Emma Wall: Hello, and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Eric Lonergan, Manager of the M&G Episode Growth Fund.
Hello, Eric.
Eric Lonergan: Hi.
Wall: So, multi-asset, which means you can invest in a whole suite of tools in order to deliver for investors. The problem is that many of these assets have become seemingly more correlated because of quantitative easing. So how do you invest in an environment like that?
Lonergan: Well, I think quantitative easing has actually created some major dislocations and opportunities. So, it has primarily distorted fixed income markets, or at least changed people's beliefs about interest rate expectations into the medium term. So, I think actually, where we are today, I think, has left us with a relatively straightforward investment opportunity, which is that if you look at the implied returns based on valuations to the equity market, they are very normal in the context of history. So, they are priced – global equities are priced to deliver you something like a 6% real return versus fixed income which now is priced to deliver you a negative real return.
Now, if you can take a three, five, seven-year time horizon, you have a very, very high probability that equities will deliver you very, very substantial returns. So, the main emphasis in episode growth is to have much high levels of exposure to equities into the medium term than it is towards bonds and that opportunity is largely a function of quantitative easing.
Wall: And looking at quantitative easing, it's a bit of a déjà vu situation at the moment, especially in the U.K. and there has been the accusation levied that quantitative easing is no longer effective and monetary policy is no longer doing what it is supposed to do. What do you say to that?
Lonergan: I think that's entirely fair. I mean, I'd say it's almost obvious now that further reductions in interest rates and more quantitative easing is having no significant positive impact on the economy because it's clear that households are not being held back by insufficiently low interest rates. Interest rates are already extremely low. The same is true for corporate sector and the same is true for government. I mean, probably the biggest irony is that the government isn't engaging in considerable investment spending given its cost of debt is so low.
There's two interesting dimensions to this though. What central bankers have tended not to focus on is the fact that the cost of equity is largely unchanged. So very interesting if you look at the pricing of the FTSE in the context of history, it's not that abnormal. So, in a sense, it's not surprising that corporate investment spending isn't very high, because the cost of equity is very normal if not elevated in the context of history.
The other thing I think that's very interesting is, what central bankers might do next and I think this is where I think one has to be very, very careful about fixed income assets. Gilt yields got down to 0.5% after Brexit. That means you are going to get paid 0.5% nominal as a yield to maturity on a 10-year view. That means after inflation there is a very high probability that you will lose money.
So, the price of that security for one for the better term is you are paying a very, very high price for that and the concern would be that actually, if these policies get more radical, which is the logical next step, they could actually succeed in generating inflation or much higher levels of growth which actually could deliver very significantly negative returns to fixed income markets.
Wall: So, bonds less attractive, equities more attractive. Are there sectors, themes, stocks within that that perhaps are the greater opportunities?
Lonergan: Yeah, there are a lot. I mean, I think also what's extremely exciting, I think, about global equity investing currently is, there are huge divergences. So, you described the fact that assets have been correlated. Within the equity market, there has actually been a huge divergence. So, amongst the exposures that I have I think you can get a very reasonably priced exposure to highly successful technology companies in the United States which deliver earnings and revenue growth way in excess of GDP. They are actually quite reasonably priced.
Some of them are developing semi-monopolistic characteristics. I mean, they have amazing business characteristics. I mean, I think the likes of Facebooks, Apples, Googles, these are incredibly profitable, incredibly strong businesses into the medium term and I don't think they are hugely unreasonably priced in. They are very reasonably priced. So, that is in a sense uncorrelated with cyclicality within the economy.
But then there are other areas of a completely different style like Japanese banks. Japanese banks are offering you very – almost double-digit implied real returns because they have reacted very aggressively in this kind of episode associated with negative interest rates. But if you can take a medium-term view, the probability of very high returns from those areas of the market. And then there are much more other interesting areas like biotech, European equity. So, I think the equity universe is influenced by multiple factors and is offering you, if you can look through short-run volatility, which is a key point of stress, very, very good returns into the medium term.
Wall: Eric, thank you very much.
Lonergan: My Pleasure.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
