Neil Birrell, Premier Miton’s Chief Investment Officer and lead manager of the Premier Miton Diversified Fund range, explains how geo-political risks might be factored into investment decision making and tries to explain why central banks have a 2% target for inflation.
For information purposes only. Any views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Investing involves risk. Premier Miton is unable to provide investment, tax or financial planning advice. We recommend that you discuss any investment decisions with a financial adviser.
In brief
- Politics presents many risks to investors, as it is always changing and difficult to predict.
- The conflicts in Ukraine and the Middle East are current examples of how economies and industries can be affected by war.
- The 2% target for inflation used in the UK, US and many other economies originated as just a made up number.
A serious topic: geo-political risk
A common question I get asked is: ‘How do you factor geo-political risks into investment decision making?’
The simple answer is that it is not easy to do. But it might be worth outlining how I think about it. Let’s make it simpler to explain by splitting geo-political risk into two buckets: politics and conflict.
Politics presents many risks to investors, as it is always changing and difficult to predict. An example would be regulated industries such as utilities (electricity or water) or transport, where the pricing structures and the returns that companies can make are controlled.
Political influence can be significant, but it doesn’t happen often as companies usually have multi-year deals with known end dates, so investors can plan.
However, politics is very much a hot topic this year, with around half of the world’s population able to go to vote in general elections, including the US and the election announced for 4 July here in the UK as well.
Let me say this first, recent research from the investment bank Citi looked back at around 150 elections in 20 countries and discovered that in developed countries election results do not really alter the path of stock markets. Nothing to worry about then? Well, we need to look in a bit more detail. A change in government could bring about a change of economic policy which could, for example, increase income tax and impact consumer spending, which would impact retail companies’ profitability. It could also bring about a change in foreign policy, a good example might be how a President Biden or a President Trump might handle trade with China.
The potential for a ‘trade war’ is clear and that could affect the technology industry among others. Therefore, we need to consider how the big picture might change and how specific industries and companies might be impacted and make investment decisions accordingly.
Secondly, conflict. Again, we need to look at two levels: the macro level, factors such as inflation, interest rates and unemployment, and then in more detail.
To give examples, when the war in Ukraine started it led to a dramatic jump in energy prices which was one of the causes of the big jump in inflation, that has taken well over two years to control. Then the Middle East conflict caused the oil price to rise, bringing inflationary pressures back to the fore. At that level, we must consider the structuring of investment portfolios to different asset classes, such as bonds or company shares.
At the more detailed level, clearly companies we are invested in when a conflict starts, that are specifically exposed to, say, eastern Europe or Israel, need to be considered.
Then we need to think about what else might be impacted from an investment perspective. For example, Ukraine produced many car components, so the production ability of German car companies was challenged as they couldn’t get the parts they needed.
This could turn into a long list.
I hope that gives some examples of what we need to look at in the short and medium-term as investors. But there can also be very significant long-term impacts. The war in Ukraine brought into question the concept of globalisation, which has been a multi-decade trend, as governments and companies sought surety of supply of energy, food and materials (particularly healthcare related).
If this ‘reshoring‘ trend grows, which seems likely, the long-term ramifications are huge – more to think about and factor in!
The quirky question: why is the inflation target 2%?
When discussing the outlook for the world economy with Jonathan (or Joffy, as we know him) Willcocks, our Global Head of Distribution, he asked me: ‘Why is the target inflation rate set for central banks 2%?’. Well, that was one question I did know the answer to.
Rather surprisingly, the small economy of New Zealand has been very influential on the world economy for decades. Their model for the independent central bank to set interest rates was copied in the UK by Chancellor of the Exchequer Gordon Brown in 1997, when the Bank of England’s Monetary Policy Committee was created. Their purpose is to set interest rates to meet a specific inflation target, which was originally 2.5% measured by the Retail Price Index, then changed in 2003 to be 2.0% measured by the Consumer Price Index, which is much more globally comparable as RPI includes the costs associated with home ownership.
UK Consumer Price Index
Source Bloomberg: 31/12/1996 to 31/03/2024.
So, the question is; why 2%? The answer can found in, yes, you’ve guessed it, New Zealand. You can Google this and find a few different versions of the story, but the gist of it is, that the 2% target used in the UK, US and many other economies originated as just a made up number. No science, no teams of econometrists running multiple models, no votes in parliament were involved. Clearly subsequently a lot more analysis is undertaken, data reviewed and modelling done, but the origin of the 2% target was a figure plucked out of the air.
Depending on which account you read, the story goes something like this. In 1988, New Zealand’s inflation rate had just come down from a high of 15% to around 10%. During a TV interview Finance Minister, Roger Douglas, was asked what he thought would be a good level of inflation. Off the cuff he came up with between 0% and 1%. As a result, Don Brash, the Governor of the central bank, added 1% as a inflation bias and hey presto, the most of the developed world targets 2% inflation. Michael Reddell, a colleague of Brash’s at the time, admitted: “It wasn’t ruthlessly scientific.” Brash himself admitted as much: ‘It was almost a chance remark. The figure was plucked out of the air to influence the public’s expectations.’
Since inflation started rising in 2022, it seems all we have cared about is it getting back to target, if only they had known the impact of what they were doing in New Zealand at the time!
