Recession delayed, not avoided

Many commentators are puzzled by the apparent paradox of a resilient economy and the ever-worsening outlook as inflation proves stubborn and interest-rate forecasts rise relentlessly. Why, also, is sterling rising steadily if the economy is in such dire straits?

In Argentina, none of this would be a surprise.

In the face of inflation, people spend their pesos quickly because they will get less for their money next week, month or year. That creates the impression of prosperity, until the money runs out. Inflation here may not be nearly as high but holding cash is extremely unattractive.

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It is possible to get an interest rate of 4% on an easy- access deposit account and over 5% by locking money up for a year but, with an inflation rate of 8.7% and a core inflation rate of 7.1%, real interest rates are still firmly negative. Moreover, interest income is taxed

so the net receipt is much lower; following chancellor Jeremy Hunt’s kamikaze budget, most savers are probably liable for the 40% rate.

The reason for sterling’s apparent strength is that currencies are not driven by economic fundamentals but by interest-rate differentials and momentum. Inflation in the UK is falling much more slowly than in the US, where it is down to 4% on an annual rate and barely 2% on an annualised three-monthly rate.

The US Federal Reserve has thus been able to pause interest rate rises at a range of 5%-5.25%. UK interest rates are likely to eclipse US ones before long and stay higher. This supports sterling until either inflation comes down and the interest-rate support weakens – or it doesn’t, and confidence in sterling evaporates.

The advice from Argentina would be to take your money out of the country, as they do. There are no exchange controls in the UK, but there were until 1979 and they could return. Using the current strength of sterling to sell might prove shrewd, especially as there has never been a Labour government that hasn’t devalued sterling.

Many wealth managers grabbed the opportunity of the spike in ten-year gilt yields to more than 4% last October to lock in the highest yields since 2010. This looked clever for a couple of months as yields fell back: the winter energy crisis failed to materialise as wholesale prices dropped and the forced selling of gilts by pension fund managers came to an end.

Now, however, it looks much less clever as ten-year yields have risen well above 4%, despite the absence of forced sellers and the collapse in energy prices. In sterling terms, gilts aren’t even reasonable value until inflation drops below yields or can be expected to do so in the short term. That may be the case at a yield of 5% but it may not. In any case, the risk to sterling probably makes US and German bonds, yielding less or considerably less than gilts, more attractive.

The resilient economy might be expected to result in an improvement in the government’s finances but there is no sign of this. Borrowing in April was £25.6bn, £11.9bn higher than a year earlier. Only £3.1bn of this increase was accounted for by higher debt interest, while extra public spending made up £9.3bn. Some of this is due to the energy-support scheme but, since it was largely wound up in March, not much of it.

Of more interest is that public-sector receipts only rose by £0.9bn, implying a significant fall in real terms. If this turns into a trend, it will be disastrous for government finances, strongly suggesting that Hunt’s swingeing tax increases have had the opposite effect to that which was intended. The Truss/Kwarteng strategy to cut taxes in the expectation of higher revenues may prove to have been right after all. As Eric Morecambe said to André Previn: “I’m playing all the right notes – but not necessarily in the right order.” Hunt has played the wrong notes in the wrong order.

Good news may, at last, come through on inflation but interest rates clearly have further to rise, hampering the housing market and mortgage holders. The British economy has been resilient but this may not last. The public finances are in a mess and both the Treasury and Bank of England are totally discredited. Fortunately for investors, the global outlook is much healthier.