An update on where I think we are in the business cycle with respect to growth, inflation and markets

I haven't written for a while about what has been happening on the economic and markets front. This is largely because little has changed, whether in my head or outside it.

Inflation came down a bit from its peak, but there is now more talk about it being "sticky" (bond yields have bounced, following declines). My view, as I have documented clearly in recent months, has been and still is that inflation would fall a bit (perhaps to mid-single digits) as a result of some sort of recessionary environment, then bounce back because central banks prioritised growth over inflation (implicit abandonment of 2% targets).

However, the recent movements in inflation and bond yields have nothing to do with recession expectation and related reduction in interest rates (interest rates are still rising!) We still have those to look forward to, though when they might happen is anyone's guess.

While the fall in bond yields in January may have been due to the easing in inflation in many parts of the world, the bounce back reflects the reality that economies are still running hot (inflation may have fallen slightly but it remains high).

Why have economies not slowed in response to the increases in interest rates across the world? There are a few reasons:

1. although high inflation lowers economic growth and is thus fundamentally bad, there will always be those who benefit from it along with those who suffer (a cost rise for someone is a revenue rise for someone else);

2. consumers are still running down savings that they accumulated during lockdown either as a result of fiscal stimulus or lower spending on travel and entertainment;

3. it is possible that consumer debt defaults are now increasing but are being absorbed by banks and thus not "spilling over";

4. although interest rates have been increased greatly over the last couple of years, they may still not be high enough to cool economies;

5. nominal wages are now rising at high rates - this helps consumers deal with high inflation but it does not cool the economy or indeed bring down inflation;

6. economies do not behave linearly. They hit tipping points at which things start to change rapidly, increasing unemployment being a key one. We have simply not hit this tipping point yet.

In relation to 2. above, consumers in the UK during the height of covid (March 2020 to February 2021) paid down £14.7 billion of credit card debt. Since February 2021 credit card debt has increased by £12.1 billion (see Chart 1 below). In other words, there is still scope for increasing credit card debt to sustain consumer spending for a little while longer, though of course higher mortgage rates will also be limiting consumers' ability to spend (as indeed will higher interest rates on credit card debt be limiting scope to borrow more).

Chart 1

Source: Bank of England

As for point 3. above, it was reported recently by Credit Strategy that, "More than 18,000 new StepChange Debt Charity clients completed full debt advice in January 2023, which is at least 22% higher than any single month in 2022. This stark data suggests that more and more people are struggling with debt in the new year following almost 12 months of rising living costs."

Of course there are still many who think central banks can engineer soft landings. I suppose that is still possible but soft landings are rare. Throughout history, the only things that have really ever brought down high inflation are hard landings.

Thus, we appear to still be in the peak phase of the business cycle in which interest rates rise in response to rising inflation but have not yet caused a meaningful growth slowdown or, worse, a recession. Equities and bonds behave poorly during this phase as rising/high inflation hits bonds, and equities are hit by higher real interest rates (this impacts equities' valuation) in response to rising inflation and the anticipation of a meaningful slowdown caused by higher interest rates (this impacts earnings).

Gilts have hardly started to perform well, and could well resume their declines of the last couple of years if inflation turns out to be stickier than previously thought, wage demands persist, etc. As for equities, ignore the talk about the FTSE 100 being close to all time highs. A high proportion of earnings from FTSE 100 companies comes from overseas so the index does not reflect the domestic economy. And remember that the high inflation over the last two years has eroded the purchasing power of both equities and bonds. The 14 per cent rise in consumer prices that we have seen since the end of 2020 would turn a 7% increase in nominal equity or bond values into a 7% decrease in real terms. And spare a thought for those poor overseas investors in UK equities and bonds who have lost further real value because of sterling's weakness in recent months and years.

Conclusion? Continue to keep some powder dry. We have yet to see the worst of the peak phase.

Additional information:

In relation to Chart 1, a reader asked how the data would look if it was adjusted for inflation. This was an excellent question, as I bang on about the importance of making that adjustment - I should have explained that it would not have changed anything i.e. that inflation-adjusted numbers would still have suggested there was scope for further credit card borrowing to sustain consumer spending. Nevertheless, the below chart presents both nominal and inflation adjusted numbers, and shows that based on inflation-adjusted numbers, the case for spending being sustained is even stronger. Note that the below pertains to amounts outstanding (rather than monthly changes as in Chart 1 above) and so includes writedowns (which Chart 1 above doesn't).

The important conclusion is that while it may be tempting to think that it is a good thing that economic growth is sustained, it isn't. Sustained economic growth just means that inflation stays high, which means that interest rates have to rise even more, which means that performance of bonds and equities in real terms during this peak phase will be even worse. Be careful what you wish for....

Source: Bank of England

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

"Every single person who confuses correlation and causation ends up dying" - Hannah Fry, mathematician, author, and radio and television presenter

Data is too often presented in an unfair, unclear and misleading way

I recently challenged two senior investment professionals in relation to things they had said publicly that I disagreed with. They were both "copied" but neither disputed my challenges. What was perhaps more interesting, and certainly more depressing, were the comments I received from third parties.

In the case of the first, surprise was expressed that I had challenged the professional in question. Little about the points I had made. I had been extremely careful to make sure that my points were fact based, but it was still a bit galling that the attention seemed to be elsewhere.

In the case of the other, I had pointed out that a chart had been presented in a misleading way. It used two vertical (y) axes, one for each line, but they did not correspond. This is something that statisticians warn about, and that regulators pounce on when it appears in public (renowned statistician David Spiegelhalter devoted a large part of his excellent book, The Art of Statistics, to the matter).

However, I received comments from individuals, themselves senior financial professionals, that betrayed a worrying lack of understanding about the need to be careful when communicating complicated investment concepts to retail investors/non experts. The fact is that making only a suggestion that there is causation as the aforementioned chart did is not good enough. It is important that one must also provide the logical explanation for it. If indeed it exists, that is.

With this latter remark in mind, it's time for something a bit more lighthearted.

I don't know who Tyler Vigen is, but he or she must have spent many many hours trawling through disparate data series looking for pairs where there was a high degree of correlation, creating charts, and putting them on a website, Spurious Correlations.

Tyler assumed the high correlations were spurious. But what if they weren't? Below are Tyler's charts, together with my entirely logical explanations for them. I have done five, and would welcome your suggestions for the rest (or indeed better ones for my five). There will be a prize, and it might even correlate with the best entry!

By the way, there are two explanations for each chart - it would be utterly irresponsible of me to assume a particular direction of causation.

Finally, thank you, Tyler, for your fabulous website. And thank you, Hannah, for your brilliant quote at the beginning of this post.

A. More math doctorates awarded means a greater understanding of the link between greenhouse gases and atmospheric temperature, of the need for clean energy, and thus of the need to stockpile uranium...

B. Uranium stored at US nuclear power plants produces dangerous radiation which turns people into math geeks...

A. The best place to practice spelling is outdoors...where the venomous spiders live...

B. It has been proven that spider venom enhances memory. While it won't have done those who died any good, it did help the survivors...

A. Americans who buy Japanese cars later feel they have betrayed their country. With that comes a great sense of remorse that leads them to...

B. Suicide attempts by crashing of motor vehicle tend to be more successful in bigger, heavier cars that have more momentum. This leads to a perception that bigger, heavier cars are more dangerous and an increase in demand for smaller Japanese cars...

A. The older the winner of the Miss America competition, the more she is admired by older generations who are more familiar with steam engines and thus how hot vapours, objects etc can be used to get rid of their annoying spouse...

B. The more murders by steam, hot vapours and hot objects, the more finger print evidence gets destroyed, the fewer crimes get solved, the greater the demand for youngsters to become crime stoppers, and the fewer youngsters there are to enter Miss America competitions, thus favouring older entrants (ok this is particularly absurd but then so too is collecting data about steam, vapour, hot object murders).

A. The more cheese people people eat, the weirder their dreams, the more they toss around in their sleep, and the more likely they are to get fatally entangled in their bedsheets...

B. The more entangled bedsheet deaths, the greater the fear of going to bed, the more people stay up snacking, which for many means higher consumption of cheese slices...

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

Liontrust's John Husselbee's arguments in support of balanced funds are lame

I first wrote about the challenges faced by balanced funds five years ago and continued to write about them. Then, an article of mine in mid-October last year suggesting that they were broken really put the cat among the pigeons.

Given the huge amounts of money invested in such funds, whether passive balanced funds or those that were 'passive in disguise' (active balanced funds that are generally part of a risk rated range and thus constrained with respect to asset allocation) the backlash has been severe. Liontrust's John Husselbee is the latest to join the chorus of voices criticising those like me who have questioned the validity of balanced funds and their flagship, the 60/40 portfolio.

I respect John immensely, though I was not impressed by his rebuttal argument, as set out in a recent Trustnet piece titled, There’s never been a better time for a 60:40 portfolio.

Let's take six of his statements one by one (the article appears to have been a write up of an interview with John and where possible I have removed the 'Husselbee said that' phrases for the sake of tidiness).

1. "In the past 100 years, 2022 was only the fourth time that bonds and equities both lost money."

My comment: There are a couple of things wrong here. First, it appears that the losses referenced are in nominal terms (in fact there was not a single mention in the entire article of 'real', inflation-adjusted', or indeed even of 'inflation'!) John would know the importance of quoting gains and losses in real terms - as I like to say, nominal returns don't buy you real bread and milk.

There being no mention of 'inflation' anywhere in the piece is particularly surprising. It is what caused balanced funds to perform so poorly over the last couple of years or so. Indeed it is generally the main reason why bonds perform particularly poorly from time to time, along with rising real interest rates and, in the case of specific bonds, rising default risk.

However, the main problem I have with the statement is that balanced funds and forms thereof are generally held in retirement accounts as long-term investments. What happens in one particular year is irrelevant. And of course you don't need both bonds and equities to fall for balanced funds to fall; you just need one to fall more than the other rises. And you can have a multi decade period of poor balanced fund performance which contains the odd year of very good performance due to good performance of both bonds and equities.

From 1965 to 1981 (chart 1) US balanced funds in real terms fell by 35% (UK equivalents would have been similar). Does it really matter to retirement savers that there may only have been one or two years during that period in which bonds and equities both lost money (chart 2)? Also, what we have seen from balanced funds the last two and a half years could be just the start (chart 3).

Chart 1: A 50/50 US balanced fund has had multi-year periods of poor performance

Chart 2: The sixteen years from 1965 to 1981, however, were dreadful ones for balanced/risk rated funds

Chart 3: The last two and a half years could be just the tip of the iceberg

2. "Such poor performance for bonds, coming at a time when equities also fell, has led many commentators to claim the 60:40 portfolio is no longer fit for purpose. However, Husselbee said that these critics were looking at it from the wrong perspective. He pointed to data showing that over the past 30 years, using the MSCI World index as a proxy for equities, there have been just two occasions when a negative year was followed by another negative year (1999 and 2000). For bonds, using the Bloomberg Global Aggregate index as a proxy, there was only one occasion when this happened – 2011."

My comment: Again, why would two year periods matter to long-term investors? And why would nominal not real returns matter? And why would equity and bond performance in isolation matter? For balanced funds, by definition, it is the combination that matters.

3. “We've seen a significant repricing in bond yields. We've seen a significant repricing in equities as well. And if there was ever a time for 60:40 to work, if there was ever a time to get above-average returns over the long term for 60:40, it’s when yields are high and equity valuations are low.”

My comment: yields on both equities and and bonds are higher than they were but that does not mean they are high. In a long-term historical context, they are still low.

4. "One of the reasons why some commentators may be shying away from the these ‘balanced’ portfolios is that this is the first time they have seen yields and interest rates this high and may be under the impression that this is in some way abnormal. However, the current environment more closely resembles typical financial conditions than the post-financial crisis period."

My comment: I do not understand this. Surely if people thought yields were abnormally high they would be drawn towards balanced funds, not shying away from them. And, yes, yields are more typical (higher) than they were following the financial crisis but this does not make them attractive.

5. "The Federal Reserve raised rates by 4 percentage points in just seven months, when such an increase would usually take two to three years. However, this spike has suddenly made bonds attractive once more, while the volatile macroeconomic backdrop has created further opportunity to add value."

My comment: Real bond yields, whether in the UK or elsewhere, are certainly higher than they were a couple of years ago, making them more attractive. But at or around 0% (1% in US) they can hardly be called attractive. In the past they have been as high as 4 or 5%. In other words, 0% is not cheap.

I would agree that the volatile macroeconomic backdrop has created further opportunity to add value, but then I've never known the macroeconomic backdrop not to be volatile. It's just that some times are more volatile than others.

6. “If I were a bond manager who had just enjoyed a 30- to 35-year bull market, I might have thought, ‘okay, that's the time to hang up my boots’. But one year on I would probably be thinking ‘hang on a minute, there are some fantastic opportunities here’, because my market has just been repriced back to yields I haven't seen for the past 10 years, the world is beginning to contract, central banks are becoming more independent of each other and I've got a wider opportunity set. It is a pretty exciting time for bond managers again.”

My comment: I do not think that a ten year context is appropriate. Yes, yields are higher than they were ten years ago, but that doesn't make them attractive. They are still low in real terms, and still well below where they have been at times in the past.

Ultimately, this entire debate can be distilled down to what inflation does for the next decade or two. If it falls as it is currently doing and remains low, balanced funds will be just fine. John will be right, and I will be wrong. If it falls and goes back up again (as I expect) they won't be.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

The effort to improve financial literacy in this country itself needs to be improved

19th century Irish poet and playwright Oscar Wilde would wake up, read the paper, then, if he wasn't in the obituaries, get up. My own early morning routine is to read the financial papers and, if I find an example of financial illiteracy, I get up feeling irate.

I am rarely disappointed, which is to say that financial illiteracy and thus sources of irritation are plentiful. You may say that if I am that sensitive to what many would see as innocent mistakes then I deserve to be miserable, and for the entire day. Perhaps, but improving financial literacy is a noble and warranted cause, and I want to be part of it. Also, the mistakes should not necessarily be considered innocent.

First, let's be clear what is meant by financial literacy. According to the National Financial Educators Council, a US social enterprise organisation based in Las Vegas, ,financial literacy is "understanding the topic of money". It is therefore something that pertains both to members of the public who would not ordinarily be expected to be financially literate, as well as to the experts who are required to set a good example.

This latter group can be divided into experts who have a specific mandate relating to improving financial literacy, and those who write or talk about money in some other formal capacity, financial journalists or fund managers, say. Whether the audience of this latter group is other experts or the general public is, to me, irrelevant. Illiteracy at any level will permeate across an entire population, whether immediately or eventually.

In fact, it is financial illiteracy among experts that I find the most obnoxious. Sure, it is hard to read comments from survey participants such as "I've heard about this 'real terms' thing. [I] keep hearing it on the news and things like that. But I think it's just word play, a little bit. I don't really buy into it.", but it is surely the experts who are ultimately to blame for this sort of financial illiteracy, not the members of the public themselves.

This misunderstanding between real (i.e. adjusted for inflation) and non-real/nominal (i.e. not adjusted for inflation) terms in relation to financial quantities is particularly common, and one that is frequently perpetuated by those who should know better. The article that cited the aforementioned survey response tried to explain the difference but itself got it wrong. Referencing two headlines which, respectively, mentioned wages in nominal and real terms, the author of the article wrote that, "One focussed on the cash increase, the other on pay after inflation was taken into account."

Wrong. "Cash" can either be presented in real or nominal terms, i.e. it does not pertain to the latter only. That is the entire point of the two concepts! I know what the author meant when they wrote that "One focussed on the cash increase" etc but it would have been better (correct!) to say that one was adjusted for inflation, the other wasn't.

My own approach to "understanding the topic of money" is and has been for as long as I can remember to completely disregard amounts that are not adjusted for inflation. Nominal wages do not buy real bread and milk. Only real wages can do that. In other words, nominal wages, as with nominal anything, are meaningless. Otherwise public sector workers would not be striking at the moment.

I understand some will balk at this approach. However, if you think about it, nominal amounts are only useful in so far as they are required, along with the consumer price index or some other measure of prices, to calculate real amounts.

I also understand that the concept of real amounts is harder for non-experts to understand than nominal amounts. But therein lies the problem. The financial industry does a very bad job at explaining to the general public why attributing meaning to nominal amounts can be dangerous (I say 'can be' because if inflation is close to zero or if you are comparing amounts over a very short period then there is little difference between real and nominal. Normally, however, the difference between real and nominal is material).

This real versus nominal mistake is rife in the media. Today's spot was ",Shell reports highest profits in 115 years". In fact, there are two things wrong with this headline. First, the 'profits' referred to are not adjusted for inflation, and so meaningless. Second, one might assume that Shell's profits were the best in 115 years but not as good as its profits 116 years ago. Wrong. Shell has only been in business for 115 years. If you saw the equivalent headline, "Semiconductors most advanced in 149 years" (note 1), you would immediately realise its absurdity.

Another thing that experts get wrong is first and second derivatives. Let me explain. If you are driving a car, three things you might be interested in are distance travelled, speed, and acceleration, which, for sake of argument, are measured, respectively, in metres (m), metres per second (m/s), and metres per second squared (m/s2). Speed is the first derivative of distance in terms of time, acceleration the second.

We can apply this to consumer prices, in which case the first derivative is the rate of change of prices (i.e. the inflation rate) and the second is the rate of change of the rate of change of prices (i.e how prices are accelerating, equivalent to the rate at which inflation is rising or falling).

So, you can imagine my apoplectic bed-exit when I saw the head of asset allocation research at a major financial institution write, “already elevated inflation accelerated further”. Inflation did not accelerate further. It rose further. Prices accelerated further, not inflation.

You may well think I am being petty. However, whether you like it or not, attention to detail matters. Some apparently small mistakes have major ramifications. In this case, however, the point is not that individual mistakes matter but that small mistakes collectively pollute the effort to improve financial literacy. Moreover, why shouldn't experts who should know better, whether financial journalists or finance professionals, be called out? I know in my own case that I am always appreciative when readers point out errors in my articles.

While the mistakes mentioned thus far are basic ones, there are many others that get made that are less clear cut. And by those who really should know better.

Raghuram Rajan, who held posts both as chief economist at the IMF and as governor of India's central bank, wrote an op-ed in The FT in August last year titled Stop berating central banks and let them tackle inflation. A number of his points were good ones but some sounded lame. And a couple were downright wrong.

For example, he invoked Russia's invasion of Ukraine as having been a major contributor to higher inflation. In the US, pre-invasion inflation was 7.9pct. At the time Rajan wrote his op-ed it was 8.5pct. In other words, most of the rise had occurred before the invasion.

Rajan then wrote that once central banks had succeeded in bringing inflation down, we would probably return to a low-inflation, low-growth world, one subject to the headwinds of, among other things, de-globalisation. De-globalisation is inflationary, not deflationary!

The FT's generally excellent ,Swamp Notes newsletter last year wrote, ,"Of course, if we save, interest rates have to go up.". The interest rate represents the price of money. If we save, the supply of money increases, and the price of it, the interest rate, falls. If we consume rather than the save, on the other hand, interest rates rise. Indeed, the FT's own Martin Wolf has written on numerous occasions about how increased savings drove down interest rates in recent decades.

Then, the FT's even more respected Lex column wrote in July last year in an article titled Gold: rising production costs add to price pressure that the gold price would come under pressure (downward) both from rising production costs as well as gold's zero yield having to compete with rising bond yields.

Production costs rising puts marginal cost producers out of business, reducing gold supply and thus putting upward, not downward, pressure on the gold price. As for yields, the FT makes the mistake of conflating nominal and real yields. Bond yields may have risen in nominal terms but because of rising inflation they had fallen in real terms, going from negative to even more negative. As bond yields became more negative, gold's zero yield would become more attractive, putting upward pressure on the gold price, not downward. Since the Lex piece was published, the gold price has risen around 10% (yes, in real terms) which, for a lowly volatile instrument, is a huge move.

I wrote emails in relation to the above to both Lex and Swamp Notes but did not get responses. Both columns invite readers to write in, but, as a result, are probably inundated.

It should be noted that I am an avid reader of the FT, not least because I know it does not often make mistakes (it is, in my humble opinion, the best global financial paper by far). Moreover, I cannot call out lesser financial journals because I do not read them. At least not as a matter of course.

Anyway, I was delighted to see a year or so ago that the FT had launched its Financial Times Financial Literacy Campaign (FLIC) and gladly accepted the general invitation to readers to get involved. I wrote in, saying that I, via my blog and elsewhere, had a particular interest in investor education, and that I would be keen to help in any way I could. I received a response in June last year thanking me for my interest, and saying that the team would be in touch in due course.

Eight months later, I am still waiting. Further evidence, if any were needed, that the effort to improve financial literacy in this country itself needs to be improved.

Note 1: the birth of the semiconductor can be ,traced to 1874

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

Grey is the new gold! There will be as many opinions about what makes a good investor as there are investors. Here's mine.

Published with the kind permission of CityWire Wealth Manager

Being good at something can mean many things but is generally understood to involve being more skilful than others, however so measured. What makes a good investor?

There will be some who think that a good investor is someone who is successful commercially, who has persuaded others to entrust them with their money and thus earn a fee. However, there are many who have achieved commercial success only to then lose their investors’ money, whether through fraud or incompetence. Moreover, why must a good investor necessarily be professional?

A good investor is someone, professional or amateur, who is able to ‘beat the market’, to manage an investment portfolio that outperforms a particular index or benchmark on a persistent basis. This means being better than others at predicting price movements. After all, ‘the market’ is the amalgam of the views of countless individuals, thus investing is a competitive pursuit. Not everyone can outperform.

There are many types of investors. Those who specialise in, say, Egyptian equities or Asian corporate bonds. Or, more broadly, in global multi-asset investing. Those who seek to predict prices directly (quant investors) or indirectly (fundamental), over the short term or the long term. Those who do it for a living (fund managers) or as amateurs. Good investors can be found everywhere, though not everyone is a good investor.

What makes a good investor? For the record, I do not address this question from the perspective of someone who thinks he is one (far from it) but as someone with a decent amount of professional investment experience and who has thought about it a lot.

From time to time, I have heard fund managers say they are not in the business of predicting prices. Poppycock. Those who say this tend to be stock pickers who claim that their job is not to predict prices but to identify and invest in great companies. But presumably they do this because they think the stock prices will perform well. The price predictions may be indirect, but they are still predictions.

The point is, all investors (technical/fundamental, short-term/long-term, bottom up/top down) are in the business in one way or another of predicting prices, whether tradable/public or non-tradable/private. Even an investor in a passive fund is predicting, whether they know it or not, that it will perform in a certain way. There is no escape.

In relation to tradable (public) markets, if the price of something, whether of an index or a particular security, follows a random walk, its future movements are entirely independent of past movements and thus cannot be predicted. Anyone attempting so is involved in an exercise in futility, like the gambler who believes that a series of ten consecutive reds on the roulette wheel means that a black must be next.

However, prices do not follow a random walk, at least not exclusively: tomorrow’s price movement can sometimes be dependent on today’s. There is still a lot of randomness, but there is also pattern. Which means there is scope to predict.

In financial markets there are two well-understood dependencies. Patterns. These relate to whether tomorrow’s price movement is more likely to be in the same direction as today’s (momentum pattern) or the opposite (mean reversion).

Moreover, these patterns exist in other so-called chaotic systems. A hot day today is more likely to mean that tomorrow will also be hot. The heat however means that moisture builds in the atmosphere and eventually it rains. Momentum and mean reversion.

Identification of these patterns in financial markets does not guarantee success, but it can tilt the odds in your favour. And that tilt, aka an edge, may be all you need to outperform and thus be a good investor.

To be clear, these patterns exist in both very short-term price movements and very long ones. Jim Simons at Renaissance together with his band of geeks and a big computer has been the master of identifying the former. Warren Buffett is better than others at identifying momentum in certain businesses and thus in their market prices.

Although I started out in investing as an equity stock picker, my speciality for the last couple of decades or so has been asset allocation. What I have learned over the years is that there are two types of predictabilities that one can take advantage of as an asset allocator.

The first are underlying cycles (patterns) that pertain over the longer term to such things as debt, inequality, and politics and, over the medium term (the business cycle), to consumer confidence and employment. These factors among others determine inflation over the respective cycles which in turn influences financial market prices, whether of equities, bonds or precious metals.

The second are patterns in markets that relate to exogenous shocks. Disconnects. Discontinuities. Bifurcations. Markets often overreact to these shocks (that in March 2020 relating to Covid-19 being a good example) which means there is a likelihood of mean reversion kicking in and thus an opportunity for the good investor to outperform.

With Type 1 predictabilities, the underlying cycles are not neat, text book-like, thus how they manifest in financial market prices is even less so. Type 2 predictabilities on the other hand only come along perhaps every few months, years even. Taking advantage of either type requires a very healthy dose of humility, an understanding that markets for the most part are impossible to tame.

The last four decades, up until recently, were ones in which inflation in much of the world fell progressively (i.e with momentum) which meant that both equities and bonds performed very well, particularly bonds. You didn’t need to do anything fancy on the asset allocation front to generate good returns.

If inflation is now in the uptrend segment of its longer-term cycle, and there are good reasons to believe that it is, this will change. A more unconventional approach to asset allocation is required.

While humility is certainly key to being a good investor, it is not something that comes naturally to human beings. Indeed, it is overconfidence, not humility, that gets selected, evolutionarily speaking. Chutzpa, after all, is a better strategy in a nightclub or when seeking a promotion.

However, while humility may not come naturally, it does come with time. Through bitter experience. With age. Thus, grey hair, along with an understanding of patterns, may be the key fundamental ingredient when it comes to being a good investor.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

Improving maths standards will involve addressing the very real problem of maths anxiety

I was fortunate when I was young to be reasonably proficient at maths. The quantitative and unambiguous nature of the subject, in combination with the way it was taught, gave me a sense of self confidence that I otherwise would not have had - I was mediocre at best at other subjects and looking back wish my soft skills had developed more effectively. That said, maths has served me well, and I am aware just how useful a skill it is in everyday life. Indeed, the current prime minister is the latest to have announced plans to improve the UK's maths standards, in his case by making the subject mandatory up to the age of 18.

PM Sunak has yet to announce the details of his plan, and I like many will reserve judgment until he does. However, improving maths standards is a huge, complicated, multi-faceted task. For his plan to have any chance of success, it must address a whole host of issues.

The UK's current ranking in relation to maths standards among 15-year-olds compared with other so-called developed countries is poor. The most comprehensive global survey is the OECD's Programme for International Student Assessment (PISA) conducted every three years.

Due to Covid-19, the 2021 survey was postponed to 2022, so the latest is the 2018 version. This latest report showed the UK in 18th spot out of 78 countries, though research by UCL found the UK's ranking had been distorted because of low levels of participation in the test and a disproportionate underrepresentation of lower achieving students. UCL's finding was supported by previous surveys which showed the UK's scores between 2003 and 2015 at a stable level between 492 and 495, followed by a statistically unlikely jump to 502 in 2018.

Adjusted for the distortion, the UK's 2018 score fell from 502 to 492 and its rank ten places to 28th, barely above the OECD average. In light of the UK's rich heritage in maths and science, being in line with the average should be considered disappointing. Moreover, some might also say that getting caught cheating paints us in a particularly poor light.

As for the 2021 survey, Croner-i, "The UK's leading information resource", wrote about it in this article titled What do the 2021 PISA results say about UK education? Which is odd, given that there was no 2021 survey.

It is clear that the standard of maths in the UK - whether among 15-year-olds, leading information resources, or in the broader population - is not as good as it should be. But what sort of maths should we be better at? And how should we go about achieving it?

The two questions may be related. Given a choice of two broadly useful maths subjects, I think it would be better to teach the one that is more enjoyable to learn. A major reason so many children drop maths after GCSE is maths anxiety aka maths phobia. This syndrome manifests as a feeling that one is not good at maths, which then feeds on itself, resulting in hatred of the subject and ineptitude.

Recently I have been helping my 13-year-old nephew with his maths revision - an eyeopening experience on many levels. Maths by its very nature is unambiguous and quantitive, and schoolchildren become palpably aware of where they stand in relation to their classmates. My nephew is capable, but he gets anxious because he is not in the top half of his class, which affects his confidence. It is not surprising that many children develop maths phobia.

Maths is unlikely to stop being unambiguous any time soon, so Sunak's plan to get disaffected 17- and 18-year-olds interested in maths again should I think focus on showing them the magic. Nowhere is the magic of maths more evident than in the fields of probability and statistics, where counterintuitive riddles can leave anyone aghast (I append three of my favourites below). And, as with magic tricks, the explanations are often simple and thus accessible.

Furthermore, a half decent grasp of probability and statistics is an asset that has many practical uses. Most of our everyday decisions involve a subconscious assessment of the probabilities of possible outcomes, while statistics is about making sense of the world around us. If one can agree that making better decisions and better sense of the world must by definition result in improved lives - presumably the ultimate objective of many, particularly prime ministers - then the case for Sunak prioritising the two subjects is clear. The only question then is how to implement.

Three examples of counterintuitive probability:

1. In a room of 30 people, what is the probability that two share the same birthday?

2. If the diagnostic test for a disease is 90% accurate, and 1% of the population have the disease, what is the probability that you have the disease if you test positive?

3. Suppose there is a family with two children. I tell you that one of the children is a boy. What is the probability that the other child is also a boy?

Answers:

1. 71%

2. 8%

3. 1/3

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

The PM should start with the BBC when it comes to improving maths standards

I was pleased on Wednesday morning to see that UK inflation had fallen slightly in December. My pleasure, however, lasted only as long as it took me to read the BBC's take on the announcement. "Price rises slowed for a second month in a row but the cost of living remains close to a 40-year high", read the sub headline.

Why was I unhappy? Because the BBC got it wrong. Again. It is not the cost of living that remains close to a 40-year high but the rate of change in the cost of living. The cost of living aka the consumer price index is always close to its all time high because prices rarely fall (chart 1, note: I have used the retail price index because of data availability but it makes no difference). On the other hand, the rate of change in the cost of living aka the rate of change in the consumer price index aka consumer price inflation has mostly been low single digits the last 40 years but is currently 10.5% which is close to a 40-year high (chart 2).

Chart 1: consumer/retail prices have almost always risen so are by definition always close to 40 year/all time highs

Source: measuringworth.com

Chart 2: Inflation on the other hand is indeed "close to a 40-year high"

Source: measuringworth.com

The BBC conflated the price index with the rate of change of the price index, which may sound like a small thing but is basic maths (this is particularly ironic given Rishi Sunak's recent announcement about mandatory study of the subject to 18 years of age - perhaps he should start with the BBC).

An equivalent would be conflating distance with speed. Imagine reading an article that stated that the distance between London and Brighton was 50 miles per hour. Frankly, you'd think the journalist was an idiot.

And, yes, it's a small thing, and, yes, I'm a pedant, but my view has for as long as I can remember been that small things matter. Why? Because lots of small things add up to big things.

It is also particularly important that the BBC gets these things right because it is the most widely read news site in this country and thus hugely influential. In this piece (https://www.chimpinvestor.com/post/naughty-auntie) I wrote about how it was possible that the BBC's misleading reporting of wage increases may have wrongly further encouraged public sector workers to strike.

Having said all this, I was pleased that later in the day the BBC changed the wording of the sub headline in the article, correcting its error (figures 1 and 2). However, given the very short shelf life of online articles, I expect the damage, however small, had already been done.

Figure 1: The original sub headline

Figure 2: The corrected sub headline ("cost of living" changed to "inflation")

Source: https://www.bbc.co.uk/news/business-64311461

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

Now is the time for truly bold asset allocation

Chimp readers may be aware that I have been warning for the last five or so years (see note 1) about funds that employ conventional asset allocation i.e. ones that follow some global balanced (equity/bond) or multi-asset (equity/bond/alternatives) index, whether strictly (passive asset allocation funds) or closely (most actively-managed asset allocation funds). If you have a large portion of your retirement portfolio in these funds, or your DIY asset allocation is 'conventional', you are risking your comfortable retirement.

Why?

Real returns from asset classes that comprise a large portion of balanced/multi asset indices such as developed market bonds and equities could be poor (negative) for the next decade or two. The reason for this is that I believe inflation will remain high for a number of years, as indeed it has done on occasions throughout history, most recently from the mid-60s to early-80s.

My concerns of the last few years related to what was clearly a bubble in developed market safe haven bonds, a bubble that appeared close to bursting. While I may have been a bit early with my warnings, the bubble began to burst in mid-2020 and has continued to deflate since. Moreover, the rising/high inflation that is the cause of the bubble's deflation has over the last year also impacted equities - funds employing conventional asset allocation are now down in real terms over most periods to date going back several years (Fig 1).

Fig 1: The global balanced fund is the investment industry's flagship retirement product...and it's sinking

Source: Yahoo! Finance, Federal Reserve Economic Data, Office of National Statistics

(Note: the reason why a GBP investor has done better in a global balanced fund than a USD investor is that since Brexit fears began to spread in 2015, sterling has been very weak. For GBP investors who were currency hedged, either with respect to only their overseas bond exposure or to both bonds and equities, performance would have been closer to that of the USD investor).

Although it was right to have been concerned the last few years, this of course does not mean that my current grim predictions about the future performance of developed market bonds and equities will prove correct. However, I do think it should give them more credibility (the poor performance, particularly of bonds, will be the result of inflation remaining high, the reasons for which I most recently set out in this post).

So, where, and how, should you invest instead?

The 'how' question is important as it is about freeing oneself from a constrained mindset in relation to risk. In investing, there are times when it is risky to diverge from the crowd and times when it is risky to be part of it. By 'crowd' I mean 'convention' which, in relation to investing, means conventional asset allocation, as described above.

The last four decades have seen both global equities and bonds produce annual real returns in the high single digits, driven by the persistently disinflationary environment. Combining them in a (conventional) 50/50 balanced fund has thus worked very nicely for those saving for retirement (there have also been diversification benefits as a result of the two asset classes often being negatively correlated). In other words, it would have been risky to step away from the crowd.

If inflation stays high, however, this will change, and employing a conventional asset allocation (i.e. being part of the crowd) will not work. In order to produce decent returns, and thus to protect that comfortable retirement, one must employ an unconventional asset allocation. One must step away from the crowd. One must be bold.

What might this 'boldness' look like in terms of where one should invest?

Fig 2 below is for illustrative purposes only but should provide an idea of what an unconventional asset allocation (one designed for a high inflation environment for the next decade or two) might look like. I should also mention that it is pretty close to where my own retirement portfolio is invested (not putting your money where your mouth is in this business considered very poor form).

Fig 2: An unconventional asset allocation in relation to a (conventional) 50/50 balanced fund

Incidentally, I was cited in this recent Citywire article in which BlackRock attempted to explain how its MyMap asset allocation funds were different to passive balanced funds such as those in Vanguard's LifeStrategy range that I had criticised. It may be true that BlackRock has an advantage because, unlike passive balanced funds, its MyMap funds employ active asset allocation, and invest in alternatives (interestingly, BlackRock didn't mention its strictly passive Consensus fund range which is almost identical to the Vanguard range).

That said, in the case of the MyMap 5 fund, investment in alternatives is minimal (less than 3%) and asset allocation has hardly changed over the last year or so (equities 65% versus 69%, bonds 31% versus 28% i.e. hardly what I would call active). Also, geographic/sector exposures within equities and bonds appear fairly conventional.

In response to my criticism of balanced funds (those that have significant exposure to bonds) BlackRock’s head of wealth for multi-asset strategies and solutions for Europe, the Middle East and Africa, Andrew Keegan insisted that investors were not able to escape from the market environment in 2022. According to Keegan, "Generally, the main asset classes are down. Unless you have a very complex hedging strategy, or you play markets perfectly, it’s difficult to be positive year-to-date."

It's true that it was difficult to produce a positive return in 2022, particularly in real terms. However, I never suggested it should have been easy, possible even. My concern has been and continues to be that if inflation stays high for the next decade or two as I think it might, funds that employ conventional asset allocation, whether strictly passive like LifeStrategy and Consensus, or slightly active like MyMap, are going to struggle. Also, if I am right that inflation will remain high, you do not need to employ a very complex hedging strategy or play markets perfectly to do well. You just need a bold - unconventional - asset allocation.

With respect to the unconventional asset allocation set out in Fig 2, if your first instinct is to think that it is too risky, I would urge you to re-read the 'how to invest' paragraphs above. Also, remember that volatility, whether in absolute terms or relative to an index (the latter is also known as tracking error) is a very poor measure of risk. As a hypothetical example, an investment that falls 1% each and every month for ten years has volatility of zero but, over the ten years, a total return of -70%. In other words, volatility gives a very poor indication as to important risk, that of loss of capital.

If you think the example cited is too extreme/hypothetical, you are mistaken. From 1940 to 1981, US government bonds were low volatility (annual volatility of 6.9% versus 14.1% for US equities). However, their total real return over the forty or so years was -67%. The reason? Rising/high inflation.

Note 1: In this post in 2017, I wrote: "Are there ‘suitability’ issues in relation to putting clients into passive multi-asset funds that have massive bond risk? Back in 2008, the real 10-year Gilt yield was around 1%. Although this was low – 10 years earlier real yields were 4% - one could still justify buying Gilts on the basis that the real yield was positive. Fast forward to today and real 10-year interest rates in the UK are close to -2%. This means that if you buy them and hold them to maturity, your real return will be -2% per annum (-1.79% to be precise)1. To make money in real terms, real yields would have to fall further and you’d have to sell the bonds before maturity. But yields are already at -2%! Expecting them to fall to, say, -3% is, in my humble opinion, not investing but speculation. In the previous section, I mentioned four providers of the more popular passive multi-asset funds. If you consider their offerings that sit in the IA Mixed Investment 20-60% Shares sector, they generally have around 40% in equities. Where is the other 60%? All or mostly in bonds, where one has to be lucky to win. In other words, are these funds really suitable for your clients?"

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

Criminologist Prof David Wilson writes on Suspected Miscarriage of Justice Case Colin Norris

As readers of my blogs and articles may know, I have an interest in miscarriages of justice, particularly those that result from poor use of statistics and probability (this is the link with investing). I was therefore interested to see renowned criminologist Prof David Wilson writing in the Scottish Herald this week about Colin Norris, the nurse who was convicted in 2008 of killing four of his elderly patients by injecting them with insulin.

Prof Wilson appears to have always had doubts about the soundness of Norris' conviction (as have many others, including me). Thankfully, the Criminal Cases Review Commission decided to refer the case in February 2021 to the Court of Appeal (the appeal is yet to be heard).

I mentioned the Norris case in a post in October titled Miscarriages of Justice in Killer Caregiver Cases, a piece that was prompted by the start of the trial in Manchester of another suspected killer nurse case, that of Lucy Letby:

Caregivers who have either been wrongly accused or convicted, or where there is for good scientific/statistical reason for suspicion of such, include Lucia de Berk, Daniela Poggiali, Jane Bolding, Sally Clark, Susan Nelles, Ben Geen, and Collin Norris. If it turns out there is no direct evidence against Lucy Letby, let's hope her name doesn't join the list.

It was therefore particularly interesting, given that Letby's case is ongoing, to read Prof Wilson's opening paragraph:

IT'S been hard to avoid discussing nurses over the last few weeks – quite apart from the fact that our daughter, who like many "twentysomethings" is still living at home, always wants to talk about her work as a nurse when she finishes her shift as a way of unwinding.

Although Prof Wilson does not mention Letby by name, her case may be what he is referring to when he writes, "It's been hard to avoid discussing nurses over the last few weeks" (it may of course also/instead be a reference to the recently released film The Good Nurse about killer nurse Charles Cullen and/or to the industrial action by the nurses' union in last few days).

Regardless, I have been following the Letby trial quite closely and thus far no direct evidence against her has been presented. Moreover, the prosecution has presented as evidence a number of Letby's text messages to and conversations with colleagues as well as her internet search history (she searched on Facebook for parents of babies she is accused of murdering or attempting to murder) which it suggests are incriminating.

I do not know what is like to be a nurse in a neonatal unit where the death of premature babies is a not uncommon occurrence, but I imagine it can sometimes be very upsetting. It certainly seems plausible to me that, once their shifts have ended, nurses in such situations would do things to help them come to terms with traumatic events. Examples might include texting or saying certain things to each other, perhaps using gallows humour, or feeling the need to seek some sort of connection with parents, albeit a passive one, via internet searches, or going dancing.

In other words, such behaviour would not be incriminating at all, but what Prof Wilson refers to when he writes about his daughter always wanting "to talk about her work as a nurse when she finishes her shift as a way of unwinding". Indeed, I suspect this is a veiled reference to Letby's post-shift behaviour and the prosecution's insinuation that it was something other than completely innocent 'unwinding'.

Thus, despite the case being sub judice, it would appear that Prof Wilson is hinting that he thinks that jurors may be assessing the evidence of Letby's post-shift comments and actions under a presumption of guilt not innocence. A different perspective changes everything.

Prof Wilson and his colleague Prof Elizabeth Yardley conducted research in 2014 on "the very small group of nurses who abuse their position of trust and kill their patients". He writes:

Why did nurses behave in this way, and what could hospital administrators and law enforcement do to ensure that this rare type of killer did not become more common? What “red flags”, as we called them, about the nurse or about their work performance give cause for concern, and how many of these red flags needed to be present before action would have to be taken?

Our research was based on a sample of nurses who had been convicted of murdering their patients in Europe and North America, and we used a 22-point checklist of personality traits and work behaviours that were associated with that sample. We then discovered how a median of six of these 22 points tended to cluster in the backgrounds of more than half of our sample. This cluster of red flags were higher incidences of death on his/her shift; has a history of mental instability and/or depression; makes colleagues anxious; moves from one hospital to another on a regular basis; is found to be in possession of drugs (both legal and illegal) at home/in their work locker; and, appears to have a personality disorder.

The most prevalent red flag that we identified was to have had higher incidences of death on his/her shift. In other words, where there were a number of deaths over a specified time period that exceeded those that were expected when compared to the usual number of deaths for that ward or the hospital, and shift patterns were then used to determine a suspect. Attendance data revealed the presence or absence of particular members of staff during, or around the time of these unusual death rates.

However, and this was the important finding, we discovered that there was an uneasy fit between scientific and legal principles in this context, as attendance data didn’t actually establish guilt on the basis of the “similar fact” principle of evidence where there needed to be a direct association between specific actions and specific events.

So, we discovered that what might appear sound and convincing from a policing point of view had great deficiencies when employed as evidence in court, and there were practical consequences as a result. Attendance data had been used to convict, for example, the Dutch nurse Lucia de Berk of killing seven of her patients in 2003, although she was acquitted seven years later when it was accepted that attendance data alone could not prove her guilt.

As a result, our research suggested that having just this one red flag should never be used as a basis for conviction, as a higher than average number of deaths over a given period of time may have various explanations – of which an active serial killer is only one – and therefore could in our view only be used as a basis to convict when found in combination with other red flags.

As I wrote in my October piece, the probability that a ward somewhere in the UK is going to have a well-above-average number (a cluster) of unexplained deaths during, say, a 20 year period by pure chance is very high, very possibly odds on. On the other hand, the probability of a particular ward experiencing such is very low, one in tens or hundreds of thousands. Think about The National Lottery. You are never surprised to hear that someone has won it, but you would be if that someone was you.

In the face of an elevated number of unexplained deaths, the hospital authority in question will often find it hard to accept that it was just incredibly unlucky, and thus search for an explanation. Furthermore, it might prefer a sinister explanation (murder) to one that implicates the hospital (poor management).

Once a hospital authority has convinced itself that a killer is in its midsts, and that the killer is probably a nurse (it couldn't possibly one of those nice and competent doctors, and anyway we might need them later to support us) the next step is to analyse nurse roster data. There is a 100% probability that the roster data of one of the nurses will match most closely with the pattern of unexplained deaths. It doesn't matter if the match is not a close one. It's the closest. And therefore the nurse with the closest fitting roster data must be the killer. As for the unexplained deaths that did not happen on said nurse's shifts - there will always be some - they are simply ignored. We have our man, after all.

What then follows is a frantic hunt for evidence against the suspect (in addition to that of the roster data). Suddenly, comments and actions that would previously have been considered completely innocent are seen in a suspicious light. Those with a grudge against the nurse might lie. Memories might get gradually distorted, pressure put on staff. And, before you know it, there is a large body of circumstantial evidence against the accused (miscarriages of justice do not tend to happen where there is direct evidence, as was the case with Harold Shipman and his tampering with his victims' wills).

Prof Wilson continues:

This nursing preamble leads me inexorably to Colin Norris. Born in Glasgow, and trained in Dundee, Norris was convicted in 2008 of killing four of his elderly patients by injecting them with insulin in Leeds, where he worked as a nurse at St James’s University Hospital and Leeds General Infirmary. It was claimed that Norris hated elderly, female patients and that was why Doris Ludlam, Bridget Bourke, Irene Cookes and Ethel Hall had lost their lives. However, Norris was an "outlier" – just like Lucia de Berk and that encouraged us to look a little more closely at how he had come to be convicted.

We were disturbed by what we found. It was soon clear that the case against Norris was entirely circumstantial but through the police interrogating attendance data he became the supposed “common denominator” in this cluster of deaths, although there was no direct evidence whatsoever to link him to what had happened to Doris, Bridget, Irene and Ethel.

There was no “good nurse” like Amy Loughren who had worked out what Cullen [Charles Cullen, an American nurse who confessed in 2003 to killing up to 40 patients] was doing, and reported her anxieties to the police. Instead there was simply rumour and tittle-tattle that was used to spin a motive for Norris, who was jailed for a minimum of 30 years, but who has never stopped maintaining his innocence. To this day both Elizabeth and I believe that there has been a miscarriage of justice, and it is good to see that his case has now been sent back to the Court of Appeal.

Norris was originally charged with five murders but it was then discovered he could not have committed one of them. The police started looking for a second murderer, right? Wrong. The fifth murder was deemed no longer a murder and...ignored.

Norris appears to have been a victim of poor use of probabilities as described above. He was also it seems the victim of expert after expert testifying that naturally occurring hypoglycaemia in the elderly was far rarer than it actually is (thus, in the case of Norris' 'victims', their hypoglycaemia could only have been caused by him having injected them with insulin).

There are many parallels between Letby's and Norris' cases. The Countess of Chester Hospital where Letby worked had received a damning review. It had had its neonatal competency level downgraded. The evidence against Letby is purely circumstantial. She is getting blasted in the press for going dancing after a shift on which one of her subjects had died. The list goes on.

I am not saying Letby is not a murderer. How would I know? What I do know is that her case bears similarities to others in the past that resulted in wrongful convictions. Judges tasked with guiding jurors are rarely also mathematicians (one UK judge is even on record as saying he did not understand the specific aspect of probability relevant to these so-called 'cluster cases'). Nor are jurors. Let's hope that in Letby's case her defence team can convert them, if only for the duration of their deliberations.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

When the time comes, will central banks prioritise employment or inflation?

The goals of central banks are price stability and maximum employment. For much of the last four decades there was little conflict between the two. Strong disinflationary forces meant that unemployment, outside of recessions, could be kept low.

Things are changing. While there are tentative signs in the US and the Eurozone that inflation is moderating, it is still far too high, at least across the developed world. Alongside this tentative moderation in inflation, economic leading indicators have been falling. If unemployment starts to rise sharply (a hard landing) at a time when inflation is still too high, where will central banks' priorities lie?

I have been arguing for some time now that inflation is likely to remain elevated for many years to come (the ramifications of which for investors are significant). But I have also been arguing that weakening economic growth will cause inflation to fall somewhat in the short term, the next year or two. In other words, I believe that inflation will ease a little but then rise again, a scenario that will be brought about by central banks prioritising employment over inflation in the face of sharply weakening growth/a recession. The social and political pressure on them to cut interest rates and boost growth/employment, even if inflation remains high, will simply be too great.

Of course, there are three other possibilities. One: there is a recession involving a sharp rise in unemployment (a hard landing) and inflation falls to very low levels, to central banks' target or below. Two: there is no recession but inflation remains high. Three: there is no recession and inflation returns to a low level, whether that is the 2% that is normally considered the central bank target or something a little above that. Let's call these scenarios HL (for 'hard landing/low inflation'), SH (soft landing/high inflation), and SL (soft landing/low inflation). As for the scenario outlined in the previous paragraph, let's call that HH (hard landing/high inflation).

The four scenarios can be depicted in the below 2x2 matrix.

Source: Chimp Investor

The short-term (1-2 years) and longer-term (10-20 years) performance of bonds and equities will vary according to the scenario. For example, in my preferred scenario (HH), bonds may perform well in the short term as inflation falls somewhat, but then perform poorly in the longer term as inflation bounces back to high levels. Hard landing scenarios will be negative for equities. In the longer term, equities will do ok as companies adapt to a high inflation environment. Etc.

The expected short- and long-term performance of equities and bonds in each of the four scenarios is presented below.

Source: Chimp Investor

Clearly the most favourable scenario for both bonds and equities is SL, one in which there is a soft landing and in which inflation falls back to central bank target or thereabouts, then stays low. In other words, a return to the 'Goldilocks' world of what was known as The Great Moderation, the period that began in the mid-1980s and ended (for some) around the time the 2007/8 crisis or (for others) in 2021 when inflation began to rise sharply (it doesn't matter which).

I have labelled this scenario SL but could just as easily have used PD (pipe dream), PITS (pie in the sky), IYD (in your dreams), or various other idioms. I realise such frivolity may risk belittling this post, but I want to convey just how unlikely I believe this 'perfect' scenario to be. What were fairly mild recessions in the US in 1970 and 1974 failed to bring inflation that had started to rise above target in 1965 under control, ostensibly because the priority was on jobs and growth. Inflation was really only tamed in the early 1980s as a result of a hard landing recession brought about by then Fed chairman Paul Volker's very high interest rates. In other words, it tends to be only hard landings that stamp out persistently high inflation.

Of more concern is the fact that the 'perfect' SL scenario is the one currently being embraced by Fed governor Christopher Waller and supported, among others, by Fed chairman Jerome Powell. Opposition to Waller's argument has come from former Treasury Secretary Larry Summers and former IMF chief economist Oliver Blanchard. I wrote about the debate here, pointing out what I believed to have been a significant error in Waller's logic that Summers and Blanchard had not spotted.

My reasoning for a belief in the HH scenario (why inflation will remain elevated in the decade or two ahead, following a recession in the next couple of years) is as follows.

• Economic leading indicators portend weak growth ahead. For example, global and US purchasing manager indices (see below charts) have been falling and are now in 'contraction' territory (below 50). Consumer confidence indicators are also very weak. Tipping points at which companies begin to shed labour in a coordinated fashion could be reached fairly soon.

• Although, as mentioned, there are signs that inflation is moderating, the moderation is happening only slowly. At the same time, wages may now be accelerating (so-called second order effects) that will increase upward pressure on consumer prices i.e. stop inflation falling much. During the three months to October, wages in the UK rose by 6.1% year-on-year (see chart below). Anecdotally, public sector strike activity is on the rise, putting further upward pressure on wages. In the US, wage growth has fallen to 5.8% yoy in November since it peaked at 6.7% yoy in March. However, although it is only one month's data, November's earnings were 8.5% higher than October's on an annualised basis.

Source: Office of National Statistics

• It seems likely, given the above two points, that inflation will not have fallen much by the time recession hits. There will be huge pressure on central banks to prioritise growth/jobs over inflation, and thus I expect interest rates to be cut sharply when inflation is still well above central banks' target of c. 2%. The reflation will cause inflation to bounce back to high levels (perhaps high single digit or low double digit).

• As I have written on previous occasions, inflation is far more complicated than is generally believed. It was not long ago that many had declared the Phillips Curve (the relationship, an inverse one, between wage growth/inflation on the one hand and unemployment on the other) to be dead, the reason being that the low levels of unemployment following the GFC did not seem to have an inflationary impact. Such declarations may well have been premature given that the high inflation of the last two or so years, as well as rising wage growth more recently, have coincided with tight labour markets.

• Covid and Ukraine were not the causes of the high inflation but catalysts. In other words, inflation will not just fall back when they are behind us. Ultimately, as American economist Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” In the face of strongly recovering private demand and unnecessarily loose fiscal policy over the last two or so years, monetary policy was far too accommodative. It is hard to get genies back into bottles.

• It is possible that quantitative easing (QE) was inflationary after all. Just because there was a lag does not mean that there is no effect. Also, QE is not considered money printing only if commercial banks believe that their huge reserves will be taken away from them at some point. Since central banks have never shrunk balance sheets on anything other than a short term basis, commercial banks may begin to think they can start to lend out their massive reserves. Particularly if capital adequacy ratios are eased as they may well be in the years ahead.

• Structural disinflationary forces that prevailed for much of the last four decades such as globalisation and offshoring of manufacturing may now be in reverse. There are other changes in structural forces such as heightened geopolitical risk and climate change that are likely to continue to present challenges to central bank policy in the years ahead.

• There are two ways for debt issuers to default: hard and soft. Hard involves non payment while soft involves the real value of principal (and future coupons) being reduced by high inflation. The latter tends to be the more politically acceptable way for governments to default when debt levels get high as they are nowadays.

Central banks in recent months have done a decent job of persuading the financial press, and perhaps markets too, of their hawkish credentials. After all, the increase in Fed Funds Rate from 0.25% in May 2020 to 4.0% currently has been rapid. However, the increases in rates in the US and elsewhere appear to be having more of an impact on growth than on inflation. If/when joblessness starts to accelerate, central banks may be forced to reveal their true (i.e. dovish) nature.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

The passive fund behemoth refuses to consider possibility that inflation will remain high

A debate is currently raging in the financial press about balanced funds, both passive and active, and I have been an active participant. With respect to passive balanced funds, the focus has been on Vanguard, perhaps because its LifeStrategy fund range is the largest in terms of size: excluding the LifeStrategy 100% Equities fund that I do not consider to be a balanced fund, total fund range AUM is GBP30 billion. However, Blackrock, L&G and HSBC also offer ranges of passive balanced funds that are large and have been subject to the same forces as Vanguard's, namely the lowest risk funds over the past two years posting sizeable losses and the highest risk funds doing ok. The reason? Bonds.

The latest article on the debate, published on Tuesday, was written by Citywire's Caroline Hug and titled Vanguard: Give low-risk LifeStrategy funds 2-3 years to claw back 2022 loss. The article presented Vanguard's defence of its poor performing low risk balanced funds, and used various comments of mine to present an opposing view.

The balanced fund concept, one that is invested in equities and bonds in specific ('balanced') proportions, is arguably the fund industry's flagship retirement product. Indeed, it should perhaps be thought of as the industry's key product, given that retirement savings account for the lion's share of total. There is a lot riding on this.

At the heart of the debate is the question of whether inflation will stay high for the next decade or two. If it does, bonds will continue to perform worse than equities and low risk balanced funds will continue to post bigger losses than high risk funds. I think it will. Vanguard doesn't.

For the record, I am generally a fan of balanced funds, particularly passive balanced funds given their low costs. Most of the time they work just fine, as had been the case, at least until recently, for the best part of 40 years. But during periods of persistently high inflation that occur every few decades, they will struggle. I have been warning about the inevitability of such a period for a few years now.

Below are various parts of the article, together with my thoughts on them.

"The struggle for Vanguard’s LifeStrategy low-risk funds epitomised the plight of the 60/40 asset allocation model, but the firm believes this year has been a ‘complete outlier’, although admitting it may take a while to recover 2022 losses."

It is true that, in the context of the last 40 years, this year has been a 'complete outlier'. In the context of the last 100, it hasn't been.

"However, faster-than-expected rate hikes in a bid to curb soaring inflation, the repercussions of the Ukraine war, and the disastrous UK mini-Budget in September have put pressure on these balanced portfolios, as the close correlation between bonds and equities left nowhere to hide."

The pressure on balanced funds began in mid-2020 when bond yields began to rise. They then came under further pressure when inflation began to rise sharply in early 2021. In other words, they were under pressure long before the invasion of Ukraine in February this year. As for the close correlation, it is true that bonds and equities both fell, but this does not mean that they both fell by the same in percentage terms. Indeed, equities have held up much better than bonds the last two years, so would have been a good hiding place.

"Vanguard multi-asset product specialist Mohneet Dhir described this year as a ‘complete outlier’ for these portfolios, describing the recovery from Covid and Russia’s invasion of Ukraine as exogenous events, which caused inflation to soar."

My view is that Covid and Russia's invasion of Ukraine were catalysts, not causes, of the soaring inflation. The causes related to overly loose monetary and fiscal policy. It is possible that inflation is showing signs of decelerating, and indeed may fall a bit in the next couple of years. However, my belief is that governments and central banks will be forced to prioritise growth over inflation in the years ahead: monetary and fiscal policy will remain too loose and inflation high, as happened after the 1969 recession.

"‘These models still invest in high-quality investment-grade bonds,’ Dhir added. ‘A large part of the performance for both LifeStrategy 20% and 40% Equity has been due to the positive correlation between bonds and equities. The central bank’s aggressive interest rate hikes drove negative bond performance this year, and ultimately tipped correlation into positive territory'...In her defence of the low-risk model, Dhir noted that the correlation between bonds and equities has historically proved to be short-lived, using 2017, when the correlation turned positive for a brief period, as an example. 'Between 1995 to today, the correlation between equities and bonds has only been positive 13% of the time,’ Dhir said. ‘Each of those times, positive correlation has been short-lived.’"

Whether two things are positively or negatively correlated depends on the time frame over which they are measured - the temporal resolution. Demand for ice cream and hot chocolate will be negatively correlated on a short-term - monthly/seasonal - basis but positively correlated over the long term. It is true that based on short-term returns, equities and bonds are most of the time, as Vanguard suggests, negatively correlated. However, short-term returns should not matter to investors, long-term returns should. On the basis of long-term returns, equities and bonds are very much positively correlated. Indeed, it is the positive longer term correlation between bonds and equities that drove the fabulous returns for Vanguard's funds until recently!

Also, measuring correlation since 1995 as Vanguard has done won't work as the period does not capture years in which inflation is persistently high as was the case from 1965 to 1981.

"One of its fiercest critics, ex-Seneca IM CIO Peter Elston, suggested Vanguard may be in denial."

Again, my point here was that to understand how balanced funds might perform going forward, one must analyse the behaviour of bonds and equities over the very long term, not just since 1995. Looking at the behaviour of each over anything up to 40 years will fail to capture how they perform when inflation is persistently high.

"Elston is not as convinced, however. In his blog, he suggests investors calculate bond volatility based on 30-year returns, rather than focusing on short-term volatility."

Based on 30 year real returns, bond volatility is 70% higher than that of equities. This is counterintuitive but reflects the fact that companies - equities - can do things to mitigate the effects of high inflation such as increase prices, cut expenditure, shift production etc. Bonds cannot.

"Elston believes that if inflation does persist, as history suggests it might, a positive correlation could be the new norm."

Over time frames that matter to investors - i.e. longer ones - bonds and equities are always positively correlated.

"Dhir admits this period was a bond bear market, but she does not expect fixed income to go through such a prolonged period of suffering this time, highlighting the average bear market usually only lasts for around a year."

From 1940 to 1981, US bonds returned -67% in real terms. That's a 41 year bear market, a tad longer than "around a year". Perhaps Vanguard needs to broaden its historical perspective.

"While she appreciates investors might have some concerns, Dhir expects central banks’ aggressive rate policy to filter through into the economy and ease inflationary pressures, which will be good news for bonds."

This is the nub of the issue. Vanguard's LifeStrategy funds will be just fine if we return to a disinflationary environment. My view is that we won't, whether because governments will be forced to prioritise growth over inflation, flawed econometric models, cognitive bias, second order effects (accelerating wages), the need to deflate debt, heightened geopolitical risk, the reversal of globalisation/developing economy labour no longer being cheap, or the need to start allocating significant resources to clearing up the waste we have pouring into our environment the last 200 years.

"Vanguard’s Capital Markets model predicts inflation will reduce to 6.3% in 2023.

This leaves it optimistic on the outlook for the LifeStrategy 20% and 40% equity funds, forecasting 2023 returns of 5.7% and 6.3% for the strategies respectively. On this forecast, it expects the funds to return to their December 2021 valuations within two to three years. ‘This is in line with the recovery periods we’ve seen historically for multi-asset portfolios, following similar periods of simultaneous stock and bond declines over the past 100 years.’ Based on these numbers, Vanguard expects a recovery period of between 30-40 months for LifeStrategy 20% investors, and 24-31 months for LifeStrategy 40% investors."

I take issue with Vanguard's assertion that their expectation for their funds' recovery is 'in line with...similar periods of simultaneous stock and bond declines over the past 100 years'. Based on the 1970s which was the last period of simultaneous declines, worse is to come.

"At the end of 2021, the percentage of negative-yielding assets in the global bond index was 16.5%. This year, as of the end of September, that percentage has more than halved to 7.8%.

Therefore, every time investors buy a new bond when rebalancing their portfolio, they buy at a higher yield and coupon rate, which has a positive compounding effect in the long term, Dhir notes."

It seems that Ms Dhir may be looking at nominal not real returns. Nominal returns are meaningless - you can only put real milk and bread on the table with real returns not nominal ones. It is true that if yields have gone up, investors will be buying bonds at higher yields when rebalancing, but if inflation has also gone up as it may well have done if yields have gone up, the compounding effect in real terms could be negative, not positive.

"‘We know it’s tempting to change allocation or switch into a higher risk portfolio in a year like this, but the reality is that the performance we’ve had this year is just a reflection of everything that has happened,’ she said. Although Dhir is positive that investors will recover in the long term, the impact of the past year has hit pensioners the hardest, who might not be able to further invest in Vanguard’s LifeStrategies to recuperate their losses."

If it is not clear, I do think that in the short term balanced funds could do ok. It is the longer term, the next 20 or so years, that I worry about.

‘"Any adviser who put their clients into [high bond portfolios], whether gilts, treasuries, bunds or JGBs (Japan government bonds), should be praying that their public liability insurance has been kept up to date,’ Elston warned."

Given where real interest rates and inflation were five years ago, it was obvious that bonds were in a massive bubble which would inevitably burst. All that was needed to pop the bubble was a catalyst or two. Passive balanced funds were a great option for retirees for much of the last 40 years, but that does not mean that they were not a lazy option.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

Some thoughts on this most important of issues following participation in a Citywire roundtable

I was kindly invited to join a Citywire Roundtable recently. The idea for the discussion had been sparked by global chief investment strategist of BlackRock’s Investment Institute, Wei Li proposing a replacement for the 60/40 portfolio, as reported in the article 60/40 or 30/30/30? BlackRock forecasts renewed focus on asset allocation mix (someone's maths looks a tad dubious). However, it was essentially a debate about asset allocation in general.

Let's address Blackrock's idea first. What Li is proposing is that instead of a static 60/40 allocation to equities/bonds, long-term/retirement savers should have a static 34/33/33 (phew on the maths front) allocation to equities/private markets (presumably private equity but possibly a combination of private equity and private debt)/bonds.

Frankly, in my view, tweaking things this way is like rearranging deckchairs on the Titanic. The issue here is not the mix but whether the allocation is static or dynamic. Systematic real returns from both equities and bonds until a couple or so years ago had been fantastic (roughly 8% per annum each) for the best part of four decades. These returns were never sustainable (why on earth should you deserve such a high real return for lending to an advanced country government?!) and we may well now be entering a multi-decade period in which systematic returns are very poor (in the US, from 1965 to 1981, systematic real returns from equities and bonds were, respectively, -1% per annum and -5% per annum).

With such poor systematic returns, there is not a single static allocation on this planet that is going to work. In other words, generating decent returns for the next several years, perhaps even the next decade or two, is going to be about alpha not beta. Moreover, given the amount of alpha that needs to be generated to compensate for the vastly lower beta, a high conviction approach is required. A high conviction approach could pertain to selection (to particular equities etc) or to asset allocation (to particular asset classes/geographies/sectors etc). My specialism is asset allocation, so my approach relates to the latter.

In terms of the Citywire debate, inflation played a starring role, as indeed it should have. Inflation is the key determinant of real returns (over time frames > 5 years) from equities, bonds, property, precious metals etc. i.e. everything. Importantly, inflation is cyclical. It is cyclical over 4-6 years (business cycles) and it is cyclical over 40-50 years (debt cycles). Furthermore, if inflation is cyclical, as indeed it is, it is predictable. And if it is predictable, active asset allocation can add value to a retirement/long-term investment portfolio.

Whether among the investing public broadly or among the panelists, it seems to me that there is not yet a sufficient recognition about the threat presented by persistently high inflation. Either 1965 to 1981 is so long ago that it does not get incorporated into thinking/models, or there is a feeling that the world economy is now able to withstand the forces that have in the past led to persistently high inflation. Also, among the panelists, there was a prevailing belief that the high inflation over the last couple of years or so was the result of exogenous shocks, namely covid (supply issues followed by excessive monetary/fiscal policy) and Ukraine (energy, food prices).

My view is that these events were not the causes of the high inflation but catalysts. Given the stable/falling inflation environment we had enjoyed for four decades, a multi-decade period of high inflation was inevitable. All that was needed was a catalyst or two. Could have been a pandemic, could have been a war. Or a meteorite. Or a major internet outage/cyber attack.

The below figure is from the paper The Burst of High Inflation in 2021–22: How and Why Did We Get Here? and it shows just how stable inflation has been in recent decades in the UK (the author considered 20 year blocks starting in 1217 so the figure does not quite capture when periods of high/low/rising/falling inflation started and finished. However, one can discern the three periods of persistently high inflation in the 20th century in the bottom right).

Figure 1. Eight Hundred Years of Inflation in the United Kingdom, 1217 to 2016

Source: The Burst of High Inflation in 2021–22: How and Why Did We Get Here?

There also seems to be a view that given the increasingly widespread predictions of recession, markets should have already anticipated such. That they haven't, some argue, means the predictions are wrong.

My view on this is that things happen slowly and it can take a while for tipping points that cause unemployment to rise (the key recession indicator, albeit a lagging/coincident one) to be triggered. People are still running down savings so consumption has held up. Or at least held up to the extent that companies are yet to start shedding labour systematically (I recall the fears of subprime causing a recession years before it did).

Indeed, I hear people say, but surely all the talk of recession should have caused some sort of reaction in financial markets? They are, after all, discounting machines.

Not necessarily. Some things are impossible to discount, even if they are inevitable (we do not feel the full force of grief relating to the inevitable passing of an elderly parent before the event, only after). Markets respond to tighter/looser liquidity, they cannot fully anticipate it. Markets respond when tipping points are reached, not before.

Perhaps a recession is not quite inevitable but the currently inverted yield curve - a reliable predictor of recession - in many countries suggests the probability is high.

Finally, we must remember that high inflation continues to erode the real value of equities, even if it is starting to show signs of decelerating. So, a 5% increase in nominal terms could well be a 5% decrease in real terms (remember, this has not been an adjustment we needed to make in the last forty years). In other words, it may be that poor-ish real returns are indeed starting to discount a recession, rather than decent-ish nominal returns that are not.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

Irresponsible reporting about real wage growth by the BBC encourages public sector workers to strike

Bank of England governor Andrew Bailey has rightly been worried about wages accelerating in response to high inflation, so called second order effects. Accelerating wages would cause further rises in inflation and a spiralling upwards.

Yesterday's wage report showed a modest acceleration in wages but nothing that should have caused Bailey particular angst. What might have caused him some consternation, however, was the way the numbers were reported by the BBC.

The article was titled 'Record wage rises still outpaced by soaring inflation' and it contained the below chart as supporting evidence.

I downloaded the data myself and was able to reproduce the above chart as below.

Source: Office for National Statistics

In relation to the above charts, however, one should be aware that:

• Wages are three month average, unlike prices which are one month. Based on one month, wages rose 5.9%, not 5.7% as reported. Thus, the gap between wage growth and inflation is not quite as big as reported.
• Wages are 'regular' not 'total'. Based on 'total', wages grew 6.2%, not 5.7%, thus gap smaller still.
• Inflation is based on the unharmonised consumer price index. Using the harmonised series, a more accurate measure of inflation, prices grew 8.8%, not 10.1% as reported. Gap narrows further.
• The timescale of the chart is just one year which is not very long in normal times. Given that the period followed on the heels on the pandemic, it had the potential to be particularly misleading. A three year period, one going back to before the pandemic, would have been much more meaningful. (Note also that there were really only three months - February, March and April - that were responsible for the gap. Outside of these months, wages were growing in line with prices.)

Adjusting for the above gives the below chart.

As you can see, wages in real terms are exactly where they were before the pandemic, a far less inflammatory message.

The article also mentioned private sector wages having grown over the last twelve months by 6.6%, compared with 2.2% in the public sector. This again is misleading, as wages in the public sector during the pandemic held up much better than in the private sector.

Although there will be many whose wages have lagged prices over the last three years and who are as a result struggling with what has been called the 'cost of living crisis', we should from a broad perspective be welcoming the fact that average wages have over the last year started to lag inflation. This is not to say that inflation is not a problem. It clearly is and needs to come down. However, poor reporting by the national broadcaster risks giving many workers the impression that they need to start demanding bigger increases, exacerbating the possibility of a wage spiral.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

The manager of the huge passive balanced fund range is clearly conflicted

I have been writing for a while now about the issue of balanced funds being broken. In 2017, I wrote:

Are there ‘suitability’ issues in relation to putting clients into passive multi-asset funds that have massive bond risk? Back in 2008, the real 10-year Gilt yield was around 1%. Although this was low – 10 years earlier real yields were 4% - one could still justify buying Gilts on the basis that the real yield was positive. Fast forward to today and real 10-year interest rates in the UK are close to -2%. This means that if you buy them and hold them to maturity, your real return will be -2% per annum (-1.79% to be precise). To make money in real terms, real yields would have to fall further and you’d have to sell the bonds before maturity. But yields are already at -2%! Expecting them to fall to, say, -3% is, in my humble opinion, not investing but speculation. In the previous section, I mentioned four providers of the more popular passive multi-asset funds. If you consider their offerings that sit in the IA Mixed Investment 20-60% Shares sector, they generally have around 40% in equities. Where is the other 60%? All or mostly in bonds, where one has to be lucky to win. In other words, are these funds really suitable for your clients?

Two weeks ago, I wrote an article in Citywire titled Wealth Managers May Need A Complete Rethink about the inverted performance of risk rated funds. In between I've made numerous mention of the issue relating to bonds, one suggesting that they could represent The Next Mis-selling Scandal and, half seriously, that "Any adviser who put their clients into...Gilts, Treasuries, Bunds or JGBs, should be praying that their public liability insurance has been kept up to date."

Anyway, it's nice that the mainstream media is finally picking up on the story - see yesterday's FT article Vanguard’s low-risk UK strategies upended in 2022 market storm (subscription required).

The article states that "Vanguard’s £35bn UK Life Strategy funds range has been wrongfooted by simultaneous falls in bonds and stocks this year, leaving supposedly low risk portfolios nursing heavier losses than racier options." It is correct that the funds have been wrongfooted but it is not quite true that the falls in bonds and stocks this year have been "simultaneous". The falls in bonds have been much worse, which is why the supposedly low risk Vanguard funds that hold lots of bonds have fallen much more than the 'high risk' funds that don't. And not just this year but since mid-2020.

According to the article:

“It’s true to say that investors would generally expect lower-risk portfolios to perform relatively better when markets are performing badly,” said James Norton, head of financial planners at Vanguard UK. “Exceptions do happen, and this year is essentially one of those exceptions,” he added.

The topsy turvy period for Vanguard’s fund range is a prominent example of how the twin falls in stocks and bonds this year have upset conventional investment wisdom across the funds industry with harsh consequences for some retail investors.

Norton said he has a “huge amount of sympathy” for investors facing losses, but said the company’s research shows investors get better long-term returns by not reacting to or trying to anticipate short-term market moves. “When times are tough, human nature sets in. It feels like something is broken but it’s not,” he said. “Changing now, Vanguard would strongly urge, is not the right thing to do, whether you’re in Life Strategy or another portfolio that you built yourself.”

Mr Norton seems to think that this year's inverted bond/equity performance is an exception, recommending that investors hold their nerve. I would urge Mr Norton to take a look at how US balanced funds performed from 1965 to 1981: a low risk 80% bonds fund was down 45% in real terms, a high risk 20% bonds just 11%. 16 years is rather longer than 1 year.

As for Vanguard's research that he cites, I'd love to know whether it goes back far enough to be able to incorporate the last period of horrific bond performance from 1965 to 1981. Given its conclusion, I very much doubt it.

The article goes on:

Vanguard’s target-date retirement funds, which automatically tilt more towards bonds as they move closer to the client’s retirement date, were similarly afflicted. Funds with closer retirement dates lost more than those with longer horizons.

It is tragic that retirees are losing big at the very moment that they can least afford to. What if Mr Norton is wrong about this being a one year aberration? What then?

Next, the article notes that:

Vanguard has made inroads in the UK markets since it started selling funds directly to British buyers in 2017, adding 100,000 new clients so far this year. Life Strategy funds were three of the top five most-bought funds on Interactive Investor, the second-largest UK platform for DIY investors, in the first nine months of the year. So-called “balanced” portfolios that mix bonds and equities are a mainstay of the funds sector, on the basis that the counterweight of safe-haven fixed income will limit losses during downturns in the equities market.

The amount of money that has poured into passive funds, whether Vanguard's LifeStrategy funds, Blackrock's Consensus funds or others, is staggering. The companies are clearly conflicted when it comes to communicating messages about how long they think the poor bond performance will last.

Following the focus on Vanguard, the article then cites Kevin Doran at AJ Bell:

Kevin Doran, managing director at investment platform AJ Bell, said balanced portfolios across the sector have suffered as central banks shift from an era of easy money and try to fight inflation. “For a typical cautious portfolio with 80 per cent bonds, the theory is that a fall of more than 12.5 per cent should happen less than once in a hundred years. But in reality that is exactly what we’ve seen happen,” he said.

I would very much like to see the model on which Mr Doran's "once in a hundred years" comment is based. My guess is that it takes bonds' low short term volatility, assumes bond returns are normally distribution, and on that basis calculates the probability of a 12.5% fall over one year. If this is the case, the calculation is completely wrong. Bonds are always going to be lowly volatile on a short term basis so that is never going to give you any idea of what they can do on a multi-year basis - and indeed what they have done in the past. Rather than use short-term volatility, I would suggest to Mr Doran that he calculates volatility based on real 30 year returns, in which case he will find not only that 12.5% falls happen more often than once in a hundred years but that every few decades there can be a 10-15 year period in which bonds fall 60% in real terms.

The article finishes with:

Vanguard said its global investment committee had examined the unusual twin falls in bonds and equities this year, but concluded that in the long run the two types of securities were likely to revert to their normal pattern of moving in opposite directions. “We don’t change the asset allocation unless there is a fundamental shift in the market over the long term . . . We don’t think this positive correlation is the new norm,” said Mohneet Dhir, investment product manager, Life Strategy. “We are not moving the goalposts.”

First, I suspect Vanguard's investment committee is not taking account of what happens in sustained periods of high inflation as I think it should. Second, waiting for confirmation of "a fundamental shift in the market over the long term" will take years, by which time the horse may well have long bolted. Third, as previously mentioned, "positive correlation" could well be the new norm if high inflation persists, something that both history and theory say it might.

As for Mr Dhir's comment about "not moving the goalposts", the reality is that Vanguard has no choice - £35 billion is, after all, quite heavy.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

Persistent high inflation will make a mockery of balanced and risk rated funds

Economics textbooks define inflation as ongoing increases in the general price level for goods and services in an economy over time, or variants thereof. This innocuous sounding definition belies the cataclysmic consequences for investors of inflation becoming high, then entrenched. History and theory suggest that we may well now be in the early stages of this process.

For the broad investing public, financial markets tend to get appraised in terms of narratives not numbers; after all, stories are easier both to sell and to digest. Furthermore, they rarely get considered in anything other than a narrow temporal context. In the case of the current high inflation, however, it is numbers, in combination with decades if not centuries of historical perspective, that are key to understanding our current predicament.

I like numbers. I like history. And I have enough grey hair to appreciate both, particularly the latter. Indeed, I started writing about the bubble in developed market government bonds, and implications of its inevitable bursting, over ten years ago, and have written countless published articles on the subject since. On many occasions, in both private and public, I was pilloried by bond investors and others who told me that, as an equities guy – yes, I had started my career in equities but became an asset allocation specialist in 2008 – I did not understand bonds. And yet here we are, with bonds now having lost money in real terms over practically every period to date during the last decade.

Business cycles have tended to average around 5-6 years in length and ultimately relate to the tendency of humans collectively to become more confident, and thus spend more money, over periods of around 4-5 years, then less confident etc over 1-2 years. Confidence is cyclical and is thus what gives business cycles their predictability.

In the developed world since 1900 there have been three multi-year periods of high inflation: 1915 to 1920, 1940 to 1952, 1965 to 1981. Thus, inflation cycles - ones that include periods of high inflation, stable inflation, and occasionally deflation - have tended to average around 40 years.

Inflation cycles also have their roots in cyclical – predictable - human behaviour. During periods of low and stable inflation, we forget how damaging high inflation is and thus become more susceptible to it. It is more complicated than that, but complacency is at the heart of it.

The high inflation from 1965 to 1981 was rooted in the first half of the sixties when, following many years of low and stable inflation, governments and their central banks had become complacent. They thus began to think they could loosen fiscal and monetary policies. They did, and high inflation became entrenched for the next decade and a half, exacerbated by the two energy crises of 1973 and 1979.

The current bout of high inflation is also due to excessively loose fiscal and monetary policies. The QE that followed the 2008 financial crisis did not lead to runaway inflation as many had feared. Thus, during covid, fiscal and monetary taps were left on far longer than they should have been. Complacency.

Karl Smith, adjunct scholar at The Tax Foundation in the US, noted in a 2013 article that economies trace a “complex path in higher dimensional space and that what we witness is the shadow of that path cast on to our two dimensions of unemployment and inflation”. In other words, inflation is a lot more complicated than we think it is. Otherwise, we wouldn’t get complacent about it, particularly those charged with understanding it.

High inflation can become entrenched easily, as wages rise in response to it, causing further upward pressure. Today, fiscal policy remains far too loose – tax cuts in the UK and student debt forgiveness in the US may win votes but economically they just add fuel to the fire. At the same time, central banks continue to seek paths to unattainable soft landings, so monetary policy also remains too loose.

The only thing that will bring down the currently high inflation is a recession, and neither governments nor their central banks want to be seen to be the cause of one at time when many are experiencing a cost of living crisis. Furthermore, even if a recession brings down inflation, as happened in 1969-70, there may still be a tendency towards overly loose policy, increasing the likelihood of high inflation returning.

For investors, sustained periods of high inflation are disastrous. In the US, during the three periods of high inflation mentioned, long bonds fell in real terms by 50%, 37% and 56%, respectively. US equities, on the other hand, fared better – after all, companies, unlike bonds, can do things to adapt to high inflation such as increase prices, reduce costs etc.

The effect of inflation on balanced funds is stark. From 1981 to 2021, a period during which inflation first fell then stayed low, a theoretical US balanced fund, one that was rebalanced monthly, returned 2,438% in real terms, equivalent to 8.4% per annum. From 1965 to 1981, however, the same fund fell 35%, 2.7% per annum. The difference between the two in terms of comfort in retirement should be obvious.

Because of the very real possibility, inevitability even, of sustained periods of high inflation, long-term bonds are much riskier than we perceive them to be. At least, that is, if you consider risk to relate to loss of capital rather than volatility, as you should. If you insist on using volatility as a measure of risk, I suggest you use 30-year rather than monthly returns in the calculation. On that basis, bond volatility is higher than that of equities.

Indeed, it is this seemingly paradoxical result that, during periods of high inflation, will make a mockery of risk rated fund ranges. If bonds are riskier than equities, then a low rated fund is higher risk than a high rated fund!

This scenario is already playing out. Over the last three years, the supposedly low risk Vanguard LifeStrategy 20% Equities fund is down 22% in real terms. The “high risk” 80% Equities fund in the same range? Down just 1%.

If high inflation sticks around for a decade or two, as it well might, such a pattern of fund behaviour is only going to continue. Financial advisers and wealth managers may need to consider a complete rethink.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

Bayes' Theorem can be used to make better decisions, whether in the courtroom or the stock market

It is estimated that a human brain is made up of between 100 and 500 trillion trillion of what we call atoms. Arising from the 100-500 trillion trillion atoms that make up your own brain is that familiar feeling of one-ness called 'you'. How your brain does this is one of the great remaining mysteries.

Thinking about a brain's function rather than how it works may be easier. Our 'decisions', conscious or otherwise, are a function of genetic information passed to us by our parents and non-genetic information that we accumulate after conception. Our decision making systems get continually updated as more information is accumulated. In other words, we learn.

While we take it for granted that we learn, we are generally unaware just how badly we do it at times. Thanks to an 18th century Presbyterian minister named Thomas Bayes, we have a simple tool that can make us aware of the flaws in our learning system, helping us in the process make better decisions.

Bayes' Theorem is a simple but frustratingly-difficult-to-grasp mathematical formula that calculates how the probability of an event changes when new information/evidence is received. That this is analogous to what the brain does intuitively on a continual basis should be clear.

Here's an example.

A test for a medical condition occurring in 1 in 1,000 people has a diagnostic accuracy of 95%. You test positive for the condition. What is the probability you have the condition?

Now, what you knew before you had the test was that there was a 1 in 1,000 chance that you had the condition. You then got new information - that you had tested positive. Based on this new information, what is your new probability that you have the condition?

You may, like most, think that it's 95%. Wrong. It's 2%.

What you want to know is the probability that you have the condition given that you tested positive. However, the 95% number - the diagnostic accuracy - is not "the probability you have the condition given a positive test" but "the probability of a positive test given you have the condition". If we denote the event you have the condition, C, and a positive test result, T, we can write the probability you have the condition given a positive test as P(C|T) which is not the same as P(T|C).

A good way to understand the difference is to realise that the probability of an animal having four legs if it is a dog is different to the probability it is a dog if it has four legs. In other words, in the case of the medical test, the 95% number is P(T|C) not P(C|T). Bayes' Theorem links the two:

P(C|T) = [P(T|C)/P(T)]*P(C)

P(C) is called the prior probability of having the condition, i.e. prior to having the test, 1 in 1,000 or 0.01%. P(C|T) is the posterior probability of having the condition i.e. after having received the test result, which I shall demonstrate is 2%. The information relating to the test result is captured in the square brackets and it is what converts the prior probability to the posterior probability, analogous to how a new piece of information about the world changes our view of the world. However, if your intuition tells you the chance of something is high when it is in fact low, as in the case of the medical test, imagine how that impacts your decision making.

In the case of the medical test, the mistake is to forget that there is a chance you will be incorrectly diagnosed as having the condition if you don't actually have it, a so-called false positive. If the probability of a false positive is 50 times the probability of a true positive, as I will show is the case, then the ratio of the probability of a false positive to the probability of a true positive is 50:1 or 98%:2%. In other words the probability you have the condition if you test positive is only 2%.

These numbers can be shown graphically:

The probabilities relating to the prevalence of the condition (1 in 1,000 people, or 0.1%, have the condition while 999 in 1,000, or 99.9%, don't) are along the bottom edge of the coloured 'square'. The probabilities relating to the diagnostic accuracy are along the left edge. (Note that lengths are exaggerated to aid visualisation.) The areas of the green, yellow and red boxes also represent probabilities - to calculate the probability of tossing a head and rolling a six, you multiply one half by one sixth to get one twelfth, or 8%. In other words, a true positive - the red rectangle - is obtained 95% of the time in 0.1% of people or ,95% multiplied by 0.1% equals 0.095%.

Now, we want to know the ratio of the probability of a true positive test result to the probability of a positive test result, true or false. This is the area of the red rectangle as a percentage of the total of the areas of the red and green rectangles. Which is:

0.1% * 95% / (0.1% * 95% + 99.9% * 5%) = 2%.

The moral of the story? Always get a second opinion.

Another area in which intuition tends to be wrong is in the justice system. What jurors are trying to do is determine the probability that the defendant committed the crime of which they are accused given the evidence. However, what jurors often instead think of is the likelihood of the evidence given that the defendant committed the crime. Indeed, prosecutors often present the latter as the former, which is why it is called the prosecutor's fallacy. The difference between the two can be huge and has resulted in miscarriages of justice in countless actual cases throughout the world, a number of them in the UK.

One tragic case was that of Sally Clark. Her two baby boys both died of sudden infant death syndrome (SIDS). A medical expert however testified that the probability of one such death was 1 in 8,500 and thus that the probability of two was 1 in 73 million (8,500 times 8,500). This was deemed so unlikely that the prosecution said the only possibility was that Clark had murdered her babies.

Now, the 1 in 73 million number is the probability of the evidence assuming innocence. It is not the probability of innocence given the evidence, which must take into account the fact that very few mothers murder their babies - this is the prior probability, equivalent to the medical condition prevalence of 1 in 1,000. However, the jurors made the mistake of thinking that because the probability of the evidence assuming innocence - i.e., the probability both babies had died of SIDS - was so tiny, the possibility of innocence had to be discounted.

As for the 1 in 73 million number, this was only correct if a) the 1 in 8,500 number for one SIDS was correct and b) the two SIDS were independent of each other i.e. 1 in 8,500 could be squared to get 1 in 73 million. It turns out that boys are more susceptible to SIDS than girls so the odds for boys are lower than 1 in 8,500. More importantly, the very real possibility of a genetic factor rendered the two SIDS dependent not independent events - according to a 2004 paper by Salford University Professor of Mathematics Ray Hill that drew on extensive SIDS statistics, "after a first cot death the chances of a second become greatly increased" by a dependency factor of between 5 and 10.

Thus, the probability of two baby brothers falling victim to SIDS may well have been more like 1 in 5 million not 1 in 73 million. To argue that this represented guilt 'beyond reasonable doubt' - assuming that 'beyond reasonable doubt' means P(guilt|evidence) greater than 99.9% - would have required the prevalence of mothers murdering two of their babies to be quite common, as many as 1 in every thousand or so, clearly absurd. Sally Clark was eventually exonerated after having spent three years in prison but the damage had been done and she died of alcohol poisoning four years later.

The trial of a nurse, Lucy Letby, accused of murdering 7 babies and of a further 15 attempted murders got underway in Manchester two weeks ago. It was clear from the prosecution's opening remarks that there is no direct evidence - she was not caught in the act. Prosecution evidence has thus far been from medical experts testifying that deaths could not be explained by natural causes. There will also no doubt be roster evidence showing that Letby was on duty at the time of all 22 events. Of course there may well have been other unexplainable events at which Letby was not present, particularly since the hospital in question received a damning report around the time the murders and attempted murders were allegedly taking place about the poor processes in its neonatal unit.

A look at the Websleuths thread about the trial clearly indicates a presumption of guilt among many posting comments. In other words, they are confusing the probability of guilt given the evidence with the probability of the evidence assuming guilt. One must not assume guilt - our justice system is based on the presumption of innocence.

Many of those posting comments are failing to take into account that given a large number of neonatal wards across the country, it is quite likely that one of them will experience an above average number of deaths/collapses - for the same reason, you are never surprised when a lottery is won, though you would be if you won it.

They are failing to take into account the fact that nurses do not tend to murder their patients, in other words that the prior probability is very low.

Let's hope the defence can do a good job of explaining to the jury the difference between P(A|B) and P(B|A).

It seems inappropriate, after having written about the tragic death of ten babies, to turn to the subject of investing. However, the reason many investors perform poorly is that they do not correctly interpret new information. Mistakes tend to relate to the belief that if the price of a stock or market goes up - i.e. new information - the probability that they will go up further increases. Bayes' Theorem will tell you that, in general, the opposite is the case.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

My latest piece, published in Citywire, takes aim at balanced and risk-rated funds

I believe that suggesting wealth managers 'may need a complete rethink' should get some attention. The message of the article is that if high inflation persists, as history and theory suggest it might, balanced and risk-rated funds would be broken for a very long time, as indeed they were for 16 years from 1965 to 1981.

I will reproduce the article on Chimp Investor at some point but you can view it directly on Citywire's website here: https://citywire.com/wealth-manager/magazines/wm-issue-572#cw-peter-elston-2. You need a subscription to view but the sign up is free.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

We are now in an environment in which bonds are riskier than equities, spelling trouble for risk rated funds

I have a piece being published in CityWire this week which I think might make some waves. Its message is that passive and active risk rated funds, in which tens if not hundreds of billions are invested worldwide, are broken and could remain so for years. The reason? High inflation.

By risk rated funds I mean balanced or multi-asset funds, active or passive, whose risk is measured, explicitly or otherwise, by the percentage held in bonds.

In other words, they include passive balanced funds such as the Vanguard LifeStrategy funds or the BlackRock Consensus funds. And the many active risk rated fund ranges whose funds are assigned a risk rating, based on short term volatility, from 1 (very low risk) to 10 (very high risk). In reality, balanced/multi asset funds are assigned ratings between 4 and 7.

The reason these funds have proliferated in recent years is that we were in an environment in which equities and bonds were generally performing well (Chart 1). Since bonds, as measured by short-term volatility, are lower risk than equities, so-called risk rated fund ranges could be built whose performance was consistent i.e. a low risk rating meant both low return and low risk. Conversely, a high risk rating meant high returns and high risk.

This conducive backdrop was thanks to inflation that had either been falling or was low/stable. Such an environment was great for both equities and bonds. However, things have now changed, as they tend to do every few decades (Chart 2). Inflation is now high, and while it may fall in the medium term as a result of a recession, it could bounce back and remain generally high for years.

There is precedent. The second half of the sixties saw inflation rise (in the US it rose from around 1% to around 5%), then fall as a result of a recession in 1969/70, then rise again and stay high throughout the 70s, exacerbated by two energy crises.

Economic theory also suggests that high inflation could remain a problem for years. Economies have been on an unsustainable bender - a bender being something that, by definition, is unsustainable - for four decades thanks to generally falling inflation. The hangover could last for years and will involve a period of high inflation. This is a crude summary of a valid theoretical argument that I will not go into here.

The fundamental flaw in risk ratings and fund ranges that utilise the ratings is that they assume that short term volatility is a good measure of risk. This may be true for prolonged periods, including that from 1981 to 2020, but it is not always the case (Chart 3). During periods of high inflation, bonds perform worse than equities, and yet on the basis of their short-term volatility they are deemed low risk. Indeed, if you calculate volatility using 30-year rather than 1-month returns, bond volatility is in fact higher than that of equities.

Since June 2020, the supposedly low risk Vanguard LifeStrategy 20% Equities fund has fallen by 13% compared with its high risk (80% Equities) equivalent which has risen 11% - in real terms the numbers are around -25% and -1% respectively.

In a high inflation world, such 'upside down' performance is likely to continue (Chart 4). Investors in balanced/risk rated funds and intermediaries who use the funds may need to have a rethink.

Chart 1: The last four decades, at least until recently, were fantastic ones for balanced/risk rated funds

Chart 2: A 50/50 US balanced fund has had multi-year periods of poor performance

Chart 3: The sixteen years from 1965 to 1981, however, were dreadful ones for balanced/risk rated funds

Chart 4: The last two years have been bad, but things could remain bad for many years

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

As another 'angel of death' case gets underway in Manchester, the spotlight is turned once again on use of statistics by prosecutors and investigation objectivity

There have been a number of cases over the years in which doubts emerged about the guilt of caregivers accused - and in some cases convicted - of murdering those in their care. Some doubts led to accusations being dropped, some to convictions being overturned, and some still linger, with those convicted remaining in prison. In many if not most cases, the doubts related to whether the prosecution had used statistics correctly at trial and/or whether the original investigation had been biased against the accused.

This week the trial of nurse Lucy Letby got underway in Manchester. Letby is accused of murdering seven babies in her care and of attempting to murder ten others. I am not suggesting she is innocent. It is possible that there is incontrovertible evidence against her as was the case with Harold Shipman. However, what I do know is if there isn't, this is yet another case in which there is scope for bad statistics and a biased investigation to be presented to the jury. And therefore for another miscarriage of justice.

There is a recognisable pattern in situations that lead to a caregiver being accused, rightly or wrongly, of malevolence. First, someone recognises what they think is a statistical anomaly in data - for example, a high number of deaths on a particular ward over a certain period compared with what would be considered normal. Then, one of two things happens: either direct evidence of malevolence is found - as was the case with Shipman and his forged wills etc - or it isn't. If no direct evidence of malevolence is found, the 'cluster' can either be attributed to chance, to a non-malevolent cause, or to malevolence.

The last of these generally involves:

• an erroneous belief that the cluster in question could not possibly have been due to chance,
• there being no 'non-malevolent' causes identified, investigated even,
• other flawed reasoning/conclusions.

Looking at each of these in turn:

1. Disbelief in possibility of chance

Let's say on a hypothetical ward the expected number of deaths per year, based on the national average for the type of ward in question, is 20, and that this is consistent with what the ward in question has experienced - most years the number of deaths has been between 15 and 25 and very occasionally a little outside this range, never less than 10 and never more than 30 . Then, one year, the ward experiences 40 deaths. If the number of deaths per year is assumed to follow a Poisson Distribution - one in which events occur at a constant mean rate i.e. 20 per year, and are independent of each other, another example of which being the number of calls received in a particular hour of the day at a call centre - as is reasonable, the chance of such an occurrence is 0.0028%, one in 36,000. Many would think this is so unlikely that the cluster must be attributable to something other than chance.

Wrong.

The mistake that is made here is to think only of the ward in question. If there are 1,000 such wards across the country, then in a 20 year period - 20,000 ward years - there is a very high probability, well over 50/50, that one of them will experience 40 deaths in one year. Nothing suspicious whatsoever. Just luck. Or, rather, bad luck.

Think about the case of a rollover lottery that gets won by Ms XYZ. The chance of Ms XYZ specifically winning is minute, one in tens of millions perhaps. However, the chance of somebody winning is 100%. In caregiver cases, it is natural for many of those involved - the hospital administrator, the police, the prosecution, juries, the public etc - to focus on the 0.0028% number not the 50/50. In which case, unsurprisingly, the possibility of chance is dismissed. There must be a cause, they say.

2. No 'non-malevolent' causes having been identified

Let's say that, instead of 40 deaths in one year on the above mentioned hypothetical ward, there were 100. Assuming a Poisson Distribution, the probability of this occurring on a particular ward in a particular year is one in 3,571,854,227,384,530,000,000,000,000,000,000,000. Not even a trillion wards and a trillion years would give the cluster even the slightest chance of occurring! Thus, in this instance, it is reasonable to assume that it must have had an active cause.

In such cases where chance can be dismissed, all possible causes should be carefully considered. In practice however this does not always happen - sometimes, people jump to conclusions and assume there is a murderer out there. Two such cases are noted in Green et al. 2022:

A cluster of deaths in a neo-natal ward in Toronto was initially associated with a nurse, who was suspected of malevolent activity. Only later was it discovered that new artificial latex products in feeding tubes and bottles could have been responsible. An apparent increase in death on a neonatal ward in England raised similar suspicions until a medical statistician identified the date at which the death rate rose, and a neonatologist recognized it as the date when the supplier of milk formula was changed. As these examples show, an increase in deaths may be caused by factors that are not immediately apparent, even to those involved. Such factors may require considerable expertise to discover and could be missed entirely in some instances.

In the cases above, fortunately, so-called confounding causes of the clusters were identified, and miscarriages of justice were avoided. But this does not not always happen. For example, a hospital administrator tasked with investigating confounding variables such as a change in hospital practices, product or treatment might naturally prefer the cluster to be attributed to misconduct rather than to an administrative mistake. His perhaps. Indeed, Green et al. 2022 recommends that such investigations be carried out by independent parties.

3. Other flawed reasoning/conclusions

In no particular order:

• Suspicion may be directed onto a nurse who is not liked or is deemed to be a bit odd;
• Better nurses will tend to notice and signal a death earlier than a worse nurse, so deaths are more likely to be registered in their shifts not later.
• Better nurses will tend to clock in earlier and leave later, so deaths are more likely to occur on their watch given the longer time they spend on the ward.
• A disproportionate number of deaths occur or are noticed/registered in the morning. Thus suspicion is more likely to fall on nurses who do more morning shifts than others do.
• Better nurses will tend to be entrusted with harder tasks, ones perhaps where the risk and thus incidence of death is higher.
• A fall in deaths following removal of suspected nurse from the ward may be due to bad publicity and people avoiding that hospital rather than a murderer being no longer present.
• During investigations, causes of death get reexamined by pathologists and there may be a tendency or pressure to recategorise deaths as unnatural, driven perhaps by a desire to atone for perceived past error. Incidence of potassium or of elevated insulin levels may be deemed unnatural - i.e. evidence of poisoning - when there are in fact completely natural explanations.
• If a particular nurse is already under suspicion, there may be a tendency to recategorise as unnatural only deaths that occurred when the suspected was on duty. As noted in Green et al. 2022, "Regardless of how it occurs, this kind of bias would undermine the fairness of the investigation by causing an increase in the count of “suspicious” deaths associated with the nurse. The higher count would arise from the very suspicions that the investigation is supposed to evaluate – an example of circular reasoning".
• It may later be determined that a nurse under suspicion was not in fact on duty when one of the deaths previously deemed unnatural and attributed to them occurred. Rather than this casting doubt on the case against the suspected nurse as it should, and it perhaps introducing the possibility of another perpetrator, there may be a tendency simply to re-re-categorise the death as natural and to press ahead.

All the above have occurred in real cases. Investigations/judgements get conducted/handed down by humans, and humans are fundamentally flawed. These flaws can relate to a poor grasp of probability and statistics, for example conflating the probability of an animal having four legs if it is a dog with the probability of it being a dog if it has four legs, the equivalent of the issues set out in 1. above. Or they can relate to innate bias, for example confirmation bias or the fundamental attribution error. Humans are also influenced by the tabloid media, so prefer lurid explanations to mundane ones.

Caregivers who have either been wrongly accused or convicted, or where there is for good scientific/statistical reason for suspicion of such, include Lucia de Berk, Daniela Poggiali, Jane Bolding, Sally Clark, Susan Nelles, Ben Geen, and Collin Norris*. If it turns out there is no direct evidence against Lucy Letby, let's hope her name doesn't join the list.

* Details of all these cases can be found online. And there I'm sure are others, perhaps many others, that I have not come across and thus did not mention.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

The ramifications of the big fall in Gilts will be far reaching

You may have heard or read that Gilt yields have been rising sharply recently. Rarely, however, is one told what the percentage change in the underlying Gilt has been, whether over the day or, of more relevance, a longer period.

You may also have heard that Gilts are low risk, perhaps from an investment professional. They offer steady - low risk - returns, you perhaps were told, because the UK government and others like it do not tend to default. The reason for this is that governments can always increase taxes if necessary in order to make coupon and principal payments to bond holders. Bond holders, in return, accept returns from bonds commensurate with the lower risk.

Below is a chart of the Bloomberg Barclays 15+ Gilt Index, or rather an ETF that tracks it. It is adjusted for inflation as indeed all financial asset prices should be - what £100 buys you today is very different to what £100 bought you 20 years ago, and two nominal amounts should never, in my view, be compared with each other. Unless, that is, they are first adjusted for the change in the price of goods and services over the 20 years...

Source: https://uk.finance.yahoo.com/

To be clear, the chart is of the real price of long duration Gilts, those with a maturity of 15 years or more. Short-duration Gilts will not have fallen nearly as much as long-duration Gilts, but they will still have fallen considerably, something you may well have been told they do not do. Unlike long duration Gilts which are low risk, short duration Gilts are very low risk. Blah blah.

Since April 2020, long-term Gilts have fallen by 58pct, equivalent to -30pct annualised. Over the last three months they have fallen by 29pct, equivalent to -75pct annualised. Low risk? Hmmm.

You may well think that similar falls have been seen in other bond markets. Wrong. Below is a chart of the real value of long-term Gilts relative to their US equivalents, real long-term Treasuries. Ouch.

Source: https://uk.finance.yahoo.com/

You may well also wonder if the big fall in Gilts is related to a big increase in their default risk. Again, this would be wrong. The chart below is of the UK 5 Years CDS (credit default swap) price. The CDS price as of Monday was 26.70bp, equivalent to an implied probability of default of 0.45pct (assuming a 40pct recovery rate). This is still low, and so the rise in the default risk since June will only have accounted for a small portion of the fall in bond values.

Source: http://www.worldgovernmentbonds.com/cds-historical-data/united-kingdom/5-years/

The ramifications of the falls in real Gilt values - whether recently or over the last two and a half years - will be far reaching.

Many, particularly those in retirement, will have been advised to invest in "safe" government bonds. Lower retirement income as a result of significantly lower bond prices will impact spending.

Other big holders of Gilts such as insurance companies will be nursing huge losses.

And if you are squeamish, don't look at the Bank of England's balance sheet...

As for the increase in borrowing costs for the UK government and thus for us as UK taxpayers, this will be substantial and felt progressively over the coming decades as old Gilts mature and new ones are issued at higher yields. The UK government may also wish to continue to increase total borrowing.

If markets let them, that is.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd