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Walter Scott: If rates start to fall, market leadership could be altered

Francis Sempill, head of client services at Walter Scott, explains what a cut in interest rates could mean for stock market returns.

Francis Sempill (pictured), head of client services at Walter Scott, a BNY Mellon Investment Management firm, reckons that we could see a sea change in the type of stocks driving portfolio returns as interest rate begin to fall.

Lured by the potential of AI, last year’s stock market returns were driven by a narrow group of technology stocks, notably Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.

This peaked in April when the so-called Magnificent Seven accounted for nearly 90% of market gains.

Since equities markets began to rally again in late October, however, this has been driven by a much broader group of stocks, largely on the back of a shift in expectations around interest rate cuts.

Sempill sees this theme playing out in 2024 as the Fed begins to lower interest rates, with the central bank last week underscoring that it expects to make three quarter-point rate cuts this year.

“The narrow nature of the market has been driven in part by the interest rate environment. Many of the top performing names are relatively insensitive to higher rates as they hold a lot of cash and therefore have low borrowing needs,” he said.

“In contrast, smaller companies that must raise capital face far higher borrowing costs and as a result have lagged. If rates were to start to fall in a meaningful way during 2024, market leadership could be altered and stocks that underperformed in 2023 and earlier this year could begin to recover.”

Sempill also underscores the extent to which the outperformance of the US, while expected to continue for the time being, is still facing potential headwinds that investors are currently ignoring.

These include inflation, higher for longer interest rates, geopolitics and the prospect of further government shutdowns, he said.

He also emphasised that quality growth companies exist outside the US too, particularly in the semiconductor, luxury goods and automation sectors.

Turning to Asia, he remains cautious on China, where numerous problems persist including unfavourable demographics, deflation and problems in the property and local government financing vehicles sectors and he says that he prefers to gain exposure through foreign companies.

With regards to Japan, which has been popular among stock pickers for the past six months or so, he remains optimistic about the opportunities there, although he cautions that equities could come under pressure were the yen to strengthen.

BNY Mellon Long-Term Global Equity fund

Sempill is part of the investment team which manages the BNY Mellon Long-Term Global Equity fund. As of the end of last month, the fund has roughly €1.55bn ($1.68bn) in assets under management.

It invests in equities globally, although since it employs a bottom-up approach to stock picking the fund has some punchy calls in terms of country allocation. Unusually for a global equity fund, it has for many years been underweight the US, albeit North America currently makes up 61% of the portfolio.

This is followed by Europe ex-UK (18.4%), Japan (7%), Asia Pacific (6.7%) and the UK (4.8%) in terms of country allocation.

In terms of sector allocation, it has for many years had low exposure to financials, which make up just 7.9% of the portfolio. Its largest holdings are in information technology (25.9%), healthcare (19.8%) and industrials (14.6%).

The fund is benchmark agnostic and while there are no defined limits around the market capitalisation of any company it invests in, it is skewed towards the mega cap and large-cap firms.

The portfolio comprises 40 to 60 holdings so it is reasonably concentrated with the top 10 holdings accounting for around 30% of the portfolio. The fund limits the concentration of any single holding to no more than 5% of the portfolio.  

Turnover is currently 8% and historically sits at between 12% and 15%, while cash rates are around 2%.

The fund generally does not hedge currencies, although as part of the investment process, the research team takes into consideration currency exposure on the operating and financial conditions of any companies they invest in.

In terms of performance, the fund has underperformed the benchmark the past three years, albeit it did beat the benchmark in both 2019 and 2020. Sempill attributes this in part to the growth to value rotation, which created headwinds for a number of holdings.

He also noted that the strong performance in the healthcare and consumer sectors was offset by a smaller weighting to financials and energy, which performed well, while their allocation to industrials was hurt by their exposure to China.

Part of the Mark Allen Group.