Jonathan Ruffer's investment review
Inflation oscillates: it’s an idea when it’s not about, and a defining feature when it is. The only other word which comes to mind with similar status is ‘war’. Irrelevant or inexorable – the human mind finds it hard to make a judgement between the two extremes.
The old timers amongst us are now a treasured breed given our first hand memories of living through a time when money routinely lost value: in the UK, the 1970s were such a period. My salient memory is of becoming increasingly impatient to be bullish. In markets that were shot through, fair value was an aspiration, not a floor. It was also the start of a preference for the good company, rather than the great one – the latter stood out like small Tristan da Cunhas in the ocean of opportunity.
Inflation and deflation are generational in scale. Most commentary centres around what inflation will do in the short term – which gives, at best, uninteresting answers, and, more importantly, irrelevant answers.
The thought that central bankers can do much to change the broad sweep of inflation is, in my view, far-fetched. Lowering interest rates and keeping them down ensured that, in the aftermath of the 2008 crash, the world escaped a dislocative deflationary recession, and experienced instead a reprieve from deflation. Their actions, however, had an inevitable consequence: the onset of a virulent inflation. This was perfectly predictable at the time, and, indeed, we predicted it. There was, however, no money to be made from the insight that money had lost stability post-2008 – the car would swerve maybe towards deflation, maybe towards inflation, but the final result would certainly be inflationary, because the authorities’ obsession was (and is) to avoid deflation. The game changer was to be rightly prepared for inflation, and for the last ten years, we have been. To call it too early is, in our book, to call it on time.
We hold, as a core investment position, a strategic block of inflation-linked bonds, which because of their long duration are extraordinarily sensitive to changes in the valuation basis. Over the course of the last six months, as the news on the inflation front has darkened, these long-dated bonds have roughly halved in price. How can this possibly be?
Shortages and disruptions can cause prices to spike upwards, but they can quickly come back down again.
The first thing to say is that the portfolios have not been hit much by this development, since they were shielded by offsetting investments we held to protect against the rising yields which inevitably accompany inflation. That protection is not perfect: it is a play on conventional (non inflation-linked) bonds – but the key relationship has held steady so far. From here, there is no scope for complacency; the inflation-linked bonds will remain volatile, and our evolving set of offsetting investments may work less well. At the same time, we see conditions that look supportive for the linkers: high inflation, pushing higher, with yields on conventional bonds not keeping pace with inflation. Will policymakers around the world put up interest rates to the rate of inflation – or higher? In the end, they may do exactly this – but at the beginning, they manage expectations (including their own) that the disease will soon pass. The US Federal Reserve first started talking about transitory inflation, then sticky. Now they are talking high inflation to the end of the year, before it drops precipitately. The hope is the notoriously haphazard progress of inflation will surprise by falling in the next six months, transferring the power of the narrative from forest fire inflation to the measured wisdom of the Fed. Will they get away with it? Ultimately it won’t make any difference whether they do or don’t.
Readers will understand from this that our sense of certainty about inflation is based on its longevity, and, intermittently, its severity. To the extent that the UK long-dated inflation-linked bonds can be given a valuation basis, they currently lose money in real terms by about 1% a year until maturity, fifty years from now. To this investment generation, that looks like a simply terrible fifty year return. But consider a repeat of the 1970s. Back then, after-tax yields on conventional bonds lagged the inflation rate by double digits on occasion – that’s a lag of more than ten times the rate currently locked in to these linkers. These bonds could be a game changer if those 1970s-like conditions repeat themselves. In our opinion, they will.
Why do we think so? Six months ago, I wrote that the key dynamic in the inflation outlook was the prognosis posited in the ‘fire in the grate’ test. Paper, then kindling, then coal. In preparing the fire, due regard had to be given to the qualities of the three fuels. Paper burns easily and quickly – so the initial combustion needs to do its duty in ensuring the kindling wood, less combustible, but with a longer fire life, catches alight. In its turn, the kindling is there to ensure the coal, recalcitrant but long-burning, catches alight.
Shortages and disruptions can cause prices to spike upwards, but they can quickly come back down again – that’s the paper not doing its work in the grate. Longer-lived problems – say, a pandemic, or a war, or sanctions – can take longer to cure, but still give way to a new price stability. That, in the analogy, is the kindling not conveying the fire dynamic to the coal.
In real life, it is increasingly hard to see supply chain refashioning as quickly resolved. The market truths that have held for decades – that the paper will turn out to be damp, the kindling green… in essence, that the world is not inflationary – were true, but are true no longer. There’s still a battle as to whether Russia’s invasion of Ukraine has ‘made the world inflationary’ – absolutely not, in my book: the world is already inflationary, and the high price of fuel and other commodities are amplifiers. The move towards the coal catching fire is now largely behavioural. If people push to have higher wages, then we’ll have the real thing: a seemingly everlasting inflationary epoch. I was asked the other day at an investment dinner how long I thought the inflation would last. Thirty years was my off hand suggestion – that being slightly shorter than the period from the beginning of disinflation to the start of covid-19.
The character of inflation is that it promotes social mobility – it is the enemy of the status quo.
In coming to a clear answer that the behaviour will endorse the inflation, I look at the history books. Karl Marx produced the roadmap. He saw that the interests of labour and capital were conjoined, and over the course of time, events conspire to favour one over the other sequentially. When capital was planted in fertile soil, assets grew in value; wages did not. When labour, often unionised, became powerful, it gained at the expense of capital. When there was a shortage of labour, then demand for it gave it power.
The great period of US comparative growth of wealth over labour came to an end in the 1890s; there was nothing like it subsequently – until the period following the 2008 crash. In the past ten years, wages as a percentage of corporate expense dropped to unexpectedly low levels. A perfect storm hit labour: weak unions; heavy industrial players bankrupted or reduced to a shadow of their former selves; globalisation; and technology – they all went to an extreme. It is now nearly half a century since the high watermark of labour’s power. Unions, though less influential, are not to be discounted. But the real danger is the smaller cadre of the workforce itself. Western birth rates have been indulgently low for two generations – and in China the birth rate has dropped to 0.8%. The Chinese miracle had at its foundation 200 million people moving from the countryside to the cities – they do not have the children or grandchildren for that to repeat itself.
For the workforce, the present knowledge is that life and its finances don’t add up anymore. This is a current worry, not a bad memory of last season. What today’s workforce hasn’t yet learned is that their best way of guarding against this mischief is to demand higher wages – but in time that will come. When this happens, labour will want to be compensated for last year’s wages, and the coming one. Even if there is a strong backwash on actual prices, there will be companies who can no longer refrain from passing on higher costs to their customers, having refrained from it the year before. I see volatile inflation from here, but not so volatile as to allow the possibility that inflation is seen to be beaten. At this point in the inflation cycle, many hope that it will be beaten; as time passes, that will give way to a fear that it cannot be beaten.
The character of inflation is that it promotes social mobility – it is the enemy of the status quo. It can be stated to be the unequivocal enemy of investors, who will be the losers in this world, and the labour force will be the winners: in times of prosperity, that will be a large workforce, and in times of deep recession, a smaller one. But the statistics show that real wages go up always, and fastest, at a time of inflation – capital pays its due to labour. Indeed, that could be rephrased as capital pays back what it has taken from labour. Inflation is a distributor, from the investor, to new aristocracies. Who are they? The young, with energy, but no capital. The workforce, if employed. The innovator. After forty years of sharp decline, the snapback might well be brutal for the investment community. The victims of inflation are the unimaginative rich, and the unemployed poor.
Our job is to put risk into portfolios, and try (on a one year rolling basis) not to lose money. That ‘no loss of money’ emphatically is in nominal terms, not inflation-adjusted. We are currently faced, as all investors are, with every asset class under pressure, and cash on deposit still yielding next to nothing. It’s the hardest year in a long while to achieve what we set out to do. That’s just the way it is, and we’ll do our best.
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. 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. Read the full disclaimer.
