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?

Essentially, risk assets like equities and bonds have performed strongly. In the US, the S&P 500, for example, is up nearly 12% since the end of October and is now less than 5% below its all-time high, achieved in January 2022. As importantly, the market has broadened out as evidenced by the recent outperformance of the equal weighted S&P 500 index relative to the primary index - which is market capitalisation weighted and dominated by the largest, largely ‘tech’, companies - which powered returns earlier in the year.

What has been driving investment markets in this period?

Growing evidence that inflation is falling, and so markets can anticipate more clearly the end of the US Federal Reserve higher interest rate tightening cycle, combined with data showing the US economy will avoid a recession. This looks increasingly like a ‘soft landing’ for the economy and bonds, and equities, rightly, have really responded to this outlook. You need to remember the background to these moves. We have observed before that this has been the most anticipated recession in US history: the yield curve has been inverted (normally a classic indicator of recession) since the summer of 2022, leading indicators have been falling, interest rates have been raised sharply and the money supply as measured by M2 has been falling. Instead, the US labour market remains strong but is cooling, inflation is falling, oil prices are lower and housing rental growth is well off the top. All markets have recently been highly correlated as, to a large extent, everything is being priced off the key macro variables of inflation and economic growth, but movements within equity and bond markets are also confirming the ‘soft landing’ outlook. Credit spreads remain tight and equities with quality, growth and cyclical characteristics have been outperforming companies with ‘value’ and defensive characteristics in the US.

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

The averaging-into-bonds-on-higher-yields-strategy, combined with holding good weightings in ‘quality’ equities and a more ‘global’ approach in the equity risk components of portfolios, have both worked very well. Of course, we could have had more bonds and more equities, but we have managed to be well paid for the risk we have taken in a highly uncertain period following a year like 2022, when we really preserved client’s capital. Again, as I have observed before, it is very difficult to get both the ‘sell’ and the ‘buy’ sides of a trade right.

The Committee feels this is a good environment for bonds, why is that?

We have been of the view through this year that inflation is likely to come down more than the consensus has anticipated and hence the strategy of buying bonds as yields rose. We are now more confident that inflation will moderate further in the US which will allow markets to anticipate cuts in short term interest rates later in 2024. This, combined with our view of no recession and ‘hard landing’, makes corporate bonds a much more attractive proposition to take advantage of the yield pickup.

If interest rates stay flat or fall, what’s the upside potential on the bonds?

We don’t anticipate yields falling much but there is an increasing reinvestment risk in holding ‘short duration’ cash through 2024, as the risk is Central Banks led by the US Federal Reserve and the ECB start to cut interest rates. If markets started to believe there was a high probability of inflation returning to a c2% ‘policy target’ then returns from longer dated bonds could be very significant. Overall, the environment for bonds is much more likely to resemble the ‘Old Normal’ period of the 1970s to 2008 before Central Banks collapsed interest rates after the global financial crisis of 2008/9 and in response to the Covid pandemic.

What happens if we are wrong and interest rates increase further?

If we are wrong on interest rates and bonds, it will be because inflation indicators start to rise again, which is likely to be a result of much stronger economic growth. The thing that causes us to be optimistic on inflation while economic growth remains resilient is the growing evidence of strong underlying productivity growth in the US, led by the positive benefits of technology. Non-farm productivity growth is now rising at an annualised rate of just over 5% which means real unit wage growth is falling slightly by c -1. In essence, US corporate profitability, the labour market and household consumption can all remain strong without (crucially) interest rates having to rise to choke off inflationary growth. Incidentally, the reason why we think inflation will be much stickier in the UK and why the Bank of England will be slower to cut interest rates is the continuing poor productivity record of the UK economy. If we are wrong on inflation, then bonds now provide much more of a cushion from running yields at current prices to protect against the possibility of interest rates rising and yield curves steepening than was the case last year. So, overall, a much more interesting each way bet with the balance increasingly tipped on the side of potentially much better returns if we are right on inflation and Central Bank policy.

What’s the Committee’s view on inflation?

Hopefully it is clear we think inflation will surprise on the downside. In addition to the underlying positive productivity story at the margin, China has returned to being an exporter of lower prices to the rest of the world. We have been long-standing China sceptics on the economy as the old growth model has run out of road in the face of over reliance on debt and residential construction and against a background of an ageing population. To us the recent Xi visit to the US is a sign that the Chinese economy is under real pressure. On inflation in the ‘West’, however, all this means that China will once again be ‘exporting’ their deflation to the rest of the world. We are watching though the recent signs of China’s attempts to stimulate the economy through liquidity injections closely.

How does the Committee view equities?

Broadly positive. The profit outlook looks reasonable for 2024 and corporate cash flow in the key US economy powers ahead. A resilient economy with no hard landing and well-behaved inflation, and hence no further Central Bank tightening, combined with the tail winds of fiscal stimulus and positive productivity growth means equity returns could be surprisingly good. Our slight caution is current valuations are not cheap and are above the sorts of levels normally associated with the start of a new ‘bull’ market. We do think that the equity market will be more broadly based than has been the case this year and, therefore, think this should be a much better environment for active managers.

Without naming specific investments because we haven’t traded yet, what does the Committee think is attractive about infrastructure?

It is not so much infrastructure as overall pricing of closed end funds where the quoted prices of these companies, in many cases, are trading well below net asset values. In the scramble for yield when interest rates were so low three or four years ago, a lot of funds were launched to offer investors bond-like yields based on holdings in infrastructure and alternative energy suppliers, like solar and wind. We didn’t participate in this, but now think there are some attractive opportunities among the wreckage.

As we near the end of the year it’s a good time to reflect on 2023. In terms of the Saltus investment team or financial markets, what will you remember about this year? What was accomplished? What lessons were learned?

I remember recalling when we last spoke, at the moment of shock associated with the Hamas attack on Israel and anticipation of the likely response, that I didn’t think there had been a year since 1945 when there hadn’t been a reasonably major conflict somewhere in the world. Just look at returns over the last eight or so weeks! So, as an investor, it is important to remember that the best returns often come when everyone is pessimistic and to own equities that take advantage of the human genius for invention and the ability of the market-based capitalist system to achieve productivity enhancing benefits and returns. I obviously remember the key calls of inflation peaking and no deep recession, as these have absolutely driven returns and movements within markets. For the investment team, it is pride in managing to navigate through a lot of policy and market uncertainty, getting better at anticipating changes that affect markets and our ability to manage portfolios across a very wide range of risk profiles and the additions to the range this year in income and sustainable strategies.

What are the major investment themes to watch in 2024?

The big potential shocks of 2024 are likely to be political in nature. Looking at the polling data, the probability of a Trump presidency in the US is surprisingly high. If this were to happen, his policy agenda is very clear and, unlike his first presidency, he appears to be much better prepared with key advisors and appointees in place to implement changes as quickly as the political system allows. This agenda looks very protectionist and isolationist so, if implemented, would be very damaging to the world’s open trading system and for the other, European, members of NATO who aren’t spending enough on defence. It would also embolden Putin and the Chinese Communist Party and encourage more geo-political turmoil and uncertainty. There is also the potential for turbulence associated with the sustainability of debt-financed growth in general and fiscal deficits and US fiscal deficit in particular. There was a mini bond riot in the summer with concerns about the US fiscal position but, given the scale of borrowing at a time when the US economy is strong, which normally is associated with cyclically strong tax receipts, there is the potential for a real hiatus over the coming years. To put this in perspective, the US Treasury needs to refinance 36% of the stock of public debt over the next 18 months, in addition to a $2 trillion fiscal deficit. The US does have the enormous advantage, or the ‘exorbitant privilege’ in the words of Valerie Giscard d’Estaing, of funding in US$ - still overwhelmingly the global financing and reserve currency - but this will be a big challenge. Other countries don’t have these advantages, including the UK which is running persistently wide trade and fiscal deficits. Similarly, there remains the potential for a Eurozone blowup over debt sustainability, one of the reasons we have low exposure to the region. Ukraine, the Middle East, and Taiwan all, of course, remain real potential flashpoints. Against all this, the climate continues to warm. I have followed the scientific literature for many years, but it is increasingly clear that we are very close to an irreversible tipping point on the climate on current policies. I don’t have the room to go into all the likely outcomes, but the potential for large parts of the world to become uninhabitable is alarmingly high with all the implications for migration and economic dislocation. It isn’t going away.