All-weather investing

Seeking good positive returns.

Come rain or shine.

Ruffer provides investment management services for institutions, pension funds, charities, financial planners and individual investors.
Ruffer LLP
Select Location
UK
Europe
Australia
US
Asia
Middle East
Channel Islands
Rest of world
Type of investor
Individual investors
Institutional
Charity
Family office
Financial planner
Individual investors
Institutional
Charity
Wholesale
Institutional
Institutional
Institutional
All investors
All investors
London
80 Victoria Street
London SW1E 5JL
Edinburgh
31 Charlotte Square
Edinburgh EH2 4ET
Paris
103 boulevard Haussmann
75008 Paris, France

A Ruffer Christmas Scrooge?

A mountain of evidence

Steve_Russell
Steve Russell
Investment Director

Negative real interest rates can be bad news for equity valuations

At Ruffer we’re used to being accused of seeing the glass ‘half empty’ rather than ‘half full’. It’s not that we’re inherently pessimistic, but our job is to protect our investors’ capital against whatever might go wrong in markets. So naturally we tend to focus more on the risks than the opportunities. Or as Jonathan Ruffer might put it – to see the mousetrap clearer than the cheese.

This month’s chart is aimed at countering the current idea that highly negative interest rates are supportive of sky-high equity valuations.

Historically whenever real interest rates have deviated from the ‘Goldilocks’ range of -2% to 2, stock market price-t0-earnings ratios (P/Es) have fallen. The only exceptions being the tech bubble in 1998-2000 and the recent post-covid period. The first ended badly, we must wait to see what happens this time.

This is all about the discount rate. The rate at which we need to discount future profits or cashflows to work out what they are worth today.

If interest rates and inflation are both zero, then the real interest rate is also zero, so we don’t have to discount future profits at all. Money received in the future is worth as much as money received today. Therefore the valuation of equity markets, or the P/E ratio, can be justifiably high. This goes a long way to explaining high equity valuations since interest rates were slashed after the credit crisis.

We know if interest rates rise sharply, markets are likely to fall, partially due to a higher discount rate. If interest rates jumped to 10%, then future profits from equities would have to be discounted at 10% a year. Bad news for all stocks, but especially for those where most of the profits and cashflows are expected to be paid in the distant future. The growth stocks, profitless companies and concept stocks so popular today would clearly be the hardest hit in such a situation.

What about the position today, with interest rates still close to zero but inflation printing at over 6%?

Let’s use another extreme example. If interest rates remained at zero, but inflation was 10%, then we would have a real interest rate of minus 10%. The interest rate element of the discount rate remains wholly supportive of high valuations, but what about the inflation part?

If inflation is running at 10%, then there will be more uncertainty on both future earnings and future interest rates. In contrast to the current market conceit this would demand a higher discount rate (and not a lower one). This implies a lower valuation for markets as a whole and potentially even worse news for those most highly rated growth stocks.

Our concern is if inflation stays elevated, even if central banks keep interest rates low, then current stock market valuations will prove far too high.

Yes, equities can be considered ‘real assets’ whose cashflows may rise with inflation. This makes them better than conventional bonds when inflation is high. But watch out for a de-rating that could cost investors dear.

So all of us at Ruffer wish you a Happy Christmas and a prosperous New Year. But to paraphrase Dickens, beware the ghosts of inflations past, present and especially future.

Inflation protection toolkit
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. We look at how the risk of inflation might be mispriced, and why it may pay to be prudent.
Read
Ruffer round up – Q3 2021
October 2021: A brief round up where we look at how recent events impacted markets and Ruffer portfolios, and what investors have learned as we move into the fourth quarter.
Read
Not all inflationistas wear flares
November 2021: Investors have divided into two camps. Those who believe inflation will subside and the rise in prices will prove temporary. And others who fear we are entering a period of high sustained inflation reminiscent of the 1970s. We consider both scenarios unlikely.
Read

Chart source: Datastream, Ruffer LLP, data 1974-2021

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.

London
80 Victoria Street
London SW1E 5JL
Edinburgh
31 Charlotte Square
Edinburgh EH2 4ET
Paris
103 boulevard Haussmann
75008 Paris, France