How to protect yourself against financial repression

With public sector debt in the UK now in excess of two trillion pounds and the Bank of England openly talking about negative interest rates, it is clear that we are entering an extended period of financial repression. This pernicious policy of forcing interest rates to be lower than inflation will make the government borrowing more manageable, but will be disastrous for investors who don’t take steps to protect their wealth. 

At the end of August, public sector net debt was £2,023.9 billion or 101.9% of gross domestic product (GDP). Public sector spending is currently far in excess of government revenue because of measures to combat the pandemic, so in the short term at least the debt burden is only going to increase. 

For most of the 1990s and 2000s, the ratio of public sector debt to GDP varied between 25% and 50%, before the global financial crisis pushed it up to 75%. The ratio is now the highest ever recorded in peacetime in over four centuries and at this sort of elevated level it increases the risk of default and acts as a drag on economic growth. 

Chancellor Rishi Sunak has stressed the importance of sound public finances, but there are only four ways of tackling the rising sovereign debt. The options are as follows: default; tax increases and/or reductions in government spending; restructuring, of which financial repression is a subtle example; and inflation. 

An outright default would be politically unacceptable and disastrous for the economy and UK asset prices. Obviously some taxes will have to increase, the Chancellor has already said so, but there is no appetite in parliament or the country at large for a return to austerity, which leaves us with financial repression and inflation.

Financial repression

During the pandemic, control of the supply of money has quietly passed from central banks to governments. Policies like the 100% guarantees on bank lending via the ‘Bounce Back’ loan scheme – of which up to £26bn may never be paid back − have helped to ensure that the broadest measure of the money supply in the UK has been growing at an annualised rate of more than 20%. 

The discovery of this magic money tree will allow the government to channel funds into the economy wherever it is ‘needed’ and the process has only just begun. Ultimately the end result will be a reduction in the purchasing power of sterling, with the prices of goods and services rising accordingly.

There is already evidence that some prices are starting to increase, but the high level of indebtedness means that it is essential for the economy and the management of the public finances to stop interest rates from rising. The Bank of England has even started talking about negative rates, where it charges banks for any deposits it holds on their behalf in order to encourage them to lend more. 

Keeping nominal interest rates close to zero reduces the cost of servicing the debt, while negative real interest rates − where interest rates are less than inflation − erodes the real value of the debt mountain. This erosion can be both successful and rapid and may reduce the need for politically and socially unpopular increases in tax.

We have experienced periods of financial repression before, most notably between the end of the Second World War and the early 1980s. During that time, interest rates and bond yields were pegged, borrowing costs were kept under control and institutions were forced to buy government debt at yields below inflation. There were also controls over the movement of capital abroad. 

Effect on the different asset classes 

Financial repression will be disastrous for those with money in savings accounts who will see the real value of their wealth eroded over time. It will also be bad news for bonds, although it will depend on the level of buying by central banks as this is keeping their prices well above where they would otherwise be. 

The long-term outlook for equities is harder to predict. Previous rounds of reflation have normally been positive for share prices to begin with, although if it turns into an aggressive period of financial repression it is probably not going to end well. 

During the financial repression that ran from 1945 to the early 1980s, equities flourished until the mid-1960s. This was because they were cheap when the war ended and then benefited from the transition from a wartime command economy to a more highly leveraged consumer-driven economy. 

The situation is very different today so the performance may have more in common with the latter part of the period between 1966 and 1982. During this timeframe large-cap US equities generated zero returns in real terms, while other stock markets fared much worse.

If inflation rates are going to pick up, then there should be some upside from inflation-linked government bonds, as the valuations currently suggest that the expected price rises are still at very low levels. The best option however will probably be gold.

In this new age of financial repression it will be essential to invest in the right asset classes and stay on top of the situation. This is a big ask, but if you don’t fancy it there are three excellent, defensively-oriented investment trusts that will do it all for you and they all go about it in a slightly different way. 

Personal Assets 

The £1.3bn Personal Assets Trust (LON:PNL) aims to protect and increase (in that order) the value of shareholders’ funds per share over the long term. Over the last ten years it has generated a NAV total return of 71%, which is comfortably ahead of the 59% produced by the FTSE All-Share with much less volatility and a substantially lower drawdown (peak to trough decline). 

PNL has an active discount control policy to ensure that its shares always stay close to their NAV. This has worked extremely well and over the last 12 months they have traded at an average premium of one percent. 

At the end of September 42.3% of the portfolio was invested in 16 blue chip stocks mainly from the US and UK with the largest holdings including Microsoft, Alphabet, Philip Morris, Visa, Unilever and Diageo. A further 9.5% was invested in gold bullion and 27.6% in US Treasury Inflation Protected securities, with cash and cash equivalents of 20.6%. 

Manager Sebastian Lyon selects the stocks on a total return basis and looks for quality companies that are able to grow sustainably. This approach proved to be remarkably resilient during the sell-off earlier this year as he described in the annual accounts: 

“The mundane activities of selling coffee, chocolate, toothpaste and pet food demonstrated the longstanding merits of staples companies like Nestlé, Unilever and Colgate. Elsewhere, technology companies with recurring revenues, like Microsoft, proved suitably defensive, thanks to the need for millions to work from home during lockdown.”

Lyon takes a long-term view and believes that those central banks that have been financing fiscal spending directly risk an inflationary environment later this decade, which should continue to support the bull market in gold. 

“We will continue to invest in the most robust companies exhibiting strong financial productivity and sound balance sheets. We will also endeavour to protect against ongoing reckless government policies by holding gold and inflation-linked bonds. We remain focussed on value with patience and discipline, thereby avoiding the distracting swings in sentiment and the fear of missing out.”

The same strategy is also available via Troy Trojan, an open-ended fund with assets under management of £5.1bn.

Capital Gearing 

The £545m Capital Gearing Trust (LON:CGT) aims to preserve shareholders’ wealth and achieve real returns over the medium to longer term with a low correlation to the equity market. When viewed in this context it has done extremely well, with a NAV total return of 78% over the last ten years compared with 59% for the FTSE All-Share Index. It has also held firm this year with a year-to-date return of 2.5% and although it suffered a fall of four percent in March, this was nowhere near the 15% decline for the UK market. 

In 2015 CGT adopted a zero discount policy that has resulted in the issuance of a large number of shares at a premium to NAV and has pushed the total assets above £540m. It has a competitive ongoing charge of 0.65% and the managers all invest heavily in the fund themselves. 

At the end of September 41% of the portfolio was exposed to risk assets, with 30% in index-linked bonds, three percent in gold and the remainder held as ‘dry powder’ in cash, conventional government bonds, preference shares and corporate debt. The expected real return of these assets over ten years is around four percent per annum.

In a recent meeting with the investment trust analysts at Winterflood, co-manager Alastair Laing said that the exceptionally accommodative monetary policy has pushed asset prices to levels that are unjustifiable by historical standards. Because of this he believes that returns from equities and bonds are likely to be modest over the medium term. 

He thinks that the excessive level of debt means that financial repression is likely to remain in order to avoid significant defaults. To protect against this scenario he is looking to shorten the portfolio duration and retain some dry powder for when better value emerges. 

Laing says that index-linked bonds offer protection against financial repression and historically they have had a low or negative correlation to equity markets. The three percent allocation to gold is seen as displaying similar characteristics to a long dated index-linked bond. 

CGT’s core risk assets include North Atlantic Smaller Companies (LON:NAS), which is trading on a discount of around 30% even though 20% of its net assets are in cash; Investor AB, a Swedish holding company; and Pershing Square Holdings (LON:PSH), a listed hedge fund managed by Bill Ackman that is on a 32% discount. 

If you prefer open-ended funds, the £435m CG Absolute Return fund that is run by the same firm provides an almost identical exposure.  

Ruffer Investment Company 

The £445m Ruffer Investment Company (LON:RICA) aims to achieve a positive annual return of at least twice the Bank of England base rate. Since its launch in 2004, RICA has delivered a NAV total return of 211.8% and has significantly outperformed the 73.8% from the target benchmark and the 176.7% generated by the FTSE All-Share. It also did well during the sell-off with a 12-month NAV return to the end of September of 8.2%. 

At the end of September the portfolio had 30.3% invested in equities, with 20.5% in non-UK index-linked bonds, 16.3% in index-linked gilts, 11% in illiquid strategies and options, with 9.3% in gold and gold equities, as well as 12.6% in cash. 

At the end of September the portfolio had 30.3% invested in equities, with 20.5% in non-UK index-linked bonds, 16.3% in index-linked gilts, 11% in illiquid strategies and options, with 9.3% in gold and gold equities, as well as 12.6% in cash. 

In a recent update the managers said that their conviction remains that financial repression will be a key part of the investment landscape in the future. 

“If this is correct it will have widespread investment ramifications. History shows us that equities, most bonds and cash are poor investments when inflation rises sharply, but real assets such as inflation-linked bonds and gold should do well.”

In an environment where financial repression and negative real interest rates are the norm, their role is to hold assets that will protect and grow their investors’ capital through the period and in the aftermath. 

“The roadmap of the last 40 years is unlikely to work; we believe index-linked bonds and gold will be key assets to hold, along with the right mix of equities and credit protection.”

The inflation protection in the form of index-linked bonds is similar to the other two funds, but they have a larger weighting in gold than CGT to protect against the debasement of paper currencies. Another important differentiator is the allocation to illiquid strategies and options that acts as insurance against further disruption in the corporate debt markets, an area that paid off handsomely during the sell-off in March. 

Like CGT they have a value tilt to their risk assets with the Ruffer management team describing it as ‘a low but potent weighting to cyclical equities in case we’re wrong and markets recover and value stocks come back into fashion.’ PNL however favours growth stocks. 

As with the other two investment trusts there is an open-ended equivalent, the Ruffer Total Return fund, but there is an initial charge that might apply and it only deals on a weekly basis. 

There is absolutely no doubt that we are entering a new period of financial repression where interest rates will lag behind the rate of inflation. This will be a challenging time for investors, but those with core portfolio holdings of the calibre of Personal Assets, Capital Gearing and Ruffer should navigate it better than most.