What if?

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Articles by Duncan

Duncan MacInnes

Fund Manager

21 July 2022

Daily we are confronted with a new reality – a world of inflation volatility. Conventional portfolios were unprepared for this new regime, and the sell-off in bond and equity markets has left investors wounded. It is an environment Ruffer portfolios were prepared for, and an environment we expect to endure. But what if we are wrong?

What follows is an exercise in imagination – what would have to happen for us to look back a year from now to discover the post-pandemic bull market had suffered only a blip and inflation, after all, was just transitory? How do we end up back in the old regime of low and stable growth and inflation?

Looking back from summer 2023

Markets hate uncertainty more than anything, and in hindsight, 2022 was peak uncertainty. There was the war on Ukraine, the return of rising inflation and interest rates, quantitative tightening, no confidence votes, covid and China lockdowns. Things felt like they would never return to an even keel, but as Abraham Lincoln (or was it King Solomon?) said, “this too shall pass” – and it did.

A short war

The most unforecastable (but most pivotal) variable was Ukraine. In the summer of 2022, Russia gained sufficient ascendency and territory to be in a strong bargaining position. Despite winning the hearts of onlookers in the West through remarkable feats of courage and determination, President Zelensky was pressured to the negotiating table by a cadre of European leaders besieged by the domestic realpolitik of energy costs and recession risks. The ‘Mad Man of Moscow’ took control of the territories he coveted. The war moved from acute to chronic. And the eyes of the world turned elsewhere. Crucially, commodities from the east resumed their uninterrupted flow into Europe. Sanctions on Russia continued, but the cost of Western multinationals staying out of Russia was minimal – a price well worth paying for geopolitical stability.

Hope restored

The market bottomed in midsummer 2022. The Nasdaq was 33% off its high. Cryptocurrencies ceded more than $2 trillion of value – the bitcoin bubble appeared to have burst. The 60/40 portfolio lost a fifth of its value. Bonds had their worst 12 months in 40 years. Some $18 trillion worth of negative yielding bonds vanished: a hiccup in the financial system, joining Dutch tulips in the chapter of anomalies in the annals of history. Sentiment plummeted to an all time low – there was, simply, nowhere to hide.

Few were brave enough to raise their heads above the parapet and buy stocks. But as the poem goes, if you could have kept your head when all around you were losing theirs… courage, it turned out, would be the rarest and most valuable currency.

From the jaws of defeat

Against all odds, the economy avoided recession. Jamie Dimon’s ‘economic hurricane’ was, in reality, more of a stiff breeze. Household balance sheets were strong coming into the year, buoyed by asset prices and accumulated lockdown savings. This proved to be sufficient firepower to sustain consumption through the cost of living squeeze. The oft forecast (seldom seen) house price crash never emerged because the labour market remained robust.

An answer was found for the question ‘Where have all the workers gone?’ So began a gradual return to the labour force for those who had exited stage left at the height of covid. As for the day traders who had SPAC’d their stonks into NFTs, early retirement turned out to be temporary. Before the crash of 2022, unemployment was at 50 year lows – it didn’t rise as there was just too much demand. The great post-covid re-opening had been delayed by virus variants and geopolitical tensions. Rather than the orgiastic explosion of hedonism once promised (another roaring 20s), what transpired was a gradual release of pent up demand sustained over 18 months. By the end of summer 2022, the pandemic was over. The airline and hospitality industries, brought to their knees by a series of compounding crises, finally found their feet again.

The inflationary beast, tamed

So determined were they to maintain credibility, central bankers convinced the market they were serious enough about raising rates that they ended up not having to. Policymakers may have taken the plaudits, but taming inflation was in large part due to the geopolitical premium coming out of commodity prices. The relentless secular disinflationary forces of debt, demographics and technology re-emerged, turning out to be only temporarily on the back burner.

We avoided a repeat of the 1970s – barring the return of flared jeans and tie dye t-shirts, of course.

Back to present day...

With inflation at 40 year highs, a fizzing jobs market and recession imminent – there are no good choices. Central bankers face an impossible tightrope walk.

A cost of living crisis now dominates the headlines and the public psyche. And central banks, supposedly immune from political pressures, find governments breathing down their necks. Their choice is stark. One option is to tighten conditions and risk an unemployment surge, thereby tipping the economy into recession and crushing asset markets. The alternative: fail to tighten enough and risk sending the economy into an inflation spiral.

The trouble with finding yourself on a tightrope is that it’s just as difficult to turn back as to keep going.

Boom or bust

Broadly speaking, there are four scenarios which could play out from here.

Our conviction is that the endgame will be in the top half of this (below) chart, inflationary boom or inflationary bust – most likely periods of both. However, as we are resolutely focused on the preservation of capital, we have significant hedges against the deflationary bust scenario.

Click to view larger image

The world we imagined above, looking back a year from now with the world’s crises resolved, would return us to the ‘deflationary boom’ in the bottom right quadrant. This is the old regime, the world of low and stable growth and inflation. It is the world imagined above, the threading of the needle, the scant tightrope.

It’s a scenario which would be least beneficial for Ruffer, but is a world many portfolios remain conditioned for.

But this view of the future seems a little rose tinted. It’s glass half full, and then some.

So when building a portfolio designed to protect capital, we find ourselves asking another question: what if we’re right?

What if?

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 document does not take account of any potential investor’s investment objectives, particular needs or financial situation. This document 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. More information: ruffer.co.uk/disclaimer

This financial promotion 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 2022. 80 Victoria Street, London SW1E 5JL ruffer.co.uk

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