Notz Stucki Investment Meeting – Charles Gave

by James Macpherson

Notz Stucki Investment Meeting – Charles Gave

The question the meeting considered was how do you manage money in an inflationary period. It is not certain that inflation is returning but investors need to be ready if it does. The question is all the more pertinent because after 30 plus years of disinflation almost no one active in the market today has needed the skill set to invest when inflation is rising. Several generations of managers have not needed to think about this, so it would be a profound test if the inflationary winds change.

Charles Gave giving his speech during our last investment meeting

In the past 30 years when inflation was declining the best portfolio was one composed half each of bonds and equities. When equities tumbled bonds rose, and when bonds fell equities rose. This gave a portfolio an inherent balance and stability. However when inflation rises, bonds and equities have a positive correlation – they both fall together, so you no longer get the benefits of diversification. An inflationary world is far more unstable. Looking at past periods of inflation the asset that suddenly becomes the star performer is gold. So one conclusion is that if inflation is coming back then the one asset to avoid is bonds which will be murdered. Instead of being reliable yield giving assets they will become volatile and wealth destroying. Similarly as bonds come down you need to reduce the duration of equities. Instead of growth stocks on high PEs portfolios will need to be shifted to short duration cyclicals. Again, this begs questions of finding the required skills. Growth strategies in equities have so outperformed value that value managers have become an endangered species. The gold price also becomes critical from here. First if gold outperforms it is an indicator of inflation. Second gold outperforming US bonds would indicate that the market is losing confidence in the USD, because gold has no yield. The greater the extent of this the greater the likelihood that the environment should favour value over growth strategies.

What should bond investors do? One solution is to invest in the bonds of a non-inflationary country. In the 1970s this was the German bond market which kept its diversifying power due to the respect in which the Bundesbank was held. From 1965 to 1988, the German bond market did much better than the US stock market, dividends reinvested. Today the Bundesbank has been emasculated by the ECB. Meanwhile China has been trying to emulate the Bundesbank in Asia, and to turn the Renminbi into the Deutschmark. Since 2006 the best bond market has been the Chinese one. China is also becoming more integrated with many markets around the world, not only its neighbours in Asia, but also places like Russia and Brazil. One can see a convergence of yields in these countries’ bonds to that of the Chinese bond, along the same lines as occurred in the 1990s as European countries bond yields fell towards Germany’s yield. Therefore over the next 5 years an attractive trade could be to buy the bonds of Brazil, Russia and Indonesia which have high single digit yields and enjoy their convergence to China’s yield, currently under 4%. Emerging market bond yields can be a strong asset class, and Asia growth stocks should be part of a similar theme.

The next bear market will be a bear market of indexation. Indices are constructed with companies that have worked in the disinflationary period of the last 30 years. The momentum buying of big companies, which has accelerated recently, is starting to look a dangerous strategy. The indices are composed of the wrong assets for an inflationary world. In fact most portfolios look as though they are invested in the wrong place. The worst asset of all is European government bonds, but most European savings have been herded into these. Together with a relatively narrow group of large cap growth stocks which have extended valuations global portfolios look in a perilous position if inflation does return.

Only when the tide goes out do you discover who’s been swimming naked. Warren Buffet

The financial world appears as though it is approaching a generational inflection point as the long disinflation of the past 30 plus years starts to turn round. If this is the case then investors will be forced to reposition their portfolios. Warren Buffet’s famous dictum that when the tide goes out you discover who is swimming naked will come into play. As the inflation tide turns portfolio managers may be embarrassed. Bonds and growth stocks will underperform value and cyclicals. A much more active approach will be required. In industries like semi-conductors and energy an understanding of their cycles will be necessary as there will be times of shortages that will lead to dramatic spikes in these sectors, and equally dramatic busts. On a more structural basis, places like Japan and Asia should do well as that is where most of the value is. So much manufacturing has been outsourced to Asia that they now control the production and prices of many goods. Asia can thrive in this new world. Elsewhere special situations can flourish. One example of this is the UK. The Brexit vote was a vote for freedom and democracy over technocracy and tyranny. Charles Gave has never seen a market decline where democracy is winning.


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