Markets don’t go up in a straight line… rarely anyway!
I’m writing this following our seminar on Friday 1st October and my quarterly catch ups with our strategic investment partners. All very timely with equity prices falling in recent weeks.
You may remember us commenting just a few weeks ago on how we expected some volatility and, sure enough, this is what we are now experiencing. Typical of what we would expect at this stage of the cycle after experiencing such strong gains.
LGT Vestra, LGIM (Legal and General Investment Management) and the team here at Blue Sky, all believe that the global economy started a new economic cycle in March last year. The extraordinary stimulus by central banks and governments delivered much needed confidence and equity markets responded accordingly. The recovery was so strong that it is highly likely that we have squeezed the first part of the cycle into a shorter time frame than normal.
A bi-product of a strong recovery is that when it stalls, in this case due to renewed Covid-19 concerns and weak supply chains, confidence wains and short-term sentiment changes. Throw in concerns around the withdrawal of stimulus as economies recover and fears over inflation, it is hardly surprising that the investment markets have not only paused but have weakened.
A difficult balancing act
We have economies which have recovered from the deepest recession for 300 years still posting strong growth figures, yet the investment markets don’t like what they see!
There is no doubt there are signs that some of the anticipated optimistic growth forecasts will not be met. On the face of it, you would expect monetary stimulus to continue. However, with inflation rising the signals are that the stimulus from central banks will be tapered, with interest rates rising. The Monetary Policy Committee (MPC) here in the UK has already signalled that it is considering raising interest rates as early as December this year.
Make no mistake, this is a difficult balancing act because if growth continues to slow and interest rates are hiked then this squeezes the amount of disposable income, not helped by rising energy prices. The latter contributing to added inflation fears.
We must be careful with generalisations
It’s so easy to make the mistake of generalising too much. We’ve spoken before about the consumer boom fuelling growth with many moving to a different property, helped by the stamp duty holiday, a change in living quality and a plethora of people deciding to upgrade their home. Now we believe we will experience a business spending boom along with an increase in government spending in certain areas of the economy.
There may be a temporary slowdown in general growth, but it doesn’t follow that this will be the case for future themes such as biotechnology, e-commerce, sustainability and infrastructure. Huge amounts of money are pouring into these areas. It’s worth remembering back to the first quarter of last year when the pandemic broke, the only investment sector which attracted positive inflows was the Environmental, Social and Governance (ESG) Sector with the emphasis on sustainability.
How will inflation unfold?
This is the big question being kicked around by economists and investment professionals. LGT Vestra believe this will be transitory and whilst this is likely to be the case, a further question is being asked around how long this transition will be? LGIM are of the opinion that higher inflation may hang around for longer than many people expect which will have implications for companies.
This then makes us think about what businesses would likely thrive in this environment. In our opinion and that of LGT Vestra, it will be those companies with strong balance sheets and more predictable earnings that will demonstrate greater resilience, especially those companies who can more easily pass on any price increases.
How are assets likely to perform in periods of high inflation?
Assets like real estate typically prove attractive in times of higher inflation, as does infrastructure with circa 66% of company contracts linked to inflation according to Foresight.
Technology companies normally respond well as they don’t have to hold much stock, much being focused on their Intellectual Property. Like LGIM, we favour robotics and artificial intelligence having transitioned away from some of the large tech companies in the US.
We don’t really like bonds and hence why we seek alternative assets such as sustainable real estate. The bond market is some ten times bigger than the equity market and is infinitely more complicated. Balanced portfolios inevitably hold some bonds, but the key is to have the right sort of bonds, such as Treasury Inflation Protected Securities (TIPS). Despite what some think, these TIPS aren’t perfectly correlated to inflation. Those that have a shorter duration (1-10 years) can offer a stronger correlation to inflation. This was mentioned by Phoebe at our seminar and the shorter duration is favoured by LGT Vestra.
I like the comments on Investopedia around inflation; “The inflation tail should never wag the investment dog. If you have specific goals or timetables for your investment plan, don’t swerve from them. As an example, don’t weigh your portfolio too heavily with TIPS if you require significant capital appreciation. Also, don’t buy long-term growth stocks if your need for retirement income is imminent. An obsession with inflation should never get you out of your risk tolerance comfort zone”.
Don’t keep switching lanes on the motorway
This is an analogy I often use, in relation to frequent switching of positions in a portfolio. It uses a lot of fuel (in investment terms, a lot of emotional energy and costs) and you increase your risks. Trying to time the markets is fraught with danger.
After our ESG and Sustainable portfolios had a difficult time in late February, March and April of this year, it would have been all too easy to switch and rotate into other asset classes. We didn’t and held our line. It wasn’t long before we overtook most of the market sectors and enjoyed a carefree journey.
In driving terms, we have now hit some roadworks, but this is not a time to try and get off the motorway. There is a clearer road ahead.
Apologies for milking this analogy but I think it’s worth having this visual image in mind.
Positioning of Portfolios
LGIM (Legal & General Investment Management)
When asked about inflation, Francis Chua’s response was that generally speaking equities hold up well during periods of higher inflation, certainly when compared to bonds. A switch to safer havens now would consign you to ‘treading water’ when there are still good growth prospects ahead.
It was interesting to hear that LGIM have added to their infrastructure holdings due to the opportunities of inflation linking and partly because of the ESG they embrace.
They are positive on risk over the medium-term. The current volatility is no surprise to them as equity markets haven’t undergone a correction of more than 5% since October 2020. Something that is highly unusual.
They once again reinforced their views on technology and confirmed that they are transitioning away from the Nasdaq into new technology frontiers like artificial intelligence and robotics.
With regards to the US in general, LGIM don’t think it’s expensive but are big believers in diversification although they do really like US smaller companies at this stage of the cycle. Here at Blue Sky, we sold our US smaller company holdings in May in our Momentum portfolio as they had been underperforming. We have been pleased we acted in this way, but we may well use this pull-back to start adding back into this position.
LGIM see huge opportunities across Europe. There are many very strong companies in Europe, and it would appear that stimuli will remain for longer in this part of the world.
Bonds wise, they also agree that this space doesn’t look very appealing except for Emerging Market debt which they really like with many economies having reformed themselves from the financial crisis back in 2008/09.
As alluded to earlier in this overview, LGIM have an appetite for infrastructure and particularly ESG.
In quarter three sustainable strategies continued to outperform traditional indices. Phoebe Stone pointed to two major drivers:
- The tailwinds behind sustainable companies because of climate change initiatives, along with more focus on the responsible use of resources.
- The markets began to recognise and consequently rewarded quality businesses over those that were more cyclical or financially vulnerable.
LGT Vestra’s Sustainable team were active and made calls which looked to navigate the changeable market conditions. Their focus being on identifying sustainable themes with fundamental strength and long-term appeal.
They reinforced that this is an exciting time for sustainability.
LGT Vestra continue to believe that much of the short-term inflation can be attributed to transitory factors, which is in line with the view of the major central banks.
Governments around the world have taken on huge levels of debt in order to finance the covid emergency and resulting recovery packages, and so are incentivised to keep interest rates low in order to service the cost of this debt.
In the run up to Jackson Hole in late August, markets were anticipating announcements from the Federal Reserve around increases in interest rates and tighter monetary policy. However, the prevalence of the delta variant meant that whilst concerns over inflation remained, any meaningful monetary policy action was pushed back until later in the year. A wait and see approach.
Through the summer months, the Chinese Communist Party (CCP) staged a number of regulatory crackdowns on various sectors and businesses in support of ensuring common prosperity across China. Most notably in the education sector with the belief that excessive profits should not be attained from schooling. Alongside this, the CCP also introduced some regulatory barriers for technology companies. These developments have naturally led to increased uncertainty and market risk in China.
Although the risks are evident and somewhat unpredictable, LGT Vestra continue to believe there are significant opportunities for growth in the region but remain highly selective. Considering these developments, it is positive to see that the Asia Pacific investments in the sustainable portfolios have outperformed the wider market, highlighting the value of selective, active exposure to the region.
There is allocation to Chinese companies in the portfolios, through actively managed Asian and Emerging Market funds. China is the biggest consumer, producer and investor in renewable energy, and at this time is certainly the global leader in climate technology and innovation. LGT Vestra ensure that both thorough financial and sustainable due diligence is carried out on Chinese companies, as well as consideration of the sectors the businesses are operating.
Fears about China were heightened further with concerns over a potential global contagion triggered by the default of the Chinese property developer Evergrande. Again, the active approach LGT Vestra take within the sustainable portfolios, ensured that Evergrande bond assets were not held in any of the sustainable fixed income funds.
There isn’t a huge volume of emerging market bond assets that satisfy the necessary sustainable credentials, however this is slowly changing as more and more emerging economies are issuing sovereign bonds with specific environmental or social targets and projects attached to them.
This is extremely important because some of the poorest countries in the world are the ones that most need funding, and the bond market is fast becoming a powerful mechanism to enable the provision of capital to sustainable projects in emerging economies. It is still a small part of the overall market, but LGT Vestra look forward to it growing significantly in the years to come.
Economic recovery is not a steady ride
As we progressed through the first half of the year, it paid to be a ‘value’ investor, seeking to buy cheaper companies under the premise that they will revert to their long-term valuation. Growth investing on the other hand looks to identify businesses with significant runways for growth and higher future prospects, albeit you are likely to have to pay more today for tomorrow’s growth!
LGT Vestra have long preferred quality growth businesses with prudent management, forward looking ambitions, and the ability to generate plenty of cash to reinvest and return to shareholders. The third quarter of 2021 saw the quality growth bias return to favour as the market rewarded those businesses with better financial strength. The gap between value and growth that had opened during the start of the year certainly closed over the course of the third quarter. LGT Vestra are not surprised by this, and like us at Blue Sky, they have been highlighting the oscillating nature of markets.
Economic recovery will not happen in a linear fashion, and the gyrations we have seen over the past nine months are a clear demonstration of this.
Government commitment and support continues
The Intergovernmental Panel on Climate Change (IPCC), a body of the United Nations, has just released the largest ever report on climate change and highlights the impact of human activities on our planet. The report is the culmination of over 8 years of work and 12,000+ scientific papers, concluding that there is a near linear relationship between anthropogenic carbon dioxide emissions and climate change.
Although this will come as no surprise to many, developments in scientific analysis and measurement of our climate now make this relationship irrefutable. Although regulation and government support will likely be the largest single catalyst for change, financial market engagement is vital and those companies that sit behind the curve of reaching net-zero and combatting climate change will likely be negatively impacted and those ahead of the curve positively impacted.
From this perspective, it’s possible to allocate to companies with lower regulatory risk and falling cost of capital coupled with high growth prospects. During the quarter the Democrats in the US further progressed the $3.5 trillion social and environmental package. This is separate to the bipartisan $1 trillion American Build Back Better Act. Focusing specifically on the climate goals of the $3.5 trillion plan, it looks to provide tax credits to areas such as green hydrogen (bringing to almost price-parity per kg with grey hydrogen), management of forest fires and energy storage.
Futureproofing gains momentum…
Futureproofing is the concept of protecting your portfolio against the risks of tomorrow, often linked to ESG issues, but the financial benefit directly attributable to this is not tangible. However, when LGT Vestra look to the companies held within sustainable portfolios and those that have benefitted from big increases in their share prices, it is positive to see that this is supported by strong improvements to the fundamentals of these businesses, including significant upwards momentum in sales and profitability. Although it very difficult to directly attribute shareholder returns directly to sustainability factors and futureproofing, it is certainly reasonable to suggest that it has played its part in generating strong returns for investors in these businesses and will continue to do so moving forward. The market feels as though it is becoming increasingly momentum driven, and there is undeniably increasing amounts of momentum from consumers, investors and governments about sustainability.
What is Foresight’s view on the outlook for infrastructure?
Foresight is seeing more assets gravitating towards the infrastructure space based on strong balance sheets, projects supported by government, an appetite for spending from businesses and more predictable revenues due to inflation linked contracts.
This asset class as we’ve seen, is not without its volatility as international investors rotate their appetite backwards and forwards towards other sectors, but increasingly money is being attracted to this space, not least because of its ESG credentials.
As with all assets, in the short-term, what happens to the direction of travel with regards to sentiment depends upon a number of things. For example, rising interest rates, but as an alternative asset class the impact on infrastructure stocks is likely to be less acute than with a fixed income bond.
You may be interested to note that within their Sustainable Real Estate fund they have an exposure to self-storage facilities. These typically profile as having short contract terms and as the contracts are renewed, the costs can be increased in line with inflation. Just one example of an inflation resilient sector.
This real estate fund is very interesting, and its risk/reward ratio is very desirable. According to Foresight it has had circa two thirds of equity volatility since launch in June 2020.
I spoke about our rotation on the 12th May towards the above fund, away from some Global Infrastructure, just to create diversification. During the sell off earlier in the year when clean energy fell out of favour, real estate held up favourably.
Foresight now has two full-time ESG analysts in their operation, reinforcing the part this plays in their decision making.
I asked our partners at Foresight whether Biden’s infrastructure plan was already baked into market sentiment and the feeling was that much of it is but there is a clear need to improve infrastructure all around us, as the pandemic clearly highlighted.
Foresight is keen to reiterate that they don’t make short-term tactical moves across their portfolios, although they are always interested to add to their positions when there is a pull-back in valuations.
They certainly don’t see valuations as being stretched and it’s worth remembering that the stability of income and embracing ESG, makes this a really good alternative asset class. Supporting valuations is the focus on mission critical infrastructure which is central to economies.
Foresight’s approach is encapsulated by the following:
- Stability of demand
- High barriers to entry
- Long-term contracted revenues with government counterparty and inflation protection
They are particularly excited by digital infrastructure.
One of the challenges to the global economy is how to harness and store renewable energy and Foresight are keeping a close eye on developments.
Although Foresight owns physical assets, it’s important to note that we are not talking leisure, hospitality, the high street or shopping centres. Their focus is more towards logistics which accounts for 34% of their real estate fund and healthcare and housing which together make up 28% of holdings. Interestingly, buildings account for more than one third of carbon emissions and so there are some fantastic opportunities in this space.
Blue Sky Summary
Volatility is normally prevalent across stock markets and there is no doubt that we have enjoyed relatively benign conditions over the last year. Weakness like we have experienced of late is what we would expect to happen after a good run of gains. Whilst it may be hard to bear when it happens, a pull-back now and again is likely to mean that longer-term growth in the portfolios is more achievable.
Whilst we are active in our decision making, we have conviction for well-run companies, with strong balance sheets, predictable income and, where possible, offering protection against inflation.
Futureproofing our portfolios is essential. The world is changing fast, and we want to be a part of it. At the same time though we are very aware of the risk/reward relationship of any assets we include across the portfolios.
We are confident as to the strategies we are embracing, and I hope this information also elevates your confidence further.
Lots of reasons to be optimistic.
Gary and the Blue Sky Investment Team
Please Note: This communication should not be read as giving specific advice regarding your personal circumstances. This would only be given following detailed assessment of your individual needs. The value of investments may fall as well as rise; you may get back less than invested. Past performance is not necessarily a guide to future returns.