Inflation is now ‘deeply entrenched’ in the UK economy

Staci West 27/09/2022 in Multi-Asset

When we last spoke to Dr. Niall O’Connor, manager of Brooks Macdonald Defensive Capital, in November 2021, the portfolio had almost 30% in real assets, Niall explains how that benefited the fund this year and gives his current views on the economic environment today. We also take a look at the portfolio with a diverse range of names from Riverstone Energy to Roundhill Music before we wrap with “what is an autocall” and how it benefits a portfolio.

Hi, I’m Staci West from FundCalibre. And today we’re joined by Dr. Niall O’Connor, manager of the Brooks Macdonald Defensive Capital fund. Niall, thanks for joining us today.

[00:11] Yeah, pleasure to be here.

Now, the last time we spoke was November last year. So, quite a lot has changed since then, but at the time you didn’t believe inflation would be as transitory as people thought. And the portfolio had about 30% in real assets, a lot of which were inflation-linked. So, that must have been a positive for the fund going into 2022?

[00:36] Well, you’re absolutely right. A huge amount’s obviously changed since the beginning of the year. And the main thing – the main theme really – has been inflation which was not transitory. But you know, one of the things we also thought, was that assets which had exposure to duration, ie. assets that would do badly in an environment where inflation was rising – so things like growth stocks, things like government bonds – looked very, very expensive at the beginning of the year.

So, we had things like the UK 10-year government bond was yielding just 1%, as opposed to over three [per cent] now. So, we felt that duration risk ie. having that negative exposure to inflation was just skewed very much the wrong way. You weren’t likely to make a lot of money buying a UK government bond at 1%, but you could certainly lose an awful lot.

And that’s clearly what’s happened during the year. Now, you’re absolutely right, we had a very high exposure, in fact our largest exposure ever to real assets at the beginning of the year. And, also at the start of the year, we added exposure to energy and basic resources. And all of those helped us enormously in this rising inflation environment, so the fund’s performance in Q1 was just over plus 1% against just about every other asset class selling off quite aggressively, say, [a] broad equity index like MSCI World was down 6%. And that real assets exposure has continued to help us year to date as well.

And what is your view on the investment environment today? Do you think that inflation will go much higher? Are you concerned about recession?

[02:12] Well, clearly it’s a very tricky investment environment at the moment. We’ve got a very complex, difficult macro environment; a combination of a high oil price, which is a bit like sort of late seventies; we’ve got a rapidly rising inflation, which again is reminiscent in some ways of the seventies; we’ve had a bit of a tech rout reminiscent of ’01-’02, but new on this occasion, we’ve got things like quantitative tightening, which is a new experience for most people. And now as well, we’ve got an environment where most, but not all interestingly, most indicators are flashing red for a recession.

Now, in terms of inflation, I’m not sure it’ll go much higher. We must be pretty close to peak inflation now. But what I do worry, is that inflation will become more entrenched than it has been. I don’t think we’re going to go straight back down to the 2% levels that we had prior to the crisis, particularly given the background where we’ve got employees are starting to get some quite big pay rises. You know, we’re seeing pay settlements up as high as 9%, and it’s going to be very difficult to persuade people that they got 9% last year, and they’re only going to get 2% this year.

So, I feel inflation could be more entrenched, so, it could be higher for longer. You know, maybe we’re talking sort of low single digits, but we’re certainly not back down to 2%, maybe 4 or 5 [per cent]. And I think the UK is particularly at risk of this higher, medium to long-term inflation, given the weakness of the pound importing a lot of inflation and Liz Truss’ sort of ‘trickle down’ economics. She seems to be wanting to spend a lot of money and put it on a government balance sheet. And then that again, I think, is inflationary.

In terms of recession, well, I think we’re probably already in a recession, aren’t we? It’s just the question is, how deep and how long is it going to be? I’m maybe a bit more sanguine about this than many people seem to be at the moment, because I think valuations have priced an awful lot in. To give you some examples, the FTSE’s on about nine times forward PE [Price Earnings ratio], which is, you know, not super low, but relatively inexpensive. But if you look at things like the UK energy sector, that’s on four times PE, materials on five times PE, and these are pretty close to recessionary type multiples.

So, I think at some point, central banks and politicians have to blink. I don’t think anybody can afford a deep and prolonged recession. The Fed [Federal Reserve] and the Bank of England know they’ve got big tools at their disposal. And I think they’ll throw a lot of money at the problem, should a recession start getting bad and, you know, when that blink happens, and I think we could see a lot of assets, which are very, very cheap at the moment, appreciate an awful lot in value

And a quick look at your top 10 shows quite clearly, how diversified this portfolio really is. You have holdings in Riverstone Energy, BioPharma Credit, Round Hill Music, Gold Shares Note, the list could go on, but perhaps you can tell us how you go about finding such a diverse range of opportunities, and then maybe just highlight one or two for us.

[05:14] Sure. We’ve got about 120 holdings, so we’re very diversified and we’ve got, maybe what you call quite an eclectic mix of assets, some of those you’ve mentioned already. We come at it from two different directions. There’s a top-down view and a bottom-up view, and I’ll start with the top-down.

So, you know, the beginning of last year, we saw UK electricity prices starting to rise, and back then we were forecasting a bit of an energy crisis. So, I sent around an internal email, for instance, trying to explain to everybody that they should fix their domestic electricity bills. And that was in June last year. Not everyone took me up on that, unfortunately. But, you know, we saw the emergence of that crisis and that led us into investing quite substantially in renewable energy companies. And in studying the UK electricity market in detail, we realised that battery storage was going to be very valuable, so we invested in battery storage.

And then, more recently, with the energy crisis in full flow, Germany still closing down its nuclear plants, we’ve come to the conclusion that actually nuclear is the only way out of this problem, and Germany will probably reverse its closure of plants, France will get plants up and running and I think we’ll see a nuclear renaissance. But, in the meantime, the uranium supply-demand balance, nobody’s been producing any new uranium since Fukushima in 2011. So, there’s a really skewed supply demand balance. So, as a result of that, we’ve invested in uranium oxide as well. So, that’s sort of top-down.

Bottom-up, the AIC, which is the Association of Investment Companies, has a list on its website of all 400 or so investment trusts. And we just look through those to see what themes are interesting, where valuations are interesting, brokers show us new ideas, every single IPO, every single placing the brokers show us. So, we’re pretty aware of all the options we have available.

So, maybe just run through some of the top 10 [holdings] we’ve got. Riverstone Energy you mentioned, that was a holding we increased at the start of the year. It’s an investment trust, which invests in north American oil and gas assets. It’s actually going through a transition now to post-carbon type technologies. So, I think it may start appealing to the ESG audience, but that’s on a 50% discount to its NAV [Net Asset Value] so it’s looking very, very inexpensive, but despite that, [has] done extraordinarily well this year.

We’ve got things like BioPharma Credit which lends to biopharma companies, but only companies that actually have approved products and have revenues. So, this isn’t biotech, it’s not the very speculative end, this is the very safe end of lending. But despite that, it’s got a seven and a half percent dividend yield and paying special dividends as well. So, that one looks quite interesting, especially at the moment as it’s on a reasonable discount.

We’ve got Round Hill Music. Some of you may have heard of Hypnosis Songs. This is a very similar vehicle. It has music rights which really should be inflation-linked and quite uncorrelated, and for various governance reasons and valuation reasons, we much prefer Round Hill to Hypnosis.

And then maybe a final example, we’ve got Next Energy Solar which is one of those renewable companies I mentioned earlier. It invests mostly in the UK, but also in Italian grid-scale solar plants. And that’s got a 6% effectively RPI [Retail Price Index] -linked, dividend yield.

So, as you can see, [a] very, very eclectic mix of what we’ve got. But all of it is very detailed, bottom-up analysis. And we read every annual report, every fact sheet of all the companies that we hold and the watch list. So, it’s very research intensive, and we have a team of four people dedicated solely to managing fund.

Well, you mentioned eclectic, so maybe just to wrap up, you have some auto calls on the FTSE and S&P, the UK and US stock market respectfully. What are these and how do they benefit a portfolio?

[09:09] Yeah. An ‘auto call’ in simple terms is a way of getting a lower-leveraged, sort of safer version of stock market index. As you mentioned, we’ve got ours on the FTSE and the S&P, so you get a FTSE or S&P like exposure, but it’s deleveraged. So, you may only 60% percent of the volatility. And the other thing is, you get a reasonable yield attached to it as well. So, you know, the coupons on ours range anything from 6% up to about 14%.

So, these really work best in an environment where markets are flat or slightly downwards. So, [to] give you an example, this year our auto calls are probably up about 2 or 3%, whereas the FTSE is down three. So, you can see that sort of yield giving you that bit of carry, if you can call it that. So, they work really well in markets that are sideways or slightly down, which is exactly what you’ve seen in the FTSE this year.

Well, that’s all been very interesting. Thank you very much for your time today.

[10:08] Thank you.

And if you’d like to find out more about the Brooks McDonald Defensive Capital fund, please visit fundcalibre.com.

 

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