208. Recession, adding risk and the dangers of overreacting to 24-hour rolling news

David Coombs, manager of Rathbone Strategic Growth Portfolio, tells us why he has been adding risk to his fund throughout 2022, despite the threat of recession. He also highlights some of the opportunities his team have been finding in both the bond market and tech stocks this year. He also explains why the current crisis is no different to anything else he has experienced in the past four decades and why investors should not overreact in periods of geopolitical instability. David also outlines his expectations for inflation and why he tries to ignore the noise around the growth/value debate.

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The Rathbone Strategic Growth Portfolio focuses not only on returns, but also on risk and correlation. Manager David Coombs uses a disciplined asset-allocation framework and a forward-looking assessment of correlation, risk and return, as the cornerstone of the investment process. Asset classes are then divided into three distinct categories – liquidity (those that can be bought and sold easily), equity risk and diversified.

What’s covered in this episode:

  • We’ve been in the recessionary camp for 12 months – it’s been lonely
  • Inflation probably falls to 3-4 per cent in the next 12-18 months.
  • Why we will have a deeper recession in the UK and Europe
  • “Testing our resolve” – adding to tech names as their prices kept falling in the first half of the year
  • Buying US, Canadian and Australian 10-year bonds to mitigate recessionary risks and using their cash allocation
  • How a big dislocation in markets has allowed them to find lots of mis-priced investment opportunities – many of which are uncorrelated to markets.
  • Preferring commodities over property and infrastructure
  • Why this crisis is no different to any other he has seen in the past four decades
  • Taking emotion out of investing and adding risk to the portfolio throughout 2022
  • It’s not about growth or value – it’s about investing in businesses that grow
  • Why investors should switch off the noise and not panic into making short-term decisions.

25 August 2022 (pre-recorded 15 August 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION] 

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. Today’s episode focuses on the macroeconomic backdrop of markets, the threat of recession and outlook for a variety of asset classes. We wrap with investor sentiment and a few words of wisdom for how to invest during a particularly challenging time. 

Chris Salih (CS): I’m Chris Salih and today we’re joined by David Coombs, manager of the Elite Rated Rathbone Strategic Growth Portfolio. Thank you for joining us again David. 

David Coombs (DC): No problem. Glad to be here.  

[INTERVIEW]

CS: Let’s start with the fund itself. Obviously this is a risk-targeted fund. Could you maybe start by explaining to the listeners what that is and why it might be suitable for investors in an uncertain period like this?

DC: Yeah. Strategic Growth [Portfolio] is kind of our middle risk fund in the range. It has a targeted risk and also a targeted return. Though where it’s a little bit different is we have these two targets, so it’s inflation plus 3% with a risk target of two thirds of global equity volatility. And they are treated equally, both in terms of the attention we pay for objectives, but also the way that I’m remunerated as well. So totally aligned to those returns. 

I think the way to look at it is that I look at that as a risk budget in that I always spend it. And that’s the way to think about this fund. I’m not trying to completely beholden to markets like some multi-asset funds, we will participate in the upside and the downside, hopefully more on the upside than the downside is the aim. But I look at that risk as what I have to spend to generate the return. That’s the way to think about it.

CS: Okay. Let’s look at the markets now, obviously most asset classes have fallen year to date, and the economy’s sort of in a bit of a flux at the moment. Could you maybe just give us your outlook? Are we moving from inflationary concerns to a recessionary environment? How do you see things at the moment?

DC: So I think the equity and fixed income markets and currency markets are in a flux, a very good word. I think that all these markets are struggling to answer your question. I think, yeah, as someone who’s been in the recessionary camp for now on 12 months and felt quite lonely and now feel that there’s lots of people around me agreeing, I think it’s now not, ‘if we have a recession,’ it’s ‘how deep is the recession’ and that’s what the markets are trying to discount. And I think they’re trying to discount them ever more quickly. 

I find it extraordinary that already the market are tilting towards rate cuts in the US in Q1 next year. I think that feels very optimistic to me right now. Certainly not my core assumption. My working assumption has not changed all year, it’s that peak Fed fund rates will be between 3.5% and 3.75%. I don’t see any reason to change that view. That’s why I was increasing my exposure to quality growth and duration during May and June and taking my cash levels to almost zero. I still think that’s where the Fed pause is. That’s why I do feel quite optimistic. I think a cut though for me would be an acknowledgement of a failure or mistake. I just don’t quite see that. 

So I do worry that the current rally is a little bit too exuberant and I’m taking some profits into that. I do though think that inflation probably falls to 3% to 4% for the next 12 to 18 months out. There are some out there saying zero inflation or below 2%. Again, I think that feels, I’m not sure if that’s optimistic or pessimistic actually, because that probably would mean a very deep recession. 

My sense is, the US will have a relatively shallow recession and the Europe will have a much deeper one, for the reasons that are probably obvious with regards to energy. But you know, there’s lots of room for both positive and negative surprises right now. So I think we’re going to see a lot of volatility.

CS: And just for clarity for listeners, when you say Europe, do you include the UK in that, in on this?

DC: Yeah, I do. I mean, I think the UK, you know, is in a slightly better position than Europe, but it’s definitely not isolated from the situation there. Obviously Germany is the obvious victim of the Russian gas imports. But you know, the UK will not be isolated, we don’t have the reserves in the UK, so we’re going to be probably have to go into the open market to fill gaps. So yeah, I think that the UK and Europe are in a very, very difficult position.

CS: And you said a bit there, but in terms of applying the outlooks to the portfolio, you know, you look at a lot of asset classes, so how much does that outlook get applied to the portfolio in a sort of company versus economy outlook? Do you sort of focus more on the companies or focus more on the economies or is there a balance to that? And an example of that if possible.

DC: Yeah. So certainly when it comes to bond markets you definitely focus more on the economies because clearly that has an impact on currency and interest rates and defaults for example, particularly in the corporate world. So going back to June, we were buying sterling high yield bonds because the yields were very elevated for fairly obvious reasons. And there’s a lot of selling. So we took advantage of that on a view that we think UK inflation will be around 3% to 4% as I just said earlier, so yields to maturity of 7% to 9% feel quite attractive on the three to four year view. But that’s really based on a weak economy, which is going to drive that inflation down and interest rates won’t rise too much. 

On the equity side, it’s the opposite. We have very little exposure to UK domestic companies that are exposed to the UK economy. And similarly in Europe almost very little exposure to European domestic stocks either. We have no European banks, no UK banks, we have US banks. So in the equity portfolio, very much focused on being away from those economies I talked about that I think have a chance for deeper recession. 

In the bond markets, we are looking for value in case we get those recessions and increasing duration if yields push up. So yeah, it is completely different way of looking at across the different asset classes.

CS: And in terms of valuations on sort of holdings, would you have taken advantage of, for example, the tech market fell quite badly at the start of this year, would that have been an opportunity? Would you have immediately gone, oh now is the time to tap into some of these companies at these lower prices?

DC: Yeah, we were adding to our tech names in both first quarter and second quarter and it’s really testing our patience and resolve because some of those names just kept falling, but very strict discipline in the fund that we have minimum position sizing so that forces us in a way to keep adding to those names. We’ve obviously benefiting from that, given the rally in tech names in July and August. We also took the opportunity for the first time to buy Apple, as it came back to a valuation that we felt was much in tune with where we think the opportunities for growth of that company are. So it allowed us to as I say, add to our existing tech names. And just to be clear, we have a very much bias to quality tech, highly profitable, low debt, high return equity tech, not some technology names which were much more…I still think they’re pretty vulnerable in the current environment.

CS: Obviously the fund sort of fits into sort of three buckets, which we’ve talked about before. Could you maybe just go through each one again and just highlight what you’re doing in the portfolio at the moment, you’ve mentioned bonds as a sort of recessionary hedge and equities are sort of the largest portion. Maybe just talk us through what’s happening in each one at the moment and tie it in.

DC: Yeah. So I guess most of the actions been in the liquidity bucket and bonds really. So we’ve been reducing our exposure to TIPS, US index linked bonds, and conventional, So we’ve been adding to our US ten-year, Canadian ten-year and Australian ten-year bonds. And that’s on trying to mitigate recessionary risks because yields tend to fall. Now we did this a few weeks ago when yields were a little bit higher than they are now, the US ten-year was around 350, it’s now down at 280. So we stopped buying for now, but we would be buyers on weakness. 

So say within government bonds, switching away from indexed to conventionals and then in, so that’s in the L [liquidity] bucket and also we’ve taken our cash down to near zero where at the start of the year we were around about 10%. So we took the opportunity the first six months to use up our cash reserves if you like. As other people were raising cash, we were kind of reducing ours taking advantage, particularly doing high yield when a lot of ETFs and big managers were having to sell positions. We were kind of the other side of that trade. 

In the equity type risk bucket doing high yield is falls into that, so that’s an addition. In the equity portfolio, like I just said earlier, no big swings around just adding to our high conviction names really. We’ve changed very little.

CS: I saw that you were sort of looking at with a view to eventually things will turn and there’ll be an opportunity in equities. Is that something that’s in the back of your mind as well for the allocation to that portion of the portfolio?

DC: Yeah. I mean, we maintained our equity levels all through first and second quarter. So we were buyers all the way through. We were also very lucky that we had inflows every day into the fund pretty much over the first six months, I think back since July and August as well. So that’s been helpful in allowing us to keep adding to those names.

CS: And equities is the biggest allocations, like two thirds of the portfolio isn’t it…

DC: 67% at the moment, yeah. So we’ve maintained that weighting and slightly increased it during the first half the year. I feel very comfortable doing that. We’ve added in our diversifiers bucket, some put options in the last few weeks as well to hopefully mitigate any, if this is a bear rally and it’s kind of peters out. We’re adding some protection in the diversifiers buyers bucket. We’ve also bought some other strategies within the diversified bucket that hopefully again, interest rate volatility, for example. So we don’t really mind if interest rates go or down, but as long as interest rate expectations continue to be volatile, which they are, we will make money from that transaction. So diversifiers bucket is full of those types of trades where actually it’s not particularly correlated to the direction of the markets we kind of should generate returns as markets return to normalisation.

CS: And I mean, touching on the diversifiers bucket, but it sort of applies to the whole portfolio in general, a lot has been made the first half this year about the challenges of finding diversified sources of return in this sort of climate. Has it become more challenging in your eyes? Are there any sort of specific areas you’ve focused on and any sort of lessons you’ve learned from what we’ve seen in the first part of this year in terms of finding those diversified sources of returning and trying to smooth out returns for clients.

DC: To be honest we found more ideas in the diversifiers bucket this year, I have to say, and that’s partly because we’ve seen such a big dislocation in markets that there’s been lots of risk being mispriced. So for example, I won’t go through all the ones we bought, but we bought something called a quality futures curve trade. And this is basically because at the moment spot prices of many commodities this year because of the invasion had bought prices at the immediate prices of commodities have been higher than future prices of those commodities. Now, most of the time the 12 month price for example, is higher than the current price, because storage costs just as a simple example. 

So we just bought a trade that will make money if the future’s curves go back to normal when the future’s prices are higher than the current prices. And because futures pricing is being so volatile because of this hopefully short term impact as we come out of COVID, the supply chain issues, you’ve had this huge mispricing of commodities for delivery. And so there are lots of opportunities like that in the market where you can take advantage of this priced risk. So we get shown lots of ideas. 

In fact, our biggest problem is being identifying the ones which we think give us the best set of returns, which are uncorrelated to the rest of our portfolio. Where I think what you’re referring to is probably in the areas like property and infrastructure, where we don’t see many opportunities actually as a diversifier. And we’ve held commodities. That’s been a very good diversifier this year, industrial metals and agricultural commodities, that’s really helped us. We’re now taking profits from those. So no, diversifies has not been a difficult area to find ideas at all. And it just performed very well for us as offset that sort of growthier equity style that we have. So that’s worked really well. 

What have I learned this year, frankly, that this year’s very similar to all other crises, I mean, I’ve been doing this now for 40 years. I don’t want to play the ageist card here, but I have worked with a number of crises and they’re all different yet they’re all the same in that the market’s become dislocated. I think the one big difference now is because the amount of algorithmic trading and passive trading, everything happens much faster. And the daily trading patterns into your bonds and stocks is more predictable in a weird sort of way cause they trade in blocks.

CS: A lot of kind of panicking about everything falling in a quarter, but you’re not investing for a quarter, you’re investing for a long period. And I think that’s been overlooked to a degree and a lot of headlines have been put out there to not spook investors, but certainly make them very aware of it. And it can be a bit offsetting, I think.

DC: I think that’s right. I was chatting to an investor funny enough on Friday and you know, I think what you are paying needs to do in a way is to not be overly emotional during, because a lot of emotion trades get done in must like this because of that fear of markets are falling and you know, we’ve become risk averse. I’ve been adding risk all year. Whereas many people have been taking risk away. I guess that’s being a professional whose managed money through various crisis, accepting that you don’t know and not trying to second guess things and read all this doom and gloom or false optimism and just keeping to what you do and believing in your process. And that’s very boring it sounds, but actually, I think it’s never more appropriate than during these periods. And that’s, I think what we do, we try and take that emotion out of the investing side and try and keep the noise or focus on sticking to your core principles.

CS: You mentioned the core principles, obviously there’s you got the title of growth in the actual fund name. What about style, investment style biases? Do you take on board value and this sort of idea that there’s a tug of war perhaps going on. Or that value could be we’re in a different cycle and all of sudden value’s interesting. Does that even come onto the radar in this portfolio?

DC: It comes to the radar only in a sense that a lot of people believe that. So I can’t ignore it because it’ll affect how markets work, right? I’ll be honest. I’m hugely suspicious of this growth value thing and the definitions of them cause they tend to be quite transient. So I try not to get too caught up in worrying a lot about that. I still think, being a bit old fashioned, that investing in businesses that grow and have very strong balance sheet and market leading product or service is how you make more money over the long term. And if you wanna call that a growth stock or a value stock, I don’t really care. I suspect they typically would be called growthier and that is reflected, but I don’t think of myself as a growth manager. I just think of myself as buying decent businesses. 

Notwithstanding that if you get a massive value rally or a dash for trash, as we call it, then we are gonna be the wrong side of that. And I make no apologies for that, to be honest, I’m not trying to shift short term. I mean, I watch with interest that many people, because a lot of equity funds out they had a tough time and they end up in that first six months and be like, oh, rebalance your portfolio. You were too exposed. Make sure you got more in value at the end of June. I’m thinking, crikey, I think you are kind of rebalancing after a lot of it’s already happened. And I think there is this.

CS: Yeah. When you see this values done this, you kind of feel like it’s a bit too late already for that, even if there is a new cycle with inflation, et cetera. 

DC: Yeah. 

CS: And I wanted to just finish you mentioned four decades in the industry and that you’ve seen everything. Very uncertain times, what would be your message to investors given your experience in the market at the moment. 

DC: Just don’t look too much. I mean, we had a very difficult Q1 relative to our peers. Q2, we were better, Q3 we’re doing a lot better. So we were regaining that loss ground in Q1. And the reason we didn’t do so well in Q1 is we had much less money in UK equities and the kind of value trade you’re just referring to, but you know, I wasn’t gonna switch back into those areas cause I just don’t believe in. 

And I guess the message is, you have to stick to what you know and acknowledge what you don’t know and just switch off all the noise because it can panic you into making silly, short term, knee jerk reaction. So I think we are in for a period of geo-instability and a market are going to be volatile. And I think one need to just accept that’s going to happen and not look too often at your ISA statement on whichever platform you have of choice. And remember you’re a long term investor. That’s what I am. And not get too caught up in it because I’m afraid in the world of 24 hour rolling news, it’s very easy to overreact to things I think.

CS: On that note, thank you for your time, David. Thanks for giving us some of your pearls of wisdom on markets today.

DC: No problem. Enjoyed it. Thank you very much.

SW: Launched in June 2009, Rathbone Strategic Growth Portfolio has an outcome-focused approach and complete flexibility of where to invest in order to achieve that. It has a target of cash plus 3-5% a year over a minimum five-year period and a big focus on delivering this via a risk-controlled framework. To learn more about the Rathbone Strategic Growth Portfolio visit our website fundcalibre.com and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.

This article is provided for information only. The views of the author and any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy or sell any fund or trust, or to adopt a particular investment strategy. However, the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions.Past performance is not a reliable guide to future returns. Market and exchange-rate movements may cause the value of investments to go down as well as up. Yields will fluctuate and so income from investments is variable and not guaranteed. You may not get back the amount originally invested. Tax treatment depends of your individual circumstances and may be subject to change in the future. If you are unsure about the suitability of any investment you should seek professional advice.Whilst FundCalibre provides product information, guidance and fund research we cannot know which of these products or funds, if any, are suitable for your particular circumstances and must leave that judgement to you. Before you make any investment decision, make sure you’re comfortable and fully understand the risks. Further information can be found on Elite Rated funds by simply clicking on the name highlighted in the article.