Uncertainty in the global economy has made markets topsy-turvy in the past few months. For instance, the recovery in fixed-income markets stalled in the second quarter as interest-rate rises remained on the agenda and 10-year US Treasury yields (which move inversely to prices) were up 31bp to 3.81%, observes Euan Munro, CEO of Newton Investment Management, a subsidiary of BNY Mellon. In this time, he observes that most major equity markets made positive local currency returns over the three-month period.
Against this backdrop, FSA spoke with Munro to understand his views and the opportunities that investors in Asia should look out for.
How should we make sense of the volatility we have been seeing this year and what are its effects in Asia?
There seems to be strong competition between China and the US for technology, materials, influence in the world and militarily to some extent. And so, that has quite profound implications in terms of the willingness of different blocks to trade with each other.
We have seen the Inflation Reduction Act in the US, which is all about trying to pull manufacturing back into the US as well as nearshoring, which we think are going to have quite profound implications for investment opportunities around the world. So, the combination of the slightly cooler relationship between China and the US, we think is going to lower the absolute level of global growth because de-globalisation is inherently less growth orientated, which makes it slightly more inflationary as well. What this means is there are investment opportunities in areas like southeast Asia, Latin America and the US. So, in terms of how we think about where the investment dollars are going to be placed and the growth in an inflationary environment, that China-US competition is quite profound.
We are more excited about India and Indonesia, which have very strong demographic trends and are also some beneficiaries of some of the inward investment that’s leaving China. There are two things you often look for when you’re investing in an economy. One is, do you think there’s going to be very strong economic growth? And we will see that as being more likely in India and Indonesia. The other thing you might look for when you’re investing in an economy is, are there parts of the economy that are really interesting, where they maybe have got some technological advantage or something that you might want to invest in? So even if the overall economy isn’t very strong, are there areas that might be more interesting?
I think China would fall into the latter category, where as it tries to pivot to services, its domestic economy is affected. And there is a domestic economy that Chinese companies can tap into. Clearly, China’s trying to move from being an investment-led economy to more of a domestic consumption-led economy. Having said that, if you are buying at an index level, rather than picking stocks, our preference would be India and Indonesia.
One of Newton’s key investment strategies is looking for ‘better income outcomes’. How do you go about doing that?
People typically allocated to Asia with a growth mindset rather than an income lens. You had this very powerful growth driver of China that reliably hit a growth rate of 7% for 20-25 years. That drove growth in the whole region.
To some extent, we can see this in the US recently, more so than China. Over the last 10 years rather than the last 25 years in the US, all of the equity allocation and excitement has been growth stocks, whether that’s been Tesla or Apple or any technology-type stocks. There has been a lot of excitement about growth so we think global growth is simply not going to be as exciting going forward. The whole point of central banks increasing interest rates is to slow down the inflationary impulse that hasn’t been so significant in Asia, but has been a big problem in Europe, the UK and the US. And so, where they are raising interest rates to deliberately slow the economy, China’s restart after Covid has been a little bit sputtering and they’re going to have to pivot away from their previous model. If you build something and you’re hiring lots of people to build, you’re digging holes in the ground and you’re spending money that way, it goes straight into the economy. If you’re relying on creating a culture and an environment, where entrepreneurism flourishes, people stop saving money and start spending money, creating a consumer economy, that can be done a lot less reliably.
So, China is trying to move from a soft type of growth that was better suited to a command-and-control economy and that type of growth is slightly harder. Our view is simply that with higher interest rates and inflation needing to be dealt with, global growth is going to be lower. So, if you’re investing in equities, thinking you’re going to make big capital gains and you’ve got the benefit of growth, you might be disappointed. If you’re investing in equities, with the view that you’re investing in companies that are generating decent cash flow, are able to pay dividends and you’re able to compound those dividends, you have two advantages. One is you are not dependent on high levels of growth for your strategy to work. And I think if you already need to really be confident, you’re going to see that and we’re not. And the other thing is those stocks have been largely ignored. These are setting quite attractive valuations.
Do you think growth stocks are more inflation and recession resistant than income-focused stocks?
When interest rates went up, when we saw inflation and when the market came back down in 2022, it was income stocks that bounced back. And I’ve been a bit surprised at the extent to which growth stocks have bounced back, even though interest rates are much higher now. We suddenly got incredibly excited again about artificial intelligence. But if you look at what’s priced into interest rates, there seems to be this expectation that maybe interest rates might peak, perhaps another 25bp hike by the Fed, and then they’ll come down again quickly after that. So, there’s an expectation that interest rates go up, that will be over in a few years and we’ll be back to levels that look more normal, somewhere about 3% or something.
My view is that’s unlikely – interest rates probably have to remain elevated for much longer than the market is thinking. And I think that will be a challenge to a number of these growth companies.
How do you see alternatives performing?
If you take something like private equity or real estate, it is going to very much depend on the amount of leverage that the underlying investments have had. And I would be very concerned that a number of them are going to be facing refinancing events at some point in the near future. And that matters a great deal. If you’re refinancing at 300bp-400bp higher than the last time you had to, that can wipe out any profit those companies were making. An awful lot private equity is financial engineering. It is the application of debt. And so, I would be nervous about anything, whether it’s a real estate structure or a private equity portfolio, that had a lot of leverage. But more generally, alternatives do bring some diversification to a portfolio. They allow access to asset classes that would be difficult to get access to in the listed market. Some of them like infrastructure are maybe linked to inflation or linked to real cash flows, which, again, for liability hedging institutions, I can see the attraction of both of those things.
However, I would warn against this with alternatives. I suspect the fact that there isn’t price discovery, a lot of people’s alternatives portfolios appear to do well, but it really has yet to price in that change, which will happen once the new reality takes place. Obviously, if you’re a private equity investor and all the listed markets come down, then your exit opportunities are going to be at a lower price and that needs to be reflected in the private equity price at some point. And so, I do think there’s going to be some markdowns on the private equity books on account of the movement seen in the listed sector and on account of the moves we’ve seen in interest rates.
Some people seem to think that the lack of price transparency is a virtue. It’s not a virtue, but it may be worth putting up with if you get access to assets you otherwise would not or you get access to, which provides greater sources of diversification. However, I think I’m seeing some evidence of this view. My view is simply extrapolating a trend that alternatives did go up historically and there was a lot more allocation to them.
