The pendulum is constantly swinging from over-optimism to over-pessimism and back again. There are clearly some very strange trends occurring simultaneously in financial markets at present.
Whilst many risk assets are gaining upward momentum, perceived ‘safe haven’ assets, such as US treasuries and the Japanese yen are also reaching new heights. These perplexing cross currents are causing us and the wider market some concern. Clearly the tug of war between the ‘deflationists’ and ‘inflationists’ is intensifying, with commentary on both ideas reaching a crescendo, as recent economic data has been both ambiguous and thoroughly confusing. Sadly, we can find sympathy with the arguments of both camps, which is a hindrance to high conviction in our investment strategies.
Central case
Our central case remains that we expect slow and sluggish growth within our ‘Boring Bumpy and Below-par’ recovery to put downward pressure on prices in the short term. However, should the economic trajectory move higher or nervous governments and central banks hit the panic button on the printing presses, we would expect inflation to be a major factor in the years further out in this decade. In fact, having been fooled by misplaced thoughts of a Panglossian ‘Great Moderation’ last decade, there is a real chance that this decade might see the ‘Great Inflation’.
The difficulty for us is to balance our views in our investment strategy and asset allocation. Given that we contradictorily have worries over both deflation and inflation, the traditional course of action would be to hold a collection of diverse investments that could benefit in both environments, whilst holding highest weightings in those asset classes or individual investments where we have the strongest conviction.
Government bonds
However, we see no value at all in conventional government bonds and by implication high grade corporate credit, which should benefit from deflationary fears. In fact, we think you might suffer serious losses, should interest rate rises and inflation start to become a feature for markets in the quarters and years ahead and there is little compensation from the paltry yields currently on offer.
This is a completely different scenario to the last time that deflation was an issue for markets in 2008, when we loaded up on government bonds and built up cash positions, as we knew that the path of interest rates was downwards and the yields were still attractive. We have therefore instead started to accumulate higher cash weightings across our portfolios, having taken profits from some of the riskier trades that we have employed over the last year. This includes a reduction in our corporate bond positions, where we feel that both market and liquidity risks have risen, following another period of excellent performance.
