This article is part of Morningstar's "Perspectives" series, which is a series of articles written by third-party contributors. In this article, Iain Stewart, manager of the Bronze-rated Newton Real Return Fund, discusses his economic and investment views.
Summary
- The investment backdrop remains much as it was at the turn of the year
- Despite the potential for short-term gains, a focus on stable, well-run companies seems sensible
- Investors should be mindful that policy action is likely to have an inflationary consequences further down the line
Look for Quality
We believe the backdrop remains much as it was at the start of the year; in a world facing the challenges of debt reduction and demographic trends, real growth will prove difficult to generate. This will not prevent the authorities from trying to boost activity in new and ever more innovative ways. The interplay between the difficult structural backdrop and the efforts of the authorities is likely to maintain a high level of economic and financial volatility.
All the historic evidence suggests that the best returns are made when investors are able to buy high-quality assets in well-managed businesses at attractive valuations. When policy is deliberately designed to prevent asset valuations from declining, it may be more challenging to identify such attractive valuations.
Volatile Times
With ‘event risk’ high, greater volatility is likely to be a feature of financial markets for some time to come. Investors face a number of uncertainties, including the Chinese leadership transition and the associated attempt to shift China’s economy from being investment and export-led to one being driven by consumer spending. In the US, the presidential election coincides with political wrangling over the country’s debt ceiling, and elections in the Spanish regions (in October and November), Italy (April 2013) and Germany (September 2013) – not to mention a likely election in Japan in November – create further reason to believe that pricing gaps and wild financial-market swings are likely to remain the norm.
...We still believe it is correct to invest in businesses that have the characteristics of high-quality cash flows and strong dividends...
In the longer term, continued economic and financial volatility is likely to increase the appeal of stable businesses and returns. However, as we have seen with the launch of QE1 and QE2, significant injections of liquidity by central banks can cause the valuations of more operationally and financially leveraged businesses, which incorporate the risk of imminent failure, to rise sharply as they receive a stay of execution.
Given that liquidity injections are likely to prove little more than short-term palliatives, and could ultimately end up allowing greater economic damage, we still believe it is correct to invest in businesses that have the characteristics of high-quality cash flows and strong dividends and coupon streams that we have long favoured. Equally, those areas of the market that offer structural growth opportunities, and which should be less affected by the ups and downs of the economic cycle should equally offer sustainable returns.
Inflationary Unknowns…
Given developments in monetary policy, it is appropriate to reconsider our exposure to ‘inflation’ hedges. The likely whereabouts of inflation are uncertain, but we can be fairly sure that ‘something’ will be inflated by prevailing policy.
Although we doubt the longer term success of the latest round of central bank intervention in delivering real growth, the apparent determination of the authorities to pursue a more reflationary approach suggests the balance of probabilities between the ‘tail risks’ in Newton’s opposing ‘deleverage’ and ‘fire risks’ themes has shifted. In a world characterised by the debasement of paper currencies, investors will need to focus on protecting the real purchasing power of their funds.
Does a greater reflationary effort from authorities mean that the low yields of ‘safe-haven’ UK Gilts and US Treasuries are exposed as return-free risk? That is possible, but in the immediate outlook it is equally likely that the authorities will act to ensure that these yields do not rise. Furthermore, in a world in which asset-price movements are driven by injections of central bank liquidity, these perceived safe-havens continue to show negative correlation with ‘risk’ assets and, hence, can be beneficial for portfolio diversification. Nonetheless, the justification for holding positions in other bonds – either those in countries where there is scope for further interest-rate cuts if growth slows, such as Norway or Australia, or in selected sub-investment grade corporate bonds where the additional yield offers a significant cushion – remains.
Morningstar Disclaimer
The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com.
Newton Disclaimer
This is a financial promotion for Professional Clients and/or distributors only. This is not intended as investment advice. All information relating to Newton Investment Management Limited (Newton) has been prepared by Newton for presentation by BNY Mellon Asset Management International Limited (BNYMAMI). Any views and opinions contained in this document are those of Newton at the time of going to print and are not intended to be construed as investment advice. BNYMAMI and its affiliates are not responsible for any subsequent investment advice given based on the information supplied.
