The risks that matter are the ones we don’t know

Jasmin Argyrou

Credit Suisse

Investing requires making a judgment about the future, and yet it is only when we grasp the limits of our knowledge that we can make good investment decisions and construct resilient portfolios.

Navigating risk events skillfully is crucial to managing portfolios successfully. While the forecasting ability of the investment community does well during normal times, predicting the nature and timing of the next risk event is all but impossible.

So how do we protect portfolios from risks we cannot predict?

Looking at the past is certainly relevant here but we should remember that history does not repeat itself; it casts a very long shadow.

Society responds to crises and shocks by building moats. These moats often prevent the same shocks reoccurring, and if they do re-occur, the damage will be less the second time around. It is not perfect though. The moats we build often have unforeseen or unintended consequences. The CIA has a name for a similar phenomenon in the realm of politics: the term is blowback.

Let us look at a few examples.

The Asian currency crisis exposed weaknesses associated with borrowing in a foreign currency. The moat which developing economies erected consisted of a large accumulation of foreign currency reserves. In the process, strong and persistent capital flowed into US treasuries for a period of about ten years, driving down borrowing costs in the US and spurring financial engineering until it eventually led to the eruption of the global financial crisis (GFC) in 2008.

One important response to the GFC came in the form of regulatory measures. One implication from these measures is that the capacity for dealers - the intermediaries in bond markets - to hold and increase their inventories of bonds, a pressure valve in times when there is a scramble to sell, is today significantly limited. The blowback from this is financial market susceptibility to major liquidity crises in times of acute market stress. This played out in March when even the US Treasury market became dysfunctional.

Fast forward to today and the risk many investors worry about is that the policy response to the pandemic will eventually unleash excessive increases in the prices of the goods and services we consume. 

The acceleration in broad money growth is the canary in the coalmine for this argument. It supposedly is a sign of immense spending capacity on the part of households and businesses.

Trying to predict the rate of inflation by looking at the rate of broad money growth makes as much sense as looking at a car’s engine capacity in order to predict the speed at which it will run on the road. Knowing the speed limit and the degree of traffic on the road is more useful, and if you know the driver, even better.

Before becoming concerned about inflation we need to see the unemployment rate fall, a lot. Only then can wages grow rapidly. Without fast wage growth, sustained high consumer price inflation is very unlikely. Just as cars move slowly in heavy traffic, so too must inflation as the economy absorbs many underutilized and unemployed people. Wage growth has slowed to historical lows during the first half of this year, making the speed limit for inflation a very distant prospect.

When one day we do get back to full employment or even experience a tight labour market, there is a lot that central banks can do to rein in inflation. The decades-old frameworks that govern monetary policy today emerged from a need to lower inflation. Central banks have a hammer to deal with inflation but a string to fight deflation. Cash rates have a lower bound, not an upper one. To take our driving analogy a little further, we have designed the road rules to limit speeding, not to speed up slow drivers. Speed cameras catch fast-moving cars, not the ones moving too slowly. Central bankers have not become more cavalier about high inflation: they simply need to redesign frameworks to deal with a problem they were ill designed to tackle: the problem of low and falling inflation and inflation expectations. This is why the Federal Reserve recently adopted Flexible Average Inflation Targeting.

What about the argument that policy makers will ignore the speed limit? Our driver may be inclined to exceed the speed limit once the traffic flow lightens up.

The idea that there is an incentive to let inflation heat up is now widely accepted. Yet it is deeply flawed. 

“High inflation will lower the debt burden”, the argument goes. Just as we may wish to stabilize or lower our debt in relation to our income, governments wish to stabilize or lower debt relative to nominal GDP. If they attempt this by somehow increasing inflation to be considerably above its target, say to 8 or 10 per cent, then interest-servicing costs will increase too, because the bond market will factor in much higher inflation and a higher future cash rate. As a result, the debt burden will actually increase. If central banks try to prevent long-term interest rates from rising by continuing with asset purchases at such a time, then the exchange rate will fall along with the credibility of the central bank. As input costs escalate, excessive inflation will eat into corporate profits and undermine employment growth. Such a scenario would see politicians and central bankers lose their jobs. There is no incentive to do anything other than grow the economy out of debt. That, we know, is not easy.

The bottom line is we have a very adequate moat to keep high inflation away.

Risks exist and shocks will occur in the future but they will probably be beyond the realm of human prediction and for which there is no oracle of Delphi to consult. High inflation is unlikely to be one of those.

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Jasmin Argyrou
Head of Fixed Income and Economics
Credit Suisse

Jasmin has primary responsibility for the fixed income funds in the DPM team and is a member of the Australian Investment Committee, contributing to the strategic and tactical asset allocation process at Credit Suisse Australia Wealth Management.

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