297. From Goldilocks to recession: the polarising outlook for 2024

18 January 2024 (pre-recorded 17 January 2024)

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.

[NTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we’re exploring the likelihood of a recession and the factors influence global markets covering equities, fixed income and real assets in this multi-asset fund.

Chris Salih (CS): I’m Chris Salih, and today we’re joined by James Mee, manager of the Elite Rated Waverton Multi-Asset Income fund. James, thank you for joining us once again.

James Mee (JM): Thanks for having me.

[INTERVIEW]

CS: So, we’ve spoken a couple of times last year, we did a podcast and I think we also spoke towards the end of 2023. The last time we talked, you were of the view that recession is perhaps possible rather than probable, and that we are likely to see a slowdown. I mean, a few months on from that, has your view changed? I mean, how likely is a recession this year? Where do you see the push and pull factors on markets as we stand?

JM: Yeah, so I think the first thing to say is, we need to distinguish between the US and the rest. A lot of what we talked about last year was US-related. I think we could probably give a little bit more detail than that as we look out into this year.

In the US, I think we’re probably unlikely to see a recession over the next 12 months. Famous last words, but let’s see!

But you know, I think we’re coming out of a manufacturing recession in the US which is generally under reported. The consumer remains resilient. They’re less rate sensitive, certainly than we are over this side of the pond. They’ve termed out their debts, their mortgages are fixed for 30 years. In fact it’s pretty under reported that the interest costs for US consumers and households are actually negative.

So, what do I mean by that? As rates have risen, they receive more on the savings that they have and they hold than they’re paying out in their interest. Balance sheets are solid, nominal wage growth is still positive, we have positive real wages. So I think the consumer’s still fairly well supported today. I don’t expect government spending to come down materially in the US in an election year. Net exports are supported by flat currency, so that’s pretty solid for the US, and they’re supported by secular tailwinds, re-shoring, investing and securing their own supply chains, et cetera, et cetera. So I think the US are unlikely to see [a recession] – unless anything materially changes.

In the UK and Europe, I think we’re probably in recession now or certainly in very low or anaemic growth. We’re much more rate sensitive over this side of the pond, less so than we were in previous cycles. So, we have fixed mortgages for longer terms. But one and a half, I think it’s 1.4 million mortgages roll off their fixed terms over the next 12 months in the UK. So, we’re more rate sensitive in general. Inflation’s higher in the UK. Early reports of Christmas spending that we’re seeing from companies, it’s been pretty mixed with signs that the mid-market <inaudible> consumer is weaker.

China is the wild card, I think, flirting with outright deflation, suffering from balance sheet recession, property market decline and so on. So, US and the rest.

And then I’d also say that we need to distinguish between recessions and recessions. It’s not necessarily that we go into recession, it’s how severe that recession is. And if we were to go into recession, either in the US or elsewhere, central banks have significantly more firepower today at roughly 5% rates that they can cut than they did going into Covid when we were there or thereabouts zero. And from a market perspective, a lot of markets ex-US, are not expensive. And they’re pricing a lot of this downside already. If you look at the UK, it’s 10-11 times earnings, Europe’s 13 times earnings. So, it’s reflected in markets to some extent.

CS: When you turn that to the positioning of the fund, I mean, how do you make a call on that? Because there’s an awful lot of data going on there. It’s an awful lot of dispersion going on there between what you’ve said the US and this potential Goldilocks scenario versus other parts of the world against 2024. I mean, how do you break that down? For example, is market leadership going to be a lot broader than just seven stocks that have AI themes running through them? You know, give us an idea of how you go about plotting a portfolio in that sort of climate, with that outlook.

JM: Yeah, I think it’s a good way to phrase it, how are you positioned. I agree with you, I think the US has been in a Goldilocks environment of declining inflation growth, 2% – 4% real, impossible to predict really with any significance what’s going to happen over the next 12 months. But as I say, there’s a lot of pessimism in the market. So, when you’re looking at allocating the fund, how are we allocated within equities? We tend to be underweight US. We tend to be underweight big tech / Magnificent Seven names – if we own them at all. And we tend to be overweight Europe, Japan, UK, which is where we’re finding opportunities from a bottom-up perspective.

As I say, the best way to answer that question, it’s a very well phrased, is to look at positioning. So, today we’re 50% in equity in the fund; that is bang in line with our 10-year average since inception of the fund. We started last year with 42% – 43%. We took more equity and other risks as we went through the year and as the data changed last year – and that’s how we manage money is we update the positioning as the data changes – 20% fixed income, and within fixed income we’re longer duration, and then 20% alternatives, which is predominantly in real assets.

CS: Okay. Well, let’s take each of the last two in turn. So I want to start with the fixed income. because 2023 was a rollercoaster for fixed income and I just want to get a view really on, well, your view on it really, for lack of a better way of explaining it and how that heads into 2024? You mentioned 20% exposure, it’s more the longer end of the duration side of things. Just go into how do you see that, are you bullish? Do you think you’ll potentially be adding to that this year? And just a bit more insight on that, please.

JM: Yeah, so from the fixed income side, it was a real driver of performance in Q4 for sure. The long duration stance that we held throughout the year and that we maintained throughout the year – and we took it in various different ways, different currencies US, UK, dollar, sterling, we had options as well – really it came good in Q4, the long duration stance we maintain. So, I think the easy moves were probably had in the decline in inflation into year-end. But the way we see it and the way we think about our fixed income allocation in a multi-asset portfolio is, it’s there to protect capital, certainly how we’re allocated at the moment with longer duration. So, our duration today is about nine years. So, for a percentage point move in the yield, you get a 9% – 10% percentage point increase in the price.

The way we see it today is if we think over this side in the UK and in Europe, if we see a recession, which you would expect to be consumer demand destructive, we would expect inflation to come down, we would expect yields to come down. And so a longer duration stance in the gilts part of the market where we’re allocated would favour the fund.

If we see inflation higher – and we had a print today that missed, if you like, so, it was higher than expectations – then short-term rates are higher, longer-term inflation expectations actually come down and, over time, yields come down and while rates stay higher for longer, you’re also more likely to lead into a recession, which as I say is consumer demand destructive. So, on any reasonable time horizon for a position like this one to three years, I think long duration remains suitable.

CS: Okay. I will come back to inflation in a moment because obviously the news this week. I want to round off by looking a bit more at the alternative side of the bucket and the real assets. You’ve said recently to me, I think it was in Q4, that you were finding quite a number of opportunities in that specific part of the market. Could you maybe just give us a few examples?

JM: Yeah, so we have roughly 20% allocation to real assets. What do I mean by real assets? Property, infrastructure, specialist lending, asset finance commodities is how we segment it. And in this, if you put it all together, call it real assets, it’s been a very tough two years. So, last year – notwithstanding a tough two years in general and on aggregate actually finished up and the positions that we own finished up, and we’ve been talking about value that we see in the space for at least two years now; we do our own work, we model the underlying, we go and meet management, the board, site visits, et cetera, so it’s proper fundamental research to understand what we own and to build the net asset value from first principles – it was very encouraging last year then to see some of the value that we see in the businesses and we see in the net asset values actually crystallise.

So Industrials REIT was a name that we owned. It was our real winner last year. It was acquired at a 44% – 45% premium to the share price on the day that it was announced on a small premium to the NAV in June. And it highlights the value – we think – the value on offer, particularly off the beaten track of that traditional commercial property space. So, the sort of retail [space] still facing headwinds, office [space] more recently facing headwinds. And we also think that it highlights the importance of doing the work from the bottom up and really understanding what you own.

In terms of what we own today – that’s [Industrials REIT] is obviously out of the portfolio now – in terms of what we own today that we’re excited about, again, this is something I’ve written about and spoken about before, but it’s PRS REIT. They provide newly-built family homes, private rental market in the UK. They’ve got a portfolio of 5,000 homes. They have a 97% occupancy rate, which is extremely high. Rent collection is 99% and compares very favourably to other parts of the property sector. And because of the demand for the product, they’re actually able to raise rents 5% – 10% per annum, depending whether you are an existing customer or whether you are a new customer, notwithstanding a cost of living crisis.

And actually that’s something we were writing about 18 months ago or so. The quality of the tenants actually has been improving because the demand for the product has been rising because we have been in times of tighter budgets, and yet the shares trade at just under a 30% discount to the company’s quoted NAV. Even if you take a haircut on that NAV, a reasonable haircut, you’ve still got a 20% upside just from the discount narrowing. And on top of that, we’re expecting to receive dividends and some NAV growth over time.

CS: Just quickly off the back of that, are you having to be quite sharp and in terms of your active fund management nature in terms of grabbing those discounts when they’re there? Because they have bounced around quite a bit in the past few years.

JM: They have, but they have been fairly persistent in the property space in particular where there’s a big cost of capital question and a discount rate question. We are active where opportunities present themselves. Another example is 3i Infrastructure that has traded out to a 10 plus percentage point discount in the last few days. We think that’s anomalous. We don’t think it’s befitting of an outstanding management team with an outstanding track record and we’ve been topping up our position there. So, you have to try and be quite nimble in those opportunities. But you know, I wouldn’t say we trade around these names particularly. We usually do the work, know what we own, and then we will own it for the very long term. Actually, 3i Infrastructure is a good example. We launched this fund just under 10 years ago and we’ve owned that for the whole period. So we tend to be buy and hold and we will manage our position around it.

CS: I just wanted to quickly talk about inflation, because obviously we see it tick up ever so slightly this week. We did talk a couple of months back about inflation where you said that falling back to 2% would be very good news on the fund. For the listeners, just explain why in a nutshell that would be the case.

JM: Yeah. I can’t remember exactly when I said that, but essentially it depends what’s priced into the market at the time. So, if the market’s expecting high and rising inflation, by extension probably high and rising rates higher for longer, et cetera, which was the narrative for much of last year, risk assets and long duration assets tend to be cheaper. The price will have already come off. If inflation then transpires to have been transitory after all, the reverse tends to be true to some extent, perhaps not to the same extent that would be seen as weakness, but certainly to some extent. And that’s actually what we saw in Q4.

And then if we think about the fund specifically, we’ve kind of touched on this already, lower inflation, lower yields will be positive for bonds. 20% of the fund, as I say, we’re carrying nine years duration. Real assets directly from a duration perspective – we tend to have duration in our core names – so, in the real asset space, long-term predictable, often contracted, often inflation-linked cashflow streams, they tend to have a higher duration and will behave more akin to you know, a long gilt and indirectly.

So, some of the shorter duration assets, PRS is a good example, they have a cost of debt and a cost of capital issue, and so inflation coming down, rates and rate expectations coming down should benefit those names. And then in equities from a portfolio perspective, inflation down, rates down makes cash less interesting. It’s not how we think about things per se in terms of portfolio construction buy cash or not cash, but you know, that’s traditional theory is if rates come down on cash, you get pushed into fixed income securities and further out on the risk curve and investment grade high yield and then into equities. And you know, to some extent that is real. There’ll be a re-rating from an oversold position, duration in the most popular parts of the equity market – you know, that sort of “growth style” where a lot of value in the business tends to be tied up in longer-term cash flows. They also have a duration tailwind as well when inflation and rates come down.

I would just say though, I think that the major move here really has happened. The market’s no longer discounting higher for longer. In fact you know, in the US we’re expecting or the market’s expecting 1.5% interest rate cuts as we go through this year. So, you know, the major part of that tailwind I would argue coming into the end of 2023, really has been had; from here, it’s much more about company fundamentals and knowing what you own.

CS: Might be slightly off-piste here, but you talked about cash sheet, I believe you had around 10% in cash in the fund a couple of months back. [JM: Yep.] Given that move you’ve just talked about there, have you been trying or thinking about deploying that, given that change of environment?

JM: Yeah, so we do look to deploy cash opportunistically. We spend the vast majority of our time doing bottom-up work. And so where we do deploy it, it’s where we’re finding opportunities. I finished the investor letter for 2023 last week, and what I wrote in there is while we became incrementally more positive as we went through the year and moved the fund around, as I said, added to risk, there are still some major risks out there.

Ones that we know about political, is that there will be the most democratic elections by number in a single year ever this year. You know, there is almost by definition uncertainty off the back of that. From a geopolitical perspective, you have the Taiwan issue, war in Ukraine, Middle East – new alliances seem to be being drawn up all the time with what’s going on with missile strikes in the Middle East at the moment. From a market concentration perspective, it just adds risk.

The US equity market is over 60% of the global equity market. The Magnificent Seven make up 28% of the S&P 500 and quite astonishingly, those seven companies are now roughly the same size as the whole of the Japanese, UK, French, Chinese, and Canadian listed markets combined. So they’re the known unknowns – or a few of them.

And then of course you have the unknown unknowns, so it’s not without risk out there. We are receiving 5% daily accrued income as we sweat the cash. And so, while we have a total return mindset as a fund, we do pay out the income we receive and so receiving 5% on an annualised basis is supporting that.

CS: I was going to say it’s the sort of timely reminder that cash in itself is an asset class in an environment like this.

JM: Absolutely. Absolutely.

CS: I just wanted to finish by talking about one of the themes which you have talked to us about in the past, which is obviously de-globalisation. That ties in nicely with what’s happened with Covid, all the geopolitical stuff we’re seeing at the moment amongst other things. One of the companies you’ve recently added is called Canadian Pacific Kansas City which is a beneficiary of re-shoring and digs into that theme of de-globalisation. Just give us a bit of a run through of why you’ve done that and tie in that theme of de-globalisation and how it benefits please.

JM: Yeah, yeah, happy to. I’d start by saying we’re not thematic investors as a fund or as a house. We look for best ideas for long-term investments across asset classes. That said, re-shoring is one of the few secular themes that we think will play out over decades, energy transition and security being another one. So, it’s part of the investment thesis, but it’s not the full investment thesis.

In terms of Canadian Pacific Kansas City Southern as it’s called now, or CP as I’ll call it, CP is one half of a Canadian Class 1, so large railway duopoly. Following the acquisition of Kansas City Southern last year, completed last year, it now operates a unique T-shaped network across the top of the continent: across Canada, coast to coast and down the middle of the US down into Mexico and the South. And we think that this network will give them the competitive advantage, which will play out over many years.

The North American rail industry in aggregate itself is somewhat tied to nominally GDP growth. So, you know, we make an assumption that this will grow to the tune of 4% on average. If you couple this with the on-shoring and near-shoring trend, so part of the thesis – and we’re already seeing this, and a secular shift away from higher-polluting truck freight onto rail, which again, we see it’s a bit more cyclical, but we are seeing – we think the industry in general should see general revenue growth in the coming years, decades, strong revenue growth in the coming decade or so.

So on top of that then for CP, we think they’ll take share from other rail providers. The T-shaped footprint gives the company an opportunity at least to offer a superior, so more productive, possibly cheaper service to their customers. In the short term, what we are seeing in the Suez and Panama Canal and the issues that they have there, this could be a boon for them in the short term. It actually could be cheaper to ship from East Asia to Mexico, take the freight off the ships onto rail from Mexico up to the east coast of the US and then back on ships again across to Europe, than it would be to go all the way around the continent. So that is a short-term boost.

And before the acquisition of KSU last year, CP had the best service performance, best operating ratio or certainly one of the best operating ratios, which is an indication we think of a superior operating culture. We expect management to be able to apply this to KSU assets over time. And we have the merger synergies, which we’re expecting to play out over the next few years as well. So sales will be tied to GDP, but digital and precision railroad scheduling and some of the operating ratio work they can do plus share buybacks, we think, could lead to double digit earnings growth. So, on-shoring certainly part of the thesis, but a lot of stock specifics on top of that sits behind the work.

CS: On that note, James, thank you very much for joining us today.

JM: Thank you for having me.

SW: Since its inception in 2014, the Waverton Multi-Asset Income fund has demonstrated strong performance. We appreciate the collaborative approach taken in designing this fund, as well as its emphasis on effectively managing potential losses. Being a global multi-asset fund, it strategically incorporates various asset classes to ensure genuine diversification. For more information on the Waverton 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.