The following article is taken from an interview with Australian financial markets website Livewire.
With the climate of political polarisation, an unprecedented shift in monetary policy, and trade wars all impacting markets globally, you need a safe pair of hands to navigate increasingly volatile global equity markets. We chat with Peter Rutter, Head of Global Equities at Royal London Asset Management, to explore his strategy and market view.
Q: As a UK-based global manager, what do you think you'd miss the most if you could only invest in UK equities?
I think the biggest thing I would miss is the breadth of opportunities. There are about 350-400 companies in the mid- and large-cap space in the UK. Globally, the number is about 4,000 and I enjoy the opportunity to find really interesting names that aren't always available in the UK market.
For example, there are almost no semiconductor companies in the UK. It's been one of the most exciting, interesting, innovative and dynamic parts of global markets. And if you are a domestic UK investor, there wouldn't really be an opportunity for you to look at it.
Q: In your investment process, you divide stocks into Life Cycle stages. What is the background to that process?
Companies go through a life cycle in terms of their profitability and growth: this is driven by innovation, which drives up profit and growth, and competition, which tends to drive those things down. Our corporate Life Cycle model categorises every company in the investment universe as:
- Early stage innovation and growth
- Distressed/potential turnaround
Early-stage companies like Amazon, Netflix or Tesla are investing heavily in disruption and growth. They often make quite low returns on productive capital. But, if they're successful in innovating, their profitability and growth can accelerate.You then get successful companies that have gone through that stage like Alphabet or Nike: companies with decent growth rates and very high returns on productive capital. We call these compounders.
Unfortunately, when you're very successful, competition is a fact of life. Once you're there, there's a very powerful tendency for competition to cause returns to fade over time. You can still be a good company, but you're slowing and maturing: we call those companies fading. Coca Cola is a great example – as new drinks and consumer tastes emerge, it causes a fade in return and profitability at some of these large incumbents.
Once excess returns have faded away, companies can still do okay, but they don't make surprising levels of profitability. A company like Ericsson would be an example of a company at the mature stage of the Life Cycle.
And even when you've been around a long time and you're a decent company, competition never stops. You get companies that become distressed as their profitability shrinks or they become loss-making because of competition. You could look at Vodafone in the UK, which is a low return on capital business, or Sony in Japan – companies at the tail of the Life Cycle that make quite low returns on productive capital. These can still be a good place to invest as long as they have turnaround potential.
So, as long as you have innovation driving returns up and competition driving returns down, there is a powerful tendency for companies to move through the Life Cycle.
Q: You thought the biggest risk this year would be the yield on 10-year treasuries. How do you mitigate the impact on equities?
Different parts of the corporate Life Cycle react differently to changes in discount rates and bond yields:
- Early-stage growth stocks tend to perform very well when interest rates are falling because the value of the cash flows they generate goes up disproportionately
- Value stocks tend to do well more when interest rates are rising.
It's hard to have a particularly strong view around long-term interest rates and bond yields. So we diversify the portfolio by Life Cycle categories, which removes some of the relative return sensitivity to changes in interest rates and bond yields. This means the risk in the portfolio is driven by stock picking, in which our investment process gives us an advantage.
Q: What are your thoughts for how the next 12 months play out for Brexit?
We come at Brexit from two angles. We've done the microanalysis of all the various steps and chains that might unfold, and become amazingly knowledgeable about the UK constitution and how parliament works in the process.
We've also looked at it from a macro perspective. The reality is nobody really knows what's going to happen. The mechanisms and paths towards the end conclusion are incredibly complex. They're not just in the hands of the UK parliament, but also in the relationship with the EU, so we don't know the exact mechanism that we’ll end up with or what the eventual outcome will be. There's a lot of volatility around the probabilities around different outcomes. As a result, we make sure the portfolios are well balanced, so we're not taking any major Brexit risk.
From the macro position, it’s possible to draw some stronger conclusions and I think there are four potential outcomes from Brexit:
- A good deal,
- A bad deal,
- A hard Brexit, where just there's no deal and we go over the edge, and
- The possibility we stay in the EU.
The one thing we can rule out is that the EU cannot allow the UK to have a good deal because that would be so damaging to the overall European project. I think the other three options remain on the table.
There is a chance of hard Brexit. Of the three it’s probably least likely, but it’s still possible and the chances are increasing as the Conservative party leadership situation unfolds. But it's bad for all sides – it's actually really bad for the EU as much as it is for the UK – so I think they will try to avoid that as well. Ultimately, we may end up staying – I think the EU would like that. A bad deal, just to get the deal done, is a distinct possibility.
Q: How will the US-China trade war impact markets?
There's a tremendous amount of US production in China, and China relies on a huge amount of US technology. So, this will run and run and will be a feature of global equity investing for years to come.
The impact is very stock specific. For example, if you own a steel company, it has a big impact. Or there are quite a few US companies like Yum! Brands, the fast-food retailer that owns businesses like KFC. The majority of their profits come from China. Different companies are affected in dramatically different ways.
There are genuine issues around intellectual property rights in China. There's a real structural challenge, which is that there is a limited separation between the corporate economy in China and the state. In the US, it's the reverse.
The two largest economies in the world with two completely different methods of delivering economic growth for their citizens. Global liberal capitalism is the US model of generating wealth for society, citizens and shareholders; and the Chinese model, which has generated a tremendous amount of wealth by tying the corporate economy into the government. How these two paradigms interact is getting increasingly challenged.
Q: How can investors avoid getting caught up in a momentum trade?
I think the challenge we have with momentum is that it is backwards looking. It's what's happening right now, but what actually matters as an investor is what happens next. Just because a stock currently has good momentum, doesn't mean it will last forever.
What you really want to own is next year's momentum. If you own next year's momentum now, you're going to have outperformed. Momentum is really just telling you how something's doing now.
So our focus is more on identifying great businesses that are very attractively priced. If we do that well, they will be next year's great momentum stocks.
Q: What are you most excited about in the three years ahead and what is it that's keeping you up at night?
We get most excited about the individual stocks we own and their potential. And, back to the idea that ultimately I'm looking after people's savings, I'm excited about some of the opportunities I've found at a stock-specific level to put those savings to work, because I think of the wealth those businesses are creating and what they might be worth over time.
There are some fantastically interesting companies that we own across the Life Cycle that are really exciting businesses. They're exceptionally well-placed structurally to create wealth for shareholders over time. And they're very cheap relative to that wealth creation.
The things that are most concerning for us as portfolio managers are, first, what the long-term implications are of very low interest rates and whether this could lead to a big structural recession at some point in the future, and with little central bank firepower to escape it. This could also usher in a massive misallocation of capital because, with interest rates so low, money just flies all over the world into growth projects, concept ideas and maybe it ultimately doesn't generate a return. So, that's the first thing that keeps me up at night – thinking about what's going to happen next in the global and corporate economy.
The second thing that's coming up on the radar for us is the US political environment, particularly as the US is 60% of the index. US politics has never been more polarised in my investment career of 20-plus years, with very different ideas about how the economy should be structured and regulation.
It's not necessarily that one is better than the other, but the impact on markets and individual stocks and segments of the economy of the US moving from the Trump model to say a further left model, where the Democrats seem to be positioning, could have massive implications for sectors, such as healthcare.
You could extend that US polarisation to pretty much everywhere, such as the Conservatives versus Corbynism in the UK. We've looked into this quite a bit. A possible explanation is that after a decade of quantitative easing and low interest rates, there's been a major polarisation in wealth in the world between people who own assets and people who don't.
And globalisation and quantitative easing and stimulative monetary policy have polarised people's participation in the global economy and the wealth effects that come with that. Some of this polarisation really relates to the stress and strains caused by the global financial crisis, multiplied by things like quantitative easing.
This is not a recommendation or solicitation to buy or sell any particular security. The views expressed are the author’s own and do not constitute investment advice. Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested.
For more information on the fund or the risks of investing, please refer to the fund factsheet, Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Price page on www.rlam.co.uk. All information is correct at May 2019 unless otherwise stated. Ref: AL RLAM W 0006.