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?

Riskier assets like equities and credit within fixed income have generally been producing reasonable above cash returns, continuing 2023’s strong run. Within equities, Japanese stocks have given back some of their outperformance of last year and Chinese stocks have performed better, after three very poor years. The big trend in equities, however, continues to be strong performance from the US, larger companies in general and technology in particular. Given the importance of central bank policy in this cycle, there has also been a recent US Federal Reserve FOMC rate-setting meeting.

What has been driving investment markets in this period?

The central issue for all markets is the avoidance of a US recession, combined with clear signs that inflation continues to ease. Financial markets have been acting on this basis, but this view had important support from last week’s Federal Reserve rate setting meeting and press conference, which painted a picture of continued strong growth combined with moderating inflation. Goods inflation continues to be very well behaved, driven by China exporting deflation with, for example, Chinese imported goods prices into the US falling 2.0% yoy in May. The problem has been services inflation which has been much stickier, but here too there is evidence from sectors like rents and car insurance that financial markets are correct to anticipate further moderation in inflation, supported by Federal Reserve guidance. It is worth repeating that this continues to be a highly unusual cycle by post-1945 standards when previously, the norm has been central banks raising interest rates to choke off inflation, effectively inducing a recession. This cycle has been characterised by no recession, in spite of last year’s inverted yield curve and the market consensus indicating one was imminent, and continued strong economic growth as US companies demonstrate a general ability to deliver strong productivity growth and cope with higher interest rate costs. Decreases in central bank interest rates in China, Sweden, Canada, a raft of emerging market countries and significantly the ECB provides further recent evidence that this is an unusual cycle as it has historically always been the US Federal Reserve that leads on timing of interest rate increases. As recently as January, the consensus was for 7 US interest rate cuts this year on expectations for a likely recession. Federal Reserve and market expectations are now for only one or two cuts by year end.

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

Full weightings in equities in portfolios have been very helpful, as have holdings in investment grade credit. Duration has recently been positive as fixed income markets liked the tone of central bank statements and policy actions. Within equities, our long-standing bias to quality companies with strong balance sheets and ability to maintain margins and deliver secular growth continues to be very positive. An overweight in Japanese equities has recently been less positive, as has an overweight in smaller and medium sized companies. It is the largest companies in the US that continue to outperform, particularly in the technology sector, although smaller companies are performing relatively better in the rest of the world, including recently in the UK. The principal detractor has been our commodity overweight, which has been impacted by what looks now, with hindsight, a reaction to a spike in prices based on technical moves in futures markets and disappointment towards the lack of a stronger pro-growth stimulus from China and, for gold, the disappearance of policy buying from India, Turkey and China, following several years of consistently strong purchases.

What decisions have the committee been making, due to the changing macro-economic conditions?

We have been focussed on getting the big picture right and as recent data has been supportive of our key call of no recession and steady economic recovery made last year, we have been making few if any significant changes to our positioning. At the margin, we believe UK growth will continue to disappoint and are adding to gilt duration at the expense of US bonds and putting more emphasis on larger UK companies in equities, following a period of smaller company outperformance, particularly as sterling will weaken if UK interest rates are cut. We are monitoring employment trends in the UK particularly closely.

Central banks across the world have started to cut interest rates, how do you see the path for cuts from here?

If inflation continues to moderate as we expect then we will see more cuts in interest rates. The interesting one is the UK where we would be looking for cuts, but the Bank of England has never cut rates in an election campaign, at least in the ‘post independence’ era. That said, if it did happen, and we think the odds are against it, it would be consistent with our observation that this is a highly unusual cycle. In the medium term, central banks clearly want to ease, where possible, to improve growth and given increasingly high levels of debt, but they also know they need to preserve some firepower to be able to lower rates meaningfully into the next recession, so they will be reluctant to be too hasty. The key remains inflation. It is also worth remarking that if the Federal Reserve did start signalling more interest rate cuts than currently anticipated and growth remained reasonable to strong, there is a very strong probability of a ‘melt up ‘ in US equities, even after the strong gains of the last couple of years.

US stock markets keep hitting record highs, do you think this can be sustained?

The US is a remarkably resilient economy which has demonstrated again in this cycle an amazing ability to deal with rolling recessions across different sectors and an ability to redeploy investment from unproductive sectors to productive ones. The US stock market is expensive by historical standards, but it deserves to be, and we do not think it to be outrageously expensive. Corporate margins remain effectively at record highs, productivity growth is strong and showing signs of acceleration, and forward looking estimates of profitability are positive led by larger companies. Historically, this would be the stage in the cycle when smaller companies would be outperforming. In the US, at least at the moment, this just isn’t happening, which we find intriguing. Our analysis increasingly appears to point to many of the most attractive smaller companies remaining private for longer, combined with private equity buying the best growth companies from public markets. If this is correct, then stock market returns could continue to be led by larger companies for some time to come.

The Japanese yen has been the worst performing developed market currency for almost two years now, do you see a change in fortunes for the currency?

It is fair to say the committee is divided on the yen. The Japanese currency is undoubtedly cheap, which explains why inbound tourism to Japan is so strong, but capital flows continue out of Japan. I would tend to focus on how all currencies have been relatively weaker against the US dollar which continues to experience strong capital inflows driven by better positive interest rate differentials, but mostly by investors wanting to participate in the remarkable US capitalist economic machine.

Commodity markets have stalled of late, do you still see these as a useful tool for portfolio construction?

Commodities are a very useful diversifier in portfolios, particularly as hedges against inflation, and they have been very helpful for us over the last five years. We see strong medium term demand and limited new supply for key energy transition metals like copper, although we are acutely aware of the substitution risk if new technologies for energy transmission were to appear. Gold and precious metals are important hedges against a potential debasement of fiat paper-based currencies in a world of increasing amounts of debt, but of course pay no interest. Recent price pullbacks appear to be based on technical futures trading. That said, these are also a timely reminder of just how much pricing in all markets, and not just commodities, are driven by short term and algorithmic traders.

UK equities are gaining more attention for the first time in a while, do you see opportunities here?

Our view on the prospects for UK equities has been unexciting for some time. Outflows out of UK equities from domestic investors continue relentlessly with wealth managers following the well worn path of UK pension funds selling equities to buy bonds to match liabilities. The UK market is undoubtedly cheap, but this largely reflects the composition of quoted companies, particularly in the FTSE 100, where there is very significant representation from large ‘value’ companies in sectors demonstrating little in the way of sales or profit growth. If the UK market is looked at on a sector adjusted basis, it is much less obviously cheap. Traditionally UK active managers have found the historically large pool of small and medium-sized companies a happy hunting ground for outperformance. Recent performance from smaller and mid sized companies has recently been better, but we are concerned about the ever shrinking pool of attractive quoted growth companies as ever more are taken over by trade buyers or private equity. Similarly, the medium term GDP growth outlook for the UK is lacklustre, which would cause us to be cautious on smaller companies, which tend to be more exposed to domestic sales and revenues. Bottom line is the UK is cheap, but we would need to anticipate better prospects and identify stronger catalysts for us to materially change our view.

How does the committee view upcoming elections and potential portfolio impacts?

We are obviously in the middle of a UK general election campaign. As with the US, markets continue to focus on the growth, inflation and central bank policy outlook and largely ignore the politics. As long as a capitalist rules-based system prevails in the ‘western world’, then this will remain the case. UK financial markets have effectively been unmoved by the campaign. The problems from the politics come when ‘shocks’ occur. Again, the key economy is the US. So far, financial markets have largely ignored the politics and anyway it is very difficult to know how to discount events. The best example is how well the US stock market performed in the ‘first’ Trump presidency. The US presidential election will undoubtedly be a very close affair, but US-based betting venues are indicating a rising probability of a Trump win in November. There are some signs of falling consumer confidence among Democratic party voters, which may be feeding into slightly weaker economic data in the US. The most interesting recent events around an election is in France. The announcement of parliamentary elections was undoubtedly a surprise following the EU elections. The French bond market has reacted badly with 10 year yield spreads over German bonds widening to the level last seen in the eurozone government bond crisis of over ten years ago. This move reflects the growing electoral success of the far right parties, against a background of many years of rising debt to GDP ratios in France, as well as the traditionally fiscally weaker countries of ‘southern’ Europe. Looking forward it is likely that volatility around politics will rise along with a tendency to extremism, given current and projected debt and debt servicing levels as governments and electorates face difficult trade offs against a background of continued high levels of immigration in the US and Europe and increasingly elderly demographics.