2024 Q1 Investment Review | Ruffer | Investment management

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Articles by Jonathan

Jonathan Ruffer

Chairman

9 April 2024

This quarterly report is the 96th since Ruffer’s inception – a mosaic of photographs adding up to a cinefilm of investment life which started in times very different to those of today.

We can now see that, when we began, markets had enjoyed the first decade of an unprecedented 40 year bull market, during which there were, for sure, opportunities to lose money, but nothing which can be described as a conventional bear market. Although it did not feel like it (for it suffered crevasse-like setbacks), it was a perpetually rising market – an equatorial climate of everlasting sunshine. How wonderful it must have been, we might think, not to have to endure the depressing cold, dark days of winter! But one has only to look at equatorial climates to see what a distorted world nature delivers when there is no winter. Either nothing grows, or – as in the Amazon – everything grows.

This absence of a cycle, the forest without fire, contrasts with the great economic leaps forward in history, which have always been cyclical in character. Kitchin, Juglar and Kondratieff recognised this truth a long time ago: the readily detectable Great Waves of human progress and prosperity.

The alarming conclusion we draw from the natural world is that the markets face, sooner or later, something unpleasant. The economist Hyman Minsky made this exact point about chaos, likening it to the sand which passes through the narrow point of an egg timer, creating mounds which collapse as more sand falls onto them. He observed that every now and again the collapse would be long-delayed, pointing perhaps to a powerful prior equilibrium – but that, when the collapse did come, it was more than usually powerful. In the 440 or so years of stock market history, we have seen every condition under the sun – except today’s decades-long stability.

Why should stability end this way? Here is a single example of a wonderful idea, beneficently conceived, which is as toxic as Sir Noël Coward’s chocolate-covered hand grenade. John Bogle launched his first index-tracking fund in the mid-1970s, right at the bottom of the bear market. It promised effortlessly average performance: the investor would never come first or last, but would always come forty-somethingth out of a hundred investors, as the fund delivered index returns minus (ever-shrinking) fees. Over a long period, as individual manager genius waxed and waned, the end result would be distinctly creditable. So powerful was this idea, and so effective were the equity markets in making money, that the index fund tail now wags the dog, and the dog is no longer dog-shaped. The top performers – the Magnificent Seven – now attract waves of investment simply because they represent such a high percentage of the market. Conceived as a free ride on the combined skills of the analysts and asset-allocators, so-called passive investments have become more than 40% of the market – the tipping point at which investor flows exert a greater influence on stock prices than the underlying investment fundamentals. Here is the law of unintended consequences writ large: a great idea – democratising investment – has become a force for potential destabilisation.

I remember a young investor who was on a winning streak, giving me a tip how to optimise returns: ‘Don’t buy the equity – buy the warrants!’ What might be regarded as a classic beginner’s mistake is alive and thriving today: use borrowing to maximise returns! To be fair, its general application is that it allows effective investment in anomalies which give too small a positive return to be worth trading. A single whitebait doesn’t fill the stomach, but catch a shoal of them, and you have a family meal. A chance of a 1.5% gain, leveraged up five times, gives 7.5%; if you are sure of the gain, it becomes an opportunity. In yesteryears, leverage was the means by which the less well-off became rich; once rich, you de-levered, and future generations could live off the income. It didn’t always work out like that, but it acknowledged a basic truth: that leveraging is inherently dangerous. To put it into the language which has relevance in this debate: leverage is an amplifier and thus destabilising. The shape of the equity market has deteriorated; after a generation of companies issuing bonds to buy back their own stock, the granite solidness of equity has been replaced with debt. This creates two dynamics – it makes the holders of the equity in a successful business much more valuable, but it sinks a struggling business much more quickly. That alone should give pause for thought. But, to us, the public equity markets are no longer the riskiest part of financial markets. Sure, the derivative and options market are priced off them, but that doesn’t necessarily make them important, any more than Greenwich is the centre of the geographical world because it is the situs for Greenwich Mean Time. The baton has passed to the private markets – for a generation led by the private equity markets, and now giving way to private credit, more properly called private debt.

The commercial opportunities for private debt arise from a deep understanding of the pathology of each unquoted business, and the knowledge that the banks, once dominant in corporate lending, are so tied up in the Sargasso Sea of legislative constraints, that this newcoming lender, unfettered, can control the debt market. The private debt operators lend at punitive rates, feasting on the high coupons, but increasingly they now end up with equity ownership, as businesses are driven to default by those same interest payments. There is nothing new in this – it is a reversion to the days before the quoted exchanges became the ‘market’; in the 19th century, businesses were owned by the controlling family, who used the exchanges in the same rodeo fashion in which the off-exchange markets operate today.

The effect of these various initiatives is that a great deal of debt is now layered into the investment universe – and, where there is debt, there is not just risk, but amplified risk.

The unbroken upward trend of the markets reveals that there hasn’t been as much risk around as the facts would suggest. The reason for this is that central banks have always been there to bail out the system, time and again medicating the wounds caused by speculation. Whatever the weather – be it pandemonium or pandemic – the Federal Reserve (Fed) has piped on. The mood of many in the market is: we rather agree with this Ruffer chap’s worrisome analysis; but while the music continues, we’ll make money in the momentum and, when it stops, we’ll hold our nerve, and the Fed will bail us out.

The market is dominated by quantitative trading, grabbing pennies in front of the steamroller.

Our co-CIO Henry Maxey has identified two flies which will likely make the Fed’s ointment ineffective. The first is that the conditions are there for a liquidity crisis. Liquidity is the upmarket word for not having enough ready cash to meet a commitment on a due day – quite different from a solvency problem, where you haven’t the resources to do so. In many situations, illiquidity is an inconvenience, but when it is systemic, it can act like a forest fire and spread its flames throughout a financial system. But surely (will ask Socrates’ friend), the Fed is alert to the danger, and will provide emergency funds? It has done so again and again in the last 40 years which, parenthetically, is a good part of the reason why the United States has been the best-performing market, and is also the reason it is the epicentre of the leverage danger.

The second fly is that in such a swift crisis, the Fed will not be able to provide the funds in time. Markets are driven by algorithms, which recognise opportunities through patterns – the speed of dealing is, in effect, instantaneous. Once those patterns signal a reversing dynamic, they will be activated, and that will trigger margin calls: borrowers will have to stump up more collateral immediately to keep their borrowing in place. Easier said than done, of course – Christopher Fildes once described an emerging market as one from which it is difficult to emerge in an emergency. It might just be that this is the fate, too, of the traditional markets. Is this outlook unprecedented? No – it’s what happened in 1987, when the crash was both unstoppable and speedy; back then it happened in a fairly valued market, in a bull phase, because the portfolio insurance protections in place didn’t work, at a point when they were absolutely required to.

‘Will it happen soon?’ Well, if the markets were a taxicab, I wouldn’t want to get into it, even if it was raining. A computer-driven market is passionless, and rapid. Trouble becomes chaos in a jiffy – five minutes before the hurricane, the market can give every appearance of calm. That adds up to a ‘when’, rather than an ‘if’. If we thought it a mere possibility, we would hold a different portfolio. We already believe that we must have a portfolio which can benefit from an extended period of tranquillity. That gives us an each way bet – but the market’s current supreme confidence in untrammelled upside means the most powerful portfolio returns will come from the onset of the storm.

In conclusion, the market is dominated by quantitative trading, grabbing pennies in front of the steamroller. This is now the dynamic driving the market, and so long as it continues, it will make money. We are invested with the steamroller, preparing for the substantial gain which will accompany the rupture of this dynamic. This is reflected in our core assets: the yen, credit default swaps, volatility plays and the inflation-linking of the portfolio’s bonds. The fragility in these core assets can be encapsulated in a single word: when?

I qualified as a stockbroker over 50 years ago, and I have spent my career peering into the future. I have found it rather easy to see the next big thing over the horizon, and the collapse of the predicated alliance between the central authorities and investors is merely the most recent of them. If the tooth fairy were to grant a second gift, it would be knowledge of the ‘when?’ Ruffer’s investment strategy has always been to claim indifference as to market direction. I would put that differently in today’s extreme tensions. We are – we need to be – indifferent to the ‘when?’. I am confident enough to believe the asymmetry of risk in our core holdings will serve us as well as in previous crevasses in the market. Our offsets – those investments held to play the current Weltanschauung – have to play their part until the core assets come alive. I cannot say we achieved that nirvana in 2023: it was our own winter. But, as in nature, nothing is forever and today’s portfolio shows greater fluency and balance. Now, it is the market’s endless summer that is to be tested.

#inflation

Past performance is not a guide to future performance. The value of the shares and the income from them can go down as well as up and you may not get back the full amount originally invested. The value of overseas investments will be influenced by the rate of exchange.

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, including interests in any of Ruffer’s funds. The information contained in the article is fact based and does not constitute investment research, investment advice or a personal recommendation, and should not be used as the basis for any investment decision. References to specific securities are included for the purposes of illustration only and should not be construed as a recommendation to buy or sell these securities. This article does not take account of any potential investor’s investment objectives, particular needs or financial situation. This article reflects Ruffer’s opinions at the date of publication only, the opinions are subject to change without notice and Ruffer shall bear no responsibility for the opinions offered. Read the full disclaimer

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