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more details, please visit the link

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in the show notes or go

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to raising.co.uk slash Pensioncraft. Gilyield

0:29

is surging, straining government finances and

0:32

raising fears of tax rises or

0:34

spending cuts. But is this a

0:36

UK-specific problem? And will the Bank

0:38

of England be forced to respond?

0:40

Our guest today is economist Simon

0:43

French, who brings a wealth of

0:45

experience from investment banking and working

0:47

at the heart of government. And

0:49

in today's dumb question of the

0:51

week, we ask, why does the

0:54

government need fiscal rules? All

1:01

right, let's get into it. Today we're

1:03

delighted to be joined by Simon French,

1:05

chief economist and head of research at

1:08

Investment Bank, Pan-Myur Liberum. Simon writes

1:10

on economics for the Times and

1:12

previously worked in senior government roles

1:14

at the UK Cabinet Office. Thanks

1:16

so much for joining us, Simon. My pleasure

1:18

Michael. So it's a sad day when I'm

1:20

excited to talk about bond yields, but here

1:22

we are. So last week UK borrowing costs

1:25

made headlines for the wrong reasons, with the

1:27

10-year guilt yield hitting a post- 2008 high.

1:29

And the further out you went on

1:31

the yield curve, the worse it got

1:33

really, with the 30-year bond yield reaching

1:35

5.4% which is the higher since 1998.

1:38

So Simon, what is going on with

1:40

this surgeon yields? Well, first and foremost,

1:42

thank you for having me on

1:44

the podcast and there is nothing

1:47

boring about Bondeels. The challenge, I

1:49

think the challenge is to explain

1:51

some of this stuff to particularly

1:54

to the retail investor or the

1:56

non-financial markets participant without bringing out

1:58

sort of cliches. about 1007 or

2:01

something that US politicians said 30

2:03

years ago. That's your staple when

2:05

talking about the bomb market. So

2:07

I'll try and avoid all those

2:10

cliches. But what is going on

2:12

in the last few sessions is

2:14

largely economic events, economic data, economic

2:16

uncertainty, the other side of the

2:19

Atlantic from where we're recording this

2:21

in the UK. We've had some

2:23

strong US economic data pointing to

2:25

a stronger jobs market than. many

2:28

had perceived, more inflationary pressure, fewer

2:30

rate cuts from the Federal Reserve,

2:32

which of course sets the value

2:35

of money around the world. But

2:37

with an overlay, an overlay as

2:39

well that UK fiscal policy

2:41

looks rather looser than you

2:43

would want at these levels

2:45

of interest. and also the fact

2:47

that growth, having been pretty strong actually

2:49

in the first half of the year,

2:52

the UK, and it's easy to forget

2:54

actually right now, the first half of

2:56

2024, was the fastest growing economy in

2:58

the G7, it feels like a long

3:00

time ago, but the data has definitely

3:03

deteriorated. Put that all in the melting

3:05

pot, actually people buying UK government debt

3:07

right now are demanding considerably high yields

3:09

than they did just a couple of

3:11

weeks ago. So just a step back

3:14

a moment, certainly the long end

3:16

of the yield curve is driven

3:18

by growth, inflation expectations, but in

3:20

the UK, we're in a strange

3:22

situation because we're very much exposed

3:25

to US rate changes. And this

3:27

is a global phenomenon, isn't it?

3:29

We've seen rates increase across the

3:31

entire developed markets. That's absolutely

3:34

right. And the UK is something

3:36

of a price taker for its

3:38

cost of money. Now, of course, the

3:40

Bank of England, if it's feeling

3:43

uncomfortable about how tight financial conditions

3:45

are as a result of this,

3:48

could step in, either using its

3:50

primary tool, which is interest rate

3:52

cuts, or indeed its other toolkit,

3:55

which is its balance sheet and

3:57

slow the pace of divestment of...

3:59

guilt, I'd rather favour the latter

4:01

because I think we do have

4:04

some fears about stubborn inflation and

4:06

also that is likely to be

4:08

amplified if the Bank of England

4:10

goes on a more aggressive rate-cutting

4:12

cycle than the Federal Reserve through

4:14

the impact on the exchange rate

4:17

and specifically on Sterling. And while Sterling,

4:19

I think there's been some... poor commentary

4:21

on what's going on with Sterling. Sterling

4:23

has definitely weakened versus the dollar, but

4:25

has actually remained pretty stable in recent

4:27

sessions on a trade way to basis,

4:29

certainly against the euro, which is the

4:31

other big cross-rate. So I think there

4:33

are a few more options for the

4:35

bank of England to be a bit

4:37

more dervish. on current FX, but of

4:39

course the fear would be that if

4:41

it really took a really strong duffish

4:44

pivot you'd start to see weakness across

4:46

all the currency pairs and that would

4:48

start to push up imported inflation.

4:50

It does seem slightly strange

4:52

doesn't it? There are in a situation

4:54

where yields are rising quite rapidly and

4:56

yet the Bank of England is selling

4:59

a load of bonds into the market

5:01

with QT, quantitative tightening. Are they

5:03

making a mistake there? Are they sort of

5:05

adding fuel to the fire? First of

5:07

all, case for the defence for

5:10

the Bank of England. It has

5:12

started, like all the major central

5:15

banks, actually extra Japan, on divesting

5:17

its asset purchases taking place over

5:19

the last 15 years since the

5:22

global financial crisis. And the pace

5:24

of that divestment has been

5:26

slightly faster than the US

5:28

and not quite as fast

5:30

as the ECB if you

5:32

look at the proportionate draw

5:34

down since balance sheets peaked

5:37

during 2022. But and you

5:39

knew you knew there was

5:41

a buck coming. It had

5:43

to do that. through active

5:45

sales of guilt rather than

5:47

passive sales because the UK

5:49

debt stock its guilt are

5:51

rather longer duration than Eurozone

5:53

bonds and treasuries. Unadjusted for

5:55

quantitative easing or the

5:57

bank's balance sheet we could a

5:59

jury of about 18 years, which

6:01

compares to the US debt burden,

6:03

the Eurozone debt burden of about

6:05

five to six years. So as

6:07

a result, if we just did

6:09

maturity divestment from the bank balance

6:11

sheet, it would take a lot

6:13

longer for it to normalise its

6:15

balance sheet. And by the way,

6:17

I use the word normalise. with no

6:19

idea what the normal size of a

6:22

central bank balance sheet is. The good

6:24

news is neither Jerome Powell, Christine Lagarde

6:26

or Andrew Bailey, they're all guessing and

6:28

quite frankly they're divesting until such point

6:31

as something breaks. I mean we're in uncharted

6:33

territory really aren't we? We haven't

6:35

seen bank balance sheets grow like

6:37

this before really. We haven't seen

6:39

them grow like this, and we haven't

6:41

seen them shrink like this. We saw

6:43

some shrinking from the Federal Reserve in

6:46

2017-2018, which came to a hard stop

6:48

when something started to break in the

6:50

US money markets. Are we at a

6:52

point again where banks go perhaps

6:55

conveniently, central banks that is, that

6:57

we've divested enough of our holdings

6:59

and financial conditions are too tight

7:01

for what the underlying economy wants.

7:03

But I think that's... probably my

7:05

thesis here, which is that a

7:08

little bit of pulling back off

7:10

the of the break pedal through financial

7:12

conditions from active sales from the Bank

7:14

of England would actually be quite a

7:17

smart move at this point. It will

7:19

still divest of about 85 billion pounds

7:21

this year, but taking off a little

7:24

bit off the top, which they're going

7:26

to do in active sales, which has

7:28

fiscal implications in the UK. It costs

7:31

the treasury to indemnify the Bank of

7:33

England against losses. And if you don't

7:35

let your... portfolio, bond portfolio run to

7:37

maturity, you're selling it less than power,

7:40

you're creating losses and the taxpayer actually

7:42

ultimately has to pick up the tab.

7:44

Yeah, at the moment, just to be absolutely

7:46

clear, the sell-off is orderly, isn't it?

7:48

It's not the case that there's no

7:50

liquidity in the treasury market or that

7:52

it's a one-way market or that the

7:54

Bank of England's going to have to

7:56

step in to stabilise markets as we

7:58

saw during the big sell-off. during the

8:01

trust quatting episode? Yes, I

8:03

think you're right. There was a

8:05

very asymmetric move back in

8:07

2020. This is partly due to

8:09

the mini budget coming a bit

8:11

out of left field in terms

8:14

of its policy prognosis, partly because

8:16

of the LDI issue that

8:18

was spoken about in secure

8:20

corners of financial markets, but

8:22

wasn't widely acknowledged, but also

8:24

a very different energy market

8:26

backdrop. And that... triggered an

8:28

intervention from the Bank of

8:30

England. I have to say

8:32

a very successful intervention. It

8:34

made a considerable profit on

8:37

its interventions of buying bonds,

8:39

particularly at the long end

8:41

of the curve, to bring

8:43

30-year yields down and bring some

8:45

stability to that market. We're probably not

8:47

there at the moment. You're right. This

8:49

isn't disorderly. This isn't quite as asymmetric

8:51

for the UK. I should say we're

8:53

recording this on Monday morning, Monday the

8:55

13th, so who knows? By the time

8:57

you listen to this, the Bank of

8:59

England might be all over it. Well,

9:01

I mean, Michael, you've actually teed up

9:03

the next sentence I was going to

9:05

say, which is things can move quite

9:07

quickly, and as a central bank, as

9:09

a financial stability guardian, you want to be ahead

9:11

of the story, you don't want to be

9:13

behind the story. There's nothing worse than having

9:16

to having to react to events and being

9:18

seen, and being seen as being behind the

9:20

cliche being behind the curve. So as we're

9:22

making this recording on Monday morning,

9:25

the banking hasn't yet taken proactive

9:27

action. But if we start to

9:29

see Bond yields rise asymmetrically in

9:31

the UK, we start to see

9:33

Sterling weaken across the currency complex,

9:35

then they may live to regret

9:38

that decision. So just turning to

9:40

government finances, because you hinted

9:42

that it has an implication, both

9:44

from the Q&T side of things,

9:46

but also just... when we're paying a

9:49

higher cost of borrowing, that is eating

9:51

away at the so-called headroom that the

9:53

government has. And I believe at the

9:55

budget it was around 10 billion pounds

9:58

of headroom, which some people are... saying

10:00

is now gone. Yes, and the Treasury have come

10:02

out with a rather defensive line, which

10:04

I don't think anybody believes, which is,

10:07

well, there's only the OBR that can

10:09

make that calculation of how much headroom

10:11

there is, because there's lots of moving

10:13

parts. We can all do the math,

10:16

and quite conveniently, actually, the OBR producer

10:18

ready reckoner for public consumption on if

10:20

you see a hundred basis point increase

10:23

across the guilt curve, that reduces

10:25

the government's headroom by conveniently about...

10:27

well just shy of 10 billion

10:29

pounds so I don't think it's

10:31

unrealistic that independent economists have said

10:33

look this move in the guilt

10:35

curve has knocked out the headroom

10:38

yes there are other moving parts

10:40

but some of those other moving

10:42

parts are not particularly favourable either

10:44

since the OBR projected back at

10:46

the end of October the growth

10:48

data for next year and of

10:50

course the year 2025 where the OBR

10:52

sees the economy growing 2% I have to

10:55

say the downside risk to that

10:57

number is growing quite appreciably given

10:59

the latest PMI's latest confidence data.

11:01

So I think you make an

11:03

absolutely reasonable assertion that all

11:05

else being equal and all else is

11:08

never equal, the movements in Bon Jield

11:10

has eliminated that headroom and leads to

11:12

a particular challenge for the Treasury as

11:14

to what it's going to do around

11:16

the 26th of March when the OBR

11:18

provides its first forecast of 2025, which

11:21

may well say the government is... close

11:23

or if not breaching its

11:25

current fiscal rules. Now I see

11:27

that the actual spending on

11:30

debt interest for the UK

11:32

was $102 billion in 2324,

11:34

so that's just a shade under

11:36

4% of GDP or about 8%

11:38

of government spending. A third of

11:40

our debt is inflation linked.

11:43

So obviously after we've had

11:45

this inflation spike, prices are

11:47

about 20% higher, do you

11:49

think it was a mistake

11:51

to have so much? inflation

11:53

linked dead. Wow we could probably do

11:55

a whole problem. I have written

11:57

a column when Robert Street them

12:00

who was the head of the

12:02

debt management office recently retired and

12:04

I said he'd done an excellent

12:06

job and I'm not going to

12:08

change my diagnosis there. There is

12:10

large institutional demand for RPI-linked debt

12:12

from our outsized DB pension scheme

12:14

in the UK at least until

12:16

the most recent spike in inflation

12:18

that had been quite a profitable

12:20

way or quite an attractive way

12:23

for the government to raise debt

12:25

because the yield were relatively low

12:27

but you are right. This isn't

12:29

just a one-off shock which we're

12:31

seeing reverberations from in the energy

12:33

market, but actually we're going to

12:35

see a sustained period of higher

12:37

inflation. That is going to be

12:39

more expensive debt. Now, just to

12:41

put some numbers to what you

12:43

said, I think the 23, 24

12:45

rolling dates are just north of

12:47

a hundred billion. I think it's

12:49

closer to about 80 billion on

12:51

a run rate on the current

12:54

rate of RPI because the RPI

12:56

has come down a long way.

12:58

But clearly if either currency weakness

13:00

or events in the global economy

13:02

become more inflationary, that's going to

13:04

ramp back up and put further

13:06

pressure on the public finances. Do

13:08

you see UK inflation as a

13:10

sort of unique problem? It seems

13:12

that services inflation is sticky, wage

13:14

growth is still strong and maybe

13:16

unsustainable. Are we in a different

13:18

position from the rest of Europe?

13:20

Certainly to the rest of Europe,

13:22

but... this is not something recent

13:25

or unique. Actually, at least until

13:27

recently, I haven't run the numbers

13:29

since. If you actually look, since

13:31

most central banks gained policy independence

13:33

in the mid-90s, and the Bank

13:35

of England's case 9798, actually UK

13:37

CPI has average about 2% within

13:39

about 10 basis points of 2%.

13:41

Actually the ECB. materially undershot. The

13:43

Fed actually undershot and of course

13:45

the Bank of Japan very much

13:47

undershot over that period. So on

13:49

while we don't have a price

13:51

level target over the last 25,

13:53

30 years actually the UK has

13:56

had higher inflation but consistent with

13:58

its inflation target but you're absolutely

14:00

right the most recent data taken

14:02

over the last three years does

14:04

suggest something of an outsized problem

14:06

with UK inflation but the suspects

14:08

for that are many and not

14:10

always the ones that Perhaps the

14:12

Bank of England's central forecasting model

14:14

would suggest they might suggest the

14:16

supply side has been impaired post-pandemic,

14:18

post-Brexit, and therefore actually what they

14:20

describe is the run rate of

14:22

the economy, the amount of growth

14:25

you can have before that it

14:27

becomes inflationary, has come down. But

14:29

all, I would take a slightly

14:31

different view. which is we have

14:33

a lot of regulated prices in

14:35

the UK, regulated prices for example

14:37

in low pay, which take no

14:39

account of the output gap, the

14:41

Phillips curve, the type of workhorse

14:43

assumptions that central bank models use.

14:45

Actually they're just regulated on lagged

14:47

inflation to hit a policy target

14:49

to get the national living wage

14:51

to two-thirds of median income. You

14:53

have other areas regulated rail fares.

14:56

broadband contracts linked to lag CPI.

14:58

So what you have, actually, and

15:00

this is where my model for

15:02

inflation differs to a lot of

15:04

other forecasters, is the most powerful

15:06

driver of inflation in the UK,

15:08

is inflation T-1, so last year's

15:10

inflation. So you have a series

15:12

of echo effects with regulated prices,

15:14

rather than if you like structural

15:16

factors. So that's why, if you

15:18

like UK inflation, in my view,

15:20

has hung around a little bit

15:22

longer. because the amount of prices

15:24

that we regulate on lagged inflation,

15:27

rather than necessarily those structural factors

15:29

that a lot of, perhaps make

15:31

a bit more of an appealing

15:33

academic argument, I don't think stacks

15:35

up to what the data is

15:37

telling us. Certainly listening to the

15:39

Bank of England doing their press

15:41

conferences, they stress the fact that

15:43

people are trying to catch up

15:45

in terms of personal wages, but

15:47

also companies are trying to redress

15:49

some of the losses they made

15:51

during the period of very high

15:53

inflation. So do you think that's

15:55

also... a factor? I think that's

15:58

a very good additional factor to

16:00

all of this, which is again,

16:02

talking about lags and quite considerable

16:04

lags. We talk about lags in

16:06

monetary transmission from interest rates, financial

16:08

conditions, economic activity, but also lags

16:10

in terms of price setting and

16:12

something of a catch-up process. I

16:14

do think that is correct. And

16:16

that makes it really hard to

16:18

know what the right level of

16:20

financial conditions and monetary policy is

16:22

for aggregate demand given the price

16:24

signals may be suggesting a very

16:26

different demand and indeed supply picture

16:29

than actually the the underlying economy

16:31

would require or indeed justifies. Do

16:33

you think the Bank of England

16:35

is kind of stuck between a

16:37

rock and a hard place, sticky

16:39

inflation on one hand, stagnant growth

16:41

on the other hand, stick or

16:43

twist, right? It's a tough task.

16:45

It is a tough task for

16:47

Andrew Bailey in the monetary policy

16:49

committee. What's the market expecting over

16:51

the next year? Well, this is

16:53

the thing. I mean, one to

16:55

two rate cuts. I think it

16:57

was only one is now fully

17:00

priced. As of Friday's close, it

17:02

was only one is fully priced,

17:04

about 45 basis points. We didn't

17:06

quite get to that 50 basis

17:08

points for two cuts. But if

17:10

you contrast that with the ECB

17:12

and the Eurozone, which is pricing

17:14

about five to six cuts. you

17:16

know, demand conditions in the UK

17:18

look much more like the Eurozone

17:20

and much less like the US

17:22

and yet the monetary policy expectations

17:24

in the market are much more

17:26

like the US and much less

17:28

like the Eurozone. So there's a

17:31

dichotomy which is only really explained

17:33

by what you are alluding to,

17:35

which is the fact that you've

17:37

got fears over some quite sticky

17:39

persistent inflation which reduces the wriggle

17:41

room for the Bank of England

17:43

compared to those other two major

17:45

central banks. Are we being too

17:47

negative here though on the UK?

17:49

We're going to talk it down.

17:51

I guess since slavery came to

17:53

power, it came in really with

17:55

this sense of optimism and then

17:57

had a long time to wait

18:00

until it was going to give

18:02

it... its budget and this talk

18:04

of black holes and everything, I

18:06

think just depressed everyone, right? And

18:08

we saw consumer confidence full, business

18:10

confidence fall. Is there a prospect

18:12

of growth going forward? Absolutely. And

18:14

has the government made a mistake

18:16

of talking down the economy? First

18:18

thing, first. I get lots of

18:20

stuff. wrong. It's an occupational hazard

18:22

of being an economist. He comes

18:24

with the territory, you'd be delighted

18:26

to go through your career and

18:28

get 51% of calls right. But

18:31

at the start of August, and

18:33

you can pull the tapes, you

18:35

can pull the sort of times,

18:37

column my road to the time,

18:39

I did say that this talk

18:41

of black holes of the worst

18:43

economic inheritance since the Second World

18:45

War. wrist being self-defeating and I

18:47

understood completely why from a political

18:49

standpoint they wanted to pin it

18:51

on the opposition as George Osborne

18:53

did so successfully with that famous

18:55

letter I think it's famous anyway

18:57

from Liam Byrne the Labour Chief

18:59

Secretary of the Treasury said there's

19:02

no more money he wanted to

19:04

pin it on the opposition I

19:06

get it I don't have to

19:08

run for elected office so I

19:10

don't have to do such things

19:12

but if your primary mission is

19:14

growth talking down animal spirits is

19:16

almost the worst thing you can

19:18

do. Now, at the time back

19:20

in August, I would have to

19:22

say I didn't get universal support

19:24

from my peers who thought that,

19:26

you know, animal spirits, you know,

19:28

how you talk up or down

19:30

the economy had very little impact.

19:33

I like to think that the

19:35

data, I don't like, because I'm,

19:37

well, I know, I think we

19:39

can be patriotic, can't we? I

19:41

want the UK to... return to

19:43

being at the sort of top

19:45

table in terms of growth, in

19:47

terms of well-being, household income, all

19:49

the key important metrics. I just

19:51

think that it was either a

19:53

naive calculation or politics overtook the

19:55

economics in the Treasury to peddle

19:57

this narrative and you could see

19:59

that there was a U-turn in

20:01

about mid-September. where they recognized it

20:04

was self-defeating. I think there was

20:06

some GFC consumer confidence data that

20:08

landed in mid-September, just before the

20:10

party conferences, and you could see the

20:12

change of tone. But by that

20:14

point, a lot of the goodwill

20:16

that the government had, businesses had,

20:18

or giving government, had evaporated,

20:20

it's very, very hard to recapture that.

20:22

I mean, they were kind of saying

20:24

the beatings will continue until gross

20:27

returns. It's just a hard message,

20:29

really. was the strategy is difficult

20:31

because others have analyzed the experience

20:34

of the current cabinet, the current

20:36

cohort of labour MPs and noted

20:38

a lack of business experience. Now,

20:41

again, generally speaking, I don't put

20:43

too much stock on, you know,

20:45

what your CV says, but what's

20:48

your capability you bring to the

20:50

party and you don't have to

20:53

have worked in a certain sector

20:55

to have certain skills. Thank God, or

20:57

I have my career would be. But,

20:59

but, and you knew there was a

21:01

bug coming, I do think if you've

21:03

worked in the private sector, if you've

21:05

had to run your own business, you

21:07

have to be an inherent optimist. I

21:10

think, I mean, I find very few

21:12

sales people who are pessimists who a

21:14

dower. they're upbeat and some people

21:16

find that a bit uncomfortable they

21:18

go it's all a bit boosterish but

21:20

you know what the boosters have

21:22

a pretty decent track record both politically

21:24

and economically you know look he's going

21:27

back into the White House next week

21:29

you look who got the biggest

21:31

or at least until the last election

21:34

the biggest majority in recent UK political

21:36

history Boris Johnson I mean people want

21:38

to follow want to support positive

21:40

narrativesatives and while they can't do everything

21:43

I think can do quite a lot

21:45

of the heavy lifting and I think

21:47

it was a bit something of an

21:49

own goal and there are lots of

21:51

structural challenges that the government is right

21:53

to to cite, there's not hide away

21:56

from them an aging population, a skills

21:58

gap, you know, the debt burden. very

22:00

benign productivity growth for a

22:02

long long period. We don't,

22:04

let's hit ourselves though, don't

22:06

exist. But equally all those

22:08

challenges are made harder if

22:10

you also stamp on animal

22:12

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22:43

pension craft. I mean just casting

22:45

my mind back to when I

22:47

was a strategist, whenever you talked

22:49

about things that would really move

22:51

the economy. We usually looked at

22:53

things like credit impulse where you look

22:56

at the change in the size of the

22:58

debt relative to its previous size,

23:00

all compared to the economy, and

23:02

that's how big the bazooka is. Now

23:04

the UK, there was no real

23:06

bazooka at all. You know, they

23:09

had these fiscal constraints, they had

23:11

fairly limited increases in spending. And

23:13

so there wasn't much of a credit

23:15

impulse at all. So I was quite

23:17

negative when they announced the actual

23:19

policies. So do you think there

23:21

are any growth stimulating policies in

23:23

there or is it all just

23:25

talk? No, I do think there are

23:28

growth-stimulative policies and the one

23:30

that we will hear a lot

23:32

about I suspect over the

23:34

next couple of months. you could argue

23:36

we've heard a lot about it already

23:39

but you have that hasn't translated into

23:41

action is planning reform. Now a number

23:43

of people roll their eyes when you

23:45

mention planning reform because it's been promised

23:47

as long as you and I have

23:50

been strategist and it hasn't crystallized because

23:52

of local opposition particularly in terms of

23:54

residential planning but also you know local

23:56

opposition on on critical national infrastructure and

23:58

it adds cost. It adds time.

24:01

My newspaper column this morning

24:03

talks about the plenty of

24:05

attractive investment propositions to deploy

24:07

capital into the UK. I

24:09

see them every single day.

24:11

But what I hear again

24:13

and again from CFOs and

24:15

CEOs is the cost of

24:18

capital deployment. The time, the

24:20

lead in time, is just

24:22

punishingly long and it deters

24:24

investment. I have seen signs

24:26

from various government departments, Andrew

24:29

Arena at Holmes' communities and

24:31

local government. Ed Milibante divides

24:34

opinion on his energy policy,

24:36

but he has approved a

24:38

lot of particularly renewable energy

24:41

projects and accelerated that process.

24:43

And he's also talking about regulators

24:45

getting the better balance between risk

24:48

and reward, and I think that's

24:50

long, long overdue. Those are the

24:52

type of things which you know. curated

24:54

together with a sort of front person

24:57

who can sell this is exactly what

24:59

the UK wants to be

25:01

achieving, to get greater capital

25:03

deployment, get greater investment, get

25:05

that impulse that you're talking

25:07

about back into the economy,

25:10

but I'm afraid it's just

25:12

been drowned out, those accretive

25:14

actions, those signs of progress

25:16

have been drowned out by

25:18

the negative sentiment. Okay, well that

25:20

was sounding a little too positive for

25:22

my liking. I want to bring it

25:25

back down to the doom and gloom.

25:27

So from the point of view of

25:29

an investor here, surely it can't be

25:31

good for risk assets if long-term yields

25:33

are above 5% now. Like what's the

25:36

picture and the outlook for UK stocks

25:38

and I guess global stocks really? Well,

25:40

let's start with the UK first

25:42

because I think it is a

25:44

special sit in terms of its stock

25:46

market. It has been at a

25:49

persistent discount. Certainly since the Brexit,

25:51

indeed since the Brexit vote of 2016, actually

25:53

it feels a long time ago, and of

25:55

course it is, more than eight years ago,

25:57

eight and a half years ago, but UK

25:59

stocks. the Futsial share was at

26:01

a devaluation premium to global

26:03

equities in early June 2016.

26:06

It's extraordinary to think about it

26:08

because my own analysis and analysis

26:10

of other investment banks have suggested

26:13

that even if you control for

26:15

sector composition and the growth outlook,

26:17

the underlying companies would recognize

26:20

the UK market is big underweight

26:22

on tech. It has a lower

26:24

EPS growth profile in terms of

26:26

consensus EPS estimates. But if you

26:28

control for those factors. you still

26:30

see a discount of about 20%.

26:32

It's very rare, and that's on

26:35

a weighted average of price earnings,

26:37

EV Bedard, price book. Very rare

26:39

that you see a fairly significant

26:41

developed market, a stock market at

26:43

that discount, but it's existed for

26:45

a long time and economic factors

26:47

have waxed and waned over that

26:50

period. It's why, actually, and this

26:52

is what I say to investors looking

26:54

and they are looking at that

26:56

long data discount and going, actually

26:58

we'd like to. arbitrage that,

27:00

like to buy into that. I

27:02

think it comes down to whether

27:05

pension funds, the UK's three trillion

27:07

pound pensions, are going to change

27:09

what has been a three decade

27:12

divestment of both risk assets and

27:14

UK risk assets. It was a

27:16

very, I thought, good report from

27:18

the pensions review interim report with

27:21

a research annex which showed the

27:23

compared, I mean everyone compares. stock

27:25

markets, the US is not a

27:28

great example, but compare the UK

27:30

to Australia, to Canada, to New

27:32

Zealand, Anglo-Saxon, and mid-sized economies, and

27:34

their pension schemes have had they

27:36

done a little bit of divestment

27:38

of their domestic market, but nothing

27:40

like on the scale of the

27:42

UK market. And so if you

27:45

believe in a re-rating of the

27:47

UK market and increase relevance and

27:49

attracting companies, private companies to come

27:51

and raise equity in big numbers

27:53

on the UK market and start

27:55

a re-rating cycle, you have to

27:57

believe that there'll be some either

27:59

carotals stick and both are being

28:01

debated in terms of tax incentives,

28:04

British ICE. Our audience is getting

28:06

worried Simon. Are you going to

28:08

force them to buy British assets?

28:10

No, no, hang on. Well, so

28:13

look, there's a carrot or the

28:15

stick. That is the stick approach,

28:17

which is mandation. And I get

28:19

why people are deeply uncomfortable with

28:22

that. I really do. Yeah. But

28:24

if you are. as a pension's

28:26

review, told that fiscal questions, given

28:28

interest tax relief, British ISA, pension

28:30

interest tax relief, are off the

28:33

table in terms of recommendations, then

28:35

it takes you down this route,

28:37

stamp duty abolition, which is only

28:40

levied on UK stocks. It is

28:42

bonkers, it is bonkers, that the

28:44

cost of buying a UK share

28:46

for UK investors is higher than

28:49

international shares because of stamp duty.

28:51

We can all agree on that. Yeah.

28:53

It is also. Pretty bonkers, although you

28:55

can do this in different ways, depending

28:57

on whether you think pension interest tax

28:59

relief, should have a line of sight

29:02

to the cost of capital for domestic companies,

29:04

or whether it's solely an incentive for

29:06

saving. If you think it's solely incentive for

29:08

saving, then you would say, well, it should

29:10

be agnostic of geography. But if you

29:12

realize that the cost of capital

29:15

for UK public companies, and by

29:17

extension private companies, is a function of

29:19

that allocation decision of your domestic

29:21

pension fund, then the fact that

29:24

it is... Agnostic whether you buy

29:26

invidia or UK technology stocks probably

29:28

needs a bit of a look

29:31

at if you're going to re-

29:33

configure those flows, those sustained outflows

29:35

out of the UK equities. It's

29:37

a really passionate, vibrant debate and

29:40

I recognise, you know, given where

29:42

I work, I'm pointing at this

29:44

logo obviously behind my head, I

29:47

get that I have a vested

29:49

interest in this, I don't, I've never

29:51

hidden from it, but it also means

29:53

that I see day to day, and I

29:55

have a fair amount of expertise

29:57

on this, why private companies don't...

30:00

money in the UK, why public companies

30:02

go private, and what that does to

30:04

the cost of deploying capital, the health

30:06

of our stock market, the health of

30:09

UK growth. So I do see it

30:11

while I fully acknowledge that, you know,

30:13

where my seat is, means I have

30:15

a vested interest, doesn't mean I don't

30:18

have, I hope, something valuable to offer

30:20

to the debate. But is this getting

30:22

the cause and effect mixed up?

30:24

For example, could it be that

30:27

the lack of success of UK

30:29

companies relative to US companies I'm

30:31

talking about isn't because they're starved

30:33

of capital, it's because they haven't

30:35

managed to scale their businesses in

30:38

the way that the US has

30:40

managed to scale their businesses? It's

30:42

not that we don't lack... you

30:44

know, we've got so many bright

30:46

people in universities, we've got the

30:48

infrastructure in order to scale these

30:50

things, but for some reason we

30:52

just don't have that model, which

30:54

you get in Silicon Valley, combining

30:57

this kind of tech hub with

30:59

capital and the ability to blitz

31:01

scale these companies. So I don't think

31:04

it's one or the other. I

31:06

think you're absolutely right that the

31:08

operational barriers, the skills barriers, the

31:10

ecosystem does not lend itself to

31:12

scale on anything like the same

31:14

rate as that example you give.

31:16

But we must also, I think, to

31:18

be even-handed, recognise that there's an

31:21

end of generality there of the

31:23

cost of capital environment, particularly in

31:25

public markets on that ability. to

31:28

scale, to acquire, to consolidate, to

31:30

grow, to go back to the

31:32

public markets and raise equity. If

31:35

that is a persistent discount, that

31:37

does disincentivise that scaling up. behavior

31:39

at least in public markets and

31:42

if that also blocks the pathway

31:44

of funding from private through public

31:47

markets and that ecosystem then that

31:49

does become an impediment. So yes

31:51

I'm not by the way no

31:54

one should ever confuse what I'm

31:56

advocating for here in terms of

31:58

the taxi ecosystem. and favoring UK-listed

32:01

assets as solving all the problems

32:03

on the growth side and the

32:05

scaling side of the UK economy,

32:08

but do I think it's part of

32:10

the challenge to scaling and growing

32:12

the UK economy? Yes, I do.

32:14

I guess I just wonder that if

32:16

UK equities are sort of unfairly

32:19

cheap, shouldn't that be enough

32:21

in itself or is it always

32:23

that you need a catalyst to

32:25

get this re-rating? I could only speak...

32:28

or what I hear from US investors

32:30

who are the largest single buyer

32:32

of UK equity and they want to

32:34

buy more. A few years ago you saw people

32:36

going where it's all compositional,

32:38

it's all a bit sectoral,

32:40

actually we're not quite convinced

32:42

it's a real discount. There's

32:44

almost no debate now, absolutely

32:46

they acknowledge those in arbitrage,

32:48

but they're also saying well

32:50

hang on you keep, as your

32:53

domestic pension system keeps selling your

32:55

market and therefore... performance

32:57

liquidity, you know, this procyclical, what others

32:59

have called the doom loop, means we

33:01

don't want to get in the way

33:03

of that. There's a fun manager in

33:05

Chicago who said to me, you know,

33:08

the moment you start buying your market,

33:10

I'll have that in because I'm absolutely

33:12

going to follow you, but you guys

33:14

have got to go first. And that

33:17

is the argument if you like for

33:19

maybe only a relatively small amount of

33:21

pump priming at the front end, because

33:23

actually, you know. Look at asset classes

33:25

when we focus on UK equities, but

33:28

look at asset classes, including fixed income,

33:30

crypto assets, FX, they are so procyclical,

33:32

trend because trend, momentum is everything.

33:34

And so to some extent, what

33:37

has been the big impediment to

33:39

UK equities could very quickly, in

33:41

my view, and maybe wrong, of

33:43

course, could very quickly go in

33:45

the opposite direction, you start to

33:47

get momentum where people want to

33:49

see. Hollow, what is an inflection

33:52

in performance, elongated underperformance? I

33:54

guess we saw a little bit of that in

33:56

Japan, didn't we, last year, where they had a

33:58

big rally? Yeah, I mean, that's... to the

34:00

fact that this is a phenomenon

34:02

in price setting and many have

34:04

linked it to the growth in

34:06

asset investment strategies, a growth of

34:09

geographical allocation to the benchmark has

34:11

been an impediment to the UK

34:13

which has been a massive tailwind

34:15

to the US that has kept

34:17

out performing and accruing. assets, but

34:19

you are absolutely right. The market

34:21

structure is such that if you

34:23

start to inflect it can move

34:25

very very quickly in your direction.

34:27

Now I fully get that some

34:29

people are very uncomfortable with that,

34:32

but it is my view on

34:34

how you need an external catalyst

34:36

to get the market moving. Investment

34:38

is very much a narrative driven.

34:40

activity. So how would you describe

34:42

the narrative if we're going to

34:44

be positive about the UK equity

34:46

market? What do you think would

34:48

be our selling point? Is it

34:50

just that we're cheap or do

34:52

we have something special, some secret

34:54

source, which makes us worthwhile as

34:57

a target for investment? Well, so

34:59

we're definitely cheap. So there is

35:01

definitely a valuation opportunity there. So

35:03

that is the, if you like

35:05

the cornerstone of the UK. But

35:07

also, look, if the UK market

35:09

was full of, you know, uninvestable

35:11

opportunities, as some like to present,

35:13

why is there so much public-to-private

35:15

transactions at the moment? A very,

35:17

very considerable premium. And private investors

35:20

are not saying, you know, we'll

35:22

do your favour by, you know,

35:24

bailing out the fund managers, he's

35:26

got out flows by buying out

35:28

some of its portfolios. So he

35:30

can... deal with his redemations. They're

35:32

buying it because they're looking at

35:34

the assets that on the public

35:36

market and going that as a

35:38

fundamental discount to embedded value. So

35:40

if these discounts were, you know,

35:42

sorry, if these premier share prices

35:45

were 10, 20, 30 percent, I'd

35:47

go, okay, well, that's a, you

35:49

know, reasonable range. But some of

35:51

these premier are in some cases

35:53

north of 100 percent. That is

35:55

telling you that particularly in the

35:57

mid and the small cap space,

35:59

less so. at a very large

36:01

cap. And that is telling you

36:03

in my view that there is

36:05

a disconnect between embedded value and

36:08

what public equity is valuing these

36:10

assets at. Yeah, certainly my UK

36:12

small cap portfolio is bleeding at

36:14

the moment. So I just hope

36:16

you're right. But I keep putting

36:18

money into it thinking, oh, it's

36:20

going to turn around. But it

36:22

hasn't. Yeah, I mean, look, I

36:24

fully understand why people. buying into

36:26

that strategy had been burnt and

36:28

part of it was linked of

36:31

course to speculation over inheritance tax

36:33

relief on aim shares which is

36:35

you know is a big part

36:37

of the UK small company ecosystem

36:39

and that speculation was unhelpful. But,

36:41

you know, as I say, I

36:43

would go back to the fact

36:45

that within that small mid-cap ecosystem,

36:47

there is still, and I don't

36:49

want to inadvertently bring you guys

36:51

over the wall, but there's still

36:53

a lot of, you know, transactions

36:56

going on or a speculation going

36:58

on around public to private, because

37:00

a lot of private capital is

37:02

going, well, the best place to

37:04

go and buy assets is currently

37:06

on the UK public markets. Now

37:10

a bond sell-off in the UK

37:12

gilt market is actually an opportunity.

37:14

If you want to learn more

37:16

about investing in government bonds and

37:18

their tax efficiency a great way

37:20

to do that is as part

37:22

of our community. To learn more

37:24

just go to pensioncraft.com/membership. Okay today's

37:26

dumb question of the week is

37:28

why does the government even need

37:30

fiscal rules? So as I understand

37:32

it we're now on to the

37:34

tenth set of UK fiscal rules.

37:36

since New Labour introduced them back

37:38

in 1997. And those 10 sets

37:41

of rules have comprised of 28

37:43

different individual rules, some of which

37:45

were met, some of which weren't

37:47

met. I guess they're there as

37:49

a signal to markets, but what

37:51

is the signal if we keep

37:53

changing them? Well, the signal lacks

37:55

credibility, doesn't it, if you keep

37:57

changing it? And while critics of

37:59

fiscal rules would say, well... let's

38:01

just detice on them completely. I

38:03

think 2022 acts as a salutary

38:05

tale of if you remove the

38:07

institutional architecture, replace it with nothing.

38:09

And in the case of 2022,

38:11

this was SAC, the top civil

38:13

servant of the Treasury, sidelined the

38:15

OBR, negative brief against the Bank

38:17

of England, what I described, the

38:19

institutional scorched earth policy. It's not

38:22

very smart. And investors look at

38:24

that and go, okay. All right,

38:26

they're not perfect. The Bank of

38:28

England haven't been perfect. Treasury think

38:30

the Treasury view is certainly not

38:32

perfect, but hang on, you guys

38:34

have not exactly covered yourself with

38:37

glory in the previous 12 years,

38:39

bringing Brexit, pretty sluggish productivity

38:41

growth, etc. So, you know,

38:44

I think that is why this

38:46

institutional architecture of fiscal

38:49

rules exists. I think the

38:51

big criticism... is that relatively

38:53

small movements in financial prices,

38:55

economic conditions, can lead to

38:57

a blowback of the kind

39:00

of decisions you're making over

39:02

capital spending, over financing public

39:04

services on tax, which a

39:06

bit like, you know, where

39:09

are the parallels between managing

39:11

the public finances and investing?

39:13

Well, the good approach to

39:15

both is making decisions for

39:18

the long term. The problem with

39:20

fiscal rules is if they engineer too much

39:22

volatility to try and gain them in the

39:24

short run. I think that's something of the

39:27

risk of the current cycle because of pretty

39:29

small headroom it has to be said has

39:31

got ourselves into. And it's all based

39:33

on forecasts and a kind of assumption

39:35

of a false precision in my mind. Like

39:37

the OBR as good as a job they

39:40

do are not going to be able to

39:42

accurately predict growth and inflation and all this

39:44

stuff five years out. Agreed, and by

39:46

the way, a controversial statement to

39:49

go with your dumb question, which

39:51

is much of what Liz Trust

39:53

was proposing, was pretty sensible actually,

39:56

much of the criticism that she

39:58

had of the institution. has a

40:00

degree of validity. What surprised me

40:02

in my big criticism of her approach

40:05

was she was one of the

40:07

most longest serving cabinet ministers when

40:09

she became prime minister. She would

40:11

have learned something about how to use

40:14

the ecosystem to deliver what she was

40:16

trying to deliver. It appeared like she'd

40:18

learned nothing. And what you do is

40:20

you have this architecture. You don't just

40:22

blow it up and ignore it. You

40:24

work on how to use it to

40:26

your favor to deliver the outcomes you

40:29

want. Yeah you just stayed the right

40:31

side of getting a cease and desist

40:33

letter there well done. It's coming my

40:35

way shortly. But do you think that

40:38

the decisions that Rachel Reeves has

40:40

made has really constrained what she

40:42

can do and a lot of the

40:44

problems we face now, or at

40:46

least she faces, are largely of

40:48

her own making if she'd have

40:50

been a bit more flexible with

40:52

the fiscal rules? I don't think

40:54

the bond market would have puked

40:57

and we could have had a bigger... stimulus?

41:00

Yeah, I mean, there was a

41:02

debate over whether going

41:04

to public sector net

41:06

financial liabilities. Pusnafel. Yeah,

41:08

Pusnapel was preferable over

41:10

public sector net financial

41:12

worth, which brings a

41:14

broader suite of assets

41:17

into the measure of

41:19

public debt. But, you know, I'm

41:21

not... accusing anybody on this, on this

41:23

podcast of having short memories, but in

41:25

the immediate aftermath of the budget for

41:27

a couple of days, there was a

41:29

bit of volatility in bond markets and,

41:31

you know, some of the criticism then

41:33

was they just gone too far from

41:35

moving from public sector net debt. So

41:37

there is an element of formative art

41:39

rather than science to all of this.

41:41

And I think the big strategic mistake

41:44

made by Rachel Reeves, absent the one

41:46

that I'm talking about the narrative that

41:48

predated the predated the budget, the predated

41:50

the budget, tax lock, to not

41:52

raise income tax VAT

41:54

and in inverted commerce,

41:57

national insurance, and then

41:59

this sort of nonsense they got

42:01

into about, you know, not raising taxes

42:03

on working people. The reality is,

42:05

if you box yourself in on

42:08

tax, you actually create heightened

42:10

speculation around relatively small but

42:12

quite influential taxes, capital gains,

42:14

inheritance tax, employer, Knicks, and

42:16

you lead to the wrong

42:18

outcome for the economy, even

42:21

though politically you might go, well,

42:23

that's the easier sell. We're not raising

42:25

the things that people really think about

42:27

as, you know, if you're like... a packet

42:29

taxes. I think that was the big mistake

42:31

because ultimately if you wanted to raise

42:33

that kind of money just whack one

42:36

or two p on income tax rather

42:38

than dancing around the handbags with either

42:40

employer Knicks at a time by the

42:42

way where there's an employer rights bill

42:45

there's the national living wage there was

42:47

speculation over pension contributions going up that's

42:49

an awful lot for employers to absorb

42:51

and just just a final point I

42:54

know it's a pretty verbose answer but

42:56

look I began my career as an

42:58

economist 23 years ago at the Department

43:00

for Work and Pensions and

43:02

there when we did labor

43:05

market reforms you do

43:07

small pilots you'd analyze you

43:09

to praise their outcome and

43:11

if they worked you'd roll

43:13

them out nationwide that

43:15

approach. has been overridden by just wanting

43:17

to be in a rush and doing

43:19

lots of things on that have all

43:21

hit employers at the same time. So

43:24

one of the deterioration in employer demand,

43:26

which we're seeing in all the surveys

43:28

at the moment, is not that

43:30

individually all these things aren't probably

43:32

in the right ballpark of what you want

43:34

to do, but actually the layering of

43:36

so much on employers at one time

43:39

feels like a bit of a policy mistake,

43:41

if I'm honest. I think you're right that they

43:43

boxed themselves in on tax. And I guess

43:45

going back to fiscal rules, that is people's

43:47

concern, isn't it? Is it a self-imposed boxing

43:49

in? There are going to be times in

43:51

the cycle where you might want to break the

43:53

rules. I'm not saying we're at that point

43:55

now, but you know, we clearly are when

43:57

there's an emergency like COVID or a financial

43:59

crisis. maybe there's other times as well.

44:02

I hope we learn the lesson. Maybe this

44:04

is deeply, deeply naive. I leave my

44:06

most naive comment to the end of

44:09

the podcast, but I hope going into

44:11

the 2029 election, if it runs that

44:13

far, this Parliament, of course, then I

44:15

hope we don't get a situation where,

44:18

look, I understand why Labour put

44:20

this tax lock in place, because

44:22

if they didn't, the opposition would

44:24

hammer them, or you're not ruling this

44:26

stuff out. But, you know, both

44:28

sides. plague on both their houses and

44:31

quite frankly if another party emerges coming

44:33

through the middle it's because they've all

44:35

been playing a little bit too much

44:37

of a cute political game for too long

44:39

rather than focusing what's really important

44:41

you know generating growth funding public

44:44

services you know you're sort of

44:46

trying to create traps for each other

44:48

it's a bit of an unpleasant site to

44:50

behold isn't it? Well Simon that's just

44:52

been brilliant and I think people can

44:54

catch up with your articles in the

44:56

times which you write regularly and which

44:58

are... Brilliant. Thank you so much for

45:00

joining us. It was my absolute pleasure.

45:03

I really enjoyed the conversation.

45:05

Thank you for joining us for Many

45:07

Happy Returns. Keep sending us your

45:09

questions, no matter how dumb, at

45:12

MHR at pensioncraft.com. And do remember

45:14

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45:16

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45:21

Returns is a pension craft production,

45:23

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45:25

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45:28

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45:30

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45:32

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