Asset allocation update

In this feature we attempt to lift the lid on the process and our views by interviewing one of the decision-makers: Andrew Fleming: Chairman of Saltus Asset Management and the Asset Allocation Committee

The Committee last met two months ago, what has happened since then?

Equities peaked at the end of July and have since lost a bit of their shine but are still up 15% in the case of the S&P500 US large capitalization index for example. The big moves have been in fixed interest where there has been a big increase in real yields. It is important to remember that in the twelve years after the GFC of 2008/9, both nominal and real interest rates and yields fell to extremely low levels. This rise in real yields has resulted in a sharp selloff in price terms of both conventional bonds and inflation-linked securities. Over the last month, for example, the 20-year conventional gilt yield has risen by 38 basis points (0.38%) and the 10-year US inflation linked real yield has risen recently to 2% from 1.06% in early April. This latter example gives a good indication of the rises in real yields. What all this represents is a normalisation of interest rates after the quite exceptional period of very low interest rates over recent history. Given how many people, governments and financial institutions expected very low interest rates to continue, it is going to take some time for all the implications of higher real yields to become clearer. The other big piece on global news is the confirmation that China has moved into deflation and that the underlying problems in the huge, indebted, domestic property market remain unresolved. China is again exporting tradable good deflation to the rest of the World and, at the margin, is one of the reasons why we continue to believe inflation has peaked.

What has been driving investment markets in this period?

In addition to the big moves in real yields, markets continue to be dominated by assessments of central bank policy, which is itself largely a function of the inflation outlook as it has been through the recent interest rate increase cycle. Equity returns have continued to be driven by quality and ‘growthier’ companies particularly in the technology sector.

What has been working well for our portfolios, and what has been less effective?

There have been no standout trends where it has been easy to identify a consistently winning strategy. That said, our equity holdings have a long-standing bias to quality which continues to serve portfolios well. Much of what has been helpful for us is avoiding the areas of conspicuous weakness like Chinese assets, where we have a long-standing scepticism, as well as infrastructure and real estate, both of which tend to rely heavily on leverage and where prices have been hit hard by the increases in real yields. In lower risk portfolios, we have been slowly adding to duration as interest rates have risen from an extremely low starting position. With hindsight, this has been a bit early and has had a negative impact on returns, but we do believe inflation will fall more than anticipated and at current levels fixed income looks much more attractive than for many years.

Have companies been able to protect their profit margins despite the rise in inflation?

Yes, and this has particularly been a characteristic of larger, ‘quality’ companies with strong balance sheets, barriers to entry and strong management teams. There is a risk to these margins, however, as the accumulated household excess savings of the Covid pandemic period are being drawn down to maintain consumption in the US. We are monitoring this closely.

In the recent asset allocation meeting you described the upwards movement in global stocks as “the most unloved bull market in history” – what did you mean by that?

Yes, it probably is. There has been lots of scepticism about risk assets and I think this is largely a function of the fact that we haven’t had the most anticipated recession in history. Given levels of debt if there had been a ‘proper’ recession associated with Covid and its aftermath, then equities could easily have fallen, as many anticipated, by 30-40% from their peak. Within equities, the leadership of the ten largest ‘mega cap’ US technology companies has also caused much angst among active fund managers as very few, if any, have had full weights relative to indices in these stocks causing stock picker underperformance.

We now have positive real yields for the first time in years (where the cost of borrowing is higher than expected inflation). Is this a threat or an opportunity for investors?

As before, higher real yields are a real problem for investments typically involving leverage like property, infrastructure and private equity. That said, there have been some big falls in prices in these areas already and investors who are able to take advantage of this repricing should be seeking out opportunities to buy good quality investments cheaply from distressed sellers. We are starting to do this very selectively in private assets where some prices already look very attractive.

Is the committee worried about the scale of debt in the US, and the game of cat and mouse its politicians play with the debt ceiling?

Again, yes, and the deterioration in the US government’s fiscal position has been one of the contributors to the recent rise in government bond yields. The concern is not the federal expenditure but rather the conspicuous weakness of receipts at what should be a strong phase of the economic cycle. The other issue exacerbating weakness in government fiscal positions, and this is a real issue in the UK, is the higher costs of debt servicing as interest rates have risen. It isn’t just companies and households that are affected by higher interest rates.

Within the asset allocation meeting reference was made to a “buyers strike” for US government bonds, what does this mean and what are the implications of this?

To be clear, there isn’t a ‘buyers strike’ for US government bonds – at least not yet. If there were, yields would be significantly higher. The relevant other big ‘macro’ contributors to higher bond yields have been the ending of the Bank of Japan yield curve control, which kept interest rates at extremely low levels, which now makes domestic Japanese bonds relatively more attractive and a pattern of much lower purchases of US Treasuries by the Bank of China and the Middle Eastern oil producers. Medium term debt projections for the US are starting to become a real concern given the scale of unfunded entitlements. There could be a real risk of governments ‘crowding out’ borrowing as they compete with the private sector for funding at a time when the sheer scale of the energy transition funding requirements is becoming more pressing. All this said, the US as the controller of the US dollar global reserve and trading system has an extraordinary ability to fund itself internationally. There is a risk to this system, which we are monitoring, but we still believe China will find it impossible to create a parallel reserve and trading system to rival the US any time soon.

The US economy, and its stock market, have been very resilient. What’s behind this? Do you expect this to continue? What could see a reversal?

I have observed before the extraordinary dynamism and resilience of the US economy. It has really been characterised by rolling sector recessions rather than one big economy-wide recession. The US corporate sector has an extraordinary ability to transfer resources from declining and unproductive parts of the economy into productive parts and its capital markets and entrepreneurs have a similarly extraordinary ability to back new ideas and, it should be said, get very handsomely rewarded for success. US stock markets trade expensively relative to the rest of the World, so a lot of value investors find it difficult to invest there. This also is part of the scepticism about the most unloved bull market in history. It has been driven by a small number of companies in the most expensive large equity market. The history of equity investing, though, over longer periods of time is that most excess returns are driven by a small number of stocks that show real innovation and that can capture the commercial returns from that innovation. It is very difficult to see the US losing this dynamism, particularly given that the Federal government is now putting real effort into onshoring supply chains away from China and the energy transition.

We have seen the Pound rallying recently, what’s been behind this, and do you expect it to continue?

It has rallied a bit as there is a more stable and economically literate team in charge of the government in the eyes of international investors and higher interest rate differentials are pound supportive. I wouldn’t get too carried away, however, as the underlying issues of weak growth and particularly productivity growth and the twin deficits in the fiscal and trade positions continue.

If you were talking to a UK based investor looking to preserve their long-term wealth, and weighing up holding cash (at higher interest rates now than in recent history) versus an investment portfolio, what counsel might you give them?

I would just say that savings rates are providing much better returns than for many years, but these savings rates are still below the rate of inflation, so the real value of money is being eroded and there is, of course, a risk that if there is a sharp economic slowdown these short-term interest rates will fall, so there is reinvestment risk. We are lengthening the duration of our bond holdings into the rise in interest rates. So, in the more ‘normalised’ interest rate word I mentioned earlier, money in savings accounts can now provide a competitive return for the first time in many years. It is important to remember, however, that over long periods of time investors who want to protect the real after inflation value of their savings need to take equity and equity-like risk. There is a particular issue for UK-based investors that there are now, so few genuine ‘growth’ companies listed in the UK that to get access to above inflation returns from equities have to go global. This introduces more currency risk. Our view is the global opportunity set, and a not particularly attractive outlook for Sterling, makes this the appropriate thing to do for most UK investors.