This week’s Investment Soundbite Q&A from FundCalibre is with Paul Flood, manager of the Elite Rated BNY Mellon Multi-Asset Income fund, who tells us tells us about the current attraction of the bond market and the “rebirth” of the 60/40 portfolio.
(Recorded May 2023)
Would you describe for us how you identify some of the long-term thematic trends that run through the portfolio.
We tend to split our thematic views into macro and micro. Macro themes tend to inform us about the asset allocation-related topics and our micro themes are much more oriented to industry and company specific opportunities. A good example of the macro discussion includes ‘big government’, as we move away from our reliance on exporting jobs and manufacturing into low-cost areas and focus more on great power competition.
A great example of the micro thematic exposures at Newton is our natural capital theme, that ultimately evolved from our previous team, which was called Earth Matters (this came about way back in 2005 due to our concerns on global warming, so well before everybody got up to speed on that over the last three to five years going through the pandemic). We’re looking for the areas that benefit from significant capital spending requirements to help us meet our goals of reducing the human impact on climate change. For example, EVs, renewables, energy efficiency and sub-themes such as clean energy – it’s not just about solar and wind farms but there are also many other methods in which we can reduce our carbon emissions.
An example of that is buildings which make up 25% of global carbon emissions which comes effectively just from heating and ventilating our offices. So, if we can find ways to reduce the carbon intensity of this, then we can also help meet our carbon goals. New heating and ventilation or HVAC (heating, ventilation and air conditioning) systems are 20 to 30% more efficient than the legacy systems. This leads to companies like Trane Technologies, which is one of the leaders in HVAC systems. [Because] an easy way to start reducing your carbon emissions is just to upgrade your HVAC systems. But it also makes financial sense to do so, given the better energy efficiencies and higher power price environment that we’re currently in.
De-globalisation is one of your key themes. Can you explain what it is and what the longer-term implications are?
De-globalisation is one of the big themes that really helps with the views on asset allocation and in particular inflation, and it’s one of the core components of our theme on big government and great power competition.
Essentially, over the last couple of decades, we’ve really benefited from the deflationary effects of globalisation. Now, if we look towards really de-globalisation, then that’s likely to be somewhat more inflationary because we’ll be trying to not just stop exporting some of the high-cost jobs to low-cost areas, but we’ll be trying to re-onshore – or friend-shore as they call it – back into Western economies. And it’s a higher labour cost and higher cost base to be doing things in the West. And so, we’re going to have to try and find ways as to reduce the impact of those higher costs.
Bonds have now come back into vogue. Are alternatives as essential as they once were within a portfolio now, given bonds are more attractive?
The great thing about some of the alternative asset classes is the inflation protection that they provide. But within the portfolios, clearly, we’ve gone from a world in which we could get no return – in fact, we had negative return from many parts of the bond market over the last decade, particularly the last five years – and so, we’ve had very low allocations to bonds and quite high allocations to alternatives. And clearly, that really worked last year in 2022 because bonds and equities sold off in unison. And we were somewhat protected against that because our investment process was very much focused on trying to find attractive opportunities.
As the backdrop has changed quite significantly over the last 12 months, we’ve gone from at the beginning of last year owning just over 10% in bonds to now owning just under 30% in bonds. So, quite a material shift in the allocation to bonds. And then, unlike a lot of the headlines that we see, you know, ‘The 60/40 portfolio is dead’, we very much believe it’s more like the rebirth of the 60/40.
And bonds are now buyable again. You offer a return and going forward, given all of the concerns on inflation that are now out there in the investment community, we think that bonds will be much better diversifiers against equities within the portfolio construction process because inflation concerns are very much in the price and we think they’re now much more likely – particularly in the government bond market, which is where we’ve allocated a large proportion of that increase to bonds – to offer diversification and be focused on the growth outlook rather than the inflation outlook.
That bond exposure obviously has come at the expense of alternatives, but you’re still very much interested in them as a diverse income stream. Can you give us some examples of asset classes that offer that inflation protection?
Alternatives as an asset class is a very broad church. But much of what we’re invested in and interested in is really that kind of real asset exposure. Things that either have inflation-linked revenue streams or those real assets that tend to do well when inflation starts to pick up. Real estate isn’t one of those sectors, in that they do have inflation-linkage in terms of their rental streams, but that’s only going to survive if your tenants can afford to pay that increased rent. And when inflation is very high, it becomes increasingly unlikely that those contracts will hold.
We’re much more interested in things like renewable energy where you’ve got fixed inflation-linked revenue streams. There’s this huge demand to decarbonise our power generation. And we like to be in areas where there’s demand for capital. And when you look at some of the numbers for trying to decarbonise our economies, we’re looking at spending up to USD50 trillion. When we started talking about this many years ago, we were thinking USD5 trillion was an extremely big number, and now we’re 10 times that number today in terms of the expectations of the amount of capital that has to go into the ground to help with the decarbonisation efforts now. So, that’s a massive tailwind for companies in those areas.
But, importantly for us, when we look at renewable energy assets, particularly within the UK context, these are operational assets which in many respects do something similar to bonds in the portfolio in that they deliver very stable kind of income streams. So, they’re very bond-like in nature, but they also have that inflation protection because the contracts with governments are fixed and inflation-linked and they are a large proportion of the overall revenues of the business. What’s interesting here is bonds are just competing much more effectively for our investors’ capital. So, it’s right that we reallocate away from the alternatives when I guess the valuations across markets have changed.
But if you’re looking at the thematic backdrop towards the end of the year, then deflation might be the word that’s printed in the press and that people will start talking about again. But in the longer term, if we are looking to reduce our globalisation efforts and are much more focused on security of supply of some of these key components, that will have a more inflationary effect and therefore you’re going to want to have some real assets in the portfolio for those periods when inflation picks up and bonds do less well. So, from a portfolio construction process, they are a uniquely diversifying asset class to have in the portfolio.
What material impact will deflation have on the state of your portfolio today?
One of the things we talk about a lot – particularly for the multi-asset income strategy – is we’re trying to find securities that can pay and grow their income streams. And if we can find those companies, then the capital should look after itself. Alongside that, you’re organically growing your income through the dividend growth of some of these faster growing companies. But if we can then get the opportunities when markets are volatile to make asset allocation shifts, then we should also be able to increase our dividends for shareholders through that process as well, as we reallocate from areas that have done well, and therefore yields have fallen as prices have risen, to areas that have done less well, and therefore incomes have risen as prices have fallen. And that’s key to the investment process as we go through the cycle is that asset allocation process, and not being constrained with fixed asset class weights.
And what do we think are the chances of this happening? Well, particularly in a UK context, the oil price was much higher last year than it is this year, so that’s now a negative contributor towards inflation. Central banks are very concerned about bringing inflation back down again. So, the likelihood is they’re going to keep interest rates higher for longer. And particularly in the United States, given the banking situation, that in itself is having a credit-tightening mechanism as credit standards have risen from the US banking sector and that’ll create some constriction within the economy.
But some of these effects will take nine to 12 months to be brought through. And if you are slowing down the economy through those credit situations, but also having a negative year-on-year effect with oil prices in the UK, if you look to the LDI crisis at the back end of last year – back then sterling was at 105 pence to the dollar, we’re now up at 125. So, year-on-year, that will have a deflationary impact as well as the cost of our imports falling on a year-on-year basis.
I think a lot of investors will be quite surprised at how fast inflation comes down at the back end of the year. Policy makers don’t want to lift the foot off the gas, because we’ve had a couple of times already where we’ve seen some indications that inflation is going to start coming down and then it’s picked up again. So, central banks really want to get the service sector inflation down and that’s about resetting wage inflation expectations.
And I think as we go through the year, that’s what central banks will be very much focused on and that will entail getting unemployment up to the point where people worry more about having a job than having a wage rise. And so that should bring some of the inflation off in the shorter term.
But given the large allocation we have to government bonds, we think they should do quite well through that period as people start worrying more about deflation than inflation. And that will then be the time to rotate back into some of those inflation-linked assets as people think they have less need for them in their portfolio.
Listen to the full interview here:
