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 Freddie Lait, of Latitude Investment Management.
Hi, Freddie.
Freddie Lait: Hello.
Wall: So, I thought we could talk today about returns expectations and reality. We are facing incredibly challenging times at the moment, not least because of geopolitical risks, but also because market valuations are very high. And I think there's a bit of a disconnect between what investors should expect to get and what they would like to get.
Lait: Yes, I think, you are right. I think since cash rates have come down from sort of 5% to nearly zero or less than that in some places in the world, investors haven't really recalibrated their expectations. And so, a lot of businesses are still targeting returns that may have been achievable with a sort of 3%, 4%, 5% carry underlying it with your risk premium on top, whereas now actually I think people will need to reset down their return expectations.
Sadly, I think, at the same sort of time when rates went down to zero, most markets seemed to have lost their investment compass. And so, you've seen increased volatility in FX markets and most markets around the world now including bond markets. So, I think, you are into a lower return higher risk world and it's a very difficult one to navigate from here.
Wall: And you are now running a long-only portfolio. You used to be a hedge fund manager. Multi-asset and hedge funds tend to work towards the sort of target of cash plus a certain amount. But as you say, I think, people are still thinking about, cash 4%, plus 2%, equals 6%. But that's just not the case anymore?
Lait: I think that's right and you've seen a lot of more leveraged funds, a lot of hedge funds striving to take more risk, thinking that the risk-return curve continues to be linear and I think that's been the danger. I think the right thing to do is to plan your portfolios accordingly to take a little bit less risk than you're used to now, because risks are broadly higher, try and think about real-time correlations within your portfolio rather than the long-standing 20-year relationships because correlations are breaking down a lot at the moment. And seeking to eke out that kind of equity risk premium, sort of, 3%, 4%, 5% above inflation or cash which are both near zero at the moment and aiming a little bit lower.
Wall: And it's not all doom and gloom before people get too depressed watching this video. There are opportunities out there. You just have to be a bit more clever about where you find them?
Lait: I think so. I think one way to decrease volatility in your portfolio which is very commonsensical is to invest in the sectors that everyone isn't talking about. And it doesn't necessarily mean being hugely contrarian or taking a deep value call. I think you need to take a long-term call on all of your equity investments in particular. But I think one example is the commodity space where everyone seems to be piling into, sort of the Trump infrastructural bill, things like this. Actually, if you look at what's been driving the commodity markets is mostly Chinese financial demand as opposed to real production demand.
If you work through what Trump's policies are going to mean in terms of the demand side for copper or iron ore, it's a couple of percent a year incremental demand and I look at that industry and say, well, the supply side is still terrible. People are still brining new mines on. There's excess capital employed going in. Margins are falling. To me, for the next five years, commodity producers will run for cash and prices will stay very low. So, that's not a sector where I think one should be going towards and it's incredibly volatile. So, you cut out a lot of volatility by not investing in spaces like that.
Wall: And where are you looking then? Where do you find the opportunities?
Lait: So, I think, a great place to be investing has been the U.S. financials, the U.S. large-cap banks. We've had a large number of those in our portfolio at Latitude and they continue to seem to be very good value to me. The returns are increasing. The competition has been decreasing. They are all earning their – sort of their return on capital is equal to their cost of capital at the moment broadly across the space at a zero interest rate environment.
So, in the worst possible world of heavy regulation and low underlying carry for them. They are much better businesses, they are much leveraged and I think in any kind of rate cycle I think they will take advantage of the Fintech in the market and I think they are going to grow very, very rapidly and should re-rate 1.5 to 2 times book value depending on who you are looking at with some growth. So, that's a great space.
And I think ultimately in the U.S. the consumer is still the place to be investing. That's the cyclical sector of choice for me, not the commodity and the primary producers. But if we get a little bit of wage inflation, the market is quite tight in terms of the output gap. So, I think, you will get some wage inflation and those consumers will spend more on everyday goods. So, consumer discretionary at the lower end is probably a very attractive place to be.
Wall: Freddie, thank you very much.
Lait: Excellent. Thank you very much.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
