Capitalism, Democracy and How To Outsmart the Market

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• While most investors focus on maximizing returns, Matt Smith, Investment Director at Ruffer LLP, has a different objective: AVOID losing money
• As interest rates rise to battle inflation, capitalism and democracy are in tension. Matt explains the impact on market volatility and where it creates opportunity for long-term investments.
• The COVID pandemic was like a war, and historical parallels in the period following WWII shed light on the current global macro market trajectory toward a higher inflation baseline.

For many investors, risk management involves benchmarking a diversified portfolio to decrease liabilities. Another strategy, however, is to be deliberately unconstrained, making whatever moves are necessary to hedge against risks and guarantee a return.

This is the philosophy of Ruffer’s Absolute Return Fund — consistent gains on client capital, no matter how volatile the markets become. The UK-based company has 24 billion pounds ($29 billion) in assets under management and aims for positive returns in any rolling twelve-month period.

“We’re quite unusual in that our primary investment objective is to avoid losing money,” says Ruffer LLP Investment Director Matt Smith. It sounds obvious — and maybe even unappealing to a risk-tolerant growth investor — but Ruffer’s defensive strategy has posted gains every year since its inception in 1994.

That includes the dot-com bubble, the global financial crisis of 2008, the COVID pandemic and the bear equity market of 2022. As global markets battle slow growth and central bank rate hikes, Ruffer’s investment directors feel confident that their approach will keep winning.

Matt joined Host Alan Dunne to discuss the philosophy behind Ruffer’s defensive capital allocation strategy and what opportunities he sees in the global macro market. Particularly, Matt sees parallels between now and the lead-up to the heavy inflation of the 1970s, not necessarily because of economic factors, but because of the sociopolitical factors influencing market sentiment.

“We need to remember that we're in a hyper-financialized era,” Matt says. “What financial markets see is absolutely critical to how they perform.”

From energy dynamics to the growing tension between capitalism and democratic governments, Matt predicts that the trend lines for volatility and inflation will keep increasing. But above that, he reveals on a Top Traders Unplugged Allocator Series edition how he removes timing from the investing equation in order to see gains in all seasons, as well as the defensive mindset that can safeguard any portfolio in a global financial storm.

Risk management vs. risk minimization

“Most investors focus on return maximization,” Matt explains. They create a portfolio by blending return-seeking assets and fixed income, then hope for the best. “They might do risk management as a kind of afterthought,” he adds.

Risk minimization, on the other hand, starts by identifying the vulnerabilities in an investment strategy. It doesn’t mean dumping everything into Treasury bonds and hiding under a rock until they mature. Instead, it’s the careful process of asking the right questions and finding asymmetric investments that can create a protective core beneath the growth assets.

“By balancing those assets to create a kind of [all] weather portfolio,” Matt says, “you can try to strip out timing from the equation.” This is the catch-22 of investing: preparing for the future by admitting you can’t predict the future.

Against the backdrop of war in Israel, a congressional leadership crisis and a series of October selloffs, the CBOE Volatility Index (VIX) spiked to its highest levels since the regional banking crisis of March 2023. Equities investors looking for opportunity are hoping to find the right entry point, but it’s well documented that timing the market doesn’t work. Historically, riding out the chaos has been the best bet.

Conversely, risk minimization looks for ways to avoid chaos. Instead of betting on an economic rebound or bracing for a recession, a risk-minimized portfolio is optimized for an absolute return irrespective of the global economic climate.

A lack of risk premium

Case in point that no one can predict the future, the widespread U.S. recession fears of 2022 never quite materialized, despite rampant inflation and aggressive rate hikes. Alan asks, “Why do you think the consensus has been wrong?”

Matt explains, “The level of inflation is much less important than its trajectory or its speed. The level of interest rates is much less important than the level of volatility.”

In other words, financial markets are pliable. They can bend and adapt to shifting economic conditions as long as those changes don’t come too fast. While prices are still rising, the rate of inflation is slowing down. Year-over-year (YoY) U.S. inflation was at 3.7% in September, still higher than the Federal Reserve’s target of 2%, but certainly lower than it was. By comparison, U.S. consumer prices were up 9.1% YoY in June 2022.

This could indicate that Fed rate hikes are working, inflation is cooling and the next twelve months will be less volatile in the federal funds market, perhaps even reaching the end of the rate hike cycle. Matt further sees a compression in credit spreads lowering borrowing costs for corporations, despite the higher Fed rates. Of course, investors also have significant risk-free opportunities in bonds and high-yield savings accounts. Every move toward stability means investors are less likely to find profits on a wild price swing or a wide spread.

“There are almost no risk premia in the market that are commensurate with both the level of risk-free rates and the breadth of potential outcomes in economic and inflation terms from here,” Matt explains.

In other words, when everything’s fine, investors play it safe. A recession hasn’t happened because the markets have found a sort of equilibrium — the so-called soft landing or Goldilocks scenario that the Fed’s economists predicted at their September meeting.

Opportunity in a bear market

But playing it safe has its drawbacks. The biggest threat to a bearish, defensive portfolio is missed opportunities in economic growth.

Matt shared that his current portfolio is about 40% short-dated bonds, plus long volatility derivatives — expecting equity markets to fall and credit spreads to rise. Yet because the biggest risk to this posting is a strong economic turnout, he sees value in economically sensitive assets that will respond well to global economic growth.

“That’s things like crude oil exposure, copper exposure and commodity-related currency like the Australian dollar alongside energy equities,” he explains.

Additionally, Matt has turned to the Japanese yen — a prime example of Ruffer’s risk-minimizing portfolio allocation. “In the short term,” he says, “it’s selling off pretty sharply alongside bonds,” providing a hedge against rising interest rates impacting the secondary bond market.

The yen has been in free fall for much of this year as the Bank of Japan differs from the rest of the world by refusing to raise interest rates to fight inflation. If there is a recession that drives lower U.S. Treasury yields, the yen is expected to strengthen relative to the dollar.

Or, if the Bank of Japan reverses its longstanding monetary policy position and raises deposit rates below zero, the yen could strengthen that way, too.

“We think it is the kind of two-headed investment that will carry the portfolio in multiple environments,” Matt says.

The new inflation regime

Ruffer’s plan is prepared for fast-shifting market dynamics, perhaps putting it at odds with those betting on a safe, predictable Goldilocks landing. Alan observes that “people who have been looking for the immaculate disinflation will probably feel that they’ve got it so far.” It’s fair to wonder if extreme risk minimization is the best play right now.

Yet in Matt’s view, inflation is unlikely to drop below the Fed’s 2% target anytime soon. He says, “Long-dated inflation risk premia are the only attractive risk premia in markets today. We are shifting to a different regime.”

The regime is not quite the Great Inflation of the 1970s, but Matt describes “an ever-present risk”: Rather than 2% being the inflation ceiling, it’s become the floor. Three key dynamics support this claim.

1. The Chinese deflation machine is gone

For more than twenty years, following the 1994 devaluation of the renminbi (RMB), the Chinese government’s intervention in currency markets artificially cheapened exports. The repressed RMB, combined with heavy Chinese purchases of U.S. Treasury bonds, contributed to low prices of consumer goods in America.

“We’ve called this the deflation machine,” Matt says. “[China’s currency policy] led to a huge fall in developed market yields and a great wave of cheap goods onto global markets.”

Now, as China’s property market is in turmoil and Chinese banks contend with bad debts, the Chinese government has made efforts to support the currency. Meanwhile, Chinese exports are still affected by U.S. tariffs that began in the Trump administration, ultimately inflating prices for end consumers in America.

2. A distributional battle in the economy

Secondly, geopolitical factors continue to push prices higher. While pandemic supply chain woes ballooned the producer price index of motor vehicles, heavy machinery and other manufactured products, Russia’s invasion of Ukraine then led to a U.S. energy import ban and a ban on all refined oil products in the European Union.

As consumer prices skyrocketed, eyes turned toward the government for financial relief. Whether it came as a stimulus check or tax break, government intervention was like oxygen to the inflation fire. Instead of high inflation suppressing retail sales, the added consumer purchasing power made the elevated prices affordable.

Then in the private sector, the last few years have seen a push for higher wages — including the United Auto Workers’ strike that resulted in a 25% wage increase, among other financial benefits. Workers want earnings to meet a higher cost of living, but, once again, increased wages can prolong a high rate of inflation.

“Whenever there is a battle between labor and capital and governments, inflation is the result. And it will continue until that battle is resolved,” Matt said. In theory, the Federal Reserve’s rate hikes are the government’s response to market forces.

3. The inability of governments to tighten properly

This is where the rubber meets the road. A strict fiscal policy only works if the government isn’t afraid to pull the purse strings tighter. Markets can’t cope with high interest rates forever — they lead to too much illiquidity and halt economic development. Something has to give eventually, whether that’s a huge sell-off, a recession or disapproval ratings that dismantle the ruling party in the next general election.

“The Fed’s tightening cycle hasn’t had contact with the enemy yet,” Matt says, referring to a market selloff or recession. “We're betting that they don’t have the stomach [to continue raising rates] because they don’t have the political support to stay tight.”

Take California, where some 23 million residents received a gas rebate in 2022 to combat rising oil prices. Or look at the U.K., where every household received a 400 pound ($497) discount on their energy bills in the winter of 2022-23. Although politically popular, these stimulus checks do nothing to combat inflation.

“The policies that governments are introducing are not ones that favor efficient capital allocation,” Matt says. “If you attempt to fight inflation by giving money to the people who are trying to buy something at a high price, you will not succeed in solving that inflation.”

A historical parallel 

So will inflation spiral out of control? Alan compares our current environment to other high-inflation periods in market history and asks, “What does the current setup look most similar to?” Although Matt cautions not to over-extrapolate, he does compare the current global market to the 25 years following World War II.

Like COVID, the war disrupted the supply chain and left people unable to travel and limited in their discretionary spending. “You were left with a lot of surplus capital in people’s hands,” Matt says, “and you saw in the 1940s and 50s very significant episodic inflation.”

What followed were restrictive monetary policies and a global tightening in an effort to restore price stability. But restrictive policies often have a short political lifespan, and Matt predicts that today’s governments will likely ease off their tightening once the pain becomes apparent, perhaps pulling the plug too early.

“What embeds inflation is taking the handbrake off at three and a half percent rather than two,” he adds. In other words, if governments stop their financial tightening too early, high inflation could remain for years, thus nullifying the efforts to control prices. 

The alternative is high interest rates and tight capital currency controls to force reallocation into government bonds, but Matt considers it unlikely for restrictive policies to come with no pushback. He recommends “The Price of Time” by Edward Chancellor as a resource on the historical impact of artificially low rates and the risk of central banks overcompensating with lax policies.

As things stand, the future will likely have higher highs and higher lows with inflation. The investment opportunity comes in recognizing and accounting for that risk.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.