310. Investment strategies for uncertain times

2 May 2024 (pre-recorded 29 April 2024)

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. This week our guest endeavours to talk us through a little bit of everything, from fund positioning and geopolitics to the intricacies of the sterling price and sectors such as defence, MedTech, and retail. I’m Staci West, and today I’m joined by David Coombs, manager of the Rathbone Strategic Growth Portfolio. David, thanks for joining me today.

David Coombs (DC): Not at all. Glad to be here.

[INTERVIEW]

SW: Now, this fund uses what you call an LED framework, which is essentially liquidity, equity risk, and diversifiers. So just start us off for those who may not know about this framework, give a brief overview how this works, what are you looking to achieve with this fund?

DC: Yeah, we start with a blank piece of paper, we don’t have a benchmark like many multi-asset funds, so we don’t weight versus a benchmark, don’t weight bonds or weight equities so we need a framework to help us allocate capital by risk.

So, the Strategic Growth fund has an equity risk budget, if you like, of 66% of equity risk, as measured by global equity markets. So think of it like I’ve got 66% to spend on risk assets, equity-type more volatile risk assets. So, basically any asset class that behaves like equities, whether in good markets or you know, risk on or risk off, has to compete for space in the 66%. So at the moment, it’s actually about 62% of that 66% is in equities, as it happens. That’s because we don’t see so much value in corporate bond markets or emerging market debt markets. So, that’s what the equity risk bucket is, the E-bucket as we call it, is kind of the risk on, what’s going to generate the inflation +3% return that we’re targeting net of fees for this fund.

The other two elements, the L and the D are kind of the stabilisers, if you like, as a bit of a crass kind of descriptor, but the L is, as it sounds, liquidity assets, really, cash or sovereign bonds. For many years [they] did not play a big part in this fund’s portfolio because yields were so low but that’s changed clearly, in the last couple of years. So today, we’ve got about 25% in sovereign bonds in the fund, whereas we had 0% a few years ago. So that’s the L bucket. So, what you’re hoping for there is that that’s your risk off asset class. Like in a 2008 scenario, you would actually expect that part of portfolio 1) to be able to be traded and 2) would probably produce a positive return.

And then finally, diversifiers is everything else that doesn’t act like a bond or an equity. At the moment we mostly use structures in there, structured products, or buy put options on the US equity market. Currently, we own interest rate volatility and we also bought some protection on US treasury bonds recently, like a put option on treasury bonds. So, it’s your insurance if you like, trying to protect you from the falls in the E-bucket. That’s probably the best way of looking at it.

SW: Okay. Well I think we will probably touch on all of those buckets today [DC: I suspect so!] in some capacity. So, let’s start with the dreaded ‘I’ word, get it out of the way – inflation which has been more persistent than people potentially thought maybe Q4 of last year, particularly in the US. So, maybe give us a few of your views on inflation, where we sit today with it and then, has it influenced your positioning on the fund at all?

DC: Yeah, I mean we started the year very much in the camp that we felt the market was far too optimistic about rate cuts in the US. I mean, at times there were some market participants forecasting six interest rate cuts – that would be around 1.5% reduction in rates from the current level 5.25% in the US and there was equal optimism around Europe and UK, et cetera. We felt that was overly optimistic. We did think inflation would trend down, but we didn’t see it getting down to 2% as quickly as maybe the market did.

So basically, when we were talking to companies, they were feeling quite positive about the world. So there was a bit of a disconnect to what many of the kind of market strategists [and] economists were saying and what you’re actually hearing from the companies themselves when you meet with them, which is why it’s important to touch base with the companies pretty regularly. So we’re not particularly surprised about where we’ve got to.

Obviously we’ve had the conflict in the Middle East, which has pushed up the oil price, which has not helped either. But generally speaking, you know, all the companies we talk to say we’re moving to normalised markets and it supports that medium-term view, inflation will continue to trend down. The market’s got itself a bit scared now in thinking, oh, actually it’s not coming down as fast as possible, well, we’re not that surprised. It’s even gone the other way, the pendulum has swung completely saying, well actually you may even see some rate hikes now, which would really upset everything. And that’s why you’ve seen bonds being particularly weak and bond yields rising over the last few weeks.

I do think it’s “be careful what you wish for”.

If you were to get six interest rate cuts between now and Christmas, that means we’d be in quite a deep recession and all the central banks would’ve made an error and earnings would be awful in the equity markets so I don’t quite understand why the market wants these interest rates quite so much.

In a perfect world, you’d want to see interest rates starting come down in the Q4, maybe one or two cuts, maybe three or four cuts next year. And if you do get that more smooth glide path down in rates, that would mean the economy was still growing, albeit relatively modestly; good for earnings, good for bond markets, inflation comes down. You don’t want the economy too strong because that will keep inflation high, but we don’t want recession either, right? So, we are threading cotton through the eye of a needle a little bit at the moment, but for me we’re pretty much on course. But of course it’s a bit 50/50 the way markets are going and that’s creating this huge volatility at the moment.

SW: And is that when you potentially expect to start seeing rate cuts, in Q4, or do you think it will be sooner?

DC: I think Q4 is most likely. The central bankers will want to see more evidence that employment markets are cooling a little bit. I mean certainly the last US employment number was mostly part-time jobs when you actually look at the detail. Also, a lot of these surveys and data are quite inaccurate and often get revised so, it doesn’t pay to get too overly excited in either direction when you get these data points: the market loves to look at it and pontificate over these things, but actually you need to look at the medium-term trends. So I do think inflation is coming down. As I said, [when] you talk to companies, they’re saying customer demand is getting back to normal levels, they’re able to now meet customer demand because supply chain is all in good shape. So, there could be another geopolitical risk that throws things off, who knows. But in general terms, you know, I can see inflation slipping back again towards the second half. In fact, we may even see rates come down more quickly in Europe now than in the US which I probably wouldn’t have thought last year, but that may well now be the case.

But ultimately, we’ve bought a lot of bonds because we think with bond yields 4.5% – 5% on a three year view, even if inflation’s at 3%, that’s a very decent real return from bonds and they give you protection if you go into recession. Government bonds should do quite well because if we go into recession, rates will come down quite quickly and that will attract money into government bond markets.

SW: I was going to say, are you rotating the portfolio at all to factor in the potential rate cuts coming, whether it be government bonds or specific sectors that could benefit? Or are you still waiting to see, so to speak?

DC: It’s more about, as it takes longer for rates to come down, the risk of recession is growing higher. So the probability of recession is now higher probably – in our view – than it was say three or four months ago. Because if the Bank [of England]’s going to wait to see more evidence of inflation getting more towards 2% before cutting, there’s a potential to keep rates too high for too long, which means recession risk is elevating and we are starting to see some defaults in the corporate bond market. We’re certainly seeing bankruptcies in the non-quoted markets, lots of businesses going under in the UK, we’ve seen quite a lot of that already. So it’s more about buying more bonds, 1) because yields have gone up so they’re even more attractive and 2) because they do provide that greater recession hedge. What we’ve been doing in the last week or so is expanding our government bond portfolio. We were principally in US treasuries and UK gilts to start with, and now we’ve broadened into European bonds, Euro government bonds; we’ve been buying Romania, Portugal and Germany. And also we’ve been adding to Australia, which is not in Europe – apart from the Eurovision song contest of course.

SW: Well, so you mentioned government bonds and your dislike, or avoidance, of corporate bonds. So, maybe, kind of quickly with the fixed income side of things, are we seeing a return of the 60/40 portfolio with how fixed income looks at the minute?

DC: Yeah, I think we are. I mean, I’ve never thought 60/40 went away, it’s just you didn’t want long-dated bonds; you wanted cash instead of bonds. You know, as we discussed at the beginning, I’m not running a 60/40 or benchmark portfolio. If I was, I would be tempted to be overweight bonds versus equities. I think, in real terms, after inflation, I think bonds look much more attractive than equities on a risk reward basis from here.

Now, it depends what the equities you’re in, of course, I mean there’s a big difference between, you know, a fast-growing NVIDIA versus a slow-growing utility. But no doubt we’ll come back onto equities in a second, but I do think bonds look pretty attractive at these levels. They could get more attractive yet. I mean, yields could still go a bit further, I think, we could easily see another 50 basis points on yields from here. So, we’re still holding cash and some money in reserve and gold, which we might switch more into bonds if that happens.

So I think with regard to corporate bonds, it’s not that I dislike them as such, I just don’t think … corporate bonds for us sit in the E-bucket and right now we don’t really see that they are fighting a way into the portfolio because spreads are very narrow versus government bonds, you’re not really getting that pickup in yield for the extra risk you’re taking.

And also if you are worried about recession, you don’t really want to own corporate bonds because remember, corporate bonds are indebted companies raising, borrowing money, right? So, if yields continue to rise, their costs rise. So it doesn’t really make sense if you’re worried about recession to keep adding to corporate bonds. So, we see government bonds having a much better diversification benefit, whereas corporate bonds don’t really give us that at the moment.

SW: We’ll certainly come onto the equity portion in a moment, but I have a final question about the fund positioning, which is how do you think about things like geopolitics? We have elections all over the world this year, probably US and UK are most noteworthy for our audience, but how does that play a role in this fund’s positioning, if at all?

DC: I mean, we’re always worried about geopolitics. We always have, for example, a decent weighting in oil because whenever there’s a conflict in the Middle East, which sadly is pretty often and throughout my career, therefore history has told me to oil. Ultimately a rising oil price is often a dampener for risk assets. So having oil in the portfolio, whether it’s through ETFs in oil itself or oil stocks, are always valuable geopolitical risk diversifiers. We also have some gold, US treasuries and US dollars, so we have a lot of geopolitical risk diversifiers in the portfolio as well as we have put options on the S&P 500. So, we’re always thinking about geopolitical risk.

Obviously, we never know where it’s going to kind of I’m going to say blow up – it’s not really the word I want to use, but you know what I mean. You never know where or what’s going to happen. So, we’re always thinking about geopolitical risk. I mean, you can’t isolate everything obviously, but, generally speaking, as I said, oil, gold, all those sorts of holdings are used in the portfolio.

I think with regards to the politics, I mean the UK to be honest, there’s no money left so the next government can’t do much different to this current one so there’s not much to worry about. I think if anything, I think the one thing I would say, without being flippant, is I do think there’s every likelihood that a [Keir] Starmer government might take the UK closer to the European Union again. And I think that could have a big impact on sterling. I don’t know what that might look like, whether it’s a customs union – they probably wouldn’t call it that because [it’s] politically difficult – but closer collaboration on pricing or who knows how politicians speak.

SW: But someone in marketing will come up with something…

DC: So, there’ll be a line, right, you know, some communique or whatever. But ultimately I do think that’s possible, sort of just some rowing back on the Brexit [decision] and becoming a suitable party because actually and including the European economies. So I think that’s possible. If that were the case, we could see sterling rally quite significantly from where it’s at today, that would have an impact on the FTSE 100 because a lot of the FTSE 100 are overseas earners. Also, from our point of view, as you know, we only have, crikey, about 8% of the portfolio in UK equities for example, you know, we do run a lot of foreign currency, hence we are hedging quite a lot of our US dollars – 50% of our US dollars, we’re hedging all of our Euro at the moment, just in case we see a row back of sterling to pre-Brexit levels. It’s hard to forget … well, it’s hard to remember, it was nearly nine years, eight years ago now since the Brexit vote. So sterling’s been quite weak now for eight years and people have got used to it. But what if it was suddenly to rise, say 145 to the dollar or 135 to the Euro? We need to think about that risk to our strategy.

With regards to the US which is the one everyone talks about – I can’t imagine why! To be honest with you, Biden and Trump’s policies, domestic policies and the economic policies weren’t that different. They were both quite loose in terms of policy, in terms of spending: Trump reduced taxes, Biden spent more money and both added to the debt and both have very similar priorities when it comes to China, et cetera. I mean, Trump will be noisy and will upset people and I’m sure foreign policy will be quite interesting. But, you know, he’s going to try and force European countries to spend more on defence. I think that’s probably right. We’ve been adding to defence stocks in the portfolio. We own two now, Lockheed Martin [Corporation] and Thales, the French defence contractor, and geopolitically it will be interesting, I suspect. But if I’m being honest, we’re not making huge changes because there hasn’t been that much difference between the two, despite all the rhetoric.

SW: And I do want to just look at the UK. You mentioned briefly, but you also said recently in a different call, that it’s the lowest UK equity weighting in the fund since inception. So I have to know what is going on, what is influencing this in the fund? Is it just a lack of opportunities? Is it something more fundamental with the UK happening?

DC: It is the lowest in 15 years. That is correct. I mean it has been that high for quite a while, but it’s definitely the lowest now. And two out of the eight stocks or nine stocks we own are pretty much totally US earnings. So, it’s very low. It partly reflects our view of the UK economy and the political situation here. But it also reflects that most good firms are moving away from the UK. I mean Ferguson, which we do own actually has moved its prime listing to the US. You could argue our UK weighting is even lower, we just haven’t switched the US listing yet.

It’s just a lack of opportunity. We’re very bottom up in the equity portfolio. We don’t allocate geographically. So the UK is just in sectors really that we don’t really love on a long term basis. So, we don’t love the UK banks, we prefer US banks. We have no position in miners at the moment. In pharmaceuticals, we have US and European. So, it’s just in some cases we just think, you know, global peers are better.

It’s not particularly negative on the UK as a country, it’s just [that] the companies don’t really match up to their overseas counterparts in many sectors. And let’s face it, bearing in mind I think the global index is about 35% tech at the moment, and the FTSE is probably about 0%, I suspect. I don’t know, it’s probably wrong. It’s probably 1% or 2%, whatever. It’s, so you can’t really compare [SW: Significantly less] Significantly less. You can’t really just compare it on a like for like basis. It doesn’t make much sense.

SW: Well, funny you mentioned technology because I wanted to talk about that as well. Technology at the minute seems to be very widely focused on AI, but there’s so many additional parts to the sector and whilst you do have chip makers in the fund, I wanted to focus on some sub-sectors of technology apart from AI. So two of which I believe you’ve been adding to and you hold in the portfolio is defence and healthcare technology. Can you just tell us a bit more about them?

DC: Yeah, so healthcare is a very long-term bias of ours because everyone on this call will know – or listening to this podcast, sorry – will know that we’ve got ageing populations just about in every country in the developed world, falling populations in many. So you’ve got less younger workers and more older people that need to be supported. So what have most countries got in common? They’ve got higher health costs coming and more healthcare to give, and that’s expensive. And the way to reduce those costs is to bring in technology and better testing.

So 1) if you can try and prevent people getting ill, that’s a good thing because then you don’t have to treat them or secondly – so you screen them earlier – and then secondly, if they are ill, then you want to make operational procedures, scans, get more people through theatres or imaging clinics per day, hopefully 24 /7 – unlike the weekdays that the NHS currently does – because that’s where we’re going to get waiting lists down and that’s where governments will be able to afford it. So, if a surgeon could operate on four people in three hours rather than two, then clearly there’s a cost efficiency there. So we like the idea of medical technology, preventing illnesses and then also, hopefully reducing the cost of treatment. That feels like a very good long-term trend to be invested in, it’s got a real tailwind there, which is pretty obvious.

So we have seven or eight medical technology companies in the portfolio from diabetes monitoring like Dexcom, through to heart valves and Edward Life Sciences, to clinical equipment Thermo Fisher [Scientific Inc.], to laser treatment on cataracts which is Carl Zeiss. So, we think it’s probably the dominant part of our portfolio, actually, MedTech.

And then on defence I mentioned earlier, we’ve held Lockheed for some time – since Trump first went into power actually – and we’ve added Thales more recently, which is a French contractor, that’s because again, Europe is going to have to spend more on defence. Countries do tend to spend on defence within their own country for security reasons, but also because it provides good jobs and high tech jobs in their own country. So, actually when you invest in defence, it’s quite good for your domestic GDP as well.

And also Thales is a bit of a leader in cyber security as well, which is increasing of course, as we’ve seen from the Russian/Ukraine conflict, you know; cyber security, stopping jamming et cetera is really, really important, and Thales leads the way there as well. So we may even add more, I don’t know, we’re looking at the sector, there are other names we quite like, it’s had a bit of a run, so we’ll see how that plays out.

But again, I think it’s not just a 12-month view, it’s a multi-year change in the way that Europe is going to invest, and, to go back to your political question earlier, I think Europe kind of looks at the US now as more of an unreliable boyfriend or girlfriend. And I think, whether it’s Trump or Biden – Biden pulled out of Afghanistan of course, Trump has not shown he is hugely supportive of Europe – so I think there will be a lot more spending by European governments, Germany and France included. So unfortunately that feels like … again, it’s high tech. With that kind of progress in those areas, there’s often a lot of civilian spinoffs as well. So, it’s an area of technology that people have shied away from probably because the ESG themes a few years ago, but I think sentiment’s changing very quickly

SW: And a completely different sector from defence and healthcare that I noticed was retail. And you have a few of my favourite names, which you have, Next and Costco. And so, I have to know – apart from the amount that I spend there – what is the appeal of these types of names? And is retail a theme in the portfolio or something that you’re looking at as more attractive?

DC: Not really. I mean, it’s not a theme we particularly like long-term really, because it’s quite a fickle industry, as you’ve seen – names come and go. Dr. Martens was huge couple of years ago and now it isn’t, and Hush Puppies come and go. So, it’s not an area, particularly in fashion, we particularly like, if I’m being honest. We do own LVMH on the luxury goods side.

Next, you mentioned; we see Next more of a platform business actually. It’s probably one of the leading retailers in Europe, if not the world, in terms of it’s really smart in the way it’s bought out other brands that have gone into liquidation, a multi-brand platform that now sells, which has been built up over many years, quite hard now to replicate, but it’s also got the stores as well. So you’ve got that – I hate the word – ‘omni-channel’ but it does have that much better than anybody else. And the reason we bought it a year or so ago is we saw it as a beneficiary in a slowing economy with higher interest rates as we felt a lot of their competitors would be weaker as they wouldn’t have access to capital, wouldn’t be able to invest in their stores. So, big – in a market like this – big is so advantageous because Next can afford to invest in its stores because of its throughput on the online channel as well. So we just think it’s a really good place to take advantage of weakness elsewhere, as the economy slows. And because where it’s got to now, it’s really hard to replicate; it’s got an up-market with Reiss, it’s got mid-market with its Next brand and it’s got other brands it’s slowly building and basically it’s only competitor is Frasers and Frasers we wouldn’t own.

Costco is a very different animal as you know, it’s much more about the membership and the pricing and more focus on less lines. It’s just a brilliantly run business basically. It just happens to be retail. We just think it’s just so … they’re just so smart, the management team of Costco, they just knock it out the park year after year in terms of innovation and the way that they continue to attract customers, even in a slowing economy. It’s a nice kind of non-cyclical retailer, which is very rare.

SW: The Costco membership has never once been on the chopping block when it comes to looking at subscriptions.

DC:Yeah, it’s the last one in the wallet, right? Yeah, I mean, and they’re just so cute in the way they operate and in the US you know, if you want to fill up your car with gas, Costco is the cheapest place to go, and so they get the people through, they get selling the petrol/gas and yeah, they’re just very smart.

SW: There’s a Costco petrol near Reading for anyone listening who’s near Reading and has a Costco membership. I have been, I highly recommend!

DC: Investment tips and retail tips. Yeah, great.

SW: The new name of this podcast. Right, so before we finish, we have a little bit more time. The one area that we’ve not covered much of is the diversifiers element of this portfolio. So, you did mention gold earlier, is that a key part of the diversifiers?

DC: It has been, but we’re kind of taking profit into recent strength because gold looks quite expensive now relative to dollars and sterling, given the yields that you can get on dollar and sterling bonds. You can get 5% yields, then gold gets 0%, so the opportunity cost of gold is high. So, we’ll probably sell into strength from here, to be honest, it’s done its job, so I wouldn’t be adding here. We continue to buy protection when you get sort of strong market days when the volatility drops. We were very happy to buy put options to get that protection, but we still own interest rate volatility. And as I say, we’ve just reduced our position in protection on the US treasury market because yields have risen so we’ve taken a profit on that. We still have some protection there – that runs off next week, I believe.

And then we have some other trades that are kind of non-correlated. I won’t go into all of them, but just give you one example. One is linked to the Swiss market where we sell protection to the Swiss corporates because they have to buy protection – a very short-term equity market protection. So because they are forced buyers, the prices are quite high, so we’re happy to sell them that. And then we buy protection to cover our market risk slightly longer dated, and we just take the money in between. So it’s kind of an arbitrage trade.

And we’ve also got something similar linked to commodity prices in we’re taking a view on the fact that, at the moment, future commodity prices are lower than the spot prices and our trade will make money once we go back to normal when longer-term prices become higher than spot. And they should be higher than spot because of the storage costs of holding commodities. So, obviously, if you’re holding onto millions of gallons of oil, it does cost you to store it over six and 12 months.

So there’s a number of opportunities that come and go on a weekly, monthly basis that we take advantage of in the Diversifiers bucket, which are just mis-priced risk or where we’re just providing hedging for corporate clients and the big investment banks. I mean, we run £7 billion across the funds now, so that allows us to work with all the big investment banks on the street, working with their corporate customers. And some of them just have to buy hedging for their businesses. And that just suits our strategy. They’re not taking different view to the market to us, they just need that hedging and we’re quite happy sometimes to provide that.

SW: Well, that has been so interesting. We covered a lot of different topics and areas today, but an excellent overview of exactly what the LED framework is set out to do for this fund and to look at all of the various aspects that go into it. So, thank you, and thank you for taking such a long, detailed look at it with me. I really appreciate it.

DC: Not at all. Thank you for having me.

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 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.