Alex Crooke, Fund Manager of the Bankers Investment Trust, explains how the team is preparing for a different investment landscape in the second half of 2019.
It’s in our nature as fund managers to continually contemplate about the future, but the level and scope of uncertainty facing investors today is almost unprecedented. What’s disappointing is that many of the questions that dominated 2018 have still not been answered as we move into the second quarter of 2019.
The most prominent of those questions include the ‘trade war’ between the world’s two largest economies; the UK’s expected exit from the EU; a tightening of monetary policy by central banks in key economies and the corporate profit growth outlook. You’d have thought by now we would have more certainty around some of these issues, but clarity is coming.
At The Bankers Investment Trust - a Janus Henderson-managed trust - we believe the second half of the year will look and feel very different to the current state of play; and we are positioning the portfolio to benefit from that clarity, which we think will restore market confidence as 2019 rolls into 2020.
It’s important to remember that markets are discounting mechanisms by nature, matching buyers and sellers. Markets are also forward looking, so the sharp sell-off we saw last October was a message from the sellers that global growth had probably peaked and a global recession is coming.
As I outlined in a recent piece, Banking on Diversification, I don’t see enough signs of stress in markets to warrant such a negative outlook. Global growth is slowing and it appears we are in the latter phases of the business cycle, but without a significant trigger I can’t see a sharp global recession or economic crisis coming this year.
Goldilocks and the three bears
My central view is that we continue to live in the ‘goldilocks’ environment where the economy is not too hot and not too cold, with modest returns in a long cycle. Around that view the Bankers investment team has identified three alternative scenarios we think could feasibly play out this year. The first comes back to the US-China tariff war. An escalation of tensions between the two nations could have hugely damaging consequences for global economic growth. It’s not in anyone’s interest to go down that route, so I only give it a fairly slim chance of unfolding into an all-out trade war and altering our view of the world.
The second and third scenarios relate to the US economy, which grew at an impressive rate last year relative to the rest of the world. There is a danger that the US’ central bank, the Federal Reserve, has ‘left the taps open’ a bit too long. By that I mean the economy is in some danger of overheating and may need action from the Fed in the form of steeper interest rate hikes, but I think that’s unlikely.
In equal measure, the US economy could slump if the Fed has overdone it with its incremental interest rate hikes over the past two years. Personally, I don’t think the banking system has been lending aggressively so I discount this risk, but the tools to get another recovery going are relatively limited from here, so we should be careful about this scenario.
The US is still the single most dominant economy in the world and the largest market in stock market terms. The Federal Reserve in the US has maintained a loose monetary policy stance in recent years but it’s probably as good as it’s going to get. There are worries that there we will shortly witness a US economic slump and a dramatic one at that, but I don’t buy that. I don’t see a recession coming in the US but I’m also struggling to see how it gets any better.
This brings me back to the central view we hold at Bankers, for which I give about a 50% likelihood of playing out this year. In this scenario, the long business cycle continues with the ongoing global economic slowdown bottoming in the summer months before picking up gradually in the latter part of the year. It might sound a bit dull but it’s not a bad world to be in and it’s one we can position ourselves for. Essentially, it rests on the notion that the economy is not broken and that markets will pick up as we get more clarity on the questions alluded to earlier.
A broad value church
As fund managers, it is our job to look for opportunities where the market has over-discounted bad news and where prices could recover. We’ve already seen a bit of that in the year-to-date, for example Chinese equities endured a rough ride in 2018 and share prices came down as the trade war rumbled on, but they have recovered well in the New Year. Our direct exposure to China (c.9%) has been creeping up in the past 12 months as more value-driven opportunities became available over the course of 2018.
I am at heart a value investor and I like to think of it as a church; you can either follow religiously buying rock bottom price-to-earnings (P/E) and price-to-book (P/B) metrics; or take account of wider measures of value. I tend to prefer looking for companies with growth opportunities but am careful not to overpay for these investments. I also look for companies with potential to grow their free cash-flow and therefore hopefully deliver dividend growth.
Since the financial crisis it has largely been one-way traffic with growth stocks outperforming value stocks on earnings growth and share price total return. The Bankers portfolio reflected that with good growth names in the US, Europe and Asia, but last year growth stocks became very expensive. Earnings growth has been decelerating on average for the largest growth companies in the past 12 months and so it looks like a sea change could be coming.
QT favours value
Our belief at Bankers is that there is probably going to be a shift towards the end of 2019 with value stocks beginning to outperform against growth. This could be even more likely if central banks - the likes of the ECB, US Federal Reserve and Bank of England - extend their tightening measures, colloquially known as quantitative tightening (QT), which in simple terms refers to a number of monetary policy actions that aim to normalise interest rates and mitigate rising inflation. The US Federal Reserve has indicated it has paused its increases in interest rates but a resumption in global growth could mean a reversal of this policy.
QT would mark a significant shift from the past 10 years during which central banks dominated asset prices by driving down the cost of long-term money to support businesses and keep employment high. Once quantitative tightening measures begin to roll out and money becomes more expensive, there will be a shift in market sentiment.
We are positioning the Bankers portfolio to benefit in this scenario, while also maintaining a healthy balance and diversification across styles, sectors and geographies. We are overweight relative to the benchmark on consumer goods and services because we think the very low levels of unemployment will be persistent and wage growth will pick up in the US and UK, as it has in Asia and China.
We have topped up our position in premium cosmetics group Estée Lauder Companies, which is now the Trust’s joint-largest position at 2% of the portfolio along with Microsoft; and we are finding more value-driven opportunities in European companies, where market sentiment is low and share prices are depressed.
All in all, I am of the belief that the global economy is not broken and the future is bright. Without a significant trigger I don’t see a dramatic recession coming but rather a gradual contraction and subsequent expansion towards the end of the year. Once we get some clarity on the macroeconomic and political questions hanging over markets, it’s quite probable confidence will be restored and some of the fantastic value opportunities of today will be gone.