Portfolio Perspective:  Hon. Dr Pippa Malmgren

Investing in a volatile environment - simple but not easy

For the past three years, one of the keynotes at PortfolioConstruction Conference has been the Hon. Dr Pippa Malmgren. PortfolioConstruction Forum publisher, Graham Rich, caught up with Pippa for an update on her views...


View the video interview - click on the icon on the right
Edited transcript of the intervew - see below

Edited Transcript

At last year’s conference, you focused on the fact that preservation of capital was likely to give rise to strong investment performance but not necessarily vice versa. Give us an update.

At the time, it was pretty controversial, and there’s been a huge rally in risk assets since. Some people would say that means I’m wrong but I would say no, I was right. Preservation of capital meant you should invest in things that had genuine cash flows behind them such as commodities. We saw a lot of capacity destruction in extracted assets, so those cash flows would rise. And the commodities rally was more impressive than the equities rally. If you’d focused on performance first, you’d have focused on some of what have turned out to be the riskiest assets e.g. sovereign credit. That's a tricky place to preserve capital.

Do you think this will be more pronounced going forward?

Yes, we're entering a much more volatile environment than we’ve had in a long time. Investors have become accustomed to the 20-25 year period since fall of Berlin Wall. But in that period we saw billions of people enter the world economy, which created disinflationary forces. People think that is normal. It’s not, normal is a higher level of volatility than we’ve used to. That period of history was an aberration. We're going back to a more normal investing environment and in that case, a preservation of capital approach will serve investors better in future years.

Western economies are burdened by debt at a level not seen before. And this debt burden is threatening the social contract – it introduces a level of risk we’ve not had to consider before. Preservation of capital has to take into account an entirely new landscape that in fact is a reversion to the past, as opposed to a new paradigm.

Will the public struggle to accept changes?

The Greek population is being asked to accept. They have to accept three years of real depression economics, followed by at least a decade of recession. That’s if all goes perfectly. If things are not so perfect, we'll see interest rates go up, and then you’re talking about longer. There’s not a public in the world that will accept that outcome without a fight - no one wants to sacrifice an entire generation of growth. The question is, where the flight will occur? In the political arena or the streets? We're seeing rioting on the streets in Greece. 

It's not just Greece, exactly the same is facing Portugal, Spain, and arguably Britain has something on a similar scale – the public just hasn’t worked it out yet. Markets are like a shark – they go after the smallest and slowest, and that was Greece. But that’s a symptom of a much larger problem. The Greek public is not especially volatile – they’ve just realised what the true cost will be. We’ll see this all through the indebted nations.

Give us a quick insight into the UK and its prospects?

It comes back to the public realising that the debt problem affects them personally - that they will have to retire later and not at the standard they expected, that public services are not going to be delivered at the same level as before. In the UK, the government has announced that rubbish won’t be picked up as frequently, the NHS won’t be able to deliver health care they did. And at the same time, taxes will go through the roof. In the UK, people can express their anger effectively through the ballot box, and we happened to have an election just at the point that the problem became apparent. I'm not surprised there was a hung parliament. I would be surprised to see this government last the full term. We’ll see disputes that will result in votes of confidence.

I think we’re going to see this in many locations. We're already seeing symptoms of this in US. Polls are showing support for all incumbents has collapsed. Again, the public is very angry about the debt burden means to them. It leads to messy politics.

As investors, what you have to think about what are your new investment parameters? At one end of the spectrum, the limit to what’s possible is the social contract – the willingness and ability of human beings to bear pain. At the other end, we have the ability of states to fix the problem. They’ll say they can fix it, but can they actually deliver? This helps to explain why the market is pricing corporate debt better than sovereign debt. The risk free rate of return is no longer sovereign debt, it’s corporate debt – and that’s a whole new world.

We're seeing the Australian government looking for ways to increase revenue through tax, for example, by bringing in a super tax on resource companies. What is your perspective on that?

It's not a one off. This is about states needing to generate cash flow, they need to find revenue. There are a number of ways to do that. They can tighten up the tax rules – and we're seeing an attack on tax havens worldwide. Enforcement of tax is going to intensify across all indebted countries.

But it won't be enough. Governments will also want to tax what they perceive as windfalls. For example, we're seeing talk worldwide of a banking transaction tax, fuelled by the view that tax payer money was used to bail out the banks and now that banks are making record profits, they should share it. The UK government has already done this, taking bonuses in the year after the GFC. Here in Australia, the government is saying the commodities rally is a windfall, and the public is entitled to some of that.

We’ll see that for every asset that can’t be moved. For example, property taxes are going to rise – property may be an inflation hedge, but in the future, you’ll be sharing your profit with the government.  If we get lots of volatility in commodities that matter to human beings, such as food, it's not difficult to see governments taxing the food compaies. In the US, Obama has just announced that there may be a windfall tax on oil.

This about the changed balance of power between the state and markets, and that’s something that everyone needs to think through.

Last Conference, you talked about inflation being somewhat suppressed/hidden. How do you see inflation playing out?

Eighteen months ago, when I started to talk about the rise of inflationary pressures, what I saw was massive capacity destruction as marginal suppliers in extractive industries (such as mining, oil, food, etc) would necessarily mean supply constraints in the near future and higher prices in those areas. Plus, in a world where governments are printing money or IOUs (i.e. bonds), those things would be devalued. So there would be an inclination to want to invest in hard assets – and that includes hard and soft commodities – and therefore that’s the place where you’d want to put capital.

In fact, today, these prices are going through the roof. Rubber prices rose 150% in the last year. The month of March saw the biggest jump in food prices in 26 years in the US. In India, the prices of core staples the population lives on, such as onions, have risen by more than 100%, particularly in urban areas. In China, the inflation rate exceeds the deposit rate – you're losing money every day your money is in the bank. Here in Austrlaia, you can feel the inflation pressures - the excess liquidity is making its way to the property market which is why we're seeing record property prices.

The question is, does all this convert in a rise in the CPI? It's fascinating. In the Emerging Markets, it does convert to CPI. India is raising rates, so is China. In the West (Europe, US), those same price pressures manifest as pressure on the margins. Companies have to figure out whether they can pass on the higher costs. It’s a margin crusher – which is not good for equities in general.

It IS really good if you’re a brand because you can pass on higher prices if you have a premium product. And this is stimulating M&A activity around brands.

Inflation is a real issue. US audiences don’t believe this – they say, 'but the CPI is not moving'. That's because food and energy aren't included in the US CPI figures. 

I’m a buyer of inflation as a major pressure that’s going to give us some profit opportunities and change the investment parameters, so we have to think even more about preservation of capital.

You've talked about corporates being preferred to sovereigns, and global brands having the potential to capitalise on inflation pressures. Does that mean investors would get performance from including global corporates in portfolios?

Yes. It also argues that index investing doesn’t make so much sense anymore. Stock picking makes sense. That’s a shift in mentality for a lot of investors.

What are you picking when you’re stock picking? You're looking for genuine unimpaired cash flows. You need to find brands that have the capacity to increase their cash flows.

Last August, you talked about rise and rise of vanilla investment strategies. How’re you seeing this play out in reality?

When you’re living in a world where volatility is sustainably falling, people feel safer taking more and more risk. And you have to, when there’s a ton of money going into every kind of investment. You have more and more dollars chasing fewer and fewer opportunities. This pushes investors further and further out the risk curve, for less and less return. So you needed leverage to pump up the performance – we needed complex structures to do that.

In this new environment, where interest rates have gone up – official interest rates are still very low, but market interest rates have gone up – the actual yield (rate of return) is much higher. It means you don’t have to take complicated risk. You can be paid a huge amount of money just from being a plain vanilla lender. If banks are not going to lend, you can be paid to be a lender. But you have to be selective. There’s a reason banks aren’t lending – some businesses are not viable.

But plain vanilla doesn’t mean easy. You still have to use your judgment.

So the environment we're in - the new reality – is simple but not easy?

Yes, that's very right. It's simple but hard.