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Diary of a Fund Manager - Early Warning

Date: 06 December 2021

In this week’s Diary, dog whistle Covid politics, business news from high altitude and ground level, together with the importance of diversification in a well structured portfolio. Finally, more from Russia.

Last week leading markets changed direction on a day by day basis and sometimes more than once in the day. By the end, equities were down, but not by much, the US dollar stronger and sterling weaker than most currencies. Gold and other commodities and food prices were quieter than they have been for some time. Government bonds were in demand ending well up on the week. Omicron was ever present, but questions continued to outnumber answers. European governments, including the UK, already grappling with accelerating domestic infection rates, and fearful of the effect of restrictions on their electability, reached for the dog whistle and isolated South Africa and neighbouring countries.

Those who look down on the global economy from the stratosphere are becoming more optimistic. The third quarter lull appears to be over and supply chain bottlenecks are starting to ease. Tentatively, growth forecasts for next year are being raised. The US Federal Reserve seems to agree. With full employment in sight and inflation no longer being described as transitory, investors are to expect an earlier end to asset purchases, quantitative easing, than expected and then higher interest rates. Covid, including new variants and vaccine effectiveness has been priced in. Here’s hoping.

Interestingly, the European Central Bank remains convinced that our collective economic survival needs its full support, implying that inflation is transitory and that interest rates will not need to be increased in the foreseeable future. Quite how this will be received in Germany where inflation is over 5%, the highest level since the launch of the euro, is to be seen. Wage rises remain low which means that those who save and those who work are getting poorer. The over-confident technocrats in charge of the ECB are playing with matches whether they realise it or not.

Staying with the theme of over confidence I was amused to read a well thought out report linking the emergence of the Omicron variant to higher inflation. The argument went as follows; as restrictions are reimposed we will spend less on services, for example going to restaurants, and go back to buying goods for use at home, thus exacerbating supply chain shortages. All entirely possible, but too clever by half I suspect.

Ground level is much more informative when it comes to understanding the present and forecasting the future. I am told that the Scotch whisky industry is suffering from a bottle shortage and more generally that UK glass manufacturers intend to raise prices by 10% next year. Plastic, whether new or recycled, is also getting more expensive, but so far business to business price increases are sticking. A farming client highlighted the problems that stem from higher nitrogen fertiliser prices driven by expensive natural gas. When all of this finally reaches the consumer, demand may come under pressure as, so far, pay is lagging. Alternatively, those with bargaining power may notice and become less content with their employers.

European governments, including the UK, already grappling with accelerating domestic infection rates, and fearful of the effect of restrictions on their electability, reached for the dog whistle and isolated South Africa and neighbouring countries.

Along with picking winners, portfolio construction is the key to long term investment success. Reviewing November returns emphasised the importance of diversification even when it is hard to make the case for all the component parts. As equities wilted, government bonds, both conventional and index linked, came into their own, whilst previously dull but worthy hedge funds also did well. After a dozen years of low interest rates, generous assumptions about risk and unchanging correlations between asset classes are fully embedded in many perfectly optimised portfolios, where risk and return appear to be as perfectly balanced as the models used by central banks. The same goes for indebted companies and countries. This is what happens during long periods of monetary stability as prudence and common sense eventually become anesthetised. Perfect structures can, however, still be fragile.

Occasionally, reading for pleasure becomes topical. At the moment I am half way through the very informative ‘Putin’s People’ by Catherine Belton which describes how an assistant to the Mayor of St. Petersburg took control of Russia and is still there 20 years later. Disturbingly, the playbook used at each stage of his ascent never seemed to change; careful preparation, misinformation, with truth lagging someway behind action. This makes events in the Ukraine rather worrying, not only for former constituents of the Soviet Union, but also for the rest of us.

Markets seldom make the news, it is usually the other way around, but are a good early warning system. That investors in Taiwan seem unconcerned about an imminent Chinese invasion is comforting and so far the same can be said about elements of the financial world that are vulnerable to Russian manoeuvres. Fine tuning early warning systems seems the best course of action for the moment.

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