Jamie Clark

Ready for rising rates

Jamie Clark

In view of January’s leg higher in government bond yields, now seems like a good time to revisit our views on what we see as a fundamental shift in financial conditions.

Key themes: Liontrust Macro Equity Income Fund

Ready for rising rates - Jamie Clark

Source: Liontrust 31.12.17, Liontrust Macro Equity Income Fund. All use of company logos, images or trademarks in this blog are for referential purposes only.

Last September, we discussed the outlook for interest rates and the various implications for equities and the positioning of the Macro Funds.

It is a very obvious, but critical, point that rates and monetary conditions are incredibly loose by the standards of history; particularly so when viewed through the lens of prior episodes of low inflation. We suggested that the present degree of monetary accommodation seemed unwarranted by the UK’s underlying economic fundamentals. We observed that the obvious strength of the UK job market was the best expression of this.

In light of the Bank of England’s Philips Curve framework, we reasoned that UK central bankers expect higher inflation as the inevitable byproduct of today’s low unemployment and that the base rate would surely rise. For us, this was proof that the UK economy was normalising after the low growth, low inflation and low rate hangover that followed the Great Financial Crisis.

To our minds, this improvement recommended one obvious course of action: increase the portfolio’s exposure to value at the expense of quality companies.

To explain, quality businesses had enjoyed a fine post-Financial Crisis period, as investors lapped up their characteristically steady earnings growth in the midst of sluggish, or uncertain economic conditions. Arguably, consumer staples businesses offered the best example of the re-rating experienced by companies of this ilk. By way of contrast, value was shunned in this time due its hallmark cyclicality. After all, why pay up for a business geared to the cycle, if the cycle is broken?

We argued that economic normalisation offered the very real prospect of change; a hint that investors could recalibrate their relative weighting to quality and value, as economic growth took hold and rates picked up in anticipation of inflation to come.

We believe life insurers will experience a re-rating as rates and bond income rise and earnings risk falls. Additionally, we believe higher rates will not hurt the profits of housebuilders. The sector’s low earnings multiples give little credit to the UK’s structural housing undersupply and the fact that measures of affordability (real vs nominal house prices; multiples of house price to income ex-London etc) are some way beneath prior points of housing market stress.

Taking a broader look at the UK economy, it is clear that this shift in financial conditions is in train. Whilst headline earnings growth is muted at best and fails to reflect historically low UK unemployment, pay growth occurs with a lag and survey evidence of recruitment difficulties and job mover pay-growth suggest that it’s finally on its way.

We also note the relative strength of the UK economy and the extent to which growth has exceeded deeply pessimistic consensus estimates; the UK economy growing at a modest 1.8% in 2017, but little changed on 2016’s 1.9%. Key to this, no doubt, has been the contribution of net trade, as manufacturers continue to reap the benefits of sterling’s Brexit depreciation; December new orders hinting at further gains to come.

But most critically of all, there is the impressive breadth of the global economic upswing; this rare episode of synchronous growth in the US, Europe and Asia, imparting a powerful tailwind to UK exports, business confidence and asset prices.

In fact, as the above theme bar chart demonstrates, we are positioned for the rise in market and policy rates that would typically flow from such an episode of economic repair.

With more than 30% of the portfolio invested in rate sensitive life insurers, banks and other financials, the portfolio has excellent gearing to higher rates. Whilst our overweight positions in cyclical industries like mining and housebuilding give direct exposure to the ongoing normalisation of economic conditions. Even our more explicitly defensive holdings, pharma and telecoms, trade at material valuation discounts to notionally defensive quality companies and offer investors genuinely defensive earnings.

Put simply, we’re ready for the reality of rising rates.

Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

Investment in Funds managed by the Macro Thematic team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. The performance of the Liontrust GF Macro Equity Income Fund may differ from the performance of the Liontrust Macro Equity Income Fund and is likely to be lower than its corresponding Master Fund due to additional fees and expenses.

Disclaimer

This content should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy.  It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, faxed, reproduced, divulged or distributed, in whole or in part, without the express written consent of Liontrust. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.
Thursday, February 8, 2018, 2:49 PM