As asset allocators, one of the most important debates we
have is our view on inflation, disinflation and deflation. The reason is really
very simple, as getting this call right largely determines whether one makes
positive or negative returns for investors. So, on that subject, I thought I
would share some of the insights of MitonOptimal.
So far this year, the press has been inundated with stories
on rising inflation; just to put this into perspective, Joanne Baynham of
MitonOptimal did a Google search recently and asked to see all the stories on
inflation over the past month alone and the number of hits was four hundred and
thirty five million, contrast this with the same search on deflation and the
number was a little over one million. Clearly the world is worried and with food
prices going sky high, it is not hard to see why. But whilst rising food prices
affect everyone and the poor especially, one needs to step back and ask whether
these increases will lead to more permanent inflation, or if these are temporary
in nature.
On that subject our view is that it depends where you are
living in the world, to determine the “stickiness” of inflation. In the
developed world, at the moment, it is hard to see inflation running away,
especially when consumers are still so highly indebted, unemployment remains
high and the output gap is still large. But at the same time, we do see prices
rising - not falling - going forward, as growth continues to be upgraded, output
gaps narrow and companies find themselves with more pricing power. Germany is an
excellent example of this, with inflation consistently higher than expected and
wage inflation starting to bite thanks to strong export growth with Asia.
The UK is another such example with inflation coming in at 4%
in mid/late February, way above the target of 2%, but in the case of the UK it
is hard to see this becoming entrenched, as wage inflation remains anaemic,
house prices are stagnating (a good proxy for consumer confidence) and a
government determined to cut back on fiscal spending. The US is similar to the
UK, in the sense that headline inflation might be rising, but not core
inflation, and once again the labour market being slack in that economy is
helping to keep inflation expectations under control.
In the emerging world, inflation has a far greater chance of
becoming more permanent. Higher food prices have a far greater impact on
inflation as they are a much larger component of the CPI basket and companies
have less slack and hence more pricing power to pass increases on to the
consumer. The tricky aspect of inflation in emerging markets (EM) is to
establish whether commodity prices are going up because of supply or demand
issues, but given the actions of central bankers in the EM, one would have to
conclude that they are more concerned about demand leading to higher commodity
prices, otherwise they would not be so intent on rising interest rates and
reserve requirements for their banks.
So on balance where does that leave us? In the opinion of
MitonOptimal, based on the fact that core inflation remains relatively contained
and slowly rising in the developing markets (DM), they continue to be overweight
equities and underweight bonds. But there will be a point when fears over higher
inflation lead to concerns about higher interest rates and this tends to lead
equities markets lower. However, they do not believe there is cause for concern
yet. The FT recently noted that CPI at 4% could be the line in the sand, as this
has traditionally been the point where equity markets have sold off. US consumer
prices have risen above 4% fourteen times since 1927 and on every occasion
except one, markets have fallen by 5% and sometimes even more. In the EM region
they see inflation going higher still and hence are underweight equities and
bonds, given concerns about rising interest rates in this region and the fact
that real rates remain negative in many EM markets.
Given all of this you can see that market timing is vital and
being in multi-asset, multi-managed funds which are liquid is equally as
important.
New York Times best-selling financial writer John Mauldin
recently wrote a piece entitled “Some Thoughts on Market Timing”. While Mauldin,
like ourselves, believes in long term themes and is not a short term market
timer he highlights the need to identify major trends. Mauldin refers to the
work of the team at Sentiment Traders who distinguish between “smart and dumb
money”.
We would never be so judgmental but we believe that too many
investors fail to diversify adequately and fail to adjust their portfolio
allocation according to changing economic conditions. A totally passive
portfolio will be wrongly aligned for significant parts of the economic cycle,
only producing optional performance when the lucky coincidence of economic
conditions line up with the bought and held portfolio.
We believe that this is because most investors are better at
recognising opportunity than risk and, therefore, are great buyers but sometimes
lack an exit strategy to sell - the most successful investors know where the
entrance and exit is for any asset they buy.
That doesn’t mean that we condone day trading. This is only
for the brave and skilled investors. Time and again the proof is that trading
with too short term a focus fails to allow enough exposure to the potential
trends and incurs too high costs. However, adaptive asset allocation means
identifying medium to long term trends - typically 18 months or longer but
reflecting the ever changing investment landscape in an ever evolving portfolio
allocation decisions - or as Lord Keynes said, “ Sir, where the facts change, I
change my mind - what do you do?”
Even more dangerous is whimsical changing of trends, after
the event - last year we wrote about non-expert investor psychology. (See the
illustration 1)
Maybe the best historical example of this is Sir Isaac Newton
and the South Sea Bubble. Newton sold his ฃ7,000 of stock for a 100% profit but
re-entered the market at the top, losing ฃ20,000 and lamenting, “I can calculate
the motions of the heavenly bodies but not the madness of people.”
The best recent example is probably Sean Quinn and the
well-publicised near collapse of the Anglo Irish Bank, which wiped out at least
€1 billion of the family’s wealth. It is widely believed that the Quinn Family
had acquired up a 25% stake, mainly through contracts for difference. Quinn had
continued to buy stock as the share price fell but his averaging in strategy
proved useless when the bank had to be nationalized by the Irish government to
prevent complete collapse.
If you are not confident on making decisions yourself or,
even if you are but need a sounding board then the following may help:
* Investment Professionals take the emotions out of the
decision making process of trading.
* It is not only about finding the right asset class but
knowing when to get in, looking for any changes in fundamentals that would
change the outlook for the asset and, finally most important of all, knowing
when to get out.
* Many people will get in to something (buy) quite quickly or
easily but it is the selling that is the hardest decision to make and the most
critical as the average person tends to sell either way too early or much too
late.
* Now with unprecedented QE2 and global financial crisis skewing markets
around the world making even old timing indicators less relevant, it is even
more imperative to leave it to the experts.
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The above data and research was compiled from sources
believed to be reliable. However, neither MBMG International Ltd nor its
officers can accept any liability for any errors or omissions in the above
article nor bear any responsibility for any losses achieved as a result of any
actions taken or not taken as a consequence of reading the above article. For
more information please contact Graham Macdonald on [email protected]
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