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Diary of a Fund Manager - Fat Tails

Date: 17 January 2022

In this week’s Diary, an update on the current consensus underpinning markets with a nod to some fat tail risks. Then on to early news from the company results season and German pay negotiations. Finally, back to Russia for the latest news from the front line.

For those of a nervous disposition it was hardly a quiet week, but by the end markets were little changed. Equities mixed, bonds fractionally lower, which might come as a surprise given the inflation numbers, gold up and the US dollar down. Oil became even more expensive.

From Melbourne to Malta, via London and Chicago, investment discussions followed a similar agenda. Pleasure was expressed about the good returns achieved in 2021, before moving swiftly to the uncertainties of the year ahead. Last week I wrote about the ‘big fat’ assumptions embedded in markets, but there are some ‘big fat’ tail risks as well. Hence the lack of certainty amongst those who think about investment, let alone those who spectate from the relative safety of the side-lines.

Starting with economic growth, the consensus remains positive, but a case can be made for recession. Optimists may become more anxious in the months ahead as the first quarter of the year is likely to deliver the lowest growth since the post-lockdown recovery started. In addition, economic historians point out that in the past high inflation leads to recessions 80% of the time, whilst acknowledging that these are far from normal times. Given the amplitude of the 2020-2021 recession/recovery cycle, short term volatility would not come as a complete surprise.

In 2019 I wrote a review of the ten year predictions that I published in 2009. The score card was reasonable with the exception of economic growth. Given the aftershocks of the credit crunch I thought at the time that growth would be volatile on a year by year basis. A return to the stop-go 1960s and 1970s. In the event, it was a remarkably dull decade with growth oscillating in a narrow and always positive, band throughout. Perhaps the years ahead will see more variability.

Interest rate expectations are also work in progress. On bad days last week those expecting the US Federal Reserve to make a concerted attempt to reduce inflation gained the upper hand. Three rate rises in 2022 could become four if policy priorities shift from defence to attack. Those inhabiting pockets of the financial world dependant on cheap money forever are increasingly nervous. Unfortunately for the rest of us, a liquidity crunch in fashionable areas built on sand can affect even the most well-reasoned investment plan.

As we work towards the post-Covid new normal there will be many check points along the way. Company results are always a good starting point and although the latest season is only just getting started highlights are starting to emerge. Banks thrive during periods of rising interest rates as more expensive loans come first before better returns for depositors. Despite this, good results from JP Morgan were treated with some caution as costs, mainly pay, showed an 11% increase compared to the year before. From the food retail sector a reminder from the distant past that inflation is good for profits. Customers accept higher prices, while suppliers with long term contracts struggle to pass on cost increases.

Germany, for long the engine of EU growth, is showing signs of instability although it is far too early to call an end to this long term success story.

Stability of employment and pay have always been important components. With inflation significantly higher than wage increases last year, the approaching pay negotiations will be watched with interest. Some 70 collective deals will need to be concluded in the months ahead, although the two biggest groups, 3.8 million metal workers will have to wait until September followed by 2.7 million public sector employees in December. Employers operating in less structured, or alternatively described as more flexible economies, are having to face this problem now. Governments everywhere buying goodwill with tax payer’s money are an additional inflationary risk.

I am often asked whether there remain any parts of the investment world where expectations are low and valuations reasonable. Closely followed by why haven’t you invested more in emerging markets? Despite being a committed contrarian it has been right in recent years to ignore the attractions of these fast growing cheap markets with young populations and plenty of room for expansion. The stars would have to align for this to change, but never say never. The emerging market optimist’s wish list includes a weaker US dollar, China returning to growth and Russia to cease sabre rattling. Worth keeping an eye on, but for now Fortress America still has much to commend it with Europe lagging some way behind.

The US-Russia-NATO talks in Switzerland did nothing to ease recent tensions and eastern European countries remain particularly nervous. Military and cyber-security plans are being reviewed and troops put on alert. Even the usually passive Swedish army is sending reinforcements to Gotland, one of its islands in the middle of the Baltic Sea, just in case. Whether Putin tries to do a reverse Napoleon is to be seen, but for those looking to history for a guide, he is the same height as his French predecessor.

Listening to a fund sales pitch last week I was struck by the thought that sales people simplify to sell whereas investors simplify to understand. The vital next step when it comes to investing in this complicated world is to remain sceptical about these simplifications. Those who stray into believing their own stories are in dangerous territory.

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