Investment insights: be prepared and expect the unexpected

This year at our annual outlook dinner, we were joined by two of Britain’s top investors: Richard Woolnough, manager of M&G Optimal Income, M&G Strategic Corporate Bond and M&G Corporate Bond fund and James Thomson, manager of Rathbone Global Opportunities fund.

From the direction of interest rates to the importance of an active approach in the current challenging market conditions, we explored some of the burning issues investors face as we enter 2024.

Economic gravity returns

M&G is perhaps the biggest name in the UK bond space, and under the stewardship of Richard, M&G Optimal Income is its flagship offering. This ‘go-anywhere’ fund has a flexible mandate, which enables the manager to shift the interest rate exposure and to invest across the fixed income spectrum. The fund can, and often does, invest in some equities and derivatives.

Richard reminded us that when quantitative easing (QE) was first introduced following the global financial crisis, the consensus was that increasing money supply would have the side effect of increased inflation. But he said this did not occur in the first phases of QE. This was a relief to central bankers who hoped the link between money supply and inflation was only theoretical– given the real-world results.

Learn more: A beginners guide to QE and QT

But as Richard explained, eventually, economic gravity returned. Monetary policy tends to work on an 18-month lag, “we had had too much money chasing too few goods, which stimulated an extraordinary wave of inflation in developed markets. Now, on the back foot, central banks are destroying the money supply. Meanwhile, supply chain bottlenecks are gone, and we have less money chasing more goods. This is deflationary,” he said.

Bond vigilante

Looking ahead to next year, Richard said a surprise may be in store on the direction of travel for interest rates.

“It is possible to imagine that by the end of Q2 next year, employment will have gone from hot to warm, inflation will have reverted to target, but rates will remain at 5-6%. At this point, central banks will be primed and ready to act if there is a shock to the economy or recession.

“I believe that the surprise will not be that rates are cut sooner than expected, but the speed at which rates are cut, as inflation rapidly comes down. This will be good for bond yields as long as it doesn’t develop into a sustained deflation.”

Richard explained that a lot of investing is about understanding risk and where risk premiums lie. He continued, “it’s our job as fund managers to find something that is first plausible, secondly something no-one else is looking at, and lastly something that makes sense. Currently, we are seeing opportunities where risk-reward is skewed in our favour, and where these three elements are in place.”

Ultimately, now could be a good time to invest in fixed-income instruments with government bonds looking particularly attractive. Dillon Lancaster, co-manager of the TwentyFour Dynamic Bond fund, recently told us more about why the fund is moving into government bonds and also, investment grade within the corporate bond market.

Turning your back to the crowd

Richard also argued that, in general, investment managers have become too index-aware in the wake of extraordinary monetary policy and, “it’s important to remain very different from the market and avoid herd mentality,” he said.

James also has a contrarian approach and is concerned the industry is too focused on benchmarks. Keeping his eyes focused on his investment process, he has outperformed the benchmark by 557%* since he took over the fund in 2003 by investing in undiscovered, out-of-favour global growth companies and holding them for the long term.

He likes simple, scalable businesses with entrepreneurial and flexible management teams. The fund is unconstrained, meaning James is free to pick the stocks he wants rather than being tied to the benchmark.

James said: “It’s important to stick to areas where you have a track record of investment success – for two decades since the fund’s launch, I have looked for hidden industry champions. But it is harder and harder to find companies with strong growth prospects – and we have seen a narrow band of just seven stocks drive the S&P 500 performance.” Fortunately, he owns five of them in Apple, Amazon, Alphabet, Nvidia and Microsoft**.

Read more: how to invest beyond the Magnificent Seven

Cautious optimism

While James says all the economists he meets are bearish, he is more optimistic. It is challenging, but a recession could create an inflexion point next year where the US Federal Reserve is forced to act.

For him, “inflation is a more important economic factor than recession, and everywhere I see that coming down, from logistics to commodities – even a Thanksgiving dinner is down 4.5%.”

“The inflation beast is finally being tamed, but now is not the time for one-way bets – there is a scarcity of certainty. We need to own the companies that can survive in any economic cycle. In my portfolio, all-weather businesses include Hermés, whose clientele is not impacted by recession. It also has an unusual demand driver of exclusivity.”

Tom Lemaigre, manager of Janus Henderson European Selected Opportunities, believes there is no global equivalent to luxury goods companies such as Hermés, or Luxottica, for example. These global champions within Europe have helped to drive the performance of European equities in 2023.

James said another example is Costco whose price mark-up ceiling retains a loyal and growing client base. He concluded, “we are in a different world, and it is important to have recession-resistant stocks. I own everything from waste collection businesses to pest control stocks, which can navigate any economic conditions.”

Looking ahead to 2024

Ultimately, we believe it’s a dynamic year ahead for investors, characterised by a blend of challenges and opportunities. But there is a consensus that it will be a year where active fund managers can truly excel. A proactive and contrarian approach will be key to navigating the market successfully.

Read more: Which sector is poised for growth?

*Source: FE Analytics, total returns in sterling, 3 November 2003 to 4 December 2023

**Source: FE Analytics, full fund holdings, 31 July 2023