Christopher Querée is Head of Charities and Investment Director at Ruffer LLP. He has over 30 years’ investment experience, with around 10 years looking after private clients and 20 focusing on charities and endowments. In a recent interview with Charity Financials, Christopher explained the financial climate charities are facing and how they should adapt their investment strategies to suit...
What does the present economic climate look like for charities?
On one level (and assuming no major escalation of the Coronavirus) the global economy is performing reasonably and looks set for another year of reasonable growth. The dilemma is, however, that after successive years of stock market growth, as well as collapsing bond yields and a concurrent strong rise in bond markets, assets are hardly cheap. The extraordinary monetary policy seen since 2008, including low-to-negligible interest rates and of course ‘quantitative easing’, has had a profound impact on all asset classes, with bonds and equities rising in unison.
This has created an environment of financial repression, whereby interest rates are kept below the rate of inflation, which has had a profound impact on investor behaviour. Prior to the 2008 financial crisis, the ‘normal’ scenario was one whereby interest rates were around 5% with inflation running at around 2%. Risk free investments, therefore, generated a positive real return, but this scenario has since been reversed.
With real interest rates (i.e. the amount of interest after inflation) now negative, if you’re sitting on cash, you’ll make a real loss. This changes behaviour because you have to seek returns elsewhere. But, everyone is doing the same thing and prices continue to rise.
In essence, the environment for investors is one where everybody is being pushed to take more risk. There’s an inextricable link between the valuation of equities and bond yields and if you can’t get a good yield on bonds, you’re naturally going to get pushed into looking at equities which then pushes up equity markets.
Bond markets are in an extraordinary place. When you look at the bonds in issuance globally, last summer a third of these gave investors a negative return! That’s an extraordinary phenomenon. The question is, where do we go from here?
We’re concerned with the level of bond yields and the level of outstanding debt in the global system. There’s been a huge issuance of leveraged debt by companies over the last 5 years – what happens if there’s a turning of the cycle? Our sense is that things will become more difficult in the next 5 years.
How would you advise charities to adopt their strategies to suit the current climate?
Charities have different time frames or investment time horizons — and often varying time frames for different parts of their assets. Our sense is that asset prices are pretty high at the moment and while that could easily continue, we remain mindful that markets are cyclical. As such, there is a need to consider how a charity could tolerate a turn in the market environment and cope with a downturn. And here there is a need to harmonise an individual charity’s investment time horizon with the ability to tolerate a loss over the next 3-5 years or potentially longer.
Many charities see themselves as perpetual organisations that will be around for the next 100-plus years, so they can sit through these periods of weakness. In these cases, it may not be a problem. It’s those charities with more imminent spending plans where asset risks should be reviewed on an ongoing business.
What is an acceptable level of investment risk?
You need to make sure that first, when risk is being assessed, you look at a long-range risk-return performance scenario. Looking back 5-10 years you can see a steady bottom left to top right chart appreciation of equities. This reflects improving economic fundamentals and extraordinary monetary policies.
However, taking a longer-term view of how the market could fall and how you might need to extend the recovery period is important. From the last two major corrections in 2008 and 2000, whereby you’ve had a fall of mid 40% in equity values, you got your money back by sitting tight for 5-10 years. For other market cycles that recovery period has been much longer.
Charities need that longevity time frame if they’re heavily invested in equities. The stock market corrections of the last 30 years have been followed by aggressive cuts in interest rates which resulted in ‘V’ shaped recoveries. Looking forward, because interest rates are now incredibly low, the response mechanism is going to be very diluted if we have another downturn. A growing theme is that central authorities will have to tilt towards a fiscal response. There’s a lot of talk about government spending and we expect that narrative to gain more ground in the next few years.
The next question for charities on this is, what does this mean for inflation? Our sense is that we’ve had a period of almost no inflation and low volatility for asset prices, over the next 5 years we’re likely to see inflation pick up and be coupled with more volatility.
Many charities have done incredibly well from this elongated market cycle. As a consequence, many will be reviewing their asset allocation with a view to reducing risk and seeking some protection within their endowments.
What happens if charities are too risk averse?
If we go back to the ‘normal’ structure of interest rates – charities didn’t have to be that active in seeking strong returns. If you had a cash reserve and could get about 5% interest rate and inflation was 2.5%, you knew at the end of each year you would get a positive return and your asset value would have gone up. Now, being that passive comes at a cost — you’re eroding your capital value in real terms.
The other issue is that what’s described as the term premium has been crushed. Going back to the 5% interest rate scenario – 20 years ago you might have expected to put your money into a 5-year government bond, and it would have yielded more than the cash rates. That no longer exists so it’s difficult for charities not to take some risk. The key is that they don’t feel compelled to take risk when that risk isn’t compatible with their investment time frame.
As far as longer term returns are concerned, our view is that equities will continue to play a part of the solution. We have about 40% in equities and so believe in that asset class. We also feel that inflation is likely to be an increasing menace. We hold index-linked government bonds because those returns are linked to the future outcome for inflation, so you get some indexation and protection. So there are solutions to these problems, assuming that the investment time horizons are aligned.
What’s your view on having an investment strategy that links with your charity’s moral code?
It’s always important to set your investment strategy first. Once that strategy is in place, you can look at how to align this with your ethics. Many charities have undertaken work in the last 5 years to align their ethical policies with their charity’s raisen d’etre. Whether that’s a religious order, a medical order etc. they are making sure that nothing in their portfolio conflicts with their charity’s mission and I think most investment managers can accommodate that.
At Ruffer, we screen all potential investments for anything non-aligned to a charity’s mission. The big debate at the moment being carbon. This is increasingly feeding into investment policies and, like a lot of investment managers, we are able to accommodate those policies. It seems most charities are on a journey to monitor the situation and evolve their exposure over time while undertaking a policy of engagement. Some have put a block on their involvement with carbon-related companies. This journey needs to be done and can be done and I think most investment managers are helping charities along, and it’s important for them to do so.
You spoke at this year’s Charity Financials Leaders’ Forum. What were the key takeaways from your session?
While financial markets have had an extraordinary run, if you look at the structure of markets today, there is reason to be concerned that things may be more disruptive in the future.
For us, leverage within the financial structure i.e. the debt structure, is a concern. We’ve had a one-way flow of events in the last 5-10 years where interest rates have been cut excessively, and we’ve had quantitative easing. We think things will get more difficult from that supportive base.
There is also a broad assumption that inflation is dead. Our view is that it has been asleep and indeed the policy narrative from the political order across the UK, US and indeed Europe, is one where governments are looking to extend deficits and spend. From that we think there is every chance that inflation will accelerate and surprise investors.
Finally, if bonds are offering an incredibly low yield and inflation starts to pick up, bonds could soon turn out to not be the defensive investments they’ve been in the past.
*This publication does not constitute investment research, investment advice or a personal recommendation, and should not be used as the basis of any investment decision. This publication reflects Ruffer’s opinions at the date of publication only, and the opinions are subject to change without notice. Ruffer LLP is a limited liability partnership, registered in England with registration number OC305288. The firm’s principal place of business and registered office is 80 Victoria Street, London SW1E 5JL. Ruffer LLP is authorised and regulated by the Financial Conduct Authority. © Ruffer LLP 2020