Official UK inflation figures fell to a six-year low of 1.5 per cent last month, supporting wide-held views that worries over inflation should not be on the agenda.
Nevertheless Ruffer, chairman of Ruffer Investment Management, believes investors should still be buying up as many index-linked bonds as possible to protect themselves against inflation, believing that it will be the natural result of the vast amounts of liquidity being pumped into the system.
In a note to investors prior to the latest inflation figures, he said: “There is no denying that they [index-linked government bonds] are impossibly expensive on any undistorted view; the deal with the UK long–linker today is that you can lend your money to the government for 54 years and not quite get your money back in real terms.”
“But they will do mightily well when the perception of inflation first appears on the scene, and that is still ahead of us.”
A number of leading fund managers disagree with Ruffer’s view on inflation.
Earlier in the year, FE Alpha Managers John Patullo and Jenna Barnard told FE Trustnet that investors were naïve if they thought inflation was inevitable because the lack of bank lending growth and huge amounts of excess capacity in the global economy mean that disinflation is the most likely outcome.
More recently, FE Alpha Manager Leigh Himsworth said that if the BoE was to raise the base rate by just 0.25 per cent over the next year, as expected, it would cause the equity market to derail because there are no inflation pressures but too much debt.
“Perhaps the economy is more fragile than it would seem, as the level of private savings has fallen, wage growth has been non-existent and demand continues to elude the authorities,” Himsworth said.
However, while Ruffer sees where Himsworth, Barnard and Pattullo are coming from, he says they have the wrong end of the stick.
“Some look at the mountain of debt, its fragility, and how it constrains economic growth. They are the deflation men. Others see the increase in asset values since 2009: around twice the size of the US economy – $26.7trn.”
“A fair amount of those debts which existed during the credit–crunch have come back from the dead.”
“Both sides can agree on the size of the balance sheet – it’s a variation on the ‘glass half–empty’ attitude: one side of the balance sheet spells deflation, the other spells inflation: both together spell monetary instability.”
Ruffer says that the level of outstanding debt in western economies is unsustainable and that all central banks have done by slashing interest rates and injecting liquidity into the market – except creating a rally in risk assets – is create distortions.
Performance of indices over 5yrs
Source: FE Analytics
“Distortions always resolve, and an investor needs to know in what manner it will be resolved,” Ruffer said.
“Monetary instability always resolves itself in a new calibration in the relative values of money and assets. If we have defaults, it’s less money in circulation, and that’s deflation. If currencies are no longer trusted, then you need to give more of it to buy the same journey – and that’s inflation.”
Ruffer says higher inflation will definitely rear its head because the huge amount of debt in the system will create an uptick in defaults which in turn, will cause currencies to weaken across the board.
“Governments have put their credibility on the line – and that credibility will fall off the perch if confidence in the sustainability of the status quo is lost. Confidence will not be lost in all of them simultaneously, just as a loss of confidence in banks in 2008 was a rolling programme,” he said.
“Each one, each time, will see a fall in currency and that leads to a rise in domestic prices.”
“As in all defaults there will be victims, but they will not be random. The grief will fall heavily on the savers, whose distress takes largely the form of diminution of their spending power, and this poses less systemic risk than borrowers in trouble.”
He added: “If this analysis is correct, regardless of the timing of it, then the absolute centrality of inflation linked government bonds remains in place.”
FE Alpha Managers David Ballance and Steve Russell, who run the £2.8bn CF Ruffer Total Return fund, have long been believers that higher inflation is an inevitable outcome.
To hedge the portfolio and their investors, Ballance and Russell hold 36 per cent in index-linked government bonds and floating rate notes. They also have 6 per cent in gold bullion and gold equities.
According to FE Analytics, CF Ruffer Total Return has been the best performing portfolio in the IMA Mixed Investment 20%-60% sector since the two managers took over in October 2006 with returns of 84.05 per cent.
Performance of fund versus sector and composite benchmark since Oct 2006
Source: FE Analytics
Its composite benchmark – FTSE All Share and FTSE British Government All Stocks 50/50 split – has returned 54.53 per cent.
Due to its cautious positioning, it has underperformed the sector and its benchmark over one, three and five year periods.
Its ongoing charges figure (OCF) is 1.03 per cent.