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Season to taste

Democritus was as an influential Ancient Greek philosopher, primarily remembered today for his formulation of an atomic theory of the universe. He also took up the challenge of explaining how humans taste; concluding, when we chew our food, it crumbles into little bits and these eventually break into four basic shapes. When something tastes sweet, Democritus believed it was because the bits are ‘round and large in their atoms’; something salty is caused by ‘isosceles triangle bits on your tongue’. A bitter taste is created by ‘spherical, smooth, scalene and small’ bits, while sour is ‘large in its atoms, but rough, angular and not spherical’. Therefore, according to Democritus, everything we taste was a combination of these four ingredients.

This theory made sense to Plato, Aristotle and many subsequent great thinkers and scientists. The discovery of taste buds, in the nineteenth century, with tongue cells under a microscope looking like little keyholes into which tiny bits of food might fit, seemed to reinforce the theory.

The idea that all prepared food had a taste created by each of the four shapes in isolation, or a combination thereof, influenced ‘chefs’ of the day. It was not until the early twentieth century that two individuals, on the opposite sides of the world, independently challenged this explanation of how we taste; one through being creative, the other with the application of science. Auguste Escoffer was a chef in Paris who opened, what was said to be, ‘the most glamorous, most expensive, most revolutionary restaurant in the city’. He created meals that ‘tasted like no combination of salty, sour, sweet and bitter; they tasted new’. Over in Japan, a chemist called Kikunae Ikeda, believed when he sat enjoying a bowl of dashi – a Japanese dish made from seaweed – he tasted something beyond the four shapes previously used to explain flavour.

Escoffer, ‘the king of chefs and chef of kings’ had invented veal stock; and used it as a base for a sauce which seemed to ‘deepen and enrich the flavour of everything it touched’. In Japan, cooks were using dashi in the same way Escoffer used stock, as a base for all kinds of food. Ikeda went to his laboratory in a quest to identify the secret ingredient and later explained, in a journal for the Chemical Society of Tokyo, that the taste was created by glutamic acid. He decided to rename it, calling it ‘umami’ – the Japanese word for ‘delicious’ or ‘yummy’.

21st century researchers now believe humans developed a taste for umami because it signals the presence of protein. Food that is fermented, aged, toasted, roasted, braised or stewed, breaks down protein into its constituent parts – amino acids and glutamates – ensuring the food packs an umami punch.

Current blend

We now understand our favourite meal tastes as it does because the blend of the 5 key flavours – sweet, salty, bitter, sour and umami – are perfect for that particular dish. We also know a tasty meal for some will be considered exactly the opposite for others and our perception of taste is something very personal to us. Our tastes also change over time and it is not unusual for us to grow to like something which, initially, we might have found unappealing or even repulsive, particularly in our younger days.

How similar this is to discretionary investment management.

The month of April 2017 marks the fifth anniversary of Affinity managing assets for clients and we have clearly had to adjust the ‘seasoning’ of each of our risk rated strategies to meet the tastes of our investors over this time. Our personal risk appetites have also influenced the blending process and this 5 year timeline has prompted us to reflect on what has been enjoyable and what has been less palatable.

Before doing so, it is important to review the key factors – or flavours - shaping our current positioning.

Sweetness is undoubtedly present, evidenced by the improving state of the global economy. As the two charts that follow illustrate, manufacturing across DM and EM is recovering strongly and there has been a sharp pick up in global trade volumes. This is leading businesses to feel more optimistic, enabling them to invest more in people (through higher wages); plant and machinery (through rising capex) and each other (through rising M&A activity).

An improving global economy

Umami can also be found in the shape of regional recoveries; with Europe leading the way. The euro’s low real FX rate is helping exports and private consumption has been a strong engine for growth. The ECB’s policies have boosted capital market confidence and compressed lending spreads for large corporates, as well as small businesses in the periphery. Job creation is following as a result, with over 1m previously unemployed people now working again, compared to this time last year.

As asset allocators, however, we have not felt in a position to overindulge. We believe some salty, sour and bitter tasting elements are present and they run the risk of over-powering the other two. The salty taste is being created by extended valuations across numerous equity markets, together with a prolonged period of very low volatility. We have always used valuation as an anchor to investment decision-making, but in the post GFC world it has become an increasingly poor indicator of near term returns. We still believe, however, long term equity performance is determined by the initial price you pay. Shorter term indicators are proving more useful in the bond space, where spreads, default rates and relative value measures are important metrics to monitor. As bond market dislocations typically lead equity turbulence, we should have some early warning signals to rely on.

Sourness pervades in the shape of politics that could go wrong. This is a heightened risk in Europe - with the key elections in France and Germany pending – and there is likely to be an ever present concern during the term of the Trump presidency. The better than feared outcome to the election in the Netherlands and polling ahead of the French vote, suggest populism may be losing momentum; but last year has taught politicians and investors alike to be wary. Italy may prove to be a more tangible risk.

Finally, we believe all longer term investors cannot avoid the bitter aftertaste created by the structural headwinds of debt, demographics and inequality. Global debt levels are at record highs and continue to grow; demographics across most DMs and a rising number of EMs, are an economic and social challenge which many nations are struggling to come to terms with. Inequality in the world’s largest economy has returned to levels last seen 100 years ago and this is not just a US phenomenon.

Structural headwinds remain

Source; Fidelity

Has it tasted good?

Based on this overview, the equity sensitivities across our strategies are at the lower end of their range, however, we are not sitting on lots of cash. Allocations to emerging market assets, Europe, technology and healthcare have combined well with our uncorrelated suite of funds. We are also satisfied by the ‘kick’ gold could bring when needed and bonds continue to bring diversification benefits.

In our May 2013 edition of VFTD we reviewed the investor’s constant challenge to balance the primary objectives of making money and avoiding losses. Getting this right is judging when to be aggressive and when to be cautious. In the investment world, hindsight is a wonderful thing and the chart below illustrates, from an equity perspective, the sweetness and umami brought by overweight exposures to US assets has been the single most important ingredient to any dish served, whatever your risk appetite.

US equities have dominated developed market returns

Returning to our 5 year retrospective, whilst our lower risk strategies have performed strongly, our higher risk mandates have – on reflection – not packed enough punch. We accept the constructive criticism that we have simply been too cautious in the past. In large part this was a consequence of the poor economic sentiment when we set up in 2011; along with a natural conservatism inherent when establishing a new business. However, we do not feel this would be a fair comment today. Why? We have learnt from our mistakes, have greater confidence in our people and process and are more open to trying new things. Just as tastes evolve over time, so has our knowledge and understanding of portfolio construction, enabling us to better enjoy the flavour of risk.

Julia Warrander and Russell Waite

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