Economic shifts: insights on US growth and inflation trends

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Hello, I’m Chris Salih, investment research analyst at FundCalibre, and today I’m delighted to be joined by James Mee co-head of multi-asset strategies and manager of the Waverton Multi-Asset Income fund. James, thanks for joining us once again.

[00:14] My pleasure. Thanks for having me.

When we caught up at the beginning of the year, we talked about this Goldilocks narrative in the US of falling inflation and 2-4% growth. Maybe just give us some insight in how that looks now and has that picture changed at all?

[00:28] Yeah, so we, we went through a process, certainly the beginning of the year of really challenging Goldilocks. We tried to set out the thesis and disprove it over time. Goldilocks, at the beginning of this year, was fundamentally different to, you know, our perception of the world and what many people were thinking the outlook might be 12 months previously.

How has it panned out? So we think about US growth to begin with. That’s really been fairly consistent with that Goldilocks narrative. So thinking about growth in particular, the consumer, generally a fairly healthy position across most of the major economies, actually, not just the US the unemployment rate is low, real income growth is above average. You’re seeing real wages and real wealth growth. Certainly in the US debt service ratios in the US in particular are low, not the case so much elsewhere. So the US remains amongst the best.

The UK actually for a number of reasons, amongst the worst. Ultimately, consumer data household spending will deteriorate most rapidly in periods of economic stress, so recession. And so we’re watching employment lead indicators very closely for any indication of this. Some of the lead indicators that we’re looking at have rolled over, and so our antenna are up. But at the moment it’s a pretty fully you know, employment is pretty full, you know, across most countries and regions.

From a business perspective, confidence in the US in particular is good. We’ve seen cyclical pickup in construction spending catalysed really by some of those major infrastructure bills. But in particular the CHIPS act in the US. This has been a pickup in non-residential construction spending in the US. That’s really been tech related investment, you know, building structures to put tthese GPUs, Nvidia produced GPUs into, but it’s not all rosy on the business side of things. So the manufacturing economy actually remains broadly in recession in the US and elsewhere.

Some of the indications or indicators that we look at of smaller businesses suggesting that they’re looking to slow spending in the next six months. So their CapEx intentions, capital spending intentions intentions, you know, look to be slowing. Chapter seven, chapter 11, bankruptcies in the US also on the rise, that’s mirroring some consumer credit delinquencies rising. Those consumer credit delinquencies have risen only back to pre-Covid levels. So they’ve normalised, if you like, but we’re watching for any further further upward move in those.

And then outside the US, which is, which is amongst the best Chinese investment is really in dire straits. They’re going through a balance sheet recession. Much of Europe remains in manufacturing and industrial production recession as well, the UK included.

So the other thing to say is we think there’s probably some wait and see while we go through the political cycle you know, amongst the major economies, US, UK, amongst others across Europe through the rest of the year. And then in terms of the government sort of impetus to GDP growth, it remains relatively elevated in the US and in the UK as we would expect in a political cycle or where we are in the political cycle in election years. China is spending on a more targeted fashion, arguably they need to be more broad brush than that, rather than whack-a-mole, given that they’re going through a balance sheet recession. But that is the policy that they’re following that in Europe due to fiscal rules. You know, there is, there are some demands on France, Italy, amongst others to bring deficits down and bring their debt levels down.

Post-Election spending will clearly have budgetary and fiscal and debt consequences, US, UK, Europe, elsewhere. It’s it’s unlikely we’ll see a material reduction in the deficit across the major economies. And in Europe where the politics actually is skewing rights, we could even see less fiscal discipline. So it’d be interesting to see what, how that plays out. So there’s definitely a challenge to that Goldilocks narrative in Europe.

The US is a real wild card there. So a Trump presidency, if we assume there’s a 60 plus percent probability that he becomes president, which is what the betting markets betting odds have today with further tariffs, fewer immigrants feeding into the working population, we could see inflation rise again. Certainly we expect that the market will begin to price this probably as we go through the next quarter, certainly within the second half of the year.

So where does that leave us on the growth front?

I think that, you know, on the growth side of that Goldilocks narrative, the, the growth dynamic is not as favourable as it was coming into the year, and that you can actually see that reflected in the Fed GDP now estimate for Q2 GDP growth. To put some numbers on it, earlier in the year, they were forecasting 4% real GDP growth for the second quarter of this year. Today their forecast is just under 2%, so it’s come down pretty markedly.

The other side of that the other side of that Goldilocks narrative is inflation. So we still expect inflation to come down at a headline level. UK inflation, if you look at the sub components, is falling in almost every sub component there is. European inflation is following a pretty similar dynamic as well. The US is a bit more of a mixed picture and our lead indicator for US headline inflation suggesting continued cyclical support to prices from commodities and supply chain issues as well, but rents amongst properties, vehicle insurance and others ought to bring inflation down on a sort of 12 to 18 month view. All else equal. So, you know, not taking account of the Trump presidency. So growth slowing inflation coming down less rapidly.

Goldilocks is is clearly challenged, but actually this sort of backdrop tends to favour the sorts of businesses that we invest in. So high quality businesses, predictable free cash flows, high returns on capital, low leverage, the sort of, you know, what we would describe as core and quality companies. And so we carry a fairly neutral equity risk position in the fund of 52% in equities. But very much you know, towards that quality end of the spectrum.

You’ve given us quite an insight there into sort of the outlook for both the US and sort of other markets. I wanted to touch a bit on UK and Europe. These are areas where perhaps inflation has fallen a bit further or faster than expected when compared to the US. Maybe just talk us through what impact that’s had on the portfolio in any way.

[6:59] Yeah, you know, did the inflation coming down rapidly surprise us? Our leading indicators were telling us that inflation would rise rapidly. They also told us that inflation would come down rapidly. It’s that same lead indicator, which actually is starting to rise again now, suggesting that inflation could well be supported from a cyclical perspective in the short term. The impact of 30 year fixed mortgages in the US that makes that economy less rate sensitive, not necessarily less inflation sensitive. What’s interesting is the UK and Europe appear to have been less rate sensitive than we would’ve expected so fast. We would’ve anticipated that we’ve been in a deeper, you know, a recession or a deeper recession. But because we have generally fixed out turned out our mortgage debts, the companies, the large cap companies, multinational companies, have also fixed their debts at low rates for longer. That has protected the economy somewhat, ultimately higher rates for longer periods of time.

The longer we go on with higher rates, they do feed into the economy at some point. And that probably is part of the reason why some of the business dynamics that we’re seeing in terms of investment, this wait and see approach is starting to feed through as well.

Have the inflation dynamics led us to allocate more to the UK and Europe? Not really.

It’s not how we do things. We don’t make top-down regional calls. So the way we allocate to companies within the equity portion of the multi-asset funds is really fundamentally driven from bottom up research. So we own shares and businesses that we think have a compelling outlook at time, clearly diversified globally across sector styles, currencies, et cetera. Today the portfolio carries about 9% in each of Europe and the UK. That’s much less than many of our peers will carry. But it’s high for us.

Looking at our history and the history of the fund going back almost 10 years now. You know, the idiosyncratic nature of what we’re looking for means that we pick up quite a few different types of companies. But a few examples, just to put some names on it. So Persimmon UK, house builder, Redrow, UK house builder. These have been additions to the portfolio just about 12 months ago. So UK house builders Persimmon is tilted to the first time buyer market, you know, generally with a lower average selling price, substantial land bank, we think you know, a pretty favourable policy backdrop in dynamic with a change in government upcoming.

Redrow, you know, similar policy dynamics we think support the thesis, but they’re higher up the quality spectrum in terms of buyers. 30% of sales are cash. They tend not to be first time buyers as a higher price point, et cetera. Actually, Redrow’s been bid for by Barrett, so we expect that to complete soon. That’s now a small allocation within the fund.

Ibstock, again, a UK domestic business and provides inputs, primarily bricks into that residential construction market amongst others. Benefiting from some of that same policy impetus and policy cycle that I mentioned about the house builders, but substantially more operational gearing. And so should pick up more of the upside as and when those orders start to come through. And they’re very well positioned to take volume share. They invested heavily in 2021/2022 in expanding their capacity. And so they’re sort of in a build and they will come mentality and ready to go.

And then in Europe, for example, Inditex’s owner of brands, Zara, Massimo Dutti, Oysho, amongst others.We’ve owned this business for I think about two years. It’s a best in class inventory company, working capital management, an early adopter of technological solutions to improve productivity. You know, supply chains are kept relatively local and they have a very clear strategy for expansion going forward in the US in particular, but elsewhere as well.

So, you know, it’s important to stress, we’re not top down allocators, as far as regional equities go, ultimately everything we own will fulfil the quality criteria that I mentioned that we’re looking for. So durable competitive advantage opportunity to grow free cash flow, most importantly, not just accounting earnings, but free cash flow. A very well aligned management team, a well constituted board, critically important that that management and the board are aligned towards shareholder outcomes to, you know, minimise that principle and agent problem and ultimately at an appropriate valuation as well.

We touched on a number of your equity holdings there, but obviously this is a fund that’s multi-asset in nature, and part of that exposure is an allocation to alternatives. And clearly these have been quite popular in the sort of post QE era where people are searching for income. But maybe just talk us through what your exposure looks like and in terms of the sub-sectors that comprise alternatives and just an outlook for the sector as well.

[12:06] Yeah, exactly right. So since inception of this fund going back almost 10 years, we have had roughly 20% in alternatives one way or another. We segment alternatives into real assets, so long only return seeking alternatives and sub-components within that would be property infrastructure, commodity specialist lending and asset finance. And then the other segment would be absolute returns. So real assets and absolute return.

Absolute return is a sort of cash plus protect capital. Way to think about how we’re allocating that space as well. Within the multi-asset income fund, we’re principally invested in real assets, partly for the income as you’ve said, but fundamentally we think that with a long term time horizon, many of the companies that we own are either explicitly or implicitly linked to inflation, explicitly linked cash flows, implicitly linked pro market price moves.

And so when we think about growing capital over time and providing a sustainable income, two of our, our key objectives in this fund, real assets fulfil a portion of the portfolio. You know, we tend to be specialist, again, it’s a bottom up constructive portfolio, so we are not, we don’t own large swathes of the property market. For example you know, the commercial property market, we’ll be much more targeted than that. So, you know, we have 4% of the entire fund in property assets, in real estate. Examples would include PRS it’s the private rented sector accommodation. It serves the needs of many people unwilling or unable to buy a house at the moment, prefer to rent modern properties. They’ve got just over 5,300 completed homes. They’ve got a further just under 300 under construction. And once those are constructed in the portfolio, we expect some uplift to nav – net asset value. They get a hundred percent rent collection of those people that remain tenants they’ll see rental price growth of 3-5% over time. For those new tenants coming in, you’ll usually see some, some reversion upside. So you’re seeing that top line revenue generation implicitly linked to inflation, as I mentioned.

Appearing student property is another example, is a company that we bought earlier this year, student living assets across the UK let out to both British and international students. Output only rents a hundred percent occupancy with a relatively new management team that are highly incentivised to improve operating ratios in the business. Close the discount to that net asset number which is currently running at 20%. So we see 50% upside to that name on a three to five year period as well.

And then just touching on that absolute return segment, it’s a relatively small allocation in the fund. The only fund that we own within our fund is a 1.5% position in Mon Lake Dunn, which is the CTA, which is a trend follower. So that’s actually there to support the portfolio in periods of sort of elongated market stress. So not a highly stressful environment where volatility picks up and markets drop. We have protection strategies there to protect against that, but for a sort of drip negative market you know, these sorts of positions perform well and they have a role to play in the portfolio as well.

And just finally, James, you started by giving us a good sort of summary of what’s happened in the world in the past six months. Maybe just talk us through what your outlook is for the second half of 2024. You know, we’re at an interesting point with rates peaking and we’ve seen some cuts in Europe and Canada already. I mean, just talk us through what impact, if any, these further cuts will have on your portfolio.

[15:51] Ultimately monetary policy inflation, the impacts between the relationship between inflation rates and yields has a fundamental impact on all asset prices. So it, you know, it is critically important and is part of our asset allocation framework on the things that we look at. Two of the things we look at, inflation and rates. So, you know, formally we do look at that.

What’s our outlook for the second half of the year?

Ultimately this is best guess no one knows. The theme that we’re running with at the moment is we’re giving risk assets and we’re giving particularly the names that are fundamentally supported in our portfolios, the benefit of the doubt. So, you know, we’ve covered it, but Goldilocks has challenged the political cycle once again, particularly in Europe, partly in the US as well as really highlighting polarisation. The UK actually interestingly, might well be swinging in the other direction as we speak but markets are now partly seeing some volatility and we could expect some volatility in the second half of the year depending what the policy outcomes of changing governments might be over time.

You know, to get to your question specifically, I think that the market will begin to price a Trump win in the next quarter, if that looks likely, which may mean higher yields, it may mean higher rate expectations or market prices thereof. Certainly in the short term.

Ultimately, earnings and free cash flow growth of the businesses that we own are supporting the share prices of those businesses. And that’s what I mean by giving them the benefit of the doubt. What we’re hearing from company management is they are hearing about all of this negative you know, macroeconomic backdrop and news, but what they’re seeing from their customer base is generally positive. That’s the last that we heard from them.

So we’re about to go through a reporting cycle now. So we’ll be able to update on that view. We continue to see a path towards lower inflation, a bit further out 12 to 18 month view as discussed. So we remain 52% in equities, roughly 20% in both alternatives and fixed income and 8% in cash.

Thanks for joining us once again, James.

Thank you.