“I thought you chaps at Ruffer said that you’d never lose money for me – what’s gone wrong?”
The weakness in markets reflects the passing of an inflexion point of mood: from a sensation that we’ve been living through extremely benign investment conditions, and that now we have moved into a much harsher environment. We have been arguing that the new climate will see a market setback punctuated by a trinity of mischiefs: the broadness of the setback, the speed of the fall, and the extent of the decline. If this proves to be accurate, it will represent some of the most challenging conditions for a generation. In broad terms, our strategy has been – and still is – to have a limited exposure to equity risk, and to combine this with powerful protections. These barely protect at all against limited falls, but will build into a powerful carapace when gales become storms. It is hard to protect risk assets from ordinary setbacks – everybody knows these can happen routinely, and protection against them is prohibitively expensive. Our central belief is that there lies ahead of us market conditions which are capable of causing permanent damage to people’s wealth, and our absolute preoccupation is to prepare for this, while continuing to accept that the timing is uncertain. It would be reasonable for investors to feel that the events of December give credence to our view that bad things are, indeed, on the way, while at the same time they might question whether we have a handle on navigating it. This review, and the accompanying report by our Chief Investment Officer, Henry Maxey, are to provide reassurance on the navigation.
The two reports – this one and Henry’s – are designed to be complementary. His report is an analysis of the pressures on the market – it is technical, going into the plumbing of the system. I highlight it because it brings together a wide range of disparate threads to create a cogent single narrative. I will therefore use this review to concentrate on what we are doing in the portfolio; the key to why we are doing it is set out in Henry’s piece.
Let me turn first to our equities. These accounted about 40% of portfolios in 2018; last year they fell, on average, by 14% – around 6% of the whole portfolio value. In a world where 90% of asset classes (as tracked by Deutsche Bank) have had a down year in dollar terms, there has been little possibility of diversifying into ‘pockets of strength’, but, even allowing for this, there needs to be a further explanation for the extent of the equity fall. At the beginning of the year, equities could be categorised as: momentum (largely growth stocks), value (cyclicals, financials etc) or safe, ‘no surprise’ companies. The right place to be was in the latter. The first category, momentum, turned out to be the hare – a stellar first half, and ‘cow attempting the moon’ in the second half. The tortoise, which won the race, was found amongst the safe staples, concentrated into those companies which did not put, commercially, a foot wrong. While they might seem to have been an obvious place for Ruffer portfolios, they were, and are, dangerously expensive. Additionally, the purpose of our equities is to make money – we parade the virtue of safety and protection, but we would not be out–performing the equity indices over 25 years of existence if we had not made good money from the companies we invest in. Last year we favoured ‘value’ stocks, many of them somewhat troubled businesses – troubles which in our view were fully priced into their ratings. With every sign of a late–cycle boom in the economy, which benefits the earnings of cyclical companies, and accompanied by higher interest rates, which assists the financial industry, we concentrated on these. We were not wrong on the economic growth, nor the interest rate rises, but the market has savaged the value stocks. If you take risk, you get risk. As the markets declined, we took out some of the risk in financials and the retailing sector, as events there showed that profits can fall as fast as, if not faster than, share prices. Simultaneously, we added a little to our protective assets.
We have been pleased to see the gold price creeping up – again, we have increased our exposure there. The value at the moment is in gold stocks, rather than gold bullion. The mining companies’ share prices have been in long–term decline, and have reached that happy–hunting ground where the enemy of stock appreciation is not bearishness, but indifference. In a world where everything goes down, before everything rallies, and then everything… here is a genuine diversifier. Gold is an opaque and shadowy investment – many refuse to admit it is an investment at all – and so its early signal of a positive response to difficult markets generally is a hopeful sign.
I want to write – for the umpteenth time – about the inflation–linked bonds within the portfolios: we have held them in the UK for a long time, and they have been reinforced by TIPS in the United States.
How can it be that we are worried about inflation while simultaneously preoccupied by market conditions which will be horribly consistent with a powerful – possibly overwhelming – deflation? A dislocative fall in markets would almost certainly create a deep economic contraction, as it did in 2008 – some of the early figures a decade ago showed catastrophic falls in national outputs. These are seemingly the exact opposite conditions of the inflation needed to make these critters crit. We do not see it like that.
The inflationary tinder is dry. The western world, excluding much of Europe, enjoys full employment. Its hand–maiden is a newly energised and militant work force in France, Germany, the US and Britain – wages in the UK are rising at an annualised 3.3%, the highest for ten years. This is no time for a gift of easy money from the Federal Reserve in America. A more interesting question is whether the newish incumbent as its chair, Mr Powell, will give in to the knock–about pressure from Donald Trump to do so. Knock–about, for sure – but is it knock–out as well? Given that posterity judges chairs of the Fed harshly if they surrender to political pressure – Arthur Burns’ teatime chats with President Nixon come to mind – our guess is that Mr Powell will leave it late. But there’s another possibility, not talked about much in the corridors in which we move – will Mr Powell be the umpteenth establishment figure to resign? His replacement, Mr Stooge, will be thought almost certain to accommodate the president and, in the eventuality, will do so.
Combine these two elements – water cannon and people’s quantitative easing, and you have created the latest version of the motorway to inflation: M1 and M3 were never intended to give inflation a name, but they will adequately signal the direction of travel. In the past, I have tended to disingenuity as regards the transfer mechanism whereby inflation appears – observing only that if there’s a war on the way, a casus belli is never hard to find at the appropriate time. This articulation goes further than previous reviews – it is now possible to look at how current events will play out inflationarily.
Inflation–linked bonds are, perhaps surprisingly, not responsive to the onset of inflation. They ask the question: ‘but where are interest rates?’ If the answer is that they have been jacked up pre–emptively to head off the inflation, then the bonds will go down. But that is far from the position today. Western financial conditions have been sustained on a diet of minimal nominal interest rates, and, because inflation has been quiescent, low real rates (ie the nominal interest rate, adjusted by the inflation rate), too. The central plank of orthodoxy, which, in today’s conditions, is not wrong – things are too brittle for interest rates to go up, whether in nominal or in real terms. The authorities, having tried to get nominal interests below zero, discovered that the side–effects were traumatic, and quickly desisted. But if inflation came into the system, the chances are that interest rates will lag the onset of inflation itself. This is the catnip for inflation–linked bonds: they are geared to the difference between the after–tax yield on money, and the inflation rate. In the mid–1970s, this was over 20% for a while. At 25%, cash in a bank account is not just hung and drawn – every year, it is quartered, too.
In short, they are an essential ingredient… for the next–but–one move.
What should be made of all this? It turns on whether we are reading things right. A critical mind might think of the seeming stopped–clockery of such a long wait for these events – a wait which is not unequivocally over, as I write this at year end. If our reading is sound, any missed opportunity will seem sprat–like in the mackerel of a maelstrom. We care about our clients, and taking yet more risk off the table might seem overwhelmingly the obvious thing to do. But we hold with equal vigour to the principle that we are trying not to be wrong – which is not the same thing as trying to be right. Noah got it right, and well done him. His story rather glosses over the many months when he was laughed at for his initiative – it is not the laughter we fear; it’s pushing hard to be right and ending up being wrong. What we do is not a game.
Jonathan Ruffer
January 2019
