One phrase of Professor Paul Samuleson’s that has stuck in my mind for 20 years was his exhortation that investors should always “work the other side of the street”, the idea being that you are more likely to find value in testing non-consensual views as in accepting conventional thinking at its face value. Given that the remarkable feature of financial markets at present is how quickly consensus thinking seems to switch from one extreme view to another, the mental gymnastics required to do as he suggests have become increasingly demanding.
But the need for such challenge remains, with the inflation-deflation debate the most important current issue. In little more than a year, market prices suggest that we have moved from fear of inflation to fear of savage deflation – and now back again. True, it is not easy to gauge where consensus thinking genuinely now lies on this subject, as short covering by frustrated bears surely accounts for a good deal of the force behind the equity market’s recent strength.
My impression is that the majority of market participants remain unconvinced by the argument that inflation is once again the main enemy. There is no denying however that sentiment to that effect is gaining momentum. Most of the professional investors whose judgement I rate highly are now acting in the belief that the inflation, not deflation, camp is the right place to belong. The belief that deflation has been licked is one of the factors that has been driving equity markets higher.
In such circumstances, the need to stand back and look at the other side of the argument is greater than ever. The bond market is one obvious place to look. Peter Geikie Cobb, who co-manages Thames River Capital’s Global Bond fund (up a handsome 36% last year), gave me a powerful corrective opinion last week. His view is that there is simply no convincing evidence that inflation is rearing its head, or will do so any time soon. So firm is this conviction that his fund’s largest position by far is now in the longest duration UK gilt you can find, namely the 4.25% 2055 issue, currently yielding 4.5%. He and Paul Thursby, his co-manager, have never, it seems, owned such a long duration government bond portfolio as they do today.
The argument for such an apparently high risk stance, in essence, is that even if renewed inflation is eventually on its way, to bet on such an outcome today is distinctly premature. The only way that the US and UK economies can redeem their spiralling debt burden in the short term is through a rapid increase in the savings rate. That is already happening, but many investors may be underestimating how far and fast that process needs to unfold. Past experience suggests it will be dramatic.
In Thames River Capital’s view, with prices still falling, it is likely to be several years before we see reported inflation rising above 0%, which is why they see real yields of 4% or more at the long end of the curve as attractive. While it is evident that quantitative easing will hold down shorter dated yields in the government bond market, there is no doubt that the prices of longer dated issues do look, in general, more appealing. Although TIPs appear better value, real yields on index-linked gilts are too low to generate much current interest.
Given the unprecedented reflationary efforts now under way, some will argue that the 20-year bull market in government bonds must already be approaching its end. The charts still tell a somewhat different story. Measured against their 20-year history, yields for 10-year benchmark gilts, at 3.5%, are still firmly in the middle of the down-trending channel they have followed over the whole of those two decades. If the tipping point is coming, in other words, it has certainly not yet arrived, let alone confirmed.
So while government bonds as a class seem distinctly unattractive to those of us who expect higher inflation, the more you look at it, the case for the long bond play, whether you regard it as a hedge or as a trade, looks not unreasonable. To put it another way, even if you are concerned about inflation, it may be the least worst option available in Government bonds.
Notable too is another of the Thames River Capital team’s current convictions, which is that sterling’s renewed has further to run. Their argument is that the eurozone has still to take the punishment that sterling has had over the past few months and that the pound could well go to $1.65/$1.70 to the dollar and 1.25/$1.30 to the euro before its current bout of strength is done. Even if sterling loses its AAA status, as is certainly possible, most other currencies will be suffering just as much, if not more.
Jonathan Davis 