In an article published on FE Trustnet earlier today, Russell outlined why he believes inflation is the biggest threat to investors in the current environment – in spite of the Fed’s intention to bring quantitative easing (QE) to an end next year. Russell (pictured) believes rising inflation and negative interest rates will push more and more yield-hungry investors into defensive stocks, which will inevitably lead to a severe bubble in the asset class.
He says the bubble is already forming, as demonstrated by the sharp rise and fall in high-yielding stocks so far this year, but thinks there could be something much worse on the horizon.
"We see the [bubble in equity income] as more of a problem than it was," he said.
"In Q1 this year, these nifty-50 stocks moved in a parabolic way that seemed to herald the end of a bubble. We’ve seen these stocks come back quite significantly and many have led the correction."
"It’s maybe a small sign of what’s to come, that safe defensives led the sell-off. It could be a sign of something bigger in the future."
High-yielding stocks led the UK rally in the second quarter of the year, but came crashing down harder than their lower-yielding counterparts during the sell-off in late May and June. Companies including Unilever and AstraZeneca rose and fell particularly aggressively.
Performance of stocks vs indices Jan 2013 – July 2013
Source: FE Analytics
The sell-off in high-yielding stocks has since petered out and Russell believes they could be set for outperformance once again as investors squeeze as much income out of them as possible; however, he is not tempted to take part in a rally that is on borrowed time.
"My view is that the hunt for yield will continue and will support these kinds of stocks," Russell explained.
"However, if you look at something like J&J – a safe and sound company with a strong and supported dividend – if the share price goes from $65 to $90, it’s on a dangerous valuation. That doesn’t mean that there’s anything wrong with the business, but if it gets bid up too far, it’s not a safe haven anymore."
"The problem is that people are buying these stocks, thinking they are safe investments irrespective of the price they are paying."
Russell likens the situation to the rise and fall of the nifty-50 in the US in the 20th century. Companies such as Coca Cola and IBM were seen as solid, yielding growth stocks that were a sure-fire way to make money over the long-term.
The nifty-50 helped drive the US bull market in the 1960s and 1970s, but came crashing down in the 1970s and 1980s when finally the bubble burst.
Similarly, he says anyone who believes the likes of Diageo are fail-safe companies over the long-term – as FE Alpha Manager Nick Train implied in a recent interview with FE Trustnet – is likely to have their fingers badly burnt when unrealistic earnings expectations are exposed.
Russell’s fears are echoed by head of asset allocation at Canaccord Justin Oliver, who believes defensive yielders have become too expensive to be considered safe havens.
Contrary to popular belief, he thinks investors would actually be safer in cyclical stocks that are usually deemed to be higher risk.
"Until very recently, there has been an undoubted investment stampede towards higher yielding areas of the stockmarket, reflecting both the attractive income which these sectors can offer and their perceived lower risk," he said.
"However, that lustre appears to be fading and it is entirely possible that investors will fare better in those under-appreciated and overlooked cyclical areas, which have been very much left behind in the equity market rally of the past few months."
"It is noticeable that, since the end of 2010, cyclical sectors have significantly underperformed, despite the fact that the market itself had risen 36 per cent to the end of May this year."
Oliver still thinks there are merits in holding some defensive sectors, namely healthcare, but believes that a "scaling back" is necessary.
"Ultimately, while cyclicals are often viewed as the best way for investors to capitalise on expectations of stronger economic growth and higher stockmarkets, this time it is just possible that these sectors might be the best way for investors to protect some value," he added.
Russell sold out of his minimal positions in high-yielding defensive stocks in the early stages of this year, trimming exposure to US food manufacturer Kraft Foods and US confectionary conglomerate Mondelez International.
The manager has around 40 per cent of his £343m Ruffer Investment Company in inflation-linked bonds, gold and gold equities, in order to protect directly against the threat of high inflation in the future, which he believes could hit the high single digits. A further 10 per cent is in cash.
The remaining assets are invested in equities. Japan is the manager’s favourite region, making up 19 per cent of the portfolio overall.
Russell took some profits from the region in the second quarter of this year following its stellar run, but is confident Japanese equities will continue to outperform other developed markets and emerging markets for the rest of 2013.
"We think Japan will be a beneficiary of more inflation, but we’re holding it more now because of what they’re doing themselves," he explained.
Performance of indices in 2013
Source: FE Analytics
"We’re very comfortable with where the market is following the recent pull-back, and have been adding to it," Russell continued.
"We anticipate rising profits to buoy the market from here, and though I don’t think we’ll see 40 or 60 per cent again, I expect Japan to be the best-performing equity market over the year in total, and over the next six months."
The manager is far less optimistic on the outlook for emerging markets, however, which he has next to no direct exposure to in his trust.
"One of our big concerns is emerging markets," he said.
"We think there is definitely the potential for downside risk to global growth due to the bad news coming out of China and the current moves in dollar block bond yields, which could have a serious knock-on effect on emerging markets, whether it is South Africa, Turkey, Brazil and so-on."
UK equities have a 16 per cent weighting in the trust, while the US and Europe have a weighting of 12 and 9 per cent, respectively.
The trust’s high exposure to gold and inflation-linkers, and underweight in equities, has seen it fall towards the bottom of the performance tables within its IT Global Growth sector over one and three years; however, given that it is a multi-asset trust and prioritises capital preservation above all else, this comparison is a little unfair.
Our data shows it has delivered a positive return in every calendar year since its inception in 2004, with the exception of 2011, when it lost 2.8 per cent.
Its most impressive year came in 2008 when it delivered 23.01 per cent; over the same period, the IT Global Growth sector and FTSE All Share index lost around 30 per cent.
On a cumulative basis, the trust has returned 145.78 per cent since launch, beating its sector and the FTSE All Share, with significantly less volatility.
Performance of trust vs sector and index since launch
Source: FE Analytics
The trust does not have a benchmark, but as mentioned previously, it prioritises capital preservation over the long-term.
The Ruffer Investment Company has an annual management charge (AMC) of 1 per cent and does not charge a performance fee. It is on a premium of 2.7 per cent to NAV according to the AIC, and uses a discount control mechanism (DCM) to ensure this figure stays as close to zero as possible.
It is not geared at present and is yielding 1.46 per cent. Russell co-manages the trust with Hamish Baillie.
