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Cash good, bonds mixed, stocks and property down: Ruffer’s guide to volatile inflation

22 February 2023

Ajay Johal explains how investors should use their cash during periods of turbulent price rises.

By Jonathan Jones,

Editor, Trustnet

Lower inflation could be a mirage for investors, who should prepare for higher prices for longer than is currently priced in, according to Ruffer investment manager Ajay Johal.

While the rate of price increases is expected to come down this year – and indeed has already started – a return to the former regime of perma-low interest rates is unlikely.

From the 1980s through to the Covid pandemic, inflation was stamped down but, post-pandemic, prices have rocketed as the world has reopened – a process that is still taking place in some countries, most notably 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,” said Johal.

“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.”

In this new era, there will be more volatility, as evidenced last year when 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,” Jahol said.

Indeed, he argued rates are only likely to fall if inflation comes down dramatically at the same time that the economy grinds to a halt. In this scenario, equities and other risk assets would struggle. However, if rates stay high longer than the market is expecting, that could also lead to further market falls.

He said the outlook for illiquid assets such as property and private equity is “particularly challenging” as prices are yet to reflect the current “economic reality”.

For bonds, the picture is more mixed as fixed income assets are likely to benefit if inflation fades, although expected future volatility means that it could be a bumpy 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,” he said.

This should be good news for investors requiring income, said Johal, who suggested that long-dated inflation-linked bonds have a role to play in portfolios as they could benefit if investors start to fear inflation will rise again.

“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 was the case in the aftermath of former UK chancellor Kwasi Kwarteng’s mini-Budget last year and the investment manager noted that this was the best way to invest – focusing on capital preservation and deploying cash when opportunity arises.

Jahol’s forecast that inflation will remain volatile and will be more unpredictable than currently believed is based on four main factors.

“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,” he said.

“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.”

The third is climate change, which will necessitate higher prices as new technologies and infrastructure are costly to develop, while the final factor is wages, where the power should shift from the employer to employees.

“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,” he said.

 

 

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