Investment conditions
Growth (economic)
Economic growth has been fairly resilient over the last few months. Recently boosted by falling energy prices, loosening of covid restrictions in China, and liquidity injections from central bankers. In the US, the labour market has remained extremely strong, with impressive retail sales numbers, and a recent unexpected increase in new home sales points to stabilisation of this important sector. However, some economic indicators are pointing to weaker growth, particularly within Europe. Business and consumer confidence appear to be waning, new orders have been falling, and measures of financial stress have increased following issues with the banking sector. Indeed, the IMF recently reduced its global growth projections, citing high uncertainty and risks as financial sector stress adds to pressure from tighter monetary policy and Russia’s continuing war in Ukraine. Notably though, the IMF still expects positive global growth this year and next. There remains significant uncertainty about the future path of economic growth, with estimates ranging from deep recessions across the globe to no recessions at all.
Interest rate & liquidity environment
Because of issues in the banking sector, investors have dramatically shifted their expectations for the path of future interest rates. The market now expects a lower peak, and that rates will be cut sooner. However, in the US there remains a disconnect, the market expects significantly lower interest rates than the decision-makers do (The Federal Reserve). Liquidity fell dramatically last year as policymakers reduced support but has increased from September to today.
Valuations & earnings outlook
Reported corporate earnings have fallen over the last twelve months but have not collapsed. Forecasted earnings imply a shallow recession this year and growth in 2024. Many asset classes are trading more cheaply than historical averages, particularly in government bonds, small US companies, and non-US equities generally.
Sentiment / flows
Short term indicators point towards positive investor sentiment. Markets have been trending above recent averages, market breadth is high and rising, put/call ratios indicate more greed than fear, whilst volatility has been relatively low.
Views by asset class
Equities
On the back of positive economic news and greater liquidity, equities have rallied strongly since October. However, the macro-economic outlook is still uncertain.
The Asset Allocation Committee decided to maintain the overall level of our equity exposure, but made changes to the styles, as well as some regional adjustments.
In the previous asset allocation cycle, the Committee had decided to increase our exposure to larger cap growth stocks in the US, which went on to outperform. The committee decided to continue the move away from smaller and cheaper companies, and to increase our exposure to larger, higher quality companies – those with stronger balance sheets and less volatile earnings than the average company.
We have for some time been tilting portfolios towards both the “value” and “income” styles, which has been very helpful for boosting returns compared to broad equity market risk. Some of this exposure is picked up by global companies listed on UK stock markets. The Committee decided to maintain this style of investing, and our exposure to those companies listed in the UK, whilst continuing to have significantly less exposure to the UK economy than many of our peers.
We remain unconvinced about the case for European equities, given uncertainties over many factors in the region. Because of the uncertainties, in the last asset allocation cycle we decided to invest in a European equity manager that can generate returns from both rising and falling stock prices. For more information about this manager, see the “manager in focus” section of this update.
Although unconvinced that China has found a new growth model, its re-opening from Covid lockdowns is undoubtedly positive for risk assets in Asia. In addition, equities in this area are significantly cheaper than most, particularly those in the US. In addition, they should benefit from a weaker dollar and lower interest rates, which is the current state of play. The Committee decided to continue increasing our exposure to emerging markets, funded by a small reduction in US equities.
Overall, we continue to tilt our equities towards quality companies (those typically more resilient when the outlook deteriorates), value companies (which are cheaper than the average stock, so have a greater margin of safety in the price), and smaller companies (which are trading more cheaply than the average stock).
Government bonds
Having avoided most of the drawdowns in government bonds last year, through 2022 the Asset Allocation Committee had been investing in the asset class, attracted by the higher yields on offer. In the prior meeting, the Committee decided to increase the duration of our government bond exposure, because it felt the higher yields now on offer should provide portfolios with more protection against economic uncertainty. This proved helpful after the collapse of SVB bank and the resulting fall in interest rate expectations. Moving into a recessionary environment, the Committee would expect to see a flight to safety, which they think would be positive for our holdings in government bonds.
Corporate bonds
Because yields on US corporate bonds have increased to attractive levels, we have been increasing our exposure to US investment grade bonds. In the recent meeting, we decided to further increase our exposure, funded by a reduction in convertible bonds. In doing so we made our bond positions slightly more defensive. The committee decided to maintain our positive view on emerging market bonds, which are still trading at significant discounts, so they offer both high yields and the potential for significant capital appreciation. Emerging market bonds should also benefit from dollar weakness, whereas other parts of our portfolio would benefit from a rising dollar, so the addition to emerging market bonds was supported by the potential diversification benefits.
Alternatives
Alternative asset classes can provide protection during market falls, with returns not correlated to the rest of the portfolio. For this reason, we are still positive on the asset class. However, the Committee did make some changes to the underlying holdings.
We are still positive on selective macro hedge funds with an established record of doing well in volatile environments.
Our positions in various commodities continue to add value. They can provide portfolios with returns not correlated with the rest of the portfolio and so provide useful diversification benefits. Many are under-supplied, but demand remains strong. Some commodities are sensitive to a deterioration to the economic outlook, so we remain vigilant, and prepared to trade commodities tactically as is often required with this asset class.
The Committee decided to increase our exposure to gold miners, because their value has significantly diverged from the price of gold, and we expect this gap to close. This was funded by a reduction in other alternatives.
Overall, the environment is characterised by high uncertainty about the macro-economic outlook, so we remain cautiously positioned, but prepared to take advantage of opportunities that present themselves.
Summary of positioning
Below is a summary of our views for each asset class, from strongly negative (- -) to strongly positive (+ +).
Asset Class
| Asset class | -- | - | Neutral | + | ++ |
|---|---|---|---|---|---|
| Equities | X | ||||
| Government bonds | X | ||||
| Corporate bonds | X | ||||
| Alternatives | X | ||||
| Cash | X |
Asset Class Breakdown
| -- | - | Neutral | + | ++ | ||
|---|---|---|---|---|---|---|
| Equities | USA | X | ||||
| UK | X | |||||
| Europe | X | |||||
| Japan | X | |||||
| Asia ex-Japan | X | |||||
| Emerging markets | X | |||||
| Bonds | Government | X | ||||
| Index-linked | X | |||||
| Investment grade | X | |||||
| High yield | X | |||||
| Emerging market | X | |||||
| Convertibles | X | |||||
| Structured credit | X | |||||
| Alternatives | Commodities, gold + miners | X | ||||
| Macro hedge + other alts | X |
Investment Committee Q&A
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 and bonds have both generally performed a bit better, but it has been volatile and punctuated by sharp reversals. The 10-year US treasury yield, for example, started the year at 3.79%, rose to 4.08% in early March, and has since fallen sharply to 3.39% at the end of quarter 1. Within equities, the best performing stocks of last year have underperformed so far in this year and the worst decile of stock performers in 2022 is up nearly 16% so far this year.
What has been working well for our portfolios, and what has been less good?
We have been running slightly under risk in portfolio positioning given the uncertain outlook, but portfolios have generally kept up as markets have recovered. Adding to fixed income has been helpful, as has the quality tilt in equity portfolios. The weakest area has been US smaller company managers. We reduced this exposure earlier in the year, but large companies have generally outperformed smaller companies in nearly all markets.
Regarding the collapse of SVB, Credit Suisse, and similar financial institutions, what impact did this have on financial markets and on our portfolios?
Markets recovered their composure quite quickly after SVB and the unrelated CS rescues following ruthless and well executed operations by regulators and central banks. We wrote at the time that we didn’t think there were systemic sector wide issues. Banks are generally very big issuers of debt -financials account for circa 40% of the Bloomberg Corporate Bond Index, for example. Of our three credit managers, only one had a small exposure to CS bonds and we had no exposure to SVB.
Are you worried about this being another “Lehman moment”, where banking collapses led to a financial crisis?
No, banks are immensely better capitalised today than going into 2007-08 and central banks have had plenty of time to develop their prudential support armoury.
The Pound has rallied recently, what are the reasons for that, and do you see this continuing?
Sterling has had a slightly better couple of months, largely helped by a slightly weaker US dollar. Closer to home, having economically literate tenants in Nos 10 and 11 Downing Street and, at the margin, less risk to the ‘Union’ given the political events in Scotland are all sterling helpful. To put all this in perspective, though, sterling is still lower on a trade weighted basis than a year ago and it is down 26% from its 2007 peak. Medium term, the UK does appear to have an inflation ‘problem’ and the woeful productivity picture, if maintained, is going to provide headwinds for sterling.
How are economies holding up? Has economic growth been better or worse than expected? How do you see this changing over the coming months?
Economic growth numbers have been better than expected. As market participants have generally been anticipating a recession, as evidenced by the steeply inverted yield curve, better growth has helped risk assets. Even the UK has seen better growth than widely anticipated, which has also contributed to a slightly stronger sterling. The key economy remains the US, where consumption in particular has held up well in the face of below inflation wage increases. The Atlanta Federal Reserve, for example, is forecasting Q1 US growth to be +2.5% year-on-year. Modest, but no economy wide recession. Looking ahead, if inflation doesn’t fall as anticipated then central banks will at least keep interest rates higher for longer and they are likely to engineer a slowdown that will look more like a recession. So far, the US is characterised by ‘rolling recessions’ in different components. On balance we think this is likely to continue particularly given the ‘onshoring‘ of supply chains and energy transition spending.
Have we stopped worrying about inflation?
No, it remains the central issue. Having been quick to identify inflation as a problem earlier this cycle, we are tentatively thinking inflation has peaked or is close to peaking. Goods inflation has fallen sharply, for example down to 1.5% year-on-year in March for the US, and there are signs that services inflation, which has been much stickier, will follow producer prices (PPIs) which are now falling in both the US and China.
Saltus have been leaning towards quality companies, how do you define what a quality company is, and why have Saltus been investing in them?
We have been emphasising ‘quality’ in our equity holdings since summer 2021 in anticipation of a more difficult phase in the cycle and the rising probability of a recession. Quality companies are characterised by less volatile earnings, stronger balance sheets and higher returns on equity. Our biggest £ exposure to an active manager across Saltus is in a ‘quality’ global equity strategy managed by RLAM which has performed well.
You’ve been concerned about commercial real estate for some time, why is that?
Much investment in commercial property is leveraged and it has been relatively easy for institutional and family office investors to ‘park’ money in real estate and take the relatively stable income stream. Higher interest rates have hit the financing model and reduced valuations based on discounting income streams. My really big medium-term concern, however, is to do with the costs of achieving higher energy efficiency targets on top of likely lower demand from more hybrid working models.
Are you worried about politics in the US, and how that could impact financial markets?
US politics is clearly very polarised, but one can only be impressed by the institutional integrity and the constitutional checks and balances of the system – so far at least. There is the potential for another fiscal crisis over the Federal debt ceiling, although similar cliff edge crises have come and gone in the past. The US economy and political system is remarkably resilient and effective with an extraordinary ability to redeploy assets from unproductive parts of the economy into productive new areas. An area I am particularly excited by is ‘middle’ America, which is benefitting from the onshoring of supply chains away from China and the vast subsidies being provided for energy efficient domestic production.
Manager in focus: Liontrust European Strategic Equity
This fund follows a style of investing called “long/short”. This means the fund can make profits from stocks that go up (its “longs”) and also from stocks that go down (its “shorts”). Because of the ability to go short, the fund can generate profits even if stock markets don’t go up, which the Saltus team felt could benefit portfolios in this market environment.
Who are Liontrust?
Liontrust are a specialist fund management company listed on the London Stock Exchange, with £34 billion of assets under management as of November 2022. Founded in 1995 and headquartered in London, they also have offices in Edinburgh & Luxembourg.
Fund overview
The European Strategic Equity Fund has been managed since launch in April 2014 by James Inglis-Jones and Samantha Gleave. The fund managers seek to deliver a positive absolute return over the long term by taking long and short positions, primarily in European companies. The Fund buys companies that can generate strong cash returns from their capital and appear cheap on these cash flows, and shorts companies that are both expensive and struggling to generate cash. (From Liontrust website).
Investment philosophy
The team believes that cashflow is the most important determinant of shareholder returns. They think investors undervalue strong cashflow, in favour of short-term profit forecasts. This leads to mispricing, which can be exploited by investing in companies the market undervalues, and shorting stocks the market overvalues.
Because of this, the philosophy is generally contrarian in nature, meaning it often bets against the prevailing market view.
Investment process
Their process is mostly quantitative i.e., driven more by data than by other factors. Their process can be split into five distinct phases:
Stage 1: define the investable universe
They only invest in companies larger than €500m in market cap, and with plenty of liquidity.
Stage 2: screen the investable universe
They screen based on quality of company cashflow, and how cheap or expensive that cashflow is compared to the market value of the stock.
- Quality – gives insights into profitability, the extent to which cash-flows are reinvested to generate more profits/cash, management prudence, financial leverage and sustainable growth potential
- Value – cashflow relative to market value is ranked, indicating how the market perceives the growth potential of the stock
Stocks are ranked in order of attractiveness based on screening criteria, with opportunities to ”long” (“short”) found in the strongest (weakest) cashflows.
Stage 3: further analysis is run using a secondary scoring system based on:
- Momentum – businesses with strong momentum, high profit margins, and self-funded growth
- Cash return – stable businesses with robust balance sheets, and those returning cash to shareholders
- Recovering value – recovering businesses, with management focussed on cost control
- Contrarian value – companies that have experienced tough trading conditions for a long time, with management responding by restructuring and selling down assets
Stage 4: market regime indicators
The team look at four proprietary market indicators to help them assess current market conditions, these are based on:
- Investor anxiety – using a range of readings, they assess the extent to which they believe investors are anxious. They use it as a contrarian indicator, preferring to invest when investors are fearful
- Corporate aggression – using various measures, they assess how aggressive companies are with regards to areas such as asset expansion and borrowing. Again, they use this as a contrarian indicator, believing that when companies are acting very aggressively, typically it’s a good time to be reducing risk/shorting certain sectors
- Valuation indicator – various metrics assessing how cheap or expensive stocks are compared to history
- Momentum – various measures of market pricing to indicate where markets movements have momentum
Stage 5: final portfolio selection
Combining all prior analysis into the selection of two portfolios. One is the “long book”, made up of the most attractive stocks, the other is the “short book”, made up of the least attractive stocks.
Performance
The fund has achieved top quartile performance against its peer group over 1, 3, 5 years and since inception.
Over the last five years the fund captured roughly two thirds of upward movements in markets, but only about one third of downwards movements in markets.
Saltus investment case
We invested in the fund for the following reasons:
- Because the market environment was uncertain, we wanted a fund that can make money whether stock markets go up or down
- We saw some fairly large distortions in market prices, and Liontrust are one manager we feel are capable of taking advantage of such distortions
- We consider this to be an exceptionally well managed European long/short fund, we like that the team have been in place for around 10 years, and have followed the same process since at least 2006 and as early as 1995 at previous firms
- We think the process is well designed, based on empirical research, choosing statistically significant metrics that outperform the market over the long run
- We think the process is both repeatable and scalable, based on a systematic approach that removes many of the emotional biases that come with stock selection
- The team have benefitted from using a range of market indicators that have been good at predicting the overall market environment, allowing the team to change the exposures of the fund at advantageous moments, whether increasing/decreasing overall risk, or the types of stock they are exposed to (e.g. growth stocks vs value stocks)
- The performance and risks statistics were exceptional
Saltus use this fund as part of a diversified portfolio. This is not a recommendation to invest in this fund. Saltus will not be liable for any losses incurred as a result of investing in this fund.
Asset Allocation Committee
The committee consists of several senior members of the investment team, all partners, who invest their own money alongside clients. The committee is led by:
David Cooke
Co-Chief Investment Officer , Saltus Asset Management Team