This week’s Investment Soundbite Q&A is with Darius McDermott and Juliet Schooling Latter of FundCalibre. They offer their opinions on the second quarter of 2023, tackling the big themes of recent months – artificial intelligence and inflation –before giving their views on the best and worst performing asset classes so far in 2023.
(Recorded 27 June 2023)
Artificial Intelligence has been making the headlines over the last couple of months. Should we worry about it or is it something you think we should be embracing?
Juliet Schooling Latter (JSL): I think it’s here to stay and, over a long time, it’s undoubtedly going to disrupt, so it’s probably better to embrace it rather than fear it. We recently met with Chris Ford, Manager of Sanlam Global Artificial Intelligence fund, and if anyone can convince you to embrace it, he’s the man. He was talking us through the exciting opportunities that AI is throwing up to businesses that do choose to embrace it. And in fact, they use AI in the management of the fund, which is quite interesting.
Darius McDermott (DM): As we have seen with other industrial revolutions in the past couple of hundred years, they have generally been beneficial; they have given increased output and GDP growth. Like a lot of these things, it’s not as ‘new’ as people think it is; machine learning or the ability for a machine to improve on its output has actually been part of our lives for a while now, but it’s just getting quicker and smarter and I think it will have an impact going forward.
What I’m not yet sure of is exactly which companies or which type of funds will be the winners. There has already been an explosion on the winners in the S&P 500 that are deemed to be the AI stocks and some of them are up 100%-200% this year, NVIDIA Corporation being the standout performer. But it will definitely cause disruption and will also benefit economic growth. But it’s far too early to say who the winners and losers will be. I think if you are a big business and you are not thinking about AI, you probably ought to be.
What’s your view on inflation? And is it worth investing in anything else at the moment or is cash actually a really good asset class?
DM: Well, cash is always a good asset class when you get a decent return, and you can compound it. Anything that gives you 5% + is a good starting place for long-term compounded savings.
It is quite tricky out there at the moment, but as you can now get 7%-8% on corporate bond funds, you’re getting a 2%-3% premium on top of a cash-type of rate. It’s unlikely you’ll make a straight line positive return of 8%, because, as we know, bonds are linked to future rates expectations and if rates are going to continue to go up – as now looks likely – then corporate bonds won’t give you a positive capital return, but at least you’re getting paid 6%-8% in income to wait for those type of returns. So, I think corporate bonds broadly are interesting and maybe even shorter duration bond funds – those funds that invest in shorter or sooner-to-mature corporate bonds. They have less interest rate sensitivity and actually the risk/reward in that area seems to be fairly reasonable because you’re not taking that duration or rate sensitivity that we still might get with future rate rises.
I’m not a big fan of equities on a valuation basis if economies slow down, but that said, I’ve never been any good at timing markets; I think timing markets themselves is near on impossible. I have made no changes to my personal portfolio other than what we do on the VT Chelsea Managed funds which we advise, because that’s what I own. We’ve been buying some very boring corporate bonds on a risk-adjusted basis.
JSL: I agree with Darius that corporate bonds are looking attractive at the moment. And what you need to remember is whilst 5% looks like a really good interest rate given rates in recent years, if inflation is running at 8%, which it is in the UK, you’re still losing 3% in real terms.
What’s interesting is that services are booming while manufacturing isn’t, which means people are spending on experiences not goods, and this is keeping employment high, which is making things difficult to forecast. Central banks obviously have been hiking interest rates aggressively, but inflation tends to lag these rate rises. I think it’s possible that inflation could fall back sharply, but I wouldn’t want to hang my hat on when exactly that will be.
DM: I think almost everybody’s got inflation wrong. It was deemed transitory by all the central banks 18 months ago and had they raised rates sooner and more aggressively, we might have seen a quicker fall in inflation. Inflation was also very high in Germany again this month, so it’s certainly not just a UK phenomenon. I don’t think we’re going back to 0.5% interest rates anytime soon.
JSL: Fund managers we have spoken to are also quite divided on a) when inflation will come down and b) whether we’re going into recession.
DM: Juliet’s right. If one was to look at the strategic bond sector, any fund that’s at the bottom over 1 and 3 years has been wrong on inflation. They thought inflation was coming down sooner and they are positioned for inflation to continue to come down quicker than the market expects. That sensitivity to interest rates and inflation is a big part of what a fixed income fund manager has to do.
Looking back at the best performing sectors of the first half of this year, we’ve got technology, Latin America, Japan, and Europe. Can you perhaps talk us through them one by one?
JSL: Technology has been the outstanding winner, being up almost 25%, largely driven by the excitement around AI. The other sectors are probably a case of bouncing back, having sold off on fears of a global recession, which hasn’t materialised yet.
DM: People forget though that technology was sold-off excessively last year and some tech stocks were down 50%. I believe that their valuations are simply reverting to within reasonable parameters.
The ‘Super Seven’ stocks have driven not just the technology sector higher, but pretty much the whole US stock market. When I started my career, some of the tech stocks were high growth and they didn’t really make any money. Now, Microsoft and Apple, just to take two examples, make millions of dollars every day in the products and services that they sell and provide so they’re actually hugely cash generative, stable companies. And yet we’ve seen them halve and double so the share price can still be quite volatile.
I think Europe has had a reasonable period. Japan has also done very well; to borrow from Carl Vine at M&G, one of our Elite Rated managers, Japan had some fairly easy self-help. By this I mean companies that are working better for shareholders as opposed to historically always being for the workers. But anything that is up 20% or so in the first half of the year, I’d be surprised if they could deliver similar returns for the rest of the year.
The worst performers were China, commodities, and UK and US government bonds – what happened there?
DM: Quite simply, if interest rates go up more than the market expects, then bonds will go down. It’s a fairly simple relationship and, as we’ve already discussed, inflation just won’t go away. And now, the UK interest rate is expected to be at 6.2%, whereas 3 months ago the market was saying 4.6%, so that is a huge difference [in expectations] in one quarter – that’s why bonds are doing badly. And if you believe inflation is going to stay higher for longer, and that further rate rises above 6% are required, then it’s probably still potentially too early to be a buyer of bonds.
When it comes to the UK stock market, it actually did very well last year because it’s quite an idiosyncratic stock market, full of oil companies and banks and some healthcare and commodities, and those were the sectors that did very well. The UK has actually underperformed this year in comparison to last year. The US however, has done very well – mostly driven by the tech stocks – whereas last year the S&P was down about 20% and the NASDAQ was down over 30%. As I say, timing is extraordinarily difficult, and swinging the bat with respect to asset allocation is never a good idea. You can edge into a theme or edge out of a theme based on valuations or your outlook for a sector, but being invested for the long term and expecting bumps on the way is generally the natural course of things
JSL: There’s been a lot of nervousness about investing in China with geopolitical concerns and Chinese policy risks, and the anti-China rhetoric in the US continues to grow. I met with a manager recently who spoke about how sentiment becomes more negative the further West he went. He spoke about how the Chinese people are out spending and restaurants are full since lockdown restrictions were lifted, but the confidence still hasn’t quite bounced back as is evidenced by the property sector where transactions were down 40% last year.
What are your thoughts on what the rest of this year could hold?
JSL: I would say that bond funds look attractive here. And we are seeing value in oversold alternative investment trusts, some of which are trading at large discounts. But I think, as always with investing, you might have to be patient. UK mid- and small caps continue to look cheap on a long-term basis and, if we go into recession, they could get cheaper.
DM: It’s a recession that hasn’t quite happened. I think technically we avoided it by 0.01%’s worth of growth in Q4, but last year felt very much like a recessionary environment to me. And with the additional squeeze on property owners who are coming off fixed-rate mortgages, I still think we could see a slowdown, not just in the UK, but potentially across the developed markets. As I’ve already said, timing the markets is notoriously difficult, and probably the best thing to do is to do nothing in the short term and buy the dips as markets potentially do come off, having had a very strong start to the year.
Listen to the full interview here:
