Investment Team Commentary - May 2024

Our full Investment Committee meets quarterly to review our recommended portfolios and consider changes in the light of current economic conditions. Here is an extract from our May 2024 Investment Team Commentary from Investment Team Manager, John Genovese.

Inflation & Interest Rates

Overall, the macro-economic environment appears to be relatively benign. Immaculate disinflation looks to have largely come to pass and headline inflation rates are now well below interest rates, with core inflation not far behind and continuing to trend downwards. Further progress on inflation towards the central bank target of 2% should be made over the coming months, as base effects play out and the impact of significantly higher interest rates continues to work its way through the economy.

This process of disinflation has happened without any major recession. Labour markets remain strong and forward-looking indicators suggest economic expansion, with optimism amongst consumers and businesses on the rise. The scene is now set for central banks to cut interest rates during the second half of 2024 and potentially into 2025, with the narrative then shifting to the likely neutral rate for the next business and market cycle. Just as rate hikes caused a re-pricing of assets downwards, rate cuts should serve to lift valuations and generate positive real returns for investors. 

Money Flows & Valuations

Across markets, investor attention has been narrowly focused on cash, money market and bonds, due to the higher yields on offer after a decade of ultra-low yields, as well as mega-cap US technology companies, owing to their dominant market positioning and optimism around the impact of AI on their future earnings. This has led to the current situation where a small cohort of stocks, making up a large proportion of the US and global stock market indices, appear very overvalued on a relative basis to the broader US market and to companies listed in other global regions, such as Europe and the UK. There is also a wall of money sat in cash and money market funds taking advantage of current elevated yields, which is ultimately awaiting redeployment into risk assets when yields fall and/or as broader market sentiment towards risk assets improves.

Another dynamic which has been in play over the last couple of years has been the stark underperformance of mid and smaller capitalisation companies vs their large and mega-cap counterparts. This has been a trend across all the major markets in which we invest, the US, Europe and the UK. The disparities in relative valuations of these companies are now at historically wide levels, making prospective future returns significantly higher for those invested in them (like us) at these heavily discounted valuations.

In the UK specifically, a number of factors have conspired which have impacted both valuations and liquidity in the stock market. These include higher inflation and interest rates, the impact of the Ukraine war on energy supply and utility bills, a lack of technology stocks in the benchmark index, a continuing hangover from Brexit curtailing foreign investment, a monumental reduction in UK equity exposure by retail investors and institutional investors alike, most notably UK Defined Benefit Pension schemes which now have only 3% allocated vs 50% 20 years ago, and regulatory issues around cost disclosure, which have contributed to widening of discounts across the universe of listed closed-ended funds. As a result, much of the UK market now looks cheap compared to its own history and to other global markets. Recent M&A activity and market commentary across the industry suggests we may be entering a more positive period for UK equities, as sentiment towards the UK is improving and market participants are starting to recognise the value on offer relative to other markets. 

Geopolitics 

Geopolitical risks remain, with the war in Ukraine dragging on and a new conflict in the Middle East now grabbing the headlines. It remains to be seen whether these conflicts will evolve into something which more fundamentally threatens the pathway towards recovery. There is a strong argument that notwithstanding a significant escalation in these conflicts, the evolution of inflation and interest rates will remain the primary driver of market returns through the remainder of 2024 and into 2025. There is however the potential for heightened day-to-day volatility in markets as a result of ongoing news flow around these conflicts and whilst less likely, the risk of further escalation can’t be ruled out.

Events such as these are extremely unpredictable, even more so is their impact on financial markets, which is one of the key reasons why we focus on maximising diversification within portfolios to hedge against potential falls in mainstream equity prices, which tend to be more sensitive to broad risk-off sentiment. The fact our equity exposure is broadly undervalued vs our peers may also serve as a cushion to any sentiment driven pullbacks, as lofty valuations in the US (at index level) arguably makes that market more susceptible to future downwards re-ratings.

Our Portfolios

In terms of our portfolios, our relative value investment style leads us to dynamically rotate into areas of the market which have the highest potential for longer-term future returns. This style means we can underperform when the market is driven by momentum and not fundamentals. This has led to underperformance vs our peers over the last 3 years, with 5-year returns broadly in line and 10-year returns still well above average, despite the drag of more recent returns.

However, we have good reason to believe that reversion to the mean is inevitable and in the coming years the repricing of our holdings back towards fair value, in combination with ongoing income and growth in earnings, has the potential to drive significant outperformance vs our peers, many of which have been herded into a narrow spectrum of assets which appear overvalued. Relative value investing requires patience, but it is proven to deliver above average returns over the longer-term, because future returns are highly correlated with starting valuations (see below – x-axis is valuation multiples at the start of the 10-year period and y-axis is 10-year annualised return). 

‘In It to Win It’

The challenge for investors is that returns are not achieved in a linear fashion, the bulk of the returns are generated on a relatively small number of trading days and predicting/timing them is impossible. The period covered in the graphic below is 35 years from 1986 to 2021 and look at the difference the 10 best trading days made to total returns. When investing for the longer-term, you absolutely need to be ‘in it to win it’.        

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” (Benjamin Graham)

With this in mind, one should judge the performance of a longer-term portfolio built based on a relative value investment philosophy over a full cycle (typically 7-10 years), as market mispricing of valuations can persist for years at a time. The market has been focused on the short-term, thus sentiment is driving asset prices and not fundamentals, when the move back to the right of the graphic below occurs, our portfolios are positioned to generate outsized positive returns.

FOMO (Fear of Missing Out)

At times like these, human nature encourages people to make significant changes to their investment strategy based on past performance and the fear of missing out. However, the solution to shorter-term disappointment isn’t to move money into assets which have had their prices bid up by the voting machine, this is akin to jumping out of the frying pan and into the fire. Smart longer-term investors (distinguished from momentum focused day-traders) ride out the storm and ignore the noise, no matter how loud it gets, and position themselves for the higher longer-term returns available through the combination of asset price re-ratings (mean reversion) and compounding of future growth from earnings and income.

Cash Deposits vs Longer-Term Portfolios

There will also be others who are attracted to the interest currently available on cash deposits. In that regard, it is worth noting that our standard portfolios have a weighted average yield ranging from 3% to 4.4%, with medium risk at 3.7%. Investors in these portfolios benefit from this ongoing income but are also positioned to benefit from the best trading days noted above, which ultimately end up determining a large proportion of the total longer-term returns they will achieve in order to fund their lifestyle and goals. As hard as it is to remain patient after over 4 years of turmoil across the globe and financial markets since the onset of the global pandemic, the world will move on from recent and current events and this patience will be rewarded in the form of positive real investment returns.

Future Expected Returns Look Very Attractive

Trying to second guess the timing of these returns is a fools’ errand. From a factual standpoint, what we can point to is the current expected future 10-year returns by asset class published by investment management industry giants such as Invesco and BlackRock. If you apply these return assumptions to our own model portfolios, they indicate the potential for very attractive real returns over the next 10 years.  

If you have any questions or comments about this article, drop us a line at https://www.chestertonhouse.co.uk/get-in-touch

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