Where we are heading was the focus of my article in last year’s Ruffer Review. Its central premise was that the demise of the existing strong growth/low inflation regime started long before the pandemic. The events of the past two years are best viewed as accelerants of malign shifts in the global economy’s structural underpinnings. The pandemic matters not because it changes where we might end up (or why) but because it provides clarity on when we might arrive.
But left unsaid was what the journey might look like. Constructing a portfolio solely with the destination in mind without an eye on the potholes in the road is foolhardy. Somewhat counter- intuitively, the journey is more uncertain than the destination. The core argument is, paradoxically, that the return of inflation risk might first lead us into a deflationary ditch – a painful outcome for any portfolio positioned solely for an inflationary future.
The logic is as follows: moderate inflation and depressed nominal risk-free interest rates are perceived as permanent features of the economic landscape and have become hardwired into investor behaviour.2 Allocations to risky and illiquid assets have responded accordingly, driven higher by the combination of low volatility and non-existent returns on ‘safe’ assets. This shift in portfolio structure has accelerated dramatically as nominal risk-free interest rates have fallen to zero.3
If, or more likely when, central banks start to respond to persistent inflation by pushing short-term interest rates closer to historic norms, the reversal of these flows into illiquid corners of the market will occur in a non-linear and disruptive fashion. The withdrawal of policy stimulus is likely to include an end to large scale asset purchases (and later active balance sheet shrinkage), the closure of emergency liquidity facilities and explicit guidance about a higher (conditional) path for policy interest rates.
This will expose the illusory and ephemeral nature of liquidity in the post- 2008 financial ecosystem, what our CIO Henry Maxey has dubbed its ‘avalanche prone nature’. If it is right that flows, rather than fundamentals, anchor asset prices in our financial system sanitised by quantitative easing (QE), the drawdown in risky assets could be dramatic.
A global financial crisis and pandemic-induced economic heart attack later, this regime is in its dying days.