Speaking on the Brewin Dolphin podcast, released earlier this week, Smith said, while most people, himself included, have spent the past few years worrying that QE would be inflationary, it looks to be having the opposite effect for two reasons.
The first reason, Smith said, was that lowering interest rates to zero leads to companies making illogical decisions about investment in productive capacity.
“They start to think their cost of capital is falling in line with falling interest rates,” he said, “They don’t think much about the cost of equity capital, some companies, they think about debt, and they can see that debt costs nothing so they end up building more productive capacity than the market can sustain in terms of demand.”
He added: “Every time in history we have seen interest rates get very low, we have seen companies start to make illogical decisions. Japan in the late ‘80s is a particularly good case, where people started to invest as if capital were free, the dot coms at the turn of the century too, people made very bad decisions.
“I think people are now building productive capacity for which there is no sustainable demand.”
The second reason for the deflationary effects of QE is the impact of zero interest rates on retirees and those soon to retire.
“In my experience retirees won’t spend any more than their income,” Smith said, pointing to Japan as a good example of this. “The lower they have driven rates, the less retirees have spent.”
This is important going forward, he points out, because across the developed world the retiree segment is the fastest growing portion of the population and, crucially, the segment with the greatest buying power.
What concerns Smith in particular about this, is the fact that those in charge of the QE policies will keep their pedal to the metal in terms of loose monetary policy until the side effects are worse than the illness itself.
But, while it is a concern, he believes his fund is well placed to weather the continued deflation likely to take place.
“Even if you do not believe that QE is the reason, there is no doubt there is deflation, especially in Europe. If that is the case, the worst place you want to be is in commodity producers, and the best thing to be is a company that uses those deflated inputs but has pricing power for their end products. Those are exactly the sorts of companies we are invested in. I think our companies are going to get a good tailwind from falling commodities
In particular he is positive, in this regard, on the prospects for medical equipment companies, which he says are probably at their lowest rating in at least half a dozen years.
These firms, the ones that make artifical joints and diabetes pens and the like have largely been ignored by the market during the bull run in defensive stocks, he said, and they should benefit from the ageing populations in the developed world.
