Currently much of our time is taken up with financial market debate and specifically by the pressing question, “what is the correct cost of capital or money?” This is a vital question as the answer is the anchor or foundation on which the prices of all assets will take their cue. In a recent debate with a colleague he expressed the desire for significantly increased inflation so that central banks could justifiably raise interest rates. The main point was that central banks are extremely adamant that rates will not be increased until they are certain that inflation is picking up. To this extent they are more than happy to err on the side of caution.
Many investors consider inflation to simply be too much money chasing too few goods, as many people learnt in first year economics. However this theory is not that simple and velocity of money also plays a large role in the short term. If we think of this two part definition, an investor would immediately argue that there is most definitely more money in the world as most developed market central banks have expanded their balance sheets fairly sizeably in the Quantitative Easing process. Hence many would rightly have expected more inflation. Unfortunately the only real effect has been in the form of what is called asset inflation and hence you have only been a beneficiary if you have had a portfolio of assets in stocks, bonds and property.
The question is where to go from here and what should the informed investor try and do to navigate this environment. If we look at the foundation of most capital markets, the US 10 year government bond, we can gauge a few things. The US over a very long time period has displayed core inflation of above the 2% level. It has occasionally dipped below this to 1.5% but not for long. Headline inflation has been more volatile and recently retraced, due in part to a collapse in the oil price. This has now rebounded off its lows and hence one would expect it to converge closer to the core number.
Figure 1. US Inflation
Source. BCA Research
If we then turn our attention to the US 10 year bond we see that the current yield is just above 1.7%. This is even lower in many developed markets and they all point to a very deflationary environment. Many people have rightly pointed out the weakness in final demand in many economies and hence terms such as ”the new norm of US interest rates” have emerged. However what we can see is that the current yield provided by a government bond does not compensate the investor for the longer term historical eroding effect of inflation plus an element of real return. There are good reasons for this, as we know that growth has been consistently adjusted lower in recent years and that near term rates are at historic lows. However, the counter argument is that productivity gains which have been achieved in recent years, and that have kept inflation lower, are not sustainable in the long-run.
The question that the long term investor must ask is if this is a permanent phenomenon or a transient one. We think there is a strong argument to suggest that the market has become complacent on inflation and is assuming that negative real yields are here to stay. The argument is, however, very complex as there is huge market intervention by central banks. There is a desire to keep the short end of the curve lower for longer since most of these banks are reluctant to have too strong a currency.
Figure 1. US 10-year government bond yield
Source. BCA Research
The main point we continue to focus on in our investment decisions is that we try and factor in a margin of safety when it comes to our risk free hurdle rates and ratings of our shares. We are also cognisant to not try and get pulled into the current convention that “cash is trash” and is not a viable asset class. Cash is a repricing asset class and provides us with optionality in an uncertain world where we continue to scour the market for good investment opportunities.