While the rise in inflationary pressure has caused some disquiet, for the Ruffer Total Return team the stars are starting to align.
‘It looks like it’s beginning,’ the fund’s co-manager Steve Russell (pictured), said. ‘While we’re not expecting everything we’ve been talking about to suddenly come to fruition, there is growing awareness in public and investment circles. People are beginning to wake up to the idea that inflation may not be dead forever.’
The team first bought into index-linked bonds in March 2009, progressively selling out of its conventional UK, Swiss and Norwegian bonds that had served it so well during the financial crisis. Prior to this point the fund had never owned an index linker, which now account for around 40% of the £3.1 billion portfolio.
‘It was 2009 when we concluded that the end result of the financial crisis would be inflationary, necessitating negative real interest rates to diminish the burden of a debt too large to ever be repaid,’ Russell explained.
While he ‘never doubted’ the position he describes as the portfolios ‘jewels’, it is fair to say that it did test his nerves at times.
‘When we first bought linkers I think investors may have thought we were a little mad because nobody really knew what they were. It took a lot of explaining to get the message across as to what we thought would happen.
‘While we may have been a little bit nervous at the beginning, we were reassured in 2011 when UK inflation overshot the target and got to 4-5% and the MPC flatly refused to raise interest rates. It gave us the confidence it would not raise interest rates to choke of inflation.’
The quarterly inflation report from the Bank of England (BoE) earlier this month would have given Russell more comfort.
Consumer Price Inflation - which surprisingly fell t0 0.9% in October after rocketing to 1% in September - was forecast to rise to 2.7% in 2017 and 2.8% the following year in the report.
This estimate was conservative against the one offered by think tank the National Institute for Economic and Social Research, which predicted inflation could quadruple to around 4% in the second half of next year.
Looking further ahead Russell believes inflation could sit between 5-10% in five years' time, although he does provide a caveat. ‘This is what we would have said five years ago and it hasn’t happened. We have a bit more certainty about it happening, rather than when.’
The UK referendum has perhaps made Russell a little more confident on his forecast this time around. ‘The Brexit vote was clearly a protest vote by the less well off, who felt they have been left behind over the last eight years.’
He believes this public resentment and the resulting monetary policy reaction will be the spark that gets inflation moving.
‘Everywhere we look we see growing disaffection and alienation and willingness by governments to accommodate and for us that points straight towards increased fiscal spending.’
Russell believes Brexit has pushed UK to the front of the global inflation queue. ‘We always knew the UK had a predilection towards inflation as it’s one of the things we’re good at, along with finance and education. We just didn’t think it would get to the front of the queue this quickly. We have effectively gone from an austerity to an anti-austerity government overnight.’
There is concern inflation could get out of control, with the BoE having little room for manoeuvre on interest rates. However, Russell does not think we will return to the dark days of the 70s. ‘The problem is that the one tool you have to control inflation, raising interest rates, is not available at the moment but we’re not forecasting hyper-inflation,’ he says.
‘We think there’s a risk of it getting out of control, but it’s quite small. Ultimately we don’t think this is an inflationary world, it’s a deflationary world because of the debt burden. There is no huge cost or wage pressures and technology seems to be putting downward pressure on inflation.
‘[However] we do think it’s a real danger of targeting inflation above official targets. If that gets traction and rates can’t be used to stop it, we see no reason why inflation doesn’t push beyond the target.’
Index linkers have lived up to their jewel moniker for Russell and Ballance, powering the Total Return fund to return 37.3% in the five years to the end of September, beating an average of 26.1% in its Absolute Return GBP peer group.
The asset class is looking a bit more expensive now, but that does not bother Russell. ‘The first whispers of people talking about inflation in the system suddenly they [linkers] are in vogue. While they may look extremely expensive, our point is that’s absolutely true but this isn’t a normal world that we live in. We think they are the best asset you can own.’