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What tightening? You’ve never had it so easy

Financial conditions have never been so accommodative 
Duncan_Macinnes
Duncan MacInnes
Investment Director
Omicron or not, the US economy is booming. The cocktail of pent-up animal spirits, household net worth at all-time highs plus hefty measures of monetary and fiscal stimulus is a potent one.

The Atlanta Federal Reserve ‘NowCast’ has US Q4 real GDP at 7%; add 6% CPI inflation and you get a 13% nominal growth rate.1 The growth picture is similar in Europe and the UK. One would have to go back 50 years to find a similar surge. 

The fly in the ointment is inflation– from energy and housing to wages, raw materials, and food. In a nutshell, too much money is chasing too few goods. 

With this backdrop, does the US really need the easiest financial conditions on record? As former Federal Reserve Chair McChesney Martin once said: “the job of the Fed is to take away the punch bowl just as the party is warming up”.2

It’s time to poop the party. 

This month’s chart shows the Goldman Sachs Financial Conditions Index, a composite including interest rates, equity valuations, borrowing costs and currency data to assess how ‘easy’ or ‘tight’ financial conditions are. This offers a broader gauge than the blunt tool of interest rates. The message is clear: the current concoction is almost all vodka, with just a dash of fruit juice. 

This matters because asset prices have been driven higher on a sea of abundant liquidity and stimulus. For the first time in at least a decade, central bankers are beginning to acknowledge they are behind the curve. The political pressure to ‘do something’ is rising. 

In 2022, it seems likely interest rates and bond yields will rise, quantitative easing will melt away and there will be less of a fiscal stimulus impulse. 

We must be clear on the broader context here: policy makers are still extraordinarily supportive of the economy. In reality, tapering amounts to less easing rather than meaningful tightening; interest rates will remain negative in real terms and near multi-century lows. But prices are set at the margin – markets respond as much to flows as they do to the stock – and financial conditions will tighten. 

In a highly financialised world policymakers face a conundrum: to tame inflation and moderate growth they must reverse the very conditions that have been so beneficial for stock markets. We are bullish on economic prospects coming into the new year. But the irony is that the stronger the economy, the more vulnerable capital markets look. What the real economy needs, financial markets can’t handle.

So how to position portfolios? Avoid the obvious beneficiaries of easy money and liquidity – profitless ‘unicorn’ technology and the Jenga tower of corporate debt. Seek out assets which benefit from strong economic activity and recovery – energy stocks for example. Own the beneficiaries of those rising interest rates: UK and European banks alongside interest rate options which hedge your portfolio duration. This is how we are positioned. 

One notion of successful investing is to have the world come to agree with you… but later. What excites us is the valuation gulf between these assets suggests most market participants don’t agree with us.

 

 
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January 2022: Investment Director Matt Smith looks ahead to what investors can expect in 2022. We briefly review the investments which worked well in Ruffer portfolios last year (and those that didn’t) and assess the opportunities and challenges arising from the return of economic, market and inflation volatility.
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2021 Q4 Investment Review
January 2022: In his latest Investment Review, Jonathan Ruffer warns of the tide coming in for inflation, “brought about in a series of waves of increasing severity”. It is important to remember what happens on the shoreline as the tide comes in – hour on hour it advances along the coastline, but there are moments, between the waves, when the sea appears to retreat. So it will be with inflation: not a straight line, but plenty of volatility headed our way.
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A Ruffer Christmas Scrooge?
December 2021: At Ruffer we’re used to being accused of seeing the glass ‘half empty’ rather than ‘half full’. It’s not that we’re inherently pessimistic, but our job is to protect our investors’ capital against whatever might go wrong in markets. So naturally we tend to focus more on the risks than the opportunities. Or as Jonathan Ruffer might put it – to see the mousetrap clearer than the cheese.
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  1. Federal Reserve Bank of Atlanta

  2. Federal Reserve Bank of St Louis

Chart source: Goldman Sachs, data to 30 November 2021

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London
80 Victoria Street
London SW1E 5JL
Edinburgh
31 Charlotte Square
Edinburgh EH2 4ET
Paris
103 boulevard Haussmann
75008 Paris, France