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The inflationary mirage

Author: Ajay Johal, Investment Manager, Ruffer

Published: 01 Feb 2023

The mirage is nature’s cruellest trick. The parched traveller, scanning the desert for signs of water, spies an oasis on the horizon and his heart leaps with hope. But, as he draws near, the oasis vanishes, leaving the traveller doubly desperate.

It may be a similar tale for investors in 2023. At some point this year, inflation is likely to drop significantly. This would of course be a welcome development, especially for charities, whose investment objectives are particularly threatened by inflationary environments. But beware mirages. Anyone who thinks that a dip in prices means we are back to the old regime of ‘permanently’ low inflation may be in for a nasty shock.

The previous regime, which lasted from the early 1980s, gave way to higher inflation as economies reopened after the pandemic – a process which is still under way, most notably in China. Savings accumulated during lockdowns chased goods which companies struggled to produce fast enough, given COVID-related labour shortages. The net result: higher prices, exacerbated by gas and oil supply pressures after Russia invaded Ukraine.

This initial inflation shock was triggered by one-off factors. But we see several reasons for thinking we have now entered a new era of higher but more volatile inflation.

Firstly, partial deglobalisation – marked by the new cold war between the US and China and accelerated by the Russian invasion of Ukraine – calls for more spending on many fronts. Both sides need to build more robust supply chains and secure access to key materials, from rare earth minerals to silicon chips.

Secondly, efforts to mitigate the current wave of inflation involve government spending on measures such as capping fuel costs. While these reduce prices in the near term, their long-term effect is inherently inflationary, especially given the rising costs of debt servicing.

Thirdly, climate change also entails higher prices. For example, not only do we need to develop and implement the technologies and infrastructure needed to make the transition to green energy, but companies also have to comply with regulation.

Lastly, one sure sign that inflation is becoming entrenched is steeply rising wages. For decades, the power in wage negotiations has been moving from employees to employers. That power is now starting to shift back. Workers are demanding higher wages – and, given labour shortages, they are getting them. In the private sector, employers must either bear the costs, meaning lower profits and hence share prices, or pass them on, meaning higher prices for consumers. In the public sector, it means yet more government spending.

In summary, many of the disinflationary forces which drove the decline in inflation from the 1980s to the 2020s now appear to be reversing, ushering in a new inflationary regime.

Investment implications

So what can be done to position charity portfolios? Last year showed how damaging a steep rise in inflation can be for investors, as almost all assets fell in tandem. More recently, many have bounced back. But markets now seem to be pricing in an unrealistically benign outcome for 2023, with growth holding up well and US interest rates starting to come back down. But rates are only likely to fall if inflation falls sharply and the economy slows dramatically, which would be bad for equities and other risky assets. If rates stay high longer than the market is expecting, that could lead to further market falls – or even a more damaging liquidity crisis.

The outlook seems especially challenging for illiquid assets such as property, private equity and private debt, where prices don’t yet reflect the current economic and financial reality. In the case of private assets, the picture is further clouded by debt which has accumulated since the global financial crisis. Last year’s leveraged LDI crisis impacting pension schemes shows just how nervous investors should be.

For bonds, the picture is more mixed. Bonds are likely to benefit if inflation fades, although our forecast of inflation volatility suggests it could be an uneasy ride in the medium term. But at least yields on US treasuries and UK gilts have now risen to levels where investors are getting paid to hold them. This is obviously good news for charities requiring income. And we still see a big role in portfolios for long-dated inflation-linked bonds, which stand to benefit if investors start to fear that inflation will rise once again in the medium term.

By the same token, cash is at last paying interest, even if real returns are still negative. But the main reason for holding cash is to preserve capital to put to work if a crisis forces holders of risky assets to divest at fire sale prices. This dynamic appeared briefly in the aftermath of former UK Chancellor Kwasi Kwarteng’s ill-fated mini-Budget, highlighting the importance of cash on hand to deploy, as opportunities may only appear for a few days before disappearing.

Overall, we think current conditions require an active approach which can preserve capital and then deploy it rapidly to take advantage of any emerging value in markets. And we would certainly place an emphasis on liquidity – vital if the inflationary oasis proves to be a mirage.

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 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 2023. 80 Victoria Street, London SW1E 5JL www.ruffer.co.uk

*The views expressed are the author’s and not ICAEW’s.
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