA has addressed questions ranging from the origins of the first Americans to the domestication of horses and dogs, the spread of livestock herding and our bodies’ adaptations – or lack thereof – to drinking milk. Ancient DNA can even shed light on social questions of marriage, kinship and mobility. Researchers can now sequence DNA not only from the remains of ancient humans, animals and plants, but even from their traces left in cave dirt.
Alongside this growth in research, people have been grappling with concerns about the speed with which skeletal collections around the world have been sampled for aDNA, leading to broader conversations about how research should be done. Who should conduct it? Who may benefit from or be harmed by it, and who gives consent? And how can the field become more equitable? As an archaeologist who partners with geneticists to study ancient African history, I see both challenges and opportunities ahead.
Building a better discipline
One positive sign: Interdisciplinary researchers are working to establish basic common guidelines for research design and conduct.
In North America, scholars have worked to address inequities by designing programs that train future generations of Indigenous geneticists. These are now expanding to other historically underrepresented communities in the world. In museums, best practices for sampling are being put into place. They aim to minimize destruction to ancestral remains, while gleaning the most new information possible.
But there is a long way to go to develop and enforce community consultation, ethical sampling and data sharing policies, especially in more resource-constrained parts of the world. The divide between the developing world and rich industrialized nations is especially stark when looking at where ancient DNA labs, funding and research publications are concentrated. It leaves fewer opportunities for scholars from parts of Asia, Africa and the Americas to be trained in the field and lead research.
The field faces structural challenges, such as the relative lack of funding for archaeology and cultural heritage protection in lower income countries, worsened by a long history of extractive research practices and looming climate change and site destruction. These issues strengthen the regional bias in paleogenomics, which helps explain why some parts of the world – such as Europe – are so well-studied, while Africa – the cradle of humankind and the most genetically diverse continent – is relatively understudied, with shortfalls in archaeology, genomics and ancient DNA.
Making public education a priority
How paleogenomic findings are interpreted and communicated to the public raises other concerns. Consumers are regularly bombarded with advertisements for personal ancestry testing, implying that genetics and identity are synonymous. But lived experiences and decades of scholarship show that biological ancestry and socially defined identities do not map so easily onto one another.
I’d argue that scholars studying aDNA have a responsibility to work with educational institutions, like schools and museums, to communicate the meaning of their research to the public. This is particularly important because people with political agendas – even elected officials – try to manipulate findings.
For example, white supremacists have erroneously equated lactose tolerance with whiteness. It’s a falsehood that would be laughable to many livestock herders from Africa, one of the multiple centers of origin for genetic traits enabling people to digest milk.
Leaning in at the interdisciplinary table
Finally, there’s a discussion to be had about how specialists in different disciplines should work together.
Ancient DNA research has grown rapidly, sometimes without sufficient conversations happening beyond the genetics labs. This oversight has provoked a backlash from archaeologists, anthropologists, historians and linguists. Their disciplines have generated decades or even centuries of research that shape ancient DNA interpretations, and their labor makes paleogenomic studies possible.
As an archaeologist, I see the aDNA “revolution” as usefully disrupting our practice. It prompts the archaeological community to reevaluate where ancestral skeletal collections come from and should rest. It challenges us to publish archaeological data that is sometimes only revealed for the first time in the supplements of paleogenomics papers. It urges us to grab a seat at the table and help drive projects from their inception. We can design research grounded in archaeological knowledge, and may have longer-term and stronger ties to museums and to local communities, whose partnership is key to doing research right.
If archaeologists embrace this moment that Pääbo’s Nobel Prize is spotlighting, and lean in to the sea changes rocking our field, it can change for the better.
Mary Prendergast does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.testing genetic dna covid-19 spread africa europe
Plunging pound and crumbling confidence: How the new UK government stumbled into a political and financial crisis of its own making
Liz Truss took over as prime minister with an ambitious plan to cut taxes by the most since 1972 – investors balked after it wasn’t clear how she would…
The new British government is off to a very rocky start – after stumbling through an economic and financial crisis of its own making.
Just a few weeks into its term on Sept. 23, 2022, Prime Minister Liz Truss’ government released a so-called mini-budget that proposed £161 billion – about US$184 billion at today’s rate – in new spending and the biggest tax cuts in half a century, with the benefits mainly going to Britain’s top earners. The aim was to jump-start growth in an economy on the verge of recession, but the government didn’t indicate how it would pay for it – or provide evidence that the spending and tax cuts would actually work.
Financial markets reacted badly, prompting interest rates to soar and the pound to plunge to the lowest level against the dollar since 1985. The Bank of England was forced to gobble up government bonds to avoid a financial crisis.
After days of defending the plan, the government did a U-turn of sorts on Oct. 3 by scrapping the most controversial component of the budget – elimination of its top 45% tax rate on high earners. This calmed markets, leading to a rally in the pound and government bonds.
As a finance professor who tracks markets closely, I believe at the heart of this mini-crisis over the mini-budget was a lack of confidence – and now a lack of credibility.
A looming recession
Truss’ government inherited a troubled economy.
Growth has been sluggish, with the latest quarterly figure at 0.2%. The Bank of England predicts the U.K. will soon enter a recession that could last until 2024. The latest data on U.K. manufacturing shows the sector is contracting.
Consumer confidence is at its lowest level ever as soaring inflation – currently at an annualized pace of 9.9% – drives up the cost of living, especially for food and fuel. At the same time, real, inflation-adjusted wages are falling by a record amount, or around 3%.
It’s important to note that many countries in the world, including the U.S. and in mainland Europe, are experiencing the same problems of low growth and high inflation. But rumblings in the background in the U.K. are also other weaknesses.
Since the financial crisis of 2008, the U.K. has suffered from lower productivity compared with other major economies. Business investment plateaued after Brexit in 2016 – when a slim majority of voters chose to leave the European Union – and remains significantly below pre-COVID-19 levels. And the U.K. also consistently runs a balance of payments deficit, which means the country imports a lot more goods and services than it exports, with a trade deficit of over 5% of gross domestic product.
In other words, investors were already predisposed to view the long-term trajectory of the U.K. economy and the British pound in a negative light.
An ambitious agenda
Truss, who became prime minister on Sept. 6, 2022, also didn’t have a strong start politically.
The government of Boris Johnson lost the confidence of his party and the electorate after a series of scandals, including accusations he mishandled sexual abuse allegations and revelations about parties being held in government offices while the country was in lockdown.
Truss was not the preferred candidate of lawmakers in her own Conservative Party, who had the task of submitting two choices for the wider party membership to vote on. The rest of the party – dues-paying members of the general public – chose Truss. The lack of support from Conservative members of Parliament meant she wasn’t in a position of strength coming into the job.
Nonetheless, the new cabinet had an ambitious agenda of cutting taxes and deregulating energy and business.
Some of the decisions, laid out in the mini-budget, were expected, such as subsidies limiting higher energy prices, reversing an increase in social security taxes and a planned increase in the corporate tax rate.
But others, notably a plan to abolish the 45% tax rate on incomes over £150,000, were not anticipated by markets. Since there were no explicit spending cuts cited, funding for the £161 billion package was expected to come from selling more debt. There was also the threat that this would be paid for, in part, by lower welfare payments at a time when poorer Britons are suffering from the soaring cost of living. The fear of welfare cuts is putting more pressure on the Truss government.
A collapse in confidence
Even as the new U.K. Chancellor of the Exchequer Kwasi Kwarteng was presenting the mini-budget on Sept. 23, the British pound was already getting hammered. It sank from $1.13 the day before the proposal to as low as $1.03 in intraday trading on Sept. 26. Yields on 10-year government bonds, known as gilts, jumped from about 3.5% to 4.5% – the highest level since 2008 – in the same period.
The jump in rates prompted mortgage lenders to suspend deals with new customers, eventually offering them again at significantly higher borrowing costs. There were fears that this would lead to a crash in the housing market.
In addition, the drop in gilt prices led to a crisis in pension funds, putting them at risk of insolvency.
The International Monetary Fund, which bailed out the U.K. in 1976, even offered its figurative two cents on the tax cuts, urging the government to “reevaluate” the plan. The comments further spooked investors.
To prevent a broader crisis in financial markets, the Bank of England stepped in and pledged to purchase up to £65 billion in government bonds.
Besides causing investors to lose faith, the crisis also severely dented the public’s confidence in the U.K. government. The latest polls showed the opposition Labour Party enjoying a 24-point lead, on average, over the Conservatives.
So the government likely had little choice but to reverse course and drop the most controversial part of the plan, the abolition of the 45% tax rate. The pound recovered its losses. The recovery in gilts was more modest, with bonds still trading at elevated levels.
Putting this all together, less than a month into the job, Truss has lost confidence – and credibility – with international investors, voters and her own party. And all this over a “mini-budget” – the full budget isn’t due until November 2022. It suggests the U.K.‘s troubles are far from over, a view echoed by credit rating agencies.
David McMillan does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.recession covid-19 subsidies bonds government bonds housing market pound lockdown recession recovery interest rates european europe uk
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