Friday, March 24, 2017

"Why active managers are praying for reflation"

As noted in the intro to  a 2012 post:
A subject near and dear. The sweet spot for P/E ratios is 1.00- 2.00% annual CPI inflation. As you move away from that in either direction multiples drop off pretty fast, to the point that equities are not an optimal investment. You won't believe what the best investments for inflation in the 8-12% and greater than 100% ranges are. I'll write about them if we ever go Weimar....

Granted that's just P/E's and it will matter if corporate management wants to show phantom earnings during ongoing inflation and chooses FIFO accounting or wants to shelter more real earnings from the tax-man and uses LIFO and then there's... some day I'll get around to posting on it. Look for a clickbaity headline with part of the above paragraph:

"You won't believe what the best investments for inflation..."

From Fund Strategy:
Investors will be well aware of the reflationary narrative in markets, with growth and inflation having picked up over the past few months. Yet recognition of this change has not been universal.

While fund managers have been going long oil, hoovering up cyclical stocks and increasing active exposure, asset owners have shown little inclination to do so. They remain uninterested in commodities and equities, still favour fixed income and prefer bond proxies
like infrastructure.

This is an interesting divergence of opinion, especially as asset owners have had the best of it over the last few years. Fund managers who positioned themselves for an environment of higher yields and rising inflation in 2013 and again in 2015 were stung badly as a slowing global economy prompted renewed policy intervention. Reflation hopes quickly faded and bond yields fell sharply; so much so that by mid-2016 more than $13trn-worth of government bonds traded with a negative yield. They were then rightly lampooned for misreading the market.

Against this backdrop, it is tempting to recall the proverb “fool me once, shame on you; fool me twice, shame on me”. Asset owners’ ever tighter embrace of passive strategies suggests they may be thinking just that.

Yet history also offers examples of fund managers eventually being proven right. The so-called “nifty 50” stocks drove US indices during the early 1970s. Many active managers shunned these quality growth stocks, underperforming the wider market for several years. But when the 1973 oil shock kicked in, the proportion of active managers who beat their benchmarks jumped from 10 per cent to well over 90 per cent.

There are some reasons to believe a more reflationary environment may once again lead to sustained outperformance by active funds. The global economy picked up speed over 2016, with indices of economic surprises running at multi-year highs. Tighter labour markets, cuts to oil production and US tariffs could all drive inflation higher, which has already picked up some speed after several years in the doldrums.

This is not confined to just one region; it is everywhere. With output gaps closing even in laggard economies like the eurozone, conditions are ripe for more sustained price pressures. Interestingly, as these developments have unfolded, the proportion of active managers beating their benchmarks is picking up.

Bond bulls will argue that even if this is all true, central banks will eventually step in and tighten policy and, in any case, structural forces like ageing populations and high indebtedness will outweigh transitory cyclical developments. But will central banks tighten?

Haunted by the 1930s, they have spent years coming up with reasons to loosen policy, rather than tighten it.....MORE