The death of inflation has been greatly exaggerated. Its return will first scare, then maim, then ruin the traditional balanced portfolios have that served investors well for a generation. Investors need to prepare for a world of greater inflation volatility. And with it a monumental risk—bonds and equities falling in tandem.
Investors’ great fear
A great fear stalks the land of asset management—the return of inflation. And, with it, the death of an investing paradigm: the dominance of a traditional balanced portfolio of 60% equities, 40% bonds. These 60:40 portfolios have been structured to provide a good level of long-term returns, but with a smooth ride; to date, they have been a successful construct.
Today, with bond yields now so low and inflation fears creeping in, investors are confronting the obvious concern. In short, are bonds still the low-risk, diversifying assets which their historical statistical characteristics suggest they are? And, if you’re feeling really jolly, you should re-examine the role of equities too. Shareholders are benefiting from receiving a historically-high proportion of stakeholders’ return. What’s more, that return to shareholders is being capitalised on very low interest rates. Both of these supports would probably be tested in an era of higher inflation. They will be further tested if, as seems likely, the political economy is tilted towards redistribution of wealth and income (resulting in lower margins).
As we saw in the 1970s, inflation is the beast that will eat your 60:40 portfolio and eviscerate your risk-parity portfolio too. Anyone running a traditional asset allocation for their clients should rightly fear it. Yet, inflation itself has felt such an unrealistic prospect because of the structural disinflationary forces that have surrounded us for the past 40 years.
In 2020, the Rubicon of macro policy regimes was definitively crossed. Governments are unlikely to be able to repeat their post-2008 efforts at austerity, particularly while the scarring effects of Covid remain evident in unemployment. ‘Balancing the books for the next generation’ is losing its traction to a combination of Modern Monetary Theory and ‘greening the economy for the next generation’.
Last August, the US Federal Reserve published its monetary policy review. The conclusion in not-so-many words: after a period of below-average inflation, we will let inflation overshoot to the upside, to ensure our employment mandate is met. Or, more simply: we will run the economy hot because we don’t think inflation is an issue, and we want to get back to full employment.
The Fed, and most other central banks in the developed economies, have come to fear deflation more than inflation. They are more confident in their inflation fighting capabilities than they are in their deflation-beating ones. They all fear Japan’s experience over recent decades.
Investors’ generic fear for portfolios today is that bond prices can’t rise much more and so they won’t be a good hedge in portfolios. This is overly simplistic.
First, it ignores the possibility of negative nominal interest rates, something we see as unlikely but not impossible. More important, it ignores the key question: what drives the bond-equity correlation, and what conditions will turn it positive again? Put simply: when will bonds stop providing an offset to equities in a portfolio?
60:40 losing balance
For 60:40 portfolios, the first of three phases will be fright. Inflation volatility rises. Bond prices no longer trend higher, but they do remain negatively correlated with equities. In this phase, bond prices are likely to fall as nominal growth and expected inflation rise (and vice versa). Equities are likely to do the reverse. So bonds remain an offset, but bond prices are probably beginning to trend downwards. The 60:40 portfolio has both dampened return and dampened volatility.
The second phase will be maiming. This moment comes when the bond-equity correlation switches back to being positive. The purpose of bonds in a portfolio is lost.
Phase three will be death. The deadly chomp arrives when inflation drives interest rates higher and this causes a de-rating of equities (investors are willing to pay less for the same level of future earnings). Bond and equity prices, being positively correlated, both trend lower together.
The negative correlation between bond prices and equity prices has been a key driver of the success of 60:40 portfolios. With bond prices rising as equities are falling, portfolios enjoy a smoother journey.
The dramatic events of 2020 have tipped us into a new, more-inflationary, regime. The demise of the 60:40 portfolio may not be imminent; the full drama may take years to play out. Rather than using the time to escape, I suspect most investors will just extend their stay in traditional balanced portfolios.
Perhaps we had a glimpse of the future in March 2020 when traditional portfolio diversification failed.
Inflation volatility, policy fragility
In the scenes immediately ahead of us, inflation volatility will rise in 2021 as economies reopen. Some of the inflation prints this year could be startling, elevated by the recovery and the low base for year-on-year comparisons. It is unlikely that high levels of inflation will be sustained. In the new macro policy regime, fiscal policy is the accelerator and monetary policy will (eventually) be the brake. So it is the fiscal impulse—positive or negative—that will be the primary driver of inflation and growth, while central banks (initially at least) will look through inflation overshooting their targets.
Having played second fiddle to monetary policy for the past 40 years, fiscal policymakers are out of practice. Hence, we can probably expect the sort of stop-go driving of an old Land Rover going off-road, where the driver is scared both of driving too fast and of stalling the vehicle in a muddy ditch. This is the bumpy journey towards a policy regime which looks more like Modern Monetary Theory or helicopter money—the explicit and enduring coordination of monetary and fiscal policy.
As inflation volatility rises, we will discover how inflation-prone economies are. This will be the first test of structural disinflationary forces clashing against more recent supply side shocks.
If the structural disinflationary forces still dominate, then inflation volatility will remain high while the underlying level of inflation will rise only slowly. In this scenario, it is currencies that become brittle—there is a higher likelihood of an eventual ‘jump to inflation’ via a run on the currency.
If, on the other hand, the economy is more inflation-prone than expected, we are more likely to see the underlying level of inflation rise steadily as inflation volatility persists. Here, the level of inflation rises through 2% inflation targets and keeps rising above 4%. This could also happen quite quickly, and currency weakness may well be a part of this story too, just not the abrupt weakness of a currency crisis.
Policymakers also have a prevailing confidence that inflation can be controlled if it does end up burning a little too brightly.
From this, a paradox emerges. Policymakers may observe an objective truth that the inflationary potential of the system is low at a given point in time. Yet the inflation volatility they encourage and tolerate—shaped by their confidence in that objective truth—may alter the subjective beliefs of the spectating public. Armed with partial truths and partial information, and powered by social media, the collective action of the public may reveal the greater truth about money and inflation: it is a confidence game.
What happens if enough of the crowd start to believe that sharp bursts of inflation (even if not sustained) are proof of the authorities’ efforts to undermine the value of their savings? It matters not whether this is actually the correct assessment. If the crowd takes a tech-enabled exit to other perceived stores of value, in that very instant the objective truth will have changed.
It is our job at Ruffer to create portfolios for clients that are resilient to the different pathways to the inflationary endgame but that don’t rely on precision timing.
Our approach thrived in the drama of 2020. We are prepared for the sequels, and to dodge the hazards that lay ahead for 60:40 portfolios.
The unabridged version of this article was originally published in the Ruffer Review 2021.
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