Governments in the west are spending and borrowing on a vast scale as they counter the effects of the pandemic. In the UK, public borrowing jumped to £62 billion in April alone—massively exceeding the previous monthly high of £22 billion in April 2012. Providing context, the UK government spent more in April than it anticipated it would in the whole 2020/2021 fiscal year. The level of debt to economic output will this year be at its highest since 1956. We could really do without a second wave.
When governments increase spending they finance it by issuing government debt in the form of bonds. With investors eager to hold ‘safe’ assets (such as bonds), and Central Banks also purchasing huge volumes through quantitative easing (QE), there is no shortage of demand for this debt. This is good news for bond markets and could continue to help many portfolios in the months ahead, though there are also some longer term consequences worth considering.
A text book would tell you that by increasing government spending, you generally get a greater demand for goods and service, and as a consequence the price of those goods and services go up. These government spending policies should really fuel inflation then… and inflation is generally bad news for bonds and therefore those who own them as their worth is slowly eroded. Instead, if prices are rising quickly, you want to own assets that benefit, such as commodities like iron ore or rice, companies selling goods and services, or property.
On the evidence of the recent past though, inflation seems unlikely. It has in fact fallen, not risen, since central banks undertook QE to counter the last crisis, the global financial crisis. Why will the same response to the global health crisis not lead to the same outcome?
Well, it seems our Investment Committee are not alone in their view that ‘this time is different’. Many economists are pointing out that today’s environment is not quite the same as last time. In 2008, the money pumped into the system stopped with the banks, as they looked to recapitalise their balance sheets, rather than lending to you or I so we could spend more. This time, with the banks in a stronger position, their ability to pass that money on to consumers and businesses is much higher, and remember higher inflation (prices) are a big risk to bonds.
So what do the financial markets make of all this? In last week’s blog we noted that equity markets were in a deliberating mood. This week, they look to be taking a favourable view, focused on the combined benefit of relaxed national lockdowns and the prospect of another round of government spending/steroids. Equity markets seem to be buying the philosophy that money will eventually show up in the real economy, which is great for growth. Bond markets tell a different story, with prices very expensive still (they should get cheaper if they fear inflation). They clearly believe there is a reasonable chance that the government stimulus won’t lead to higher prices, as people might end up saving it instead of spending it.
This is a conundrum, and one that we won’t know the answer to until later. Our central case would be that over the 12 months’ prices should fall or remain steady, not move higher, with people remaining cautious amidst an uncertain outlook. Beyond that though, with a vaccine achieved for example and job growth bouncing back, greater confidence could cause households and corporates to run down cash balances, leading to upward pressure on prices, with too much money chasing too few goods and services.
There is therefore a real chance, that if governments keep spending at the current rates as expected, they drive inflation higher. Holders of cash and secure interest-bearing securities like government bonds are therefore potentially significantly exposed. For a number of years, we have, to our detriment, avoided significant holdings in these areas as they have consistently offered poor value. As an example, a typical low risk portfolio would hold around 40% in government bonds, compared to our 2.5%. We would argue many of these comparatives have a hidden risk therefore.
Alas, the phrase, ‘a penny for your thoughts’ was delivered by the novelist Thomas More in the 1500’s. A penny back then is equivalent to £58.83 today, so you can see how money can devalue if it does not keep pace with inflation. Today’s core issue of low activity and falling prices is in place for now, but Central Banks and governments are leaning hard against the downturn (as they need to), seeing Inflation, if it comes, as tomorrow’s problem. We are, as you would expect, thinking about the solutions today.