Doubt is Good

by | January 18, 2021

‘…the stupid are cocksure while the intelligent are full of doubt.’ 

-Bertrand Russell

Bertrand Russell’s admonition rings true. In life, certainty is rare. Believing erroneously in certainty is perilous. In financial markets, investors are warned to be wary of certainty’s close cousin – consensus thinking.

Today, the overwhelming consensus of market participants, economists and policymakers is that inflation will not meaningfully accelerate given the pandemic is raging and unemployment remains elevated. Many investors are equally confident that inflation won’t meaningfully increase even when full employment has been restored. 

Such thinking is not surprising. History is on the side of the consensus. 

One year ago, when the U.S. unemployment rate reached its postwar low of 3.5%, U.S. consumer price inflation was just 2.4%, below its postwar average of 3.6%. Strikingly, in no single month this century has inflation in the world’s biggest economy reached or exceeded 3.0%. Today, U.S. consumer price inflation is 1.4%. In most other advanced economies, inflation is even lower.

Yet it is precisely because low inflation is so widely expected to persist that the risk of rising inflation demands our attention. The sustainability of easy monetary policies, low bond yields, tight credit spreads, the lengthening of duration in fixed income portfolios, prevailing high equity valuations, the appeal of private debt and equity markets, as well as the draw of alternative return streams (‘alternative risk premia’) depends on a continued belief that inflation will remain quiescent.

Still, questioning the consensus, however useful, must be well timed if it is to be financially wise. So why might we now doubt confidence in low inflation?

For one, because commodity prices have been on a tear since last autumn. Leading the charge are soybeans and coal, whose prices have advanced over 60% in the past six months. Crude oil and wheat prices have each climbed over 25% since the end of last summer, while copper, steel and aluminum prices have registered double-digit increases since October.

Interestingly, the strongest performers are foodstuffs, industrial metals and crude oil, rather than precious metals. This points to fundamental supply-demand imbalances, rather than to financial speculation or hedging. 

It is important to note that languishing gold and silver prices suggest that broader concerns about the US dollar, inflation, debt sustainability or the future of fiat currencies is not what is driving most commodity prices higher. And, precious metals may be losing some of their luster as inflation hedges to Bitcoin and other cryptocurrencies, whose prices have skyrocketed lately.

Bitcoin, however, appears an outlier. That’s because soaring prices of ‘consumable’ commodities are echoed by other cyclical assets. From their August lows, US Treasury bond yields have risen about 60 basis points. With the Federal Reserve and other central banks pinning down short-term interest rates, yield curves have accordingly steepened, a typical sign of improving growth, higher inflation or both. In equity markets, cyclically sensitive sectors, styles and regions have also performed strongly (and durably) since October 2020.

In previous market commentaries, we highlighted the factors behind these shifts in commodity, fixed income and equity markets. Topping the list are falling political risk premiums and hopes for an economic recovery founded on successful global inoculation against the Covid-19 virus. More recently, expectations for additional U.S. fiscal stimulus accompanied by renewed commitments to monetary easing have reinforced market rotation.

Still, it remains premature to declare ‘all clear’ for 2021. The highest rates to-date of Covid-19 infection, hospitalization and death have forced governments in the UK, France and the U.S., among others, to reinstate restrictive lockdowns and social distancing measures. Worryingly, more contagious variants of the virus have been reported in the UK, the American mid-west, South Africa and Brazil. And apart from China, growth in major economies softened at the end of 2020. That weakness was reflected in outright U.S. job losses in December, accompanied by rising jobless claims at the start of 2021.

Flagging growth, however, has not prevented bond yields from rising. Moreover, according to data from the Federal Reserve Bank of St. Louis, most of the rise in U.S. long-term yields in recent months stems from increasing inflation expectations, not rising real yields. Specifically, over two-thirds of the increase in nominal Treasury yields since October can be attributed to rising inflation, with real yields up by just 20 basis points. Investors are apparently becoming concerned that tight global inventories, impaired global supply chains and under-investment in production could translate fiscal and monetary stimulus disproportionately into higher prices, rather than to increased output, employment and income.

In short, the prices of raw materials bear watching, for they may be a harbinger of price pressures further along supply chains. If the responsiveness of inventories, production and distribution has been impaired by anti-globalization polices – tariffs and trade wars – as well as by the pandemic and stuttering business investment, then bottlenecks may prevent policy stimulus from restoring full employment without simultaneously stoking inflation fears.

The biggest threat to capital markets, and even to global economic recovery, may not be the pandemic and renewed lockdowns. It also may not be a high probability that inflation will accelerate. Rather, the greatest risk investors may face in 2021 is doubt. If investors merely question the most important underpinning of asset prices, namely permanently low inflation, the portfolio implications will be dramatic. Little refuge will be found in stocks or bonds, public or private.

The arrival of doubt, if it comes, will reveal the cost of consensus thinking. The fundamental problem, as Bertrand Russell reminds us, is believing in outcomes with certainty. 

Or, as Voltaire put it: “Doubt is an uncomfortable condition, but certainty is a ridiculous one.”

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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