Stephen King: What would the fashionable investor do now when desperate for returns?

Monday, 14 July 2008


Faced with an unfortunate rise in inflation and financial markets with a bad case of indigestion, what does the wise investor do? The old-fashioned, 1970s-style, wise investor would probably sell his entire government bond portfolio and, instead, buy so-called "real" assets which are directly linked to the performance of the economy. Thumbs up, then, for property, commodities and equities.


The rationale for this view is straightforward. Governments may have a claim on taxpayers, but governments don't always choose to make that claim. It might be easier, instead, for governments to allow inflation to rise, thereby destroying the wealth of their creditors. This so-called "inflation tax" is a tax by stealth, which catches out the unwary holder of government bonds. Stealthy taxes, as we've discovered under the current UK Government, are preferable to those which lead to public controversy.

Why, then, during this latest pick-up in inflation, are government bonds doing better than equities and property? Why, last week, were newspapers full of gloomy stories about the onset of a bear market in equities? Perhaps the fashionable new investor, not wedded to the experiences of the 1970s, has an answer. What might she be thinking?

The first thought, presumably, is that central banks in the developed world are a lot more credible than they used to be. Most of them are independent and, hence, not beholden to the political whims of the hour. Indeed, one of them – the European Central Bank – has already buffed up its anti-inflation credentials by raising interest rates despite considerable political opposition. Inflation may be uncomfortably high, but it won't remain so for very long.

This argument can only be taken so far. Central banks are independent, but only to the extent that politicians allow them to be. It's possible to imagine, for example, that a government in desperate straits (can anyone think of one at the moment?) might be tempted to pressurise a central bank into doing the wrong thing. Could the threatened removal of independence, for example, water down a central bank's determination to fight inflation at all costs? The recent rise in measures of inflation expectations suggests this worry is more than academic.

The fashionable investor's second thought might relate to the underlying reasons behind the granting of central bank independence. Why, in the developed world, does the public now have such a deep dislike of inflation? One likely explanation is population ageing. When the West's baby-boomers were young and daring in the 1970s, a dose of inflation was, for them, no bad thing. They borrowed heavily to buy houses and discovered, subsequently, that high inflation delivered capital gains and reduced the real value of their mortgage debts. Others – notably pensioners – may have lost out, but the boomers – large in number and hence politically influential – made a bit of a killing.

The boomers, though, are now facing retirement. They simply won't stand for inflation anymore. After all, they saw what it did to their parents' pensions. As Japan's ageing population has already shown, mature voters reduce the likelihood of any sustained inflationary pick-up. The third thought is likely to reflect on the source of inflation. It's not really coming from the developed world. Most of the excess demand in the global economy is associated with overly loose monetary conditions and booming conditions in the emerging markets. If that's the case, perhaps the fashionable investor will take a safety-first approach, reducing exposure to tricky emerging markets but increasing exposure elsewhere. But why not buy developed market equities? After all, while they lost the old-fashioned wise investor money in the 1970s, they didn't perform as badly as government bonds after adjusting for the corroding effects of inflation. Surely, the case for a claim on real resources is as relevant today as it was then?

The fashionable wise investor thinks otherwise. If the inflationary threat is coming from abroad, and the domestic central bank has a decent amount of anti-inflation credibility, the likelihood is that steps will be taken to squeeze inflation out of the system. That, presumably, means higher interest rates and lower growth. Not, then a good environment for stock markets.

The wise investor also knows that lower growth will make the ongoing housing and financial crisis worse. House prices will fall further and banks will cut back on lending. Consumer spending will probably soften and corporate profits might begin to decline. In these difficult circumstances, equities look pretty dreadful. It's the difference, if you like, between a world in which inflation is allowed to let rip and a world in which the central bank takes decisive – if unpleasant – action to prevent inflation from rising. No one likes cod liver oil but the equity market is receiving a jolly good dose of it.

If all this is true, the wise investor also shuns property. Housing and commercial property may have done well in the 1970s but that was when policymakers were trying to maximise growth and keep the lid on inflation. Nowadays, they're supposed to be minimising inflation and hoping growth won't sink too far as a consequence. For the time being, central banks won't be providing too many favours to the property sector.

So where does the wise investor put her money? In a world of undesirably high inflation pressures and sluggish growth, index-linked (or inflation-protected) bonds are the obvious, if unexciting, choice. Corporate bonds might also look interesting, particularly as markets have recognised that, no matter how bad the current economic situation, it's not likely to be a repeat of the Great Depression.

But what of plain vanilla government bonds? Towards the end of last week, 10-year Treasury yields temporarily dropped below 3.8 per cent, a return to the remarkably low rates seen earlier in the year when inflation had yet to rear its ugly head. The wise investor, though, remains unperturbed. After all, if the financial system is fragile, and it's impossible to tell which institution might next succumb to the credit crunch, why not own pieces of paper that enjoy the ultimate backing of the taxpayer?

The wise investor looks as the portfolio so far and scratches her head. It's all very well being heavily invested in government bonds, index-linked paper and corporate credit but none of these will deliver decent returns. The wise investor, like any other investor, wants to be able to make money (although, in current circumstances, not losing money is probably something of an achievement). So where else to invest?

She looks back to the 1970s. Perhaps equities and property aren't terribly attractive any more but what about commodities? After all, they depend on still-buoyant emerging market demand. Their prices have been rising despite the developed world's housing and credit crises. They should provide ample protection against inflation. And, although prices are already very high, who's to say they can't go a lot higher?

Desperate for returns, the wise investor decides to put a large amount of money into commodity funds. She wonders though, whether she really has been wise or, like so many investors before her, merely greedily fashionable.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com