Written By: Alex Lennard
Alex Lennard, Investment Director at Ruffer, outlines Ruffer’s approach to the current distortions in asset markets, which includes the use of inflation-linked bonds to protect against a combination of high inflation and low growth
At Ruffer we believe booms and busts are inevitable and inseparable features of financial markets, and whilst it may be possible to spot what will cause the next crisis, it is impossible to know when it will be. To avoid being dependent on the direction of markets, we seek to create a balance of offsetting investments within portfolios. We therefore always hold “growth” and “protective” assets alongside each other, varying the allocation to each over time.
Growth assets allow investors to participate in the positive returns available during periods of benign market conditions. Protective assets defend these returns from specific, long-term risks.
Over the past decades the seemingly relentless accumulation of debt in the global economy has necessitated a coincident decline in interest rates. For most of the last quarter of a century – which spans the career of most fund managers – simply holding a portfolio of equities and bonds has been sufficient to generate steady positive returns, and weather most market crises. Since the mid-1990s, the promise of central bank support (the so-called “Greenspan put”) has encouraged and sustained rises in asset prices, whilst at times of distress negative bond-equity correlation has ensured a diversified portfolio of equities and bonds would be sufficient for multi-asset managers to make at least some headway. More recently zero (and negative) interest rates have suppressed yields while also driving up equity values. This has resulted in a significant increase in the correlation between equities and bonds, which has substantially reduced the effectiveness of traditional offsetting assets.
With all asset classes at or near historical highs, and correlations between asset classes increasingly positive, the negative correlation between bonds and equities may not hold in the next crisis. As interest rates affect the pricing of all assets, a crisis precipitated by rising interest rates could see not just asset classes like stocks and bonds fall together, but also real estate, land, private equity, and commodities. Many investors could face losses despite the illusion of diversification.
In the past, simply avoiding the areas of obvious overvaluation (for example, not owning TMT stocks in 2000), as well as placing ourselves the other side of bubbles (for example, owning carry-trade funding currencies like the Swiss franc and Japanese yen in 2008) allowed us to avoid and counter the inevitable fall in prices when the bubbles burst. Now that the distortion, and mania, is spread across the spectrum, how does one go about getting the other side of the current mania which has infected all asset classes?
We are not alone in asserting that valuations are high and that most asset classes are expensive. Market participants are looking for investments that are less over-priced than others. Whilst this relative argument is not necessarily an indicator of an imminent end to the party (that is usually signposted by the fear of missing out), it does suggest that prospective returns are likely to be low in most asset classes over any sensible timeframe, and investors are readily accepting greater risk than they would previously have done in order to generate adequate returns.
Current growth rates are providing sufficient confidence to allow the Federal Reserve (and potentially the ECB), to discuss reducing the size of its bloated balance sheet as we move into 2018. It is difficult to judge what impact this will have on the market, but historical precedents are not pretty. Given today’s starting point, an element of circumspection is therefore warranted. The previous certainty of central bank asset purchases may be called into question, suggesting that the pricing of both bonds and bond-like equities may not be underpinned. This leads us to look into some more esoteric asset classes for protection. For example, we hold credit default swaps, which tend to gain at times of stress in corporate bond markets. We also hold call options on the VIX index. The VIX is a measure of traders’ nervousness, derived from the pricing of derivatives on the S&P500. When markets plummet, we expect our VIX options to soar. These investments, by their very nature, have a cost of carry. This is definitely uncomfortable, but is a necessary price to pay in order to protect portfolios from what we believe will be a correlated fall in most asset classes. These can be combined with more traditional investments (inflation-linked government bonds in various countries) in order to help preserve client capital.
A sustained period of inflation above the prevailing interest rate has been the central banks’ cure to the world’s unmanageable, and still growing, debt burden. Whilst this resolves the problem of over-indebtedness, it does so slowly and at considerable risk to the asset owner. It is our long-held conviction that inflation will move higher, resolving the debt issue faster. In the scenario of a move to higher inflation, few asset classes are likely to perform well: conventional bond prices would fall (yields would rise), since the fixed coupons in the future would be worth less in real terms. For this reason we have avoided the asset class entirely. Equities would likely fall in value as discount rates (based off bond yields) also rise; the UK equity market lost 70% of its value between 1972 and 1975 as inflation rose from 5% to 25%.
We believe index-linked government bonds provide the ultimate protection for such a scenario. Although they are expensive, their relative scarcity in a world where most asset classes fall substantially in real terms, suggests they would trade on a substantial premium as the one asset class that provides some protection from inflation.
Inflation-linked bonds did not exist in the 1970s, but they are the perfect protection from the “airless valley” of high inflation and low growth that we fear, precisely because they are so potent: prices move inversely with yield, and if the real yield on the longest dated inflation-linked bond changes from -1.7% today to -3.5%, the price of this bond would move from £245 to £609 (a c.150% increase). One doesn’t need to hold many in a multi-asset portfolio to protect investors from an otherwise catastrophic risk to asset values.
What if we are wrong? The policy maker’s dream, namely a normalisation (of sorts) of monetary policy, whereby economic growth returns and interest rates can be nudged away from emergency levels, is not an impossibility. Should the global economy continue to show evidence that the recovery remains in place, we need to guard against the prospect that bond yields may rise more than inflation. This influences the structure of the growth assets (principally equities) in portfolios. As well as eschewing the much loved ‘bond-like’ equities we have tilted our growth exposure toward cyclical companies in the UK, US, Europe and Asia that are most exposed to global growth. The Japanese equity market is a great place to look for these stocks. We envisage a successful reflation of the global economy being accompanied by rising global bond yields, increased growth expectations and possibly a rising US dollar and falling yen: these trends have historically been a magical combination for Japanese equities, and in particular banks and other financial stocks.