Do you remember what life was like back in 2008? It was financial life before the big fall. A kind prelapsarian period in markets where signs of risk were ignored. The S&P ASX/200 hasn’t traded at these levels since June of 2008. Could there be a second falling?
You bet your fearful heart there could be. Let me refresh your memory of what happened right before many illusions were shattered. The S&P ASX/200 made a good solid run at 6,000 in May of 2008. In fact, between late March and late May of that year, it rallied 15.7%. It looked like the worse was behind us. And then it got much worse.
The rest is history and not worth belabouring. But I bring back this unhappy memory for a simple reason: Signs of trouble always emerge at the margin. Notice them, and you can make for the exits in an orderly fashion. Miss them, and you’ll be caught with the crowd in a panic. Let’s not panic.
Let’s take the first sign: inflation. And no, I’m not talking about median Melbourne house prices rising by 10% since this time last year. They’ve done just that, though, according to data released yesterday by Australian Property Monitors. House prices in Melbourne rose by 1.7% in the June quarter to a median value of $607, 721.
Now that’s proper inflation! The rise amounts to about $154 a day, according to the firm, or about 14 pints of Sapporo at the Railway Hotel down the street. Expressed in terms of beer (which is also rising in price), house price inflation doesn’t seem like a bad thing. And according to my friend Phil Anderson, all is proceeding the way you would expect at this point in the Grand Cycle.
But poor old Glenn Stevens, the governor of the Reserve Bank of Australia. He must be wringing his knuckles in a clammy sweat this afternoon. Higher inflation and lower growth is a counterfeiter’s nightmare. If you all the cheap credit you make available goes into house prices or stock prices, you’ve shown everyone how powerless monetary policy is to produce real growth.
The second sign is also inflation, courtesy of yesterday’s numbers from the Australian Bureau of Statistics. Only this time, the numbers show that consumer prices are rising too (although not as fast as financial asset prices). Inflation in Australia is running at an annualised rate of 3%. That’s the top range of the RBA’s target. Check out the numbers.
Source: Australian Bureau of Statistics
You can never really take these numbers at face value. In this case, falling ‘communication’ prices helped suppress the overall rise in the price level. All the things that people buy routinely are going up in price. That general rise is ‘deflated’ by the falling prices for transport (really?) and mobile phones.
But mobile phones are not loaves of bread or pints of beer. You buy them once and use the often. Bread, beer, milk, fuel, broccoli…these items you buy often. That’s why the data is alarming. Once your perception of inflation changes, your behaviour changes, too. Then inflation becomes a psychological phenomenon as much as a monetary one. Here’s how Jim Rickards put it in the forward to The Death of Money:
‘Inflation often begins imperceptibly, and gains a foothold before it is recognised. This lag in comprehension, important to central banks, is called “money illusion”, a phrase that that refers to a perception that real wealth is being created, so that Keynesian “animal spirts” are aroused. Only later is it discovered that bankers and astute investors captured the wealth, and everyday citizens are left with devalued savings, pensions, and life insurance….
‘Inflation can gain substantial momentum before the general public notices it. It was not until 1974, nine years into an inflationary cycle, that inflation became a potent political issue and a prominent public policy concern. This lag in momentum and perception is the essence of “money illusion”.
‘Once inflation perceptions shift, they are extremely difficult to reset. In the Vietnam era, it took nine years for everyday Americans to focus on inflation, and an additional eleven years to re-anchor expectations. Rolling a rock downhill is much easier than pushing it back up to the top.’
So here’s a question for you dear reader: What if the underlying trend in markets from 2008 to 2011 was deflation and what if the ‘cure’ for that deflation (falling asset prices) was the multi-trillion dollar expansion in central bank balance sheets and corporate debt…and what if that increase in debt and credit is only now starting to translate into higher inflation?
In fairness, that is an awkward question. It’s really more of a statement. We are at a momentary state of equilibrium in markets. The various interest rate, fiscal, and monetary policies have prevented the collapse of a massive asset bubble. They’ve reinflated it. Now they’re going to blow it to smithereens, and take consumer price with them.
That’s one scenario, anyway. It’s the hyperinflationary nightmare. And thus far, it’s been only the stuff of bearish nightmares. It hasn’t happened. Yet.
That is the trouble with inflation though. It sneaks up on you. And by the time you recognise it for what it is, your stocks have fallen, your housing bubble has blown up, and your latte is five dollars.
Keep your wits about you. There are plenty of other sings, at the margin, that we’re near a tipping point in perceptions of inflation. Another boutique funds management firm is returning money to investors. The founders of Kosmos Asset Management are shutting up their $600 million fund, liquidating some positions, returning cash to investors, and putting the money in rival funds.
They’re not the first, either. And not the first that works almost exclusively in small cap stocks. Small-cap fund manager David Paradice returned $800 million to investors last month. He still has $1 billion in assets. But why do you think small-cap fund managers are handing back cash to investors?
One easy answer is that size matters. The bigger a fund gets, the harder it is to take a small position in a small stock without blowing it up, or owning more than 5% of the register. This is, of course, one of the main advantages punters have in small-cap stocks: They’re too small for big funds to invest in. The field is clear for the individual investor to uncover and profit from the best stories.
But small caps are also a kind of leading indicator for the market. As a proxy for risk, they lead the market on the way up. And as a proxy for risk, they lead it on the way down too. The fact that the professional fund managers are giving money back instead of piling it back into the market is significant.
What does it mean exactly? I’m not a mind reader. But I’ll have a guess. The fund managers know that risk is badly mispriced right now. Low interest rates have dulled investor’s perception of risk. Stocks are too high. Growth is too low. Something’s going to give. And it’s going to give soon.
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