At the same time, however, we recognise that no company exists in a vacuum: many of the factors that determine movements in its share price are beyond its control.
We recognise that no company exists in a vacuum: many of the factors that determine movements in its share price are beyond its control.
Changes in expectations for interest rates, for instance, have a huge impact on the relative performance of different regions and sectors of the global market. In the short-to-medium term, macroeconomic factors – and the way in which other investors respond to them – can overshadow an individual company’s financial characteristics.
So the way in which we select stocks and assemble them into a portfolio takes place within a framework we build through analysing macroeconomic conditions and investor positioning. The US Federal Reserve likes to say that its decisions on monetary policy are ‘data-dependent’; the shape of our fund is too.
Building a macro framework
Because we run an income fund with a focus on companies who can pay a high and sustainable income to their shareholders, we must pay particularly close attention to changing views on interest rates and inflation. Risk-free rates (such as the 10-year US government bond yield) act as the benchmark discount rates for the global financial system, influencing the valuation of almost every tradable asset in the world. They have particular relevance for ‘bond proxies’ – equities whose reliable dividend yields make them act like bonds, such as tobacco and utility stocks. Like bonds, their fortunes are closely intertwined with expectations for interest rates. If long-term interest rates are expected to fall, their dividends become more precious and their share prices appreciate. This process, of course, can also work the other way. We have long believed that, by keeping bond yields artificially low, central banks have driven prices of some types of equities to a point where they trade on extremely high multiples of their earnings. That could make them vulnerable as interest rates rise. So our fund has less exposure to bond proxies, particularly in the US, than many of its peers. Instead, we tend to prefer cheaper equities whose share prices should, in theory, benefit from a higher interest-rate environment.
Economic expectations also influence the performance of ‘growth’ stocks (companies whose earnings can grow independently of the wider economy) relative to ‘value’ (cheaper stocks with slower growth in sales and earnings whose fortunes are more attuned to the performance of the economic cycle – such as car manufacturers). When investors are worried about slow growth and deflation they will pay a premium for companies whose earnings can continue to grow in a hostile environment. But when the economy as a whole
is growing, inflation expectations and growth is less scarce, it helps value stocks. So, in seeking to determine the balance of different types of equities that the fund holds, we look at the macroeconomic picture.
What next?
If growth slows and inflation continues to disappoint, the fund’s ‘core’ (which consists of stable, higher yielding bond-like investments) will bene t and we will allocate more capital to it. But that is not our central expectation.
Today, we are seeing synchronised growth in every region of the global economy and liquidity remains abundant. After a slow start to the year, the US economy is reaccelerating and jobs are still being created. If this growth continues, inflation will return to the system and, as the market anticipates tighter monetary policy, bond yields should start to move higher. So although our portfolio is not positioned for one narrow outcome, at the time of writing its largest holdings are beneficiaries of continued growth, rising inflation expectations and higher bond yields: cyclical stocks (such as miners) and financials.
Yet although we have a view on the way in which the economic environment is most likely to develop, we are not complacent. It is difficult to predict how markets might react once the Fed begins to shrink its $4.5 trillion balance sheet, draining liquidity from the global financial system. No central bank has ever tried to reverse a quantitative easing programme of this size before. Should the Fed make a policy mistake, we would hope to find some protection in valuation: the portfolio trades at a 20% discount to the global market (in price-to-earnings terms) with similar earnings growth and a higher yield (around 3.5%).
In the first half of 2016, ‘growth’ stocks did well; in the second, ‘value’ outperformed. In the first half of this year, ‘growth’ outperformed again. It is tiring that the market has become a fairground ride whose direction changes every six months. But in a world with a muted business cycle and stop-go patterns in both fiscal and monetary policy, such reversals may be inevitable. By keeping an eye on the data, however, our aim is to be ready for them.
Issued by Artemis Fund Managers Ltd which is authorised and regulated by the Financial Conduct Authority.
