The Fool.

There once was a fool who prized being right above being rich. He placed his bets to hedge the pain he might suffer for his failings and, fool that he was, was more often right than wrong, and therefore succeeded in being more right than rich.


Two models of inflation and interest rates

I’ve written about this elsewhere, always part of a wider survey of inflation and rates, but I really need to record this in one place now as it may be important later.

The Gibson Paradox observes that rates and inflation seem to be positively related more than can be explained by lag effects. I therefore went in search of theories that might support a positive relationship between the two and found one such article on the website of the St Louis Fed. The argument goes like this:

If the Fed raises interest rates the nominal rate and the real rate instantaneously rise. However, as the real rate is determined by the productivity and resource endowments of an economy and not monetary policy, the real rate must fade back to the original rate. This happens by inflation rising by the size of the rate hike. Conversely, rate cutting leads to weaker price pressures.

See the St Louis Fed’s article on Fisher’s view on interest rates here:



I also sought a causal microeconomic theory to support the macroeconomic one. There were none I could find and so I formulated one of my own, which, and here is a serious caveat, has not been peer reviewed. The argument goes like this:

Cutting interest rates makes capital and land cheaper relative to labour. Labour has to compete by suppressing wage growth pressure. Conversely, rising rates makes capital and land more expensive leading to a substitution towards labour, putting pressure on wages to rise.


Ten Seconds Into The Future 2022 10

Current Observations:

On the positive side of the ledger:

  • Economic growth is still strong.
  • Household & bank balance sheets are strong.
  • Corporate balance sheets are fairly strong.
  • Fiscal policy is still fairly expansionary.
  • Green capex momentum is strong.
  • Equities are fairly valued.

On the negative side:

  • Inflation is persistent.
  • Central banks are tightening.
  • Governments are over borrowed.
  • Interest rates are rising.
  • Fixed income is expensive.
  • Financial system liquidity is stressed.
  • Financial conditions are tight.


Expectations, Risks and Opportunities:

On the positive side of the ledger:

  • Inflation may fade.
  • Central banks may pivot.
  • Economic slowdown may be shallow and short.

On the negative side:

  • Fiscal policy will need to tighten.
  • Credit costs may continue rising.
  • Leverage may be less available.
  • Economic growth is expected to slow.
  • Valuations mean revert and overshoot.

Geopolitics and other distractions:

On the positive side:

  • Emerging markets ex China have young populations.

On the negative side:

  • China’s increasingly a one-man rule system.
  • China v USA rivalry continues.
  • Globally, mercantilism likely to continue.
  • Weak European economic growth is a risk to social stability.
  • US partisan politics likely to remain tense.
  • Russia Ukraine war yet unresolved.

The last 12 years saw an acceleration in monetary accommodation as central banks worked to bail out the financial sector, developed a taste for QE, and supported the economy while inflation remained benign enough to allow them to do so with impunity.

Fiscal policy has been restrained since 2013 after the initial surge of bailouts during the 2008 financial crisis. Discipline was maintained until broken by the global COVID pandemic in 2020.

These fiscal and monetary impulses have driven demand beyond supply capacity resulting in a surge in inflation. Long term inflationary forces have made it hard for inflation to fade as quickly as expected and has left central banks reacting rather than preempting.

Tightening monetary conditions too late and too slowly may require central banks to remain more hawkish for longer and risk inciting recession.

Higher interest rates put pressure on highly indebted governments to reign in budgets. Monetary tightening is likely to be followed by fiscal tightening albeit with a lag. (Interest rates will likely peak when this happens, and, this should be driven not by a central bank pivot to dovishness but from tighter fiscal budgeting.)

The current bear sentiment in markets will eventually abate, if they haven’t already. However, the future is likely to face a) less availability of leverage, b) higher equilibrium interest rates, c) higher overall cost of debt and equity, and consequently als0, lower operating margins, and slower earnings growth.

Long term equity returns are likely to remain positive in nominal terms and perhaps barely in real terms. If we didn’t believe this, we would not be in this business. However, lower expected returns and heightened volatility (from disparate factors from slimmer margins to heightened geopolitical and climate risks) mean equity allocations should be reduced, all things being equal. The trouble is that the same challenges plague corporate debt markets. At some level, yields will present attractive returns but until then duration needs to be hedged leaving meagre spread returns even with the recent spread widening.

Assets have cheapened from acutely expensive valuations but even when they revert to near long term averages, the historical tendency to overshoot whether when rising or falling means that assets may cheapen further.

This analysis doesn’t really consider the deeper implications of geopolitics and demography. Slow growth amid rising inflation does not foster an environment for cooperation and fraternité.



UK Mini Budget 2022

I was trawling around London soliciting views mostly from the main beneficiaries of the Chancellor’s tax cuts announced 23 September. How? Why? What?
The problem with the budget is not that it doesn’t make sense, we can make anything sensible given enough experts’ opinions. The problem was marketing, communications, governance, those sorts of inconveniences.

A first time budget by a first time PM and Chancellor requires some handholding, explanation and marketing. Yet it took them almost a week to explain themselves leaving the public thinking that either they couldn’t (a question of competence), or they wouldn’t (a question of arrogance.) In the meantime, the silence came to be interpreted as cowardice as everyone from those in the 19% tax bracket (formerly 20%), to, surprisingly, those in the 40% bracket (formerly 45%).

The consensus seems to be that the budget had the 2024 elections in mind, by which time, temporary fiscal irresponsibility would have incited economic growth, and a second (this time popularly elected) term, or it would be a problem for a new Labour government to clean up. So far so clever except that things didn’t go to plan. The pound now carries less weight and is worth fewer dollars and borrowing costs a bit more than last week.

A government less wedded to factual accuracy might have sold the budget thus. I’m not advocating this, just saying it could have been a Monty Pythonesque pitch, which these days cannot be ruled out.

Basic rate payers, you get a 1% discount on income tax. It’s too small to be inflationary and it puts some change in your pocket. You’re welcome. Top rate payers get a 5% cut, which won’t be too inflationary since they’ll save it anyway and use it to fund the 1% basic rate cut. Hopefully this will take pressure off the Bank of England having to buy long dated gilts while raising short term interest rates. That the maths probably do not add up is incidental when you’re selling dreams but then so much of life is just that.



Investing Responsibly and Thoughtfully. ESG and all that.

ESG investing has been an excellent growth opportunity for the investment industry to demonstrate innovation and introduce new products and services. For investors seeking to obtain both purpose and returns, the experience has been mixed.

I believe that the human species seeks to make things better, that we are inherently good, even if our efforts are sometimes thwarted by circumstances. Every action we take has complex and numerous consequences for the world around us. Consumption, investment, trade and social interaction, have diverse and complex positive and negative impact on the environment and society. I believe that we, collectively, have a grand purpose, which is beyond the knowing of the individual, but that we can know our own purpose and that it is our duty to pursue that purpose.

In our pursuit of purpose, we should be thoughtful regarding all we do including how we think, behave, communicate, consume, trade and invest. We should certainly be clear about antecedents but further, about consequents as well. Investment orthodoxy focuses on antecedents, on knowing how things work so that investment theses may be sound. The thoughtful investor extends the analysis to consequents so that they are aware of the possible impact of their decisions. The data we consider include business models and financial and commercial metrics. Lately, ESG has opened the door to considering the non-commercial impact of our actions, but it opens the door but a crack. ESG factors are a subset of the data we should consider. Other factors that bear consideration include geopolitics and ethics.

The thoughtful investor asks, is this a good business model, do we need it, do we want it, can we provide it economically, what is the economic cost, what is the cost to the environment, to society, to geopolitical and strategic relations, to the mindset, worldview, for shareholder, management, customers, suppliers, competitors, today, tomorrow and in the future. Not all considerations deserve the same weight, not all things can be quantified, but the extent and limits of our knowledge should be considered in the decision to invest or not. The thoughtful consumer, worker or producer should ask the same.

We have much to thank the ESG community for for opening our eyes. To do it justice, we must go a little further to including other metrics so that our decisions are informationally efficient and based on as much knowledge as possible.

What ESG also brought us was the aspiration to validation, through better measurement and systematic processes. The investment industry is a highly efficient one and in its pursuit of scale has systematized the process of considering ESG factors. Other factors outside of ESG may not be so easy to measure or quantify. As it is, social factors are difficult to measure, hence the pragmatic bias towards environmental factors which are more tractable. The aspiration to measure is a good one but its limits should be recognized, especially when one widens the scope of factors that influence investment decisions. One general issue is that long term impacts can be very significant due to compounding effects and yet, long term forecasting suffers from greater uncertainty. Theories of change improve consistency yet introduce complexity and uncertainty. The honest pursuit of thoughtful and responsible investing requires that we consider such tradeoffs and make decisions in the face of many unknowables. This adds to the concept of risk taking introducing non-commercial or non-financial risks to the analysis.

Where an investor invests with an impact objective, other responsibilities arise. Is the impact desirable? What are the non-financial consequences of an error? Is the strategy or solution desirable or efficient? Is the investor sufficiently qualified to make these determinations?

If no one can be sure they are right, then perhaps the better solution is to harness the opinion of the collective since the collective decision is based on a larger information set. Harnessing the information of mass decision makers is simply the free market at work.

One slightly inconvenient question arises. If we employ a voting system such as the free market to process our information, should it be one person one vote, and what does this say about concentrations of votes in the hands of the few?

From a practical perspective what it means is that ESG and Impact investments become simply Impact and Financial investments. The distinction is between all the things that could influence our investments and all the things that could be impacted by our investments. Whenever we invest in anything, all the things that could impact our investments should be considered. When we invest in impact investments, we additionally have to consider the things that could be impacted by our investments. The concept of ESG investing falls away or is diminished, not because it is less important but because it is subsumed into a much wider concept of thoughtfulness.

With this standard of thoughtfulness, the application of a simple exclusion methodology (to rule out the sin industries and environmentally unsustainable industries), results in a practical and comprehensive basis for an investment framework.