A walk along Risk Road with Jim Hall
Deflation and rising interest rates
At Mawer, we spend a great deal of time asking and answering the question: So What? A company’s share price is down 6%...so what? A central bank moved interest rates up…so what?” Google re-named itself Alphabet…so what?”
It is not always an easy question to answer and often leads us to ask even more questions in an effort to develop key investment insights. “So what?” is one of the questions that can lead us to investment action (or inaction) in our process of building well-diversified, resilient portfolios. In an effort to pass on our “so what” learnings, I interviewed our Chief Investment Officer, Jim Hall, with specific questions pertaining to his views on risks in the current environment.
CW: Jim, Mawer conducts a quarterly risk review, rating macro risks on both probability of occurrence and degree of severity. I see a few with 9/10 on probability but lower severity and a few with the opposite profile, high severity, lower probability. Help us understand the way Mawer is viewing some of the broader risks at the top of the list right now.
JH: It is not enough to just look at the rankings. We need to ask ourselves is it something we need to do something about? Is this something upon which we need to act? Is it a biggie? Is it important? That’s the value in evaluating these risks on both probability of occurrence and severity of consequence.
CW: So, looking down the list, we have a few interesting choices to discuss. Deflation, lower energy prices for the medium term, European deflation, a China slowdown—these are all derivatives of deflation. Let's go there first.
JH: Deflation. How did we get here? Overcapacity and too much capital in the system. China is a perfect example of that; it just overbuilt industrial capacity. Commodity businesses are another good example—whether it’s steel, iron ore, copper, oil, natural gas—there have been technological changes that have essentially ended in a whole lot of excess capacity.
CW: So these are some big deflationary forces. What does that mean for portfolios?
JH: The “So what?” You may actually need to increase your weight in bonds. There are a lot of calls out there to lower bond weightings on the expectation of higher rates. Yes, but in a deflationary world, you want to get your hands on as much fixed income as you can because it’s worth quite a bit if that’s the way things are going. Ditto for duration—it’s a very counter-intuitive move to consider. Whereas more investors are considering shortening duration and reducing bond weights in anticipation of rising rates, the right move may actually be to increase duration if we’re going to experience a deflationary world for the next 5, 10, 15 years. You actually want to go the other way. The real “so what” is you want to have a balanced portfolio, be diversified. Yes, we understand the interest rate shock on the other side—it’s probably number two or three on the risk list. But mitigating against this risk would require the exact opposite approach to protecting against deflation So the actual, true “so what” is you want both. A properly diversified portfolio will have contradictions in it, and this is a good case in point.
CW: I’m hearing that it’s not so much deciding definitively if the world is in a deflationary phase; rather, the point is that there are multiple scenarios in terms of interest rate expectations. Let’s broaden the discussion out to interest rates.
JH: Let’s characterize that as uncertainty around rates. We’ve had the U.S. raise short term rates. Does that mean all rates are going higher? Well, maybe. We’re at a historical low point. Even if you look back 50 or 100 years, we’re still at a relatively low level for rates. But there’s no rule that says rates have to go up from here, even though there is a certain level of fear out there that rates are going to go higher. Reducing interest rate risk in your portfolio to defend against a higher interest rate scenario might mean reducing exposure to highly interest rate sensitive sectors or decreasing duration in your bond portfolio. But at the same time, there’s a legitimate deflation risk which is also a multi-decade type of trend. If interest rates start to go up, they could go up for decades. Likewise, if we’re in a deflationary environment, we could be stuck in it for decades. So the real true recommendation is that you position your portfolio to have exposure to the upside in both scenarios. If we actually knew which rate scenario were going to play out, we’d go that direction. But we don’t so we have to have both feet in two camps at the same time.
CW: What are the characteristics you look for in equities in a deflationary world?
JH: Avoid companies with a big asset/liability mismatch, especially among those that are highly leveraged. Concentrate on asset-light business models. E-commerce and wealth management are a couple of examples. Information Technology in general is an asset-light sector. In a deflationary world, growth is going to be in short supply so you want to look for businesses that can grow volumes and raise prices. If you can raise your prices in a deflationary world, that is distinctive. Companies growing geographically are also something to look for, particularly those expanding into geographies with growing populations.
CW: On that note, how would you characterize India as an investment opportunity right now?
JH: India may be a good beneficiary in this environment. India is not highly leveraged, they don’t have a lot of debt so they are not hurt by deflation. Again, in a deflationary world, debt is a real burden. India has very good growth opportunities and growth appears to be in very short supply. They need a little bit of everything so, outside of energy prices, deflationary forces will not be as concerning a factor for India.
CW: And where would India sit in terms of overcapacity, any issues you have observed on your trips there?
JH: There are some, but fewer than other growing economies. Many elements of India’s economy are dealing with the opposite: under capacity. Take banking—India is not overbanked. Electrical distribution is under capacity whereas generation capacity is adequate. Highways are getting better but there’s a lot more work to be done and rail infrastructure is very antiquated.
CW: OK Jim, that provides perspective on dealing with a deflationary world and expected direction of interest rates. What I heard was that you need to be thinking about both deflation and a rising rate environment at the same time; therefore, have exposure to both scenarios in fixed income. Within equities, tilt to asset-light, debt-light business models with pricing power and exposure to geographic expansion in areas that may be positioned to do better than most—perhaps companies with exposure to India.
Thanks for the stroll down this risk road. I know there are more to explore. It seems there is growing concern over global growth. I think next time we should walk down that road.
JH: Sounds good.