Prepare for change – things aren’t normal any more

A friend’s grandmother telephoned her  earlier this week to say she was frightened. She had a feeling she hadn’t had since just before the second world war. The feeling? That another big war isn’t terribly far away.

She has watched the rise of China; she has watched the explosions in the Middle East; and she has noticed how inflation is eating away at living standards worldwide. She isn’t quite sure what will happen next, but experience tells her things can change very fast.

You can discount her wobbles as those of a nervy 96-year-old and I dare say you will. But you could also look at her list of worries another way – and ask if the rest of us aren’t a tad too complacent about everything.

The vast majority of people suffer from what behavioural scientists call ‘normalcy bias’ – the assumption, even in the face of evidence to the contrary, that things will continue as they always have. If something hasn’t happened before, why would it now?

This explains why people don’t leave nightclubs as soon as they smell burning, and why a bafflingly large number of people refuse to evacuate their homes even as floods begin to engulf them.
It might even be why Mervyn King refuses to accept that high inflation in the UK is more than just a blip: it has been so low for so long, the change is hard to accept – in spite of the evidence that it is getting pretty dug in.

For more on this, it is worth reading Barton Biggs’ 2008 book, Wealth, War and Wisdom, in which he looks at how, when bad things happen, “events move much faster than anyone expects… and the barbarians are on top of you before you can escape”. Biggs doesn’t appear to suffer from normalcy bias: he advocates preparing for the future by buying up a small farm and stocking it with “seed, fertiliser, canned food, wine, medicine, clothes, etc”.

However, the reason I’m thinking about this now is because investors are particularly prone to normalcy bias.

Consider the housing bubbles. One of my striking memories of the pre-crisis period was being told by a TV presenter that the fact that house prices hadn’t fallen made it clear they never would. The more they rose, the more she assumed they would rise – even in the face of chart after chart showing the house price to income ratio hitting impossible heights. She still thinks that the falls of recent years are a “blip”.

Then look at what’s going on today. I’ve written here about China before, but the bias is happily at work here: there’s plenty of evidence to suggest a massive credit bubble is ready to blow. But still the consensus is that the Chinese government will somehow manage to make it OK – “they always have so far”, one fund manager told me this week. Sound familiar?

Then there are the emerging markets. Their stocks used to be cheap relative to developed markets. So they went up. That led investors to assume that they would outperform developed markets indefinitely. It hasn’t quite worked out like that.

Emerging markets aren’t cheap any more and, from Brazil to India, they are being slammed by the kind of rampant price inflation that doesn’t do much for any asset class. The result? Not outperformance but underperformance: the FTSE Developed All Cap Index is up 5.4% so far this year, while the All Emerging All Cap is down 4.2%.

One final example: commodity markets. The general view now is that we are back on track with a commodity supercycle – one in which the price of copper will hit a new high every day for ever. But what if, as Ruffer’s Henry Maxey suggests, the huge rises in commodity prices at the moment actually only reflect a shift in money flows?

The average investor can’t see the point of taking the political risk of being directly invested in emerging markets so he is moving his money to make a bet on growth and inflation via commodities instead. As a strategy, this makes some sense but it also makes the bubbling market more fragile than the supercycle argument – which relies on real not speculative demand – suggests.

So what might choke it off? The obvious answer is tighter monetary policy in the US and China. That could be coming sooner than the market thinks: with the US consumer price index up 1% in January, the days of free-wheeling quantitative easing – which has provided much of the liquidity to markets over the last few years – might be numbered. Note too that China has raised interest rates twice in the past six weeks and only yesterday tightened things a little more by increasing the reserve requirements of its big banks.

Much more of this and perhaps it will suddenly look more normal for commodity prices to fall rather than rise.

• This article was first published in the Financial Times