Jonathan Gregory
Head of UK Fixed Income

About 40 years ago when I arrived at my local flying-club for my long anticipated first lesson in a glider (sailplane) the first thing handed to me was a parachute. I suppose this should have made quite an impression – but it didn’t. We were given little instruction in its use and throughout training I never came close to needing to use it, nor did I know anyone who had. We slipped them on pre-flight with barely a thought; the law required it, and that-was-that (more importantly it made an uncushioned wooden seat more comfortable). Some 30 years later though it strikes me as odd that we paid such scant attention to how we would use those ‘chutes in a life-or-death moment.

Most flying manuals shared my insouciance. The advice was: “if you need to leave the aircraft in flight, slide back the canopy, unfasten the harness and roll the aircraft onto its back … ” therefore letting gravity take over. Only now, with those days long in my past I wonder: if you had enough control to calmly pull a half barrel-roll in level flight, how much of an emergency could that be, and why would you need to jump? If I was persuaded to jump for my life 5,000 feet up, then that would have to be a pretty desperate situation. An uncontrolled, vertiginous, spinning and probably terminal descent might do it. But then the exit just wouldn’t be easy. For context, imagine reclining in your bathtub then trying to get out while the room is spinning violently and your body weighs three-times normal.1

There was also a second order problem. A parachute really must be treated with respect, even if never used. Damp from long periods sitting on wet grass and accumulated debris from hours on the storeroom shelf (or floor) can fatally compromise its working. So it is essential for each one to be professionally repacked a number of times a year. I suppose this must have happened (it was the law again after all) but I just don’t recall being that interested. Club parachutes were shared and passed around, sometimes a few times a day. In fact they seemed to get lighter, with acquired rustling sounds, as the summer floated on. The joke was that if you ever did jump your last sight as you fell to earth would be tattered shards of moth-eaten silk and some desiccated mice twirling above your head.

Did I say we were young? By dwelling on this only now, perhaps I merely illustrate the difference in risk perception that age brings.

Losing control

Policymakers around the world appear to be trying to pull-off their own emergency descent, but in this case from dizzyingly high inflation. Around 15 months on from the first rate hikes and 400-500 basis points later and yet inflation, jobs and wage growth are not slowing nearly as much as expected across the Eurozone, UK and US. In some ways this is a horrible mirror image of the 10 years after the Great Financial Crisis (GFC), when inflation stayed stubbornly below target despite zero (and even negative) policy rates, trillions of dollars spent in asset purchases and ‘forward guidance’.

I can’t say for sure, but I imagine most policymakers were as shocked then about the policy response needed to try and raise inflation, as they are likely now about how resilient inflation has been and hard to bring down.2 Given the lengthy inflation undershoot followed by a surprisingly lengthy overshoot, perhaps more citizens (voters) will even question whether central banks have the right ideas anyway. When the outcome constantly falls far short of the theory you may be encouraged to start thinking for yourself.

So the immediate problem for central banks is that they may have to inflict more damage on their economies, via higher rates, than had been expected a few months ago. This is an extremely painful trade-off and fraught with potential political fallout. But it’s the scenario today in the UK where core inflation recently increased again, despite the Bank of England’s forecast for it to fall. Result? A surprise 50 bps hike to 5% in June, market pricing projecting 6% by December and politicized debate about why already stretched households should pay the price for perceived central bank incompetence.

Again, I can’t say for sure, but I can imagine other central banks will look mindfully at what is happening in the UK. Uppermost on the minds of the Federal Reserve (Fed) and the European Central Bank (ECB) will be the point that, despite the most aggressive rate hiking cycle in 40-years in terms of speed and magnitude (at least in the US), their own forecasts put inflation well above target by year end. While reputations might just have survived a very lengthy period of below target inflation after the GFC, a lengthy overshoot might not be viewed so benignly.

This is probably behind the rather hawkish messages that went out from both banks in June. If the policy choices are living with higher inflation for longer, or accepting the inevitable economic pain that more rate hikes will bring, then the Fed and the ECB go to great lengths to persuade everyone that they embrace the latter idea.

The jump zone

But the theory of how to execute the jump and the jump itself are totally different things.

The chart below is one we have used before from the Institute of International Finance (IIF) and shows total global debt levels in absolute terms and relative to global output (GDP). It spans developed and emerging markets and government and corporate bonds.

Don’t be fooled by the dip in the green line that shows debt relative to GDP falling recently. This is really an artifact of high nominal growth rates following the pandemic. In reality, the total global debt relative to GDP measure, as reported by the IIF, is still higher than it was pre-COVID-19. The blue line is simply the path of the fed funds rate. The point here is that US dollar funding costs find their way into almost every borrowing market you can think of either directly via absolute levels and credit spreads, or indirectly via opportunity costs. (Do you still like your loss-making, high-yield, crypto company bond when two-year treasuries yield nearly 5%? No. I thought not.).

Chart 1: Global Debt Levels and Funding Costs

Bar chart showing global debt levels in absolute terms, as well as showing global debt relative to global output (GDP)
Source: Institute of International Finance, Bloomberg Finance L.P. Data as at 16 June 2023

This chart shows an overall increase in global debt since 2003. Global debt levels peaked in 2022. The green line (showing debt relative to GDP) has started to fall recently. However, this decrease is the result of very high nominal growth rates following the pandemic. The reality is that the total global debt relative to GDP measure, as reported by the IIF, is still higher than it was pre-COVID.

If monetary policy acts with a lag then there is a lot of pain still to be felt anywhere in the global economy where there is leverage. Which these days, as we can see, is pretty much everywhere.

Tangled up in debris

This is perhaps where a second order problem comes in. Since the GFC governments and central banks have become determined and adept in offsetting various shocks to households and businesses: the problem now is it is hard to know how to stop. Most of that support came via direct borrowing by governments or incentives to borrow through low rates. Now that much of this support has to be unwound, especially via higher rates, we might wonder whether policy makers can really follow through.

Even the International Monetary Fund recently pointed out central banks should not risk overall financial stability in the service of a slavish devotion to an inflation targeting.3

All these factors were discussed during our recent June Fixed Income Investment Forum. Our consensus view is that reducing inflation back to target in the US and Europe will probably involve real economic pain (although the degree may differ across regions). We also think central banks should be taken at face value, at least for the time being, and that market pricing for one or two rate hikes later this year is probably right (albeit more in the UK). But that pain is building and we have already seen some tremors through the global economy, implying we are close to peak policy rates. So the higher yields available since mid-May are looking more attractive from a risk/reward perspective, particularly in the front end of the yield curve. On the other hand, we signalled a slightly more cautious view on credit markets – higher rates for longer mean more possible trouble for risk assets.

That is simply our base case. Unlike a 5,000ft jump, where you only have to plan for one plausible direction, the global economy is more complex. Other outcomes are clearly a risk, not least that financial stability risks mean central banks decide to live with higher inflation for longer. Or, indeed, the opposite happens and much higher policy rates are in fact required and delivered, triggering a much deeper recession. To me, these risks seem finely balanced around the base case. Flexibility in positioning will remain a hallmark of our investment approach in the multi-sector strategies for the foreseeable future.

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