In lockdown, I have been watching the blockbuster Deutschland 89. There’s a moment in the hours before the fall of the Berlin Wall when the top-dog commissar considers whether to shoot himself—but a little piece of hemp consoles him with the thought that times of change are times of opportunity, times that bring up new winners.
I take it pretty much for granted that the 40-year bull market is ending, and that it will be replaced by hard investment times. I am sure it will be a period dominated by what has come to be known as financial repression—a period when the post-tax returns from assets don’t keep pace with higher inflation. Savers will endure many years of enforced declines in the value of their wealth—in real (inflation-adjusted) terms.
It is through the eyes of the income owner I want to examine this phenomenon. Those who own assets outright can look at the ‘total return’ from their investments, indifferent to whether the money they spend (or accumulate) takes the form of income or capital. But not everyone is in the fortunate position of retaining flexibility in how they seek gains. For those with restrictions—such as the trustees of others’ assets—there is often a need to balance the competing interests of income today and capital tomorrow, regardless of which way the financial winds are blowing.
One strategy which has done well for total return has been the standard 60:40 ‘balanced’ portfolio. A 60% allocation to equities—believed always to be long-term winners—is offered protection in hard times by 40% in bonds (because in difficult conditions, bond yields come down and—crucially—the price of the bond goes up). It’s a great game, but only when inflation is falling. Ruffer’s early fortunes in the 1990s were made on this single insight—we went for 50:50, rather than 60:40—matching War Loan (oh those days when government bonds told the truth about their past!) with a broad spread of equities. Back then, we had the field to ourselves, as few believed inflation could be comprehensively beaten.
A quarter century on, a bond yield may drop, in a matter of days or weeks, from, say, 0.5% to 0.25%. This sounds, in common sense, to be a drop from ‘very little’ to ‘very little indeed’—but the arithmetic of the bond markets is mechanical, and that drop in yields moves the capital dial a fair bit. Yet this is arithmetic that works both ways. It makes today’s fixed interest security not a safe pairing for equities, but simply the opposite sort of danger. Now that inflation is about to go up, we enter a world in which bond and equity prices look poised to fall in tandem.
This review is the outcome of the struggle to understand the difference between income and capital, in a world where today’s true things may be fleeting, but where tomorrow’s true things will ineluctably become market truth. We can go back 10,000 years, to the banks of the Nile. The earth was barren until it was worked (that’s the industrial element) and the tilled field, planted up, is the capital asset. The crop provides the income. For sure, there were many uncertainties, but the difference between soil and a cucumber could be grasped with little further education. English law—unlike many other jurisprudences—recognised one individual might own the field, and another could own the crop. Pension funds, family trusts, and charities typically live by this principle—although many of the latter, through necessity, have bowed to the inevitable and passed to an investment manager the job of even-handedly balancing income and capital.
Inflation distorts fairness in this distribution. The golden years for investment fairness were in the 19th century, when the income yields were stable, gradually falling from above 3%, to under 2.5% by the 1890s; the value of money also increased gradually, to the advantage of the owners of the capital. Since then, it has been much more difficult to keep the balance. And over the past decade we have seen yields drop almost to nothing in conventional high-quality bonds, while risk assets have risen markedly—it has been better to hold the capital, even where trustees have striven to provide commensurate benefits to the income class. Again, this is about to change—with higher inflation, rising yields will provide some compensation to the income beneficiary, and the mischief will be suffered by the capital holder. Generation-on-generation, this may all come out in the wash; decade on decade, it will not.
The 1970s saw the mischief of high inflation, with somewhat-elevated interest rates, washed down with punitive rates of taxation. Then, there was no place to hide. Now, there is an asset class—the inflation-linked bond—which was created from the rubble of that period. These bonds are doubly attractive today because they compensate holders both for the actual level of inflation, and also the return computed on the difference between the rate of inflation and the yield on the equivalent conventional bond. One might expect that at least to match the rate of inflation, but in the 1970s, such was the fragility of the UK economy, interest rates got nowhere near the inflation rate—and the shortfall accrues to the holder of the inflation-linked bond. Why is it, then, that articles on ‘what to do to beat inflation’ often don’t mention these bonds at all, or if they do, dismiss them as being too expensive?
The answer is that they are already expensive. The world’s longest-dated inflation-linked bond is issued by the UK government; it matures in 2068 and is priced to lose more than 2% of its real value every year—and there are another 47 of those years to go before maturity. Commentators are reluctant to recommend something which turns out not merely to be wrong—but culpably and self-evidently wrong—if the music stops. Yet this misses the point of the investment, which is to protect portfolios through the next phase of markets. It’s what I call the ‘bottle of water in Mafeking’ moment. You can afford to pay an elevated price for the water when the enemy looks about to start a siege, but you absolutely don’t want to own it at the cock-a-doodle-do of the relief of Mafeking.
Looking back over the past year and a bit, we feel a sense of relief Ruffer has performed well through another crisis—protecting clients from the initial Covid turmoil and making good money in the many weathers that have followed. Yet the markets remain our master—they will do what they do, when they do it: we must do our best in that context. And that context is about to change.
Over the past 40 years, there has been only one real bear market with claws—2000 to 2002. For the rest of the time, it’s been a relentless climb, punctuated by the occasional crash. We have proved dab hands at crashes, and intermittently good at bull surges, with the typical Ruffer portfolio producing an average return after fees of 9.1% a year over the 26 years since we started. How will we be in the arid landscape of a chronic bear market? I believe we are about to find out: it’s this next investment regime we are looking towards.
Someone—I don’t think it was us—described our style of investing as ‘get rich slow’. If we can live up to that moniker over the next decade or two, I suspect we will feel a trifle smug.
2016 10.9 | 2017 0.5 | 2018 -5.8 | 2019 7.0 | 2020 16.7
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