A BIT MORE EEYORE? A PESSIMIST’S GUIDE TO OPTIMISM IN FINANCIAL MARKETS

By Ajay Johal, investment manager at Ruffer.

“All that is, is for the best. If there is a volcano at Lisbon it cannot be elsewhere. It is impossible that things should be other than they are; for everything is right.”

So said Dr Pangloss, the tutor of Candide, the eponymous protagonist of Voltaire’s 1759 novel. Throughout the book, Pangloss constructs elaborate but patently fawed arguments to justify his optimistic philosophy. In this case, he is attempting to fnd the silver lining in the Lisbon earthquake, one of the most devastating natural catastrophes of the 18th century. Because there was chaos in one place, there would be order in another.

Investing in the stock market requires an underlying optimism, a faith – which we share – that companies will grow, be more proftable and deliver a return to shareholders.

After a dismal 2022 for almost all assets, investors are casting around for reasons to be cheerful. And there have recently been some positive signs, notably evidence that infation may be peaking and hopes that US interest rates will too. But is this optimism justifed? Indeed, could a base level of optimism prove dangerous for charities and their portfolios amidst the challenges of this new market regime?

To understand investors’ new-found bullishness, we must revisit the annus horribilis that was 2022.

Apart from the US dollar, there was nowhere to hide. The volcano was not just in Lisbon, as Pangloss might have observed; eruptions were everywhere. It was a particularly terrible 12 months for acronyms – FTX, SBF, LDI, NFTs, UK PM, ARKK and HODL all had notably bad years.

Another shorthand, the 60:40, had its worst year in almost a century –falling 18%.

As the ‘everything bubble’ burst, diversifcation died, with stocks and bonds falling together for three consecutive quarters. Stocks, bonds, property, private equity and venture capital were all revealed as one large trade based on low interest rates and easy money.

So why have markets rallied so far in 2023?

Like Pangloss, investors now appear to be relying on faulty logic. In our view, markets believe several contradictory things at once. They want to have the cake of stronger growth, while also eating the cake of interest rate cuts later this year.

Crucially, as this chart shows, investors don’t believe what the Federal Reserve (Fed) keeps telling them: that rates will stay high to combat infation. We think the chart represents the defning question for 2023. Who will be right – the Fed or markets? It can’t be both. Fed chair Jerome Powell and his colleagues are desperate to restore some of the credibility lost when infation turned out not to be transitory in 2022. They have repeatedly emphasised the need to avoid the mistakes of the 1970s and not loosen policy too quickly. So, if a recession is avoided, how quickly can the Fed realistically reverse course?

Stock markets are now assuming an almost impossible trinity of events: better growth and no recession; rapidly falling infation; and interest rate cuts by the end of the year. But you can’t have further corporate earnings strength and infation coming back down to 2%. You can’t have a boom from China reopening and low energy prices. And, most obviously, you can’t have an economic soft landing and a big Fed pivot to looser policy.

Can it? Investors are geed up by infation appearing to have peaked. But the major risks to asset markets haven’t magically vanished, and we think underestimating infation volatility poses the greatest risk to charity portfolios.

For 40 years the world enjoyed an economic order where globalisation brought us cheap goods, cheap energy, cheap labour and cheap capital. Cheap goods from China’s mercantilist policies. Cheap energy from OPEC and Russia. Cheap labour as globalisation brought two billion people into the global workforce and held down developed world wages. Combined, these three forces kept infation low and geopolitics stable. That meant interest rates and risk premiums could also be low, resulting in cheap capital. For multi-national corporations and for asset prices, this provided a steady tailwind which came to be taken for granted.

In the last decade, infation not only averaged around its 2% target but also stayed in a remarkably narrow range. For the coming decade, however, we expect infation to average 3% or 4% and to be much more volatile. We won’t just have an infation problem; crucially, we will have an infation uncertainty problem.

Why do we believe infation will be so volatile? There is a new world order marked by great powers in geostrategic competition and the primacy of stakeholders over shareholders. The US is engaged in three wars simultaneously: a cold war against China; a hot war against Russia; and an energy war against OPEC.

This splintering backdrop is what we think gives birth to the age of infation volatility. The diagram below shows the journey we are on. The ultimate destination is higher infation.

And last year showed how challenging high infation can be for assets. As higher interest rates shocked assets into a move lower, no one investment allocation suffced. Success followed from a series of short-term positions, regularly reversed.

Unfortunately, a regime of infation volatility is even harder to navigate. Crucially, the old ways may no longer be the best.

It would be tempting to simply invest for the infationary endgame. But infation volatility could be with us for some time. And, when infation is on a downswing, a portfolio positioned solely for infation risks major malfunctions.

To survive the turbulence of infation volatility, investors will need a hedged portfolio. And not just any hedge – a topiary. Portfolios will need to be intricately constructed – active, for sure, as no static portfolio will survive. These hedges will be crucial to protect portfolios but are likely to be expensive.

In addition, a portfolio positioned for resilience, rather than optimisation, will sometimes need to have a weighty cash balance. Cash is an uncomfortable asset to hold in an infationary world, but we see it as essential to pick off opportunities as they emerge amidst the volatility.

Most investors build portfolios based on what they think will go right. This is a perfectly valid investment approach – and, for the past few decades, has been a successful one.

But Ruffer’s approach is the obverse. Our portfolio is constructed frst and foremost to defend against the risks we see and thus aims to preserve capital.

When bad things happen in markets, the succour for investors is the hope that things will get better. That is the default of human intuition. Even that perennial pessimist, Winnie the Pooh’s pal Eeyore, was occasionally unable to resist its lure: “The nicest thing about the rain is that it always stops. Eventually.”

In an era of infation volatility, the danger is that things can seem to be getting better – but don’t. The rain may appear to pause. But investors who put away their umbrellas do so at their peril.

The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or fnancial 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 specifc 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 fnancial situation. This article refects 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.

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