Ruffer LLP Q4 2022 Investment Review
Fifty years ago, inflation was the household word to describe the difficult times we lived in. Nobody knew what it meant; everybody knew what it was.
When the country went decimal in February 1971, a letter from a girl named Ambrosiana was published in The Times. It read: “I am seven. When I am old, will the money still be called new pence?”. Shortly afterwards, another letter appeared. “I am seventy-seven. When Ambrosiana is my age, it will be called nuppence”. In my own life, the value of money, measured in sterling, has dropped by around 96%.
In an inflation, prices go up – it is not best understood as a currency diseased since there is no simple pathology to explain its decrepitude. It is shorthand for a world where one of the ol’ reliables, the cost of stuff, becomes unreliable. I believe its seeds were sown in the aftermath of the great financial crash of 2008; in the first Investment Review which followed it (January 2009), I wrote, “…the shape of the struggle to come has become clearer. In essence, it is a battle as to the future value of money – are we facing a deflation, exemplified by the Great Depression of the 1930s, or an inflation, as governments and central banks man the printing presses to combat this deflation?”
The answer, of course, was sequential – first the deflation, then the inflation. I reached for the analogy – the car on the clifftop road runs over an oil slick. The previous stability becomes instability; in that moment, it is anyone’s guess whether the car lurches left or right. But the totemic and constant fear has been the possibility of deflation: the driver will correct – and, inevitably, overcorrect – by turning the steering wheel in the inflationary direction. The exchange of monetary stability for instability was as clear as Claribel; the ultimate ‘victory’ of inflation equally so. For setting the compass, this showed the whereabouts of true north.
If something happens which you are expecting, it helps you to see what is coming next. A cold realisation that inflation’s onset is finally upon us is an easier place from which to make decisions than dumb astonishment. Where there’s shock at the change of impetus, some things that are obvious will be missed; other features, of only momentary note, will appear transformational.
The reason for much wrong-headedness is that stark problems feel as though they can be solved with stark answers. My own judgement is that there have been three different root causes of inflation over the centuries – and there is perhaps also a fourth, a variant of two of the others.
The first of those is the balance between supply and demand. When people are poorer, there’s less demand for steaks, bungalows, and new Ford Fiestas, so there’s an assumption that recessions cause, at the very least, an abatement of inflation (and possibly, if untethered, a deflation). This truth puts the ‘central’ into the central banker. Demand is not a bad test, but it didn’t work in the 1970s, when recession and inflation combined to spawn a Scrabble special: stagflation.
The second root cause is the amount of money around. This was irrelevant in nineteenth century Britain, when much economic theory was created since gold was settled in quantity, and gold acted as money in the international financial system. All the paper-based securities had to be convertible back – and back on due date – into gold. In those days, a series of interlocking financial agents responded to changes in interest rate levels, set by the Bank of England, and, lo and behold, for some decades the system could control the amount of money around, thereby controlling the volume of business, which, by extension, allowed supply and demand to dictate the price level. It is today a lot more complicated than that, and even the monetarists are routinely at a loss to demonstrate whether or not money is being created at dangerous velocity. The fact that money’s growth cannot easily be measured, however, does not compromise an underlying truth: its power creates higher prices when it is growing more quickly than productivity allows.
The third is the bargaining power of labour, in the never-ending encounter between workers and investors. This is a marathon, one that has ebbed and flowed between the two contestants for the greater share of prosperity. Crucially, it swings between extremes – each has its period in the sun, then the shade. Over the past forty years, we have completed a cycle of dominance by the investing dynamic. And the pendulum is now swinging back, to the workers’ advantage. It will keep swinging back, if history is any guide, for a generation or so.
If that happens, the complaisant assumption that inflation will go back to sleep again might look justified – but it will be a false dawn.
The pattern is always the same – when inflation comes, to begin with, wages lag the value of money. Then real wages are forged in the anvil of inflation. Real wages do well – historically – in inflationary times. Here is a description, written in 1928, of events at the end of the First World War. “The steady falling away of the dollar exchange rate [after 1918] is important as a measure of the degree of inflation [with its] vast growth of banking credit in London, and the consequent growth of paper currency. The inflation gave rise to a quite unhealthy trade boom of a purely artificial character. The upward trend of wages, as always during a time of inflation, lagged behind the cost of living, and strikes became frequent and menacing, as in the case of the railway strike of 1921”.
The fourth root cause of inflation – the variant often forgotten by countries with a stable economy – is that it is the reciprocal of the value of a currency. In a death spiral, inflation and currency lock arms; markets can destroy what they already judge to be valueless. These things usually remain theoretical in advanced economies. But in the UK last autumn we saw a brief, clumsy, and painful attempt at something unorthodox – the eager beavers of the Conservative party trying to spend a lot of money they would need to borrow – and a market snarl followed. Perhaps the rarity of this fourth root cause owes more to general prudence on the part of the authorities, rather than somnolence in the markets.
These are the pieces on the chessboard; how does the game play out? The most telling factor is wages – they will keep going up, as the generational pendulum swings in workers’ favour. This forms part of a broader political economy – it’s now labelled a ‘cost of living crisis’ more than an ‘inflation problem’. The pendulum swinging means the rich, rather than the poor, will be bearing more of the cost of higher inflation. And orthodox fiscal policy may turn out to be another of those ol’ reliables that becomes unreliable.
The next most important factor is supply and demand, with the demise of ‘just in time’ and the international supply chain. A balkanisation of production is underway, favouring supply which is more firmly rooted. More reliable supply is almost always more expensive.
Last year, supply disruption, the Ukraine war, and uncertainties over the political impasse with China caused prices of goods and commodities to surge. Some of the most extreme moves in prices are now falling back, sometimes almost back to where they started; in other sectors, second-order events are causing prices to continue to rise. On balance, this is likely to cause a fall in the rate of inflation in the short-to-medium term – think inflation volatility, rather than inflation on a permanently high plateau.
It is perfectly possible that, year-on-year, some inflationary measures fall back through zero, and prices actually deflate in an odd month. If that happens, the complaisant assumption that inflation will go back to sleep again might look justified – but it will be a false dawn. The chorus of central bank optimism may be reassuring, and yet one is reminded of Mandy Rice-Davies, starlet of the Profumo scandal, remarking on a suspect who denied all wrongdoing, “Well he would say that, wouldn’t he?”
The markets of late have been treacherous, often appearing calm, but subject to powerful contraflows. I was once told not to go swimming off the coast south of Cape Town, as it was the meeting place of the waters of two oceans. In 2022, the elemental bullishness of 40 years of ‘up’, met the ‘down’ of a series of fundamentals, partly in economic conditions, but mostly in a revised valuation regime, reflecting the initial shock caused by the move to a world of higher interest rates. No one investment allocation has sufficed. Success has followed from a series of short-term positions, regularly reversed. This is a hard way to run money in the long term, but the restlessness has been necessary to keep long-term money safe in the short term. Looking ahead, investment fundamentals and valuation now matter a lot more than they did a year ago, and we expect to see a greater divergence in returns across assets, regions, and currencies. While we don’t like the look of the ocean whose water we expect to prevail, our job as fund managers is to swim, not to sit it out on the beach.
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