A low probability high impact event
Stagflation: A low probability high impact event.
And………The role of time in absorbing high impact events.
This month we put the microscope on a specific possible event as a front agenda (stagflation), and thinly hide a secondary agenda: the importance of time whilst planning investment portfolios. Stagflation (its possibility) is something on which we turn for advice to our Herd of investment research departments. As to time, as financial planners, the Mondial consultant should be expert. Financial planners see their clients in most distress during “Black Swan” events. The theory developed by Nassim Taleb covers events which were hard to predict that have massive impact. He quotes events such as the rise of the internet, World War 1, the fall of the Soviet Union, such thinking came to prominence with the GFC (Global Financial Crisis). Subsequently, all readers have experienced COVID as another Black Swan event. Whilst some will argue that a pandemic was predictable, the negative equity market reaction in March 2020 was fully unpredicted- making it a verifiable Black Swan as far as market practitioners are concerned.
STAGFLATION- WHAT IS IT?
If stagflation is a possible high impact event- then what is it? Is it a bad thing? The temperature and blood pressure equivalents for an economy are described in our cartoon as GDP and inflation. With a healthy economy enjoying a sustainable economic growth (GDP) lingering between 2 and 4% per annum, and 1.5 % to 2% p.a. as an inflation rate. After COVID some asset managers are prepared to enjoy slightly higher inflation to “recover” inflation which was missed since the pandemic’s arrival. Our cartoon also seeks to demonstrate the extremes of discomfort with inflation rates at around 5% plus for the developed economies, although we can see extremes of discomfort locally in the Lebanon (88.18% p.a) and popped balloons in Venezuela (over 2,000% p.a). Arguably, deflation is a better pain to bear than hyperinflation. But I stress arguably. If prices are falling some consumers will be happy, but if deflation is out of control jobs will be lost. The Japanese equity market experience of the 1980s and beyond was not a good one for investors. Equity markets enjoy some inflation, they are becalmed in a deflationary environment.
STAGFLATION- GOOD, BAD or UGLY?
Stagflation is a mix of stagnant economic growth and inflation. For many, stagflation is worse than a recession because stagflation combines the bad bits of recession (falling equities, increased unemployment and downward property price pressure) together with higher prices for goods and services. The classic economic example of stagflation was the US economy of the 1970s. My generation lived through it- but the “internet generation” should heed the experience. After the 1950s-60s of high economic growth, the Oil embargo of the 1970s created a “cost-push” inflation. Wages were not able to keep up with the higher cost of goods and services. Demand dropped, prices rose, and stagflation sank in. It was not a happy period.
STAGFLATION: THE HERD VIEW
This month we focus on two reactions. We asked them: are they prepared for stagflation and what actions are you taking? The first from Phil Smeaton at VAM Sanlam: “The short answer is yes, and we are prepared and in fact believe we are (almost) already there. We already have high inflation and over the next 12 months real growth is likely to be negative (nominal growth – inflation). So, we expect rising prices but falling volumes, in other words we will produce less stuff but the price will be more expensive. That seems pretty clear from the Atlanta Fed GDP now tracking down towards 0, so our guess is 2022 is a year of stagflation on that definition.
We have already moved for it given that expectation, so we are invested not too heavily in equities, because equities can come under pressure with profit margins being squeezed, and we are doing our best to be invested in companies that can pass through that inflation (i.e., those with a competitive advantage) and have a defensive tilt to the portfolio, rather than a cyclical tilt. On the bond side, higher inflation means rising yields, so we’re invested in short duration fixed income and have recycled some of our low yielding government bond exposure into property and other alternatives (such as gold). In a stagflationary environment, property should hold relatively well, as it did in the 70’s. “
Interestingly, Lorenzo La Posta at Momentum Asset Management is less certain but seemingly taking a just-in-case position: “We see stagflation as being a tail risk: low probability but very negative consequences. Our portfolios are, to some extent, prepared for it. With falling growth and rising rates, we expect to see equities and government bonds lose a lot of ground. Commodities, and their producers, should do well, benefitting from rising prices. Inflation-linked bonds should outperform nominal treasuries. UK and Japanese equities, with their cheaper starting valuation, should outperform the rest of the developed world, also thanks to a higher banks and commodities exposure for the former and a certain stagflation experience for the latter. Uncorrelated assets, such as hedge funds or alternative assets, should help from a diversification perspective. “
THE FINANCIAL PLANNER AND THE ROLE OF TIME
We have covered our first Agenda: Stagflation. It’s a concern. How should we prepare? The financial planner’s key skill is to separate the needs of the short term versus the needs of a medium/long term financial plan. In Stephen Hawkins “A BRIEF HISTORY OF TIME” he mentions the idea that if you step back from planet earth far enough all time becomes a continuum. I think I gave up on the rest of the book but that concept is the key to the skill of a successful medium to long term financial plan. Should stagflation set in, should it be a high impact negative event then it is only a spot in time, it should not define your financial planning.
The word “should” is underlined because for those seeking major lifestyle changes- i.e. retirement, at the same time as a high impact event then the need to overhaul and review financial plans is much greater than for those who can swim nonchalantly through short term storms. For those who have the power to be nonchalant to events, the key point for any expected trauma (predictable or otherwise) is the management style you absorb. Here we see the battle between passive and active investment becoming a feature of 2022.
Any high impact negative event is likely to effect passive investors far more than those relying on active investment advice. In theory, the passive investor has already made their choice- they are tracking market indices (or something similar), high impact negative events might bring downward volatility. Whilst this might be a good thing for regular savings plans it will hurt lump sum portfolios. On the other hand, the research departments of multi-asset managers and Discretionary Fund Managers can chop and change and avoid some of the more negative aspects of downward volatility.
Passive vs active- the debate will intrigue in 2022.
Key Take-aways:
Early October 2021- IMF Managing Director, Kristalina Georgieva scaled back the IMFs Q1 2021 prediction for global economic growth. Economic growth she said was like “walking with stones in our shoes”.
In Sept 2021 the S&P endured its deepest monthly drop (4.8%) since the start of the pandemic (although October saw recovery). Stagflation being part of the September fear.
From our Herd of research departments: Phil Smeaton, VAM/Sanlam: “ our guess is that 2022 is a year of stagflation” (explanation in article below).
For Lorenzo La Posta at Momentum Asset Managers: “We see stagflation as being a tail risk: low probability but very negative consequences. Our portfolios are, to some extent, prepared for it. “
Financial Planning: should stagflation set in, should it be a high impact negative event, it is only a spot in time. It should not define your financial planning, unless you have a major lifestyle change planned (i.e. retirement). A high impact event at a major lifestyle change does require a very intense review.
Financial Planning: we see the debate between passive and active investing becoming a feature of the asset management universe as positions are taken on how to manage high impact events.
Passive vs active- the debate will intrigue in 2022.
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