Why you need to act before markets agree on the inflation story

Human beings love stories.

There are good reasons for this. We are pattern-spotting creatures. Spotting patterns helps us to predict what might happen next in an otherwise highly uncertain world. It’s an ability that is key to our survival.

It’s practically impossible for us to switch this instinct off. It’s the reason why optical illusions work, whether or not you understand that they are illusions.

Stories are simply elaborate patterns. They might tell us how morality works. They might tell us how to behave in a given situation. The right story at the right time can teach us very valuable lessons.

On the other hand, believing the wrong story at the wrong time could prove to be very costly indeed – especially in investment markets.

Markets can’t decide on which story to believe

Robert Shiller (of cyclically-adjusted price/earnings ratio fame) is a well known Yale professor. His latest big idea (he’s writing a book on the topic) is “narrative economics”.  

He talks about tracing how stories “go viral” and the potential economic impact of all that. He focuses particularly on the role of stories in helping to drive booms and busts. He has an interesting take on how narrative drove the short but painful depression in the US in the early 1920s (you can read more about this here).

So what’s the story driving markets today?

Shiller tends to be a bit vague on these things. I’ve seen him talk about Donald Trump, or talk about the automation narrative (the one about robots replacing human beings in all these jobs, which is now finally starting to be questioned).

My own view is that market are between narratives right now. We’ve just seen the conclusion of one big story: “How central bankers and QE [quantitative easing] saved the world from deflation”. Now we’re moving onto the sequel, which is all about the consequences: “QE – the fallout”.

For now, the market can’t quite settle on what the fallout is going to be. We’re mostly pretty sure that it’s going to involve inflation in one way or another. But no one is quite willing to commit to the new story yet. They’re not keen to leave the old one behind (mainly because it had such a comforting moral: “buy everything, because central banks won’t let you down”).

It’s this process of narrative transition that makes it very difficult to figure out when the tipping point might arrive. But at least one investment analyst has been trying to grapple with this notion of timing a turn in the narrative.

When inflation becomes common knowledge rather than public knowledge

Ben Hunt of Salient Partners writes a lot of thought-provoking pieces about markets and philosophy and thought processes at his website Epsilon Theory. While I can’t recall him ever mentioning Shiller in his work, he ploughs a similar furrow on narrative.

The difference is, Hunt actually tries to apply the theory to investment strategy. Shiller’s ideas are all very well, but they’re classic academia: quite vague, and – to my mind – with too much focus on the media as a shaper, rather than a reflector, of people’s views.

Hunt by contrast, tries to quantify how a narrative is forming – and what effect that might have on markets – in a much more practical manner.

To illustrate, let’s take the most salient investment story right now: the return of inflation. In essence, by looking at the quantity of stories on a given topic and how closely they interconnect, Hunt can monitor the evolution of a narrative.

For most of 2016 and early 2017, according to his data, inflation was largely a side-topic that was mentioned briefly in stories that were primarily about something else: Donald Trump, US Treasuries, the Federal Reserve, etc.

That’s changed. In the last year or so, the number of articles on Bloomberg that mention inflation has risen sharply (by about 75%). Moreover, inflation is increasingly “the core topic of the article, not just a side issue”.

Hunt is particularly interested in the point at which a story becomes “common knowledge”. Right now, everyone is starting to be aware of inflation as an issue. But it’s not yet at the stage where this narrative is dictating market movements.

That’s because, while individuals might be worried about inflation, they are not yet convinced that other individuals are sufficiently worried about it. So they don’t change their own portfolios because they’re not convinced that other investors will follow them (which means they’ll end up underperforming – you only make money by going against the crowd if the crowd actually follows you at some point).

It’s like the scene near the end of The Emperor’s New Clothes. Every individual in the crowd “knows” that the emperor is naked. But they’re not convinced that everyone else in the crowd knows this. So they don’t change their behaviour.

It’s only when the tipping point arrives – when the child points out that the emperor has no clothes on, and suddenly everyone realises that everyone else knows that he’s naked too – that the narrative changes.

This is where what Hunt calls “public knowledge” (something that everyone knows) becomes accepted wisdom, or “common knowledge” (something that everyone knows that everyone knows).

And at that point, things really start to move fast. Because if everyone else has woken up to inflation, then suddenly you want to act fast. You need to get to the door before everyone else does.

What could trigger this change in mentality? Hunt reckons the answer is all tied to wage inflation in the US. We already saw the brief panic that a higher-than-expected wage inflation figure caused earlier this year.

That’s inevitably going to happen again. Recent figures have shown wage inflation to be relatively calm, but that’s partly because of statistical quirks (all to do with minor fluctuations in the measurement of hours worked per week).  

It’ll be interesting to see what happens when the next inflation panic takes hold. But I’d make sure you’re holding some protection before that happens.