After years of near zero interest rates in the West investors have been pushed up the risk spectrum into bonds and then into equities, with many professionals opining there is no other choice.
However, FE Alpha Manager Steve Russell (pictured) and Hamish Baillie say that anyone investing on this basis is likely to be disappointed, as inflation will erode their paper gains.
“There are some expressions that are excluded from the Ruffer lexicon; new paradigm, super-cycle, win-win, guaranteed outcome, this time it’s different,” they said. “The expression du jour is New Normal; the assertion that the natural level of interest rates after the financial crisis will be lower than the long term average (i.e. around 2 per cent rather than 4 per cent).”
“The Federal Reserve and Bank of England, as part of their new policy approach to say more and do less (forward guidance is the technical expression), have been the main proponents of the New Normal and they have been accompanied by a supporting cast of investment heavyweights such as Bill Gross.”
“Of course, behind closed doors there is some self-interest in promoting the New Normal. For a fund manager heavily exposed to financial assets, be they bonds or equities, it justifies record high prices.”
“For the central banker it buys time; the cycle of deleveraging in the west is in its infancy and will act as a drag on future growth.”
“Lower interest rates help borrowers and punish unproductive savings thereby oiling the wheels of deleveraging.”
“Far be it for us to question the great powers that be, but perhaps the focus of the New Normal advocates should be on real rather than nominal interest rates.”
“The economist Peter Warburton (of Ruffer and Economic Perspectives) put it eloquently in his Halkin Letter: ‘I don’t believe in the New Normal; I believe in the Old Peculiar, the volatile, jumpy world where honest money is made and foolish money is lost.”
“Yes, we live in a world where governments and their central banks have repressed nominal interest rates and clearly would love to continue to do so.”
“The problem is that they have not yet pulled off the other leg of the trade: the burst of inflation that stabilises the financial system while wrecking conventional government bond prices.”
“The harder that central banks lean towards perpetual accommodation, the more certain it is that one day they will destabilise inflation and inflation expectations.”
“The ‘capping’ of nominal interest rates tells us nothing about prospective investment returns. Let’s be clear, if inflation expectations drift into outer space there is no Yellen put.”
“For a time all assets – except gold and a few other honourable exceptions – will generate negative real returns.”
“As much as central banks are adamant that they are in control of the inflation outlook they also need the inflationary surprise.’ Well said – we may yet need those index-linked bonds to fight for us.”
The Ruffer Investment Company has 35 per cent of its funds in index-linked bonds in sterling and other currencies.
It also has a 4 per cent position in gold and gold equities, which many expect to outperform in times of inflation as well.
Inflation-linkers have been a boost to performance this year, with the index-linked gilts making 4.23 per cent and US inflation-linked treasuries up 3.35 per cent.
Performance of indices in 2014
Source: FE Analytics
However, overall it has been a bad period for the trust, which has lost 2.25 per cent in 2014. This compares to gains of 3.37 per cent for the FTSE All Share.
Performance of fund versus sector and index in 2014
Source: FE Analytics
One of the drags on performance has been the high weighting to the Japanese equity market, which the managers have had high conviction in for some time.
They currently have 17 per cent in Japanese equities compared to 13 per cent in the UK and 12 per cent in the US.
The TSE Topix index is down 3.13 per cent this year, however, as they most recent round of reforms to the market work their way through the system.
Despite this rough patch the managers remain convinced there is more to come from the Japanese revival and have been beefing up their financial exposure in the country.
“We added to our Japanese bank exposure at the beginning of May (now 5 per cent of the portfolio) and thus far these have been profitable trades,” they said.
“We remain positive on the outlook for the Japanese economy and the banks stand to benefit from any credit growth that accompanies a domestic recovery.”
“Unlike western banks these institutions have finished deleveraging and are ready, willing and able to lend.”
Ruffer is up 105.14 per cent over a seven year period which includes boom and bust legs of the past cycle, compared to returns of just 39.42 per cent for the UK equity market.
Performance of fund versus sector and index over 7yrs
Source: FE Analytics
The portfolio has also been the least volatile fund in the 32-fund sector over that time with an annualised volatility of just 8.14 per cent.