The Pessimists Are Still in Confusion

Returning from a summer absence to face the financial markets provides the normal mixture of pleasure and incredulity at how much – and yet how little – many things have changed. The pile of research material that has built up on the desk ranges, as always, from the profound to the incontrovertibly inane.

As a longtime collector of sentences of meaningless guff that masquerade as investment research, I particularly enjoyed the report of one market analyst who concludes his recent review of the UK market as follows: “We will therefore only know if the market has run out of steam when it shows clearer signs of having done so”. True – but hardly useful information!

The issue that has pre-occupied investors for most of the year – is deflation or inflation the greater threat? – appears no nearer a resolution. The bond and equity markets appear once more to be discounting different versions of the future. Government bond yields have been falling over the last few weeks while the rally in many stock market indices has rolled on with impressive persistence for most of the summer.

Gold meanwhile appears finally to be on the verge of the breakout that its noisy adherents have long been anticipating, although the latest uptick has been accompanied by what looks like at least temporary signs of a halt to the dollar’s recent downward trend. Making sense of these conflicting narratives is not easy.

Marc Faber this week quoted a comment from the late and much missed economist Peter Bernstein that I have also used in the past. “In their calmer moments” said Bernstein “investors recognise their inability to know what the future holds. In moments of extreme panic or enthusiasm, however, they become remarkably bold in their predictions: they act as though uncertainty has vanished and the outcome is beyond doubt”.

This has certainly been the experience of the last few months. It is doubtful whether there is any scientific way to forecast the precise shape of a future economic recovery, but you wouldn’t know it from the acres of space devoted to just that issue. Most likely is that it is simply impossible to tell whether it is going to be V-shaped, L-shaped, or some other form. Even if it were knowable, I am not sure that it would not make formulating investment strategy any easier.

For those reasons, it seems best to leave such speculations to those who are paid to form a view about such things. As it happens, my money is on the economic recovery, whatever its shape, being stronger than many expect. Having taken the view in the spring, on the basis of valuations and historical precedents, that the 2007-2009 bear market was over, nothing that has happened since as far as I can see yet provides any compelling reason for changing that stance, even though many markets look temporarily overbought. I would be a lot more worried about being wrong if I were on the other side of the argument.

An environment in which reported consumer price inflation is falling, while asset prices are rising, is however clearly one in which both deflation-worriers and inflation-fearers can plausibly claim to have right on their side. It is possible that events will show that both viewpoints turn out to be valid, albeit over different time horizons. The balance of the argument is likely to swing back and forth as the months go by and new data points, many initially misleadingly inaccurate, emerge.

The point about living through unprecedented times, as these clearly are, is that historical parallels can only take you so far. How far is quantitative easing by central banks distorting prices in the bond markets and what impact is QE going to have on the pace of economic activity? I would be surprised if many central bankers think they know the answer to that question, which is why the risk of policy errors remains high. Yet it has not stopped many commentators from professing to know the answer.

It is still too early also to know for certain what second order effects will follow from successful reflationary policies, assuming they occur. Dhaval Joshi of RAB Capital makes the point that reflation will inevitably lead to a further increase in income inequality, which until the bear market in 2007 had already reached at its most extreme level since the 1930s. The radical policy changes that followed the Great Depression, including progressive taxation and increased regulation, had a negative impact on employment and profitability. Will the same happen this time round once the crisis is over?

Nevertheless the danger for investors is to veer too far towards the dark side. Bad economic times are by definition usually the best opportunity to make outsized investment gains, and this crisis is unlikely to turn out to be any different. Jim Grant quotes the distinguished Cambridge economist A.C.Pigou in his latest bulletin, to the same effect: “The error of optimism dies in the crisis, but it dying it gives both to an error of pessimism. This new error is born, not an infant, but a giant”.

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