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By Steve Schifferes, City, University of London; Andrew Burlinson, University of East Anglia; Brian Scott-Quinn, University of Reading; Catherine Waddams, University of East Anglia; Morten O. Ravn, UCL, and Steven McCabe, Birmingham City University 

Newly installed UK chancellor, Jeremy Hunt, has unveiled a raft of changes to Kwasi Kwarteng’s September 23 mini-budget, which essentially amounted to a rollback on most of its headline points.

The September mini-budget, which included £45 billion in unfunded tax cuts, created significant volatility in financial markets in the weeks after it was announced. The resulting impact on the cost of borrowing for the UK also filtered through to consumer mortgage rates and pensions.

Hunt has indefinitely postponed a planned cut to the basic rate of income tax and rolled back most of the other taxation plans from the government’s growth plan. Only the repeal of the National Insurance increase and the cut to stamp duty remains because they are already in the process of being signed off by parliament.

We will be updating this article with more expert insight about the impact of the announcement and what else the government should do to restore the UK’s economic reputation.

Rolling back energy price support

Andrew Burlinson, Lecturer in Energy Economics, University of East Anglia and Catherine Waddams, Emeritus Professor of Economic Regulation, Norwich Business School, University of East Anglia

The new chancellor has a chance to ease the pressures facing some of the most vulnerable energy consumers in the UK. We welcome the continued promise of help for all until April 2023, and the opportunity to target help more to those who most need it after that.

The government is right to take time to explore how best to achieve this challenging combination of objectives, including protection of households in the most vulnerable circumstances. The £2,500 limit on the average bill under the energy price guarantee scheme is more than £1,000 less than the Ofgem price cap it replaced. But the energy price guarantee will still see the average household paying twice as much this winter compared to the same time last year.

More protection is needed for those households who struggled to afford the prices faced last year, never mind this year. By adjusting the current package, the government could move towards supporting those most in need with a new social tariff, by coordinating with Ofgem to rebalance the prepayment price premium, and establishing vital channels for advice and financial assistance to those in energy debt.

The Government must further reconsider imposing a windfall tax on energy companies to help pay for these measures, as well as considering how to bolster energy efficiency schemes to improve the warmth and comfort of homes and the health of those most in need.

On the other hand, all other households will become more exposed to the volatility shaping the energy market. Given other cost of living pressures, many may still need some help when the energy price guarantee is reviewed next spring. Government objectives should include consumer protection, inflation reduction, market confidence and an ambitious programme of carbon reduction.

Financial market reaction

Steve Schifferes, Honorary Research Fellow, City Political Economy Research Centre, City, University of London

The government appears to have stabilised the financial markets with an emergency statement by the new chancellor, Jeremy Hunt. The statement was brought forward by two weeks, in an unprecedented move designed to calm recent financial market turbulence in the weeks following ex-chancellor Kwasi Kwarteng’s September 23 mini-budget.

The interest rate on a key measure of government debt, 30-year gilts, had been rising sharply over the weekend to 4.8%, but fell back to 4.4% immediately ahead of Hunt’s statement. Such drops are uncommon in this market, which has now stablised. The cost of government borrowing has still not recovered to the 3.5% level of before the mini-budget, however. Similarly, the pound strengthened from US$1.11 to US$1.13, but remains 18% below its level one year ago.

In addition to scrapping £32 billion of the £45 billion in unfunded tax cuts announced in the mini-budget, Hunt also announced there would be further public spending cuts. Most importantly, however, the government has abandoned its commitment to fund an energy price cap – expected to cost £60 billion this year alone – beyond April 2023.

It will replace the scheme with a more targeted measure to be developed by the Treasury in the meantime. This will substantially reduce the deficit for the next two financial years – the original time period for the plan, announced in September. This will not have a direct impact on the Office of Budget Responsibility’s five-year deficit forecast, which discounts temporary measures, but it will lower the amount of debt interest payments the government will have to make.

But there are limits to how far his announcement can completely reassure the markets. Investors are likely to continue to add a “risk premium” when it comes to the UK, which means the markets will still demand higher interest rates when lending to the UK government than before the mini-budget. Among other issues, concerns remain over political instability, with the fate of the prime minister Liz Truss, in particular, remaining unclear.

Additionally, the increased likelihood of a UK recession (which would reduce government revenues) has increased. This is partly because the Bank of England is now expected to raise interest rates more sharply than previously planned, and also because the global economy – especially in the US, Europe and China – is slowing down faster than anticipated.

The next test for the government will be the Office for Budget Responsibility forecast and full budget statement on October 31. Despite buying some time, the fate of this government is still in the hands of the markets.

Business certainty

Steven McCabe, Associate Professor, Institute for Design, Economic Acceleration & Sustainability (IDEAS), Birmingham City University

Businesses tend to be successful when there’s confidence that the government has a coherent plan for the economy and is consistent in its implementation. The past three weeks have been anything but coherent or consistent. Hunt’s five-minute emergency statement consigns Trussonomics to the bin and acts as a warning to future governments about ignoring the markets.

The reversal of Kwarteng’s unfunded tax cuts, as well as the review of the energy support scheme – expected to cost more than £100 billion before it was cut from two years to six months – means public finances are on a surer footing. Creating a sense of stability and showing there is a grownup in charge will restore confidence among the international financial markets. This will be excellent news for businesses which, although they will be paying more corporation tax after last week’s U-turn, can at least make investment decisions with reasonable certainty.

Nonetheless, problems remain. Inflation is still very high, which may require the base rate to remain elevated for months. The pound, which has risen today after Hunt’s announcement, is still lower than when Kwarteng became chancellor in early September. Many businesses are in a precarious state and beset by a range of challenges including skill shortages and the prospect of higher energy after April.

Hospitality businesses – already being squeezed by rising energy costs – will not be helped by the scrapping of the alcohol freeze. Equally, Hunt’s reversal of plans for tax-free shopping for tourists will be a kick in the teeth for those hoping to see the UK attract more overseas visitors. The retail sector is also bracing itself for tough times as people in the UK become collectively poorer and cut back on discretionary spending. More intervention may be essential to stem the rate of business closures this winter.

The real economy

Professor Brian Scott-Quinn, Emeritus Professor of Finance, ICMA Centre, University of Reading

Many politicians have referred to the “magic money tree” in recent years. In 2017, then-prime minister Theresa May warned nurses: “There isn’t a magic money tree that we can shake that suddenly provides for everything that people want.” More recently, Labour leader Keir Starmer has promised there will be “no magic money tree economics” if his party gets into power.

It’s good news then that this “magic money tree” has been well and truly cut down by the new chancellor of the exchequer, Jeremy Hunt. By trying to increase spending substantially without increasing taxes, the UK government was losing credibility – and fast – in recent weeks. So Hunt is really only accepting the reality that slowing growth around world at the moment is making everyone, everywhere poorer. He is facing reality, which means ensuring that the UK remains creditworthy, even while the world becomes poorer.

So, where do we stand now? Central banks like the Bank of England must raise interest rates to damp down the economy and try to stop inflation getting of control and causing financial instability. On the other hand, governments want interest rates to be low to achieve their growth targets. But growth is not determined by interest rates so much as by a stable and low risk economic environment. This gives companies the opportunity to develop new products and provides households with access to new skills to supply such firms with appropriate labour.

A focus on the real economy (and today that would apply with even more force to clean energy asset growth), would be a much better policy than the tug-of-war over interest rates that has recently led to instability and loss of confidence by buyers of gilts, investors, industrialists and consumers. These are the people that matter when trying to achieve a growth target.

Targeted policies needed

Morten Ravn, Professor of Economics at University College London, UCL

This was an inescapable U-turn. The September mini-budget brought market turmoil because it caused an unsolvable policy inconsistency with the Bank of England. This inconsistency was seriously threatening the economic and financial stability of the UK economy.

The unfinanced tax cuts announced in the mini-budget immediately affected government bond prices and the Sterling exchange rate. Declining long-term government bond prices put pressure on large UK pension funds, which forced the Bank of England to support the gilt market by buying long-term government debt.

The Bank of England has therefore, on the one hand, had to increase short-term rates to reduce inflationary pressures on the UK economy while, on the other, support long-term bond markets with its recent purchase programme. Such policy inconsistency can only persist for a short time before it risks a speculative attack on the gilt market and further downward pressure on the sterling.

The increase in inflation in the UK hurts lower income households more than those that are better off because these people spend a greater portion of their incomes on goods and services with rapidly rising costs such as energy. Therefore, there is a need for targeted policies offering protection for the poorest parts of society – something the government should bear in mind when designing a replacement energy price support package after April.

So will the U-turn work? Markets appear to have been stabilised so far. What is still missing in an Office of Budgetary Responsibility evaluation of the fiscal framework and details about the financing of the government deficit. It is important that both of these issues are resolved quickly. This might involve very difficult spending cuts.

It is extremely unfortunate that precious time has been lost over the last few weeks that could have been used for designing these cuts in the least harmful way possible. It is also extremely unfortunate that this episode has seriously undermined the credibility of the UK’s monetary-fiscal framework. Confidence must be restored as fast as possible. It is equally important to rethink the energy price cap and replace it with targeted policies and better incentives in terms of energy efficiency.

About the Authors:

Steve Schifferes, Honorary Research Fellow, City Political Economy Research Centre, City, University of London; Andrew Burlinson, Lecturer in Energy Economics, University of East Anglia; Brian Scott-Quinn, Emeritus Professor of Finance, ICMA Centre, University of Reading; Catherine Waddams, Emeritus Professor of Economic Regulation, Norwich Business School, University of East Anglia; Morten O. Ravn, Professor of Economics at University College London, UCL, and Steven McCabe, Associate Professor, Institute for Design, Economic Acceleration & Sustainability (IDEAS), Birmingham City University

This article is republished from The Conversation under a Creative Commons license. Read the original article.

Source: Ron Struthers  (10/15/22)

 Markets will remain in a bear market for some time, and it is best to look for short trades. Lumber stocks ran up in price with high lumber prices and a post-Covid-19 recovery in the economy. They are priced too high and not reflecting lower lumber prices and a softer housing market induced by a coming recession.

Canada Bank Stocks

I will try to pinpoint that. This past Tuesday, the Canadian bank stocks broke down on the charts, except for Royal Bank, which managed to hold at its July low. I show the chart here on CIBC where we have the March 2023 $65 Put option that has a good gain now.

I suggested selling half our Bank of Nova Scotia in March 2023 for $80 Put where we have a 100% gain. The bank stocks are starting to price in a recession and a plunging real estate market. I expect they could test their 2020 Covid lows.

TD Bank had forecast that Canadian house prices would fall -19% by end of 2022. Now they are predicting another -11.2% in 2023. That works out to about a -28% drop, coming in line with my -30% or more prediction. TD’s Sondhi expects home sales to drop -20% below pre-pandemic levels.

That will probably mean a drop in housing construction and lumber prices that have already fallen to pre-pandemic levels. The housing in the U.S. is a different story as it was not so highly leveraged as Canada, but U.S. housing starts have fallen with a combination of a weaker market with labor and supply shortages.

US Housing

That said, an economic slowdown and recession will negatively affect U.S. housing too. Surprise, surprise, surprise, as Gomer Pyle would say.

Well, you should not be, as I have been warning for a year. The September report is the seventh out of nine CPI readings this year to have topped expectations, according to Michael Brown, the senior market analyst at Caxton.

As I have been commenting numerous times, this inflation is entrenched and will be very tough to tame. Year-over-year CPI retreated to 8.2% last month from 8.3% in August, while the annualized increase in core CPI, which strips out volatile food and energy prices, rose to 6.6% from 6.3%. Both numbers came in higher than economists polled by the Wall Street Journal had expected.

The 0.6% core versus a Wall Street forecast of 0.4% was a big shock. The increase in the core rate over the past year climbed to a new peak of 6.6% from 6.3%, marking the biggest gain in 40 years. Take note, it is the core (PCE) that the Fed focuses on.

Markets initially plunged Thursday on the bad inflation report and then rallied in one of the biggest reversals I have ever witnessed. S&P futures peaked +1.57% ahead of the CPI release, bottomed out -2.4%, and the S&P 500 closed +2.6% with a round trip intraday range of 5.52%, according to Deutsche Bank.

The reversal is impressive, and I show a chart on the popular Spyder ETF that represents the S&P 500. What is noteworthy, the volume was not very impressive for such a move. This is a powerful reversal from a new low indicated by a strong engulfing bullish white candle.

All the talk I heard was about this is peak inflation, the market has bottomed, blah blah blah. We could have a bear market rally, and that is it. Bear markets bottom when everyone is bearish and calling for new lows, not bottoms and reversals. This alone convinces me this is no bottom but could be another bear trap a rally emerges.

Thursday could just be a one-day wonder, but if we do get a bear rally, I marked in resistance levels that would relate to 3,700 and 3,900 on the S&P 500. Friday, markets bounced lower off the 3,700 area. I would be surprised if the market could move much above 3,900; all the problems facing the economy and markets have not improved and will probably get worse before they get better.

I commented and had a chart on lumber in May 2021 and called it a bubble top. As it turned out, I was within days of calling that top. Times then were too unpredictable to suggest a way to benefit from lumber decline, but not today.

Lumber

This is a monthly chart until the end of September, and the current lumber price has rallied a little to about US$500. With a recession and weak housing, I expect we will see a drop to $300 and possibly lower.

Lumber prices are back to pre-pandemic levels, but the lumber stocks are still at lofty levels and not priced in a weaker market. They are great short candidates now. U.S. housing starts in June were down to 1.6 million annualized units, their lowest level since September 2021. In July, U.S. housing starts fell further to 1.45 million annualized units but rebounded in August to 1.58 million. Weaker numbers are in store with a Fed-induced recession. I think the best two to short are West Fraser Timber (WFG:NYSE) and Boise Cascade (BCC:NYSE).

Both companies are focused a lot on the lumber market, with West Frazer affected more by Canada and the Canadian housing market than Boise.

The U.S. Commerce Department said Thursday it will decrease the duty rate for most Canadian lumber producers to 8.59%, compared with the current 17.91%.

The Commerce Department had made its intentions known in January to reduce tariffs, proposing a preliminary duty rate of 11.64%, and has now reduced that amount further with the final rate of 8.59%.

This has probably been accounted for in the recent rally in lumber prices.

West Fraser has grown beyond the company’s original base in British Columbia and today is one of the largest lumber and OSB manufacturers in the world.

You can see from the slide above from West Frazer’s Q2 presentation that CA$ earnings are about 100% lumber and Engineered Wood Products (EWP), which are strands, fibers, veneers, or particle boards bound together with strong adhesive.

Currently, Boise looks like a very solid company.

There was a substantial earnings decline from Q1 to Q2, and lumber prices have seen a further decline in Q3.

West Frazer also shipped a lot more volume in Q2 over Q1, with lumber shipments up +17% as transportation constraints eased in Western Canada. OSB (board) shipments were also up 10%. This was shown on slide six of their presentation, with slide 16 below showing huge dependence on housing.

The Housing Market

It does not take a rocket scientist to know that a recession and rapidly rising interest rates will crush the housing markets. Credit Suisse says.

“Our lower estimates reflect our expectation of a sharp slowing of housing turnover and a reduction in home improvement spending in 2023 based on this lower turnover,” wrote analyst Dan Oppenheim in a note to clients Friday.

West Frazer stock ran up in price because of the housing boom and high lumber prices caused by Covid-19 policies. Lumber prices have come down, and the housing boom is ending as North America falls into a recession.

The stock ran up about 120% from around CA$60 in 2019 to the 2022 high of CA$132, and it is currently not reflecting lower lumber prices and a looming recession with a housing slowdown.

I expect the stock can easily drop to around $66 and, with a bad recession, could easily see prices back to around $40. I would sell the stock, short it, and/or buy Put Options.

I like the February 2023 $110 Put for about $14. There is little activity on these, but on the U.S. side, in February 2023, $70 Put around $5.00 has more trading, showing huge dependence on housing.

Boise Cascade’s recent price was $58.60.

Boise is totally focused on the U.S., and that is why I prefer West Frazer more of a short because of the Canadian market exposure.

Nevertheless, I expect Boise stock will take quite a haircut in a poor housing market driven by high-interest rates and a U.S. recession. Boise also has a big focus on residential real estate and home improvements.

What I am saying is the good times are over, so sales and profits have peaked and will soon decline.

They are one of the largest U.S. wholesale building products distributors, with 38 warehouse centers and one truss plant.

This partial slide on the right from their presentation is interesting because it shows that 79% of sales were from their Building Materials distribution segment but only accounted for 49% of profits. It is a clear sign that high lumber prices have driven high profits in their Wood Products Division. As I mentioned above, lumber prices have dropped further in Q3.

Currently, Boise looks like a very solid company, as shown in the slide below from their presentation, and had strong sales and earnings growth since 2020. What I am saying is the good times are over, so sales and profits have peaked and will soon decline.

Boise gives this warning in their Q2 financials: “As a manufacturer of certain commodity products, we have sales and profitability exposure to declines in commodity product prices and rising input costs. Our distribution business purchases and resells a broad mix of commodity products with periods of increasing prices, providing the opportunity for higher sales and increased margins, while declining price environments expose us to declines in sales and profitability. We expect future commodity product pricing and commodity input costs to be volatile in response to economic uncertainties, industry operating rates, transportation constraints or disruptions, net import and export activity, inventory levels in various distribution channels, and seasonal demand patterns. EWP and general line products have historically experienced limited price volatility but are also subject to price erosion as economic activity slows. “

Boise has a very similar chart to West Frazer, just at a different price level. The percentage gain from 2019 and the potential percentage drop are around the same. For Put options, I like January 2023, $60 Put for around $6.00.

Struthers Stock Report Disclaimers: 

All forecasts and recommendations are based on opinion. Markets change direction with consensus beliefs, which may change at any time and without notice. The author/publisher of this publication has taken every precaution to provide the most accurate information possible. The information & data were obtained from sources believed to be reliable, but because the information & data source are beyond the author’s control, no representation or guarantee is made that it is complete or accurate.

The reader accepts information on the condition that errors or omissions shall not be made the basis for any claim, demand or cause for action. Because of the ever-changing nature of information & statistics the author/publisher strongly encourages the reader to communicate directly with the company and/or with their personal investment adviser to obtain up to date information.

Past results are not necessarily indicative of future results. Any statements non-factual in nature constitute only current opinions, which are subject to change. The author/publisher may or may not have a position in the securities and/or options relating thereto, & may make purchases and/or sales of these securities relating thereto from time to time in the open market or otherwise. Neither the information, nor opinions expressed, shall be construed as a solicitation to buy or sell any stock, futures or options contract mentioned herein. The author/publisher of this letter is not a qualified financial adviser & is not acting as such in this publication.

Charts provided by author.

Disclosures: 

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By John W. Diamond, Rice University 

Social Security is set to boost the benefits it provides retirees by 8.7%, the biggest cost-of-living adjustment since 1981. It comes as sky-high inflation continues to eat into incomes and savings.

The changes are set to take effect in January 2023 and were announced following the release of the September 2022 consumer price index report, which showed inflation climbing more than expected during the month, by 0.4%.

The automatic adjustment will surely come as a relief to tens of millions of retirees and those who receive supplemental security income who may be struggling to afford basic necessities as inflation has accelerated throughout 2022. But an annual adjustment wasn’t always the case – and other government benefits and programs deal with inflation differently.

John Diamond, who directs the Center for Public Finance at Rice’s Baker Institute, explains the history of the Social Security cost-of-living, or COLA, increase, what other benefits are adjusted for inflation and why the government makes these changes.

1. How fast is the cost of living rising?

The latest data, for September, shows average consumer prices are up 8.2% from a year earlier. The monthly gain of 0.4% was double what economists surveyed by Reuters had expected.

More troubling, so-called core inflation – which excludes volatile food and energy prices – gained even more in September, ticking up by 0.6%. Core inflation is a measure that’s closely watched by the Federal Reserve, as it helps show how pervasive and persistent inflation has become in the economy.

2. How are Social Security benefits adjusted for inflation?

Automatic adjustments to Social Security benefits began in 1975 after President Richard Nixon signed the 1972 Social Security amendments into law.

Before 1975, Congress had to act each year to increase benefits to offset the effects of inflation. But this was an inefficient system, as politics would often be injected into a simple economic decision. Under this system, an increase in benefits could be too small or too large, or could fail to happen at all if one party blocked the change entirely.

Not to mention that with the baby boomers – those born from 1946 to 1964 – entering the labor force it was already clear that Social Security would face long-term funding issues in the future, and so putting the program on autopilot reduced the political risk faced by politicians.

Since then, benefits have climbed automatically by the average increase in consumer prices during the third quarter of a given year from the same period 12 months earlier. This is based on a version of the consumer price index meant to estimate price changes for working people and has been rising slightly faster than the overall pace of inflation.

While helpful, these inflation adjustments are backward-looking and imperfect. For example, 2022 Social Security benefits increased by 5.9% from the previous year, even though inflation throughout this year has been significantly higher – which means the higher benefits weren’t covering the higher cost of living. Thus, the 2023 increase in benefits primarily offsets what was lost over the previous year.

3. Are the benefits taxable?

A growing portion of Social Security benefits are taxed in the same way as ordinary income, except at different threshold with various caps and percentages. Only 8% of benefits were subject to taxation in 1984, but that’s climbed to almost 50% in recent years. That percentage will likely continue to increase as the taxable thresholds are not adjusted for inflation.

For example, if an individual filer’s income, including benefits, is below US$25,000, none of that is taxed. But up to 50% of a person’s benefits may be taxed at incomes of $25,000 to $34,000. After that, up to 85% of their benefits may be taxed.

Such a big increase in Social Security benefits likely means some people who paid no tax will now have to pay some, while others will see larger increases in their tax liability.

4. Why does the government adjust benefits for inflation?

Rapid gains of inflation, like the kind the U.S. and many other countries are currently experiencing, can have significant impacts on the finances of households and businesses.

For example, it might mean seniors cutting back on heating or food. Government policies generally try to account for this to reduce the negative impacts that rising prices can have on those with limited or fixed resources.

In addition, reducing the impacts of price changes creates a more efficient and fair allocation of resources and reduces the arbitrary outcomes that would otherwise occur.

5. What other government programs typically get a COLA?

Other government programs and benefits also increase to account for inflation.

The U.S. Department of Agriculture estimates the cost of its Thrifty Food Plan each June and adjusts Supplemental Nutrition Assistance Program or SNAP benefits – formerly known as food stamps – in October of each year. Beginning in October 2022, food stamp benefits rose by 12.5%, which helps make up for the largest increases in food prices since the 1970s.

In addition, the federal poverty level is adjusted for changes in the consumer price index annually by the Department of Health and Human Services, an adjustment that affects a number of government-provided benefits, such as housing benefits, health insurance and others, including SNAP benefits.

6. Does the tax system also adjust for inflation?

While some aspects of the tax code adjust for inflation, others do not.

For example, income tax bracket thresholds, the size of the standard deduction, alternative minimum tax parameters and estate tax provisions all increase annually for inflation. That means come tax filing season next year, U.S. tax filers will likely see big changes in all these items.

But examples of provisions that are not adjusted for inflation include the maximum value of the child tax credit and the $10,000 cap on the deduction of state and local taxes. In addition, the threshold that determines who is liable for the net investment income tax – the additional 3.8% tax on investment and passive income for taxpayers above a certain income level – doesn’t adjust, which means each year more individuals are subject to it.

About the Author:

John W. Diamond, Director of the Center for Public Finance at the Baker Institute, Rice University

This article is republished from The Conversation under a Creative Commons license. Read the original article.