Warning signs

A running theme throughout this blog has been the quality of governance, particularly in the UK. As concerned citizens this is something we should all care about but as an economist this normally has only tangential relevance for the way in which mature western economies operate – at least in the short-term. But the alleged failings in the handling of the biggest health crisis in a century has had a huge economic impact, with only Spain amongst the major economies registering a worse output collapse in 2020 than the UK. There is also some evidence to suggest that the quality of national governance has an impact on corporate social performance. Good governance therefore continues to matter.

Pandemic pandemonium

Having spent much of the spring reporting on allegations of corruption in government, the British press had yet another field day this week following the testimony by Boris Johnson’s former adviser Dominic Cummings before a parliamentary committee on the handling of the Covid crisis. One of the unremarked ironies of the saga was that those media outlets which have been criticised for giving Johnson an easy ride over issues such as Brexit were happy to directly report Cummings’ allegations that the government mishandled the process from the start which resulted in many thousands of excess deaths. He was scathing of the competence of many members of government, including the prime minister (“he made some terrible decisions, got things wrong, and then constantly U-turned on everything”) and the health secretary (he “should’ve been fired for at least 15-20 things, including lying to everybody on multiple occasions”).

As much as people might wish to believe Cummings’ version of events, the fact that he was effectively sacked from government last November suggests he has an axe to grind. Whilst revenge is as good a motive as any to stick the boot into someone else’s political career, we should be very wary of taking his seven-hour testimony at face value. It is indeed ironic that many of those who had previously viewed Cummings as the devil incarnate were quick to accept his version of events, largely because they have an even bigger problem with Johnson. As the journalist Jonathan Freedland points out “Cummings is an unreliable witness”, as anyone who listened to his risible defence as to why he flagrantly breached lockdown rules last year will recall.

Nonetheless, the many independent fact checks (here and here for example) that have been conducted into Cummings’ claims conclude that there is some truth to them. The single most damning is that Johnson failed to take mounting evidence of the pandemic sufficiently seriously and that the government reacted too late. It is possible that in January and early February 2020 the government was basking in the glow of finally having delivered Brexit which may have caused it to take its eye off the ball (not that this is any excuse). Moreover, the advice from the SAGE committee was not as unequivocal as is often remembered today (as I pointed out in this post).

One of the bigger criticisms which Cummings failed to bring up was that many senior politicians believed there to be a trade-off between protecting the economy and protecting the health of the nation. This has been widely debunked. The greater the ring fence that can be put up to prevent the virus from taking hold, the smaller the hit to the economy – as Germany has demonstrated. It is certain that all these issues will be debated again when a public inquiry into the handling of the pandemic is established. However, since its terms of reference will be decided by the government it is a safe bet that it will not be allowed to undermine the government’s position (for one thing it will deliver its report sufficiently far in the future that it is unlikely to derail Boris Johnson’s front line career in politics).

The bigger picture

Much of what we learned from this testimony merely repeats what has been said at various times by other people. It was given added significance by the fact that Cummings was in the room when the decisions were made. Aside from the political points scoring, the evidence reveals that the political culture in which we now operate is one in which truth has become an elastic concept. As Freedland points out, Cummings is one of the fathers of this culture, particularly since he knowingly plastered the false claim on the side of the Brexit battle bus that the UK would save £350 million per week by leaving the EU. It is therefore ironic (to say the least) that he should accuse the health secretary, Matt Hancock, of lying.

All of this intrigue makes for good copy and has kept journalists busy in recent days but as we discovered with the furore surrounding financial impropriety allegations at the heart of government, this may not have much cut-through with voters. But there is evidence to suggest that governmental culture matters for the way in which the economy is run. In particular, there is solid empirical evidence to suggest that the quality of overall governance matters for corporate social performance. The authors of the study[1] identify a series of good governance attributes (accountability, political stability, government effectiveness, regulatory quality, rule of law and control of corruption) and explore the relationship between these factors and corporate social performance for a number of OECD countries. They find a positive correlation between the two and conclude that “policymakers that want to stimulate the transition toward a more sustainable society should consider their country’s overall governance quality.” What is significant about this study is that it does not simply focus on emerging markets where this pattern has long been observed – it holds for the industrialised economies too.

It is important to stress that the UK is not some ungovernable basket case economy. Like (nearly) all western economies, it retains a strong institutional framework that is able to impose some checks on the way in which government operates. But the warning signs flashed by efforts to prorogue parliament in 2019 or the NAO’s findings that the pandemic “laid bare existing fault lines within society, such as the risk of widening inequalities, and within public service delivery and government itself” suggest there is clear room for improvement. Mounting concerns about the cost of Brexit in those areas which were initially most enthusiastic (notably farming and fishing) have done little to enhance trust in the government’s operating methods.

We should discount some of the more rabid media commentary which focuses on personality rather than policy. But there are creeping signs that a decade of fiscal austerity, a pandemic and the bitter Brexit fall out are eroding the quality of governance. This trend needs to be nipped in the bud for otherwise we will all pay the price.

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[1] Kaufmann, W. and A. Lafarre (2020) ‘Does good governance mean better corporate social performance? A comparative study of OECD countries’, International Public Management Journal, DOI: 10.1080/10967494.2020.1814916

 

Not the 1970s but not the 2010s either

Inflation concerns have been rising up the market agenda during the course of this year. These fears appeared justified following last week’s release of US CPI inflation data which showed a jump from 2.6% in March to 4.2% in April – the highest rate since September 2008. This week’s UK release also showed a big jump in CPI inflation from 0.7% in March to 1.5% in April, and whilst the pickup in euro zone inflation was more modest (to 1.6% from 1.3% in March) it is now at its highest in two years. Obviously there are base year effects at work with last year’s total shutdown in activity making price measurement in April 2020 extremely difficult. Nonetheless, there are indications that price pressures are building. How worried should we be?

Dissecting CPI inflation data reveals the extent to which it has recently been driven by the recovery in oil prices. Recall that in April 2020 the price of Brent dropped to a monthly average of $18 versus $64 in January and $56 in February and whilst it subsequently recovered, it was only in February/March 2021 that oil got back to pre-pandemic levels. But whilst US core CPI inflation stood at only 3% in April – more than a percentage point below the headline rate – it was still almost double that in March and its highest in 25 years. On the basis of price trends further down the chain, consumer prices are likely to rise further. Aside from oil, industrial metals such as copper have reached record highs whilst there have been well-publicised warnings that shortages in key industrial components such as semiconductors will also push up prices. A further warning sign is that Chinese producer prices are now running at their fastest pace since late-2017 (6.8%) suggesting that price pressures in the workshop of the world need to be viewed with caution.

In addition to the base year effects, the inflation pickup in 2021 reflects the concerns expressed a year ago that the damage to the supply side of the economy during the lockdown would generate a pickup in inflation as capacity bottlenecks emerged. If this is the case, then surely the recent resurgence in inflation will prove temporary. This is not to say we will not see a further big rise to levels which many people might think scarily high, but it does suggest that we are not on the verge of a 1970s rebound. To the extent that inflation is driven by the difference between what economies consume and what they can produce (the output gap), and given that output gaps across the OECD remain in negative territory, suggesting that there is plenty of capacity to accommodate any pickup in demand (the average across the OECD is estimated at -5.2% in 2021 - see chart below), there is no obvious sign that a sustainable burst of inflation is in the offing.

It is true that lax monetary policy has helped support the rebound, leading in effect to a monetary-induced burst in inflation, but the expectation is that this will be temporary. As the demand catch-up from 2020 begins to fade, so it is widely expected that demand-supply pressures will ease and price inflation will slow (hopefully back towards central bank targets). The likes of the BoE have adjusted to this by slowing the pace of asset purchases although it has not adjusted the overall target for the stock of asset purchases which is ultimately what matters for the degree of monetary easing. 

Although it is expected that inflation in the UK and US will overshoot the central bank’s central 2% target we should view this in part as a consequence of the post-pandemic adjustment process. Indeed, there is likely to be a change in the product supply-demand mix which will leave an overabundance of productive capital tied up in areas where demand has declined, whereas there is a shortfall in areas where demand has increased. Accordingly we might expect strong inflation in some classes of goods and services, whereas in others it is weaker, which might persist for some time until the demand-supply balance has been restored.

Central bankers will thus be closely watching inflation expectations for some time to come for indications that it is set to take off. But inflation expectations differ according to who we ask. For example, the BoE’s survey of UK households shows that they have consistently overestimated expected inflation over the past 20 years. There is thus a strong argument for attaching a low weight to household expectations. In any case, households have limited bargaining power when it comes to setting wages so their weight in the price setting process is limited. Moreover, financial literacy amongst many households is not as high as it could be with the result that the concept of inflation is often hazily defined. Much of the academic literature thus attaches greater weight to the expectations of companies and those priced into financial markets. From a financial market perspective there has been a small pickup in inflation expectations, as derived from 5y5y swaps in the US and euro zone (chart below), but it is no higher than at any time in the last five years. Nor does corporate survey evidence across the industrialised world suggest that a pickup in wage inflation is likely anytime soon.

For all these reasons, some of the more lurid headlines suggesting that we may be on the brink of a 1970s-style inflation pickup are likely to be wide of the mark. There appears to be plenty of spare productive capacity; inflation expectations remain well anchored (for the moment); the ability of organised labour to push for higher wage claims is much more limited than it was 50 years ago plus – and this is perhaps the critical difference – in an increasingly global economy, inflation is a function of world rather than local conditions. None of this is to say that inflation will not run above target. The BoE, for example, looks for a UK inflation rate above 2% until around autumn 2022 although crucially it is not expected to exceed the upper 3% band.

If, however, we are about to experience higher inflation there is also a case for taking away some of the extreme monetary easing put in place over the last year. Over the last decade, central banks have used the argument of low inflation as a reason for keeping the pedal to the metal. Above-target inflation surely warrants a move in the other direction.

Good days, bad days

Market volatility is a simple fact of life – it is always with us and as a consequence we just have to deal with it. Sell side financial institutions like it because higher volatility prompts corporate and retail investors to look for some form of asset protection, giving them the opportunity to write more tickets. They also like it because it is possible to make very decent returns if you time the entry and exit from your positions correctly. Conversely, retail investors hate it because their portfolio value can whip around without any obvious fundamental explanation.

How the professionals deal with volatility

Equity volatility is conventionally measured using the prices of index options with near-term expiration dates. The global benchmark is the VIX, which measures volatility for the S&P500. It is currently trading at 22, which is slightly above its long-term average of 19.5 based on data back to 1990 (chart above). This is not excessively concerning. Indeed, as I have noted on previous occasions (here, for example) markets have been far too complacent in recent years as central banks have anaesthetised them with their huge asset purchase programmes. Given the exceptional uncertainty surrounding the economic outlook in the Covid era, it is probably a good sign that volatility is perceived to be slightly above average.

Excessive volatility spikes are rare: We have experienced only a couple of major volatility surges in recent years – once in the wake of the Lehman’s episode in 2008 and another in 2020 as the Covid crisis began to unfold. Institutional investors can hedge some of the risk by investing in an Exchange Traded Fund (ETF) which moves inversely with the VIX. Such indices are only suitable for short-term hedging purposes – those who try a buy-and-hold strategy tend to get burned very quickly. This makes them unsuitable for retail investors who seek more durable protection.

Avoiding the downside yields bigger returns than chasing the upside

As it happens, one of the better protection methods is abstinence. To demonstrate the impact of volatility on investor positions I looked at daily equity market data going back to 1990. Starting with the S&P500 I calculated what would happen if investors missed out on the days with the biggest gains and losses and assumed that on those days the portfolio value reverted to the level prevailing in the previous period. Arbitrarily assuming that investors missed out on the 30 biggest single daily gains, a portfolio which tracked the S&P500 since 1990 would be almost 83% below one which included all trading days. By contrast, excluding the 30 biggest daily losses would have resulted in a seven-fold increase in portfolio value. Putting these two factors together by taking out both the top 30 increases and decreases, the index would have ended up almost 22% higher than one based on the S&P500 alone (chart below). The results are broadly similar for the FTSE100: excluding the largest 30 daily gains and losses resulted in a gain of almost 14% versus one based purely on the benchmark.

In theory we can extend our analysis for the S&P500 back to 1928 without materially changing the results although the volatility in the index during the 1930s means that more than half the biggest daily swings occur before 1940. Arguably the macro environment today is very different to that in the 1930s with economic policy much more sensitive to market volatility. Accordingly it seems reasonable to exclude the 1930s from the calculations. Running the calculations since 1940, and maintaining our exclusion threshold to encompass the top 30 gains would lead to an 85% loss but excluding the top 30 losses would increase the value of our portfolio ten-fold. Excluding both the highs and lows would increase our portfolio value by almost 60% compared to the benchmark over the last 81 years.

If you don’t have perfect foresight, hedge

This demonstrates two key takeaways: (i) big movements in indices have a disproportionately big impact on future gains, perhaps because they trigger sentiment shifts which generate a change in market direction and (ii) avoiding the worst excesses of decline have a bigger impact on portfolio returns than chasing the big gains. Obviously the foresight to know when we are about to experience a massive correction is not gifted to most of us, therefore the best we can do is to hold a balanced portfolio comprised of assets whose prices are either inversely correlated with equities or not correlated at all. As I noted last summer, the 60:40 portfolio strategy which comprises 60% equities and 40% bonds is as good a way as any to hedge risks.

The upshot of all this is that investors who pursue a minimax strategy (minimising maximum losses) are likely to outperform those who follow a maximax strategy (the aggressive maximisation of gains). Indeed the latter is viewed by many in the media as the way in which sell-side investment operates and some hedge funds still publicly hail such an approach as the ideal investment strategy. But a maximax strategy is like building a football team comprising only strikers. Whilst strikers score the goals and grab the glory, the team is unlikely to win anything unless the defence is strong enough to repel the opposition. In football terms a minimax strategy allows the team to build a stronger defence which will allow them to be more successful over the longer term. When it comes to portfolio investment we cannot eliminate our exposure to volatility but we can take steps to reduce our exposure to it. As in other areas of life, buying some protection can considerably reduce our long-term costs.

Left behind

Exactly eleven years ago, on 7 May 2010, we awoke to find that the Conservatives under David Cameron had emerged from the previous day’s general election with more seats than any other party. This proved to be sufficient for them to form a coalition government with the Liberal Democrats which lasted until 2015. The Tories have since won a further three elections under three different leaders and are unlikely to relinquish their grip on power any time soon. Although yesterday’s elections were less important than that of 2010, they were nonetheless an important litmus test of the state of domestic politics given that they represented the biggest plebiscite outside of a general election.

In England, 143 local councils (including London) were up for election; 129 members of the Scottish parliament were elected and 60 members were chosen for the Welsh Senedd. The full results are not yet in but the Conservatives have performed well in England and the SNP retains hopes of winning an outright majority in the Scottish parliament which will rekindle the issue of Scottish independence.

Labour’s decline and fall …

But the most significant result of the past 24 hours was the Conservatives’ victory at a by-election in the town of Hartlepool, called following the resignation of the sitting Labour MP.  This was a result of huge symbolism since Labour has held the seat since 1964 and indeed the Tories had previously only won the seat once since 1945. For those not familiar with the town, Hartlepool is traditionally one of the most solid Labour voting regions in the country, with roots in an industrial base extending back to Victorian times. Recent years have not been kind to Hartlepool as north east England’s industrial base has been steadily eroded (as a native of the region I have watched the steady process of deindustrialisation gather pace). As far back as 1971 the town recorded an unemployment rate of 12.3%, more than twice the national average, and in the early 1980s it was running at 33%. In 2016 the town voted 70-30 in favour of Brexit driven in part by the fact that successive governments had failed to deliver much prosperity to the area and its people were fed up. One can hardly blame them: In the words of Public Health England, “Hartlepool is one of the 20% most deprived districts/unitary authorities in England.”

We should be wary of reading too much into what most political commentators are calling a seismic shift in British politics and which the Labour Party itself described as a “shattering” blow. There have been numerous instances of by-election results over the years which have promised radical change only to find that business as usual was restored by the time of the next general election. But this time really does feel different.

One of the remarkable features of the 2019 election was the fact that huge numbers of voters in previously safe Labour seats voted Conservative (the so-called Red Wall effect). This was attributed to two factors in particular: (i) distrust of then-Labour leader Jeremy Corbyn and (ii) the promise by Boris Johnson to “get Brexit done.” In the subsequent 17 months Corbyn has vacated the leadership so in theory this should not have played a role (though there is a suspicion that he has poisoned the Labour brand). In addition, Johnson delivered Brexit and to the extent that a lot of Brexit Party votes in 2019 are likely to have transferred to the Tories in 2021, their Hartlepool triumph could be interpreted as a reward for getting Brexit done. There are also a number of other factors in play, notably the feelgood factor derived from the vaccine bounce and, perhaps more importantly, questions about what Labour stands for (see this article by political journalist Paul Waugh for more detail).

… despite the odds apparently being stacked against the Tories

What is even more striking is that the Tory win comes on the back of extensive media coverage of sleaze allegations against senior Conservative politicians. Former PM Cameron is alleged to have used his influence to secure aid for a company in which he had a significant financial stake. This was compounded by allegations that Johnson had improperly sourced funding to redecorate his flat in Downing Street; a spat with his former adviser Dominic Cummings on behind-the-scenes machinations in government and claims that Johnson was desperate to avoid a third lockdown at any cost (the “let the bodies pile high in their thousands” furore). In times past the torrent of bad news would have spelled doom for the Conservatives but it does not appear to have made a scrap of difference. In that sense there has been a seismic political shift.

What has changed? One possibility is simply that for all the frenzied speculation by journalists inside the Westminster bubble, the issue does not in any way impact on the lives of ordinary voters (there was no “cut through” to use the political jargon). After all, it seems that everybody accepts Johnson has a strained relationship with the truth and simply don’t care what he gets up to. Why should it matter to many voters that Johnson has engaged in “unethical, foolish, possibly illegal” actions if he has not personally inconvenienced them (not my view, by the way)?

A Europe-wide phenomenon

It is not only in the UK where the political centre-left has lost ground. The fortunes of the SPD in Germany have dwindled over the past decade to the point where the Greens are more likely than the SPD to form the next government if current polling results are repeated in the September election. Similar trends are evident across other European countries where centre-left parties have seen their vote shares collapse to varying degrees (chart below).

On the surface it would appear that there has been a reappraisal of the centre-left since the GFC (France being the partial exception where Francois Hollande won the presidency as recently as 2012). A one-size-fits-all explanation cannot be applied to all countries equally but there are some stylised facts which get us part of the way there. In many countries, what we once called traditional working class voters who worked in industry have become much more scarce and the retirees who once would have fitted that description are fewer in number. In addition to these demographic shifts, there is a sense that centre-left parties were left to carry the can for the fallout from the GFC. Many of them were in office in 2008-09 and chose to put in place austerity programmes which hurt their supporters the most, or they left power soon afterwards and were blamed for the austerity that followed. In reaction there was a surge in support across the continent for what could broadly be called right-wing (semi) nationalist parties as voters sought radical solutions to the economic woes that ensued. This was countered by a surge in radical left parties which overshadowed the more moderate centre-left.

Ironically, as Chris Giles pointed out in the FT last week, “the left is winning the economic battle of ideas.” As the pandemic has shown, government has a big role to play in stabilising the economy at a time of deficient private sector demand – a lesson which Keynes highlighted in the 1930s. As Giles put it, “the model of pre-coronavirus capitalism, with high levels of inequality, is losing popular support, suggesting the need for a post-Covid world with more support for the vulnerable and higher taxes, especially on extreme levels of income, wealth and profits.” If nothing else, this suggests that the policies of Joe Biden are in tune with a large part of his electorate.

Here in the UK, the Labour Party has tried to differentiate itself from its Conservative opponents in recent years by promising a bigger role for the state and increasing taxes on the more affluent. However, after having frightened voters by telling them that Labour planned to stymie efforts to reward enterprise, the Tories have since stolen many of their clothes by running huge budget deficits during the pandemic and committing to raise corporate taxes rather than lower them, as previously planned. Faced with this volte face, the centre-left are clearly going to have to find a different economic tune to play.

It is hard to know how to respond

For the British Labour Party, and indeed for their counterparts across Europe, it looks as though they will struggle to remain relevant unless there is a radical change of tack. Quite how that can be achieved right now is very difficult to imagine. They have nothing economically new to offer and in the UK there is no one who can compete with Johnson in the charisma stakes. Sometimes you just have to accept that it is not your day and the best you can do is hang in there and hope that the tide turns your way as the opposition makes mistakes. It is not a particularly palatable message for Labour leader Keir Starmer but it might be all he can do for now. If he cannot generate cut through sooner rather than later, the Labour Party’s spell on the sidelines looks set to continue for a long time yet.