The Coronavirus crash - protection against the inflationary burn

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Imagine it’s May 2020. You’ve just emerged from a period of complete isolation that started the previous August. You are told the world was struck by a global pandemic, thousands of lives were lost, and the economy suffered the worst GDP contraction since the great depression. Would you guess that the US stock market was flat over the period?

An astonishing outcome, but where do we go from here?  With events moving so quickly, perhaps the only appropriate place to start is with the ‘known knowns’.   

Deflation today, inflation tomorrow?
There is no doubt that we are amid an enormous deflationary shock. 

Nearly 1 in 5 of working Americans filed jobless claims in the month following lockdown [1].

British business confidence has collapsed, with the CBI business optimism survey hitting its lowest level since the survey began in 1958 [2].  

The Chinese economy shrank 6.8% in the first quarter of 2020 - the first time China has reported an economic contraction since 1976 [3]. 

The world will not be the same after this crisis. 

Investors must now answer one critical question when constructing portfolios - will the unprecedented levels of stimulus injected by central banks and governments in response to the Corona-crash result in inflation? 

We recognise that you don’t have deflation today and inflation tomorrow, but we believe this is the direction of travel. 

So how do we get there?
Let’s start with where we’re coming from. For the last thirty years, central banks have provided investors with an unfailing safety net. The ‘Greenspan put’ – the idea that the Federal Reserve would step in to support financial markets at the first sign of trouble – gave investors the ultimate hedge against prices falling. 

The warm embrace of central banks was never clearer than in the 2008 Great Financial Crisis as the authorities flooded markets with liquidity and took remarkable steps to keep asset prices afloat. Since then, and despite the many trillions of dollars printed in the name of recovery, we have had a decade of benign inflation.

This time, as they say, it’s different. 

We have seen combined monetary and fiscal stimulus greater than anything other than World War II, central banks have all but exhausted their arsenal and governments have stepped in with a fiscal response which could define a generation.

The key difference is that in 2008, all the money got locked up in the balance sheets of banks. We saw asset price inflation, but not price inflation in the real economy. This time, money is going directly to businesses and individuals. To people who will spend, because they need to. Eventually, more money will chase the same number of (if not fewer) goods. This is the recipe for inflation.

We know too that the virus will pass. But will extreme monetary policy fade with it?  We expect not. 
Government spending taps have been turned on and cannot be easily turned off. What government will refuse a wage increase for NHS nurses and our other public service heroes? Pressure for governments to spend is going up and now authorities have a new mechanism to drop money into the economy.

The already intimidating mountain of debt will continue to grow as well.

For governments and central banks, inflation may cease being the problem, and soon become the solution. By keeping interest rates nailed to the floor (the cost of servicing debt) and allowing inflation to run ahead of this rate, gradually the value of this debt mountain can be eroded – a paradigm known as financial repression. This is surely a tempting option for any government faced with the alternative of imposing eye-watering tax hikes on its electorate. 

So what to do – and what to own?
Inflation, by definition, erodes asset values almost indiscriminately. It has the power to undermine precisely the strategies which have been successful for investors in recent decades. 

From here, there will be fewer ‘safe’ stores of value. But we see some clear opportunities to grow capital in an inflationary environment – index-linked bonds, gold and the right equities.

At Ruffer, we hold index-linked bonds which could prove to be the most powerful of these opportunities. Index- linked bonds, as opposed to their conventional counterparts, pay a coupon (and have a redemption value) linked to the rate of inflation. These bonds price off the difference between interest rates and inflation which means, with rates pinned down, even moderately high inflation should see them do very well. 

In the past gold has been the go-to hedge against inflation as its purchasing power cannot be diluted like paper money. The precious metal is particularly potent now in the context of rock-bottom interest rates the absence of income generating assets elsewhere means you don’t miss out by owning zero-yielding bullion.

Lastly, perhaps most importantly, the right equities. Inflation hurts companies when their costs balloon and they are unable to pass these costs on to their customers. But take Tesco, for example –the dominant UK supermarket can raise prices in line with the prevailing market in an inflationary environment, enabling the company to maintain margins by growing revenue and controlling costs. 

Labour costs rank amongst the most demanding liabilities for any business. This is why we like Disney, as the US media conglomerate owns its content and its new streaming service, Disney +. This should enable the firm to grow on ever higher margins. Unlike the Premier League, where football players have all the pricing power, Mickey Mouse is yet to ask for a pay rise in 92 years of service…

A different portfolio for a different world
In phase one of this crisis, sitting tight and holding your breath has been rewarded - investors haven’t been forced into drastic portfolio changes.  

But to preserve and grow capital in the next phase, investors will need to rethink. The portfolios which have triumphed over the last decade may be the very ones which suffer in the next.

Want to hear more from Ruffer?
If you are interested in hearing more about the way we think and invest, Ruffer is hosting a webinar on Thursday 4th June at 3pm. Covid-19 has driven the global economy to a standstill. What impact will this have on the investment landscape, how this might affect your investments and what could happen next? To register for the webinar click here.

Or alternatively get in touch with Charles Lynne, one of our Investment Directors by calling him on +44 (0)20 7963 8222 or alternatively you can email him at clynne@ruffer.co.uk.

Ruffer is a limited liability partnership, registered in England with registered number OC305288 authorised and regulated by the Financial Conduct Authority © Ruffer LLP 2020. The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument. The information contained in the document is fact based and does not constitute investment advice or a personal recommendation, and should not be used as the basis for any investment decision. References to specific securities should not be construed as a recommendation to buy or sell these securities.

[1] https://edition.cnn.com/2020/0...

[2] Reuters: https://www.reuters.com/articl...

[3] National Bureau of Statistics in China

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Ruffer offers financial planners something deliberately different. Your clients like making money, and hate losing it. Most will hate losing money more than they like making it. At Ruffer, this shapes our investment philosophy, and the way we invest. We offer a distinctive all–weather approach, designed to perform in all market conditions. Our focus is on capital preservation and prudent growth, not chasing short–term fads or trends. Since we began in 1994, our investment process hasn’t changed. For over 20 years, it has delivered solid returns well ahead of cash and UK equities. More importantly, it has protected our clients from market crashes, including the bursting of the dot.com bubble and the credit crisis.

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