Investors are at risk from a sell-off in markets due to rising interest rates in the face of “deflationary forces”, according to Jonathon Ruffer of the Ruffer Investment Company.
Interest rates have sat at their current lows for six years after central banks dropped them to near zero at the nadir of the post financial crisis plunge and most major equity markets have rallied hard in the time since.
Performance of indices since March 2009
Source: FE Analytics
An increasing focus on when this period of very low interest rates will end and how this may affect both bonds and equities has dominated headlines and prompted ever greater scrutiny of the respective minutes and speeches of central bankers of late.
Many were expecting rates to go up sooner rather than later but due to slowing inflation or falling prices in several key developed markets, this has been revised to be at least a year away by several commentators.
Ruffer, chairman of Ruffer Investment Management, says it is pointless to try and second guess the central bankers. However, he believes that the dual action of central banks’ quantitative easing programmes alongside low interest rates has caused bonds to be mispriced and has led to the whole fixed income market becoming a bubble spelling trouble in the event of a rate hike.
This is particularly so due to the presence of “deflationary forces” in global economies – evident in yesterday’s announcement that the UK has seen a broad fall in prices compared to a year ago – he says, adding to the worry for investors who already have one eye on rising rates.
“You can see the pressure and you don’t have to be very astute to see that one day that pressure will be resolved. I see it as a binary thing. Putting interest rates up when there is that sort of deflationary force around is a pretty dangerous thing to do but that doesn't mean it won’t happen,” Ruffer said.
“Now, if you look at those countries that have tried to put interest rates up in the last two or three years, they very quickly had to reverse what they did. One of the dangers is that lack of confidence is one the hallmarks of deflation. One of the few things that is keeping confidence up is that markets are high; that is keeping people feeling confident.”
“If you do something that destroys confidence then the ferocity of the deflationary impulse will become very apparent. That is something the central banks, particularly in America, are aware of and will not that stop them doing it? Well they're prats just like the rest of us. Depending on whether they will or they won’t depends on what they have had for breakfast.”
Ruffer says when you have structural deflationary forces, falling asset prices “are never far away”.
“If central bank response to deflationary forces has driven them to high levels ahead of it, then the reversal of this becomes hard to avoid,” he said in a recent note.
“We may look back and see that the present phase in the worldwide economy is in a cross–current: the deflationary forces offset by the exuberance engendered by rising asset prices. Remove the latter and you are left not only with existing deflationary forces, but also with the superimposition of the migraine imposed by financial pressures and thwarted hope.”
Ruffer, who is known for his focus on downside protection, says that investors need to fundamentally rethink how they assess assets in such a scenario.
“It is not helpful to think in terms of asset classes – bond, equities and so. It is much better to think it terms of long duration assets or short duration assets.”
Ruffer overseas the Ruffer Investment Company, which is managed day-to-day by Steve Russell and Hamish Baillie.
According to FE Analytics, it has returned 157.79 per cent compared to an IT Global sector average of 191.15 since it was launched in 2004, putting it bottom quartile.
It has not always underperformed, having seen a very strong performance in the dire markets of 2007-8. In fact not only was it the best in the sector in 2008 but it was also the only fund to make a profit. The ‘next best’ performing trust lost almost a quarter of its value.
Performance of fund versus sector and composite benchmark since Oct 2006
Source: FE Analytics
Due to its cautious positioning, it has underperformed the sector and its benchmark over one, three and five-year periods.
It is currently stuffed with index-linked treasury bills, which make up at least a third of the portfolio followed by Japanese equities. Russell recently told FE Trustnet why he was do bullish on Japan as well why he was buying gold.
It is on a discount of 0.4 per cent while its ongoing charges figure (OCF) is 1 per cent.