Index-Linked: The Pathway to Safety

A truth almost universally acknowledged often turns out not to be true at all.  One of Roosevelt’s best, ‘the only thing we have to fear is fear itself’, may just turn out right now to be one of them.  Are we heading for depression, recession or near-miss?  Who knows?  But when the brakes have failed the appropriate response is fright.  There’s not nearly enough of it about at the moment, and what fear there is is concentrated into the banking, property, leverage and retail sectors.  Since fear is a lagging indicator, there will presumably be time enough for a confidence-boosting Fireside Chat from a latter-day Roosevelt in due course.  The key now is to grasp the enormity of the situation and to work out what is the best way to keep safe.  We think that it is in inflation-protection: best of all are the index-linked government stocks.  The purpose of this review is to explain why.

The key to the current crisis is the existence of massive debt.  Even in the best-regulated world, there is always an element of it providing two lunches today at the expense of tomorrow’s.  When the time comes debt must be repaid, tomorrow’s lunch is foregone, and both economic growth and asset prices take the strain.  These features are very much at the forefront of today’s economic world; Billy Bunterdom has reigned supreme, and now it’s yarroo time.

The world is slowly coming to realise the extent of the problem now that the failures are hitting the blue-chips: Bear Stearns’ was the fifth largest US investment bank.  It’s easy to appreciate the submarine menace when a U-boat happens to sink the Ark Royal, but leverage’s destructive power has been apparent in theory for a long time, and the speedy work it made of Bear Stearns’ hedge funds last June was its early manifestation.  Yet, even today, there is a sense that if other capital ships can avoid the torpedoes, we can somehow return to the old order.  That world is as passé as the Dreadnought, and we live with circumstances where, to quote economist Roger Bootle, ‘the umpteen billions of dollars which have been magicked out of nowhere must return whence they came.’  The losses have to be borne (the easier part) and, more worryingly, the world has to live lunchlessly.

This is a recipe for a deflation (Why index-linked then?  Wait and see . . .), but the Federal Reserve has as its Chairman the one man who has spent almost a generation assessing how to avoid deflation in these circumstances.  What Bernanke has written in his theses, what Bernanke has spoken in his set-speeches, and what Chairman Bernanke has done to combat the deflation have been utterly consistent.  It is a common cry that the financial world is in uncharted waters, but the captain of the ship is a man with a one-note trumpet: he sees his job as providing liquidity and resources to the embattled financial system in its day of testing.

This steadfastness has drawn a favourable response from the investment community, but there are worries whether the Fed has enough fire-power to continue.  This concern is utterly naïve.  In the nineteenth century, Jonathan Backhouse, the Darlington banker, had a row with the Duke of Cleveland.  Backhouse challenged His Grace to a duel: who was the richer?  Could His Grace, for instance, tear up five pound notes without even flinching?  So they set to, and every time the Duke tore one up, he was five pounds the poorer, every time the banker tore up a note issued by the Backhouse Bank, he lost the cost of printing another one.

What’s this got to do with anything?  It highlights the difference between paper and money; the Fed sits in the Backhouse banker’s seat, not the Duke’s.  Bernanke alone controls the quantity of dollars, and he is choosing, as he always said he would, to create as many as it takes to preserve the financial system.  And when these crises occur, the amount needed to staunch them is huge.  Northern Rock required backing of £100 billion, of which a fair proportion will likely not be recovered.  This is the equivalent of more than 15% of the total government debt: an expensive hobby – the central bank equivalent of trying to breed a Derby winner.  So large, in fact, that it compromises the currency – and that creates inflation.

A quick diversion to consider inflation.  I’ve always regarded the French as being basically untrustworthy because they use the same word for ‘straight on’ as ‘turn right’.  There’s a similar issue with inflation.  Most of the time inflation describes the situation when we all want a bushel of wheat, and there’s not enough wheat to go around and – hey presto - the price goes up!  (And so does the price of bread.)  But sometimes, for instance in South America in the 1980s, the price of bread doubles in a fortnight, although there is no shortage of wheat, and no unusual demand for loaves.  The reason then, of course, was that the peso no longer acted as a store of value.  In the golden days, a sovereign did not change its value – only the wheat price did.  Today there are two moving plates – in this example, the wheat price and the peso.  A fall in the value of the peso masquerades as a rise in the value of wheat – but that’s to look through the wrong end of the telescope.

Money has three jobs to do – it acts as a medium of exchange, a unit of account and a store of value (how much spending power have I got in my wallet?).  In 1923, it took a wheelbarrow of money in Germany to buy a week’s groceries – a prodigious amount of printed paper.  It is said, probably apocryphally, that all Germany’s printers could only process a quarter of the necessary banknotes in that October.  But a lot of paper added up to almost no spending power – and in that, crucial, sense although there were a lot of banknotes, there was almost no money as defined in its ‘store of value’ role.  This failure to be a store of value is something which is most likely to be a problem in deflationary times – because deflation exacerbates the likelihood of default.  The German Mark ‘defaulted’ as a store of value – yet it goes by the name of ‘the great inflation’.

We are pretty confident that this is what Bernanke has in mind for the Dollar.  Not a currency wipe-out – but a steady reduction in its true value which is manifested both through the exchange rate and through the retail price index.  There is far too much borrowing about, and there is immense danger in the deleveraging process – it makes practical sense to effect some part of that deleveraging through the compromise in the currency.  A million dollars borrowed can thus still be a million dollars outstanding several years hence – but if it only buys half a Cadillac, the effect is the same, economically speaking, as a repayment of half the debt.  The crucial point is that this only helps the hapless debtors if interest rates remain below (well below) the inflation rate.  We can be sure the Federal Reserve will oblige in this respect.  The phenomenon was invented by the British in the 1970s (by accident, like all the best inventions) and observed by both Greenspan and Bernanke.  To recap: inflation is both necessary and unavoidable if Bernanke’s trumpet-tune plays out.  If it does, interest rates will almost certainly remain low.  There will be few places for investors to hide.  It is the Britain of the 1970s – equities lowly rated, not much appetite for risk, and cash certain to lose value as the gross income (and a fortiori the net income) is less than the value lost each year through inflation.

Thirty years ago, investors had to buy a hole in the ground in South Africa (the gold producer Vaal Reefs was the preferred counter), to protect themselves from negative real interest rates since there were no index-linked, and gold ownership was disallowed.  Today there are index-linked gilts (and similar instruments in most other major countries).  They are already difficult to buy, and there are not nearly enough to act as a lifeboat for all.  It’s time for investment ungallantry – we’re going for the lifeboat now, elbowing aside the women and children: sauve qui peut!

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Investment Review January 2008