Who is Beating Inflation?

Due to a consequence of mistakes in fiscal and monetary policies, inflation in 2022 has jumped to levels not seen in decades in the western world. The good news is, US inflation now seems to be heading back down to 3%, the UK has broken through the 8% barrier, while Europe is still hovering around 5.5%.

As the US always leads in most things, one should expect both the UK and the Euro area inflation to slowly trend back down to the ranges that policy makers like by year-end. Therefore, two questions beckon. Have we beaten inflation? And if so, who beat inflation?

The answer to the first question is that we need to see a few more readings to be sure that inflation has been tamed.

The answer to the second question is more interesting. We need to look at the causes of inflation. In the last three years, the world has witnessed unprecedented disruption due to the war in Ukraine, and the effects of Covid-19 which forced governments around the world to lock people at home and pay supplemental income to those who lost their jobs or simply couldn’t ‘work from home’. Governments that prevented people from working had to take on the responsibility of paying them, and this was done both indirectly, by helping companies and directly, individuals.

The problem was that governments made a dosage mistake. Most people in the developed world, especially the relatively affluent young professionals, tend to spend an important portion of their income on entertainment, eating out, and travel. Due to long lockdown periods, the supplemental income that people received, that was not spent, increased savings. These savings were initially invested in stock markets, cryptocurrencies, watches and the like. But then, as the world reopened, pent up demand for travel, restaurants, and entertainment resulted in a flood of money into a plethora of services, that were themselves facing supply shortages in every aspect imaginable while they ramped up their capacities. Scarcity of service staff at restaurants, handlers at airports and the inability to refill old positions due to people moving for various reasons during the long lockdown period lead to higher costs in the aftermath of the lockdowns. And to compound policy errors, as soon as he got elected, Biden decided to give more money to more people in an unprecedented stimulus package while the effects of Covid-19 were subsiding, in a move that most economists thought was a colossal fiscal policy error.

The result: low supply of goods and services, high savings, new stimulus, and pent-up demand, high inflation. Prices moved up, and if history is an indicator, they will not really come down. There has been a parallel shift in the curve but inflation is not a measure of price levels, it is a measure of acceleration. Just like getting sucked in to your seat on a plane during take-off at 250MPH but not feeling anything when it stabilises at 550MPH, what is felt is acceleration, not the static higher levels of speed.

Monetary authorities, who were asleep at the wheel when inflation started moving up and were still priming the economy with low rates and quantitative easing (remember QE? Simply put, buying bonds and increasing money supply), had to catch up rapidly and deliver nearly constant monthly interest rate increases that have brought short-term rates around the world from around zero to the 4-6% band.

The question to ponder is, was it higher rates that was taming inflation? If inflation went up because of a supply and demand mismatch that has since subsided, perhaps inflation too has now stabilised after moving the prices higher. This would mean that this stability has less to do with higher rates and is more a result of the absence of the reasons that brought it up in the first place. Or alternatively, we have entered a price-wage spiral reminiscent of the ‘70s that will take much longer to cure.

The next few months will tell. In the meantime, medium-term low risk bonds could be a bargain in either scenario.

The First Bailout is the Cheapest….

What if …. on that infamous September week in 2008, the Fed decided to do for Lehman what the Swiss Central has announced tonight in connection with Credit Suisse, namely announce a backstop, if necessary. History probably would have been very different.

Lehman wasn’t a basket case, it had a liquidity problem deriving, among other mistakes, from a funding mismatch. If given the time, it would have probably been able to weather the storm. But at the time the Administration and the Fed decided, for multiple reasons, to look away and let them file for Chapter 11. The chaos that ensued forced the Fed and the US authorities to have to spend trillions to save the US banking system. The Fed had to cut rates to near zero and to embark on a quantitative easing program that lasted a decade.

This incredible avalanche of cheap money had soothing but also long-term negative effects by distorting the capital markets’ usual functioning and bringing rates down to negative in many countries around the world.

Negative rates adversely affected savers, gave huge headaches to insurance companies whose liability matching was made nearly impossible. It also led to super high equity markets whose valuations are also a function of the discount rate.

Then came Covid-19 and the unprecedented stimulus that President Biden bestowed upon Americans at a time when it was probably not needed anymore, at least in that magnitude. That, coupled with other exogenous factors (spike in energy costs, stressed supply chains, war…) stoked inflation to forty year highs.

To combat inflation, the Fed starting to reverse course, late, and therefore even more abruptly, with consecutive 50 and 75bps hikes that brought rates higher by nearly 500 bps in less than one year. And this is now the cause of the current crisis, the bank crisis.

Usually, banks tend to do well in times of higher interest rates because they are more efficient at managing their treasury than their clients at managing theirs. Money kept on current accounts or in low yielding deposits can be placed in loans, bonds, and deposits with other institutions at higher rates. And, in fact until just over a week ago, the banking sector seemed to be doing just fine. But under the apparent calm, another big problem was brewing, asset liability mismatching, or a reverse Lehman problem, to turn full circle.

SVB collapsed for a very simple reason. When its clients, inundated them with cash they received from tech investors and PE funds deposited their funds with SVB, the bank had to deploy this cash, and typically banks will buy safe government bonds, as a preferred part of their investment portfolio. Usually government bonds are relatively safe, except that bonds’ performance are a factor of two components, credit risk and interest rate risk. Credit risk is by definition low (or zero) for US Government bonds, but the interest rate risk component blew up in historic proportions in the last ten months. As bonds decline when prevailing interest rates rise, banks such as SVB, and many others, found that the mark to market value of their bonds had declined by possibly over ten percent. However, certain accounting rules allow banks to report the value of their bonds as they will be worth at maturity, and at maturity bonds go back to par. On the liability side of the balance sheet, as prevailing money market rates started to go up and investors time deposits rolled, SVB had to pay increasingly higher coupons to its clients, whilst being stuck with fixed rate assets now (temporarily) underwater. Once client started to smell this mismatch, they started pulling money out and created the proverbial bank run. This same scenario is playing out in many variations at lenders across the world.

One policy mistake fifteen years ago is reverberating across the markets leading to more mistakes, more corrections, more bailouts, more pain. When will it end?

“Reverse” Sanctions?

President Biden has been credited in the media and in democratic circles for having responded swiftly and effectively to Russia’s invasion of Ukraine.  While it is true that the sanctions plan that his administration has orchestrated against Russia was one of the few available arrows in his quiver that didn’t risk a wider conflict, it is becoming quite apparent that the sanctions are not effective, or at least not as intended.

A few weeks after the start of the war Biden boasted that “sanctions are working”, with the ruble in free fall worth not much more than an American penny. However, six months later, the ruble has more than doubled in value since mid-March and is now worth more (61 to the Dollar) than it was worth before the war (83 for one Dollar). In addition, Russia’s income on its Crude and Gas exports are higher than before, with a lower level of sales more than compensated by higher prices. If Russia were a corporation, it would be having a great quarter, with stable income and a fraction of Cost of Goods Sold.

So who is suffering from these sanctions? Very simple: Europe. While one should remember that Europe’s ills are mainly of its own making, with a disastrous energy policy that relied on Russia being their friend forever, it doesn’t take a sophisticated econometric model to understand that in the zero sum game of trade economics, Russia is not losing, rather it is actually winning, while European consumers and factories have to pay for its gas up to ten times the cost of last year. This is ravaging energy-heavy industries such as steel and ceramics for example, and in a way all heavy industry which is dependent on energy. We are now hearing of factories in the continent that will not reopen after the August break, as in many industries production cost is now higher than prices. Producing means losing money. If this vicious circle is not corrected, look for industrial production to take a nosedive in the fall, with all the economic and social consequences. Requests for layoffs are already being made.

The sanctions on Russia have become sanctions on Europe. There may not be a quick fix, but it is obvious that Biden’s sanctions have failed miserably. Time for a change, before the European united front fractures and populist parties gain.

Italy’s revival despite its moribund airline…

Italy has generally taken good advantage from the Covid-19 tourism hiatus, to develop new world class hotels, refurbish aged ones, build new airport terminals and more. Milan’s city airport Linate has been upgraded and it is a pleasure to spend some time in it between flights. Rome’s Fiumicino airport has become a world class hub with state-of-the-art facilities, full wall LCD screens everywhere, tasteful design, real high-quality malls with the best global designers and brands. In short, an apt window into what Italy is best at, design, fashion, and good taste.

Rome’s aging hotel stock is also being upgraded and complemented with global and local brands which are attracting well-heeled tourists from around the world. This is in addition to a reborn short-term letting industry which has suffered during the pandemic but seems to be emerging stronger than ever. Away from Rome and Milan, “new” beautiful tourist destinations have also gone international, imagine places such as Puglia and Forte dei Marmi, which were traditionally domestic destinations, and are now boasting world class hotels with an increasingly jet setting international clientele.

The remaining black mark for Italy is unfortunately in its national visiting card—its flag airline, Ita Airways (PKA Alitalia). Despite uncounted billions of euros of government investment during the last two decades, Alitalia was always on the brink financially, and barely acceptable from a passenger experience point of view. Last year, after the umpteenth auction to sell it to private equity or to a global competitor failed, the state was forced to buy it and recapitalise it by letting Alitalia close down and setting up a ‘new Alitalia’, Ita Airways that effectively acquired its planes, slots, and most of its employees. Nine months into the process, very little seems to have changed, starting from the planes, most of which are still painted Alitalia, even though there is a growing number that have been repainted with Ita’s livery at a cost of $50,000 a plane. Aside from this, the airline is setting new lows for client service. To get a glimpse you can check online reviews, which give it an average of 2/5 on most categories.

While nations can thrive without a national carrier, one would think that if you have one, it has to adequately represent its host nation. Emirates had a big role in promoting Dubai as both a hub and a destination in its own right. Alitalia/Ita is today a poor window into an Italy that is turning around, a mediocre low-cost carrier with a major airline ambition and cost base. On a recent trip in business class, I was one of three passengers in a class that can carry 16, and the reasons are obvious… the seat configuration, not to speak of the service are simply inadmissible in today’s competitive marketplace.

The airline seems to be up for sale again…Let’s hope that it can find a suitable buyer that will either upgrade it to a national pride or downgrade it to an efficient low cost. The middle seat is untenable as well as uncomfortable.

Why shouldn’t we call a spade a spade? This is Biden’s Saigon Moment

There is one key difference here. Biden is (D) and is supported by a left-wing democratic party. True, the decision to withdraw was initiated by President Trump. It was a bad idea under Trump, and it has become a national disgrace under Biden. The incumbent cannot blame his predecessor here, this is not a policy that takes months or years to reverse, like many in economic policy. In his first day in office Biden reversed with the stroke of a hand many Trump policies and he could easily have ordered a reappraisal of why and how to leave Afghanistan.

Twenty years after 9/11, after investing (squandering?) over 2 Trillion dollars and thousands of lives of its servicemen and contractors, the US is leaving Afghanistan, less than emptyhanded, humiliated and with its reputation in tatters.

As the Taliban conquer the presidential palace, and the US send helicopters to evacuate its embassy, the memories of Vietnam become vivid. If there was a Republican at the white house, the media would have crucified the president presiding over this terrible precedent that the US is showing to allies and foes. One could argue that in recent years the Afghanistan campaign was highly successful in terms of costs vs benefits. The US only had less than 3,000 troops in Afghanistan, and hasn’t suffered a human loss in about a year and a half. In life it is usually not prudent to throw good money after bad, but protecting one’s investment on the cheap seemed the better strategy here…

When More is Less

French President Emmanuel Macron has criticised Austria and Denmark for their declaration of wanting to cooperate with Israel in the production of vaccines. This comes on the heels of Austria’s eastern neighbours’ decision to approve the Chinese and Russian vaccines. According to M. Macron, European states should not attempt to forge alliances outside the EU perimeter but rather concentrate their efforts to centralise solutions within the EU frameworks.

M. Macron is wrong on multiple counts. Firstly, centralisation is very often less effective than states competing to get best results. Older readers will recall the famous/infamous 5 year economic plans of the Warsaw Pact countries. It was a recipe for economic disaster, which took decades to unfold but at the end, in 1990, unfold it did. Federal countries like the United States have honed the centralist/state model for nearly 250 years, and they are still bickering about it, witness the recent decisions of some states, led by Texas, who will drop Covid measures next week.

Furthermore, the EU bureaucracy has proven inept at managing the procurement process. Britain and Israel, free from centralised shackles have understood very early that vaccination was a health and economic must that had to be approached in a non-conventional fashion. Britain was lucky enough to have left Europe at just the right time to be able to make preparations and orders independently, while Israelis, who can’t usually be criticised for over-paying, decided to do just that in their quest for national vaccination.

Picture this. By some counts, one day of lockdown in the UK costs £500m-1bln to its economy. The average double dose of vaccine costs, say, £25. This means that the cost of all the vaccines to cover an entire country can be financed by avoiding a few, extra days of lockdowns. Which means that the cost paid per dose is completely irrelevant, yet the EU allegedly spent weeks if not months bickering on price. These delays will translate into a 3-6 month delay in vaccinating their populations, which will costs EU countries hundreds of billions of Euros. A CEO making such a mistake would be fired by his board. A prime minister would face his angry voters. What are the consequences of the lack of foresight of the EU executives?

The Vaccine Saga

Italy is a country historically rife with conspiracy theories.

In the past, they have ranged from who were the political backers of the Red Brigades (the Americans or the Russians?), to why Juventus wins so many championships (the Agnellis control everything), to how gnomes in New York play with Italian politics by ‘adjusting’ the BTP/Bund spread. There are many more examples.

Today, the mother of all conspiracies is why Italy is not getting enough people vaccinated. The argument goes that other non-European countries are somehow deviating Italy’s supplies of vaccine. The reality is that Italy is suffering the results of the incapacity of the EU to manage the centralised purchase of the vaccines for hundreds of millions of Europeans at the same time. The EU is an institution that is quite good at putting on the brakes, not at swiftly making things happen. The EU’s executive is appointed and not elected. Its appointers are not looking for charismatic leaders that could eclipse them, they are rather looking for dependable administrators who will follow the protocols. The problem is that the EU had no experience in negotiating purchase agreements of this size and in order to ensure it be seen to do the right thing, it wasted precious time in negotiating with a fine tooth comb and arguing for better prices. The problem is that it didn’t recognise that there are times when price is irrelevant and redundancy crucial. Israel and the UK understood much earlier that it doesn’t matter if you pay $30 (apparently what Israel agreed to pay) for a vaccine or around $10, like the EU did. Every extra week of lockdown is worth a lot more than a few dollars of savings, especially in the midst of a pandemic.

Mario Draghi is credited for having saved Italy and the EU in the midst of the financial crisis. He will now have to apply his ‘we will do whatever it takes’ modus operandi to independently acquire vaccines if he wants to prevent League leader Salvini and his Fratelli d’Italia colleague from running on a very popular vaccine-denial, anti Europe platform in the near future.

Learning the lessons?

This week marks the approximate anniversary of the arrival of the Covid pandemic in mainland Europe. It is notable that while certain towns and regions in Italy were already in lockdown mode at this time last year, other countries such as the United States seemed to be immune until March. On this day last year, we were in Florida where everything was open and masks were unheard of. Meanwhile, Italy was already testing the body temperature of arrivals at airports, and beginning to curtail flights from China.

In the UK it was still more or less business as usual. In fact you may argue that it has taken the UK twelve months to get a hold on its borders, as the harshest measures have only been introduced in February….. 2021!

Consider the difference. Granted that we are worried about mutant viruses, but as of today, the UK has administered over 18m doses of vaccine; if you take into consideration the subjects who are somehow immune, or protected, because they had the virus already, and children who don’t seem to get sick, we are now getting close to 50% of the population being vaccinated or immune. In addition, one year ago, the UK had no real testing capacity. Today they are doing many hundreds of thousands of tests per day.

One would have thought that the borders should have been closed (especially to China) when the disease was difficult to diagnose (for lack of testing capacity) and non-curable/preventable (no vaccines and no effective therapy), and that the restrictions should be relaxed now that the combination of cheaply available testing and vaccines are an effective barrier to contagion. True, it is not proven that vaccination means non transmission. It is also true that testing (especially rapid testing) may not be exact; however, public policy in almost every field aims to minimise and not eliminate problems and to balance prevention with the negative effects of limitation of liberties, commerce, travel etc. No government gives its citizens a guarantee that the streets will be 100% safe from crime. Covid prevention should also fall into the minimisation rather than elimination, bucket.

From Mario to Mario… there was none like Mario

When in 2011, the then President Napolitano asked Mario Monti to form a new government of technocrats, Italy wasn’t very far from its own version of a financial crisis. Credibility in Europe and in the financial markets was near record lows, and the new Prime Minister assumed his role by promising an economic version of “blood, sweat and tears.” His job was to cut costs, increase taxes, reduce the budget deficit and therefore resume Italy’s access to financial markets, a very delicate matter for a country with one of the highest Debt/GDP ratios. Professor Monti succeeded to a certain extent, but his government only lasted two year. By that time his political capital was eroded by having to administer such bitter medicine.

Roughly ten years later, President Mattarella gave his approval a few days ago to another professor, another Mario, the Central Banker emeritus Mario Draghi. While certain circumstances are similar, their mandate couldn’t be more different. Whereas Monti had to cut the budget deficit and start reducing the national debt, as a proportion of GDP, Mario Draghi’s mandate is twofold. He will need to ensure that Italy gets its full allocation of the recovery moneys, which have already been generously earmarked for Italy, and even more importantly, he will have to ensure that those funds are spent well, so that from the ashes of the crisis, Italy can find its renaissance. Both Marios’ jobs were and will be challenging, but the big difference is that Draghi will put money in people’s pockets, whereas Monti had to do the opposite. If Italy ever had a chance to emerge from nearly two decades of stagnation, Mr. Draghi is its best chance.

Mr. Monti’s political career ended quickly with a failed election and he soon returned to academia. Mr. Draghi probably has no intentions at all to stay in politics. He has a mission to do, and he has the skills and the credibility to get it done in the two years before Italy’s next general election.

Give the guy a break?

Make no mistake. Trump’s behaviour in the last two weeks in office was highly objectionable, if not much worse. His call to the mob was indeed outreagous.  As CNN loves to repeat, the peaceful transfer of power is the hallmark of every democracy, first among them the United States, where there is a constitutionally long transition period that is required in part also by the complexity of the government.

However, we learned in school that the institution of impeachment applies to sitting presidents,  in order to attempt to remove them for having committed the highest crimes in the book, including treason. While it isn’t clear that it shouldn’t apply to a president in the last days of his term, as Trump was, impeachment wasn’t framed by the founding fathers as a way to continue a political fight once the president has left Pennsylvania Avenue. The Democrats have four years now to prove their case to the American people and if the Republicans were to run again with Trump in 2024, they will have to beat him at the ballot box.

One fails to see how the continuation of this vendetta post his term will help the healing of the nation and especially Biden’s agenda. Paraphrasing  Nikki Hayley, our preferred Republican candidate for 2024: give both guys, Trump and Biden, a break!