Going beyond the sole

Never let it be said that a 40-year-old can’t learn new things. This month, I learnt the word ‘ultracrepidarian’, which is a term for someone who offers opinions beyond their area of expertise. Apparently, it comes from the (probably apocryphal) tale of a cobbler giving advice to a painter about how to render a foot in paint, and literally means ‘beyond the sole’.

Finance professionals can be like that, pontificating about a hugely varied array of topics – probably because investments can be affected by such a diversity of factors. Trying to determine which factors are actually important can be an endlessly fascinating pursuit, particularly within the field of economics, where disparate schools of thought give divergent and even contradictory answers to many economic questions. It is said, with some justification, that if all the economists were laid end to end, they would not reach a conclusion.

The most germane issue currently exercising economists and, by extension, the field of investing, is inflation; more specifically, the re-emergence of higher inflation. Many of us in the investment industry have been fretting about the re-emergence of inflation for years. The reasoning is fairly straightforward, in that many of us belong to the monetarist camp. Monetarists believe that money and, more specifically, the supply of money, holds the key to understanding inflation. As Milton Friedman put it, ‘Inflation is always and everywhere a monetary phenomenon’.

Conceptually, it is very simple (and this simplicity probably explains some of the concept’s allure), but in a post-Great Financial Crisis (GFC) world of very lax monetary policy, inflation has been notable by its absence. After the GFC, many central banks around the world began purchasing their own government bonds from the private sector at any price using capital (money) created from nothing; a process known as quantitative easing (QE). In theory, this increase in the money supply should have led to inflation, but it didn’t – officially.

Had one invested on the basis of higher inflation at the start of the QE era, one would have been invested in some of the worst-performing assets of the past decade. An inflationista would have been invested in short maturity bonds and cheap, lower-quality stocks, but it turned out that the opposite kind of investments performed best. This poses the following questions: 1. Are/were the monetarists wrong? 2. Are they guilty of going ‘beyond the sole’ by investing on a world view that simply didn’t come to fruition? 3. More importantly, does the recent spike in inflation alter the investment outlook?

Taking the first question, the reason monetarists didn’t see the high inflation they anticipated at the start of QE is because the new capital that was created remained trapped in capital markets, and thus didn’t affect consumer prices. This is because the purchase of government bonds by the central banks from private institutions didn’t alter the imperative for these institutions to invest. Faced with a dearth of investment opportunities in government bonds, a bank, insurance company, pension fund etc will simply invest one rung along the risk spectrum. This concertina of investing through the risk spectrum had the effect of elevating asset prices, but because the money wasn’t circulating in the consumer economy, consumer inflation was unaffected. That’s not to say that this asset price inflation didn’t affect ordinary people, but rather it only affected them at the point at which their lives intersected with the capital markets. Principally, this was through higher house prices and lower annuity rates, both of which have serious consequences to a person’s long-term standard of living, but are poorly measured in consumer inflation.

The answer to the second question is one of humility. An old guy who I knew early in my career, and who has long since retired, once told me that in investing, the problem with absolute opinions is that you’re either absolutely right or absolutely wrong. A monetarist at the beginning of the post-GFC era could have invested somewhat to benefit from higher inflation without betting the farm on it, simply by maintaining a diversity of possibilities in portfolio construction. Thus, whilst wrong at a fundamental level, the portfolio should perform perfectly well by reflecting diverse potential outcomes.

To the third question, it may seem rather flippant, but the best answer we can give is ‘maybe’. Our view is that there is a higher risk that higher levels of inflation may be persistent, and that this will affect the investment outcomes of disparate asset classes. Those assets likely to perform best are cheap stocks (so-called value stocks), and low-duration bonds (those of relatively short maturities), so we tilt portfolios slightly to reflect this view, whilst maintaining a worthwhile exposure to the alternative hypothesis.

In that sense, we seek to take a careful, considered approach to asset allocation – one that accounts for the very real possibility that the future doesn’t end up looking like we currently think it might. Our view is that there’s a risk of persistent inflation that is higher than many are used to, becoming the norm. We reflect this view not with great sweeping allocation decisions, but by simply tilting the portfolios slightly towards inflation beneficiaries. Our style of investing is to be as well-informed and considered as possible, whilst being very alert to the risk of going ‘beyond the sole’.