Global equities: Is a new (theoretical) pecking order required?

Capital at risk. This content has been prepared for professional investors only. All financial investments involve taking risk which means investors may not get back the amount initially invested. Yields will fluctuate so income from investments is variable and not guaranteed.

Which stocks should a global equity fund invest in? If you were building a global portfolio from scratch today – and if you wanted to deliver a decent and growing yield at a time of inflation – which parts of the market would you look at? And which would you avoid?

Which areas of the market best are best placed to perform in a world where:

• inflation (rather than deflation) is the dominant worry?
• geopolitical tensions are escalating and 30 years of globalisation are being reversed?
• central banks are draining liquidity from financial markets (turning QE into QT)?and
• the cost of servicing debt is rising sharply as nothing is longer ‘for free’?

We launched our fund in 2010. So we are emphatically not building our portfolio from scratch. Furthermore, we are stockpickers rather than thematic investors. At the same time, however, undertaking a periodic ‘sense check’ of our portfolio against our broader view of the world is a useful discipline. So from time to time – and especially around big market events such as Covid or the Russian invasion of Ukraine – we step back from studying cashflow statements and balance sheets and try to predict how the various forces that are shaping the global economy will translate through to cashflows and dividends.

So, as the year began – and then again as Russia invaded Ukraine – we ranked different areas of the global equity market and different types of assets and asked ourselves where we would allocate our capital if we were building a portfolio from the ground up. The ranking we arrived at looked like this:

1.         Defence stocks

2.         Real assets and ‘upstream’ assets

3.         Defensive assets

4.         Downstream consumer assets (and ‘downstream’ cyclical stocks)

5.         Financial assets

This theoretical pecking order does not to prohibit us from investing in a particular sector (for instance, although we are currently avoiding the major US banks, we do have a number of financial holdings). We are also conscious of the need to be nimble: in contrast to the last decade, when QE and free money (the so-called ‘central bank put’) artificially suppressed market volatility, its withdrawal seems likely to provoke it. So we must be prepared to take short-term tactical positions that are at odds with our long-term direction of travel: it’s not a straight line from A to B. But our ranking does provide a strategic road map – an indicator of which parts of the market are in the process of becoming relatively more – or less – attractive, and where it might be wise for us to raise (or lower) position sizes.

Our process – and our theoretical pecking order – result in a portfolio that has little in common with the ‘typical’ global equity income fund

1. Defence stocks

That we placed defence stocks at the top of our pecking order doesn’t mean that they dominate our portfolio; they collectively account for less than 10% of our holdings. At the same time, however, we have never previously had such a high weighting to this area of the market …The reason that defence stocks appear so attractive should be as obvious as they are regrettable: the world is less peaceful than it was.

The case for investing in defence companies, however, is not simply a kneejerk response to Russia’s invasion of Ukraine or to heightened tensions in the Taiwan Strait. They are beneficiaries of broader, longer-lasting processes of deglobalisation. Increased geopolitical tensions that began with trade wars have intensified to the point that we are seeing rising defence budgets and the expansion of NATO.

Relevant holdings: Rheinmetall; Mitsubishi Heavy Industries; BAE Systems; Raytheon

2. Real assets and ‘upstream’ assets

For a number of years, we have been noting that a long period of underinvestment by the energy sector (the carbon bit of it, not renewables) had degraded its ability to respond to surges of demand. Assets were not replaced or upgraded and, as production from mature fields declined, there was little investment in the next generation of oil and gas fields. That discipline towards capital expenditure helped to pacify the oil companies’ shareholders, both ESG activists as well as income-hungry investors, who preferred dividends and share buybacks to capex and drilling. But it also meant there was limited capacity for supplies to increase when demand returned. The implications of that dynamic were starting to become apparent even before Russia invaded Ukraine. And although oil prices have given back the gains they made in the immediate aftermath of the invasion, they remain significantly higher than they did a year ago – as do the share prices of energy companies. As with defence stocks, energy holdings only constitute one element of our diversified portfolio – but our weighting to them has rarely been higher,

Sector allocation

The mining sector offers a vivid example: during a long period of retrenchment, mining companies slashed investment, paid down debt and scrapped plans to open new mines. We appreciate that the cyclical element of the mining cycle remains – but the lack of investment meant that supplies of commodities and raw materials are tight and companies that make or distribute them have more pricing power today than they have for years.

Relevant holdings: ExxonMobil; Glencore; Archer Daniels Midland; Nutrien; GTT

3. Defensive assets

As 2022 began, it seemed likely that the global economy would follow one of two broad paths. One possibility was that post-pandemic surge in economic growth would wilt under pressure from rising input prices and that recession worries would become self-fulfilling. The second possibility was that growth would remain strong in the short term, putting further pressure on input prices and labour costs and so forcing the hand of central banks to choke off demand. Neither option appeared particularly supportive for cyclical stocks. As a result, relative to pre-Covid times, we’re investing in stocks with stronger balance sheets and more predictable earnings; we have fewer ‘deep value’ names with leveraged balance sheets. In broad terms, we have reduced our exposure to economically sensitive cyclical stocks and added to defensives such as pharmaceutical companies and utilities.

Relevant holdings: RWE; Vinci; AbbVie

4. Downstream consumer assets and ‘downstream’ cyclical stocks

Although we retain exposure to upstream cyclical stocks – such as energy companies, miners and fertilizer companies – that are beneficiaries of input-price inflation, we have reduced our exposure to their customers. In broad terms, we want to own companies that benefit from rising input prices and to minimise our exposure to ‘price takers’. Today, many consumer-facing companies find themselves between a rock and a hard place. The rock? Rising costs for a range of inputs: energy; raw materials; labour. The hard place? Consumers whose finances are under pressure as their non-discretionary expenses (petrol, utilities, mortgage payments, food bills) ratchet higher.

Relevant holdings: None.

5. Financials

That interest rates are moving higher should be good news for financials – at least in theory… The hope is that higher rates will allow banks to increase their lending margins. In reality, however, the yield curve has remained stubbornly flat (even inverted at times) signalling a fear that higher interest rates will succeed in crushing economic growth without taming inflation. Banks tend to do well when the economy is strong and the yield curve is steeper than it is today. A recession will result in more defaults and more bad loans. So we have lowered our exposure to the major banks this year despite their modest valuations.

One caveat: there is more to the financial sector than banks. And there are a number of financial stocks (broadly defined) that seem well-suited to the current environment. Some real estate companies, for example, find that while their funding costs may be increasing as bond yields rise and corporate spreads widen, that is offset by a shortage of housing supply, which allows them to more than recoup those costs by imposing higher rents on their tenants.

Relevant portfolio holdings: AvalonBay Communities

All data as at 31 July 2022. Dividend yields are 12-month forward basis. Source: Refinitiv. Portfolio weightings. Source: Artemis as at 31 July

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