Russell (pictured), who manages the Ruffer Investment Company and CF Ruffer Total Return fund, accepts that the likes of the US and UK have deserved to make strong gains since March 2009, and regrets not picking up some quality companies at cheap levels.
However, he believes the latest stage of the rally has been based on false pretences. Russell is forecasting a severe financial crisis in the longer-term, but thinks a significant market pull back will happen before then.
“We are wary of a full scale crisis in the developed world, but this is likely to go hand in hand with an inflationary denouement. In the meantime however, I think a 10 to 20 per cent pull back in the equity market is very feasible,” he said in an exclusive interview with FE Trustnet.
“The fact that the West emerged from potential financial collapse warranted a rally. The fear of absolute collapse has gone away, but I don’t think that has justified a doubling in stock market returns since 2009.”
Performance of indices over 5yrs
Source: FE Analytics
“The initial bounce was very logical, and so was the second phase later on as we have seen some growth. However the last phase of the rally – in other words the last 20 to 30 per cent – has come because everyone seems to be pretending that the huge pile of government debt has gone away.”
“If the market was 20 per cent lower I think it would be reasonable, but it would still be in a financially unstable backdrop. With levels where they are at the moment, I’m concerned,” he added.
Russell says he has upped the cash exposure in his CF Ruffer Total Return fund from 5 per cent to 8 per cent, which he says in part reflects these concerns.
He still has 45 per cent in equities, almost entirely in developed markets. Japan has long been a favoured area, while in the US and UK he targets cheap quality companies that he believes have limited downside risk.
“We’re worried about valuations, but we recognise that at this moment in times equities are the only place investors want to be,” he said.
Among his largest positions are BP and Shell, which are among the cheapest companies from a price-to-earnings (P/E) point of view in the FTSE 100.
Russell’s weighting to gold and inflation linked bonds are more a tool against eventual inflation, but he points out these assets are likely to hold up much better than equities in a market sell-off. The manager thinks future rumblings in the eurozone could be one of the possible catalysts of the sell-off, arguing that investors have become complacent about this part of the world.
“We are still very concerned about events in the eurozone. We don’t think the crisis has gone away,” he said.
“The biggest risk is that lower and lower inflation results into Europe entering a debt deflation trap, which will highlight the amount of debt that remains on the balance sheet. A lack of inflation will stop the eroding effect of debt, and this will put pressure on economies once again – not only the peripheral countries, but France and even Germany.”
“At the moment there is a lack of any central bank action to address this, which makes it a bit of a ticking time bomb.”
There were reports earlier this week that inflation in the 18-nation eurozone fell to 0.5 per cent in March – the lowest level it has been since November 2009.
Russell adds that western markets have also failed to price in the numerous risks in China at the moment, though the manager says he thinks an all-out emerging market debt crisis is unlikely.
“The external deficits in these countries are much better than they were in the late 1990s, and economies are generally in much better shape,” he said.
“I don’t think there will be a full scale crash, but given our cautious bias they are not in good enough shape for us to invest.”
Although Russell has worries over deflation in the shorter-term, he believes inflation is the biggest risk to investors over the medium to long-term.
“Inflation remains our base case, yes,” he explained. “The eventual inflationary denouement of the crisis is looking like it will take longer than we expected, however as the Budget recently highlighted, government debt is still at a very high level.”
Russell says the cost of borrowing has gone up in recent years as a result of disinflation, which he says will make government even less averse to risking a spike in inflation.
He commented: “The pressure is still there for more growth, which is very difficult to come by. Central banks are so desperate for growth they don’t mind if inflation is a by-product, and I think that’s dangerous.”
“I don’t think there will be anymore QE for now as it seems out of fashion. However, I think there will be a continued tolerance for real interest rates to be lower for longer, as well higher inflation.” “I have no firm view on where it’s coming from, but the point here is that there is a tolerance for it happening. When it does, I don’t think central banks have the weapons to control it.”
“It could be a pick-up in the velocity of the money already in the system, or it could be that the output gap is smaller than the central bank believes. Currency devaluation could be another contributing factor.”
Russell has recently increased his exposure to US long-dated inflation linked bonds on valuation grounds, after the steep falls from last year.
He and co-manager David Ballance have run the CF Ruffer Total Return fund since late 2006. The fund is well ahead of its sector over the period, though the duo insist capital protection as opposed to relative outperformance.
Performance of fund and sector since Oct 2006
Source: FE Analytics
FE data shows the fund has delivered a positive return in nine of the last 10 calendar years, including the down years of 2008 and 2011.