As part of their business planning and risk management processes, many of our clients pull together “perfect storm” scenarios in which multiple variables all hit negatively at once in a “what would it take to break our plan” type exercise.
To summarise the perfect storm facing the UK this winter:
- CPI Inflation is running at 8.8% with Bank of England forecasting a peak of over 13% in Q4 2022 and more extreme scenarios from other forecasters, as high as 22%
- Energy costs are likely to be 3x higher this winter than last year
- Base rates have increased from 0.1% in December 2021 to 1.75% today with more increases on the way
- Ten-year gilt yields have increased by c.2% over the last 12 months
This changes everything.
Take for example a household with a £250k mortgage relating to base rates (there are circa 1.9m of them). If they suffer the full impact of base rate increases, their interest payments will have increased by more than £4k per annum or just under £350 per month. Now, layer this on top of a possible increase of over £200 each month for energy bills, not to mention higher food and petrol prices. A perfect storm indeed.
Now, I use a household for illustrative purposes, but you can apply the same set of issues to pretty much every business in the country, particularly businesses like many of those that we advise which are capital intensive in nature and therefore utilise significant volumes of debt. Since all businesses are energy users and many businesses utilise debt at some level, it is safe to assume that the pain is being felt, or will be soon enough, right across the board. In many instances, you can track this same set of issues right through the product life cycle:
- Commodities/extractive industries/agriculture
Energy costs, commodity/input prices (including by-products such as fertiliser which requires natural gas) and debt servicing costs will strike at every level of the system on the way through – and right at the end of that chain? The poor consumer, who is already seeing disposable income diverted in order to meet the calls on cash outlined above.
So, what gives?
There isn’t much sugar coating to be done here. The combination of factors at play here is a toxic one which does indeed present a perfect storm for many businesses. In my view we are likely to witness one of those periodic shake-outs of the system which will test the resilience of business models and the nerves of those charged with not only safe navigation but in many instances, survival. It didn’t quite happen post-financial crisis but maybe in due course some of the policy responses to that last ‘big event’ will be seen as a contributing (if not only) factor to the economic story of the 2020s.
Some thoughts on what the coming months and years may hold:
- More bailouts – one way or another, UK and European governments face a massive bailout bill to mitigate the societal and economic impacts of what many would consider to be their mismanagement of energy policy over recent years. Some estimates have suggested that just in the UK this may reach as much as twice the cost of the Furlough Scheme at well over £100bn. The incoming Truss Government will have to square this impact on public finances with its desire to stimulate economic growth and investment through tax cuts. Either way, UK and EU countries face huge bills which will worsen national debt and likely maintain Sterling and the Euro under significant pressure against the US Dollar for the foreseeable future.
- Political uncertainty – there will continue to be many and varied views on how to run a democracy, but it’s fair to say that in the US and Western Europe the “range of normal” is widening compared to, for example, the post war period through to the Global Financial Crisis (perhaps with the notable exception of the 1970s). One can see obvious tensions in the US, to a lesser extent in the UK and many European countries, and a mixed bag around the rest of world including for example some evidence of tensions emerging within the Chinese polity in response to somewhat faltering growth there. And this piece isn’t about the war in Ukraine but that clearly has triggered some of the factors noted above; it would be wrong not to acknowledge the unfortunate level of uncertainty for people living there and the surrounding countries.
- Security & self-sufficiency – regardless of pressure on the public finances, the Government will be under intense political pressure to step up to a wartime footing in respect of greater energy (and food) resilience and self-sufficiency. So, expect to see large investment programmes and policy support in agriculture, fossil fuel exploration/production, gas & battery storage, renewables and nuclear, along with associated grid infrastructure.
- Technology – this investment boom, along with increased re-shoring of supply chains (again driven by security of supply, even at higher cost) will drive and accelerate technological advance and adoption as countries with high labour costs and ageing populations seek to compensate with technological advances
- National Finances – the urgency of spending commitments outlined above and in terms of increased defence spending will likely trump orthodoxy around control of the national debt and it is interesting that these factors appear to be aligning with an apparent desire on the part of the incoming Government to “de-fang” HM Treasury. Wartime style spending commitments may also require continued “financial repression” in the form of further QE type programmes and ultimately perhaps capital controls, in the event that this feeds through to currency instability (as the Bank of Japan is realising at the moment, you can cap JGB yields when the rest of the world is raising rates, but this feeds through to the currency in the shape of a massive Yen depreciation).
- “Creative Destruction” – What about businesses? Margins will be key to navigating the choppy waters ahead. Businesses operating on wafter thin margins or reliant on ultra-low borrowing costs for their survival are unlikely to last the course – brutal perhaps (and unnerving for business owners, including ourselves…) but on the other hand, a normal part of the capitalist cycle, which was arguably put on hold following the global financial crisis and Covid.
- Essential Service Industries – the policy predictions above are likely to present a mixed bag for businesses operating in regulated and/or essential service industries. On the one hand, Government will be keen politically to be seen extracting its pound of flesh through hard-nosed intervention around price settlements to benefit the beleaguered consumer. On the other, large scale and capital-intensive investment programmes will see the Government needing to tap private capital and therefore not wishing to destroy its credibility as an investment partner in key infrastructure. Opportunity beckons for professional tightrope walkers.
- Risk Management – some businesses are fortunate enough to be able to pass on their own cost inflation to customers – think scarce commodities, specialist manufacturers or luxury brands. Most however, will see margins squeezed by higher debt, input and energy costs. Larger businesses may have hedging in place to mitigate one or more of these cost increases, even if only for a relatively short period. Hedging and risk management will likely be more widely used by these and other businesses as a result of the recent levels of volatility and the desire to reduce further risk in future.
- Credit Ratings – rating agencies will be running the rule over businesses to understand the impact of these changes and risks to their models. Sovereign rating downgrades as the result of deteriorating public finances may trigger corporate and sub sovereign downgrades where there is a clear link through the ratings methodology for essential service sectors.
- Higher Debt Costs – in the real assets space, growth in the “Alternatives” asset classes has provided investors with reasonable, low risk, fixed income like returns, during a period of abnormally low interest rates. Bringing some of these asset classes into the investing mainstream has had many positives, in particular, the ability to harness long-term pensions and savings into societally useful asset classes such as infrastructure, PRS, Affordable Housing and Logistics to name but a few. However, the resilience of the case for equity investment in these sectors will be tested as fixed income returns return to levels only marginally below equity cash yields.
- Asset Prices – there is little doubt that ultra-low (or even negative) interest rates have distorted pricing mechanisms and inflated prices of many real assets. Ultimately, a sustained higher cost of debt capital will likely feed through to lower asset prices. There is already some evidence of yield expectations rising in commercial real estate for example.
Many of the issues highlighted above point to a recent “reveal” of the fragility of many aspects of the current system, not only in Western Europe and the US but globally. If Central Banks and policy makers were repeatedly “kicking the can down the road” the current crisis certainly has the feel of the impending brick wall. In addition, this lack of resilience is showing itself not only in energy but in housing, health, water, transport and other areas, not only in the UK but beyond.
This is providing a rude wake-up call and forcing governments to at least consider whether the current system is fit for purpose and may herald more fundamental and radical changes. One can’t help but feel that there is a neat (albeit not entirely comforting) confluence of these issues with a re-shuffling of the geopolitical deck and the end of global US and Dollar hegemony. Certainly, the dollar based global financial system is starting to crack and it is likely, that we will, in the not-too-distant future see a co-ordinated monetary re-set at least amongst the US aligned nations a la Bretton Woods, Plaza Accord etc.
On a positive note, many of these changes will force system re-sets, partly market led, partly policy led and will likely herald a new wave of accelerated technological advance to help address current shortcomings across many areas which will bring about new high growth sectors together will employment opportunities, particularly in parts of the UK which are still awaiting the “levelling up” dividend.
This will likely be an unsettling period for both households and businesses and may see some further political turmoil along the way. However, as with most systems, decay gives way to growth and out of the current challenges we face, new opportunities will abound, so sit tight!