When I was on honeymoon in Venice, I spotted a pair of Chinese dragons, one chewing a toenail and the other picking its nose. Smart shop, Grand Canal – my wife, Jane, and I set an upper limit on what we’d pay. We later walked out with the dragons having written a cheque for slightly over four times our upper limit.

That’s the problem with the markets today. How high a rating can a fixed interest security fetch? Ten years ago, the answer might have been a 4% yield. We doubled our money in the government bond known as a war loan, selling it triumphantly at 80. It was redeemed sometime later at 100. Today, it would be trading at around 705 if it still traded as an irredeemable. How about Tesla – a great story, going to the moon – is $600 about right? If yes, then you missed the latest double.

Look down the other end of the telescope – how much debt is too much debt? There has been a relentless rise in levels over the past 50 years. As yields have pushed higher, they have done so to a chorus of ‘they have now reached an unsustainable level’. In the first division currencies this constant cry has always been wrong, but the crickets on the hearth are still chanting, ‘emergency, emergency’.

The more one understands what is going on, the more likely it is that one will have taken action to reduce risk or bet against the continuance of the status quo. The current conventional UK Treasury of 2071 was issued three years ago on a yield of 1.625% (Bloomberg). That equated to a yield to a top rate taxpayer of 0.89%, a yield that therefore becomes negative in real terms with inflation at under 1% (Bloomberg). I used to run a (mythical) portfolio for the man who I secretly hated. The art was to make it look like a sensible portfolio, but the sole purpose would be to lose money for him.He would have had lashings of this 2071 – but in early December this security was trading at nearly 150, yielding, gross, 0.5% (0.3% after tax [Bloomberg]).

Is it a sell, I ask myself, at 150? The perverse thing about something trading far above its apparent upper limit is that it’s just as likely – perhaps more so – to put on another 50% gain. Value is like beauty – in the eye of the beholder.

I am rather proud of shutting up about inflation in my previous investment review, when it was the key issue of the day. Do we feel vindicated that it is again an issue? Not yet. The index-linked gilts – of which we have a prodigious amount – trade enormously expensively, but they are still good value. I describe this phenomenon as the overlooked Canaletto in the Bond Street Gallery – priced much too highly for what its owner thinks it is, but still a bargain for what it actually is.

Views on the direction of inflation can be quite fascinating, but only ‘quite’, since no one really knows what they’re talking about. The trick with inflation is not to worry that the completed crossword of clues is beyond one’s grasp: certain riddles can be cracked, and they can sometimes be enough to know what journey one should embark upon. One of these is ‘transitory’ – the idea that the inflation rate is like a goat passing through the anaconda – one serpentine belch and all will be well again. 

The central banks have enjoyed 10 years when all the forces were deflationary, which has allowed them to claim a great victory in keeping inflation under control. Initial fears that there might be a return of inflation were met with denial and then, when inflation arrived, pretty aggressively, it was held to be a goat – the code word was ‘transitory’. The recent pivot by Jerome Powell, the Chair of the US Federal Reserve, is that transitory is an inappropriate word (which was always the case) and should be discontinued. This gives him credence whatever happens – bad inflation (“I warned you of it last December”) or inflation-as-goat (“I always said it was transitory”). Mr Powell has no better idea of what is going on than others – remembering the exchange between F E Smith, a barrister appearing before Lord Darling, who commented testily: “I have heard your evidence, Mr Smith, and I must say I am none the wiser”. “No my Lord,” was the reply, “but perhaps better informed.” 

J K Galbraith put it unkindly thus: “Since the US Federal Reserve was founded in 1913 it has had a record against inflation and notably against recession of deep and unrelieved inconsequence”. That was in 2004 – the latest 17 years have not shown improvement.

My thought (worth perhaps the proverbial penny) is that the progress of inflation is similar to the old-fashioned domestic fire-in-the-grate my nanny taught me to make. First, the newspaper is crunched up, banker-style, into a ball. Then the kindling wood. And, on top of that, the coal. Once the coal is glowing, great logs can be consumed. In my mind, the transitory phase of inflation is when the paper is burning fiercely, but the kindling does not catch alight. Perhaps the kindling burns well, but is itself consumed before it passes the heat and energy to the coal for it to conflagrate; that, too, is transitory.

Milton Friedman said inflation is always and everywhere a monetary phenomenon. Yet that is only true when the fire in the grate is already burning bright. The journey to that point can be phrased similarly, but with one crucial word changed: ‘psychological’ in place of ‘monetary’. Everywhere the start of inflation is a psychological phenomenon. To translate that into the language of the fire-in-the-grate – today, the newspaper is burning strongly, as prices randomly keep popping higher. Businesses are putting their prices up – will that set the kindling alight? Then come demands for higher wages: sustained wage increases make coal catch fire. With glowing coals, inflation is starting the long road to entrenchment.

Not all the inflationary impressions occur within this closed loop. Many office workers have reevaluated their lives and will not be returning to the office – in a fit of absent-mindedness, they have retired. In Britain, Brexit has sent home many of those who have done the hardest and least prestigious of the labouring jobs. It has long been a standing joke that the last people you want for the seasonal crop-picking are the locals – but they’re all that seem to be left. Stand by for some 25%+ pay rises come harvest time.

It should be clear from this analysis that Britain is particularly vulnerable to this cycle, not least because we may be coming to the end of stable currencies – which is comparatively unusual. If these structural weaknesses combine to lower sterling, then we can expect an amplified response to price rises. We believe the tide is coming in for inflation, brought about in a series of waves of increasing severity. It is important to remember what happens on the shoreline as the tide comes in – hour on hour it advances along the coastline, but there are countless moments, between the waves, when the sea appears to retreat. So it will be with inflation: not a straight line, but plenty of what the French call the reculer pour mieux sauter.

Henry Maxey, our Chief Investment Officer, gave an important bodice ripper of a presentation in New York, which has been making waves in the Anglophone world. He believes we are in a dangerous time for markets. The responses to the crash of 2008 have been aspirin-led, which have given short-term relief, but at the expense of exacerbating the long-term imbalances, especially the size of the debts, and the lowering of interest rates to ensure the cost of servicing the debts remain no more than troublesome, not destructive. As inflation increases, fanciful explanations need to be stated – and accepted – if investors, and the political system generally, are to pretend there is a pass through the implacable mountains of default/recession (or, possibly, recession/default).

The losers are the workforce, who have seen the ‘solution’ to the 2008 crisis make things worse for them through downward pressure on wages, and better for the top notches, through the increase in value of assets. Those for whom the figures don’t add up have little energy to fight back – but their numbers are swelled by the young, who see their parents’ generation sailing off on Swan Hellenic cruises, while they are cooped up in a central chicken shed through Covid. 

All these factors are threats to capital values, at a time when those assets are partying. Our view is this is no time for exuberance – it is a time to keep safe.

Originally published by Ruffer and reprinted here with permission.