Uncertainty, what uncertainty?

Dear Readers and Fellow Investors,


We have received an interesting number of comments with regards to the uncertainty investors are having with determining whether inflation or deflation will be the biggest problem in the future (see "political risk is feeding the natural tendency for deflation to appear" blog comments).

This is understandable. This decision will be primarily made by politicians. All we know is that debt will have be wiped out, there is simply too much of it. Its burden will have to be reduced before steady growth can resume. The question is, will it be inflated, or will there be defaults? History suggests politicians generally prefer the former option (until afterwards the latter option occurs and finishes the job!).

I have often commented that the valuation of the market can be interpreted by how much the market is discounting uncertainty. Uncertainty is always present. Sometimes the investment community ignores it, in other cases they obsess about it excessively. Today, uncertainty is correctly causing panic amongst investors on whether earnings currently being forecasted will become reality for individual companies, as well as for economies as a whole. Indeed, I believe the market has not discounted enough, yet.

Our principle fear is that debt reduction is generally always followed by a reduction in the quality of life, on aggregate, for a country. In Europe, this is likely to lead to social unrest, as we are starting to witness, and which we hope will remain subdued. However, we fear, this is unlikely to be the case. In such an environment, politicians will be hard pressed to NOT deliver the medicine that is required, which can lead problems to drag on.

Politicians in such a scenario can hope that the problem will be diluted (the same unit of debt reduction will be done over a longer period of time), but eventually, the medicine has to be delivered.

Indeed, this approach often leads to more medicine being necessary in terms of overall resources allocated to the problem. Economic problems arise primarily when capital is poorly allocated (be it in war, excess housing, or too much hope on future corporate profits). John Stuart Mills elegantly said that “panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”. Hence such a dilutive approach may only exacerbate the problem in the medium term.

We feel that all systems that depend on finite resources eventually tend to a pricing equilibrium. Though money is not, in theory, finite (it can be printed at the whim of the central banks/governments wishes), the assets that are priced in its currency are. Hence the two are in reality locked together, and hence money cannot be printed to ad infinitum without severe consequences (i.e. hyperinflation). A tendency to approach equilibrium will occur: whether we like it or not. “Mean reversion” are the two most important words in long term investing.

As a result, we feel there is a natural deflation tendency within the system, due to the large de leveraging process currently occurring. This can only be counter acted by public spending/lending, using money primarily created from thin air. This is not a sustainable solution, as we all know. As long term investors, we will therefore not be investing considering government yields will remain as low as they are now. A unit of accessible debt will be harder to get, and as a consequence, is likely to become more expensive (it has been most apparent to the consumer rather than other economic participants such as corporations and governments. However, without a strong consumer, it is hard to see growth and strength in the corporates or governments happening). This naturally puts pressure on the valuation of all risk assets, as government bond yields are often referred to as the “risk-free asset”. All assets are therefore commonly valued relative to government bonds.

We therefore remain wary of the current valuation using such a “macroeconomic” approach, as well as a more fundamental approach analysing individual companies. We remain overweight cash, for the moment, with a wondering eye for cheap equities.

We would like to conclude with the statement that in a deflationary environment, a unit of cash becomes more valuable. In an inflationary environment, the opposite happens. Many clients find this “relative capital gain” of the value of cash in a deflationary environment difficult to interpret, and are willing to forego it by buying government bonds yielding 2% with 5 year maturities. Though “fixed income” bonds benefit in an environment where that fixed cash flow is worth more, it is highly likely that in a deflationary environment equities would suffer severe declines in value. Hence a wonderful opportunity could arise, which should not be missed. We cannot ignore the risk that the particular bond you have may suffers “a bout of government credit risk”, leading to a capital loss if sold before maturity. With such low yields, we are not willing to take that risk.

I am often asked what will be the trigger for a real change to the current “range bound” market we have been in recently. The answer is usually always the same: the bond market.


As always, we look forward to hear your thoughts and comments.


Yours sincerely,

Alessandro Sajwani