The biggest practical problem facing us at the moment is the use of currencies in protecting the portfolio from loss. Our philosophy is to strive for protection by investing in a wide range of assets which will protect, and be protected by each other. For many years this has worked well, and is still working well – but the increasing importance of liquidity provided by central banks means that there is a non-plussing correlation of all asset prices: up when the quantitatives are eased: down when they are reversed. If bonds, equities, commodities and real estate all go down simultaneously, what’s the fun of finding that you lost money in each of them? In this world, currencies have become the only effective way to achieve true diversity. But currencies are not very obedient to the fundamentals and this feline quality means that even a correct analysis of the situation does not ensure a satisfactory result. In the event, the gains (so far) in 2010 have largely been achieved through a bold move into the dollar.

There’s another danger with currencies. Our glory is in having no benchmarks – but a base currency is an implicit benchmark – stray too far from sterling (or other base currency), and the risks increase. This put us in a difficult position in Japan, where we have (correctly) identified that a weak stockmarket will be accompanied by a strong yen, and vice versa. The obvious way to protect our largish positions in Japanese equities would be to keep the yen unhedged – but a big dollop of dollars, and a big dollop of yen would have meant, for sterling investors, the risk of being too much away from sterling as a general election and a harsh budget approached. In the event we broke the wrong way arithmetically – the stockmarket did go down, the yen did go up, and we suffered in the former with no benefit from the latter. This need for currencies as an asset class is a temporary phenomenon, lasting only as long as the dominance of central bank intervention in the investment mix. When this dominance fades, we will be able once again to remember the adage: if you have a view on currencies, have a little sleep and hope that, when you wake up, you’ll have got over it. In the meantime, it will provide a specious excuse for any future underperformance.

The current weakness in the stockmarket is generally attributed to fears of a ‘double-dip’ recession – there is, however, little hard evidence of this, although leading indicators in both America and China would be consistent with a slowdown. For what it is worth, we incline to the view that the adrenalin afforded by extra liquidity will keep things bowling along for a while, and evidence of this should reassure markets. Nevertheless, it is worth taking a step backwards and reminding ourselves of the fact that the economic world is the instrument of a massive real-time experiment to see what happens when you pump extraordinary amounts of money into the system to neutralise the deflationary effects of the credit crunch. Eighteen months ago nobody knew whether this would turn world economic growth around. We now know that it did. Nobody knew whether the bond markets would tolerate such an injection of liquidity. They have done.

So far so good. Where are today’s uncertainties? Nobody knows whether this tolerance will continue for long enough to allow economies to recover their internal strength, so that the indebtedness they have created can be repaid. Those who speak the most authoritatively on such things are the economists, who not only failed to see it coming, but are so unblushing that one might almost imagine the dislocation didn’t occur, and the credit-rating agencies, who combined an equal lack of understanding with an egregious dose of conflicted interest. That’s as sensible as putting Messrs Pétain and Quisling in charge of the inauguration of the United Nations.

Despite this bankruptcy of understanding there is a sharp conflict of thought as to whether belt-tightening or continued assistance is the better way to treat the economy. Cynics might think that it largely depends on the election cycle, with Obama’s call for further easing playing into the mid-term elections in the US, and Britain setting off on a budget-cutting cliff-hanger (the only way is down) having established an uneasy political consensus following the May elections.

The theory behind this debate is reminiscent of the conundrum in the 1930s – balance the books and bring on a depression, or print the money and blow up sound money. Or, in today’s language, deflation or inflation? The two are very nearly the same thing. Imagine driving down a straight road when a tyre bursts. The car lurches to the left, and if the driver does nothing the car ends up in the (deflationary) ditch on the left hand side. More likely than not, the driver will desperately pull on the steering wheel to avoid this and then, of course, the danger is the right hand ditch of inflation. We have always said that for America the iconic mistake of the twentieth century was the depression (just as for the British it was the Battle of the Somme). Back to the analogy of the runaway car, the odds on left-leaning mistakes or right-leaning ones are not evenly balanced. There is an overwhelming dynamic away from the ‘do-nothing’ deflation, towards the soothingly-delayed consequences of monetary compromise.

We are – and have been for over a year – inflationists, but the travails of Europe and Japan – followed probably by China – will put this resolution to the strain. We believe though, that the worse the deflationary forces the more the policy response is towards monetary compromise. This is seen in the situation after Greece’s crisis: the contagion quickly threatened Portugal and Spain, so after a perfunctory show of firmness, the ECB produced a reserve ‘shock and awe’ cheque-book package of €750 billion. The more the deflationary lurch, the harder the steering wheel is turned.

We are increasingly excited about Japan in this context. The central bank has a good understanding of the need for financial easing – and, unlike the west, their shot is still in the locker. The onset of inflation is massively effective in rebalancing the comparative advantage away from the saver towards the borrower – provided, and here’s the rub – citizens don’t see it coming. Fifteen years of Japanese deflation or near-deflation means that nobody there has any inkling of how easy it is to inflate if the authorities are prepared to compromise on currency. They are as nervous as a * about pulling the trigger – it will take a crisis for them to act. What form might the crisis take? Exactly the sort of deflationary forces which abound everywhere, and which doubly afflict the Japanese economy. How will we recognise the moment – we won’t, of course, but if the yen strengthens to $¥85 – then hold on to your hats. Intervention will weaken the yen, steepen the yield curve, strengthen price expectations – and the equity market could be absolutely remarkable in its upward parabola. You heard it here first.

Although this may appear to be a second downbeat investment review, it should be an encouragement to readers. We are more than halfway through – probably – this period where the fundamentals of economic forces are willed into quiescence by politicians and bankers. We have taken our positions for the ultimate resolution of this tension – and it will be terrific for all of us if we are vindicated!

Jonathan Ruffer
July 2010

* little fluffy kitten

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The result of this is that success in the markets over the course of the next nine months will probably depend on opportunism. We remain convinced that the ultimate resolution of this time of uncertainty will be through high inflation – but first we have to get there. The management of the portfolios will require on the one hand, not to be bounced out of our core investments which protect the portfolios for this future development, and, on the other, not to sit disconsolately only in assets which in the short term may seem inappropriate. 

What are the elements of the cross-currents? The first one is bullish. Underlying economic growth remains firm across the established world. Many investors have been surprised – not to say incredulous – at the snapback in prosperity over the last year. There is a biggish constituency of bears waiting for its end – and they are set to be disappointed. We think that economic growth figures, unemployment and company profits are all set to produce favourable surprises. This is a continuation of a trend.
At the other, bearish, end of the scale, we think that China looks pretty flaky at the moment, manifesting all the hallmarks of a seraphic over-exuberance. Most bubbles have at their core an undoubted truth and the difficulties occur when unrealistic implications are drawn from the basic observation. The tyranny of the dotted line, stretching into the future, is where the heresy is incubated. China is a text-book example of this phenomenon. In the last generation, the nation has changed out of all recognition. The existence of 1.3 billion people, most of them still dirt-poor, shows what a driver of the world economy an energised China could be. Tired communist governments now look rather astute, and their inscrutability adds to the idea that there is a master plan. Unlike India, whose patron saint is the pothole, China is bursting with new infrastructure products. Capital investment at 58% of the economy puts the rest of the world to shame – but it also broadcasts a command economy which is completely out of control. How about this for a quote from China’s Housing Minister last month? In response to a question whether Beijing could stabilise home prices he said, ‘We can definitely stabilise them! The premier has said so! So how can we not stabilise, we can for sure! Even if we can’t, we can!’ Not even Harold Wilson at his most manic talked like that. The same E.coli bug is at work in China as it has been in the rest of the world: interest rates held below the natural rate for an indefinite period. The West has seen its unfortunate consequences in the last two years; in China they are yet to manifest and the timing is uncertain. But it is the same disease, and when we look back at the 2008 crunch in the West and the crunch to come in China, that will be confirmed. 

The situation concerning Greece is complex. The British are enjoying the cine-film of the EU emperor revealing himself to have no clothes, but the pleasure of all the Pathé films in the world would not disguise the fragilities under-girding the EU system. There is an uncanny parallel with ‘sub-prime’. Even after it became clear that sub-prime mortgages were largely valueless, there was a view in the United States that their comparatively small (about $250 billion in toto) meant that there could be no systemic risk. The nature of the derivatives market proved otherwise, since they were a constituent part of a much broader block of collateral which, when compromised, resulted in substantial losses in other supposedly riskless areas, relentlessly impairing the balance sheets and lending capacity of US banks. 

Continental European banks were also involved in the US problems, and now they have an additional issue with Greece. EU sovereign bonds – of which Greek bonds are a part – are used extensively in collateral baskets within the European financial system. Increased risk aversion towards these credits forces a contraction of the lending system, reducing leverage and credit availability; Greece may only be 2% of European sovereign debt, but as with subprime, the knock-on effects are large as the liquidity multiplier works in reverse.

There has been an interesting development in the swaps market which is pertinent to the Greek situation. This seemingly arcane area of the market is an important one, since it allows any financial institution to readjust the duration of its borrowing or lending without having to go to the trouble of trading the underlying assets. The swaps spread is really a yield, and given that there is a counterparty risk (you take out the swap with a financial institution, which could go bust – and sometimes does!) the yield is always higher than the government bonds on which the swap is based (which, by definition is guaranteed by a government, not a bank). Recently, however, the swaps spread has yielded less than government bonds. This might seem an arcane and uninteresting fact, but it is the financial equivalent of water flowing uphill. Regulators want banks, which look obese in gross asset terms, to slim down. Government bonds meanwhile offer wonderfully attractive risk adjusted yield spreads, providing an incentive for banks to expand balance sheets by buying them. The resolution of this is for banks to get exposure to these spreads synthetically in the swaps market rather than actually buying and holding the bonds on their balance sheets: hence the anomaly. But the dynamic is clear: following the relentless drumbeat of aggression from the regulators, post-Lehman, banks everywhere are rationing, reducing and simplifying their balance sheets.

Japan remains intriguing. It is the one economy which has not benefited from quantitative easing. The result is that Japan remains anaemic: sluggish retail sales, low borrowing, poor growth in hourly wage rates, an economy teetering on the edge of deflation. Each of these symptoms would be cured by a blood-transfusion. It is our belief that a powerful stimulus to Japan would weaken the currency, steepen the yield curve, and the lugubrious predictions of an implosion of government indebtedness would prove wide of the mark. Such a move would be unequivocally positive for equities.

All these disparate factors – and there are more – make it difficult to come out with a single coherent strategy. It is rather like those rather silly competitions which one used to find on the back of cornflake packets: ‘Put in order of attraction the following characteristics of Tupperware®: a) Tupperware® is strong, unbreakable and comes in many sizes, b) Tupperware® makes a family a go-ahead family, c) Tupperware® is hygienic and kills 99% of all known germs . . .’ The point is that these characteristics cannot really be put in order, Tupperware®-style. Nevertheless, it is possible to balance off risks in a way which should establish that if we cannot be absolutely right, then we can avoid being absolutely wrong. The strategy is that of Napoleon marching on Moscow – to preserve sufficient forces to represent a military threat to the Russians. Let us hope that we do it better than him!

Jonathan Ruffer
April 2010

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There is no such alarm in the financial world, yet the same thing has happened; what is more, its architects intended that it should be so.  Everybody can see that summers of prosperity are more enjoyable than winters of recession, and the dynamic has been: 'so let’s get rid of recessions!’.  Nobody is foolhardy enough to say that lower heating bills and fewer frozen pipes are a good reason for abolishing winter – and yet, economically speaking, this is precisely what the Fed has done.  The ambitious theme of this investment review is that the Federal Reserve has had the will and the resource to influence the very shape of the economic landscape, and has used this power so comprehensively that it has interfered with the rhythms of the world’s economy.

Its dynamic was a simple one.  From the late 1980s, whenever the economy looked like slowing down, the Fed simply lowered interest rates and made money freely available.  At the time of the LTCM crisis in 1998, a long period of prosperity was approaching exhaustion, and a recession was on the way.  The result of the Fed initiative was not only to sustain economic demand, but to set off a stockmarket (TMT) boom, which itself encouraged further economic activity.  But when that boom turned to bust the economic world was faced with two summers’ worth of detritus, and the likelihood of a deep recession.  The Greenspan trick was repeated, and, lo, there was no deep recession; instead a housing boom which itself turned into a housing bubble.  When this bubble burst in 2007, the world was looking at the stabilisation of the detritus of three summers – the original one following from the 1990s’ prosperity, the aftermath of the stockmarket bubble in the early years of the century, and the excesses which reached their crescendo in 2006/2007 in the leverage boom based on the housing market.  We were thereby faced, not with a recession (appropriate in the 1990s) or a deep recession (appropriate in the early years of this century) but a full-blown depression.  And when the US administration butterfingered the Lehman crisis in October 2008, it was upon us.

Unsurprisingly, the Fed responded to this crisis in the only way it knew how – lower interest rates and a massive injection of liquidity.  Slowly, hesitantly, sluggishly, the ship of state picked up – overwhelmed at first by the awfulness of the trade crisis which followed hard on the heels of the financial dislocation.  It seemed a forlorn hope that the depression could be avoided, but it has happened; for the third time, the winter season has been delayed while, this time, the balance sheets of sovereign nations take the strain.  But one day, perhaps soon, perhaps not, this new pillar of support will prove inadequate and then what will happen?  The pattern looks unmistakeable.  It starts, ‘no recession now, but a deep recession later.’ Then it becomes, ‘no deep recession now, but a depression later.’ After 2008 it becomes, ‘no depression now but...’ and it seems clear that the dynamic is going to be something like, ‘and then there will be a complete wipe-out’.  But this is emphatically not the case.  This is the moment for writing in green ink and in block capitals, NOT SO.

This may seem amazing, but it is the case.  The central bank dog has twice barked and made the position more and more unstable – how can the hair of this dog put us on course for a cure?  Before we rejoice in the introduction of a new stability into the world financial system, it is worth pointing out the frighteningly unsatisfactory feature of it: it is the money of the savers which is going to plug the destabilising gap between the accumulated debts and their lack of collateral.  We are all about to become a lot poorer.

To understand the background to this, one has to revisit the Victorian debate as to the nature of consumption in an economic system.  Can you consume what you haven’t got?  In the world of moral absolutes, morality and common sense came together in declaring that only accumulated wealth could be consumed.  This raised the tricky question as to where borrowings fitted into all this; a bicycle bought with borrowed money was every bit as much a bicycle as one bought from savings.  Did the motivation matter – whether the bicycle was to be used for a paper round, or for the pleasure of butterfly–catching?  The traditionalists took an absolutist line, standing alongside their theologian–brothers who were at the time defending the Bible against Professors Darwin and Huxley.  But they chose their positions badly.  Just as the Bible was a lot less brittle in accommodating darwinism than its defenders feared, so it turned out that the economy could handle a great deal of money borrowed for frivolity and pleasure.  In defending the wrong battle line, the traditionalists not only got the theory wrong, but the practicalities, too: in the 1930s, the policy of balancing the books made things worse, whereas Maynard Keynes’ suggestion that governments who borrowed money would give a helpful jolt to an economy, turned out to be spot–on.

For the last sixty years the idea has been discredited that you can’t create something out of nothing (an argument attested to by both King Lear and common sense: an unusual alliance): because borrowings have had the power to increase asset values, and have done so comprehensively, it has been assumed thereby that wealth also has increased.  The powerful lesson to be drawn from the leverage boom of the last ten years is that borrowing on the basis of an increase in asset value alone is not, in the long-term, a sound proposition.  The extra value in the stockmarket bubble created borrowing–capacity, but when the bubble burst the borrowings secured on this virtual wealth were left beached.  Its replacement by the housing boom provided an alternative support – for a while – but by 2007 it was seen to be no more real than its predecessor.

We have now moved into a new third stage.  Bank loans in the private sector have been replaced by government borrowings – which create deficits.  Any problem in these will be felt through the currencies of sovereign governments – stand by for this next default!

Earlier generations would be amazed at the utter naivety of our financial generation to imagine that a paper currency could possibly – could possibly be a substitute for wealth.  Property, land, claims on profitable enterprises, even tulips, yes!  But paper currencies?  Surely the 1825 Colombia Loan (money lent, ammunition bought, ammunition fired off, end of loan) proved that?  Like all sophisticated societies we have to learn the obvious lessons last.  When currency values buckle, a third chimera of wealth will fade as inflation causes monetary spending power to decline.  Nevertheless, providentially, this inflation has within it the seeds of hope.  Provided interest rates are held below the rate of inflation (helped along by taxes charged on nominal returns rather than on an inflation–adjusted basis), then savers will find that the value of their wealth goes inexorably down, year after year.  Riskless returns that are negative were enjoyed – if that is the right word – in Britain between 1975 and the early 1980s.  Savers and those on fixed retirement incomes became poorer and poorer with each successive year.  This was an effective transfer of wealth from those who had it, to those who didn’t, either through poverty or debt.

Today, the man with £1 million of debt, and an asset worth, say, £500,000 is not only  insolvent, he is also a threat to the stability of an economy.  If money halves in value, he may well be able to sell the asset for £1 million in devalued currency.  If he has paid only a small amount of interest in the meantime, then it is the creditor, the man with the savings, who is repaid in devalued money, and he has had no proper post–tax reward for his pains.  This is the cure which is unfolding upon us – but for the saver it is more of a curse than a cure.  This practical and immediate danger is very hard to guard against, and extremely irritating to live through. That is why your portfolio looks as it does at the moment.

Jonathan Ruffer
January 2010  

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At the start of the year, there was a sense that an elemental force had been unleashed which had smashed its way through the accumulated reserves of the financial system – what could the pygmy politicians and timeserving central bankers do to avert it? The long term answer to that question remains open, but in the short term, quite a lot. Now that the policy of pumping vast streams of liquidity into the system is well established, things are on the move. There are, of course, critics who point out that the central authorities should never have got themselves into the problem in the first place. There was a Victorian doctor, not much good, who gave all his patients a powder which induced a seizure, because, as he explained, he was ‘a dab at fits’. So it is with Dr Bernanke and his predecessor, Alan Greenspan, at the Fed. Any plaudits for their decisive action need to be seen in the context of the past enormities which created the crisis.

Nevertheless, the Fed, and its counterparts elsewhere have indeed proved to be dabhanded at halting the slide into a depression. Wherever there are pockets of economic strength, the hand of government action is to be seen. Car sales, which were in crisis last Christmas, have now recovered – thanks to the ‘cash for clunkers’ initiative whereby you swap your old car for a new one and get a government hand out of $4,500, £2,000 or €2,500, depending where you live. House sales are recovering in America – but it is estimated that fully five-sixths of all transactions have some form of government subsidy.

The bears didn’t think that these initiatives would work – but they did. Our economist, Peter Warburton was shrill in his warnings to us not to underestimate this central monetary shock and that the world economy would likely recover quickly and powerfully. How wise he was! And he continues his theme today, saying that the growth in the last half of 2009, and particularly the final three months of the year, could be awesome. This could really spook the bears who belatedly will come to see that the spring rally was not fanciful. Moreover there are still plenty of people who feel that last year’s events were an unreal nightmare which came from nothing, and will return to the ghost-cupboard with a good squirt of WD40 on the bits which had gang a-gley (Lehman’s banking arm?), and it’s now time to make up for lost ground.

Sharply improving dynamics in economic growth are driving markets higher, and they are much reinforced by the hunger for income which has arisen from a world where bank deposits offer barely any return at all. Equities are a natural beneficiary of this. They are liquid, sold at the drop of a hat (or the flip of a coin); after last year’s fright over illiquid investments, they are the asset class of choice. Being a ‘real’ asset, they offer protection against paper entries in paper currencies in possibly paper banks. Above all many of the blue-chip super-companies have superior yields, in the UK, for instance, Vodafone and BP come to mind. Do not, therefore, be surprised if the prices of these sorts of stock exhibit bubble characteristics over the coming months.

But these are tactics. The key insight is to understand that it can’t last this way. The demand for cars is based on the government handout, and without it (and the one thousand and other incentives and injections) the economy would fall lifeless to its end-2008 dynamic. The fires of the world economy, post-Lehman, were doused with cold water and were in danger of being extinguished. The central authorities, with their response, are effectively the providers of firelighters on an industrial scale. The result is the fierce flame of economic strength – and it is real strength. The bears missed it, and the bulls are in danger of missing its temporary nature. Yes, the market may rise higher – considerably higher perhaps – but in the long run the firelighters are not the answer. This is a key moment for asset allocation and as is so often the case at such times, the optimal mix may be quite different depending on timescale. The longer out one looks, the less interesting – and the more dangerous – a strong equity exposure looks.

How does it go from here? There are so many variables to consider that the path (which we will come on to in a moment) is impossible to gauge – but the destination of inflation is the same whether the world takes the high road or the low road.

We believe that in the New Year the markets will be trying to assess the significance of sharply stronger economic and possible wage growth. There will be those who think – using my analogy – that the firelighters have succeeded in lighting the fires of the real economy. We have to say that we don’t think so (too much detritus from the recent past): we might be wrong, or even if right, the market may take an opposite view. The resolutions of this uncertainty give rise to a greater uncertainty – what will the Fed do? We described in last quarter’s review how we could well be looking at a widespread disruption in the supply-chain for goods and services around the world – and disruption means inflation. The extra bottle of champagne from the all night corner shop is a lot more expensive than from the wholesaler – but if you run out of booze it may well be your only option. You pay more, although the cost of champagne has not moved.

The irony is that the Fed may have to (or choose to) respond to this corner shop inflation by cutting its programme of quantitative easing – horribly exposing the fragility of the underlying economy. This would be terrible for markets – the realisation that for all the accommodation, it had been ineffective. This is hard to prepare for within portfolios. Its occurrence is a surmise on a surmise – not necessarily a high probability. It would require a substantial shift in assets towards conventional bonds, which are already fully priced. It would hit equity markets at a time when other possibilities point to their continued upward movement. It calls, more than ever, for a philosophy of an asset distribution which forgoes the possibility of being absolutely right to protect from being absolutely wrong.

We remain sure that this ends in inflation. If things improve it will come, if things get worse, there could be a moment of deflationary fear, and then the inflation of currency compromise. Either way the losers in this inflation will be savers, especially those trying to keep their money safe – in short, dear reader, you.

We are half way – almost exactly – through the crisis.

Jonathan Ruffer
September 2009

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This is what we think is going on. The destruction of the financial system in 2008 led irresistibly to negative consequences in the real economy – lack of consumer demand, fractured world trade and an almost complete cessation of borrowing opportunities in the corporate sector, auguring badly for the medium-term economic outlook. A wide range of radical – not to say revolutionary – incentives were applied to the financial system by central banks. The Fed’s defibrillator was activated, but the equity markets at the beginning of the year felt that it might be too late; perhaps the entire world system was irreparably broken. These extreme fears have proved to be unfounded. Oiled by the TARPs, the TALFs, the Quantitative Easing and the PPIP, the fly-wheels of industry have restarted, and with the new CEO of the Royal Bank of Scotland’s pay now edging towards the £10 million mark, the Titfield Thunderbolt is back in business. The optimists check their timetables to see when the economic locomotive will reach its furthest destination, the bears wonder how good an idea it was to power the train with a large dose of plutonium. The picture is confused, but economic conditions are showing signs of stabilising, and the threat of a bank failure bringing down the financial system seems much less probable.

The easier part of the Fed’s work is done. By making credit abundantly available to the banks, the derivative markets recovered, dragging the ‘cash’ market (ie, the stockmarket and other asset prices) up in sympathy. From the Fed’s point of view this initiative had one big advantage, and two disadvantages. The ‘plus’ was that it could be done in the shadows, without being easily visible, and crucially without increasing the of the Fed’s balance sheet, which the vigilantes have identified as primary evidence of money-printing by the authorities. The bad news is that the injection of credit into the system has to be done through the banking system. This has ensured that their second quarter’s profitability has been enormous – not perhaps the signal to give the world. Moreover, the bankers can be relied upon to create further bubbles to extend their profitability – they have had years of practice at it. The old apparatchiks continued unchanged in a post-perestroika world: capitalists are no different from communists in this regard.

If the Fed is to continue its easing, it must find another conduit, and that is proving to be a straight purchase of assets in the market place. This change of emphasis focuses attention much more directly on the Fed’s balance sheet, which expanded alarmingly last year from $800 billion (of which $600 billion was cash equivalent) to over $2 trillion – this exercise will probably take it to over $4 trillion. The danger is that the vigilantes ambush the US political system and force a discontinuance of the Quantitative Easing by the authorities. Then the comprehensive nature of the deflationary forces will be laid bare. The citizens of Ireland know how terrible its dead hand can feel: the combination of competing with Britain’s weak £ and suffering the indignity of an overseas central bank (the ECB) setting the rules for circumstances independent of Ireland itself means that inflation is now running at -4%: in other words harsh deflation. Make no mistake; the Fed is doing the right thing by printing money to avoid this elemental force of deflation. The gallows of inflation may well be tomorrow’s theme – but another day, another opportunity, and the Fed is underwriting today’s survival.

Far from worrying about inflation, the consensus is unconvinced that the Fed can do enough to stave off this Irish-style deflation. Our belief is that they absolutely can – because they are in a position to create money faster than the economic downturn can destroy it. A silly, but possibly true, story can illustrate it. At the beginning of the nineteenth century there were two grandees in County Durham – one was rich and stupid (His Grace the Duke of Cleveland) and the other was rich and clever (William Backhouse of Backhouse’s Bank, Darlington). One day they had a schoolboy spat as to which one was the richer. William Backhouse challenged the Duke to a competition: they would sit opposite one another in a pub, and tear up £5 notes. When His Grace tore up a £5 note, he was £5 poorer: when Mr Backhouse did so, it was at the trouble and expense of printing another one. So it is today. It doesn’t really matter how rich the Duke is, or how deep the write-offs are: the Darlington banker and the Central Banks can always match it – and more – so long as there are trees to provide the paper. This is what the Chairman of the Federal Reserve, ‘Backhouse’ Bernanke wrote in 2002:‘What has this got to do with monetary policy? Like gold, US dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.’* These much quoted words reflect his intention. This is his moment. There is as much chance of him changing his mind or losing his nerve as Maggie Thatcher joining the Liberal Democrats. Only the political machinery can thwart him, and just as Mervyn King had to abandon his strong £ policy last year when the economy slumped, so the political opponents of Quantitative Easing will be swept aside by the deflationary forces which will quickly turn Celtic in their ferocity. Inflation/deflation? This is the burning question for investors at the moment. We believe that it is nearly a certainty that we are headed for inflation, although we accept that this view could look horribly wrong – not for long, maybe, but our discomfiture could be great.

Let us emphasise again that, in terms of the economic situation we are out-and-out deflationists. Every pressure is for prices to go down, as economic activity withers away, companies default. The inflation we fear can be seen as simply one more default – the default of the currency. In a corporation, though, it is binary – a company is either alive or dead. With currencies there is an infinity of gradations from absolute loss (Weimar Germany), destabilising loss of value (Britain in the 1970s) to the rumbling problems of gradual but persistent erosion which were the pattern for most countries in the latter half of the twentieth century.

What then will be the transmission mechanism of this inflation? Peter Warburton here has argued powerfully that the financial alarms of last year could easily upset the fragile supply-chains which, in this ‘just in time’ world have little resilience to rupture. Even a mild inventory re-stocking would lay this problem bare, and a widespread series of one-off ‘special’ price increases could aggregate into general inflation.

But the real place to look is in the psychology of the world’s citizenry. The widespread ridicule of Gordon Brown’s initiative to ‘invest’ the UK out of recession is a short step from a realisation that the cornucopia of money which he prints to pay for this investment is equally ridiculous. A £20 note, so devalued, is likely worth less – invert that idea, and the cost of a £20 item is likely to go up in this circumstance: inflation! In the circumstances, it would not be the Bank of England or Goldman Sachs’ strategists who call this inflection point: it will be the Sun newspaper, whose front page will show a picture of a £50 note, with the banner headline beneath: BOGPAPER! If people fear inflation, they act in ways which bring it about – the danger of inflation comes from the activities not of the rogue elephant, but the power of an army of ants. Psychology is apt to change quite suddenly – the financial world saw it when everybody became fearful of bank deposits in a matter of days in that dark month of September 2008. The same could be true of paper currencies. Crowd behaviour is impossible to observe, but of immense power. It could bring about inflation very quickly. We think it will not necessarily come soon, but that when it does come, it will come quickly: not a chip-pan fire of bubbles, smoke, blue smoke and fire, but the sudden burst of petrol catching alight. This could be quite disconcerting.

* Governor Ben Bernanke, 21 November 2002 ‘Deflation: Making sure ‘it’ doesn’t happen here’ before the National Economists Club, Washington DC

Jonathan Ruffer
July 2009

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World trade has had a heart attack, and the paramedics have applied their shock therapy.  Wild events are rampaging through the world of money, but every morning in London the sun rises a little earlier, and shines for a little longer, taxi drivers still moan and the commuters go about their business as they always do.  We at Ruffer while away the day by deciding whether the US railroad stocks are due a decent bounce in the market, or perhaps whether the Swedish Krone is somewhat oversold.  It reminds me of the 1963 report and accounts of Gamble-Skogmo, a US retailer, whose report began with a trundle through their revenue growth, their dividend policy in the light of the revenue growth, and a couple of other housekeeping trivia.  Then the report went on (I paraphrase): 'Some people have asked how Gamble-Skogmo would fare in the event of a nuclear holocaust.  With stores in Alaska, Hawaii, Caracas and Fiji, we believe that Gamble-Skogmo is well placed . . .'  Now that the Cuban crisis is a distant memory, the bathos is quite amusing.  But we should not lose sight of the enormity of what is going on, and the moral inadequacy of believing that a money-making wheeze is a sufficient response to the crisis that the world is facing.

It is striking that the first property crisis comes a mere ten chapters (in Genesis) after the creation of the world.  The judgement on Babel was not that some Old Testament Fred Goodwin had recklessly leveraged the enterprise, but rather that human beings have a moral warble fly which in certain conditions will breed a collective hubris of exuberant wealth creation.  Now that we are mired in the inevitable consequences of its aftermath, it is hard to avoid the feeling that the authorities' attempts to present themselves as the Master Problemsolvers of the Universe demonstrate a similar hubris, since the money which they inject into the system, directly or indirectly, is money which has been created at the will of the authorities, not represented by any corresponding wealth.  In the days when government bailouts needed gold, you either debased the currency (effective for about five minutes until the coins start rubbing against one another) or you couldn't do it.  Today, the power of money creation is infinite, and so, in a sense, are the stakes.  Just like weapons of war as the decades have gone by, so their power of destruction has increased.

The enormity of this is more easily seen by the common man than the sophisticate - so it was with the emperor's clothes.  The clever chaps know that money creation does not require collateral.  They know that when money usage declines - as it does precipitously in dislocative deflation - then you can print more of it to maintain its old equivalence.  If business is crashing, and bad debts are destroying money, is it not desirable - no, essential - to create it in wholesale proportions?  The honest answer is that we just don't know, but the ordinary man knows that a banquet is inclined to be followed by the bill.  He can sense that his £20 is not the store of value that it was before tens of billions of new ones were created.  He doesn't perhaps know how to express his uneasiness.  One day he will - and on that day, money will begin its journey of inflation.

It is our task to build the core of the portfolios around this priority, and to protect that inflationary 'centre' with a wide range of assets whose primary job is to protect its value in the event that we are either wrong or too early.

Over the years these investment reviews have been the expression of my own idiosyncratic views, but I would like to introduce the reader to the team who are primarily responsible for the wholesome ingredients of the portfolios.  Robert Tamworth runs the partnership effectively, and on a tight budget.  It has earned him the nickname 'Discount Tamworth'.  He has been there from the beginning, along with Jane Tufnell, herself a stockpicker, friend and strong tower to those whose lives here are dedicated to the lonely task of stockpicking.  I am thinking especially of Tim Youngman, whose ability to find value in Europe has been quite literally second to none in London – no, Europe, and Alex Grispos who should really be Warren Buffett's right hand man, but luckily works with us.  At the epicentre of our investment process sits Henry Maxey, whose insights and technical understanding of the arcane world that we live in caused him to write 'Cracking the Credit Market Code' in April 2007, which will remain for its insights and timeliness one of the great predictive calls since the Captain of the Titanic cried 'abandon ship'.  I have forgiven him for being better than me.  Peter Warburton, whose economic understanding and judgement has been recognised by his membership of the Shadow Monetary Policy Committee has meant that we have two tigers burning bright on our 'big picture' calls.  We are already indebted to the cautious boldness of Kentaro Nishida, our Japanese specialist.  It is hard to know how we could possibly have steered our way through this opaque market with such stock-specific success without him.  Trevor Wild, James Heal and James Verdier have recently joined the partnership, and make a really valuable contribution in their analysis of the equity universe.  A determination not to be bound to any one asset class be it bonds or equities has led us to bring in the previous Global Head of UBS' Credit Repo Operation, David McClean.  Mary McBain runs our Hong Kong office, and from there she continues her enviable ability to spot safety and success.  And this is not an end to it on the research side: I am jolly proud of them, as the lawyers would say, 'jointly and severally'.

Above all, what I want to provide at Ruffer is a service.  Although half the world seems to work in a service industry, the idea of being a servant seems rather Gosford Park and not at all what the doctor ordered in the twenty first century.  I think it is a question of defining one's terms.  To me, being a servant is not a matter of the forelock, but rather it is seeing a situation from the other chap's point of view.  This is what I believe it is humanly possible to do all the time.  To produce constantly good performance is, alas, not always possible, and I hope you will be gentle with us when we fail on this latter point.

Jonathan Ruffer
April 2009

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