258. How to deliver consistent income in difficult markets

25 May 2023 (pre-recorded 15 May 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the ‘Investing on the go’ podcast brought to you by FundCalibre. In today’s episode, we delve into the fascinating world of global multi-asset funds, exploring themes that are at the forefront of investment discussions, including the role of big government, the impact of globalisation, navigating inflationary pressures and the potential of alternative assets.

Chris Salih (CS): I’m Chris Salih, and today we’re joined by Paul Flood who manages the BNY Mellon Multi-Asset Income fund, a fund that’s recently been given an Elite Rating by FundCalibre.com. Thanks for joining us today, Paul.

Paul Flood (PF): Thanks very much for having us.

[INTERVIEW]

CS: Let’s give a bit of an intro to the fund, given it’s recently been added to our Elite list. So, clearly you’ve managed this portfolio through a very busy and challenging time in markets – we’ve had the likes of Brexit and the pandemic. In that climate, you have been tasked with delivering a consistent income. Could you maybe talk us through how you’ve managed to achieve that, and do you have to look at things differently through an income prism?

PF: Well, yes. I mean, since the fund was launched back in 2015, we’ve obviously had a couple of very challenging periods for income investors, and as you mentioned, firstly Brexit and then the pandemic where we saw lots of companies cutting their dividends to preserve cash, you know, which wasn’t great for income investors, clearly. But to help avoid these situations, we’ve really focused our investment process around what we are trying to achieve for clients, which is, in essence based on providing a stable and consistent income – pennies per share, pounds in pockets – rather than focusing on just say, a high yield that can result in chasing income and buying into investments to undermine what you’re ultimately trying to achieve for the end investor, and lead you to paying out income at the expense of capital.

CS: Let’s maybe take a sort of general step back and look at the portfolio on a wider sphere. You have a number of long-term thematic trends that run through the portfolio. Can you talk us through a few of them, well, talk us through all of them really, and just give us a bit of an insight on how they benefit investors and how you go about identifying these trends?

PF: Yeah, we certainly can do. I mean, to go through all of them would take quite a while, so maybe pick off a few of them. But themes are incredibly relevant for us. We want to be in areas where there are long-term structural tailwinds and avoid areas that face significant headwinds. And that’s ultimately what themes are broadly trying to achieve.

Our macro themes, we tend to split our thematic views from macro to micro, and macro themes tend to inform us about the asset allocation related topics. And our micro themes are much more oriented to industry and company specific opportunities. A good example of the macro discussion include big government, as we move away from our reliance on exporting jobs and manufacturing into low cost areas and focus more on great power competition. A great example of the micro thematic exposures at Newton as our natural capital theme, that ultimately evolved from our previous team, which was called Earth Matters, which came about way back in 2005 due to our concerns on global warming, so well before kind of everybody got up to speed on that over the last three to five years going through the pandemic.

As we came through the pandemic, it was clear to everyone in the investment community that, you know, the earth did matter. And so, we’ve evolved that team to natural capital to indicate we’ve moved on and we’re looking for the areas that benefit from significant capital spending requirements to help us meet our goals of reducing the human impact on climate change. You know, that’s things like, you know, EVs, renewables, energy efficiency and underlying that natural capital theme, we’ve also evolved some of the underlying themes there, the sub-themes such as clean energy which has evolved to decarbonisation to indicate it’s not just about solar and wind farms [but] there are other, many other methods in which we can reduce our carbon emissions.

And a great example of that for instance is buildings which make up 25% of global carbon emissions which comes effectively just from heating and ventilating our offices. So, if we can find ways to reduce the carbon intensity of this, then we can also help meet our carbon goals. So, you know, new heating and ventilation or HVAC (heating, ventilation and air conditioning) systems are 20 to 30% more efficient than the legacy systems. So, just upgrading HVAC systems, you can have a material effect on carbon emissions in a higher power price environment and a payback period and upgrading your HVAC system is much shorter now. So, this leads to companies like Trane Technologies, which is one of the investments we have, which is one of the leaders in HVAC systems, where we think they have a long runway where HVAC installation, as management teams of corporations are under intense pressure to reduce their lifetime carbon emissions and disclose carbon emissions, and an easy way to start on reducing your carbon emissions is just to upgrade your HVAC systems. But it also makes financial sense to do so, given the better energy efficiencies and higher power price environment that we’re currently in.

CS: And just for listeners, one of the themes that perhaps is quite relevant in the market today is obviously the idea of de-globalisation. I mean, that’s something a lot of investors will have heard about, perhaps don’t understand the longer-term implications. Could you talk us through that? I mean, is that a relatively new theme for you? How does that work out in practice? Just give us a run through of how that theme is sort of being used in the portfolio at the moment.

PF: Yes, I mean, that’s, you know, one of the big themes that really helps with I guess the views on asset allocations and in particular inflation, and it’s one of the core components of our views or our theme on big government and great power competition. You know, as governments in the West look to move away and solely focused on the low costs, they’re more likely to be looking away from countries that don’t have the same priorities and values that we do, and that’s all about security. And that’s leading to a lot of tension with trade wars and tech wars.

And essentially over the last couple of decades, we’ve really benefited from the deflationary effects of globalisation. And so if we’re moving into a world where perhaps there is less globalisation, even if we stop globalisation, that will be somewhat inflationary going forward because we won’t be benefiting from those lower cost manufacturing centres. And so, therefore the level of inflation relative to what we’ve seen over the last couple of decades will be slightly more elevated.

Now, if we look towards really de-globalisation, then that’s likely to be somewhat more inflationary because we’ll be trying to not just stop exporting some of the high-cost jobs to low-cost areas, but we’ll be trying to re-onshore – or friend-shore as they call it – back into Western economies. And we’re just … it’s just a higher labour cost, higher cost base to be doing things in the West. And so, we’re going to have to try and find ways as to reduce the impact of those higher costs.

CS: Okay. And just as a bit of a backdrop before we move on, obviously this isn’t just, you know, a couple of you in a room. This is using the full wider powers of BNY as a business and Newton as a business. Could you maybe just talk us through the sort of team you have in the background that helps you with these decisions?

PF: Yeah, so, we’ve got a very much a kind of multi-dimensional investment process at Newton. So, we’ve got a huge number of analysts and they’re very much focused on trying to find the best ideas in their coverage. And they recommend securities to us, portfolio management team and a multi-asset desk –  there’s eight of us that are looking after our portfolios – and we’re just trying to pick from that menu of ideas, the best companies that suit the risk and reward process for each of the funds that we manage, and clearly, for the multi-asset income strategy, we’re very much focused on the stability of income and we want to ensure that income can be delivered in an environment if it’s even tough times for income.

So, we very much have to have a focus on that multi-dimensional research function. And that includes, you know, having forensic accounting exposures that can really delve into the accounts of some of the companies that we’re invested in. But also, out in San Francisco, we’ve got our systematic team who’s very much using quantitative processes to try and develop tools that can help try and look at where we think markets and economies are going. And that can help with our stock selection, industry selection and asset allocation views. And it’ll all feed into ultimately the individual security selection.

CS: You mentioned markets and views. I mean, change is the big word in the markets at the moment. We’ve seen a lot of change in the last 12 months with the rise of inflation. Obviously, bonds have also come back into vogue. Throughout the life of this fund, it’s had a reasonable allocation to alternatives as a way of sort of offering a diverse sort of stream of income to investors at a time when there’s been a lot of dearth, but that change in environment has perhaps brought bonds back into focus as an opportunity. I guess, talk us through what you’ve been doing and, you know, looking, looking a bit deeper, are alternatives essentially as essential as they once were within a portfolio now, given bonds are more attractive?

PF: I mean the great thing about some of the alternative asset classes is the inflation protection that they provide. But within the portfolios, clearly, we’ve gone from a world in which we could get no return, in fact, we had negative return from many parts of the bond market over the last decade  – particularly the last five years – and so, we’ve had very low allocations to bonds and quite high allocations to alternatives. And clearly that really worked last year in 2022 because bonds and equity sold off in unison. And we were somewhat protected against that because our investment process was very much focused on trying to find attractive opportunities.

You know, ultimately, we do multi-asset very differently than a lot of other people do multi-asset in that we’re essentially investors, not asset allocators. And so, all of the securities are individually selected rather than, you know, carving out our equity portfolios and giving it to an equity team and our bonds to our bond team. And so that really brought into focus, you know, the types of securities we wanted to own, and very few of those securities were in the bond market because on a forward-looking basis, we felt they offered very little in the way of return and very little in the way of diversification for a multi-asset portfolio.

Now as you mentioned, you know, that backdrop has changed quite significantly over the last 12 months. And so, we’ve gone from at the beginning of last year, owning just over 10% in bonds to now owning just under 30% in bonds. So, quite a material shift in the allocation to bonds. And then unlike a lot of the headlines that we see, you know, ‘The 60/40 portfolio is dead’, we very much believe it’s more like the rebirth of the 60/40 [60% of the portfolio in equities, and 40% in fixed income].

And bonds are now buyable again. You offer a return and going forward, given all of the concerns on inflation that are now out there in the investment community, we think that bonds will be much better diversifiers against equities within the portfolio construction process because they’ll be you know, the inflation concerns are very much in the price and we think they’re much more likely now, particularly in the government bond market, which is where we’ve allocated a large proportion of that increase to bonds, they’re much more likely to offer diversification and be focused on the growth outlook rather than the inflation outlook.

CS: That bond exposure obviously has come at the expense of alternatives, but you are by no means sort of, you know, kicking them out of the house with all their luggage, you’re still very much interested in them as a diverse income stream. Can you maybe give us a couple of examples of a couple of asset classes that offer, for example, that inflation protection that you are really keen on at the moment?

PF: Yeah, I mean, ultimately a lot of what we invest in, I mean, alternatives is a very broad church. But much of what we’re invested in and interested in is really that kind of real asset exposure. Things that  either have inflation-linked revenue streams or those real assets that tend to do well when inflation starts to pick up.

Now unfortunately, you know, real estate’s not one of those in that they do have inflation linkage in terms of their rental streams, but that’s only going to survive if your tenants can afford to pay that increased rent. And when inflation is very high, it becomes increasingly unlikely that those contracts will hold.

But we’re much more interested in things like renewable energy where, you know, you’ve got fixed inflation-linked revenue streams. There’s this huge demand to decarbonise our power generation. And we like to be in areas where there’s demand for capital. And you know, when you look at some of the numbers, you know, trying to decarbonise our economies, we’re looking at spending up to 50 trillion dollars. And then when we started talking about this many years ago, you know, we were thinking 5 trillion dollars was an extremely big number, and now we’re 10 times that number today in terms of the expectations or consensus expectations of the amount of capital that has to go into the ground to help with the decarbonisation efforts now. So, that’s a massive tailwind for companies in those areas.

But importantly for us, when we look at renewable energy assets, particularly within the UK context, these are operational assets which in many respects do something similar to bonds in the portfolio in that they deliver very stable kind of income streams. So, they’re very bond-like in nature, but they also have that inflation protection because the contracts with governments are fixed and inflation-linked and they are a large proportion of the overall revenues of the business. So, we do think that real assets such as renewables … so, we certainly don’t think we’re going to kick the baby out with the bathwater! What’s interesting here is bonds are just competing much more effectively for our investors’ capital. So, it’s right that we reallocate away from the alternatives when I guess the valuations across markets have changed.

But in terms of, if you’re looking at the thematic backdrop, which we believe, you know, as we come through to the back end of this year, you know, deflation might be the word that’s printed in the press and that people will start talking about again. But in the longer term, if we are looking to reduce our globalisation efforts and are much more focused on security of supply of some of these key components, that will have a more inflationary effect and therefore you’re going to want to have some real assets in the portfolio for those periods when inflation picks up and bonds do less well. So, from a portfolio construction process, they are a uniquely diversifying asset class to have in the portfolio.

CS: Let’s go straight on o that because I was going to ask you about deflation because we talked before, and we mentioned how that could be a word that takes up a lot of column inches by the end of this year. If we do get to that scenario, and maybe you can give us an idea of how likely you think that is, does that make a material impact on the state of your portfolio today? Ie. are bonds going to be worth a lot less? Just give us some insight on how much change you’d have to do, should that happen.

PF: Yeah, so I mean it’s very similar. I mean, one of the things we talk about a lot – particularly for the multi-asset income strategy – is we’re trying to find securities that can pay and grow their income streams. And if we can find those companies, then the capital should look after itself. And then, you know, alongside that, you’re organically growing your income through the dividend growth of some of these faster growing companies. But if we can then get the opportunities when markets are volatile to make asset allocation shifts, then we should also be able to increase our dividends for shareholders through that process as well, as we reallocate from, you know, areas that have done well, and therefore yields have fallen as prices have risen, to areas that have done less well, and therefore incomes have risen as prices have fallen. And that’s key to the investment process as we go through the cycle is that asset allocation process, and not being constrained with fixed asset class weights.

And so, as you know, we talk about, you know, what are the chances of this happening? Well, particularly in a UK context, you know, the year-on-year oil price effect; the oil price was much higher last year than it is this year, so that’s now a negative contributor towards inflation. Central banks are very concerned about bringing inflation back down again. So, the likelihood is they’re going to keep interest rates higher for longer. And particularly in the United States, given the banking situation, that in itself is having a credit-tightening mechanism as credit standards have risen from the US banking sector and that’ll create some constriction within the economy.

But some of these effects will take nine to 12 months to be brought through. And if you are slowing down the economy through those credit situations, but also having a negative year-on-year effect with oil price in the UK, you look to the LDI crisis* at the back end of last year – well, back then, you know, sterling was at 105 to the dollar, we’re now up at 125. So, year-on-year, that will have a deflationary impact as well as the cost of our imports falls on a year-on-year basis. And so, I think a lot of investors will be quite surprised at how fast inflation comes down at the back end of the year. As well, you know, policy makers have continued to see inflation as a key thing. They don’t want to lift the foot off the gas, because we’ve had a couple of times already where we’ve seen some indications that inflation is going to start coming down and then it’s picked up again. So, central banks really want to get the service sector inflation down and that’s about resetting, I guess, wage inflation expectations.

[*Liability-driven investing, or LDI, focuses investment policy and asset allocation decisions on matching the current and future liabilities of the pension plan. The LDI crisis in September 2022 came about when many pension schemes did not have sufficient liquid assets to meet their provider’s (very urgent) collateral calls to increase the “cushion” requested by the Bank of England]

And I think as we go through the year, that’s what central banks will be very much focused on and that will entail getting unemployment up to the point where people worry more about having a job than having a wage rise. And so, that should bring some of the inflation off in the shorter term. But given the large allocation we have to government bonds, we think they should do quite well through that period as people start worrying more about deflation than inflation. And that will then be the time to rotate back into some of those inflation-linked assets as people think they have less need for them in their portfolio.

CS: And just lastly, to sort of bring it all together, you know, we’ve talked about the number of asset classes you invest in, the various types of assets you invest in and the sheer size of the team that supports the fund: how do you manage a fund in a period like this where there is a lot of uncertainty? We’ve talked about deflation, inflation, we haven’t even really gone into recession yet. Do you run the portfolio with like a set position that’s ready for anything? Do you have to take a position on markets when you build the portfolio or are you sort of ready for any scenario? Is the portfolio built to take that sort of attrition of change in market conditions?

PF: Well, I mean it’s very difficult because you know, we don’t have the crystal ball, so we never know what exactly is going to happen! And that’s one of the things I’m very focused on reiterating to the team, is let’s not try and bet the house on one backdrop, let’s try and have a range of outcomes where we think we will do well in many of those outcomes and try and bias our opportunities into the areas with the highest probabilities of success.

What we want to do is keep an open mind. And where we are most likely to benefit is when there are extreme changes in the marketplace. And that will allow us to pick up opportunities when others are fearful. And so the investment philosophy that we have, it kind of turns investment on its head.

Because what we’re looking for is very different from what other people are looking for. Absolute return investors are very much focused on locking down capital when markets are volatile. Relative return investors are really focused on outperforming an index. What we are trying to achieve is an outcome that’s very much income-orientated, where we can provide clients [with] the confidence that year in, year out, we will provide a stable and growing income for them, whether that’s for retirement, whether that’s because they believe in the power of compounding. And what we need to avoid is investing in areas where the income becomes susceptible to a downturn, when the hard times lead to dividend cuts and income cuts because that’s the most important time for us, you know, because that’s when our clients really need the income as perhaps other income sources of income have dried up.

It’s when the power of compounding is at its best because you’ll be in an area where you can reinvest into low valuations that will power your wealth creation over the longer term. So, it’s not just for people that need an income, it’s also a way of investing. And so, if you can find the companies that you have a high degree of confidence in, that will pay the income in a downturn, then you can reinvest that income and really power the long-term wealth creation. And, you know, unique[ly] in the income space, we’re very fortunate that we’re very focused on that income orientation because as we went through the pandemic, we saw lots of dividend cuts from companies trying to shore up their balance sheets and conserve cash. Whereas we were invested in areas that were growing their dividends going through the pandemic.

So, whilst we weren’t immune to dividend cuts, we did provide a stable income for investors going through that period where a lot of income funds, particularly UK income funds, saw dividend cuts for as much as 30%.

So, having an investment philosophy very much focused on ensuring you can achieve what you set out to achieve, is important to avoid the behavioural biases of buying and selling at the wrong times. It’s the great thing about being global and multi-asset, we are just waiting for something to happen in the marketplace that we can take the opportunity to invest in. The key to that is making sure you’re well-diversified and you’re not overexposed to any one characteristic or any asset class.

CS: That’s great. Paul, thank you very much for giving us an intro to the fund. I certainly agree on the compounding point you made as well. I still think a lot of people overlook that, but we appreciate your time today and for speaking to us.

PF: Thank you very much for having us.

SW: The BNY Mellon Multi-Asset Income fund offers investors an unconstrained and flexible approach – and as we’ve heard today – takes advantage of Newton’s extensive resources. This approach provides a stable and expanding income stream, as well as the potential for capital appreciation. To learn more about the BNY Mellon Multi-Asset Income fund visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.