Vladgrind

My initial thought twelve months ago following the Russian invasion of Ukraine was that the tectonic plates have shifted. Nothing that has happened in the interim has caused me to change my view. It soon became obvious that the war was going to be a more protracted affair than Vladimir Putin anticipated (or was told by his advisers) and slightly belatedly the west realised that it had a duty to provide physical support to show that its support for democracy amounted to more than just words. There has been a cost, both economically and geopolitically, and the issue over the next twelve months will be whether the international community is prepared to continue paying the price.

Polling evidence shows that Europeans and American citizens believe Ukraine should continue its fight to regain the territory occupied by Russia, although in other geopolitically important states there is less support for such a position (chart above). The continental European position is understandable. There is more concern than elsewhere that the war could spill over and draw them in to defend their territory or that of their neighbours. Quite how events will pan out over the next twelve months is difficult to say. The likelihood is that the war of attrition will continue, with Ukraine not having the resources to push Russian forces out of their territory but Russia unable to make significant territorial gains. Further ahead, the manpower differential makes it difficult to see how Ukraine can regain the territory it has lost without regime change in Moscow, suggesting that some form of negotiated settlement might be the best we can hope for.

The economy has so far avoided the worst case outcomes …

Undoubtedly the Ukrainian war has had a big impact on the global economy, following hard on the heels of the Covid pandemic. This has manifested in an inflation shock, the likes of which we have not seen in 40 years, and prompted central banks around the world to raise interest rates, having kept them at historical lows for far too long after the GFC. The slowdown in the global economy has been pronounced but perhaps less dramatic than anticipated towards the end of 2022, with euro area GDP eking out a small rise of 0.1% q/q in 2022Q4, thus ensuring that the economy continues to avoid recession. Germany is facing a tougher haul but even the 0.4% contraction recorded in Q4 was better than anticipated a few months ago.

Germany in particular has coped far better than anticipated in managing its gas storage. As of end-February, storage levels were at 71.7% of capacity (chart below) whilst gas consumption in the week beginning 13 February 2023 was 22.7% below the average for 2018 to 2021. As a consequence, Europe’s largest economy has avoided significant blackouts which has prevented sharper falls in output. But contrary to suggestions expressed in the media of late, we are far from out of the woods. Indeed, although it is likely that Germany – and indeed the rest of Europe – has sufficient gas on hand to get through to the autumn, much depends on how easily gas storage levels can be topped up ahead of the winter. In the event that Germany cannot easily top up supplies from non-Russian sources in 2023, we could go into next winter with perilously low supply levels which would be problematic if there is a cold winter.

… But …

A tightening of monetary policy has helped to curb demand but this all points to the fact that rather than a winter 2023 recession, we could instead face a similar outcome in twelve months’ time. For this reason, markets are looking nervously at the actions of central banks as they continue to tighten monetary policy in the face of a rising inflation threat. But it is not headline inflation they care about so much as the pickup in core inflation as prices respond to the big rise in energy costs that occurred in 2022. On top of this central banks also care about the prospect of a response from wage inflation which could set off a wage-price spiral. So they keep nudging rates higher. And the higher they go, the more likely the prospect that the economy finally tips into recession – not as a direct result of higher energy costs but as a result of tighter monetary policy.

That might seem a remote prospect in the US today but the operation of monetary policy involves lags which are often not known with any precision. As interest rates in the US rise and inflation falls, so the real interest rate – which is assumed to be a key factor in driving real activity rates – becomes less negative. Based on latest data, for example, the real Fed funds rate climbed from a low of -8.2% in March 2022 to -1.8% by January 2023. Admittedly this is still in negative territory but add 25bps to the funds rate and assume inflation comes down by another 1.5 percentage points to 4.8% and the real rate is back at zero. The further inflation falls as the energy price shock drops out of the calculations, the greater the upward pressure on real rates and the bigger the drag on the US economy – and by definition the rest of the world.

Back to where we started

Putin calculated that NATO’s European members, which were heavily dependent on Russian gas, would scale back their opposition to the invasion as the restriction of gas supplies put intolerable pressure on the European economy. So far this calculation has not worked out. European opposition may yet soften if the economy falls into recession, either as a result of domestic policy errors or those of the Federal Reserve. However, rather than a short, sharp recession, it is far more likely that the European economy will experience a longer period of little to no growth, which will raise the pressure on policymakers in different ways. Coupled with high budget deficits, which may prompt some form of fiscal consolidation, the near-term outlook for the European economy is not a pretty one. The polling data suggests that European governments can afford to stay the course in 2023. Whether they will be prepared to do so further ahead as elections loom may be another matter.

Don't do dumb stuff

A decade of distress

On 23 January 2013 David Cameron gave his (in)famous Bloomberg speech during which he announced his intention to hold an in-out referendum on the UK’s membership of the EU. The intervening decade has been a difficult one. Looking back over all this time, the speech might be viewed as the starting gun for a process which led us through four prime ministers, including the incompetent Boris Johnson and the hapless Liz Truss, and the steady erosion of trust in the political process.

However, in some ways what Cameron said in 2013 needed to be said. We should remember that at the time the euro area was in the throes of a debt crisis which came very close to scuppering the single currency project. He called for enhanced European competitiveness by extending the single market; a flexible structure which "can accommodate the diversity of its members"; allowing "power … to flow back to member states" and enhanced democratic accountability and fairness so that “whatever new arrangements are enacted for the eurozone, they must work fairly for those inside it and out." There was in 2013 a growing sense that the EU was disjointed and unsure about how to proceed and it was important to ask the right questions which would allow it to get back on track. Moreover, as I wrote at the time, “the speech also gave a reasoned and rational account of the benefits of staying within the EU, notably the enhanced influence which it gives the UK on the global stage, and the benefits to jobs and growth arising from the huge FDI inflows which have come from the EU.”

But Cameron’s relationship with the EU was fractious. He was not a committed player and was unable to reach an agreement with the other members that would allow him to land the killer blow to knock out his domestic anti-EU opponents. Consequently, he left the door open to the “fruitcakes, loonies and closet racists” associated with UKIP who went on to run a campaign that knocked the Remainers for six. Unfortunately, the promises made by those intent on winning the Brexit referendum at any price now lie in ruins. Who can forget the pledge to use the £350 million per week that would be saved by not having to contribute to the EU budget to improve the NHS? Not only was that figure a gross distortion (pardon the pun) but it ignored the fact that part of any funds not sent to Brussels would have to be devoted to those areas that the EU previously funded. Consequently the NHS got very little extra cash, despite being protected from the worst ravages of George Osborne’s misguided austerity programme. It is hard to imagine that the NHS could be in worse shape than it is today without actually collapsing. Admittedly the pandemic placed great strains on the system but the fact that it was underfunded long before Covid struck has been a bigger contributor to its current dire predicament.

No shelter from the fallout

The fallout from the Brexit process has had a profound effect on Britain – on its unity, identity and its place in the world. Having taken a close-run, non-binding referendum and imposing a winner-takes-all outcome the government failed to unify the electorate around a strategy to take the UK forward. In the process of trying to square the circle of unreconcilable promises, the government wasted three years of time and effort failing to tackle the mounting economic problems of the day and did a lot of damage to the public perception of parliament. Admittedly, the pandemic blew everything off course but by then the zealots had taken over in Downing Street as moderates within government were either marginalised or exiled from the Conservative Party altogether.

Perhaps one of the most pernicious aspects of the Brexit saga is that it has enabled politicians to lie with impunity and not face any sanctions. As a consequence they have been able to ride out crises that would previously have been a resignation offence as former Chancellor Nadhim Zahawi’s latest trials and tribulations testify and further exemplified by the position of the chairman of the BBC whose close relationship with senior politicians has raised questions about a conflict of interest. Faced with a cost-of-living crisis not seen in decades (even the 1970s were not this bad as wages more than kept pace with inflation) public trust in government has collapsed. It is all very reminiscent of the 1990s when John Major’s government lost public trust following its handling of the ERM crisis and spent almost five years limping towards a heavy election defeat.

The immediate future

Quite where we go from here is difficult to say. The genie cannot easily be put back in the bottle but given the increasing realisation that the current form of Brexit is a mistake it is incumbent on the government to do all it can to mend fences with the EU. Doubling down on the current strategy is not going to get the electorate back onside, given the wide margin in opinion polls of those who think voting to leave the EU was a mistake (chart above). Issues that need to be addressed include the terms of the Trade and Cooperation Agreement between the UK and EU, which allows for tariff free trade for a wide range of goods but does not address the issue of regulatory harmonisation, which is a key element in agreements designed to increase trade flows. The issue of the Northern Ireland border has yet to be settled with the Northern Ireland Protocol Bill seeking to unilaterally override parts of the protocol that governs some aspects of trade in goods between the province and Great Britain.

Businesses face the prospect of considerable disruption in the face of government action/inaction on a number of legal matters. For example, the UK ‘Temporary Permissions Regime’ which allows EEA-based financial services to maintain their ‘passporting’ rights into the UK market, expires on 31 December 2023. If this is not extended or amended, there is the risk that financial services trade could be severely disrupted. Then there is the prospect that the Retained EU Law Bill, which passed unamended through the Commons last week, will intensify business uncertainty. In brief, this allows the government to revoke certain retained EU law at will, undermining the position of many businesses which continue to trade with the EU.

Simple fixes that the government could make include extending the Temporary Permissions legislation and deferring the introduction of the Retained EU Law Bill in a bid to kick it into the long grass. Similarly, postponing debate on the Northern Ireland Protocol and accepting that the current arrangements will have to remain in place for a while, will take some heat of tensions with the EU. None of this is to say that the UK is about to reconsider its position on EU membership. For one thing it is unlikely that the EU would be thrilled about a UK application anytime soon, nor is the electorate likely to have the stomach to rerun the debates of 2016 once again. Needlessly picking fights with the EU on issues we were told were settled two years ago will not get us anywhere, however.

But it is evident that the political class needs to address the elephant in the room that the current form of Brexit will not make the UK better off. That the Conservatives cannot or will not do so is perhaps understandable, given that so many members of the government were pro-Leave. Labour’s position is less forgivable. It continues to deny the extent of the problem for fear of upsetting the anti-EU media ahead of an election, despite recent polling evidence. At the very least politicians owe it to us to take a leaf out of the Obama playbook on foreign policy: “Don’t do stupid sh**.” Whilst in some ways this may be sound advice that comes too late, the next best option is don’t make it worse by ignoring the problem.

2022 in review: Setting us up for a difficult 2023

The economy in 2022

For the second year in three, 2022 was characterised by a one-off event that completely changed the economic landscape. Whilst 2020, and to a large extent 2021, was derailed by pestilence, this year was dominated by war. Those of a religious persuasion might recognise these as the first two Horsemen of the Apocalypse. Most of our predictions were derailed by the Russian invasion of Ukraine which resulted in a bigger surge in inflation than anticipated and forced central banks to raise interest rates to their highest since the GFC. However, this year was not just about monetary policy: governments were forced into using an active fiscal policy to offset the worst effects of the cost-of-living crisis on households. However, it will not be enough to prevent recession in large parts of the industrialised world in 2023 and the continued rise in government liabilities may yet turn out to be a big problem in future.

Covid slipped down the list of things to worry about in 2022. In my year-ahead piece almost a year ago, one of the options I laid out was that the Omicron variant would prove to be the last hurrah for Covid, which would regress to become an endemic problem. That is indeed how things panned out in 2022 although as China opens up following its zero-Covid measures there is every prospect that global cases will start to pick up once more. We cannot yet be sure that we are out of the woods. However, I did expect that as Covid related supply shortages began to ease, inflation would slow towards the end of 2022. It has not worked out like that.

Newspaper headlines have been full of suggestions that recent events herald a return to the conditions of the 1970s, with a commodity price shock triggering a surge in inflation accompanied by increasing industrial unrest as unions push for higher wage claims. Whilst the parallels are attractive on the surface, a closer look at the evidence suggests the comparison does not quite hold up. One of the key differences so far is that real wage growth has been crushed by the recent surge in inflation whereas in the 1970s it remained positive (although we have been compensated with lower real interest rates). Here in Britain, the strikes that have hit train, postal and health services are a response to the fact that many workers are being squeezed very hard, two years after they were lauded as key workers who kept the country going during the initial Covid lockdown. Labour relations are going to be a problem for governments in 2023, particularly in France and the UK.

One way to think about the inflation problem in the short-term is that it is the outcome of a distributional conflict between firms, workers and taxpayers which will only be resolved when the various actors accept the outcome. Indeed all players have to accept that they will be made worse off: At issue is the extent of the losses they are prepared to bear. The fact that central banks have raised interest rates to combat inflation has complicated matters by raising the burden on households. My issue has long been that higher interest rates will do nothing to offset a supply-side inflation shock, although central banks have to be wary of second round effects, particularly where labour markets remain tight as is currently the case in the US and UK. But as pointed out by the journalist Sarah O’Connor, author of this article on why worker power has not strengthened in 2022, while central banks fret about a wage-price spiral, the current situation looks more like a living standards bloodbath.

On the basis that inflation slows in 2023, as base-year effects drop out of the annual calculations, and as European economies – and maybe the US – fall into recession, the calls for interest rate cuts will build. Central banks are unlikely to heed these calls, and maintain policy tighter than might be justified by economic conditions, which would be a contrast to the post-GFC period when they held policy looser than justified by economic conditions. Central bankers are paranoid about repeating the mistakes of the 1970s when they eased policy too early only for inflation to take off again.

A bad year in the markets

On the basis of data back to 1928, 2022 was one of the worst years for total asset returns with the S&P500 losing around 17% whilst returns on Baa corporate bonds were the second worst in history (beaten only by the collapse of 1931). It was not supposed to be this way. Indeed I expected equities to perform relatively well, largely because of an absence of alternatives. But the surge in interest rates and fears of recession well and truly did for markets. It is not usual for a year of losses to be followed by a second consecutive decline but it has happened before – most notably for equities over the period 2000-2002. I would like to say that things can only get better but we cannot be sure that they will.

2022 was also the year in which crypto assets were reassessed. Long-term readers will be aware of my scepticism regarding cryptocurrencies but I was not prepared to write them off at the start of the year on the basis that there seemed to be genuine retail interest in their adoption. But as the energy costs associated with mining Bitcoin continued to rise, they became an increasingly unattractive prospect. Matters were not helped by the bankruptcy of the FTX exchange amid allegations of fraud. As a result Bitcoin lost two-thirds of its value against the USD, to currently trade at 16558 – still almost triple my back-of-the envelope estimate of fair value.

Politics: Some right calls, some wrong

If I got anything right about 2022 it was that geopolitics would be at the forefront of the agenda after two years in which governments were preoccupied with Covid. I did point out there was a risk that Russia would invade Ukraine and that western relations with China would continue to fray. I also tipped Emmanuel Macron to get a second term as French President. However, the one call that went badly wrong was that Boris Johnson would end the year as UK prime minister. As I wrote at the time: “Ditching a third Tory leader in six years, before their term is up, will not play well with an electorate that appears increasingly restive, particularly when there is no obvious candidate to replace Johnson.” I stand by the logic – Johnson’s departure will do the Tories no favours at the ballot box. But I could not have foreseen that Johnson’s replacement would themselves be replaced after a spectacularly incompetent fiscal plan was rushed through.

Last word

Tough times are now the order of the day. We survived the GFC, coped during the pandemic and are having to tighten our belts to deal with the most significant war on European territory since 1945. I look back fondly to the days of the Great Moderation when we had to invent things to worry about (who now remembers the Millennium Bug?). We can be thankful we got through 2022 relatively unscathed but as we look ahead to 2023, there will be bigger challenges ahead. Happy New Year to you all.