7 from 7
Midway through a quarter, we like to take a temperature check of what’s worrying our clients – and give clear and direct responses. This quarter, there are some issues that we haven’t seen for a few years now, giving an indication of the changing global environment we’re facing.
We’ve tried to put it all into some kind of context – but as ever, let us know if you would like more detail (although there’s quite a lot already).
1. Is rising inflation a continued concern and what could it mean for the broader market?
The problem with inflation is that pundits can make headlines with open-ended predictions – ‘inflation will go higher!’ – without saying how high and for how long. It’s easy to end up feeling that inflation will spiral out of control.
At 7IM, we want to be absolutely clear on our inflation view.
We believe inflation will settle in a range of 2-4% over the next 3-5 years. That doesn’t mean there won’t occasionally be higher or lower numbers during that time, but in terms of structural inflation, that’s the way we see things. That’s materially different from the environment of the past ten years, where structural inflation has been in the 0-2% range.
The current high inflation numbers will start coming down soon, supply chains pressures will ease, the impact of COVID will fade and energy prices will level out. Inflation between 2-4% will be enough to encourage economic dynamism, but not enough to damage the economy. Part of the inflationary impulse will come from rising wages, which should help dampen the impact of inflation on people’s costs of living.
However, the biggest impact won’t be on ‘Main Street’ but is more likely to happen on Wall Street. The market is priced in a way that expects the last decade of sub-2% inflation and sluggish growth to continue. We don’t think this is the case. The implications are clear – rotate portfolios away from last cycle’s narrow winners (government bonds, the US dollar, US equities) and towards a more diversified set of asset classes.
2. It has been so long since the world has experienced inflation above 2%, what do you think will be the ramifications on 7IM’s ability to beat inflation?
Taking a step back, we need to remember that some inflation is a permanent feature of our lives. It’s a feature of the global economic system, not a bug. Economies adjust, policymakers react, and markets reprice.
And 7IM have always built portfolios assuming that there will be a reasonable level of inflation. We do so by making inflation-protection a key building block of our Strategic Asset Allocation (SAA) – the foundation of all our portfolios – alongside interest rate exposure and economic growth. We treat all three of these factors separately.
Many investors associate growth and inflation, assuming that you can’t have one without the other. However, there are plenty of examples of high-inflation, low-growth environments, like the UK in the 1970s. There are also plenty of low-inflation, high-growth periods, with the last decade being a prime example.
We want to make sure our portfolios are ready for all kinds of environments when constructing them. We do this by incorporating real-time measures of Consumer Price Inflation as well as oil prices into our portfolio construction process.
All of this is to say that the SAA is deliberately built to deliver above-inflation returns (regardless of the absolute level of inflation) over the long term, in line with what our clients need.
Markets and portfolios
3. What makes a value stock vs a growth stock? What are the tailwinds and headwinds for the former?
Using technical terms without explaining them properly is a common habit in finance. And actually, the terms value and growth aren’t that helpful.
Roughly, value investors look for established companies with a proven business model and cashflows that, for some reason, are undervalued by the market. They are prepared to wait for the market to come to its senses. They’re bargain-hunters.
Growthinvestors want to invest in business models that might not make money now but have the potential to make big profits in the future. They’re willing to pay more than a company and then wait for the world to change and for it to benefit.
Over time, a company can move from being growth to value, and even back again – it’s all in the eye of the investor. But that describes an investing style rather than what a company does.
In our view, it’s easier to think about cyclical and non-cyclical companies.
Cyclical companies are exposed to the economic cycle. When the world is expanding fast, the earnings of cyclical companies grow. Banks, energy companies, miners, airlines, railroads, and manufacturers are all good examples. These might be value investments, but they are cyclical companies.
Non-cyclical companies are the opposite. They tend to have business models that have steady, recurring revenues, and make money regardless of economic trends. Classically, these have been utilities companies, healthcare and consumer staples – but more recently has included technology companies too, as they’ve become more embedded into our lives and increasingly charge monthly fees for their services.
Now, at the moment, there’s a big overlap between cyclical companies and value companies – the most unloved investments of the last few years have tended to be cyclical. But remembering the above difference is important.
4. We saw most developed equity markets have a rough start to the year – do we anticipate that this will be the theme for 2022?
Getting over an old relationship can be difficult. It takes time. As investors start to tear themselves away from the large tech companies, we’re seeing some friction while they reacquaint themselves with the rest of the market.
Ultimately, the positives will outweigh the negatives. Our work suggests that the global economy is in good shape, and there are plenty of exciting investments available to capitalise on a new and different cycle. We might have to be a little patient, but we’re only six weeks into the year. There’s plenty of time.
5. Why have ESG strategies struggled recently, relative to the broader market, and how long do we see this persisting? (Hat tip to our ESG expert Jack Turner for this answer)
There are three reasons why ESG strategies have struggled since the start of the year;
- Firstly, the rotation from non-cyclical to cyclical (mentioned above) is particularly troublesome for ESG strategies. ESG strategies and screens often favour non-cyclical companies which typically rely on low-emission technology rather than more capital and resource-intensive business models.
- Secondly, recent spikes in oil and gas prices have been short-term headwinds. Investors have rotated away from long-term energy winners, such as wind and solar, into the old-world energy producers. This has been most pronounced in the UK, where the likes of BP and Royal Dutch Shell are among the largest parts of the FTSE 100, but are often ineligible for ESG portfolios.
- The final is the underperformance of healthcare stocks so far this year – pain which we’ve felt across portfolios where we have a long-term tactical allocation to healthcare. ESG strategies tend to overweight this sector as it contributes to solutions for the third Sustainable Development Goal: Good Health and Well-being.
Many companies in the areas outlined above are now trading at a significant discount to the rest of the market, in some cases having fallen by 50% or more. These stocks are in key sectors that will support the world in fighting climate change and in many cases, government regulation, changing consumer preferences and technological change will steer capital towards these companies and lead to outperformance over the long term.
This period of underperformance should be looked at as an opportunity.
6. Boris Johnson has had a difficult start to 2022. How important is UK politics for portfolios?
The last few years have been a roller-coaster in UK politics – one pandemic, two referendums and three prime ministers. This doesn’t include the multiple deadline extensions, EU-related bills in parliament or leadership contests (on both sides of the house).
It’s natural to worry about how a sterling-based portfolio, with all these ups and downs, should fare. The answer is, quite well. The reality is that exposure to the UK is very small – less than 10% of a balanced portfolio.
7IM portfolios are globally diversified, meaning they are more linked to the ups and downs of the global economy. UK politics, quite simply, doesn’t matter much.
7. How worried are you about Russia/Ukraine, and what impact could a conflict have on portfolios?
Geopolitical risks are a constant of global investing. Our base case is to take the longer-term view, rather than focus overtly on short-term risks. So typically, we’d prefer to look for opportunities generated by market overreactions, rather than try to predict when and where military tensions might spill over. The current tensions on the Ukraine border are no different – headlines are screaming, but we should remember that there are other big things going on in the financial and economic world at the same time.
We trust our diversified portfolio construction approach to limit our exposure to any one risk, and there are multiple points in history to suggest that it is the right approach. Think, for example, of the Russian annexation of Crimea in the first quarter of 2014. Over that period, our AAP Balanced Fund was up by 0.75%, with a maximum drawdown over those three months of less than 3%, which is entirely normal for a strategy of this risk profile.
And we’re not just backward looking. The risk team runs a full set of stress tests to help us assess portfolio risks on a daily basis. In the last weeks, we have also added a specific Russia stress test (looking at oil price spikes and Russian equity falls). The results of those reiterate the diversified nature of our portfolios and at this point give us no cause for concern. Our forward-looking stress tests show that our SAA and TAA positions are well placed to protect our clients’ capital.
Note, too, that our portfolios have little direct exposure to a potential Russia-Ukraine conflict. Firstly, Ukrainian assets are not part of our investment universe – the MSCI Ukraine index has just two companies in it! Secondly, all of our investments in Russia are via emerging market index-based investments or active products benchmarked to those indices, i.e. they are diversified emerging market plays, rather than concentrated Russian positions held directly. Russia is just 3% of the Emerging Market Equity Index.
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.
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