Investment Management -
Market Musings
Over the past few weeks, our Co-Chief Investment Officer, Gregory Perdon has been touring the country giving a talk entitled: The UK’s place on the global stage, opportunities and challenges.
On a mid-October morning at the Clifton Club, a private members club founded in 1818, accountants, lawyers and clients gathered in the Drawing Room for coffee, tea and croissants. For many, it was the first large gathering since the start of the pandemic, and participants eagerly spoke with one another whilst enjoying the views of the Mall Gardens from the floor-to-ceiling windows.
They were keen to hear Gregory’s take on the challenges facing the UK, from labour shortages impacting truck drivers, meat processing and healthcare to global gas shortages and supply chain issues which have sent energy and food prices skyrocketing. They were equally interested to hear about the UK’s opportunity set.
Julian Telling, Chairman of the Clifton Club, gave a brief history of the Club before participants moved through double doors to the Centenary Room, with its domed skylight providing natural light.
Gregory began the talk by making it clear he was not going to talk politics. “We all know the arguments on Brexit and realistically it’s too soon to judge the long-term impacts,” he said to the audience.
“We traded certainty for optionality, and we won’t know if that choice is successful for years to come.” Likewise, he didn’t want to look at the UK through the lens of the pandemic.
What are the main challenges facing the UK economy?
Rather than subjecting the attendees to a 50-page Power Point presentation surveying the technicals of the UK economy, Gregory stood up with no notes and took the audience on a journey around the country, portraying the challenges and opportunities facing the UK through the eyes of various people from different walks of life.
He started with an economist from Manchester who was worried about our low investment into capital stock and weak labour productivity. Our flexible labour force has disincentivised investment in machines and automation. With only 85 industrial robots per 10,000 employees, the UK ranks 22nd versus our industrial peers, according to the International Federation of Robotics.
Gregory then moved onto a student in Bristol who talked about a lack of affordable housing and how young people today won’t be able to buy a home without the help of ‘the bank of mum and dad’. (Gregory joked that as a father of four, he expected to be speaking at the Clifton Club for years to come!) Government spending on affordable housing is down relative to 2010 levels and getting planning permission is difficult. Tack on efficiency issues and employment in the construction sector dropping due to a lack of workers and we have a problem that will not be solved overnight, Gregory said.
He said the investor in Edinburgh’s biggest worries centred on the FTSE 100 not being as attractive to international investors as the S&P 500. The UK has a culture of dividend pay-outs and a domestic tendency to view research and development as a cost as opposed to an investment, which might deter foreign interest.
He took us to the scientist in Cambridge, who spoke of our many Nobel Prizes but also our failure to commercialise scientific research and discovery. We tend to focus on academic citations but less on applied research. In those circles it’s referred to as ‘the valley of death’ [Footnote1]. In addition, our free-standing research institutions are quite thinly funded, unlike in the US.
Then, he brought us the head of a think-tank in London, who worried about our place in the global stage and questioned where we wanted to lead in a post-Brexit world and equally where we are happy to follow.
But the long term picture is not all doom and gloom, and where there are challenges there are also opportunities. Gregory took a step back to discuss where the UK sits compared to our global peers from a hard and soft-power perspective – because opportunities are indeed relative.
Does the UK still have international influence?
The UK is a permanent veto member of the UN security council with a nuclear deterrent, 145 military bases across 42 countries and a government that has promised to increase military spend, Gregory said, adding that the UK is in a strong position to exercise hard power should we wish or be required to do so.
But he argued that hard power is far less interesting than soft power, which really means how much influence a country has. This influence can be utilised to attract foreign investment and promote general trade, amongst other factors.
“Did you know there’s a soft power index?” he said to the audience. “I didn’t before preparing this speech.” He then asked where people thought the UK stood globally. There were surprised murmurs when Gregory gave the UK’s ranking—second in the world on the Portland Soft Power 30 Index [Footnote2]. “This is important because of our strong global network,” he said.
Gregory went on to outline the influence, which comes in many ways. He pointed to how international companies see the UK as an attractive country to do business outside the US. Our news organisations (BBC, FT, the Economist) are the go-to for English speakers outside of the US, he said.
After the Olympics, the Premier League is the greatest sports franchise globally and accounts for £1.3 billion of exports for the UK, Gregory said.
In financial services, the UK’s brands and balance sheets are strong, and rising interest rates should help banks’ balance sheets further, he argued.
The UK’s legal system is robust and recognised, and the country’s universities remain some of the best in the world, he said.
“None of this is changing,” Gregory said. “That means our global influence will not waiver for the foreseeable future.”
Reasons to be optimistic about the UK economy
Gregory then took the audience back around the country to hear about the opportunities:
He spoke of a solicitor in London who argued the UK has a real chance of becoming the global centre of ESG and sustainability. Gregory pointed out the UK’s efforts to decarbonise are material. We are world leaders in offshore wind and charging stations for electric cars are popping up everywhere as petrol and diesel cars will be off the menu by 2030. Just over a decade ago, coal made up around 40% of the UK’s electricity. In 2019, that figure dropped to about 2% and by 2024, will be phased out entirely. Today, 44% of the UK’s electricity comes from renewable sources, a figure that will grow to meet the country’s climate goals of net-zero emissions by 2050.
He discussed how a builder in Leeds said there is a huge opportunity to upgrade and renovate our stock, change our windows in our Victorian homes and become more energy efficient.
Then he brought up a technology investor in London who pointed out that we have had a tenfold increase in the number of unicorn start-ups from eight in 2010 to 81 in 2020. Our start-up and scale-up sector is valued at $585 billion and the UK is the third destination for venture capital after the US and China.
“We may not have any Googles, Apples or Microsofts,” Gregory said. “But the fact is those firms have huge footprints in the UK, employing thousands of British citizens.”
Gregory then handed the floor over to Ed Johnstone, Associate Director who leads fixed income research, serves as one of the key investment managers on our investment committee and looks after many of Arbuthnot’s clients in the Southwest.
Arbuthnot Latham investment portfolios
Ed dove into the nuts and bolts of Arbuthnot’s underlying portfolios and discussed where the firm is putting capital to work on behalf of clients. He took the audience back to Monday, 9 November 2020 at 6:45am. Pfzier’s vaccine was found to be more than 90% effective in their Phase III trial.
Arbuthnot had a higher allocation to cash and corporate bonds at the time. The investment committee agreed a successful vaccine would give global equity markets a boost and represented a buying opportunity. Soon after the vaccination effectiveness announcement, the investment team began rotating out of corporate bonds and bought US, European, Japanese, Asian and emerging market equities.
Ed noted the disparity in the public’s perception of banks from the global financial crisis compared to the pandemic. “In 2008, banks were part of the problem,” Ed said. “In 2020, they were part of the solution.” Now, banks are healthy, allowing for overdrafts and helping drive the economy forward. Indeed, monetary and fiscal support coupled with vaccine rollouts would be very supportive to global equity markets, further strengthening the base case to pull money out of credit and into equities, Ed said. Inflation lasting longer than expected was another reason to shift out of credit, he added.
“Bonds are not as ‘safe’ as they were previously,” Ed said. “We’re more than happy with the credit quality of bonds. But on a day-to-day basis, there is a strong possibility that what’s seen as a safe investment – i.e., government bonds—could end up detraction from performance because of inflation.”
Where to put the money aside from equities? Alternatives, namely global macro hedge funds. “Don’t tell your buddies on the golf course we’re invested in macro,” he joked. (Macro funds have underperformed for years now amid extensive quantitative easing and record-low interest rates. Central bank policies are starting to diverge however, and most agree interest rates will begin rising. This should, in theory, provide a good environment for macro hedge funds, which seek to profit from price disparity among currencies, equities, bonds, commodities and interest rates.
Arbuthnot Latham Investment Committee decisions
Ed was interrupted by loud banging and construction work next door. “Reminds me of our Investment Committee meetings,” he joked, alluding to the heated debate which takes place over future asset allocation decisions. He concluded by discussing the firm’s outlook. Inflation is going to be stickier for longer. It’s not transient but rather “transient sticky”, a phrase Ed coined in one of the firm’s most recent Investment Committee meetings.
Interest rates could rise in the UK as soon as this year and will most likely rise next year. Our investment team has pulled back our overweight position in equities slightly although the firm remains confident in developed and emerging market equities generally. The future prices for many commodities remain lower than today’s price, offering an opportunity to make money by simply holding longer-dated contracts. Finally, the firm has rotated into short duration bonds and will continue to do so.
The floor opened up to questions:
The first question came from an attendee asking for more detail on the investment team’s outlook. Ed explained that the firm has just reduced its aggressive bullishness on global equities and planned to increase allocation to short-duration bonds (bonds which mature in 2-5 years as opposed to 10-30 years). As Ed put it, he’d rather lend to issuers that will pay him back in 2 years rather than 20 years. The firm is also researching absolute return funds, a process Ed describes as kissing a load of frogs before you find a prince. There are a lot that don’t deliver and charge high fees but there are also some excellent managers out there who generate returns without just owning the S&P 500, he said.
The next question was on ESG. “The financial press is full of green and ethical investing stories,” the attendee said. “I have a number of unethical and un-green investments and I must say I quite like the 9% yield I get from British American Tobacco. Is the green story overblown?”
Gregory acknowledged that many large investors, namely sovereign wealth funds and pensions, have divested entirely from energy stocks to help improve their ESG rating. “It’s a key debate for our investment committee,” he said. “Some agree, take it out of energy because the future is green. Others thought that would be a misstep.”
The fact remains that a lot of the large energy companies will be part of decarbonisation efforts going forward. Divesting from them entirely may not be the best solution. Gregory also believes there are opportunities to make money in the green economy. Baskets of renewables for example have made money for two of the last three years.
The next participant asked about rising interest rates and what impact that would have on consumer spending and confidence. Ultimately, the UK’s mortgage market is held hostage to interest rates, unlike in the US which much of it is fixed rate and longer term, Gregory said. But the Bank of England knows this, and the reality is, they will likely raise interest rates at a much slower rate as not to upset the apple cart, Gregory said.
“In my heart of hearts, I believe the UK economy can live with a bit of normalisation,” Gregory said. “Could we function if the base rates went to 3% tomorrow? No. But the Bank of England is very mindful that would be a shock and raising rates will have to be gradual. There won’t be a shot to the upside.”
Ed added Arbuthnot’s base case is that the UK could raise interest rates first later this year with the bulk of the increases coming in 2022. The US will lag and will only start hiking interest rates next year, then doing the majority of increases in 2023. Europe and Japan won’t be making moves anytime soon.
One participant asked about the utility, gas and electricity situation and the impact in the UK. Gregory described the situation as a mosaic, a perfect storm that’s impacted global markets. According to energy provider SSE, the wind was not blowing strongly enough this summer. This low-wind output has contributed to the energy crunch in Europe. Then there’s the commodity price boom. Floods in China mean coal production has been held back, sending prices up higher. “Usually, the best thing to do is not to get too stressed, and pray that your newly installed heat pumps work,” Gregory said to laughter.
The difference in growth investing in the US versus the high dividend pay-out culture in the UK came up, and whether it’s possible to change it. Gregory argued it all comes down to the shareholders and our ability to influence.
Despite the short-term challenges facing the UK, it’s important not to lose sight of the opportunities and the country’s current stance in the world. Getting caught up in negative headlines, whether it’s petrol shortages, supply chain issues or inflationary concerns, is not necessarily helpful. There are many opportunities in the UK. The key will be execution. Or, as Gregory said, getting together a solid group of “deliverologists.”
Gregory is voting with his feet. Although some of his friends and colleagues have moved back to Europe, he is staying put. “I decided to stay calm and carry on and continue living in one of the greatest countries in the world,” he said to thunderous applause. “The last time I checked, that’s still the UK.”
Written by Suzy Waite, Investment Writer, Arbuthnot Latham
Notes
Footnote 1: https://www.kcl.ac.uk/policy-institute/assets/the-road-to-2.4-per-cent.pdf
Footnote 2: France is number one