A golden ticket?

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Articles by Jasmine

Jasmine Yeo

Fund Manager

18 January 2024

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.

#inflation

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