Our Insights

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June 18, 2014

When multi-year themes get stale

These are highly unusual times: central banks are supposed to fight inflation, but today deflation is seen as the bigger risk due to the high debt levels. As a result, all the major central banks (US, EU, Japan) have declared that they will try to lift the inflation rate higher.

Be careful what you wish for. History has shown that equity returns are higher with a low inflation rate and vice versa. Bonds fare even worse once inflation moves higher.

Inflationannual returnannual volatility

US equity returns have historically been highest when inflation was between 0-2%. The strong performance of the S&P500 in the last few years is a good example. However, once inflation moves into a higher CPI bucket, equity returns tend to drop meaningfully.

To be clear: so far the central banks have not had much success in raising the inflation rate. In most major industrial countries, the inflation rate is far below the official 2% target. Actually in the G13, there are only 2 countries currently with a CPI in excess of 2% (Singapore and Australia). However, just because the central banks didn’t have much success yet, doesn’t mean that they will fail forever. If you look at the median CPI in the US, you can even detect a small up-tick in the last few months. Maybe the trend-break is finally here?

To us the up-tick in the inflation rate is driven by the improving US economy (and the reovery has still a long way to run as we explain here). Many market commentators still insist that the US economy is weak – but we think they suffer from recency bias and don’t recognize how much progress has occured in the last 1-2 years. Aren’t Americans without a high-school degree particularly hard hit by the fall-out from the finance crisis? Sure, but that is looking into the rear view mirror. Today, there are  fewer unemployed workers without a high school degree than there were in mid-1997 or mid-2005.

Investors are usually trend-followers but struggle to predict trend-breaks. In 1999 everybody believed  the hyper growth of the internet economy would continue forever and in 2006 everybody believed US house prices could only ever go up. Isn’t everyone convinced these days that the inflation rate will stay too low for too long? Investors need to consider the following data-points:

  • Wage growth bottomed 18 months ago
  • The „rent of primary residence“ component of CPI is accelerating, up over 3% YoY
  • Core CPI is beginning to rise, in May to 2.0%.
  • Labor’s share of output bottomed 2-3 years ago
  • Thanks to Baby Boomer retirements, there’s likely to be little to no labor force growth over the next 10-15 years (see here)
  • In Germany, we saw wage settlements for nearly 3m employees in various sectors far in excess of inflation and productivity growth.

Just to be clear: we don’t expect a dramatic rise in the inflation rate, it is too soon to get agitated about this. But we are wondering if we are now at the point in the cycle where inflationary pressures are starting to build. To us, the US is showing signs of inflation bottoming out. In Europe, the story is a bit more complicated, mainly because the ECB has so far been less agressive than the FED. So what is all the fuss about if we only expect marginal changes in the inflation rate, you may ask? The reason why we spend so much time speculating about inflation expectations is that it matters to the Fed Policy and interest rates. How would you feel about the stock market if cash paid you 3%? Would you still own Nestle at a 3% dividend yield (despite it trading at a 20x P/E multiple, far in excess of its historical average of 16x trailing) or High-Yield bonds that barely yield 3% net of all fees? We think that life will become more interesting when we read anecdotal type articles describing nascent pressure on wages in the labor market. The following chart shows that this could be close:

Evidence of Wage-Inflation pressure


  • Market consensus is calling for low nominal US growth and low inflation rates. But the consensus is rarely right. Not even during the worst time of the financial crisis in 2008 and 2009 did the US experience falling price levels (=deflation). Now with the economy slowly improving, why should we suddenly fear deflation?
  • Fixed income investors with high duration risks are potentially playing with fire. The Fed keeps promising that they will keep the rates low at the short end – and we have no qualms with that. But at some point, this ultra-loose policy is going to back-fire and we see the risk that the Fed could lose control of the long end of the curve. Bonds at current levels offer a very asymmetric risk-return profile in our opinion (we would even go so far as to call bonds „return-free risk“). Could we be early on our call? Sure, but we think it is better to be early than wrong.
  • Future equity returns will be lower. Not just because the current valuation levels are elevated (see here) but also because rising inflation rates tend to depress returns. Should investors still be in the equity markets? Absolutely yes, but first the allocation should be less than during the preceding 5 years and second, we suggest increasing the non-US equity exposure at the expense of the US, as we find more attractive valuation levels in the rest of the world (see here). Investors should also overweight sectors that benefit from rising price levels (basic materials/industries) and underweight sectors that historically have shown poor performance during these times (retailers).
  • The opportunity costs of a high cash level in our portfolio is low at the moment. Also don’t forget that cash has option value. We think the transition from a reflationary to an inflationary environment will come with higher volatility attached to it and a higher cash level than previously will allow us to take advantage of that. The part of a portfolio that can be squeezed is the fixed income part.

Some readers may wonder why we are so cautious with government bonds since they are considered to be safe investments. However, as value investors, we think safety is only a matter of price, not a matter of which asset class an investment belongs to. Investors should maybe listen to what one of the architects of the current monetary policy has to say about QE. Bank of England’s Executive Director Andrew Haldane said last year: „Let’s be clear. We’ve intentionally blown the biggest government bond bubble in history”. We don’t disagree and prefer not to invest in bubbles. Since 20011, the US central bank has bought 90% of all new issued government bonds with a 5-30y maturity. Once QE3 ends in October, we will find out where the market clearing levels really are.

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