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Boiling Frogs

Updated: Sep 1, 2022

There is no bigger question for investors currently than where UK consumer price inflation is headed in the medium term. Judging by the performance of bond and equity markets lately, the consensus appears to be that the recent rise in inflation istemporary.

"Even the Germans appear to no longer worry"

If this view is wrong, and this rise is the start of something prolonged and persistent, real returns from bonds and equities are going to be poor for the next decade or two. Few people alive today remember just how damaging was the global stagflation – low growth and high inflation – spanning the 15 years or so of the late ’60s and ’70s.

The end of this high inflation is generally attributed to US Federal Reserve chairman Paul Volcker and his punitive highinterest rates. However, the ’80s also saw the beginnings of new secular economic forces such as the offshoring of manufacturing to cheap developing countries, the rise of paper money and a silicon- chip-induced productivity increase, which all helped to spur low-inflation growth.

Whatever the reasons, the past 40 or so years have seen inflation in the UK and elsewhere fall to, then stay at, comfortably low levels. The risks relating to complacency having set in have rarely been higher. Even the Germans appear to no longer worry about the inflationary impact of loose monetary and fiscal policies.

I have cited in a few of my articles over the past 20 years a 1994 paper by aeronautical engineer-turned-fund manager BillBengen. In it, Bengen assessed the performance of 50-50 US equity-bond balanced funds during the three major financialshocks in the preceding 100 years, namely those in 1929-31, 1937-41 and 1973-4. Perhaps surprisingly, it was the last ofthese that saw the worst balanced fund performance. The reason? High inflation.

All three shocks resulted in equities falling significantly in real terms, by 45%, 44% and 57%, respectively. However,bonds during the first two performed well because of low or negative inflation, while the 22% increase in consumer pricesbetween 1973-4 saw them register negative real returns.

Bonds are considered low risk because default risk is minimal. This may be true, but negative real returns due to high inflation is a form of default, and thus bond risk should be viewed in this context.

The difference is between hard and soft default, with the latter being more insidious because it happens slowly and thustends not to be noticed – at least not until it is too late. The bond holder during periods of rising and high inflation can be as unaware as the frog in a pan of water being gradually heated.

In some respects, a bond bear market may already be underway. Gilts have returned -8.3% in real terms over the past five years, compared with +26.7% over the previous five years.

The last two bond bear markets, from 1900 to 1920 and 1940 to 1980, saw, in the case of US bonds, total real returns ofaround -50% and -65%, respectively. Thus -8% would be just the start.

And US bonds have produced a total real return since 1980 of around 1,500%, with similarly high returns from other countries, so a bear market is overdue.

In my last column, I set out cases for the two inflation scenarios mentioned at the beginning of this article. I argued that both cases sounded valid and that it was hard to know which one will play out. Will the disinflationary forces that have prevailed in recent decades soon reassert themselves, or have they run their course, reversed even?

Even those tasked with managing inflation – central banks – are unsure, having failed to predict the recent uptick in consumer prices. Last month, the Bank of England’s financial policy committee warned that “Asset valuations could correct sharply if, for example, market participants re-evaluate the prospects for growth, inflation or interest rates”.

With such an uncertain outlook, it is hard to know how to position portfolios. Perhaps the key message of Bengen’s paper was that one should not attempt to position portfolios in relation to future inflation. What one can do, however, is respond correctly to market ructions caused by high inflation or deflation.

For his 50-50 balanced fund, he argued that in the event of a significant inflation-driven drawdown in equities, one should, until they recovered, increase the portfolio equity weight to 75% or higher. The simplest advice is often the best.

Published in What Investment

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.

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1 Comment

May 26, 2022

Like the analogy. NN

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