The difficulty today is that currencies are having to play a larger role in our offsets, and currencies are subject not only to economic influence, but political interference. An example of this has been the Swiss franc, which we (correctly) identified in 2010 as being a likely beneficiary of trouble down at t’Merkel. We didn’t buy it, because we were afraid that their central bank would ambush the speculators. In 2010, the Swiss franc shot up: the Bank of Switzerland intervened in huge size, the Swiss franc hesitated for about 10 minutes and surged higher and higher. Then in August 2011, the Bank acted again in massive size, and the Swiss franc dropped against the US dollar from 1.37 to 1.06. The point is not that calling the Swiss franc is difficult. It is that calling the Swiss franc is impossible, and that removes one letter from the alphabet of investment opportunity. The same is true of the Japanese yen, which is a pity, since back in 2008 these were the very currencies which gave us our protection. 

The key to the avoidance of poor performance in 2011 was to have a big weight in the government fixed interest markets: especially in UK gilts. The latter started the year expensive by any previous standards, and investment managers who avoided them were no sillier than those who sold their technology holdings shortly before the dot–com boom got started. As retail price inflation breasted 5½% in Britain, what would the odds have been of War Loan 3½% returning to par (100) in 2011? Well, it didn’t quite, but 99.57 isn’t far off! Our large holdings of inflation–linked bonds rose sharply in sympathy with their conventional cousins: but if these cousins are in bubble–territory how wise is it to be travelling in the same charabanc with them? Blood may be thicker than water, but it makes more mess on the carpet. 

So the biggest danger going into 2012 is our holding of UK and US government index–linked stocks, whose performance in 2011 was the backbone in neutralising a 6.6% fall in the world equity indices. Shouldn’t we just sell them, and if the fundamentals are favourable, buy them back when they’ve dropped back in price? That requires two right decisions, and runs the risk that one gets out, and never gets back in again. 

And the fundamentals are sensational, absolutely sensational – every bit as good as buying Amazon and Apple at the top of the TMT boom. (The former has gone up twelvefold since then). We are going into a period when everybody from the Governor of the Bank of England to the Deputy Governor predicts that inflation is going to drop sharply in 2012. They may well be right, but what happens thereafter? At the risk of going over old ground, I will set out why our – your – inflation–linked bonds are uniquely in a position to protect you in 2012 and beyond. 

The 2008 credit crunch remains the crucial starting point in this. A dislocation accompanying a massive and comprehensive indebtedness led inexorably to those debts being unrepayable – as always happens at this stage of the cycle. The inevitability of an increasing wave of bad debts beckoned – but Dr Bernanke, supremo of the Federal Reserve, bought in a mass of this debt through government action: quantitative easing. It was a brave move, and was intended to buy time – and it worked: time was indeed bought. The hope, of course, was that in that time, the economy could grow and thereby make the debts smaller in relation to the larger economy (just as a student loan is big to a new graduate, but small to the successful lawyer he becomes in a few years). We described the Bernanke initiative as a ‘firelighter’ – burning fiercely, but of limited duration. The story of 2011 is that the duration of that firelighter has run out, and subsequent easings have been decreasingly effective: more inflation, less proper growth. Only one barrel of Bernanke is still in place: interest rates so low that they knock your hat off as they fly past. The other barrel – central–bank money available for the system – is shot out. The result is something of a phoney war: the lack of money available for investment will eventually asphyxiate economic activity, but in the meantime, near free interest rates stimulate spending, and make already existing borrowing easy to service. The net effect, short–term, is better than the pessimists fear. But it raises again the 2008 spectre of a world which cannot repay its debts. 

This condition was the very essence of deflation in 2008, and its return is no less deflationary today. But 2012 is, crucially, different from 2008 – the debt is increasingly in the form of government debt, and when government debt defaults, it takes the form of inflation, since the currency goes to ruin. And just as with Enron, Worldcom or Ceausescu, the end comes surprisingly suddenly, since it is a failure of confidence in the currency which acts as the trigger. The credit agencies have worked this out already, and can’t afford to repeat their mistakes of asset–backed loans going bust with AAA ratings. So France and the other Europeans may have to learn to live with AA ratings during the interim period. When the loss of confidence comes (and we are arrogant enough to believe it is a ‘when’, not an ‘if’) a country’s citizens will fear that the value of their money is compromised – and they will rush to spend it, thus making a reality of their fear. Every schoolgirl who has studied economics knows that a price level is determined by multiplying together the amount of money in the system (‘quantity’) by the speed with which it circulates (‘velocity’). Economists, being mathematicians, and therefore formula–fanciers, spend all their time measuring the quantum; the next generation of schoolgirls will know much more than their elder sisters about the velocity. 

This new inflation could be really exciting, although rather like admiring the pretty pattern of the tracer bullets as they arc towards you. Throughout this period, interest rates will be nailed to the floor. Inflation of 5.5% didn’t get them to move (‘economy’s too brittle, old boy’) – the same could well be true with inflation in double–digits. This will tear through investment values, where cash on deposit will lose money in real terms at a similar double–digit rate, and most investments will not match cash. But index–linked are exactly designed for this eventuality. They prosper not so much from high inflation, as high inflation coupled with low interest rates. It’s the difference between the two which makes them move, and the long–dated ones can match a soaring Amazon for investment return as the yield–basis changes. 

A quick word on my personal plans. I shall cease being full–time at Ruffer on 31 March and after a few weeks return to work here on Mondays, Tuesdays (in the morning) and Fridays. With Henry Maxey, I shall remain responsible for the asset allocation of our assets under management – this partnership has been in place for over five years. And I shall continue to write this quarterly review! 

Jonathan Ruffer 
January 2012

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In our last review, I wrote that it was almost ‘impossible to call’ the coming events – that remains true, but it is abundantly plain where we will end up. In this context, the fog of the journey is perhaps less important than the destination: high road or low road, we are on the way to high inflation with low – eye–wateringly low – interest rates. It’s the insight of Knut Wicksell, over a century ago, who articulated its determining principles.

Wicksell was the man who observed that there is an interest–rate level which keeps borrowers and lenders in balance. Tilt interest rates up; the savers love it, the borrowers hate it: and of course, vice versa. He went on to observe that if interest rates are kept constantly below the happy medium – which he described as the natural rate of interest – it started to change the way a society behaves. Many savers become discouraged, and become either spenders or investors, depending on their temperament. Indeed it might be unclear which dynamic it is – those who bought a surprisingly large house 20 years ago might well have been motivated by the cachet of it, but they now boast about their excellent investment which has turned out well. So it is that the tenor of a society can be changed. According to Wicksell, this process has a momentum that cannot be checked, and if interest rates stay too low indefinitely, asset prices will rise to infinity. This reductio was intended to highlight the unreality of such a world. He described it as a fictitious futuristic concept; in a world where currencies were based on gold, it must have indeed seemed mythical. 

If you wait long enough at a bus–stop for a sea–horse, no doubt eventually one turns up. Wicksell’s myth is our reality. As I write this, the retail price index in the UK is 5.2% and Bank Rate is 0.5%. Can there be any credibility for the Bank of England’s policy makers (whose mandate is to hold inflation at below 2%) in having such a low interest rate? Not only have they achieved it, but the lone soldier who recklessly believed they should be put up to ¾% was regarded as a man of radical bravery! He has now retired.

When turkeys vote for Christmas, it’s worth looking for distortions. And you didn’t have to look far – the fragility of the financial system. It was Warren Buffett who noted that when the tide goes out, you get to see who has been swimming in the nude (step forward the heroes of my first paragraph!). The light–touch regulators, the stress–testers who passed as fit any bank that could lift an eyelid, the subsidies, the AAA–rated no hopers, the traders who wish from the bottom of their hearts that their rogue trades had worked – all combine to make the world unsure of where stability is to be found. There is far too much debt in the world, debt which should in an ideal world be serviced and eventually repaid. We know in our hearts that much will not be repayable – this intuition will become horribly apparent quickly if the payments of interest are anything other than near–zero. (On a different note, here’s a Victorian riddle: what’s the difference between a model woman and a woman model? One is a bare possibility, the other a naked fact. Boom–boom!) Contrast the aftermath of the savings and loan banking crisis in 1992 America with today’s. Then the Chairman of the Federal Reserve lowered interest rates to 3%, and invited the war–weary banks with their shot–to–pieces balance sheets to borrow from the US government at this rate of interest, and re–invest it in three year US government debt at 4.5%. Even the stupid ones could see that 4.5% is more than 3%, and since the counterparty was the same, there was no third–party risk. It worked, and the current Fed Chairman, Ben Bernanke is trying hard to do the same today. Interest rates are effectively free, but if you are outside the charmed circle, you may find yourself paying 0.25% (lousy European banks are currently finding they’re having to pay 0.35%, they’re so risky). If they invest in three year, US government paper, they get 0.38%. Even on ten year paper (which is far from riskless: ten years is a long time) they only get 1.7%. The latest Federal Reserve lifeline is another distortion on a distortion – Operation Twist is designed to ‘flatten the yield curve’. You have to be as clever as an economist to understand why this will help. 

But one thing is clear. Interest rates are welded to a near–zero rate. The central banks simply cannot put interest rates up, almost whatever happens to inflation. It is a gaping hole above the waterline, which could sink the ship if rates are raised to combat inflation. It leaves us all defenceless.

There seems no violent inflationary storm about to break upon us. There are, however, plenty of places from which inflation could break loose. And if Wicksell is right (which he is), the fact that it’s over the horizon is no reason to discount its inevitability. High inflation, low interest rates are a disaster for the saver (ie our client base) – and, in addition, in the UK we live in a world where nominal gains are taxed, notwithstanding that they are sometimes illusory if money loses value through inflation. Inflation–linked government bonds (of surviving nations) are designed for exactly this economic climate. It is not a high inflation rate which makes them thrive – it is the differential between inflation and interest rates. They have the capacity to become enormously valuable – like Titanic lifeboats – in a world where the ordinary saver despairs of keeping his nest egg safe. We have a great deal of your assets in them because we are approaching what I’ve described before as an airless valley which we have to pass through. Every investor suffers when interest rates are held below the rate of inflation; money on deposit guarantees a loss of capital in real terms, and it requires a risk–taking policy (along with many other people) even to hold steady in real terms year–on–year. This is unlike the 2008 credit crunch, where grief was optional – loud the bangs, and bright the flashes, but there were trenches to hide in. 

Are we feeling relaxed about these big inflation–linked positions? Absolutely not. The key to an untroubled investment performance is to be diversified in investments – always coveting being not wrong, and leaving being right to others. This is a unique asset class, apart from gold, which makes a tempting mistress, but an unsatisfactory wife. The absolute key to ultimate safety, in our view, is the presence of these bonds. In the meantime, they are subject to the vagaries of an investment consensus which is quite unaware of anything other than the fact that they are already unprecedentedly expensive. They are indeed expensive, travelling in the same charabanc as their conventional fixed–interest government securities, which are in a bubble every bit as dangerous as the dot–com stocks used to be – more so, actually, because they are at the very centre of the financial system. We’ve done our best to lay off the specific risk to this asset–class, and time will tell if we’re right or not. 

Jonathan Ruffer
October 2011

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The markets need to re-calibrate to accept a world in which the dollar and equities can be firmer, but this would be at the expense of commodity prices and less emerging market growth. Without this, a too-shrill response from China would risk a descent back into deflationary mire. This could happen anyway were there to be another financial accident, but the system is on its qui vive for this, and we judge it unlikely. In contrast however, it looks reasonable to acknowledge that if China needs to slow its economy, then most of the developed world will need to maintain very low policy rates to support growth and the banking system. The dynamics would make the relative economic merits of the United States manifest, which themselves should provide support for the dollar. Japan can well be seen as a warrant on the United States. A stronger dollar and reasonable US growth is benign for Japan, which is bouncing back from the earthquake (is this what one does from an earthquake?) fuelled by the cheapness of its stock market and strong position in niche markets. Ten years ago there was a lot of money to be made from identifying the mittelstand companies in Germany and Switzerland which were lowly rated and were entering a period of capturing market share. We think exactly the same thing could happen in Japan.

Central authorities everywhere are living in a world which is quite new, and all their initiatives are, by their very nature, experimental. Zero interest rates in America mean that the monetary policy of the entire world follows in its wake. It is clearly a powerful weapon to move people out of the passivity of cash, and into investment, whether financial or commercial. Nobody knows whether the anaemic recovery in western economies is testimony to the damage done in 2008 despite this stimulus, or whether the stimulus will have an increasing power to create prosperity. The accumulated debt of the last 25 years looms large; this is sometimes feared and sometimes ignored. Meanwhile the investment community itself experiments with different asset classes designed to protect against some of the darkest scenarios, but all the while assuming that the world will be able to glide on, narrowly missing frightening prospects. We are all aware of the bird which glides serenely on, paddling furiously below the water line – but none of us know whether it is a white swan or a black one.

Jonathan Ruffer
July 2011

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It is relevant today because we are known as a house to favour Japan: we have almost one-third of our equity exposure there - and for those who have had bin-liners over their heads for the last three weeks or so, we can report that there has been a massive earthquake, social dislocation and economic mayhem, and a sickening fall in the Japanese stockmarket.

The valuation which accompanies this investment report should deal decisively with the question: have our portfolios been badly hit? The answer is: scarcely at all, and the reason for this is the same reason which always applies in a Ruffer portfolio – it is not that we did not lose a lot of money in Japan (we did), but that other, offsetting, assets did sufficiently well largely to neutralise that mischief. If investors wish to worry about their money at Ruffer, they should worry that we lose the ability to find differing sorts of investments which act as offsets to one another. It is this ability which has kept the portfolios safe these many long years.

The rest of this investment review will largely be taken up with assessing the future of Japan through an investment lens. In this we are much helped by regular visits to that country; indeed we had two members of the team out there when the earthquake struck: they got out safely: Kentaro Nishida returned to Japan the following week to assess the situation on the ground, and this report relies heavily on his insights.

Our conclusion is that, while in the short term the direction of the markets is anybody's guess (and may well be frighteningly volatile), this is a turning point which will introduce the structural changes in Japan and, in turn will lead to a sustained bull market lasting for years. There is, frankly, no other market for which this is a remotely possible outcome.

Our enthusiasm for Japan at the beginning of the year was opportunistic. The political background was poor even by their desultory standards: the mire was hardening from mud to concrete. It left the Bank of Japan, always timid, always looking over its shoulder at the politicians, free to tiptoe towards a policy of boosting the stockmarket. This argued for a tradeable rally in Japan (which duly happened) – but the danger was that this rally would relieve the anxieties of the authorities who would feel a corresponding lethargy in tackling the structural problems.

Japan’s problem is its timidity. A senior official in the Tokyo Stock Exchange explained to us that 'Japanese investors suffer from vegetable spirits’ – and not only the investors. The refrain we heard on our trip was, ‘If only there were a crisis’ then changes could occur. We now have that crisis: Japan is reeling. The economy, beset with supply dislocations, electricity rationing and infrastructure damage, is bound to contract in the short term. The oil price is sky-high; this is an unlikely combination since economic contractions are usually brought about by conditions which cause oil demand, and by extension oil prices, to fall. And the yen, which needs to go down, to combat the deflationary forces, was forced up, as money was repatriated. A three-pronged trident aimed at the throat of Tokyo: the options for doing the wrong thing – of opting for a deflationary solution – are now decisively removed. Having a first-hand Japanese insight into the situation is immensely valuable. Kentaro’s view is that although there is a strong reluctance to accept that existing models and ways of behaviour are no longer working, when the Japanese do accept it, they will change their ways with comprehensive effectiveness and lightning speed. The original westernisation of Japan during the Meiji dynasty is typical of this, as was its post-war reconstruction in the 1950s and 1960s. We are witnessing, we believe, another such turning point.

One of the striking features of a first visit to Japan (I am told) is that what looks from the outside like a twenty-year old recession looks from the inside like a very rich country at ease with itself. The inexorable rise in debt which has accompanied this prosperity would not look alarming in the west, because the size of the western economies has grown, too: little matter that much of it was ‘money illusion’ (ie inflation): nominal growth of gross domestic product was the necessary ingredient. Last year Bank of Japan officials noted the widening gap between rising government expenditure and falling tax-take: this was laughingly referred to as the alligator’s jaws. Now they all appreciate that it’s snap-back time.

We expect to see massive injections of liquidity into the system from the Bank of Japan. They know exactly what to do; up until now, they have chosen not to do it. The effect will be to bring about top-line growth to companies: and to the economy as a whole. It will be bad for the yen (which will be good for Japan). It will cause interest rates to go up: everybody in the west worries about the harmful effects of increased borrowing costs, but what about the boost to savers? In a country where literally all the debt is owned locally, that is pretty much a one-for-one transfer. It will, over time, remove anomalies, and anomalies are the bane of economic effectiveness.

One of the least convincing arguments against long-term hope for Japan is demographics. Statistics show that the last Japanese couple die of old age in about 150 years’ time. It’s a ridiculous argument, matching almost the eminent Victorian economist Professor Jevons’ theory that recessions were caused by sunspots. For one thing, known problems nearly always get solved – it’s the unknown ones which do the damage. Secondly you could cite example after example of a static population economy performing in line with those whose population is growing. France’s failure to grow its population from the 1850s up until the 1920s seems to have had no adverse impact on its GDP growth (although it did alarm the military strategists as Germany grew stronger in terms of the numbers of its citizenry).

If there is a worry in all this, it is that both our Japanese investments and our index-linked holdings are jam-tomorrow ideas, which leaves us somewhat at risk if we find ourselves in a jam today. We think it is an acceptable one: the risk is neither probable nor extreme, but it highlights an eternal truth: the performance of the portfolios here does not come without risk.

Jonathan Ruffer
April 2011

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That was then, and today's decisive question is a different one – but still related to debt. It is this: can the debt built up over the last two decades be paid down? Our answer is that it cannot. Two years ago that assertion was based on rather less than it is today. The tsunami of liquidity known as quantitative easing (the first barrel, in the spring of 2009 known as QE, and its autumn 2010 successor as QEII), which followed in the aftermath of the credit crunch, has achieved many things. It has stabilised the world economy, which is growing (in the US, anyway) at an above average 4% per annum. Confidence has returned, and investment valuations have normalised. Everything is back to normal, it seems – except for one thing: the absolute level of debt. Quantification of debt is not easy, but there is a useful metric which divides a country’s debt by its GDP (the of the economy). For the US this sat at about 140% a generation or more ago, but rose from 220% in the later 1990s, through 300% in late 2005 to 373% at its peak three years ago. The latest published figure is 357% – effectively unchanged from its highest point. This is the world’s problem, and all the prestidigitation of the Federal Reserve has not alleviated it.

Debt can be extinguished either by repayment, which is not happening, or by default, which is the granite path to a depression. There is only one way in between: inflation, with interest rates kept well below that rate of inflation. This is what we are seeing in the UK, where there is already inflation, and what we will see in the United States when it reappears there.

In the meantime, the stockmarkets around the world are rather enjoying themselves, and, rather to our consternation, we have been enjoying a full benefit of this phenomenon. How can we have any sort of bullishness when there is so much danger about?The way to understand this 'benign’ phase of US monetary policy is not only to see that the policy of quantitative easing is massively inflationary but that it is being superimposed on an economic world which has many elements of deflation. We saw how effective this combination was in the 1990s, when China’s cheap labour and cheap goods pouring into the West masked policies which were, even then, unequivocally inflationary. While the hot sun of inflation beat down, the land was protected by a deflationary mist. A similar dynamic is at work today. The credit crunch provided massive and instantaneous deflation: the US easing has been burning off this mist.
Thus, the momentum is of increasingly inflationary pressure from the Western authorities which, while it neutralises lingering deflationary conditions, is broadly benign for markets. It will become malignant when it creates overheating. In early 2009 it was a fairly easy decision to climb aboard the donkey of asset appreciation; everywhere and everything was deflationary and was in need of inflationary measures. Investors need to be more selective now than hitherto as to where the money goes: when it comes to equity markets we prefer sclerotic to exotic. 

We take it as a certainty that a policy of easy money will continue: take the United Kingdom – retail price inflation nearly 5% and rising, Bank of England interest rates at 0.5%, with a lone soldier on the Monetary Policy Committee, Andrew Sentance, recklessly suggesting that perhaps 0.75% is more like it. But the key to this policy is not what happens in the UK but, rather, events in the United States. There, the Federal Reserve sets a level of interest rates not only for domestic America, but, through the reserve currency status of the dollar, great swathes of the rest of the world as well, particularly emerging markets. China, Brazil and the Far East don’t need quantitative easing at all – the mist has already been burnt away, and they manifest the classic signs of overheating in their respective economies. The consensus view in the market place is that while this will no doubt end in tears, it will first create a boom in asset prices. There will, so the thinking goes, be time enough to worry about the problems to follow. We think that investors will be disappointed. The Far East was on the wrong side of the disinflation trade in the 1990s – six years of boom, and a terrible bust under the baleful eye of the International Monetary Fund in 1997 and 1998. They will have no desire to repeat so recent and painful a memory. Expect to see liquidity constraints at national level, whether they be capital controls (withholding taxes on dividends, anyone?), credit controls or the like. Brazil has raised taxes on foreign bond investors, and Chile has started to intervene to support the peso. Markets hate these sorts of conditions, and those who are invested in the emerging markets simply because that’s where future growth will be found, will have to relearn this lesson.

The exact opposite is true for America. High unemployment, and a housing market barely stable at critically low levels, point to the lingering chill of deflation. QEII makes sense for America and most of the West (and, especially, for Japan). 

There is a compelling investment opportunity in Japan. As any fule kno, Japan is the poster-child of deflation: there may be summer mists of it in the United States, but there’s a blanket fog in Tokyo. Worldwide, a perception of deflation is the only thing which stops the accommodative monetary forces being inflationary, rather than growth-inducing. QEII will, we believe, work for long enough in the US to give an investable window of opportunity – similar measures in Japan could give something considerably more exciting. But will the Japanese authorities ease? 

A team from Ruffer has recently returned from Japan and we are persuaded that they will (in fact, they already are doing so). Frustrated by the stasis in the political arena, the Bank of Japan has become explicit in its encouragement of risk-taking behaviour. This has the dual advantage of buoying animal spirits and relieving pressure on the Bank of Japan’s independence. It has already launched a policy of purchasing risk assets, but the market was unimpressed by the amount: ¥5 trillion (just shy of £40 billion in real money – one fifth of our own Bank’s QE). However, the message our team received is that it may be the first of many moves: it will cause the economy to grow. Thus Japan is the beneficiary of inflation, the opposite of China, which is its victim.

We have also been building a position since the summer in German property stocks. The eurozone’s one fits all monetary policy is the most ill-fitting for Germany that it has been since its inception; the reason for lax policy is clear enough; to keep the indebted peripherals and the European project afloat. But the side effect is inflation at the eurozone core.

I remember complimenting a one-legged ballet dancer on the excellence of a party he had given. ‘I’ve never heard so elegantly expressed’, he said, ‘so much piffle’ [except he didn’t say piffle]. So, cutting through the piffle, what exactly do we have in mind in the portfolios? Japan remains the top beneficiary of the world for a reflation trade. America and the UK are just fine – for the time being. The outlook for Europe in general is cloudy (with sunny intervals) – too dominated by politics for comfortable investing. And avoid the emerging markets. Christopher Fildes, author of so many of the best one-liners, never got it better than when he defined emerging markets as being those places from which it is difficult to emerge in an emergency. You have been warned!

Jonathan Ruffer
December 2010

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The answer is clear enough: the words in the latest Federal Reserve announcement, ‘and is prepared to provide additional accommodation if needed’. This provided the signal that it is prepared for another round of quantitative easing. Connoisseurs of the mixed metaphor will know that we have provided a quiverful in our oft-repeated prediction of a series of deflationary shocks in the economy, each leading to the same resultant policy of Central Bank easing. Eventually ordinary citizens will lose confidence in their respective currencies, a dismay which will cause them to spend it – on a party, on the house repairs needed to be done for a bit, an investment – and the increased velocity of circulation will bring about the very inflation he has feared. Indeed the Deputy Governor of the Bank of England, Charles Bean, has commended exactly this course of action to hard-pressed savers! You really couldn’t make it up.

But we are going to look at quite a different aspect of this policy, that of encouraging the consumer (and the borrower) at the expense of the saver. A quick glance at a recent bank statement will set the scene. This appeared on a deposit statement of a client with slightly over £2.1 million in it– 

While this example might be an extreme example of customer care (rumour has it that one institution is changing its name to the ‘lessening bank’) it highlights a frightening development for savers: it is no longer possible to keep your money safe. The choice of a ‘riskless’ option in the form of an instant access account is now certain to lose money in real terms. With inflation currently running at about 4% in the UK, this is death by slow drowning.

The consumer is, of course, plagued by a series of insect bites: the car driver faces parking and speeding fines, householders are impotent in the face of council taxes (‘we’re from local government and we’re here to help you’), and face utility bills that can’t be utilised for anything – so a tax from the relationship manager at the local bank feels like just another of these things. There is within it, however, a great danger – most people who received so recently a risk-free return of 5% nominal on their deposit accounts will not easily stand for a return of nearly nothing, or nothing at all. Some will take Mr Bean’s advice, and be savers no longer. Others will judge that it will be better to accept a bit of risk and find an investment which gives the requisite yield. Those who have already taken that route have found to their pleasure that there is a brighter side to risk; they have received a reward! Government bonds, or even better, first class corporate bonds with names like Tesco, have given not only the running yield which substituted for the lack of deposit interest, but they have also made a decent capital gain as well. ‘Safe’ money has rarely been so imaginatively invested: buy-to-let back on the menu, high yielding ‘safe’ equities (we confess to liking these at Ruffer). But it is a distortion. By putting a false value on riskless assets the slightly risky, and the somewhat risky investments take their cue from that distortion. The easiest way to see this is in the price of the shortest index-linked stock, the Treasury 2.5% 2011. It is priced to give a real (inflation adjusted) return of minus 2.5%. Why would anyone want to own that? The answer, of course, is that with inflation running at more than 4%, the proceeds in cash will lose rather more (in real terms) than the loss of the index-linked gilt. The distortion in the price of the 2011 vintage is felt throughout the universe of index-linked stocks. The Treasury 1.25% 2017, not due to mature for over seven years, now gives no return at all. (Actually, a very small loss, in real terms to that maturity date.) This thought is reinforced by the Government’s quiet withdrawal of index-linked National Savings certificates some months ago.

Investors who look for safety first have to consider whether the capital is safe. Their failure to do so ahead of the credit crunch meant that everybody is now aware of the danger on this front. Consequently, there is a great attraction in the undoubtedly secure asset, but a second mistake is easily made; for an investment to be safe it must be both secure, and bought at a sensible price. There is no doubt that a government bond in Germany is safe in the sense that it will repay bondholders their contractual due, but with stocks on a three year maturity yielding less than 1% and the twenty-five year maturities yielding less than 3%, there is quite a possibility in the meantime of a substantial capital loss if circumstances change, regardless of the absolute security of the underlying investment. 

It does not often happen that the cost of money is so distorted that it changes the whole basis of market valuation, but it did happen in Britain in 1935/1936. Interest rates were so low that the Government was able to issue a 1% Treasury stock, maturing in 1942 – what price did that fall to in the ‘re-armament’ inflation of 1937 which reached 6%? Equities bought in late 1936 (taken as a whole) did not get back to the purchase price in real terms until 1985 – the longest period of nil returns for equities there has ever been in Britain.

How do we tackle this issue? The answer is with difficulty, since the distortions mean that the price of just about everything of investable quality is like shopping for bargain antiques in Bond Street. There are two ways of finding true safety. The first is to find stable assets which will inevitably be expensive on their conventionally assessed value, but which nevertheless have virtues which are currently underestimated. Pre-eminent in this category is the inflation linked government bond market and, in particular, the UK index-linked. Two years ago, nobody would ever have imagined that some of these stocks could be priced for a guaranteed loss in real terms. The circumstances which we have already described show that this is now so. The distortions which are explicitly observable in the short-dated stocks will run on through the longer-dated issues as well: real yields will become negative, driving index-linked prices higher. Since our primary view is that there will be a period when inflation will be much higher than interest rates, this distortion will be much magnified, and so index-linked stocks provide not only directionally the right place to be, but the chance of a massive re-rating as the distortion becomes more pronounced. On the other hand, conventional bond markets are dangerous almost in their entirety. The best opportunities will be at the junk end of the market, where stock-specific dangers are perhaps less than perceived. But the inflationary developments will be a body blow to the valuation of conventional issues, and the certainty of a nominal return, so much valued at the moment, will not be translated into confidence in a similar real return.

The second thought is to find assets which look more dangerous than they in fact are. High yielding large-cap companies perhaps fall into this category, but it is a well-worn theme, and is arguably more dangerous than it seems. The Will Sutton factor is largely ignored. (Will Sutton was the American bank robber who, when caught, was asked why he did it. ‘Because that’s where the money is’, he replied.) We live in a world where governments have desperately weak balance sheets, largely as a result of the bailouts to avert the consequences of the credit crunch. Foremost among the winners from this has been the corporate sector – so it will not be a surprise to see, for instance, the drugs companies’ tax rates go up, the integrated oil companies having to drill more safely, the corporate rules changed against the telecommunications companies in India. Each of these seems like a one-off hazard, but collectively they form a pattern. Nevertheless, the dividend yields are attractive, they are sufficiently risky to avoid somewhat the distortions of riskless money, and if (a big IF) their profitability can be maintained and enhanced, the dividends could provide an alternative inflation-linked return.

Another such area is Japan. The Bank of Japan is under terrific pressure to respond to the deflationary pressures within the system, and we believe it is only a question of time before the current regime in the Bank of Japan is either removed, or of its own volition provides a stimulus beyond simply currency intervention to the embattled Japanese consumer. If this happens in decisive style, we think the yen will be forced sharply lower, and the stock market sharply higher. This is truly one of the few markets which is cheap in almost any environment. We feel like the schoolboy with sixpence in his hand, and finding that the sweet shop has knocked 50% off all their stock. Which is it to be? The rum butterballs of financials, or the sherbert dip of exporters? This has the capacity to be a really exciting market.

In short, the distortion which has arisen within the markets drives a stake in the whole concept of keeping clients’ money safe: there is now a tax on safety. The need is therefore to think carefully about the juxtaposition of assets to keep the portfolios safe despite this impost; we are determined not to try to be clever in what we do. Long observation shows that clever fund managers lose their clients’ money rather more quickly than stupid ones!

Jonathan Ruffer
October 2010

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The biggest practical problem facing us at the moment is the use of currencies in protecting the portfolio from loss. Our philosophy is to strive for protection by investing in a wide range of assets which will protect, and be protected by each other. For many years this has worked well, and is still working well – but the increasing importance of liquidity provided by central banks means that there is a non-plussing correlation of all asset prices: up when the quantitatives are eased: down when they are reversed. If bonds, equities, commodities and real estate all go down simultaneously, what’s the fun of finding that you lost money in each of them? In this world, currencies have become the only effective way to achieve true diversity. But currencies are not very obedient to the fundamentals and this feline quality means that even a correct analysis of the situation does not ensure a satisfactory result. In the event, the gains (so far) in 2010 have largely been achieved through a bold move into the dollar.

There’s another danger with currencies. Our glory is in having no benchmarks – but a base currency is an implicit benchmark – stray too far from sterling (or other base currency), and the risks increase. This put us in a difficult position in Japan, where we have (correctly) identified that a weak stockmarket will be accompanied by a strong yen, and vice versa. The obvious way to protect our largish positions in Japanese equities would be to keep the yen unhedged – but a big dollop of dollars, and a big dollop of yen would have meant, for sterling investors, the risk of being too much away from sterling as a general election and a harsh budget approached. In the event we broke the wrong way arithmetically – the stockmarket did go down, the yen did go up, and we suffered in the former with no benefit from the latter. This need for currencies as an asset class is a temporary phenomenon, lasting only as long as the dominance of central bank intervention in the investment mix. When this dominance fades, we will be able once again to remember the adage: if you have a view on currencies, have a little sleep and hope that, when you wake up, you’ll have got over it. In the meantime, it will provide a specious excuse for any future underperformance.

The current weakness in the stockmarket is generally attributed to fears of a ‘double-dip’ recession – there is, however, little hard evidence of this, although leading indicators in both America and China would be consistent with a slowdown. For what it is worth, we incline to the view that the adrenalin afforded by extra liquidity will keep things bowling along for a while, and evidence of this should reassure markets. Nevertheless, it is worth taking a step backwards and reminding ourselves of the fact that the economic world is the instrument of a massive real-time experiment to see what happens when you pump extraordinary amounts of money into the system to neutralise the deflationary effects of the credit crunch. Eighteen months ago nobody knew whether this would turn world economic growth around. We now know that it did. Nobody knew whether the bond markets would tolerate such an injection of liquidity. They have done.

So far so good. Where are today’s uncertainties? Nobody knows whether this tolerance will continue for long enough to allow economies to recover their internal strength, so that the indebtedness they have created can be repaid. Those who speak the most authoritatively on such things are the economists, who not only failed to see it coming, but are so unblushing that one might almost imagine the dislocation didn’t occur, and the credit-rating agencies, who combined an equal lack of understanding with an egregious dose of conflicted interest. That’s as sensible as putting Messrs Pétain and Quisling in charge of the inauguration of the United Nations.

Despite this bankruptcy of understanding there is a sharp conflict of thought as to whether belt-tightening or continued assistance is the better way to treat the economy. Cynics might think that it largely depends on the election cycle, with Obama’s call for further easing playing into the mid-term elections in the US, and Britain setting off on a budget-cutting cliff-hanger (the only way is down) having established an uneasy political consensus following the May elections.

The theory behind this debate is reminiscent of the conundrum in the 1930s – balance the books and bring on a depression, or print the money and blow up sound money. Or, in today’s language, deflation or inflation? The two are very nearly the same thing. Imagine driving down a straight road when a tyre bursts. The car lurches to the left, and if the driver does nothing the car ends up in the (deflationary) ditch on the left hand side. More likely than not, the driver will desperately pull on the steering wheel to avoid this and then, of course, the danger is the right hand ditch of inflation. We have always said that for America the iconic mistake of the twentieth century was the depression (just as for the British it was the Battle of the Somme). Back to the analogy of the runaway car, the odds on left-leaning mistakes or right-leaning ones are not evenly balanced. There is an overwhelming dynamic away from the ‘do-nothing’ deflation, towards the soothingly-delayed consequences of monetary compromise.

We are – and have been for over a year – inflationists, but the travails of Europe and Japan – followed probably by China – will put this resolution to the strain. We believe though, that the worse the deflationary forces the more the policy response is towards monetary compromise. This is seen in the situation after Greece’s crisis: the contagion quickly threatened Portugal and Spain, so after a perfunctory show of firmness, the ECB produced a reserve ‘shock and awe’ cheque-book package of €750 billion. The more the deflationary lurch, the harder the steering wheel is turned.

We are increasingly excited about Japan in this context. The central bank has a good understanding of the need for financial easing – and, unlike the west, their shot is still in the locker. The onset of inflation is massively effective in rebalancing the comparative advantage away from the saver towards the borrower – provided, and here’s the rub – citizens don’t see it coming. Fifteen years of Japanese deflation or near-deflation means that nobody there has any inkling of how easy it is to inflate if the authorities are prepared to compromise on currency. They are as nervous as a * about pulling the trigger – it will take a crisis for them to act. What form might the crisis take? Exactly the sort of deflationary forces which abound everywhere, and which doubly afflict the Japanese economy. How will we recognise the moment – we won’t, of course, but if the yen strengthens to $¥85 – then hold on to your hats. Intervention will weaken the yen, steepen the yield curve, strengthen price expectations – and the equity market could be absolutely remarkable in its upward parabola. You heard it here first.

Although this may appear to be a second downbeat investment review, it should be an encouragement to readers. We are more than halfway through – probably – this period where the fundamentals of economic forces are willed into quiescence by politicians and bankers. We have taken our positions for the ultimate resolution of this tension – and it will be terrific for all of us if we are vindicated!

Jonathan Ruffer
July 2010

* little fluffy kitten

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The result of this is that success in the markets over the course of the next nine months will probably depend on opportunism. We remain convinced that the ultimate resolution of this time of uncertainty will be through high inflation – but first we have to get there. The management of the portfolios will require on the one hand, not to be bounced out of our core investments which protect the portfolios for this future development, and, on the other, not to sit disconsolately only in assets which in the short term may seem inappropriate. 

What are the elements of the cross-currents? The first one is bullish. Underlying economic growth remains firm across the established world. Many investors have been surprised – not to say incredulous – at the snapback in prosperity over the last year. There is a biggish constituency of bears waiting for its end – and they are set to be disappointed. We think that economic growth figures, unemployment and company profits are all set to produce favourable surprises. This is a continuation of a trend.
At the other, bearish, end of the scale, we think that China looks pretty flaky at the moment, manifesting all the hallmarks of a seraphic over-exuberance. Most bubbles have at their core an undoubted truth and the difficulties occur when unrealistic implications are drawn from the basic observation. The tyranny of the dotted line, stretching into the future, is where the heresy is incubated. China is a text-book example of this phenomenon. In the last generation, the nation has changed out of all recognition. The existence of 1.3 billion people, most of them still dirt-poor, shows what a driver of the world economy an energised China could be. Tired communist governments now look rather astute, and their inscrutability adds to the idea that there is a master plan. Unlike India, whose patron saint is the pothole, China is bursting with new infrastructure products. Capital investment at 58% of the economy puts the rest of the world to shame – but it also broadcasts a command economy which is completely out of control. How about this for a quote from China’s Housing Minister last month? In response to a question whether Beijing could stabilise home prices he said, ‘We can definitely stabilise them! The premier has said so! So how can we not stabilise, we can for sure! Even if we can’t, we can!’ Not even Harold Wilson at his most manic talked like that. The same E.coli bug is at work in China as it has been in the rest of the world: interest rates held below the natural rate for an indefinite period. The West has seen its unfortunate consequences in the last two years; in China they are yet to manifest and the timing is uncertain. But it is the same disease, and when we look back at the 2008 crunch in the West and the crunch to come in China, that will be confirmed. 

The situation concerning Greece is complex. The British are enjoying the cine-film of the EU emperor revealing himself to have no clothes, but the pleasure of all the Pathé films in the world would not disguise the fragilities under-girding the EU system. There is an uncanny parallel with ‘sub-prime’. Even after it became clear that sub-prime mortgages were largely valueless, there was a view in the United States that their comparatively small (about $250 billion in toto) meant that there could be no systemic risk. The nature of the derivatives market proved otherwise, since they were a constituent part of a much broader block of collateral which, when compromised, resulted in substantial losses in other supposedly riskless areas, relentlessly impairing the balance sheets and lending capacity of US banks. 

Continental European banks were also involved in the US problems, and now they have an additional issue with Greece. EU sovereign bonds – of which Greek bonds are a part – are used extensively in collateral baskets within the European financial system. Increased risk aversion towards these credits forces a contraction of the lending system, reducing leverage and credit availability; Greece may only be 2% of European sovereign debt, but as with subprime, the knock-on effects are large as the liquidity multiplier works in reverse.

There has been an interesting development in the swaps market which is pertinent to the Greek situation. This seemingly arcane area of the market is an important one, since it allows any financial institution to readjust the duration of its borrowing or lending without having to go to the trouble of trading the underlying assets. The swaps spread is really a yield, and given that there is a counterparty risk (you take out the swap with a financial institution, which could go bust – and sometimes does!) the yield is always higher than the government bonds on which the swap is based (which, by definition is guaranteed by a government, not a bank). Recently, however, the swaps spread has yielded less than government bonds. This might seem an arcane and uninteresting fact, but it is the financial equivalent of water flowing uphill. Regulators want banks, which look obese in gross asset terms, to slim down. Government bonds meanwhile offer wonderfully attractive risk adjusted yield spreads, providing an incentive for banks to expand balance sheets by buying them. The resolution of this is for banks to get exposure to these spreads synthetically in the swaps market rather than actually buying and holding the bonds on their balance sheets: hence the anomaly. But the dynamic is clear: following the relentless drumbeat of aggression from the regulators, post-Lehman, banks everywhere are rationing, reducing and simplifying their balance sheets.

Japan remains intriguing. It is the one economy which has not benefited from quantitative easing. The result is that Japan remains anaemic: sluggish retail sales, low borrowing, poor growth in hourly wage rates, an economy teetering on the edge of deflation. Each of these symptoms would be cured by a blood-transfusion. It is our belief that a powerful stimulus to Japan would weaken the currency, steepen the yield curve, and the lugubrious predictions of an implosion of government indebtedness would prove wide of the mark. Such a move would be unequivocally positive for equities.

All these disparate factors – and there are more – make it difficult to come out with a single coherent strategy. It is rather like those rather silly competitions which one used to find on the back of cornflake packets: ‘Put in order of attraction the following characteristics of Tupperware®: a) Tupperware® is strong, unbreakable and comes in many sizes, b) Tupperware® makes a family a go-ahead family, c) Tupperware® is hygienic and kills 99% of all known germs . . .’ The point is that these characteristics cannot really be put in order, Tupperware®-style. Nevertheless, it is possible to balance off risks in a way which should establish that if we cannot be absolutely right, then we can avoid being absolutely wrong. The strategy is that of Napoleon marching on Moscow – to preserve sufficient forces to represent a military threat to the Russians. Let us hope that we do it better than him!

Jonathan Ruffer
April 2010

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There is no such alarm in the financial world, yet the same thing has happened; what is more, its architects intended that it should be so.  Everybody can see that summers of prosperity are more enjoyable than winters of recession, and the dynamic has been: 'so let’s get rid of recessions!’.  Nobody is foolhardy enough to say that lower heating bills and fewer frozen pipes are a good reason for abolishing winter – and yet, economically speaking, this is precisely what the Fed has done.  The ambitious theme of this investment review is that the Federal Reserve has had the will and the resource to influence the very shape of the economic landscape, and has used this power so comprehensively that it has interfered with the rhythms of the world’s economy.

Its dynamic was a simple one.  From the late 1980s, whenever the economy looked like slowing down, the Fed simply lowered interest rates and made money freely available.  At the time of the LTCM crisis in 1998, a long period of prosperity was approaching exhaustion, and a recession was on the way.  The result of the Fed initiative was not only to sustain economic demand, but to set off a stockmarket (TMT) boom, which itself encouraged further economic activity.  But when that boom turned to bust the economic world was faced with two summers’ worth of detritus, and the likelihood of a deep recession.  The Greenspan trick was repeated, and, lo, there was no deep recession; instead a housing boom which itself turned into a housing bubble.  When this bubble burst in 2007, the world was looking at the stabilisation of the detritus of three summers – the original one following from the 1990s’ prosperity, the aftermath of the stockmarket bubble in the early years of the century, and the excesses which reached their crescendo in 2006/2007 in the leverage boom based on the housing market.  We were thereby faced, not with a recession (appropriate in the 1990s) or a deep recession (appropriate in the early years of this century) but a full-blown depression.  And when the US administration butterfingered the Lehman crisis in October 2008, it was upon us.

Unsurprisingly, the Fed responded to this crisis in the only way it knew how – lower interest rates and a massive injection of liquidity.  Slowly, hesitantly, sluggishly, the ship of state picked up – overwhelmed at first by the awfulness of the trade crisis which followed hard on the heels of the financial dislocation.  It seemed a forlorn hope that the depression could be avoided, but it has happened; for the third time, the winter season has been delayed while, this time, the balance sheets of sovereign nations take the strain.  But one day, perhaps soon, perhaps not, this new pillar of support will prove inadequate and then what will happen?  The pattern looks unmistakeable.  It starts, ‘no recession now, but a deep recession later.’ Then it becomes, ‘no deep recession now, but a depression later.’ After 2008 it becomes, ‘no depression now but...’ and it seems clear that the dynamic is going to be something like, ‘and then there will be a complete wipe-out’.  But this is emphatically not the case.  This is the moment for writing in green ink and in block capitals, NOT SO.

This may seem amazing, but it is the case.  The central bank dog has twice barked and made the position more and more unstable – how can the hair of this dog put us on course for a cure?  Before we rejoice in the introduction of a new stability into the world financial system, it is worth pointing out the frighteningly unsatisfactory feature of it: it is the money of the savers which is going to plug the destabilising gap between the accumulated debts and their lack of collateral.  We are all about to become a lot poorer.

To understand the background to this, one has to revisit the Victorian debate as to the nature of consumption in an economic system.  Can you consume what you haven’t got?  In the world of moral absolutes, morality and common sense came together in declaring that only accumulated wealth could be consumed.  This raised the tricky question as to where borrowings fitted into all this; a bicycle bought with borrowed money was every bit as much a bicycle as one bought from savings.  Did the motivation matter – whether the bicycle was to be used for a paper round, or for the pleasure of butterfly–catching?  The traditionalists took an absolutist line, standing alongside their theologian–brothers who were at the time defending the Bible against Professors Darwin and Huxley.  But they chose their positions badly.  Just as the Bible was a lot less brittle in accommodating darwinism than its defenders feared, so it turned out that the economy could handle a great deal of money borrowed for frivolity and pleasure.  In defending the wrong battle line, the traditionalists not only got the theory wrong, but the practicalities, too: in the 1930s, the policy of balancing the books made things worse, whereas Maynard Keynes’ suggestion that governments who borrowed money would give a helpful jolt to an economy, turned out to be spot–on.

For the last sixty years the idea has been discredited that you can’t create something out of nothing (an argument attested to by both King Lear and common sense: an unusual alliance): because borrowings have had the power to increase asset values, and have done so comprehensively, it has been assumed thereby that wealth also has increased.  The powerful lesson to be drawn from the leverage boom of the last ten years is that borrowing on the basis of an increase in asset value alone is not, in the long-term, a sound proposition.  The extra value in the stockmarket bubble created borrowing–capacity, but when the bubble burst the borrowings secured on this virtual wealth were left beached.  Its replacement by the housing boom provided an alternative support – for a while – but by 2007 it was seen to be no more real than its predecessor.

We have now moved into a new third stage.  Bank loans in the private sector have been replaced by government borrowings – which create deficits.  Any problem in these will be felt through the currencies of sovereign governments – stand by for this next default!

Earlier generations would be amazed at the utter naivety of our financial generation to imagine that a paper currency could possibly – could possibly be a substitute for wealth.  Property, land, claims on profitable enterprises, even tulips, yes!  But paper currencies?  Surely the 1825 Colombia Loan (money lent, ammunition bought, ammunition fired off, end of loan) proved that?  Like all sophisticated societies we have to learn the obvious lessons last.  When currency values buckle, a third chimera of wealth will fade as inflation causes monetary spending power to decline.  Nevertheless, providentially, this inflation has within it the seeds of hope.  Provided interest rates are held below the rate of inflation (helped along by taxes charged on nominal returns rather than on an inflation–adjusted basis), then savers will find that the value of their wealth goes inexorably down, year after year.  Riskless returns that are negative were enjoyed – if that is the right word – in Britain between 1975 and the early 1980s.  Savers and those on fixed retirement incomes became poorer and poorer with each successive year.  This was an effective transfer of wealth from those who had it, to those who didn’t, either through poverty or debt.

Today, the man with £1 million of debt, and an asset worth, say, £500,000 is not only  insolvent, he is also a threat to the stability of an economy.  If money halves in value, he may well be able to sell the asset for £1 million in devalued currency.  If he has paid only a small amount of interest in the meantime, then it is the creditor, the man with the savings, who is repaid in devalued money, and he has had no proper post–tax reward for his pains.  This is the cure which is unfolding upon us – but for the saver it is more of a curse than a cure.  This practical and immediate danger is very hard to guard against, and extremely irritating to live through. That is why your portfolio looks as it does at the moment.

Jonathan Ruffer
January 2010  

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At the start of the year, there was a sense that an elemental force had been unleashed which had smashed its way through the accumulated reserves of the financial system – what could the pygmy politicians and timeserving central bankers do to avert it? The long term answer to that question remains open, but in the short term, quite a lot. Now that the policy of pumping vast streams of liquidity into the system is well established, things are on the move. There are, of course, critics who point out that the central authorities should never have got themselves into the problem in the first place. There was a Victorian doctor, not much good, who gave all his patients a powder which induced a seizure, because, as he explained, he was ‘a dab at fits’. So it is with Dr Bernanke and his predecessor, Alan Greenspan, at the Fed. Any plaudits for their decisive action need to be seen in the context of the past enormities which created the crisis.

Nevertheless, the Fed, and its counterparts elsewhere have indeed proved to be dabhanded at halting the slide into a depression. Wherever there are pockets of economic strength, the hand of government action is to be seen. Car sales, which were in crisis last Christmas, have now recovered – thanks to the ‘cash for clunkers’ initiative whereby you swap your old car for a new one and get a government hand out of $4,500, £2,000 or €2,500, depending where you live. House sales are recovering in America – but it is estimated that fully five-sixths of all transactions have some form of government subsidy.

The bears didn’t think that these initiatives would work – but they did. Our economist, Peter Warburton was shrill in his warnings to us not to underestimate this central monetary shock and that the world economy would likely recover quickly and powerfully. How wise he was! And he continues his theme today, saying that the growth in the last half of 2009, and particularly the final three months of the year, could be awesome. This could really spook the bears who belatedly will come to see that the spring rally was not fanciful. Moreover there are still plenty of people who feel that last year’s events were an unreal nightmare which came from nothing, and will return to the ghost-cupboard with a good squirt of WD40 on the bits which had gang a-gley (Lehman’s banking arm?), and it’s now time to make up for lost ground.

Sharply improving dynamics in economic growth are driving markets higher, and they are much reinforced by the hunger for income which has arisen from a world where bank deposits offer barely any return at all. Equities are a natural beneficiary of this. They are liquid, sold at the drop of a hat (or the flip of a coin); after last year’s fright over illiquid investments, they are the asset class of choice. Being a ‘real’ asset, they offer protection against paper entries in paper currencies in possibly paper banks. Above all many of the blue-chip super-companies have superior yields, in the UK, for instance, Vodafone and BP come to mind. Do not, therefore, be surprised if the prices of these sorts of stock exhibit bubble characteristics over the coming months.

But these are tactics. The key insight is to understand that it can’t last this way. The demand for cars is based on the government handout, and without it (and the one thousand and other incentives and injections) the economy would fall lifeless to its end-2008 dynamic. The fires of the world economy, post-Lehman, were doused with cold water and were in danger of being extinguished. The central authorities, with their response, are effectively the providers of firelighters on an industrial scale. The result is the fierce flame of economic strength – and it is real strength. The bears missed it, and the bulls are in danger of missing its temporary nature. Yes, the market may rise higher – considerably higher perhaps – but in the long run the firelighters are not the answer. This is a key moment for asset allocation and as is so often the case at such times, the optimal mix may be quite different depending on timescale. The longer out one looks, the less interesting – and the more dangerous – a strong equity exposure looks.

How does it go from here? There are so many variables to consider that the path (which we will come on to in a moment) is impossible to gauge – but the destination of inflation is the same whether the world takes the high road or the low road.

We believe that in the New Year the markets will be trying to assess the significance of sharply stronger economic and possible wage growth. There will be those who think – using my analogy – that the firelighters have succeeded in lighting the fires of the real economy. We have to say that we don’t think so (too much detritus from the recent past): we might be wrong, or even if right, the market may take an opposite view. The resolutions of this uncertainty give rise to a greater uncertainty – what will the Fed do? We described in last quarter’s review how we could well be looking at a widespread disruption in the supply-chain for goods and services around the world – and disruption means inflation. The extra bottle of champagne from the all night corner shop is a lot more expensive than from the wholesaler – but if you run out of booze it may well be your only option. You pay more, although the cost of champagne has not moved.

The irony is that the Fed may have to (or choose to) respond to this corner shop inflation by cutting its programme of quantitative easing – horribly exposing the fragility of the underlying economy. This would be terrible for markets – the realisation that for all the accommodation, it had been ineffective. This is hard to prepare for within portfolios. Its occurrence is a surmise on a surmise – not necessarily a high probability. It would require a substantial shift in assets towards conventional bonds, which are already fully priced. It would hit equity markets at a time when other possibilities point to their continued upward movement. It calls, more than ever, for a philosophy of an asset distribution which forgoes the possibility of being absolutely right to protect from being absolutely wrong.

We remain sure that this ends in inflation. If things improve it will come, if things get worse, there could be a moment of deflationary fear, and then the inflation of currency compromise. Either way the losers in this inflation will be savers, especially those trying to keep their money safe – in short, dear reader, you.

We are half way – almost exactly – through the crisis.

Jonathan Ruffer
September 2009

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