Asset allocation update

How we're thinking about markets

1 June 2022

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Investment Process funnel diagram

Investment conditions

Growth (economic)

War in Europe, lockdowns in China, tougher financial conditions, and high inflation. These factors have caused the growth outlook to deteriorate and have increased the risk of recession. World GDP estimates have reduced, but remain positive and above the long-term average, estimated at 3.3% this year and next, 3.1% in 2024, reflective of a business cycle that is maturing rather than ending.

Interest rate & liquidity environment

Interest rates are rising in the West but easing in the East (China and Japan). Financial conditions have tightened markedly, especially in the US. Liquidity is falling as central banks reduce the size of their balance sheets (unwinding QE).

Valuations & earnings outlook

Given recent falls, most equities are trading more cheaply than at the start of the year. Parts of Europe and Japan look particularly cheap. However, the US market is still above long-term averages so not unambiguously cheap yet. Corporate earnings are broadly stable, despite the tougher conditions, as better quality companies appear able to pass on higher input costs thereby maintaining margins.

Sentiment / flows

Sentiment has been hit by the aggressive market repricing and the confluence of major structural themes. Cash levels amongst institutions are higher than normal, and some fund manager sentiment surveys are at all-time lows although US retail flows remain strongly positive.

Views by asset class

Equities

Equities have fallen in value since the start of the year, reducing our exposure to a neutral weight. We have decided to maintain this positioning. Our views on the asset class are described below.

Since earnings season began, expectations for US company earnings growth have been revised 1% higher, to over 10% for 2022. With positive earnings growth, low unemployment, and record cash balances for both consumers and businesses, the US has some advantages over the rest of the World, supporting the relative attractiveness of US equities. They remain our largest absolute allocation in portfolios.

We have further emphasised quality and resilience by reducing our exposure to smaller companies and adding to higher quality stocks. We expect these to outperform as the business cycle matures.

We made reductions to domestically focussed UK companies, preferring to invest in larger UK companies with more globally focussed revenues.

We continue to have low exposure to mainland Europe, which is closest to the fallout from the crisis in Ukraine.

Overall, our equity exposure is tilted towards higher-quality, and less expensive companies, compared to the global equity market.

Government bonds

We continue to avoid medium and long dated government bonds, but keep our high quality short-dated US Treasuries.

Corporate bonds

With high inflation and rising interest rates we chose to further reduce our portfolios’ exposures to corporate bonds and convertible bonds.

Investment grade and high yield bonds are beginning to look attractive, some are yielding above 7%. We continue to monitor default risks and wait for a better entry point as we are concerned about recession risks.

Alternatives

Alternative asset classes can provide protection during market falls, with returns not correlated to the rest of the portfolio. For this reason, we maintain our strongly positive view on the asset class.

We are positive on macro hedge funds which typically do well in volatile environments.

Our commodities positions have been doing well due to the rising oil price and inflation. We view future returns as asymmetric, with shorter term gains are likely to be limited compared to potential losses particularly as it has become a ‘crowded trade’. We have taken profits on some of our commodity exposures.

Overall, the environment is characterised by high uncertainty and rising recession risk so we remain generally cautious.

Summary of positioning

Below is a summary of our views for each asset class, from strongly negative (- -) to strongly positive (+ +). Arrows indicate decisions made at the most recent asset allocation committee meeting.

Asset Class

Asset class---Neutral+++
Equities X
Government bonds X
Corporate bondsX
Alternatives X
CashX

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 Asset Allocation Committee

Global growth appears to be slowing, are you worried about recession in developed markets?

Yes. The committee has been on recession watch since last summer and we would now put the probability of a recession at 30-40%. Our current thinking, however, is that any recession is likely to be relatively mild as real interest rates are still negative and bank balance sheets are generally in good shape. The risks of a deeper recession lie in high levels of debt combined with central banks over tightening which is why we are very cautious on credit.

If we do see a recession so soon after the pandemic, do policy makers have the ability to provide much assistance?

The pandemic has made this a very unusual cycle with governments and central banks providing extraordinary levels of fiscal and monetary stimulus. The latter is being withdrawn sharply, partly to try to head off inflation but also because central bankers know that they need to raise interest rates to be able to lower them again into the next recession. This is why the debate about the level and persistence of inflation is so important. At the same time western governments have much less room to ease spending as levels of borrowing have reached historically very high levels.

Have we seen the peak in inflation?

We think we are mathematically close to a peak, particularly if economic growth turns down. Crucially we don’t think inflation will return to the sort of (less than 2%) levels that prevailed in the last twenty or so years due to supply chain changes associated with de-globalisation largely involving China.

What period in history does this remind you of? What lessons can investors learn from that period?

History, of course, never repeats itself exactly but hegemonic great power transitions are always fraught with danger as the US and China are increasingly engaged in a deepening strategic rivalry exacerbated by the Ukraine war. In this sense there are potential parallels with the last great period of globalisation leading up to the First World War. The other period that is relevant today is the 1970s due to an inflation shock partly induced by higher oil and commodity prices. This caused a deep recession and at least in the UK and a big fall in equities. The lesson to me is to be wary of investors who only have experience of the very benign conditions of the last 30 or so years.

The US dollar has been rising strongly, what are the implications of this?

The $ has been appreciating due to huge capital inflows as the US has been running large current account deficits. These inflows are from investors seeing a ‘safe haven’ for their capital in an uncertain world and to take advantage of higher interest rates as the Federal Reserve is in the vanguard of the tightening cycle.

To what extent has liquidity reduced, and how does that impact financial markets?

Central banks, led by the Federal Reserve, are tightening liquidity quite sharply, as we have been signalling for some time, to head off inflation. Liquidity really matters for financial market pricing, for example, p/e ratios. As liquidity is withdrawn it becomes much more difficult to get funding for risky ventures which is partly why we think credit spreads will widen further.

What is your view on China? Is it investable right now?

It is a question that is increasingly being asked by investors given the known behaviour of the Chinese regime around human rights and their attitude to external financial investors who have been spooked by often arbitrary changes to the rules. That said Chinese equities have de-rated sharply and are relatively cheap in a historic context. In my view China won’t be really attractive again until they develop a new long term growth model to replace the one, based on exporting and property debt, that served the country so well in the last 40 years. There are signs that a new growth model will be heavily based on renewables.

Germany looks more exposed than most to the situation in Ukraine, are you concerned about the German economy and its impact on investment conditions in Europe?

Germany is exposed on two counts: firstly they are very big importers of Russian hydro carbons and secondly the largely manufacturing-based economy is very exposed to the slowdown in China. Germany remains the largest and dominant economy in Europe but there are parallels with China in the sense that the country will need to make big strategic changes to its economy to reduce dependence on Russian oil and exports to China based on, for Germany, a very cheap Euro exchange rate. Overall Europe’s proximity to Ukraine increases vulnerability and in terms of finance EU-area banks’ balance sheets are less strong than in, for example, the US.

Manager in focus: Royal London Global Equity Select

This fund aims to deliver long-term capital growth by investing in a portfolio of global equities, diversified by country, sector and life cycle.

It does this by using a rigorous investment process that has been refined over 20 years.

Investment process

“The investment philosophy of the Global Equity Team has been utilised since the early 2000s. It seeks to deliver favourable performance through superior stock-picking, a differentiated investment process and proprietary technology.

The team’s Economic Return Framework and Corporate Life Cycle Concept form the basis of their approach and provide a high-quality set of data that can be used to identify and evaluate companies which are both creating wealth for equity shareholders and that are fundamentally undervalued. They believe that corporate returns on productive capital and growth tend to progress along a life cycle that moves companies through the following stages:

  • Accelerating – heavy investment to promote growth
  • Compounding – a potential “sweet spot” for global equity investing characterised by high returns and rapid growth
  • Slowing & maturing – Returns defended against increasing competition
  • Mature – in the long-run most businesses become mature, earning productive returns around their cost of capital
  • Turnaround – Restructuring to improve returns and avoid failure

The team uses the Shareholder Wealth Creation Test to identify companies that are creating good shareholder wealth. The drivers for this are very different depending on what stage of the cycle the company is in. These companies then progress to the Fundamental Analysis and Valuation stage of the process, during which the team performs more detailed fundamental analysis. The aim is to identify companies with the strongest evidence of long-term wealth creation and then value them. The companies with the most attractive combination of wealth creation and valuation form the idea pool from which the portfolios are constructed.” (Source: Royal London website)

The managers

The fund is managed by Peter Rutter (Head of Global Equities), Will Kenney and James Clarke (Senior Portfolio Managers). They have worked together for about 20 years, at Royal London (since 2017), Waverton Investment Management, IronBridge, and Deutsche Asset Management.

Environmental, Social & Governance (“ESG”)

Like many strategies within our portfolios, this fund considers “ESG” factors an important part of its investment process, even though it is not an “ESG” fund.

ESG analysis is firmly embedded into the investment process. Company specific ESG and climate analysis is captured and recorded at the qualitative Wealth Creation stage of the process. Although ESG data from providers are contained in the quantitative data layer and form a part of their quantitative scoring, they recognise that most of this data is incomplete, inconsistent, and often based on unstable subjective analysis. They consider governance as part of the management factors and E&S in the internal and external factors. ESG factors are also taken into account in their discounted cash-flow analysis e.g. carbon tax can be explicitly built into forecasts.

Poor quality third party ESG analysis and data in more complex ESG situations may create opportunities for the team. This is particularly the case in areas of ‘positive change’ around ESG issues, where a company’s ESG credentials may currently be misperceived by the market. In addition, third-party ESG ratings are often conducted without any understanding of the investor context or forward-looking strategy of a business. These market inefficiencies are often exploited.

Performance

The long-term performance of the fund has been excellent. What stands out is the consistency of outperformance, as the strategy has performed well in all market environments (rising and falling, and value and growth rallies), highlighting its core nature.

Saltus investment case

  • The investment process is rigorous and repeatable. Each step is clear and has proven to add value to the portfolio
  • Impressive team who have worked together for many years
  • Consistent outperformance in a variety of market conditions (rising, falling, “value” winning or “growth” winning)
  • The fund has an upside downside capture ratio of 1.4, this shows it has been able to protect capital when stocks fall globally, but outperforms when stocks rise

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.

Royal London fund chart

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:

Saltus Asset Management is a trading name of Saltus Partners LLP which is authorised and regulated by the financial conduct authority. Information is correct to the best of our understanding as at the date of publication. Nothing within this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less than you invested.

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