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Equities: a false sense of security

15 mins | Market views
Duncan_Macinnes
Articles by Duncan
Duncan MacInnes
Fund Manager
15 October 2021

For the current generation of investors, equity markets have been remarkably happy hunting grounds. There have been crashes, bangs and wallops in recent years but, so far, central banks have ensured any pain was short-lived. As interest rates have fallen, investors have chased stocks up the page and global equity markets are now more highly valued than ever.

But these halcyon days may be coming to an end.

Not since the 1970s has inflation risk loomed so large. The bond market promises woeful returns in an inflationary world, and so investors have waded yet deeper into equity markets. The right businesses, after all, can withstand the corrosive force of rising prices.

Can’t they?

We fear not. And a look under the market bonnet reveals just how destructive inflation can be for equities.

The case for equities

Some investors have concluded that the answer to the problem of a low-risk asset (bonds) becoming un-investible is to buy lots more risky assets via equities. This is a prime example of the frequently quoted financial nihilism of the digital age: ‘There Is No Alternative’ (TINA). And so long as there are no more attractive assets available, equity investors can rest assured that there will always be a willing buyer for their stock.

But the case for owning equities doesn’t just rely on the absence of better options. Many investors consider equities a direct inflation hedge. The logic is simple: companies may suffer from rising costs, but they can pass these on to their customers by raising prices. By doing so, they protect the real value of their cash flows.

Most investors recognise that inflation is uneven, prices rise faster in some industries than others, and so they seek broad and diversified equity exposure – often by tracking an index.

However, this strategy might not afford investors the protection they expect.

How does inflation affect the market?

There is a well-attended school of thought which believes broad-based equity exposure can be an effective hedge against inflation. The facts, however, suggest otherwise.

The chart below shows inflation versus price/earnings multiples and the relationship is clear – as inflation rises, valuations fall. Equities like low and stable inflation, as we have experienced in the last 30 years. Equities do not like deflation or higher inflation – both scenarios cause a significant de-rating of the market.

This risk is particularly pernicious from the current starting point (orange dot) of the highest equity multiples on record.

Click to view larger image

To use a crude example, Microsoft may well have the pricing power to pass on inflation to its cus-tomers. But inflation could quite feasibly add an economic risk premium that takes the price-to-earnings (P/E) multiple from the current 34x to 20x, where it was five years ago (a 40% drawdown). For context, in 2012, Microsoft’s P/E ratio was 10x1.

De-rating hurts even the best companies. Take the example of Hershey (the chocolate makers) in the 1970s. The top table is the operating performance of the business, the bottom table is the perfor-mance of the listed equity.

Click to view larger image

As a quality business with growth and pricing power, Hershey was able to navigate the inflationary and economic volatility of the 1970s as well as anyone – successfully passing input cost rises onto con-sumers so revenue and operating profits grew handsomely over the four year period.

However, the equity market is not forgiving of economic uncertainty. Despite impressive earnings growth, the price of Hershey stock plummeted from $24 to as low as $8. The P/E multiple fell from 16x to 5x2.

In the 1970s, inflation didn’t just rot the odd apple – it brought blight to the entire orchard.

A higher discount rate means fewer bargains

Equities are the ultimate ‘real duration’ asset. Due to their infinite maturity they carry much greater interest rate sensitivity than any other asset class. In theory, all equities should be priced at the dis-counted present value of all future (estimated) cash flows. The key variable is therefore ‘the discount rate’ – also equivalent to your expected/required return.

Put simply, when the discount rate is higher, the present value of future cash flows is lower. In ef-fect, this reduces the value of a given company.

The chart below shows the impact of a change in that discount rate on a perpetual stream of earn-ings from a hypothetical equity eg, an enduring and predictable business – such as those in the luxury or consumer goods sectors.

Company X generates £100m of cash flow per annum. Valued at a 3% discount rate (say the UK 30 year bond at 1% and a 2% equity risk premium) this company is worth £3.3bn. Just a 2% change in the discount rate, via bond yields/bank rate or the equity risk premium changes the fair value to £2bn. This equates to a 40% drop in the value of the equity. So in this instance, stocks may even be more vulnera-ble to rate rises than bonds3.

Click to view larger image

The advantage of being active

Reality is nuanced: some equities will act as effective inflation hedges – even in the event of a broad market de-rating. We own many in the Ruffer portfolio; some financials, energy stocks and commodity producers for example.

The problem for passive or benchmarked investors is that these sectors have withered to a small percentage of the index. If you own the index, you do not own enough of them to make a difference. In 1980 the Energy sector, an obvious inflation beneficiary, was 28% of the S&P 500, in 2008 it was 15%, today it is 3% – the whole sector is about half as big as Apple4.

Click to view larger image

10,000 spoons when all you need is a knife

Today’s elevated asset prices are built on the shaky edifice of low interest rates and compressed risk premiums. Valuations are high across the board and therefore sensitivity to changes in the discount rate have never been higher. High valuations mean almost all asset classes have a high duration.

Different asset classes are all now dancing to the same tune – it is one big duration concert. Growth stocks and infrastructure assets are underpinned by the same low bond yield that makes conventional bonds an unattractive addition to the portfolio.

This dynamic is pervasive, reflecting a huge swathe of portfolios in the market and yet, as per bond prices, it could breakdown spectacularly if inflationary pressures persist.

At Ruffer we aim to get our investors on the other side of this trade, that is how we have made our big returns in the past, eschewing the mania, and owning the assets investors panic into at turning points.

When we get our portfolio construction right, we are putting uncomfortable assets together in a way that the overall result is a comfortable, lower volatility one.

Getting to the other side

We aim to keep the menu of potential assets we can own as wide as possible. By being global, unconstrained, and un-benchmarked we can pick different assets, in different amounts, at different times. We do not rely solely on equities to drive returns – and so we feel comfortable reducing our exposure when we need to.

Crucially, this allows the Ruffer portfolio to exhibit low or negative correlation to equities at times when risk assets are selling off.

This skill of active asset allocation – with a broad investment toolkit and an unconstrained mandate – could prove decisive in protecting the real value of our clients’ capital in a new inflationary regime.

#inflation
Worried about inflation
The return of inflation poses a critical threat to balanced portfolios – severing the relationship between bonds and equites which has held steady for nearly half a century. And yet investors, so far, have stuck to what they know – trusting a portfolio built for the world which we are leaving.
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Inflation protection toolkit
Investors have been wrestling with how best to defend their portfolios against 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. Here, we assess the options available to investors and look at what we’ve chosen in our inflation protection toolkit.
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Investing in big oil
October 2021: The energy sector has fallen from 16% of the S&P 500 just 13 years ago, to below 3% as of today. And yet the integrated oil majors make up more than 6% of Ruffer portfolios. We often receive questions from clients about the rationale and justification for these investments.
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  1. Factset and Ruffer calculations
  2. Ruffer calculations, Hershey company accounts
  3. Ruffer calculation
  4. FactSet and Ruffer calculations, data as at 4 October 2021

Past performance is not a guide to future performance. The value of investments and the income derived therefrom can decrease as well as increase and you may not get back the full amount originally invested. Ruffer performance is shown after deduction of all fees and management charges, and on the basis of income being reinvested. The value of overseas investments will be influenced by the rate of exchange.

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. References to specific securities are included for the purposes of illustration only and should not be construed as a recommendation to buy or sell these securities. 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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London
Ruffer LLP
80 Victoria Street
London SW1E 5JL
Directions | Map +44 (0)20 7963 8100
Paris
Ruffer S.A.
103 boulevard Haussmann
75008 Paris, France
Directions | Map +33 (0)1 88 45 02 54
New York
Ruffer LLC
300 Park Avenue
New York NY 10022
Directions | Map +1 917 947 3003
Edinburgh
Ruffer LLP
31 Charlotte Square
Edinburgh EH2 4ET
Directions | Map +44 (0)131 202 1602