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Articles by Duncan

Duncan MacInnes

Fund Manager

24 September 2021

Investors have been wrestling with how best to protect their portfolios from financial repression (higher levels of inflation relative to lower interest rates) ever since the Financial Crisis in 2008. And now with inflation numbers hitting multi-decade highs, this search has become increasingly urgent.

The asset management industry provides investors a toolbox brimming with options. Some of these tools worked in the past, others promise to work in the future.

Here, we’ll assess the options available to investors and look at what we’ve chosen in our inflation protection toolkit.

Equities

Many investors, especially those who have never experienced inflation in their careers, are pinning their hopes on equities to ride out any storm. Such hope, however, may be misplaced.

Investors derive their faith in stocks from two main observations. Firstly, that equities are ‘real’ assets – tangible things that have intrinsic value. And secondly, that many companies can pass on price rises to their customers. This is theoretically sound, but history tells a different tale.

In fact, periods of high inflation have been disastrous for stock markets. As inflation rose between 1966 and 1974 the US Cyclically-Adjusted Price/Earnings ratio (CAPE), developed by Nobel laureate Robert Shiller, fell from 24x to just 8x – the market ‘de-rated’. De-rating occurs when (even if interest rates are held to the floor) rising inflation causes the discount rate on future equity earnings to rise with it. The result is that the present value of future cashflows is much lower.

This would be calamitous for highly rated growth stocks and currently profitless businesses. Given the current starting point of record high valuations for equities and the overwhelming concentration of markets in growth and high PE stocks, it will take remarkably agile stock picking to avoid severe losses in equities if inflation rises.

Credit/Investment Grade Bonds

For many investors, income is as important as growth. With interest rates at historic lows, yield seeking investors are being forced into ever more risky investments.

Investment grade credit has been a happy hunting ground for income hungry investors – and it has had a fantastic decade. But from today’s starting point, credit markets are in a state of paradox - they offer record low yields, despite record levels of debt.

The mathematics of bonds is such that at lower rates the duration (sensitivity to interest rates) increases. This means that credit as an asset class is vulnerable to even the smallest change in yields. This could be in response to a change in inflation, or credit and term risk premiums. Just a 1% upward shift in bond yields would wipe out 7 years of coupon income in capital losses (see below). Even if central banks keep bond yields nailed to the floor, at these yields even modest rates of inflation would eliminate any real return. This looks disconcertingly like ‘return free risk’.

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Strategic bond funds

Worried about interest rates going up?

You could use a strategic bond fund which can use derivatives to hedge the duration risk out of its portfolio and can oscillate between government bonds and company debt.

However, this only solves part of the problem – these assets swap duration risk for credit risk, investors are compensated by lending to riskier businesses or structures. As with investment grade, credit risk premiums are extremely low by historical standards. High yield bonds yield just 4% which is not an attractive return for taking on significant business and cyclical risk, especially with current US inflation running above 5%¹.

More money has been lost reaching for yield than at the point of a gun.” Raymond DeVoe

Infrastructure

Infrastructure assets are worthy of consideration for a place in portfolios – they can work well as a bond replacement, but they aren’t a perfect solution.

We think of these as “real duration” assets which often benefit from strong covenants and inflation linked revenue uplifts. However, like bonds, infrastructure assets are vulnerable to rising interest rates due to their long duration cash flows from long-lived assets. The same applies to risk premiums, a 2% rise in the discount rate on a 40-year expected life asset can equate to a 20-30% fall in the present Net Asset Value. There are additional risks to be considered here too – could the government or regulator change the rules or alter the terms of the agreement? If inflation surprises on the upside are governments really going to allow utility and infrastructure costs to be fully passed through? At the extreme there is also expropriation risk – most developed nations are actually just one general election away from an administration which promises to nationalise these assets for the people.

Property

Bricks and mortar has been a gilded haven for investors in recent decades.

Property is another “real duration” asset with, generally, inflation-linked cash flows. But property investments come with more economic risk. Crucially, many clients will already have significant exposure to this asset class, so it does little to help diversification. There can be significant sector performance variations – imagine five years ago allocating to London office space and shopping centres rather than server farms and logistics warehouses. Global super prime real estate assets, and much of quality residential, now trade on full valuations with cap rates of 3-4% so prospective returns look comparatively low.

Not hiding in real assets, either

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Renewables

This has been one of the hottest sectors in the last few years in terms of fund launches and inflows.

This tends to be a warning sign of froth and is generally better for sellers than buyers. Renewables sit at the intersection of property and infrastructure with many similar attractions and risks. Long term returns are not so easy to predict because of the same regulatory and discount rate risks as infrastructure. Additionally, individual technologies and businesses come with obsolescence risk and almost always some dependency on government subsidies, which can be withdrawn.

Commodities

Once a stalwart of defensive portfolios, commodities have become less fashionable as an inflation hedge.

Implementation can be difficult, and the cost of carry can be high due to costs of physical storage, or technicalities such as contango on the futures curve. Over the long term the real return on physical commodities has been zero or negative.

Which tools are Ruffer using?

The benefit of being global, multi-asset, unbenchmarked investors is you can go anywhere and invest in anything.

This flexibility is increasingly essential in a world where safe havens are so expensive that they have become dangerous.

Inflation-linked bonds

Investors historically don’t like these as they are perceived to be expensive.

Paying a premium for something you don’t think you'll need would be a wasted cost. However, we think of inflation linked bonds as akin to an insurance premium. You hope you don't have to use it but if you do it will be the best money you’ve spent.

We have 25-30% of the portfolio in these bonds, the key asset being 13% in long-dated UK inflation linked gilts. The main driver for index-linked returns is the gap between inflation and bond yields – a move to more negative real yields. This is something we expect to widen significantly as inflation and growth accelerate, but bond yields remain pinned to the floor under the heavy boot of central bankers.

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Gold

Both bullion and gold mining stocks continue to be valuable assets for protection against rising inflation, financial repression and failing trust in institutions.

We continue to think of the gold price as the inverse of the market’s faith in central bankers’ ability to micromanage the economy. Bitcoin played a similar role in our portfolios.

We believe we’re entering a more inflationary and more volatile regime in markets. Such an environment threatens asset classes of almost every flavour. For true protection and diversification, we think investors need to rely more heavily on unconventional protections.

These include:

Credit protection

In effect, shorts on corporate bonds.

Where we can find ways to do this, we have an asset that is pretty much guaranteed to go up when risk assets go down. That is rare under current conditions. These protections proved their worth last March when these investments almost doubled for our portfolio.

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Payer swaptions

These derivatives offer the right, but not the obligation, to enter a ‘pay fixed, receive floating’ swap agreement.

In essence, an option which benefits from rising bond yields. Rising yields are a tough environment for most asset classes and that makes this a rare and potent protection. Payer swaptions, along with financial equities are one of the very few negative duration assets.

One thing is clear - no one asset, nor single strategy, can guarantee success. Instead, investors will require a diverse toolkit – flexible, adaptable and resolute.

At Ruffer, we believe we have built exactly that.

Bloomberg Barclays U.S. Corporate High Yield Index, September 2021

The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument, including interests in any of Ruffer’s funds. The information contained in the article is fact based and does not constitute investment research, investment advice or a personal recommendation, and should not be used as the basis for any investment decision. This document does not take account of any potential investor’s investment objectives, particular needs or financial situation. This document reflects Ruffer’s opinions at the date of publication only, the opinions are subject to change without notice and Ruffer shall bear no responsibility for the opinions offered. Read the full disclaimer.

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