As long term investors, KMG looks through the short term cloud of confusion to try and spot some structural changes and here are some key pointers:

• is the era of extra low interest rates going to come to a conclusion much quicker than we anticipate?
• is rising inflation much more likely that we all believe is remotely possible at the present time?
• is KMG’s investment strategy and general approach remotely relevant or correct in the current situation – reference Greece, UK referendum, Eastern Europe, Syria, North Africa and terrorism?

The first idea

The political will is changing across the world.

I suggest that the evolution of events in Greece may be quite significantly different when the German election happens in 2017 if Angela Merkel loses power. The growing sense of antagonism amongst the creditor nations of Europe, i.e. Germany, Holland, Finland etc is likely to move towards euro scepticism as these countries go to the polls in the next few years.

The rise of far right parties in Holland and in France let alone UKIP in the UK is a seismic change in political sentiment and voting tolerance.

Interest rates in Europe are set on a risk premium, i.e. the current very low rates of interest are predicated on the absolute certainty that the European Central Bank relies on two facts:

1. European governments will honour their debts.
2. That they will service their interest payments.

It is not just the Greeks who don’t want to pay (or cannot pay) either the interest or the debt, but it is the creditor taxpayers who are also increasingly wondering why they should pay the debt back on behalf of Greece, Portugal, Spain, France or Italy.

If the risk premium cannot be guaranteed by European governments then the European Central Bank may have no choice but to put up interest rates sooner than we anticipate.

This would be cathartic, painful and would lead to inflation, but of course ultimately it would also move more rapidly towards a solution to the debt crisis because some of the debt would have to default and other parts of the debt would be devalued by inflation.

This could be taken further if the ECB decides that sovereign debt is not risk free as it could then require the banks, who hold large amounts of sovereign debt as part of their core capital, to purchase significant quantities of other assets to boost their capital ratios. This would probably require a further Basel accord, and would be disruptive and expensive for the banks. It would leave them even less willing and able to lend to industry and private individuals.

Second point

Quantitative easing clearly is not working. Printing more and more money and piling up greater and greater debt is clearly not working.

The FT ran a series of articles on the weekend of 27th/28th June, explaining how quickly an alternative economy is developing. This builds upon our observations from our autumn seminars about creative destruction and it builds on our observations about the shadow economy which is not illegal, but simply takes advantage of technology to in effect barter our wealth in ways which makes it hard for governments to levy taxation.

The flaw in the Greek deal, whether it is settled or not is the fact that technology is enabling the population of Greece to live more and more efficiently paying less and less tax in all sorts of different ways as we have explained on numerous occasions.

It must be remembered that we are all taking advantage of efficient technology to reduce our overheads and improve our way of living without money in circulation.

If you haven’t got money in circulation and there is a reduction in the velocity of money going around the system, then it is increasingly difficult for governments to obtain taxation, leading to a fundamental conundrum.

If you cannot raise taxation we therefore cannot service the debt and the interest on the debt. If central bankers realise that this is a significant change in economic activity then interest rates have to go up because the risk premium increases as it becomes less likely that any government is capable of raising the funds to meet the debt and interest applied thereon.

Third issue

I was listening to Moneybox on Radio 4 on Saturday, 27th June and an article about Cameron’s plans to reduce the welfare state and dependency thereon and force up wages is very interesting in one economic aspect. Clearly wage increases are the key driver to inflation. This is an absolutely established economic principle. Indeed, all central bankers have retained low interest rates because of the conundrum about a lack of wage inflation across all western economies, due to low labour demand.

Even in Japan, the government wants unproductive capital put to work to increase wages and income.

Coincidence

The above observations may be a coincidence and may not coincide for some significant time but I believe that they are significant moves in the tectonic plates of global economics which may change our way of thinking far quicker than we anticipate.

FTSE and the 15-year bear market

Bear in mind that the FTSE 100 index is still only just about where it was 15 years’ ago, which is a remarkable statement of fact. Yes, we have made good returns, yes there have been good dividend yields and some reasonable interest rate returns but in terms of capital, pricing the market really has not gone up and yet the price-to-earnings ratio is significantly ahead of the average.

Therefore, one of two things has to happen, either the market has to collapse or we are at the start of a significant increase in asset prices possibly as a consequence of all the reasons set out above.

Finally, property

On the one hand if we are to see higher interest rates then property prices will go down, but on the other hand, if we are also to see inflation then property prices will not go down that much and then will come back up.

Conclusion

Is there anything else that we should be doing to reposition your funds in light of the current economic conundrum?

The answer is no other than to move steadily through the rebalancing process which we have started with some clients. If we have not yet spoken to you about rebalancing we will do so when your next valuation is due.

Our view is to reduce money invested in fixed interest funds, whilst maintaining exposure to the upside on equity but nevertheless recognising that in the very short term all of our investment strategies may e incredibly volatile.

Finally, key European elections are approximately two years’ away but markets will start to move ahead of those elections particularly as they see political sentiment moving away from the current consensus.

As always, it is about being ahead of the game and thinking through all of the options.

Patrick McIntosh
1/7/2015