Inflationary pressures are building at a moment when corporate taxes are about to spike, given weakening national finances. The combined effect could spook the markets, writes Victor Hill.
Inflation expectations inflate
Last week China revealed that factory gate prices were increasing at an annualised rate of nine percent. In the US, the Fed announced on 16 June that consumer prices were rising at over five percent. US house prices are rising at a tick of 11 percent. The US central bank opined that interest rates might have to rise twice in 2023.
We might have expected Treasury bond yields to rise on the news, yet the yield on the 10-year Treasury has fallen since March from 1.75 percent to 1.494 percent as I write. This is because the markets consider that the current bout of inflation is transitory (the latest mantra of the central bank priestly caste – used by Chairman Powell in his testimony to Congress on Tuesday (22 June)). Transitory inflation is supposedly caused by supply chain blockages brought about by the lockdowns. The equity markets reacted more predictably with the DJIA marginally down last week – yet closed at a new record high after Mr Powell’s testimony. So, the equity markets buy the transitory thing too.
In both the US and the UK there are labour shortages, particularly in the hospitality sector. There are currently a record 9.3 million job vacancies in the USA. In Australia, shortage of labour is even more acute. This is partly because workers have retrained during the lockdowns, but it is putting upward pressure on wages. UBS expects the US economy to grow by eight percent this year; and the UK may not be far behind. This will be the first year for a long time that the Chinese economy at around five percent grows at a slower rate than the US or the UK. We are in boom territory.
At the same time, big government is back with a vengeance. Mr Biden is driving spending plans that will result in a federal government budget deficit of 17 percent this year, and eight percent next year. That will be much more than under Lyndon Johnson, the 36th President, who ramped up spending simultaneously to fund the Vietnam War, the Great Society social programme and the space race. And yet the Fed is still printing new money. The Fed grew its balance sheet by $3 trillion last year. The money supply (or at least M3) has risen by 24 percent in twelve months. The Fed is still buying about $120 billion of bonds every month.
Moreover, the Treasury General Account (TGA) – the account that the federal government maintains with the Federal Reserve – has been tapped extensively since the 46th President was inaugurated. It seems that this alone has injected an extra $800 billion into the US economy since February.
The Fed under Chairman Jerome Powell aims not just to maintain full employment, with about 7.5 million jobs lost since the start of the pandemic, but also to drive the social equality agenda. The previous chair was of course Ms Yellen, who is Treasury Secretary, so there is now an unusual symbiosis between US fiscal and monetary policy.
Back in Europe, eurozone budget deficits are set to balloon. Italy, where prime minister Draghi (another ex-central bank chief) is pursuing his own version of Bidenomics, will have a fiscal deficit of 12 percent this year. The EU Recovery Fund is to disgorge €750 billion of grants and soft loans. Yet the ECB’s bond purchases are running at about €100 billion per month. DZ Bank expects German inflation to reach 4.2 percent by November – a level last equalled in the 1990s in the aftermath of reunification. Interest rates in the eurozone are still negative at around minus one half of one percent.
All this has stoked fierce resentment in Germany. Germans have a deeply held historic antipathy towards inflation. Their consternation was magnified when the EU launched infringement proceedings on 09 June against the Bundesverfassungsgericht, the German constitutional court. This august body ruled last year that an EU-backed economic stimulus programme was contrary to the Federal Republic’s basic law, and that the ECB had interfered in fiscal policy – something beyond its competence.
As for the UK, the Bank of England now owns about £875 billion of government bonds – that’s about 44 percent of the roughly £2 trillion of national debt outstanding. It also owns £20 billion of corporate bonds. The money presses are still purring.
Food prices are on the rise
The oil price has risen by 80 percent over the last year and Bank of America thinks it could spike to $100 a barrel in 2022. (Oil stocks are looking tempting for the first time in a while.) The prices of rare earth metals are rocketing. Copper prices have doubled in a year. This is well known.
Not as many people know that food prices are soaring too. Global wholesale crop prices, as measured by the Bloomberg Agriculture Spot Index, have risen from 228.80 one year ago to 362.93 as I write. That is an increase of nearly 60 percent year-on-year. The prices of grains, soybeans, dairy, sugar and oils have all rocketed.
The reasons for this are manifold. One is the occurrence of extreme weather events including severe drought across Southeast Asia and Brazil; and another is the increased demand for grain from China and elsewhere to feed growing herds of livestock. Then, shipping costs are on the up. Further, Russia and Argentina are trying to restrict the export of grain in order to hold down domestic prices.
Last week, Deutsche Bank research released a paper punchily entitled Higher food prices and the coming wave of unrest. Historically, food price shocks of this magnitude, from the Arab Spring (2011) to the Russian Revolution (1917) to the French Revolution (1789), have been correlated with social unrest. The poorer the household, the greater the percentage of its income spent on food. The least well off are therefore most sensitive to increases in food prices. In the same way, developing countries are most vulnerable to food price shocks, especially since this comes just as household incomes in many emerging markets have been savaged by the coronavirus pandemic.
Developing countries which have significant tourism sectors such as Thailand (middle income) and Kenya (lower income) have been hard-hit by the collapse in global travel. Poorer countries are expected to suffer more economic scarring than advanced ones. Few were able to roll out the equivalent of the UK furlough scheme to prevent sudden mass unemployment. It does not help that many of them are (as they see it) at the back of the queue for vaccines. Countries with large foreign currency debt burdens such as Brazil and South Africa will be most at risk going forward, especially once dollar rates edge higher. I would not be at all surprised to see widespread social agitation in Brazil in the months to come.
The World Bank reckons that, after two decades of consistently declining levels of poverty, about 120 million people entered the ranks of the extremely poor over the last year. And even in a supposedly “rich” country like Britain, around two thirds of households have less than one month’s disposable income in savings, according to the Resolution Foundation.
And it’s not just food prices which are on the up – building materials are surging in price meaning the cost of new homes will be higher too. Domestic electricity and gas bills jumped by nine percent in April in the UK, partly due to the lifting of price caps.
Private sector debt accumulates
What is striking about the pandemic recession is that there were not more bankruptcies. Last month there were just 1,011 company insolvencies in the UK. Astonishingly, that is 25 percent below the level for May 2019 in those halcyon pre-Covid days. That is no doubt partly because of unprecedented government support, not least the furlough scheme, which has cost £64 billion so far, plus about £75 billion of soft loans under the Coronavirus Business Interruption Loan Scheme (CBILS – now withdrawn).
But the flip side of that is that British businesses are more indebted than ever. Bank of England figures show that UK companies now owe £484 billion in debt, up 11 percent on the year before. The government has extended the moratorium on commercial rents until March next year, but the furlough scheme will be wound up in September. Under the OBR’s worst-case scenario, up to £33.7 billion of corporate debt could go bad this year.
With interest rates still at near-zero levels and central banks keen to buy corporate bonds as part of their QE programmes, private companies issued a record $4.4 trillion of new corporate debt globally last year.
The Tax Man cometh
The UK has already determined that corporation tax will rise markedly in 2023 to 25 percent. That should be seen as part of a global trend. The stand-out policy initiative of the Biden administration so far is fiscal internationalism – the bid to orchestrate the manner and amount by which businesses are taxed across Europe, North America and beyond.
Hitherto, there has been a degree of business tax competition, whereby countries lure global titans to their shores with the promise of lower taxes than those that apply across the border. Many would say that it is the sovereign right of a free people to set their own taxes – but that is no longer the view of the British government which desperately seeks new tax revenues without hurting the swathes of low-to-middle income earners who voted for it.
The outline agreement on company tax amongst the G-7+ in London and Cornwall the other week will be submitted to the G-20 and then to the OECD (a club of 38 supposedly like-minded countries). For all the millions of words written on this topic, the details are still sketchy. A global minimum corporation tax rate of 15 percent is too low to make any meaningful impact. (The Biden administration originally wanted 21 percent). OK, Ireland (12.5 percent) and Hungary (nine percent) would have to raise their corporate tax rates a bit. But the proposal to levy taxes based on where revenues are generated rather than where they are booked is more significant. 20 percent of total profits will be taxable in the jurisdiction where they accrue – but only on corporations which exceed a ten percent profit margin.
So far, so opaque. Even Amazon may elude these rules. And how would Mr Sunak’s regime of super deductions fit into this framework? As I have noted in these pages before, the headline rate of corporation tax is less significant than the regime of capital allowances which prevails, by terms of which companies can offset capital (and sometimes even revenue) expenditure against tax.
Pillar I of the new tax package (it’s already sounding like the Basel Accord, with its three pillars) seems to be designed to target the masters of cyberspace – and thus to displace the various digital services taxes (DSTs) which European countries (including Britain) have dreamed up to tax those who generate revenues online. Currently, the UK DST levies a two percent charge on online sales, including digital advertising, for companies which have over £500 million in revenues. Everyone agrees that the tech titans – who are now more resented than banks were in 2008 – pay far too little tax. Amazon paid just £300 million of corporation tax in the UK in 2019 on revenues of £14 billion.
But it is far from clear that these proposals will be adopted anytime soon. International tax treaties are tortuously slow to be ratified. In the US, Republicans will balk at allowing foreign governments to tax US multinationals more, tech or otherwise. And the treaty would require a two-thirds majority in the Senate to be enacted.
In any case, the EU is travelling in the direction of a common European rate of corporation tax as part of its long, slow glacier-slide towards fiscal union (necessitated by monetary union). That is much to the chagrin of the Republic of Ireland, which is already threatened with legal action over its tax agreements with the likes of Apple.
On the plus side, the cost of Covid in the UK when the bill is finally in may be less than had been feared. While monthly borrowing figures this year have been huge, they have consistently been at the lower end of expectations. The government borrowing figure for fiscal 2020-21 turned out to be nearer £300 billion than the £400 billion expected by the OBR last November. We are about to undergo what outgoing Bank of England Chief Economist, Andy Haldane, who is an inflation hawk, calls the fastest recovery in history. The pound has also held its value in choppy markets. That means that the expected tax hikes might be delayed for a year or two. But come they shall.
It was a bout of inflation in the late 1960s which ultimately undid the Bretton Woods monetary system and gave way to the Nixon Shock of 1971. But the worst experience of inflation since WWII was in the 1970s. The doubling of the oil price in the wake of the Yom Kippur War in 1973 unleashed a surge in inflation in response to which unionised labour demanded widescale wage rises. Company costs rose as purchasing power fell. The result was stagflation – something that economists of the day thought only possible in developing countries. Paul Volcker (Chairman of the Fed 1979-87) was eventually obliged to raise rates to unprecedented levels – and that in turn set off the Mexican and Brazilian debt crises.
Today, we face a demand shock as the economy resumes business as usual just as the decarbonisation agenda gets going. The markets don’t think that we are heading back to the 1970s – yet. Forecasting inflation is always a challenge: and the analysts’ best guesses vary hugely right now. Central banks seem to be attached to the new paradigm that near-zero interest rates are here to stay. This time is different is a mantra that should always inspire concern. But we are unlikely to have a strong recovery from the coronavirus recession without an uptick in inflation, short-term at least. The question is how far it will rise and for how long.
For now, the markets remain eerily calm. But is this the calm before the storm? The US equity markets are still at about 30 percent above their pre-pandemic levels. But a sharp spike in US Treasury yields could unsettle investors. Any such abrupt re-pricing would have massive impact for government finances across the globe – which is why central banks will only raise rates with the greatest reluctance. But the longer they postpone a rate rise, the more chance there will be of the economy overheating. If inflation remains moderate, then real interest rates (the nominal interest rate minus the inflation rate) may continue to be negative. Negative real interest rates support asset prices. But if real interest rates go materially positive there would most likely be a major market correction.
The yield on UK 10-year gilts has already risen from a low of 0.2 percent last year to 0.77 percent as I write. Once it gets to nearer two percent there would have to be a major re-appraisal of the capacity of the government to service its debt without cuts in public expenditure or increases in personal taxes. That could seriously undermine market confidence. The UK has one relative advantage which is that most of its outstanding debt is at the longer end of the maturity range as compared with other countries.
The danger globally is that inflationary expectations become a self-fulfilling prophecy. The more companies expect inflation, the more likely it is to ignite – because they will set their prices accordingly. Once inflation takes hold, it is difficult to dislodge.
Inflation combined with a material increase in the corporate tax burden is a heady mix. Higher corporate taxes mean, ceteris paribus, that companies are pressured to increase their prices. That pressure could mean the difference between the transitory inflation expected by central bankers and something nastier and more enduring.