7 from 7

It’s been a very busy three months. Our previous edition of Seven from 7 was produced just one week before Russia invaded Ukraine, but in many ways, investors have already moved on. It’s perhaps interesting to note that none of our questions this time have been directly related to the war, although some of the ripple effects are certainly evident in some of the questions below.

As ever, we’ve tried to be as clear as possible (although not particularly brief this quarter!).

1. Do you still believe global growth will be higher, in a world where central banks are downgrading forecasts and warning about inflation?

Ahmer Tirmizi, Senior Investment Strategist

There is a saying in finance – ‘markets can only look around one corner at a time’. Headlines tend to jump from one narrative to the next. Suffice to say, investing on this basis is not a great strategy. Worrying about the next corner often results in poor decision making – usually demonstrated by selling after the fear has already been priced in. Instead, we try to build portfolios for the longer term, looking around 3 or 4 corners.

When we look around the first corner, there are some near-term concerns. Goods producers thought we’d be at home for longer than we were, and as a result, have made too much stuff – there is almost certainly a manufacturing slowdown coming. The surge in rates is taking the steam out of the housing boom. And higher inflation is eating into strong wage gains.

But looking beyond this first corner, it looks to us that any growth slowdown is likely to be short-lived. The manufacturing slowdown is just a reversion to normal production – we overspent on goods while locked down, and now we’ll underspend for a bit. The imbalance between housing supply and demand means that the rates impact will be short-lived – people need to live somewhere! And those pent-up savings are still there, ready to supplement spending where required.

Putting it together, we believe any near-term growth slowdown will be moderate, short-lived and eventually give way to stronger growth.

2. How much higher will interest rates go, and what does that mean for our bond positioning?

Ahmer Tirmizi, Senior Investment Strategist

For a long time, central banks have kept interest rates at emergency levels. For the last four or five years, we believed the post financial-crisis emergency was over and that the economy could tolerate higher rates. We believed that the lower rates meant i) bond returns were unattractive ii) the diversification benefit of bonds were limited and iii) the downside risks of bonds were high. As a result, we moved underweight bonds and shifted portfolios towards alternatives. This view has proved to be correct over the last three years.

Clearly, central banks are now moving away from emergency levels – even the European Central Bank is looking to hike rates! As central banks look to tame inflation, bond yields have risen accordingly. The flip side of our view from the last few years is that we are starting to reconsider our underweight to bonds: i) returns are looking more attractive ii) diversification benefits are reappearing and iii) at higher yields, downside risks are lower.

The decision to buy back bonds depends on how high yields go from here. To answer this question, we need to consider at what level of interest rates will the central banks be successful in taming inflation. Our best guess is that US yields at 3% will start that process. But eventually, yields will likely creep up to +4% at some point in the next few years. If this turns out to be true, the case for adding back could be soon. In the meantime, we are looking for some evidence that inflation is starting to come down meaningfully.

3. Why is the FTSE100 performing so strongly?

Ben Kumar, Senior Investment Strategist

The FTSE 100 index – as we’ve said a lot – has very little to do with the UK economy. The top ten stocks are all large global companies, spread across a few key sectors.

There are the big energy and mining companies (Shell, BP, Glencore and Rio Tinto), as well as the large pharmaceutical businesses (AstraZeneca and GSK), and of course, a large international bank (HSBC). These represent 50% of the total index!

Table 1: FTSE 100 top ten weights and performance, Source: Bloomberg

The outperformance of the FTSE 100 vs. every other developed equity market can partly be explained by the strong performance of these individual companies, which are currently market leaders in favoured areas of the market. Rising commodity prices have boosted the drillers and miners, while strong and reliable earnings have helped the others. With the global equity market down around 17% this year, the performance of all of the businesses in the table above has been a huge boost for the FTSE 100.

But just as notable is, what’s not in the index; no large technology/internet stocks. So far in 2022, the success stories of the last few years (exemplified by the famed US FAANG stocks) have struggled in the face of rising interest rates and rising inflation expectations, leading to market volatility.

It’s not just that the biggest FTSE 100 companies are doing well, it’s that the big stocks in other areas of the world are struggling at the same time. The winners have become the losers, and vice versa.

We’ve spent a lot of time over the past few years explaining why the FTSE 100 has underperformed, and why we still hold it. Periods like the last few months help to demonstrate the benefits of diversifying.

4. What are the risks in China and how are we thinking about our emerging market allocation?

Ben Kumar, Senior Investment Strategist

There seems to be a lot of risks in China right now. We’re reasonably calm about all of them – the bigger risk is ignoring China – but it’s worth addressing why we’re not worried.

First, the risks. There’s the government regulations and scrutiny of large listed Chinese companies such as Alibaba and Tencent. Then there’s the ‘zero-tolerance’ COVID-19 policy resulting in strict lockdowns which stifle growth. Add in recent concerns over the geopolitical risks in light of Ukraine/Russia. And finally, there are the somewhat vague fears that China’s days of growth are behind it, and that the data is misleading.

We think that most of these risks are overstated and have caused an overreaction in Chinese equity prices:

• Government clampdown. The negative government intervention in the stock markets has largely stopped. The big announcements were all last year, and designed to stop a small number of Chinese companies accumulating government-like levels of power – whether through access to data or through control of communications. China won’t allow challenges to the state – and most businesses have got the message. At the same time, lots of small, more obscure policies have made it clear that the government needs strong, functioning capital markets, and is doing what it can to stimulate growth. Chinese companies aren’t going away.
• COVID-19. China is still applying the playbook from 2020; locking down huge sections of the country – with the predictable impact on growth. This isn’t something that can happen forever, though, and eventually, we believe China will join the rest of the world and abandon the ultra-strict approach. And as we know, once the lockdowns end, things bounce back quickly.
• When something happens which results in conflict, public attention naturally turns to other possible flashpoint areas, and the China-Taiwan relationship has certainly had more of the spotlight than it has for a while. But just because we’re talking more about something, doesn’t mean it’s likely to happen. And it’s difficult to see how Russia’s experience in Ukraine could have increased China’s appetite for conflict.
• China can’t (and won’t) grow like it used to in the 1990s and 2000s. But that doesn’t mean it’s slowed to a halt. Two decades of fast growth have increased the Chinese middle classes from 39 million people in 2000 to nearly 800 million people today. And those 800 million people are changing their habits – buying Chinese brands, rather than Western. The best way to access the growth of those consumers is via Chinese companies.

Chinese companies represent around one-third of the emerging market equity index, so part of our overall emerging market optimism comes from that positive view.

The Latin American and Middle Eastern/African commodity exporters are going to see strong growth domestically, and finally, get to recover from the Global Financial Crisis. The other large Asian nations – India, Taiwan and Korea – are economically stable, with some very strong domestic demand beginning to come through.

With emerging market equity prices around the same levels as they were five or six years ago, the opportunity exists for some strong returns.

5. Are mortgage-backed securities still a good bet if interest rates are going up in the US (I.e., would this not increase defaults?)

Tony Lawrence, Senior Investment Manager

We invest in so-called ‘legacy’ mortgages. These are mortgages issued before 2008 but haven’t been refinanced since. This has some important implications:

1. These mortgage borrowers kept up repayments even during the financial crisis. The recent rise in rates is a walk in the park compared to the stresses of that crisis.
2. Better yet, most of these US mortgage rates are fixed for 30-year terms (imagine!). Surging bond yields may put off new borrowers, but in the US, interest rates are locked in at the time they took it out – rising rates won’t unduly affect legacy borrowers.
3. These are bonds that have consistently been paid down for the last 15 years – the amount outstanding on each mortgage is much, much lower than pretty much all new mortgages taken out.
4. House prices are materially higher than they were in 2006-2008, when these mortgages were first taken out. And the housing supply shortage means house prices aren’t coming down any time soon. The last two points mean that loan-to-value levels are extremely low in this cohort of borrowers.
5. The job market is much tighter than a decade ago – a huge chunk of retirees plus Trump-era immigration restrictions have meant there aren’t enough jobs to go around for the number of openings there are – these mortgage borrowers aren’t about to lose their jobs any time soon.

Putting it together, the proven credit worthiness, low loan-to-value levels and low sensitivity to rates mean that legacy US mortgages are amongst the strongest credits in the world right now. We don’t believe this is an area of stress to be concerned about.

6. How have the recent market falls affected clients taking an income from their investments?

Ben Kumar, Senior Investment Strategist

It’s a question we hear often. Market declines are scary when someone is solely relying on their investment returns for their income – especially if it’s the first time they’ve been through a volatile period since retirement.

In those times, it can be reassuring to know that there’s a plan in place, which has been designed to meet income goals even through periods of market difficulty. One such strategy can include ringfencing ‘nearer-term monies’ (i.e., monies in the portfolio that will be drawn on sooner) in a lower risk profile, in order to reduce sequencing risk when taking withdrawals. Sequencing risk is essentially the danger that the timing of withdrawals will damage the overall return and capital value of your investments.

Bottom line though, the recent market movements are well within expectations, and clients are unlikely to have seen a material change in their likelihood of achieving their goals. As ever, the dangers of selling out are far greater than the dangers of staying invested!

7. How should clients think about annual guideline returns vs. current high inflation?

Ben Kumar, Senior Investment Strategist

The current level of high inflation is not a sensible one for clients to anchor to. While inflation could reach 10% in the UK this year, we think that inflation will settle lower than that; around 3-4% is a more likely level over the next decade.

And annual returns aren’t worth spending too much time worrying about either – there will always be good years and bad years for markets and predicting them exactly is impossible. Often, short periods of weak returns will push up our long-term return expectations (buying low is better than buying high!).

What we’re interested in is preserving the real value of our clients’ capital over time – regardless of the level of inflation. Our process is designed to deliver that over the long term, at a strategic level, with our tactical decisions and with our manager selection.

The past performance of investments is not a guide to future performance. The value of investments can go down as well as up and you may get back less than you originally invested. Any reference to specific instruments within this article does not constitute an investment recommendation.