Portfolio Perspective: Hon. Dr Pippa
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
View the video interview - click on the icon on the right
Edited transcript of the intervew - see below
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
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
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
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
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
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
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
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.