Keep the faith, whilst navigating bumpy terrain.
Jill Turner - Ethical Pension Specialist
Chartered Financial Planner and IFA at Big Picture Financial Planning Embracing Ethical & Sustainable investing
Sorry to go on about inflation but it does seem to dominate conversations at the moment, particularly because we are experiencing the double pressure of demand-pull, we want to buy more white goods after lockdown type of inflation and the supply-cost, we need to buy essential goods such as fuel, food but the scarcity of manufacture and supply has pushed up prices, type of?inflation.?
This article looks the effect on our savings, investments and how to navigate the current macro economic conditions, with reference to the ethical and sustainable investor, plus a few graphs to help along the way. It's a bit of a long article so a mug of tea may be in order.
Hello, my name is Jill, director and life centred financial planner at Big Picture Financial Planning, working with clients to plan for their future, have the best life possible with the money that they have, align their investments with their values, manage risk and protect the ones they love.?
It's a long article because :
we have not experienced this type of a macroencomic environment for 40 years, with all the “super factors" ( Robert S Kapito 2022 President and Director at BlackRock) ?
These are:
By way of an opener, I’ll start with a question. “What investments might an investor consider including in their portfolio that could give some protection against the return of inflation ?” For as long as I have been answering exam questions the answer has always been, “ in theory the protection offered by real asset investment ( company shares and property )?because their value generally moves in line with inflation, if prices generally double, real asset values should probably also double.?In practice, inflation and asset values may not move simultaneously.”?( 1.)
In practice inflation and asset values may not move simultaneously, or perhaps I should add, in the same direction, which is what we are witnessing right now. Inflation has risen yet valuations of real assets in pension and ISA funds have fallen, which led me to look for answers, to research why this should be the case.
It will depend on what type of equities are in your funds or portfolios.? The MSCI ACWI IMI ( All Country World Index Investable Market Index ) which includes the share price performance of 9,297 companies, large, medium and small in size across all different sectors, 23 developed and 24 emerging market countries. The index which covers 99% of the investment opportunity set and is used by investment managers as an indicator for global equity performance and to benchmark the returns of their own funds.?
From the start of the year the MSCI ACWI IMI there has been a downward - 20.44% in the value of the index. ?This is an aggregate though, within this, there will be sectors that have performed better and styles of companies that have become more favoured by “market participants”, the traders and the investment banks, as they react to the super factors.? Whilst there was an overall negative move in global equity prices,?the energy sector, containing the oil and gas companies, showed an overall positive price movement of?24.63% year to date as of 30th June 2022, as a consequence of rising demand post lockdown and scarcity of supply. ??
According to research by Liontrust, the energy sector was joined by the top three FTSE World Sectors over the last three months have been Tobacco +21%?Industrials and Mining +17.9% Aerospace & Defence +10.6%.? This means that portfolios designed for ethical investors that screen out investment into the oil giants, tobacco and arms manufacturers, will have been more exposed to the current market conditions and volatility.
Source: MSCI sector indices: Kouzmenko and Sampieri : MSCI ( 2 )
Coming out of the covid pandemic ( remember China was still imposing lockdowns until the end of June ) it was uncertain whether we would see a contraction or expansion of the business cycle.? Inflation had started to increase but the banks chose a "wait and see" approach waiting until?21st December in the UK to increase rates by 0.25% then again by 0.75% on 3rd February.? This was thought to be enough to dampen demand inflation. Other commentators felt the banks had left it a bit too late. ?
The US Fed increased their rates first and by a higher amount of 0.75% and the European Central Bank ( ECB ) has only just made their first interest rate rise in June this year, the first for 11 years, in a "mexican wave" response to global conditions. Europe being most effected by energy price increases.
We are however in more a supply type of inflation, due to external factors and these can't be influenced by interest rates.?
Concerned by the spectre of inflation, market participants sold out of growth stocks in favour of value stocks.? Commentators call this a rotation from growth to value stocks.? The latter, by nature, are already undervalued companies and on a just in case basis, should the markets fall, their prices have less further to fall. That’s the thinking anyway.??If value companies also have a steady stream of dividends they begin to look quite attractive, as a “cash cow” if nothing else.?
The oil companies’ history of falling share prices yet recent increases to dividends, makes them fit the bill and provided an opportunity for investors in the growth to value rotation,?quite a turnaround from January 2019 when according to a Financial Times article, Bob Bracket, a Bernstein analyst commented, “There’s just this hate for this commodity right now,” referring to the oil companies.?Those that bought into the energy sector will have benefitted from a year to date increase.?
Some portfolio managers, however, will have an active ownership and an ESG engagement approach, whereby they seek long term shareholder value though exercising voting rights and active engagement with a company to effect change.? Under this type of mandate it could be entirely acceptable to hold Shell and even Exxon Mobil within a portfolio, therefore benefitting from dividend distributions, an increase in share price, whilst also challenging their commitment to move towards renewable energy production.?This approach is more visible in sustainability focussed funds.?
Whether this recent uplift in oil prices turns out to be a dead cat bounce, we will have to wait and see.? It may well be, if legislative pressure to cease exploration and production increases and there are more tax raids by governments seeking to redistribute some profits to help with the high cost of energy bills. Bigger than this are the geo-political tensions over oil and gas supply, which serve to magnify the need to increase renewable energy production and shift capital investment in this direction.
There are two more pieces of the jigsaw puzzle that show why the ethical investor has been more effected by recent market reactions are because ethical portfolios screen out a number of sectors they will have a higher concentration of stock plus a bias toward growth companies, that are more effected by inflation and sensitive to interest rates.
Growth companies, by nature tend to have lower internal revenue sources and?therefore have a greater reliance on borrowing and when the cost of borrowing increases they are more sensitive and less likely to pay dividends. Furthermore growth companies are more likely to be given a current value based on their future earnings potential. So when inflation enters the?equation this gives a higher rate?by which to discount back the growth, to present day values. ?The companies are still decent companies, producing goods and services that are needed, it’s just that macro economic conditions and market participants have “got in the way” to give them a lower valuation.?
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Over to Peter Michaelis, Head of Sustainable Investing at Liontrust who gives a couple of examples of companies with attractive earnings that have been caught up in the rotation to value.? Docusign, a clear market leader in paperless signatures and now four times the size it was, yet a 6 month derating of 71% sees the share price is back to where it was pre-pandemic. With its ability to be part of the circular economy, save billions of sheets of paper, countless trees and time Michaelis sees a 5 year upside of 122%.?Similarly he favours US headquartered Masimo, as part of the Liontrust's innovation in healthcare theme. The company manufactures pulse oximeters and has seen a five year average of 19% return on equity yet its shares have been derated by 60% over the last six months.?“We see an upside in the region of 120% over the next five years”.?( Michaelis 2022)?
This current divergence is seen graphically in the chart below, taken from the?latest FTSE Russell Sustainable Quarterly Investment report available online.
This current?downward valuation of growth companies has impacted on ethical, sustainable and impact portfolios but it does seem to be at odds with what the world needs, innovation, goods and services that will meet the current global challenges of climate change, nature preservation, food security, clean water, waste management, health care for an ageing population amongst others.
This may explain why the most bought funds in the IA Global sector over the last six months. Funds that were added to far more than the most sold funds had withdrawals, were actually funds with an environmental, social and governance ( ESG ) mandate. L&G Future World ESG Developed World being the most popular with ￡740.8 million of new inflows followed by Vanguard FTSE Developed World ex UK Equity Index coming in second with ￡673.7 million.
According to Black Rock in their half yearly outlook, the themes going into the next half of the year?were to brace for volatility, live with inflation and position for net zero “ by investing in high-carbon emitting companies with credible transition plans or that are key to the transition, can give investors exposure to the transition as well as mitigate the impact of bumps” ?( Wei Li?2022 )?
The traditional mitigator of bumps in an investment portfolio has been bonds because when equites enter a period of volatility, bonds act as a cushion by because they react differently to the external economic and market conditions. ?In these last six months bond valuations have also shown negative returns.
However it’s not all bad news and as one of our investment managers states “In times of chaos, it’s worth taking a step back and asking what protection means for your portfolio. If you enter a phase where equities fall 20% and bonds fall 4% it’s easy to say they both fell in the same direction but bonds fell materially less than stocks and offered somewhat of a cushion; In a 50/50 portfolio, this means your portfolio would have suffered a 12% loss rather than 20%." ( Chana EBI 2022 ?)
In the graph below we can see the comparative journey for a 100% equity portfolio in blue, 100% global bond fund in bright red and short term bonds follow the maroon line. Source : EBI Research from Morningstar
While equities have their own battle on one side, bonds are also feeling the pressure due to the increase in inflation and interest rate rises.?The reason is the inverse relationship between interest rate rises and bond prices.?I’ll explain but it does get a bit more mathematical.?
A bond can be issued by a government or a company.? Through buying a bond, the investor hopes to get their capital back at the end of a fixed term and whilst the issuer has their money, the bond holder receives a fixed interest payment or coupon.
When interest rates rise an investor needs to decide whether they are better to hold cash with a set investment rate or a bond which also carries a risk of credit default ie the issuer can't repay the investor's capital . If interest rates rise giving, for example, 3% per annum from a cash deposit, a bond that pays 1.5% can look unattractive on a like for like basis so the value of the bond goes down. The bond is still paying 1.5% but to make it a more attractive return an investor would need to pay less for it. Why would an investor pay the face value of a ￡100 for a bond with a coupon of 1.5% ( when 3% is available for cash ) depending on market conditions, the price an investor may be prepared to pay is ￡90 and this is a fall in value. ?In fund manager parlance, this gives an increased yield, where yield is the return on the price paid.?
A further point to consider is the duration of the bond, the length of time the investor has to wait before getting their capital back.? Bonds with longer durations are more sensitive to interest rate movements, on the basis that?there a greater number of coupon payments are at stake and a lot can happen between now and the maturity date to effect the bond's value. Times of volatility and rising interest rates tends to favour bonds with a short duration as there are less coupons to pay before the bond matures, they will therefore trade with a slight premium, to take this into account.
It is important to remember that analysts report that companies coming into this period of volatility are coming in with strong balance sheets and capital discipline and this keeps the risk of default low. ? Bonds are still doing their job in acting as a cushion and reducing the volatility of equities. Government bonds have perhaps faired better and again for ethical investors who have screened out buying into government debt on the basis that they servicing a government, will be experiencing increased volatility.? I'll resist getting caught up in the government bond debate here and there will be increasing opportunities for ethical and impact investors to invest in green bonds and social bonds.
So in summary, interest rates are expected to increase but to reach a level that is acceptable to companies reliant on borrowing for growth, without triggering a recession. Therefore we possibly need to live with inflation for a while, particularly scarcity/supply push inflation, until the factories can fulfil orders, farming yields and food supplies increase and of huge importance when more sources of renewable energy come on board.
I've always said it's not possible to time the market, neither a good time to sell or a good time to buy. It is time in the market that counts. If anyone has money left at the end of the month after paying super high fuel bills, the current low valuations represent a good time to invest for the long term. For investors who want to position for net zero, investing in climate opportunity portfolios with an exposure to high carbon emitting companies with credible transition plans alongside other companies that are key to the transition, can give investors the opportunity to be part of the transition as well as mitigate the impact of bumps. ( Wei 2022 ) Going green and electrifying the power base will be incredibly resource & labour intensive. It will also require innovative products, services and infrastructure.
this is the story of the first half of the year.
We continue to support ethical and impactful investors who want to invest with a zero tolerance to fossil fuels, tobacco, armaments whilst directing their capital to solutions that create a positive impact around the world. in addition to model portfolios we can work with our investment managers to build a bespoke portfolios to accommodate specialist needs. Although expect to experience amplified volatility if the investable universe narrows significantly.
For maximum diversification and the widest exposure to the investment universe, we have a range of risk rated portfolios that are ESG screened on the equity side and offer aspects of both approaches above.
The main point is to be diversified as possible, understand the investment brief and trust that the investment managers will be taking stock of all the economic indicators, conducting their own analysis and will navigate you through short term periods of volatility towards your longer term goals.
This article is for information and does not constitute advice. Advice needs to be tailored to your particular set of needs and circumstances. The value of investments and the income they generate, can go down as well as up. Your capital is at risk.
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