The Fund has historically been allocated at approximately 60% equity weighting and 40% fixed income weighting. This is designed to remove the market timing element of portfolio management and allows the team to focus on security selection. The equity portion of the portfolio follows a value-based approach has generally been invested in a blend of global, large-cap value equity securities. On the fixed income side, the team employs a broad, global investment grade focused approach, across both government and credit markets.
The team expressed that this does not feel like a normal bear market. Bear markets don’t necessarily cause or come with recessions, but a recession can make a bear market much worse. Usually there is a collapse in risk appetite, often a function of a worsening macro environment where profits fall sharply, defensives outperform cyclicals and credit risks become important. A key feature of markets this year has not just been risk aversion, but the complete collapse in demand for bonds. A bond selloff is different, leading to valuation uncertainty, where avoiding valuation risk is key. There remains further downside risk in equities as valuations have fallen due to ‘multiple compression’—the price has moved, but earnings expectations have stayed high, making it difficult to anchor valuations. Add a recession and the equation becomes even harder. The team believes consensus earnings forecasts look way too high, indeed still suggesting earnings will rise this year by about 10% and still positive after stripping out the energy stocks (+3%). This seems unlikely to materialize as more companies struggle to pass inflationary cost pressures through to a weakening consumer. Leading indicators and CEO surveys point to tougher times ahead. On a brighter note, equity markets are forward looking and tend historically to bottom out before the trough in earnings. The debate is to what extent are current valuations looking through the inevitable fall in earnings as the market heads closer to recession.
Valuations have fallen and no longer look stretched but are not yet stressed to the same degree they were in the global financial crisis. The team has warned previously about the surge in asset prices and pockets of overvaluation which resulted from the extraordinary stimulus provided by central banks over the last decade. This kept bond yields artificially low and pushed investors into riskier assets, notably high growth stocks, often loss-making, and recent IPOs with a promise of returns far into the future. Many of these stocks have seen big share price collapses as reality beckons. It feels healthy that this ‘froth’ has been blown off the market as these more speculative assets fall from grace. Some better-quality technology stocks are starting to offer value putting them onto the radar which the Fund previously put off by high valuations.
The shape of the portfolio has not changed materially as the team makes gradual changes and invests for long-term. The biggest sector overweight’s relative to MSCI World Index are Industrials, Financials and Consumer Staples, where the team continues to see attractive opportunities. The team continues to reduce the Fund’s position in Consumer Staples by trimming stocks that have outperformed and have trimmed its position in Colgate given its relatively stretched valuation to fund better opportunities elsewhere.
This is a value strategy, not a ‘deep value’ strategy, with a clear focus on business durability and valuation. The team thinks carefully about the long-term prospects of businesses they own and pay a lot of attention to understanding the downside risk to business models. The Fund’s average holding period is six to seven years. They continue to find great opportunities across industries and geographies in good businesses with shares trading at attractive valuations, often overlooked in the short-term focus of other investors.
During the period, the team-initiated position to Northern Trust Corp (Financials), and Omnicom Group (Communication Services), and added to BNP Paribas SA (Financials), Glencore PLC (Materials) and Suncor Energy (Energy). The team trimmed Colgate-Palmolive (Consumer Staples), UBS Group (Financials), Travelers Cos Inc. (Financials), Wolters Kluwer (Industrials) and Texas Instruments Inc. (Info Tech).
The team believes premiums of more than 60 bps between European and US investment grade makes European bonds look attractive and fairly prices the very strong probability of recession in Europe. They also feel the chance of recession in the US has increased over Q3, making the US market appear relatively expensive. The Itraxx Crossover Index, an index that comprises the 75 most liquid sub-investment grade entities, has been very volatile in Q3; at its worst point it has been pricing in cumulative levels of default (assuming 40% recovery values) of over 20% over a 5-year period, a level which would be very hard to achieve even in deep recessionary conditions. On the fundamentals side, while a recession would inevitably lead to higher leverage and declining margins, they are inclined to see this as more of a challenge for equity holders with net interest coverage extremely strong for investment grade companies. Leverage also declined post COVID, and investment grade companies also benefited from a strong wave of debt issuance in 2020/21 at attractive funding levels.
Dispersion between sectors remains high, especially in Europe. This in turn means that cyclical sectors facing similar risk to fundamentals from an economic slowdown are trading at marked differences in valuations. Examples include chemicals versus certain luxury goods and retail companies. The current “taper tantrum” regime, where both risk-free yields and spreads have risen in tandem, has seen some huge drawdowns in longer-maturity corporate bonds, and presents some very heavy discounted bonds to par. For instance, many bonds around a 2045 maturity can be found at under 60 cents per dollar. Such bonds offer attractive convexity as they approach recovery values. They are also more desirable to hold in many cases than primary bonds, forcing new issues concessions to attract investors. The team continues to like hard currency emerging market bonds which they feel offer compelling relative value to developed market corporates. EM corporates have exhibited relatively resilient earnings and have lower leverage than developed peers. Spreads offered per turn of leverage are also far greater.
The team continues to favor some structured sectors such as higher quality CLOs and CMBS as a lower beta way to achieve carry with less economic risk relative to higher quality corporates. They have also been reducing benchmark short in agency mortgages. MBS appear fairly valued for an environment of quantitative tightening and cheap versus their long-term history. The team sees better opportunity in coupons not heavily owned by the Fed or by banks.
The team likes markets which are at a mature stage of their tightening cycles, and where the underlying local economy is sensitive to tightening monetary conditions because of higher household leverage or inflated real estate markets. They feel such markets could see their central banks pause earlier than the Fed, leading to an outperformance of their local bond markets. Examples could be Canada and New Zealand, where the Fund was overweight. Canadian inflation appears to be showing signs of peaking and employment has declined for 3 months in a row, causing Canadian bonds to outperform sharply in Q3. The Fund was overweight South Korea bonds, which is another example of a central bank at a mature stage of their tightening cycle. In addition, its open, export-orientated economy is vulnerable to global trade and geopolitical risks.
The team dislikes the UK market, especially longer maturity bonds. The increased issuance because of the unfunded government tax cuts and energy rebates will cause increased issuance at a time of weakening domestic demand from UK pension schemes and quantitative tightening by the Bank of England. They are cautious on Italian bonds despite relatively attractive spreads. The team would not expect a durable outperformance to core European peers in the current environment. They expect ongoing volatility as the market adjusts to life outside more regular QE support and a slowing growth environment, made all the worse by rising fears of a European energy crisis.
The ECB might struggle to control Italian spreads and challenge market fragmentation while tightening rates. The most recent political turmoil in Italy also added unwelcome idiosyncratic risk, with foreign policy in Ukraine potentially exposing differences in the fragile coalition government. The new government could potentially scupper the €19 billion recovery fund, slow down reform and undermine investment confidence in Italy, which had been improving in recent years.
Although a clash with the EU is not an imminent risk (indeed Meloni softened her anti-EU tone during the electoral campaign), the team still sees risks for fiscal stability in the medium term. They prefer other expressions of periphery risk such as Cyprus and Greece. South American countries have been very proactive in raising rates with markets such as Mexico and Uruguay offering attractive real yields and FX valuations. The team continues to be defensive towards Japanese bonds, despite recent outperformance caused by ongoing support to the bond market by the Bank of Japan. Existing policies might increasingly be seen as unsustainable, with the JPY dropping a further 6.6% in Q3 causing the central bank to intervene in the FX market and harden its rhetoric. The Fund was also underweighted Chinese bonds, where valuations look expensive, especially on a hedged basis, with 10-year Chinese bond yields now 109 bps lower than US Treasuries.
Within FX the team continues to be long the USD especially against the EUR, CNY and the GBP. They are looking for currencies in emerging markets where the fundamentals and carry can balance the long USD view. Examples are the Mexican peso, the Chilean peso and the Brazilian real. The team also likes the Singapore dollar versus the Taiwan dollar, given the strong pipeline of inflation in Singapore, largely imported, but also on domestic factors (tight labor market, GST increase) leading core inflation to be well above their 2% target. Short TWD remains a positive carry position. So far there have been sizable foreigner equity outflows (TWD negative) from the stock exchange, which is tech/growth stock heavy, and these stocks seem like they will remain challenged for some time, given global recession risks and growth headwinds for China and semiconductors.