September 2009

The economy – and the stockmarkets – have entered a sweet spot in the saga of the credit crunch. A year ago the financial world was fighting for its very existence, and the consequences were not long–delayed in the economic world. Six months ago, they bottomed, and the markets have recovered fully half what they lost. The purpose of this review is to analyse the conflicting forces which have led us to our present state – and to assess what we might expect in the future.

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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Benjamin Boucher–Ferté

Investment Director

Graduated from ESCP Europe in 1999 and joined the Private Wealth Management group of Goldman Sachs in London after completing his National Service with Renault Financial Services. In 2004, he participated in the launch of Fulcrum Asset Management where he was a Director until 2010, when he joined Ruffer.