Why we’re happy to swim against the ‘new paradigm’

You may have noticed there’s a new paradigm being discussed in investment circles – that inflation and interest rates may never rise again. This paradigm has been accompanied by a wave of irrational exuberance, with prices of various assets breaking records by the day. At Montgomery, we are concerned this could all end in tears so, for now, we will swim against the tide.

In the context of the end of Quantitative Easing – now widely referred to as Quantitative Tapering – a subtle shift is occurring in the discussion about whether inflation and higher interest rates emerge. This shift is an interesting marker in its own right but it’s not what we are focused on.

Up until now, market sentiment has been broadly divided between those who believe a strengthening US economic and employment picture will lead to rising inflation and ultimately higher rates (aka ‘rate-normalisation’), and those who believe that inflation is not emerging, and that inflation is in fact ‘structurally’ low.

The tension between those who say the employment picture is heating up and those who believe inflation is cooling down is arguably what has led to historically low levels of volatility and a very flat yield curve.

Our own observation is that the global economy probably seems to be plodding towards the end of a credit cycle and is indeed, therefore, past its peak.  It is also plodding along without enough strength to prompt an official increase in interest rates but it is not so weak that it is at imminent risk of collapsing into recession.  Perhaps unsurprisingly then, interest rates are unlikely to spike imminently, and consequently volatility is at record lows.

The dialogue however is being impregnated with a new subtle suggestion that inflation and interest rates may NEVER rise again.

The following comment from BT Investment Management’s Vimal Gore in his September 2017 Income & Fixed Interest Newsletter is typical of this thinking;

“Within the current framework of how QE (Quantitative Easing) is conducted by the Fed, there is no mechanism by which money is put into the hands of the population to spend, and thus we see the absence of demand-side inflationary pressures even against the backdrop of ever tightening labour markets.” And, “…prior attempts by the Fed to reduce its balance sheet have resulted in yields falling considerably. This makes sense when considering that the purpose of QE is to stimulate economic activity, leading to a more optimistic economic outlook and higher yields will result. Therefore, the removal of QE ought to have the opposite effect.”

Asian Hedge Fund manager Danny Yong, from Dymon Asia Capital, observed; “In the past whenever a country didn’t manage its fiscal spending and budget, debt sustainability was in question, [a country] would be massively punished by the market…Bond curves would steepen, credit spreads would widen and the currency would weaken.  Today, nobody seems to care.  That’s the new paradigm.”

Whether it is credit ratings becoming redundant or QE pushing rates down, and its reversal pushing them down further, new paradigms are precisely what investors need to be most fearful of.

In a recent interview, famed Investors Mutual founder Anton Taglieferro observed that the last ‘new paradigm’ was his “toughest time”, and that it was during that time that his firm’s name was made.

According to the interview, Tagliaferro observes, “It was a very difficult time, the first two to three years,” adding “a number of people were questioning whether we knew what we were doing because everybody wanted to talk about the new economy.”

Today, Robert Shiller’s CAPE ratio is close on its highest level since 1871.  High stock prices are justifiable only when compared to bonds.  More than a dozen stocks in the NASDAQ 100 including Netflix and Godaddy are trading on PEs greater than 200 times, money is being concentrated in companies that offer ‘the hope of a future untrammelled by the past’, and record prices for all assets, from art to collectible number plates, are being smashed around the globe.

Amid this extended bull market, talk of ‘new paradigms’ is increasing. At Montgomery we wonder whether this is an eerie reminder of the “irrational exuberance” witnessed at the turn of the century and just ahead of the tech wreck.

Investors have to make a choice; does one throw caution to the wind and bet on the idea that low rates of inflation and low interest rates are here to stay?  Does one conclude that we have entered a ‘new paradigm’ and, for example, the recent rush to lend money to Argentina for 100 years at 7.29  per cent makes sense?  Or does one stick to their investment knitting – like Tagliaferro did – and accept a few rough years of underperformance as the optimists dance, perhaps unaware that the band might be playing its final set and the punchbowl is already being drawn away?

The increasing frequency of references to ‘new paradigms’ is itself a signal that many investors are throwing in their cautionary towel.  It should be accompanied by a reduction in cash balances, and simultaneously, a reduction in the proportion of investors who can continue to drive asset prices higher.

At Montgomery our high cash weightings render us ‘out of step’ with current enthusiasts but until we can find high quality assets at reasonable prices, we’ll have to accept the consequences of swimming against the new paradigm.

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