Adapting to a more volatile world

Political volatility is a signal of the collapse of one era and the birth of another. Out with Pax Americana’s disinflationary impulses, peace and relative stability – the so-called ‘rules-based’ order and economic ‘Great Moderation’. In its place has emerged a more shock-prone, volatile and inflation-prone system that we have called the New World Disorder. 

The speed of the global regime shift is now unavoidable. As the US security umbrella is folded away, regional security is breaking down. Russia’s invasion of Ukraine and the latest conflict in the Middle East are two recent examples, both of which have brought energy shocks and renewed inflation volatility. 

Iran has established greater de facto control over Gulf traffic. Add to this the democratisation of precision strike due to cheap drones and it’s clear other maritime chokepoints, through which the vast majority of our trade and commodities flow, are vulnerable too.

But global regime change is driven not just by the relative decline of American power, or the rise of China and some regional powers – but by other mega-trends too. 

These include the reversal of the Thatcher-Reagan small state revolution and the return of the activist state, equipped with interventionist fiscal and industrial policies. Add to these ongoing revolutions in energy, electrification, AI and demographic revolutions, all of which encourage further government intervention and a larger state role in the market

AI and robotics are already creating generational opportunities in both real and financial worlds. But great technological change always brings great social and political change. The result? More upheaval. And demands for fiscally stressed governments to moderate the disruption. 

Yet welfare states built during an era of higher growth and more favourable demography are already creaking under the accumulated commitments of post-War publics and popular demands for the socialisation of risks (think the credit crunch, Covid, energy price spikes). 

Outright default would cause a major crisis, so governments are trying to grow their way out by running economies hot. That means lots of fiscal spending and central banks which have broadly been prepared to look the other way when they overshoot inflation targets. That’s bad news for anyone with savings. 

And whilst deflationary pressures also abound – think debt and Chinese dumping of surpluses – the authorities in the West will respond with more stimulus to a system now wired to pass on inflation faster thanks to the experience of the Covid years. 

The chronic cost of living crisis and political Age of Rage mean that political volatility is a feature, not a bug of the new era. Yet another reason to expect more volatile inflation.

So, what does all this mean for investors? The good news is that this regime change is driving a huge range of new growth opportunities, from AI, electrification, infrastructure and clean tech to space, defence and robotics and much else besides. Lower rates could drive fresh credit cycles, unlocking faster growth, whilst US tech is unlikely to be the only game in town as it has been for 15 years.

But the regime change also brings major challenges for anyone building an all-weather portfolio. In the disinflationary decades pre-Covid, bonds provided a reliable offset to equities whilst also producing equity-like returns. It was an amazing ‘free lunch’, underpinning the strong returns and low volatility from a 60/40 stocks-to-bonds portfolio.

But in an era of more volatile inflation, the correlation between stocks and bonds is often positive when inflation is sticky or rising, meaning bonds cease to act as a portfolio offset and instead behave like equities. Suddenly the ‘60/40 is actually a ‘100’ portfolio, with everything moving in the same direction at the same time. Take 2022 as an example where bonds and stocks fell together. 

For those aiming to preserve and grow capital in all weathers, that’s a problem. Bonds have proved flaky friends in recent years. Whilst they present trading opportunities, we expect this flakiness to be the norm. 

For investors based in pounds or other traditional ‘risk’ currencies – ones which tend to rise and fall with global growth and markets – the US dollar has also been a great free lunch, typically rising versus sterling when the S&P 500 has fallen. But as for bonds, several times in recent years we have seen periods where the dollar has fallen with US equities and bonds, amplifying the pain for investors. 

Anyone looking to preserve capital and reduce volatility must therefore seek alternative offsets. For us at the Ruffer Investment Company, these include various commodities, both hard and soft, tactical use of currencies, cash and derivatives (financial contracts that can rise in value during periods of elevated market volatility, including when bonds are falling). The investment trust structure gives us maximum flexibility to use the full range of assets, including unconventional protections.

The world is changing faster than ever. Most portfolios have yet to catch up. That creates big risks, and bigger opportunities.

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