"Playing Chess with Mr Spock"

Anybody willing to spend, say, an hour or so sitting on the wall outside our house watching me try and park the car will understand that some of us are not blessed with much in the way of spatial appreciation. Fortunately, there are people who do, or believe they do, and as such would probably enjoy the idea of playing 3-dimensional chess with Mr. Spock on the Starship Enterprise.

Unfortunately, economic or strategic thought comes in many dimensions and seeing your way through multi-variable ideas that are constantly interacting with each is apt to give the average person a more than average migraine. Yet, if you read enough market and economic commentary, you get the feeling that there are lots of people who think we live in a Heath Robinson world of levers and pullies, seesaws and weights that interact in a nice series of events to create an outcome. Nothing could be further from the truth.

For instance, many economists start from equations like this:

Where M = money supply, V is the velocity of money, P is prices and Q is the quantity of output (GDP). Looks simple, doesn't it? Wrong. For instance one of the rearrangements of the equation is:

From this many people conclude that if money supply is high (M is a big number) then prices (P, which equivalent to inflation) automatically rise. You see in your head nice straight lines of thinking, lots of seesaws going up and down in the mind. But as we are shown at conferences with seemingly endless charts, the reality of our world is that just about everything comes in waves. So over time (yet another dimension - is your head hurting yet?) all of these variables could look something like the first illustration. Notice here just to add an extra level of realism these waves move independently in time meaning that the peaks and troughs of the waves aren't synchronised.

If you start to play around with the interaction of these waves it doesn't take long for you to find things that would under normal circumstances start to confound your logic, Captain.

For instance, we set up the waves so that they represented deflation, normal growth and low money velocity (which is normal when you have deflation). Guess what happened to money supply? Take a look at the second graph (second chart) - it exploded or at least rises quickly.

If we were just using our normal logic, like in equation 1, high levels of money supply growth would automatically be inflationary. How wrong we can be - the interaction of waves, beating at different times gives unusual results.

Just to hammer home the point, here is another situation - high money supply growth, stable prices and low velocity of money. This time growth (Q) goes through lots and lots of mini-cycles (see third chart).

Obviously, these cases have been chosen for a reason. They sort of illustrate some of the situations that we are in today. It is possible, for instance to have high levels of money supply growth (like we have right now in the West) without having to automatically conjure into existence some kind of Victorian villain (in the guise of inflation) that lurks around the corner. Similarly, in another high money supply situation which is eerily like today, other conditions being as they are, we should expect economies to experience unstable fluctuations and display a kind of on-again off-again growth character that sends investors running to the hills or wandering the corridors of their office buildings with exaggerated confidence depending, pretty much, on which quarter it is.

You can send yourself quite mad playing around with all of the possible combinations of waves and circumstances and, in the end, begin to neglect your family somewhat. But the point is, while we sit within the current regime, barring an external shock, we should be looking for the less obvious outcomes from the current circumstances. In that sense we should, among other things, expect to manage the duration elements of portfolios in a dynamic manner with the ebb and flow of the data until something quite obviously serious manifests itself and we are ready to send bond yields, on balance, lower.