For nearly four decades, the traditional ‘long-only’ balanced portfolio of stocks, bonds and cash has been remarkably profitable, providing stellar returns for long-term investors. 
Notwithstanding the odd bump in the road, equity prices have soared even higher since the 2008/09 crisis. Meanwhile, government bond yields have crashed to historic lows. Low bond yields imply high bond prices – and high prices today imply low returns tomorrow. How did we fall so far down the rabbit-hole?
In the public’s eyes, asset prices are sky high because central bankers have pushed interest rates far below historic norms. There is much to commend this view although it isn’t the whole story, but the decline in bond yields, the root cause of structurally higher equity prices, must be related to the actions of the central bankers who anchor the financial system and control interest rates.
Unsurprisingly, they rail against such a suggestion. Their case instead is that developments in the ‘real economy’ – demographics, emerging economies’ failed economic management, increased inequality, slowing productivity growth and the legacy of the financial crisis – mean there is simply too much savings chasing too few investment opportunities. Rates of return on financial assets had to suffer, hence the sustained fall in interest rates.
They then add that these forces will persist for some time, sustaining the low government bond yields we see today. Thus, the high prices of government bonds and equities reflect the inevitable consequence of slow-moving structural forces in the global economic system. This time is different, one might say...
There is an obvious paradox: if historically high government bond and equity prices are caused by long-lasting, durable economic forces, then how did those same forces apparently cause the global economy to suffer a near-fatal heart-attack a decade ago?
There is an alternative view, that before the crisis central bankers fuelled the asset bubble that burst spectacularly in 2008, and their choices since have taken us even further down the low-interest-rate rabbit-hole. All the major central banks have bought substantial quantities of government debt to lower longer-term interest rates (quantitative easing), and have lowered short-term interest rates to zero or lower. Equally, all have signalled to markets that policy ‘normalisation’ will be limited and very gradual, if at all.
Given these consistent signals, it’s no wonder that longer-term government bond yields remain pinned to the floor.
But what if central bankers have misdiagnosed the problem? Since the 2008/09 crisis, the struggle to get inflation back up to target has seemed all-consuming. If only they could provide sufficient stimulus (lower interest rates) to fire-up the economy, the thinking went, central bankers could once-and-for-all slay the deflationary bogeyman. But ‘cheap money’ has side effects.
Over the last decade, financial markets have been re-wired, shifting risk to corners of the system least scrutinised by regulators. Sound familiar? Low returns on risk-free securities have sparked a ‘search-for-yield’, not inside banks as happened before 2008, but in the world of asset management. This dynamic has become stronger recently and penetrated deeper into the financial system as interest rates dived towards zero. More opaque asset markets have appeared easily accessible and liquid, and prices have seemed sustainably high across all asset classes, but appearances are deceiving. History tells us dangers tend to be greatest when measured risks like volatility or liquidity are lowest. We are approaching such a point.
Here’s the rub. The re-wiring of markets has happened because interest rates have been on the floor. A generation of investors are conditioned to believe they will remain historically depressed, which has been central bankers’ core message for a decade. The risk of high inflation has been vanquished – supposedly for good - but what happens if inflation returns?
Long-term bond prices are especially susceptible to such fears. But if current elevated valuations in equity and other ‘risky’ asset markets are themselves predicated on the continued low inflation, low interest rate environment, then where are traditional ‘long-only’ investors meant to hide if inflation rears its ugly head? Bonds and equities would both be hit.
The future path of inflation is highly uncertain and central bankers may be proved right, but why are they and financial markets so certain? They argue that deep-seated forces will ensure that the current state of affairs continues, but why is it so implausible that after a decade of deliberate policies designed to generate inflation we will actually get some?
It’s not just plausible but probable. Trends ranging from the integration of China into the world economy and the economic liberation of eastern Europe, to the globalisation of supply-chains and the liberalisation of cross-border finance, have undoubtedly suppressed inflation in recent decades. In whole or in part, all of these disinflationary tailwinds are dissipating, and have - or soon will - reverse. Most obviously, constructive engagement between the US and China was the centrepiece of the post-1980 disinflationary world order. By contrast, destructive economic and technological rivalry between them looks set to be the defining feature of the coming era.
This is not to say that high inflation will emerge this year or next, but three things seem self-evident about the current environment. Policymakers are pressing hard on the accelerator to create more inflation; toxic political forces are being marshalled in favour of pro-growth, anti-business and pro-inflation policies; and background developments in the ‘real economy’ have turned decidedly less disinflationary.
This is a dangerous combination for frothy financial markets so conditioned to believe that inflation has been slain for good.
Bertie Dannatt is an investment director at Ruffer. The views expressed above are his own and should not be taken as investment advice.