The risk of governments letting the inflation genie out of the bottle has not disappeared and it is vital investors resist the temptation to sell their hedges such as index-linked bonds, Ruffer’s highly regarded investment research team has warned.
The message comes as market commentators begin suggesting another bout of quantitative easing, dubbed QE2, was needed.
Last week, Goldman Sachs chief US economist Jan Hatzius led the call for further stimulus, backing Keynesian economists such as Nobel laureate Paul Krugman, who also believes the recovery is still very fragile and government help is required.
‘The need for long-term budget restraint should not stand in the way of a near-term boost when the economy clearly needs it,’ Hatzius said.
Hamish Baillie, investment director and head of Ruffer’s Edinburgh office, says investors should not underestimate the fierce resolve of central bankers to prevent another crisis, thus increasing the possibility of overcooking the response.
‘Let’s not fool ourselves, the central banks have a great deal of power at their disposal and we are absolutely positioned for inflation, which is a core theme in the investment strategy at the moment. Around 35% of our investments are in index linkers, both in the UK and overseas,’ he said.
Ruffer runs £7.9 billion in assets on an absolute return basis for private clients, institutional investors and charities.
On top of its UK index-linked gilt holdings, the firm has overseas exposure to equivalent credit in the US, Australia, France and Japan, among others.
Baillie said: ‘It gives us some comfort that central bankers haven’t changed their tune in terms of their desire to avoid what we went through in autumn 2008. Quantitative easing is ready to restart if required.’
The Bernanke effect
Both the US Federal Reserve and the Bank of England (BoE) have indicated that they would be willing to start printing money again. Yet BoE governor Mervyn King has conceded that another bout of quantitative easing would be risky. This time around, action by the BoE would be swift because they would know which levers to pull, argues Baillie.
He is also encouraged that the Fed is headed by Ben Bernanke, an economist who has written extensively on the political and economic causes of the Great Depression and what he sees as the monetary policy mistakes of the 1930s.
‘What that does is gives us is more courage to hold index linkers – even if in the short term we suffer a deflationary scare.’
Indeed, in recent months Citywire Wealth Manager has encountered countless investment managers selling out of their index-linked exposure as the spectre of deflation looms large on the horizon.
Economic headwinds strengthen
Recently the market has also become more sensitive to the headwinds facing the global economy, namely fiscal tightening and concerns over banks shrinking their balance sheets. The fear has gripped the markets and prompted many investors to believe the fledgling private sector recovery could be undermined, eventually leading to deflation.
Carl Astorri, head of economics and asset strategy at private bank Coutts & Co, believes households rebuilding savings could also impede the global recovery, in addition to the problems facing banks and fiscal tightening.
However, while conceding that the authorities are on stand-by with a further injection of QE, he points out fiscal tightening ultimately takes demand out of the economy and has a deflationary effect. ‘We are more afraid of deflation than inflation, which we see as an outlier risk.’
The deflationists grow louder
Astorri’s view is not unique but is echoed by well known names such as Hugh Hendry, the founder of Eclectica Asset Management, and Jacob Rothschild, who believe the threat of deflation has increased sizeably in scale over the past few months.
Astorri (pictured below) added: ‘We had quite a large exposure to index-linked bonds but six weeks ago we sold virtually all of our holdings.’
Moreover, with growth in the UK and eurozone apparently snuffed out by the eagerness of many governments to start cutting their structural current deficit, some asset allocators such as Astorri have said it no longer appears necessary to hold inflation hedges such as index-linked bonds.
‘We sold them because they had done very well for us since we bought them in 2008, when they were incredibly cheap, and because we’ve seen fiscal tightening come faster than we anticipated in the UK and Europe.
‘We didn’t feel the need to hold index-linked bonds as we have become even more concerned about deflation, so it seemed wrong to continue holding them.’
However, Ruffer’s macro team clearly disagrees with what is becoming a consensual view.
As an insurance policy, Baillie concedes inflation hedges such as index-linked bonds may not currently appear the most appealing asset class but believes investors should think twice before selling out.
He said: ‘Index-linked investments are actually quite expensive in terms of the running yield relative to conventional bonds but because we are always asking “what if we are wrong?”, we can afford to have quite a lot of money invested in index-linked because if we are wrong on inflation then there will be other parts of the portfolio that will perform.’
Ruffer is not the only investment house piling into index-linked bonds. Troy Asset Management’s AAA-rated fund manager Sebastian Lyon told Citywire he has been buying index-linked bonds due to fears Western markets will see another round of QE that sparks higher inflation.
‘On a two-year view, we expect inflation to come back and we think markets will start to anticipate that return of inflation in the next year or so, and then index-linked bonds will do very well.’
Last week, long-dated UK index-linked gilts slumped up to 6% on fears that existing issuance will become linked to the consumer price index rather than the retail price index.
Ruffer sees parallels with Swiss franc
However, Baillie said Ruffer was sticking with its index linked exposure, which he compares to its successful call on the Swiss franc before the financial crisis gripped the globe.
He said: ‘Our index-linked positions feel a bit like our Swiss franc exposure in 2005/06 in that it is not very exciting but is also not doing much harm. Over the past 12 months there has been much money made in equities and index-linked has been a dull place to be.
‘While we still have over 40% exposure to equities the index-linked are the crown jewels of the portfolio and we believe their day is yet to come so we must resist the temptation to sell out of them when other assets are doing well,’ he added.
In 2006 Ruffer resisted such a temptation to sell its Swiss franc exposure, despite pressure to scale back the holding in a currency that offered little in return and was being used as a source of borrowing.
However, when the global markets began to collapse and investors started looking for safe havens, the franc quickly appreciated as carry trades were unwound, and it protected the Ruffer portfolios.
Looking back, Baillie believes it would have been impossible to get back into the Swiss bond market quickly enough to capture the upside. Trying to time such switches is a mug’s game, he said.
‘Don’t be tempted to sell down index-linked to play risk assets. While I don’t think you can understate the significance of what the central bankers did in 2008/09 to support the economy (and therefore equity markets), the destination of today’s monetary policy will be an inflationary one.’