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A golden ticket?

Mr Market believes inflation has been conquered and recession avoided – but what if we’ve entered a new regime?
Jasmine Yeo
Fund Manager

The market is showing increasing signs of investor certainty. Inflation is being crushed and, once at target, will stay there over the years ahead – that’s the message from the bond market and breakevens. Recession has been avoided, and corporate earnings will continue to grow – that’s the message from the equity market and risk premiums. 

Just look at the Bank of America survey which shows, even after accounting for the inflation bulls, more than 80% (net) of fund managers expect lower global inflation in 2024 and nine out of ten fund managers think short-term interest rates will be lower by year end – levels of conviction matched only in the global financial crisis. A remarkably one-sided consensus. 

But what if they’re wrong?

This month’s chart looks at the relationship between bonds and equities in the US going back to 1802. When the green line is below zero, as it was for the two decades to 2022, bonds and equities are negatively correlated – they move in the opposite direction and therefore work as offsetting assets within a portfolio. Above zero, it tells us the two asset classes are positively correlated. As is clear, bonds and equities have generally moved in the same direction, and the period between 2001 and 2022 (spanning the majority of the careers of most working in the industry today) has been anomalous in its consistency. A key driving force of this anomaly? The absence of inflation. 

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Our view is that we have entered a new regime of inflation volatility, with periods of high inflation (like 2021-2022) followed by aggressive disinflation (as was the case in 2023). That’s important because it doesn’t just change which assets perform best, it also changes the way the assets in a portfolio relate to one another – as illustrated by the chart. If inflation is a more persistent risk, and one to which the market currently ascribes a near zero probability, then it changes the way assets should be priced and portfolios need to be constructed.

In 2022, investors lulled by the illusion of diversification suffered as stocks and bonds became positively correlated to the downside and many alternative assets revealed themselves as duration in disguise. Whilst 2023 reversed these losses, bonds and equities continued to move in the same direction – just up, not down. At the start of 2024, we appear to be back in an environment where the major asset classes are falling together. 

What if the risk rally of 2023 has given investors a golden ticket – an opportunity to rebalance and re-orient their portfolios for a future they are ill-prepared for, and to do so at 2021 prices? This is a second bite of the cherry most would have given anything for in October 2022.

The catch: it is nearly impossible to distinguish between a ‘normalisation’ back to a world of low, stable inflation and a disinflationary leg within a regime of inflation volatility. So we would argue investors should have exposure to both. At Ruffer, we are taking the other side of the perceived market certainty that inflation has been conquered. In doing so, we offer investors exposure to a genuine, uncorrelated alternative to both conventional and less conventional asset classes.

A paper tiger after all?
December 2023: Chairman of the Federal Reserve Jerome Powell is seeking to emulate his predecessor Paul Volcker in bringing runaway inflation back under control. So far, markets have cheered his progress. Volcker was able to tighten policy - and keep it tight – because the politics of the day allowed for it. But as Economist Jamie Dannhauser points out, this Fed may not have those same favourable political winds in its sails. The real challenge for the Federal Reserve, may still be to come.
Read
So you want stock TIPS?
November 2023: After a bond market rout commensurate with the steepest and fastest rate hiking cycle in a generation, is there now a case for adding fixed income into portfolios? Perhaps - there might even be two. In this month’s green line, Fund Manager Duncan MacInnes looks at the cyclical and structural cases for inflation-linked bonds.
Read

Sources: Refinitiv, Global Financial Data, Ruffer, data to October 2023

The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument, including interests in any of Ruffer’s funds. The information contained in the article is fact based and does not constitute investment research, investment advice or a personal recommendation, and should not be used as the basis for any investment decision. References to specific securities are included for the purposes of illustration only and should not be construed as a recommendation to buy or sell these securities. This article does not take account of any potential investor’s investment objectives, particular needs or financial situation. This article reflects Ruffer’s opinions at the date of publication only, the opinions are subject to change without notice and Ruffer shall bear no responsibility for the opinions offered. This financial promotion is issued by Ruffer LLP which is authorised and regulated by the Financial Conduct Authority in the UK and is registered as an investment adviser with the US Securities and Exchange Commission (SEC). Registration with the SEC does not imply a certain level of skill or training. © Ruffer LLP 2024. Registered in England with partnership No OC305288. 80 Victoria Street, London SW1E 5JL. For US institutional investors: securities offered through Ruffer LLC, Member FINRA. Ruffer LLC is doing business as Ruffer North America LLC in New York. Read the full disclaimer.

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