Source: Bloomberg
“When inflation appeared, it was deemed transitory. When it persisted, there was a pause of disbelief. Then everyone lost their nerve.”
JACK BE NIMBLE, JACK BE QUICK
In 2022, the passive strategies which worked for so long failed, and investors were forced to flick the switch off autopilot.
Long-only investors had few places to hide. Cash, preferably non-sterling, was one, but it was subject to the decay of interest rates lower than inflation. Otherwise, you had to concentrate in specific equity sectors like energy or in individual commodities, which is highly risky.
You needed the ability to shift asset allocation nimbly and to hedge aggressively at the right moments. To illustrate the point, 2022 was the first year in Ruffer’s history when our options protection made the biggest positive contribution to the portfolio’s annual performance.
But let’s look at something that didn’t go so well: our core portfolio asset.
JACK FLASH SAT ON A CANDLESTICK
We have held UK long-dated index-linked bonds for many years. Our thesis: financial repression will be a key feature of the emerging regime, and the most powerful tool of financial repression is a negative real interest rate (ie below the rate of inflation).
But the market never allows you to hold the assets you need to survive financial crises without extreme discomfort. We were braced for volatility as the linkers transitioned from trading as long duration government bonds in the old environment to trading as real assets in this more inflationary regime.
Even so, the price action was breathtaking (Figure 4).
‘CAUSE FIRE IS THE DEVIL’S ONLY FRIEND
Perhaps, fire and leverage. Markets have a knack of exposing over-leveraged positions. That’s what happened in the UK.
Former Prime Minister Liz Truss and Chancellor Kwasi Kwarteng will carry the can in the history books. However, the UK gilt market would not have dislocated so spectacularly in September but for leveraged LDI strategies. We had analysed the risk from the strategies, but we had not realised the extent of smaller pension funds’ outsourcing of derivative exposures to Irish funds with far greater leverage than would have been employed if the pension funds had done the hedging directly within the fund.1 When bond prices plummeted, the pension funds were asked to post more collateral, but they were unable to sell assets quickly enough to meet these demands. Hence, the third party funds were forced to deleverage abruptly, creating a vicious circle.
EIGHT MILES HIGH AND FALLING FAST
Ironically, just as the UK Retail Price Index showed inflation above 12%, with interest rates stuck at 2.5%, the asset specifically designed to protect against negative rates fell more than Bitcoin.
Thankfully, our hedges on interest rates, equities and credit offset the losses from the index linkers. This allowed us to trade the extreme volatility in the bonds. The end result: over the year, the interest hedges we held more than offset the loss on our linker holdings.
FOR TEN YEARS WE’VE BEEN ON OUR OWN
Until 2021, our view that the West would end up with an inflation problem was considered eccentric. It was ‘obvious’ that the forces of secular stagnation were too powerful.2 So, when inflation appeared, it was deemed transitory. When it persisted, there was a pause of disbelief. Then everyone lost their nerve. Now, the idea of a more sustained problem, even if inflation falls this year, has become consensus.
However, the paradox of our view is that it will be the instability of both inflation and policymakers’ views of it which will lead to higher average levels of inflation in the years ahead. The inevitability of inflation is likely to stem from inflation volatility.
1 Small pension funds which didn’t have the derivative counterparty paperwork in place got their leveraged bond exposure through funds which were leveraged 3-5x 2 The forces of secular stagnation: debt, demographics, peace dividend and disruption/technology