284. Investment opportunities amid changing economic landscapes

19 October 2023 (pre-recorded 9 October 2023)

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.

[NTRODUCTION]

Staci West (SW): Hello and welcome to the Investing on the go podcast, brought to you by FundCalibre. Today I’m joined by Darius McDermott and Juliet Schooling Latter to look over Q3 of 2023 in our quarterly market update. Darius, Juliet, thanks for joining me.

Darius McDermott (DM): Hi Staci, thanks for having us.

[INTERVIEW]

SW: So, let’s maybe start with the economic environment and the million dollar question – or million pound question perhaps: have interest rates peaked? And if they have, what does this mean for our investments?

Juliet Schooling Latter (JSL): Well Staci, as you can imagine, it’s a strongly debated topic amongst managers and economists alike, many of whom disagree. Companies and hence markets crave stability. So, if interest rates simply don’t go up any further, even if they remain high, at least this gives some ability to forecast. At the moment it looks like they may well have peaked, inflation is coming down, both in the US and in the UK, and both the Fed and the Bank of England kept rates on hold at their last respective meetings. The only fly in the ointment is the oil price at the moment., so, that’s one to watch.

What it means for investments?

Well, if interest rates have peaked, it depends whether we’re looking at a hard landing ie. recession or not. If we are, then that’s obviously going to be a tough environment for consumer-facing companies, so you want to be in more defensive stocks and with regard to fixed interest, defaults would likely rise. So you’d want to be more defensively positioned there.

On the other hand, if we get a softish landing, then fixed interest would do well because as interest rates come down, their higher levels of yield look attractive and companies would also benefit.

DM: Yeah, it’s, as you say, well-debated. Something odd happened, though this time. Both the UK and Europe – sorry, and the US – stopped raising rates. Normally that would lead to government bond yields falling and they didn’t, they sort of stayed still. And then the last week, particularly US government bond yields were up a lot, suggesting that the bond market doesn’t believe the central bank — it probably means a) to your scenario, rates are going to be higher for longer, or b) they actually still have further to go. The key, the only data that matters on future rate rises, is inflation in America – US – and Europe. And I think it’s definitely coming down, but maybe not as fast as everybody would like.

What does it mean for investments?

Fixed income, at least you are getting paid to own fixed income now. For the previous decade when rates were on the floor, government bonds yielded half – and in many instances negative, you just weren’t getting paid for waiting. And now, if we think we are at least near the end of the rate-rising cycle and then the next direction is down, then actually fixed income can actually enjoy capital gain as well as a decent yield for holding it. So, certainly on any form of risk-adjusted basis, it would be a preferred asset today; investment grade bonds yielding 7%, you know, it’s a good rate and we might make some capital gain today. Equity markets are naturally all over the place with the volatility that we’ve seen, but it’s all being driven by the bond market at the moment.

SW: And touching then on a bit of politics of the last few months, the Prime Minister has recently backtracked on some of the UK’s net zero goals and actions, as well giving the go ahead for a new oil and gas project in the North Sea. So, without getting into the yes and no and right and wrong of this, what does this actually mean for investors, especially coming off the back of Good Money week last week in the UK – so, perfectly timed! How do we think about these trends or potentially rethink about decarbonisation, for example?

DM: Yeah, I mean decarbonisation as a trend is a mega trend. It’s not going anywhere. It may have had some of the deadlines moved and some of the pledges, particularly as you say within the UK to get carbon neutral by 2050, may well be pushed out, because, at the end of the day, after Covid, governments can’t afford to meet all these pledges. And this whole mega trend, and let’s be honest, we’re talking about the investment side, is you want government pounds and dollars to support renewables and energy infrastructure or green energy infrastructure – that makes them a good investment. So, you want to have a match between people supplying capital alongside governments to make good money. So, I think it’s a hiccup rather than a disaster from an investment point of view.

JSL: Yes, I agree. I mean, you know, however shortsighted governments might be, I think investors need to take a longer-term view. As an investment, yeah, it’s going to go in and out of fashion, but as Darius says, it’s a long-term trend and I think it’s here to stay.

DM: Yeah, and a lot of the investments in that space – and there’s a real generalised catch-all called responsible or sustainable investments – most of those strategies tend to be global growth strategies. So, they’re a growth strategy and hence, as we’ve seen a lot in the last three or four years, a big whipsawing between growth strategies being in favour then out of favour, and then growth … or value strategies being in favour and then out of favour. So that is as much, and probably actually more than the recent news, is a much greater driving factor to actually some of the underperformance of responsible global funds.

Then you’ve got the sort of the clean energy, which are utility in nature, you know, we’re talking about more places to charge your car and all those sorts of things, that is a mega trend. It may not grow at the same speed, but it’s definitely not going away.

SW: So, you mentioned the underperformance of a few sustainable strategies. On the other side of that, let’s look at what’s performed well. So, leading the pack has been Indian equities, followed by commodities and no fewer than three high yield bond sectors. So, maybe talk us through why these sectors have done well.

JSL: Yeah, well I’ve always been a fan of India. I think it’s got incredible long-term potential. It’s got fantastic long-term headwinds from factors such as strong demographics and the potential benefits of reforms going on there and increasing domestic consumption. And it has done well recently. I think it’s also benefited from those investors who want to allocate to emerging markets but are avoiding China. You know, it’s also benefiting from some of the moves away from China to to manufacturing there as well.

DM: Yeah, and you touched earlier on oil price. I mean, oil price is a leading component of a broad commodity basket. So that has, you know, that higher oil price has been beneficial for commodities.

High yield bonds I think is quite interesting because whereas other government bond and investment-grade bond sectors have actually done a bit poorly given that rates are actually still going up – or at least the bond market says they are – that high yield bonds have less sensitivity to that interest rate movement, and that’s probably the main reason why they have outperformed this year. But yeah, oil I think is a real key driver, a key commodity to watch, because it is a big part of a commodity bucket, but it’s also a big part of most inflation buckets as well.

JSL: Yeah, and I mean it’s gone up from sort of below $70 a barrel in June to over $85 today. So that’s, that’s quite a lot…

DM: Yeah, I think it was in the nineties last week. So, it’s quite a volatile commodity, clearly.

SW: And then we have the laggards, which have been infrastructure, index-linked gilts and European smaller companies. So, in these areas, do you think that their prospects could improve anytime soon?

JSL: Yeah. Yes. I mean, you know, I think certainly it’s often after something hasn’t done well that it bounces back. I mean on the infrastructure side, for well over a decade with QE [Quantitative Easing] cash and sort of corporate bonds yielded next to nothing. So, those seeking income had to look further afield to the likes of infrastructure equities. And now people simply just have more options, which means that infrastructure has sort of temporarily lost its appeal.

DM: Yeah, I think there’s been huge outflows from infrastructure product, whether that’s open-ended funds, investment trusts, closed ended funds, or in fact private funds. So, as sure as night follows day, when money’s coming out of a sector, it tends to underperform. Also, the other thing about infrastructure is, it is of interest to an investor because you have these long duration cash flows. You know how much your tower or your toll road or your airport is going to earn, you can put a bit of inflation on the top and it’s just a pure cash proxy — sorry, bond proxy — and what’s happened of course, is bond yields have been going up and the prices of bonds have been coming down. So you’ve got higher cost of financing — infrastructure generally comes with some leverage — so, on a project, there’ll be some leverage on a new build of a toll road or a port or whatever it might be, so the cost of debt has gone up [and] people have got other alternatives as Juliet says, in fixed income. And you know, those cash flows have a different value in a 5.5% interest rate environment than they do in a 0.5% interest rate environment. So, that’s the obvious bit on infrastructure.

Index-linked gilt is a bit odd. We know that index-linked means they have inflation attached to them, yet throughout this rate-rising cycle, they’ve been a terrible investment and that is because they come with a lot of interest rate sensitivity or duration. I think we discussed this in one of our podcasts, if not earlier this year, late last year. And from memory, I think that the average index-linked gilt has something like 20 years of duration – or interest rate sensitivity – so, when rates are going up, the prices are going down. So, that’s the key one on index-linked gilts.

JSL: Yeah, I mean they’ve actually fallen back quite sharply. Their peak was in November 2021 since when they’ve declined over 45% and…

DM: That’s exactly when UK rates first went up in December 2021. [JSL: Yeah.] Followed then in the US in March. And that tells you everything you need to know; there’s a nasty negative correlation between index-linked gilts and raising rates.

JSL: Yes.

SW: And what about European smaller companies? Do their prospects seem to be improving?

JSL: Well I think that they’ve been hit quite badly as well, going into a period of higher inflation, [of] higher interest rates, because smaller companies tend to be more domestically-focused and they carry more risk. So they just look less attractive when investors prefer safer ground. But they looked oversold about this time last year and they then sort of bounced back strongly until about March. So, I think investors have just been taking some profits recently and probably with a long-term view [that] there’s still, you know, reasonable value there.

SW: And Darius, you’ve been a long time proponent of UK smaller companies. How are they looking at the moment?

DM: Cheap, cheap! If you can put a pound into a UK smaller companies fund, put the contract note in the draw, close it and come out in 10 years, ignore the subsequent volatility, I think you’ll find you’ve made quite a lot of money. But could it go down 50% before that comes? Absolutely, it could. Smaller companies tend to underperform volatile markets, but especially if they’re recessionary [and] the jury is still out on recession. I think there’s no question with raising rates, rising mortgage costs, cost of living, there’s going to be a global slowdown in GDP. Markets tend to be forward-looking to that.

So, I mean, markets had a bad 2022, but again, that was the start of rate rising and a lot of highly-valued tech names in the [United] States having a difficult period. I don’t think we’ve seen a recessionary stock market yet. And if we don’t, great – smaller companies now is as good a time as any. If we do, I think you might get a slightly cheaper entry point, but as we always say, it’s about being in the market. Timing markets is notoriously difficult. So, as I say, if you can stomach a bit of volatility and just not check on the valuation, I’m sure buying smaller companies or UK smaller companies at this stage, you’d make a lot of money over the next decade.

JSL: Yeah, one UK — I’ve seen a few UK smaller companies’ managers recently — and one of them who’s been in the industry a very considerable time, over 30 years I believe, said it’s the worst bear market he’s been in for UK smaller companies. So yes, I think taking a long term view, they certainly look oversold at the moment.

SW: And then finally, looking ahead at the next couple of months of the year, we have the Autumn Statement coming up in November and rumours about ISA allowances and changes to the pensions triple lock bound. So, what do you think investors should be looking out for in Q4?

DM: Well, there are far wiser people in our industry when it comes to pensions and triple locks, so I should probably fairly gently stay away from that. What I do think the government would like to do is give some stimulus to the UK stock market for both, particularly for mid and small-sized companies. There has been this muted suggestion of an increased ISA allowance, but only if you invest in a smaller company or a mid-sized company, either on a stock or on a fund basis. So, that I think would give some stimulus to the stock market, but to my mind it’s the big pension funds, which again, government can influence. If they [the government] sort of said all big pension funds must have 5% in UK smaller companies, well, I can tell you one thing, – [and] again, back to our supply and demand comments from earlier – you’ll see UK smaller companies start to re-rate positively in that environment.

What they’re going to say? I don’t know, I don’t think they know – they change their minds on a sometimes hourly basis – but some form of stimulus to make being a listed company on the UK stock market, I think, would be extremely welcome to all companies that are listed on the UK stock market, and all people who have an interest in the UK stock market.

JSL: Yeah, again, the managers that I’ve seen recently that are looking at UK small caps say that they are aware that the government are looking at various measures to take because they are aware that it’s quite important to attract investment to the UK stock market because otherwise companies aren’t going to want to list here. And that’s quite important for us.

But yes, I was looking recently at the amount of debt that has been racked up during Covid and it’s really quite frightening. And we’ve had a lot of inflation and everyone’s higher [with] wages and so forth, but there’s actually not much money left in the kitty. So – not that I like to feel sorry for politicians – but you know, the triple lock has increased the value of state pensions and hence the cost to the government. And had the state pension increased in line with either prices or wages since 2011 when it was introduced, it would be about 11% lower than it currently is. So, it’s cost the government an additional £11bn a year, which is you know, a reasonable sum of money. So, I don’t claim to know whether they’re going to do anything about that.

SW: You’re not finding that in the couch cushions, are you? <laugh>

JSL: Indeed, not.

SW: Darius, Juliet, thank you very much for walking through the last few months and what investors can expect going forward.

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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 fun calibers research methodology and are the opinion of fun calibers research team only.