Merryn Somerset Webb talks to Richard Davidson about inflation, China, Japan, and emerging-market currencies.
I’m in trouble. Apparently I shouldn’t have written last week about how Alliance Trust’s Katherine Garrett Cox wears nice clothes. John Stepek said it was interesting that I even noticed her pink dress, given that “you don’t mention clothes when you interview men”. Which I don’t. A colleague of this week’s interviewee, Simon Milne, contacted me to ask if he would have had a better write up if he had worn a pink dress too. Perhaps not better, I said, but certainly different.
The truth is that I just write about what I am interested in. I’m not interested in grey suits, but I am interested in dresses. Still, for the sake of gender equality and an easy life I would like you all to know that Richard Davidson arrived for our interview wearing a darkish grey suit and a tie. And that he looked very nice in them. Let’s move on.
The first interesting thing about Richard is that I’m meeting him in Edinburgh. Matthew Lynn thinks that, if the Scottish vote for independence, Edinburgh might (just might) challenge London’s position as our island’s top financial centre.
Matthew justifies his extreme-sounding ideas by suggesting a couple of tax incentives that might draw everyone up here. I’m with him on the idea, but tax breaks alone aren’t usually enough: you need to offer lifestyle too if you want to get the hedge-fund managers in. And Edinburgh certainly offers that. You want culture? There’s the festival. You want a huge Georgian townhouse in the centre of town for under £1.5m? Done. You want good food? There are five Michelin-starred restaurants. You want golf, beaches and long walks? It takes about 20 minutes to get to any of them from the city. As for the weather, sure it’s colder than Cornwall, but it rains less too.
It isn’t even isolated – everyone in finance you might want to talk to passes through here at some point. Note that this week Edinburgh is hosting the CFA conference. So anyone who is anyone in money is spending three days knocking around the Edinburgh International Conference Centre. Finally, there’s amazing office space aplenty. Hedge funds like an impressive entrance (for obvious reasons) and in Scotland even the smallest of start-ups can usually afford at least a floor of a smart townhouse in the West End.
So I meet Richard at a smart townhouse in the West End. It – all of it – is home to Aubrey Capital, a boutique fund manager founded in 2006 – he has just become a member of its macro board. I wonder why. Run your eye down Richard’s CV and you won’t imagine it’s to raise a few quid for the school fees. It isn’t. He is Scottish; he’s moved back here because he likes Edinburgh; and he wants something part time to keep him interested and interesting. So why Aubrey? A “meeting of minds”. He likes the “dynamic” nature of the company and the way its small team is working to build a business. And he agrees with the company’s fund managers on the way we should be investing.
The notes from the last macro board meeting pretty much sum it up: this is a year for inflation not deflation; it is a year for equities not bonds; and it is the beginning of a second good decade for commodity prices. We start with commodities. All major bull markets are “characterised by extreme volatility”, says Richard (think back to the tech bubble). When all markets fell in 1998 on the Asian crisis, tech fell “substantially faster” than everything else. Then it recovered more or less in line with the rest of the market before entering its “blow-off phase” into the second half of 1999 and 2000. So regardless of volatility, “I would argue that the commodity bull market is still intact”. I wonder what will bring it to an end. The answer is simple: it will end when “real interest rates start to move up”. When will that happen? “I would expect that interest rates will have to go up faster and by a larger amount than the money markets are pricing in, in pretty much all of the major economies.” That’s because, while it has been “a long time in coming”, inflation is now beginning to be transmitted through the system.
We look at various charts showing supply bottlenecks in the system in the US and at the sales prices reported in the Philadelphia Fed’s Business Survey, where there has been a “dramatic recovery”. It could be about the weak dollar, it could be about supply constraints, or about global commodity demand. Whatever the trigger, Richard thinks, regardless of Federal Reserve chairman Ben Bernanke’s constant claims that any inflation is transitory, that inflation is here to stay.
He also expects it to show up in the Consumer Price Index (CPI) numbers soon and for that to push the Fed into tightening policy sooner than most people think. When rates move they should move fast. This is the first time since the mid-1970s that real interest rates have been negative – usually they are at around 2%. So to get back to ‘neutral’ – or the long-term average – there is a good way to go. Richard also points out that the market expects tightening to come slowly – we are used to rates moving around the place in occasional quarter or half points. But it hasn’t always been this way: when the Fed started its unexpected series of rate hikes in February 1994 they went from 3.25% to 5.5% by mid-November.
But what if the Fed doesn’t raise rates? There is a view – being put about by Russell Napier of CSLA at the CFA conference – that whatever they might say, central banks aren’t much interested in rising prices anymore. Instead, in their efforts to avoid deflation they look at credit (how much is credit expanding rather than how much are prices rising). So they might well not get on with the job, says Richard, but if they don’t there will be “consequences”, such as double-digit inflation.
So when does the first rate rise come in the UK? Earlier than you think. “This quarter.” Regular readers will know that I think that, given the damage a hike would do to house prices, any move is a lot further out. But Richard reckons bankers know “a little bit earlier means a lot less later” and that they will act on that knowledge. He also isn’t entirely convinced that very low interest rates are the panacea for the economy that most of us think they are. What of the net savers and the retired, who are getting almost nothing in income from their savings? Given that the retired tend to spend all their income, even a 1% increase in rates could mean a “significant difference in spending levels”. Zero interest rate policy (ZIRP) is supposed to stimulate economies, but what if, by restricting the spending of the elderly, it is in some ways doing the opposite?
While we’re discussing the elderly I ask about China, where the demographics aren’t looking great. Richard isn’t worried. As far as he can see China has been “successful at engineering slowdowns”. It also still has huge control over the economy. So he thinks that, for now at least, China is capable of managing a soft landing from its 10% a year growth rate. I have a go at shifting him from this position with a few statistics about what happens in gender imbalanced economies and so on, but he just isn’t worried about China.
What about Japan? The CFA conference was pepped up on Monday afternoon by a presentation from Dylan Grice forecasting imminent hyperinflation in Japan (which would be nice for well currency-hedged equity investors – more on this next week). Does he see any chance of the value caught in the Japanese stockmarket ever being released to patient MoneyWeek readers? As it happens he does.
We look at another chart. It turns out that when bond yields in the US start to rise, the Japanese market rises too. This is connected to the yen: when interest rates rise elsewhere, hot money moved out of Japan (where rates are consistently low), so the yen falls. And when the yen falls, the Japanese stockmarket rises. So one of the best hedges against inflation in the US, as it turns out is an (again currency-hedged) investment in Japanese equities.
I’m pleased with that (my long-term bullish position on Japanese equities occasionally embarrasses us – support is always welcome). So I ask Richard for his trades of the decade. He suggests waiting until the shock of the first rate hike has passed and then buying equities on the basis that, even now, “just the straight dividend yield case for equities is a very powerful one”. That makes sense to me too, as does his final call – emerging-markets currencies. They are “undervalued on a purchasing power basis, are higher yielding and have stronger growth”. And if Richard was going to jail for ten years and could make one trade before the door slammed behind him, they are the one thing that he would buy.
Who is Richard Davidson?
Richard Davidson was European strategist at Morgan Stanley from 1990-2003, and was ranked No. 1 investment strategist by Institutional Investor, among others. He took the reins of Morgan Stanley’s $7bn Global Asset Allocation Fund from 2003-2005, before leaving to run a macro fund for hedge fund Lansdowne Partners, where he worked until 2009. He returned to Edinburgh in 2010 where he acts as a strategic consultant to Aubrey Capital Management, a specialist investment boutique.
Davidson’s role is to provide “a macro roadmap” to guide the “strategic thinking” of Aubrey’s funds. This top-down approach is valued by the group, which has a particular focus on ‘global thematic conviction funds’. One example is the Collective Conviction Fund, run by Simon Milne. It is an unconstrained fund of funds (in other words, the manager can invest in any asset class he sees fit) that aims to protect capital “when markets turn ugly”. It’s up 13.9% since launch in 2007, against an 11.4% rise in the MSCI World Index. The Wall Street Journal recently highlighted Aubrey’s European Conviction Fund, which returned almost 50% in 2010, as its top-ranking European fund.