Ruffer January 2015 Letter
The last year has been interesting in a number of ways. We have seen, at uncomfortably close hand, two of the Four Horsemen of the Apocalypse. The outbreak of Ebola has reminded us that disease has been a greater killer than war: (my 1912 manual of military hygiene tells me that in the 1895 Madagascar campaign, 5,600 people died from disease, as against seven killed in action). The Ukraine shows that Putin’s style of leadership has a long pedigree. Plucky North Korea illustrates the ‘woodlouse which bites’ phenomenon – objects of fun which need to be taken seriously. Our prediction for 2015? Don’t hold your breath for a film called ‘The Interview’. The horse named ‘famine’ was held at bay this year – commodity prices slumped.
Commodity prices illustrated the relentless power of the deflationary conditions which are as strong as ever – and which, indeed, have gathered strength in 2014. There is now an articulated fear that the inflation rate, which has been dropping towards the zero level, might go negative, representing real deflation. Those who control monetary policy around the world are genuinely fearful that this deflationary force is unrelenting. Before addressing this interesting question, let me deal with an inevitable question – are we admitting that Ruffer have made a wrong call by predicting a coming inflation, and owning long dated inflation–linked bonds? The second part is best dealt with arithmetically – the longest such bond in the UK is up by 50 per cent in 2014, and the US equivalent (which we also own) is up by around 30 per cent. Both were comfortably ahead of the Portuguese bond market – the ‘best’ bond market in the world. We also held gold bullion and gold shares to protect the portfolios from deflation – both bad investments, notwithstanding the deflationary conditions. Investment is not as straightforward as it looks!
When the central authorities think of deflation, they think primarily of America in the 1930s, and, less often, of Japan in the 1990s; it is, rather, the 1880s which provide the more authoritative parallel. The years 1873 to 1896 saw consistently falling prices, low profitability, low wages, fullish employment, and a world of opportunity to all; it was the period when Andrew Carnegie became the richest man the world has ever seen – a phenomenon one would intuitively associate with boom conditions. It was a world of white bread for all, of sugar in the workman’s tea. Its key feature was ‘winner takes all’ – in the 1880s, changing technologies saw the Western hemisphere’s sugar–refining industry move no less than five times, ending up in Puerto Rico. The earlier iterations were left with almost modern plants, scarcely depreciated – but utterly useless. When the winds of change blow, they can destabilise even the most conservative of business models: a graphic example is food–retailing in the UK. When a hitherto profitable model breaks down, the ramifications are wide; the retailers try to protect themselves by squeezing suppliers – it is estimated that some 30 per cent are underwater, including the whole of the milk producing industry, where prices are running at less than the cost of production. Its mischief stretches out into real estate – who would regard a 25 year upwards only rent on a Tesco warehouse with quite the same benign complacency as in days gone by? Aldi and Lidl may look like giant–killers, but they are entering an arena inherently compromised in terms of overall profitability – the very hallmark of 1880s–style deflation.
More recently, the world of central–bank economists has made a series of wrong calls – the humiliating thing for them is that it hasn’t really mattered. There was an assumption that economies could be declared robust again when unemployment fell; when Mark Carney, the new Governor of the Bank of England, drew his inaugural line in the sand as to when interest rates would rise, the employment figures on which he had hung his cap immediately signalled ‘time for a rise’. He wisely retracted his position on this. There were misgivings, though – perhaps interest rates would be held low too long, and inflation would erupt? But no, the inflation rate has continued down. This accounts for the rather odd situation of the fall in the oil price being treated as a solemn warning of deflation – when it was obvious to every cab driver and shoe–shine boy that this was manna from heaven to all except those in the oil industry.
This is the background character of the world in which we live. One last aspect remains to be considered; it explains why the authorities have been seemingly powerless to combat these elemental deflationary forces. It is clear that quantitative easing (QE) is not enough to stop mother nature – and the effect on government balance sheets has been sufficiently damaging to bring this money–creating initiative to a halt. Why hasn’t it reversed the primary dynamic, even in Japan, where the target of doubling the money supply, accompanied by a sharp fall in the yen’s value, has not worked? The answer in layman’s language is that QE did not create fully–effective money, so much as vouchers which were only valid in the financial system. It did a great job in improving the finances of the banking system, but it did not go further than that, because the financial institutions did not remit it further – into the real world of corporations and consumers. It is partly a result of that ‘winner take all’ dynamic that we have already visited – corporations are not at all sure that they would be the winner in the present climate, so are disinclined to borrow. Bank regulators, ruthlessly pursuing the problems of yesteryear, have reinforced this tendency by making it more expensive for banks to take risks on their balance sheets. In times of stability, this shows itself in subdued borrowing figures; if and when unstable markets appear, there will be an alarming lack of liquidity in the system, since the natural counterparties to frightened sellers are market makers accommodating them, and the banks have curtailed the size of their books. As things stand, no weapons have been fired against this deflation – but these weapons exist, and we believe that they will be used, early in 2015 in Japan. When it is established as effective, it will be used elsewhere – and the inflation we wait for will have arrived.
To repeat, quantitative easing is a voucher, and not money – and, crucially, it is not available to consumers, who alone are capable of expanding the stock of money enough to create a rise in prices. The insight is to see that a drop in taxation has precisely that effect. We have seen that money to banks, coupled with an injunction to pass it on by way of loans does not work – the banks are ‘frit’. An increase in spending power through lower taxation is the way to achieve it. (Parenthetically, the drop in the price of oil might just have a similar multiplier, and end up as an inflationary force.) Governments are reluctant to do this,