Ruffer: the biggest risks facing markets in 2023

Duncan MacInnes, fund manager of Ruffer Investment Company (LSE:RICA), explains why he is cautious about the outlook for stock markets in 2023, including his views on inflation and interest rates. MacInnes’ pessimism is reflected by the portfolio having a record low weighting to shares, of around 14%. In terms of the equities held, MacInnes explains why energy is a key theme, and why BP (LSE:BP.) is the standout stock in the sector. He also runs through why making active use of cash is a strength when markets are volatile, and explains why, from an income perspective, bonds are now offering better value than shares.

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Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview Today in the studio, I have with me Duncan MacInnes, manager of the Ruffer Investment Company. Duncan, thanks for coming in today.

Duncan MacInnes, fund manager of the Ruffer Investment Company: Thanks for having me.

Kyle Caldwell: As we head into 2023, there's no shortage of headwinds. What would you say are the main risks for markets and what are your views on inflation and interest rates?

Duncan MacInnes: The first bit I think is easier than the second bit. So, I think the risks for markets are recession. For the first time ever, we have central banks openly talking about raising the unemployment rate, which is public servants talking about actively putting people out of work, which really shows how far down the rabbit hole we are. So, central banks are willing to tolerate a recession at this stage, and I think that seems likely.

The second thing to worry about is corporate earnings. So, the stock market's down a fair bit. It's really come down because of interest rates going up. It's not come down because of corporate earnings being reduced. The S&P 500 is still forecast to grow earnings 8% next year. We think that's way too optimistic. In recessions, earnings usually fall 10% to 20%, so earnings could still fall. Things like flows are still very positive into equities, we don't normally see that in bear markets, and you would expect to see outflows at the bottom of a bear market.

And maybe the last thing to worry about from a market perspective is liquidity. So, we've written a lot about this in the last couple of months, and we've got some documents on our website if you want to go into detail on it. But effectively, the emergence of alternatives in higher cash rates has, we think, risks, putting it very simply, a sort of global synchronised de-risking of portfolios. So, people who were previously forced to take risk [are] choosing to sell up and go to safer investments.

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In terms of inflation and interest rates, we are known as a house that focuses on inflation, that is very worried about inflation on a longer-term basis. However, it's important to note, the nuance of our views is that we think we'll see a decade or so of inflation volatility, and that means higher inflation and lower inflation.

The last decade had 2% inflation with very little volatility around that. The next decade might have 3% or 4% inflation on average, but with 10% inflation like today and some periods of lower inflation, zero inflation or deflation, I think as we move into next year, we're at peak inflation now and we head into that sort of disinflationary part of the inflation volatility journey. So lower inflation next year would be our guess. But as we have seen in the last couple of years, these things are incredibly difficult to forecast. And the whole way that we construct our portfolio is that, yes, we have a view and, yes, we try to express that view, but we also try to make sure that we don't lose any money if we're totally wrong.

Kyle Caldwell: Are there any other risks concerning you that are perhaps a bit more under the radar that other investors may not be thinking about as much?

Duncan MacInnes: I think that liquidity risk is the one that's under the radar. So, everyone is worried about recession. Everyone is worried about corporate earnings. I think those shoes are still to drop, but they're at least being focused on. I think this idea of liquidity being drained from the system in numerous ways, I mentioned investors de-risking. But, of course, you've also got quantitative tightening from almost every major global central bank.

You also have, again this is very technical and is in some of the stuff we've published, you have this dynamic where people are moving funds from banks to money market funds. Now, that does not sound like a particularly consequential event, but I assure you it is. Basically, it's because banks have a money multiplier and that money gets fired around the system and re-lent to corporates and so on. Money market funds deposit their money directly with the Treasury and there is no multiplier in that. So that has another source of significant liquidity being drained from the system. That leaves markets very vulnerable, we think.

Kyle Caldwell: The equity exposure is at an all-time low of around 14%. In terms of individual holdings your top holding is BP, which is just under 2% of the portfolio, and I noticed the rest of the equity weightings are less than half a per cent. So why is BP the top holding, and why do you have a lot more [of] it [than] others?

Duncan MacInnes: So, BP is our biggest holding. It's our preferred oil major. But really it is reflective of an investment in the theme of energy. So, we also own Shell (LSE:SHEL), we own Exxon Mobil Corp (NYSE:XOM), we own Chesapeake Energy (NASDAQ:CHK), a couple of other names, too. So, energy, in particular oil, is the biggest theme in the portfolio, why? I called it [in] the Ruffer Investment Company annual report last year, Homer Simpson's investment idea. So, Homer Simpson's thing was beer is the cause of and solution to all life's problems. And I thought energy equities were the cause of and solution to all your portfolio problems. So clearly, much of the economic pain this year has been caused by rising energy prices, and one of the biggest beneficiaries of that is energy stocks. And we have this supply-demand problem at the heart of the energy crisis, where supply has been constrained for a decade or so because of ESG, because historically many of these companies were bad capital allocators, they squandered shareholder money. And shareholders have been reluctant to give them any more. So, supply has been constrained. But because global GDP has continued to grow, because emerging markets have emerged, global oil demand continues to be very robust and lower supply, higher demand usually equals higher prices.

Now, what normally fixes that is an increase in supply. But interestingly, governments around the world seem to be determined to keep supply low because of the continuation of ESG pressures, because of windfall taxes. If you tax these companies, that's fine. You can choose to do that as a government, but it means they will have less money to invest. So, this very toxic environment, where I don't think the governments are offering sensible solutions, means that I think these investments will continue to be quite unpopular from a political perspective and from the man on the street, but they will remain highly profitable. And just to finish, BP, for example, at $80 oil, trades on seven times cash flow, at $100 oil it trades on five times cash flow. So, these are extremely cheap equities still, and they're an inflation hedge. And I suppose you could also say they're a hedge against the situation in Ukraine worsening.

Kyle Caldwell: And I understand that you make active use of cash in the portfolio to have some powder dry. Could you explain your approach?

Duncan MacInnes: So we are, I think, very lucky to be given a blank canvas by our investors. We have this totally unconstrained and benchmarked mandate. And yes, today we have about 35% of the portfolio in cash or cash-like instruments or shorter-dated government bonds. Why do we do that?

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Well, we think in this environment of inflation volatility that we've discussed before, you want to be able to be tactical, you want to be able to be nimble and to be opportunistic. So, you need to have cash on hand to do that. Cash allows you to be a market maker or buyer of last resort. So, at the very end of September when we had the gilt market crisis in the UK as a result of the Truss-Kwarteng budget, we were able to buy a pretty significant amount of long dated inflation-linked bonds when they were down very significantly on the week, in the hours before the Bank of England intervened.

If we hadn't had cash on hand, we wouldn't have been able to do that. And you know, if you're the only buyer that shows up to an auction, then you can get pretty good prices. The second reason why I think you want to hold cash is that it's an acknowledgement that tomorrow's opportunity set could be more fertile than today’s. So, if we're right about markets and the economy, we'll be able to buy assets at cheaper prices in the future. If your cash is on hand, you can do that.

Kyle Caldwell: How much cash do you typically have as a range?

Duncan MacInnes: So, I think the current level is high. As I said, it's about 30%, 35%, but that is also easier to do now that interest rates are positive. Now that you can earn 3% or 4% on that cash rather than 0% as we've been used to in the last decade. There have been times in the last decade where cash has been 0%. We use that unconstrained mandate.

Kyle Caldwell: You recently coined a new acronym, PATTY: pay attention to the yield. Could you explain what that is and how you reflect on that in the portfolio?

Duncan MacInnes: I should credit my colleague Rory McIvor for PATTY. So, what we were getting at was we've lived for the entire post-financial crisis period in an environment that was characterised as TINA, which was a phrase borrowed from Margaret Thatcher, and means there is no alternative. And what it was getting at reflecting was that when interest rates were 0%, investors were forced to take risk.

So, everyone, retirees had income requirements, pension funds, endowments had return targets, and if rates were 0%, you were forced further out on the risk curve, so everyone iterated from sovereign bonds to investment grade to high yield to structured products and then to equities chasing those returns. Now, there is an alternative, or PATTY, because you can now earn just under 4% on a US government bond, just under 4% on a UK government bond, or inflation plus 2% on US tips. And that is an area that we've been focusing on. So, if you've got those options available to you, if you're paying attention to the yield, then why take risk if you don't have to?

Kyle Caldwell: And is it that safer end of the bond market that you've been focusing on more?

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Duncan MacInnes:  Yes. So, I've heard a lot of people in the market have been reinvesting or topping up in high yield or investment grade credit because those yields now do look attractive. Our concern there would be that the economic deterioration could cause a lot of trouble there. Again, those spreads have not widened that much. They've fallen in price because the interest rates have gone up, not because the credit spreads have widened. Our buying has been very much focused on US inflation-linked bonds, which, as I said, offer inflation plus 1.8%. I think over the next 20 or 30 years that is arguably the safest investment in the world, and it's finally offering an attractive rate, the best rate it's offered in more than a decade.

Kyle Caldwell: Would you say from an income perspective that bonds are offering better value than equities at the moment?

Duncan MacInnes: Yes, because they are safer. So, 4% in a government bond is a safer income prospect than a 5% dividend yield, of course. And in fact, that's something that has really struck me this year, is that the equity risk premium - which is perhaps a little bit too technical, but basically the earnings yield of the markets minus the bond yield, the government bond yield - has come down.

Now, given the deteriorating market environment, the deteriorating liquidity environment and the economic outlook, the geopolitical outlook, I think the equity risk premium should be significantly wider, not narrower, so definitely the risks that we have been reintroducing into the portfolio have all been via the bond market...because we think interest rates might have peaked and might come down rather than diving into the equity market.

Especially in the US and the UK, investors are very equity-centric. They sort of think that's the only risks that you can take. You're either taking risk in the equity market or you're not taking risk at all, but we're expressing quite a lot of risk at the moment, but we're doing it via those inflation protected bonds.

Kyle Caldwell: And finally, a question we ask all fund managers. Do you have skin in the game?

Duncan MacInnes:  Yes. Yes, I do. My largest investment would be my stake in the partnership of Ruffer LLP, and my second-largest investment would be my holding in Ruffer Investment Company. So, yes, I'm very much aligned with shareholders.

Kyle Caldwell: Duncan, thank you for coming in today.

Duncan MacInnes: Thank you.

Kyle Caldwell: That's all we have time for today. You can check out the rest of our Insider Interviews on our YouTube channel, where you can like and subscribe. Hopefully see you next time.