MoneyWeek Editor, Andrew VanSickle and James Montier, a member of the asset allocation team at investment management group GMO, discuss inflation, slow-burn Minsky moments and cheap investments.
Andrew VanSickle: Most analyses of the big picture start with inflation. We know that like us, you have always been sceptical of central banks, so we were intrigued a couple of years ago to see that you thought the US Federal Reserve was broadly right in its inflation outlook: that it would subside rather than become ingrained. Do you feel you got that right?
James Montier: Yes, I think so. US inflation has come down fairly rapidly from its peak. The supply constraints that had underpinned the price rises have eased. Thanks to energy prices there has been a slight uptick in inflation recently, but there has been no evidence of a significant swing towards workers’ bargaining power. So a wage-price spiral fuelling sustained inflation seems unlikely. The UK is harder to assess in this regard – we have probably had more evidence of wages potentially bolstering prices. Britain has always had a lot of imported inflation from sterling being weak, so the Bank of England’s job has been considerably harder than the Fed’s.
Andrew: We’ve been struck by the fact that core inflation seems more entrenched in the eurozone and Britain, so there may well be scope for inflation to take hold. Gold is traditionally seen as a store of value and an inflation hedge, but we gather you’re not a fan.
James: The problem for me is that as I am a value investor, I have trouble working out how to value gold – whether I am paying a high or a low price for the insurance it may offer. I can’t gauge what is already in the price: as with all commodities, there are no cash flows attached to it. It is ultimately only worth what someone else is willing to pay for it. To my mind, if you want a long-term store of value, you need value stocks. Value stocks do not correlate with the ups and downs of inflation in the short term, so they’re not a good hedge in that sense. But their cash flows are essentially insulated against inflation.
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Andrew: The idea being they are often the kind of solid, defensive company in a position to raise prices along with inflation?
James: Yes. If we think of wage-price spirals as the key transmission mechanism for inflation, companies span both sides of that equation. They pay the wages, but they are also the ones charging the prices. So they can insulate your portfolio from price rises. They are a form of cheap insurance in this context.
Andrew: Was that true during the last inflationary era, too? Commodity stocks did especially well then, didn’t they – is that because they tend to be value stocks?
James: Yes, that’s right. People often go and buy commodity stocks thinking that commodities are a hedge against inflation. But a look at commodity prices paints a very different picture. Some commodities do very well: oil in the 1970s, for instance. It was the source, or at least the proximate source, of some of the inflation. So oil equities flourished. But a bunch of other commodities did appallingly badly. Yet the stocks based on the commodities thrived. It was because the stocks were cheap and represented good value that they proved a good investment, not because they were commodity stocks. So if you are worried about inflation and looking for a store of value, look for cheap equities.
Andrew: Turning now to the world economy more generally, what is your key worry
James: I think the global economy looks vulnerable to what I term “slow-burn Minsky moments”.
Andrew: Named after Hyman Minsky, the economist who said stability breeds instability.
James: The trouble is that we have built up huge levels of private-sector debt in the world. These buildups sometimes occur through high rates of credit growth, giving rise to credit bubbles, but often they sit simmering in the background, largely unnoticed until the proverbial hits the fan. When that happens, the structural vulnerability created by the debt amplifies an economic and market downturn.
High private debt has been a worrying feature of the world economy for a good 20 years now – in the US, household and non-financial corporate debt are jointly equivalent to 150% of GDP, for instance. Britain’s private-debt ratio is similar, while France's is 230%. Australia is on 180% and emerging markets on about 150%. The high private debt levels are an important reason why, for the last 20 years, we seem to have been living in an era of rolling financial crises.
So the upshot is that the economy is on shaky foundations. Think of a house built on quicksand. Your house might be there for a while, but it probably won’t be there for the long term. The difficulty is that you can’t predict what the proximate trigger for the crisis will be; the fact that we have this vulnerability sitting in the background is the issue. More broadly, however, having high levels of private debt means we need the cash flows to keep servicing them, and anything that hits those cash flows becomes a problem. That’s why recessions are a big danger when you have this precarious foundation.
It’s also worth bearing in mind that soft landings are as rare as hens’ teeth. Now here again value investing makes sense because in value investing we are used to dealing with uncertain timing. There is no rule that says cheap stocks can’t get cheaper and expensive ones more expensive, so you cannot know when your investment might pay off. So in a value framework, we insist on what Benjamin Graham used to refer to as a margin of safety. You want to make sure you have enough wiggle room in your purchase price to account for things that can go wrong. That makes sense in the context of these Minsky moments, too; you never know exactly when things are going to go wrong. The value-based approach makes for an interesting framework for thinking about how you protect a portfolio. As the Athenian general Pericles noted, you can’t predict but you can prepare.
Andrew: So again, we have value investing as a form of insurance: if you have that margin of safety, you’re guarding against potential problems.
James: Yes. Remember financial author Elroy Dimson’s definition of risk, which is that more things can happen than will happen. This touches on an important point. History seems strangely linear, predictable and obvious looking back. Only certain things happened. But at the time there was massive uncertainty and so many different paths we could have taken. So building a robust portfolio that can survive different outcomes is important.
Andrew: Coming now to where investors should be looking, we know that if you buy when something is attractively valued you should be able to enjoy much better long-term returns than if it is pricey.
James: Yes, and that’s very easy to lose sight of. Because the times when things are really cheap are often the times when people don’t want to invest.
Andrew: What has been catching your eye?
James: The overall US market looks obscenely overvalued. If you look at the Shiller price/earnings (p/e) ratio (the cyclically adjusted p/e, which uses ten years of earnings to smooth out the profit cycle), it is around 30. But drill down and you find that value stocks are on a large discount to growth ones. They cost 18 times earnings, and growth stocks are on around 45. And “deep value”, the cheapest 20% of the market, looks absolutely bombed out, using a composite valuation measure developed by GMO.
In the rest of the world, deep value is also extremely cheap. Value looks appealing compared with growth in Europe, Japan, and emerging markets, too: the Shiller p/es are around 12, 18, and seven respectively. Emerging value seems to be the world’s cheapest asset. We like it because it is being shunned. At this valuation, an awful lot of potential bad news has been factored into the price. It looks cheap enough to be able to generate annual returns of 6% in real terms over the next few years. You can also make a similar case for European value stocks.
Meanwhile, Japanese value looks really interesting. Japanese stocks have witnessed a substantial change in their profitability, but that hasn’t been discounted by the market. And a cheap currency adds to the investment case. So however scary the global outlook, value stocks are providing a huge margin of safety for investors. Things will go wrong, but the risk of losing money and never being able to get it back is much lower if you buy cheap. This situation is an interesting contrast to 2012. Back then, we couldn’t find anything we liked at all: assets had been priced for perfection as everyone thought low interest rates would last forever.
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