In financial markets it is just as important to know what you think is going to happen, as it is to know what the average person thinks is going to happen. Investment performance is driven not by correctly estimating for how long or how fast something might grow, but by correctly estimating that something will grow at a different pace or for a different length of time than is currently ‘priced in’.
The economist, John Maynard Keynes covered this point in 1936 where he described investment as being like choosing the winner of a beauty contest saying, ‘it is not a case of choosing those (faces) that, to the best of one’s judgement are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.’
Today, one of those seemingly ‘average opinions’ is that we will see a rebound in GDP and inflation in the coming years followed by a return to the slow and low growth that has characterised much of the early 21st century.
That initial rebound is almost guaranteed as a result of the base effect; this is the idea that any numbers now will be compared on a year-on-year basis against a time where economic activity was nearly non-existent. However, more than being the average opinion, the industry appears at times unanimous in thinking that this dramatic pace of rebound and corresponding inflation will be temporary.
The Monetary Policy Committee of the Bank of England takes the view that ‘in the medium term, the pace of expansion in UK GDP slows, as supply growth returns to subdued longer-term trends and the effects of some factors boosting demand growth wane’. Jay Powell at the Fed agrees as he continues to trot out his phrase of the moment that any pickup in inflation will be driven by ‘transitory’ factors and should therefore be ignored. And it appears that investment markets too agree – the expected average inflation in the US over the next five years (ie 2021-2026) is currently priced in to be higher than the expected five year average inflation in five years’ time (ie 2026-2031).
Sensible positioning in this environment looks very different with a skew towards businesses whose growth is less predictable and more cyclical.
It is extremely unusual for investment markets to price in lower expected inflation in the future than in the present, and as good as confirms the view that the average investor sees a rebound in growth followed by a return to a slow and low world. Sensible positioning in this environment means owning businesses that either (a) offer steady and predictable growth such as Fast Moving Consumer Goods (FMCG) companies or (b) offer supernormal growth such as tech companies.
But what happens if that view isn’t correct? What happens if pent up savings leads to higher spending which leads to increased employment and wages and even higher spending? What happens if the Covid era marked the end of fiscal austerity and we should now expect to see sustained periods of ever increasing Government deficits? What happens if creative destruction during a time of crisis sees a new era of productivity that drives growth rates ever higher? Sensible positioning in this environment looks very different with a skew towards businesses whose growth is less predictable and more cyclical – it would certainly not make sense to pay premium valuations for businesses who are more likely to deliver growth in a world where every business delivers growth.
We do not know exactly what the future holds, but we do have a good idea what the average investor expects. Perhaps the bar to beat that dreary longer term outlook is not too high and remember, investment performance is driven by correctly estimating that something will grow at a different pace, or for a different amount of time, than is currently ‘priced in’.
James manages the JM Finn Coleman Street Investment funds, a choice of three portfolios with different investment objectives that pools your assets with those of others.
Illustration by Jordan Atkinson