Portfolio construction conventions that have worked for decades might now be “all the wrong trades”, according to Ruffer’s Steve Russell, who believes many investors need to consider adopting new ways of achieving diversification and protection. 
Recent months have seen markets undergo a swift rotation as investors start to price-in the dramatic economic rebound that looks likely after the coronavirus pandemic. As well as a sell-off in long-duration bonds this has manifested itself as a move away from growth stocks towards value.
One element of this that is causing some nervousness among investors is the risk of inflation, which has largely been absent from the global economy for much of the recent past. While growth style tends to do well when economic growth and inflation are weak, value has historically outperformed when both are strong.
The impact of this has become one of the biggest worries among investors. The latest Bank of America Global Fund Manager Survey found 27 per cent of asset allocators regard inflation as the market’s biggest tail risk, second only to another taper tantrum in bonds (which would probably be linked to rising inflation).
Fund managers’ biggest tail risks
Source: Bank of America Global Fund Manager Survey, Apr 2021
FE fundinfo Alpha Manager Russell (pictured), who co-manages the £3.8bn LF Ruffer Total Return fund with Alexander Chartres and Matt Smith, thinks that most investors have never had to consider the impact of inflation on their portfolios – but warned that they have to start doing this sooner rather than later.
“Conventional portfolios have become, by design and by default (via benchmarking), wired to the assets which performed well in the last market regime. That was a period of low economic growth and falling inflation.
“In a nutshell, this equated to prioritising conventional bonds over inflation-linked bonds, a preference for growth over value and for technology over everything. The problem is that in the new regime these might all be the wrong trades,” the LF Ruffer Total Return managers said in a recent update.
“Today, we expect an economic boom in the latter half of the year and hopefully into 2022. What is the recipe? Take one part pent up animal spirits, mix with accumulated lockdown savings, pour on lashings of stimulus – serve in a supply constrained glass. Even central bankers are in party mood – they have said they will not take away the punchbowl until we have overshot policy objectives.”
Russell and his co-managers believe that most investors will need to become “more creative” in how they diversify and protect their portfolios, instead of relying on the handful of assets that have handed strong returns for much of the recent past.
Focusing more on this topic, Russell said: “Whichever side of the inflation debate you are on, it makes sense to assess the impact inflation could have on portfolios.
“Most of today’s investors have never seen meaningful inflation in the whole of their professional careers. So, as we emerge from lockdowns and pent-up demand meets ongoing supply constraints, we consider how different asset classes might fare if inflation does return.”
Starting with fixed income in his explanation of how different assets would hold up, the manager warned that higher inflation could be “the death knell” for the bull market in conventional bonds.
While there has been a four-decade bull run in bonds, driven by low inflation and loose monetary policy, this hasn’t always been the case.
Russell noted that between 1946 and 1981, 30-year US Treasuries lost over 80 per cent of their value and British Consols lost 97 per cent of their purchasing power – leading to government bonds becoming known as ‘certificates of confiscation’.
“Before we even consider equities, this spells the end of the 60/40 portfolio,” he added.
Likewise, cash is no place to turn in times of inflation as the primary effect of inflation is an erosion of the purchasing power of money. Russell predicted that “huge amounts of cash” could be looking for new homes if interest rates are kept below the rate of inflation (as the Federal Reserve has promised) while it rises.
On the outlook for equities, the LF Ruffer Total Return manager continued: “Many investors who have never experienced inflation are pinning their hopes on stocks to ride out any storm. But periods of high inflation have been disastrous for stock markets.”
Demonstrating this, he pointed out that the US cyclically-adjusted price/earnings ratio (CAPE) fell from 24x to just 8x as inflation climbed between 1966 and 1974.
“Even if interest rates are held to the floor, rising inflation means the discount rate on future earnings also rises. This would be a calamity for highly rated growth stocks and profitless businesses,” he added.
Commodities have a better chance of holding up in times of inflation, so long as it comes with strong economic growth. Given that this might be the situation as the world recovers from the pandemic, commodity stocks could be a good placed to hide in equity markets, Russell said.
Continuing onto infrastructure, Russel said this is one of the main go-to assets for inflation protection.
Russell described infrastructure assets as “essentially disguised bonds or equities with inflation-linked revenues” but noted that they come with illiquidity and execution risks as well as being at risk of a derating in equities or bonds.
The manager also pointed out that most infrastructure projects rely on governments to honour their promise to lift revenues in line with inflation, but said “governments have a habit of changing the terms of trade”.
No discussion of inflation protection would be complete without a look at gold, which has been used as an inflation hedge for centuries. Russell agreed that the yellow metal deserves a place in diversified portfolios, even though Bitcoin seems to offer some stiff competition.
This leaves index-linked bonds (in the UK) or Treasury inflation-protected securities (in the US), which the LF Ruffer Total Return managers think could become “a key asset class” in the future.
“The clue is in the name. Hiding in plain sight, but missing from too many lists of inflation protections,” Russell said.
“They pay income that rises with inflation and return your capital with compensation for inflation. If inflation returns, and especially if interest rates are held below the rate of inflation, investors could find themselves panicking into this asset.”
So which assets should investors consider if they think the return of inflation could cause continued turmoil for portfolios? Russell pointed to the positioning of the LF Ruffer Total Return fund.
“Our recipe for protecting against inflation – take some index-linked bonds, mix with value/commodity equities, add a decent slug of gold and, if liked, at most a pinch of infrastructure,” he finished.
“Avoid conventional bonds and high-priced growth stocks as these stop your mixture rising. Beware cash – it can cause a bitter aftertaste.”
Performance of fund vs sector over 10yrs
Source: FE Analytics
LF Ruffer Total Return has generated a total return of 68.28 per cent over the past 10 years, outperforming its average IA Mixed Investment 20-60% Shares peer by around 5 percentage points with lower volatility.
It has an ongoing charges figure (OCF) of 1.22 per cent.