How to prepare your portfolio for the coming inflation bogeyman
Investors should take heed of likely higher inflation, a scenario that keeps real interest rates low and erodes debt levels at a rapid clip
Every so often an observation comes around in finance that works as a law – but just when you think you’ve got it – it doesn’t work.
So it is with my own rule of thumb, which I call “Harris’s First Law of Quarterly Investment”. This states that market sentiment will often inexplicably change at the end of a quarter. A boom could lead to a consolidation, a bust to a recovery. What frustrates is that market movements may not occur exactly at quarter end but may lag by a month, or skip a few days. Nevertheless these cardinal dates are a quirk of behavioural finance and often signal a turning point in sentiment.
The last quarter of 2017 in the Hong Kong market was a stormer, as for once the Hang Seng decoupled from China and followed the US markets rising gently, but unfailingly, with little volatility. Unbelievably the rally accelerated in January but just like building a mountain of sand; eventually one final grain causes the whole pile to slip.
It is determining when that last grain slips that is so desirable to investors. If you had sold on January 31, you would have trousered an extra 10 per cent. Yet we are still slightly above the year start – January saw a big dump of sand, so we haven’t really lost that much off our portfolios. I have been saying on CNBC and Bloomberg television, since the January 2, that the market could fall as much as 12 per cent and still be in a bull market.
We have had flash crashes and taper tantrums but we are now into an “inflation frenzy”. As I wrote in this column two weeks ago, inflation is creeping up, making future payments less valuable. Long bonds have consequently fallen, and this has pushed bond yields up – good for savers, bad for debtors.
Ironically the strong economic statistics out from the US on Friday spooked the markets into fearing higher inflation. Rising economic growth across the world is naturally inflationary. The US unemployment is 4.1 per cent, close to a structural minimum, setting the scene for wage rises and mass inflationary expectations. To add to the perfect storm, the chairwoman of the Federal Reserve Board that sets US interest rates, Janet Yellen, finally stepped down as her successor Jerome Powell took over. He looks like more of the same, but a new chairman always brings uncertainty.
We are not in bubble territory in terms of fundamentals but stock market prices are still high. Dame Janet even said as much in her leaving speech. It would not be unusual for the markets to look for excuses to consolidate. It was merely a case of identifying that last grain of sand – which nobody did, of course.
The indicator that this was more than a two-day wobble was the big 600-point fall on Wall Street on Friday. Markets usually have a big fall on Thursday and traders flatten their books on Friday, so prices are less volatile. A harsh Friday leaves traders festering at home prepared to hit the offers early Monday morning. As everyone went for the door at the same time, the street fell 1,175 points (4.6 per cent).
To put this into perspective, the previous record drop was 778 points (7 per cent) during the 2008 financial crisis – but that was in the depths of the crisis, after months of falls. This fall is after months of rises – there is a significant difference in sentiment between the two.
And yet inflation frenzies do not lead to recessions – debt crises do. The temporary silver lining is that the Trump liquidity surge from the tax breaks and likely infrastructure spend will resist an imminent liquidity-driven crash. Inflation keeps real interest rates low and that is good for economic growth – and for eroding debt levels. Interest rates will have to stay relatively low because the central banks cannot send highly indebted countries and companies into bankruptcy. So this is not the big collapse – yet.
January always looked like the critical month to set the scene for the rest of the year. A strong January and an ultra weak February portends a sluggish March, and a dull first quarter. Come back in April. A market rhyme gives some perspective:
the bulls will run, for a bit of sun,
to lands where the beaches are heaven,
to take some time to drink some wine,
but return for the Rugby Sevens.
Richard Harris is a veteran investment manager, banker, writer and broadcaster and financial expert witness