Health Check – Global Equities
One of the observations that we have made since March 2020 is the speed of this business cycle. What is typically a seven-year cycle has been compressed into a cycle that is more likely three or four years in duration. At the time of our last global equities health check (July 2021) we believed we were transitioning from early to mid-cycle. Now, given the acceleration of the interest rate tightening cycle, we believe we are in late cycle. Late cycle is typically good for defensive sectors such as consumer staples, healthcare and utilities.
Late cycle investing presents more tactical opportunities
A number of characteristics are typical for late-cycle – economic growth begins to moderate, credit conditions tighten, corporate earnings come under pressure, inventories begin to grow, inflation and interest rates are rising. Directionality becomes clearer in the market making tactical asset allocation more profitable.
As can be seen in our Trade Tracker below, just three tactical trades were implemented last year when we were in mid-cycle and market directionality was less clear. Already this year, we have implemented three trades, with one already closed. More tactical opportunities should present themselves this year as we move further into late cycle.
Table 1: CIO Trade Tracker
Table 2: Asset Allocation
To accommodate the transition in the cycle we have adjusted our global equities model. From a macro perspective, as the cycle ages, inflation and interest rates rise, and investors shift away from economically sensitive assets to defensives. Higher inflation typically weighs on the performance of longer duration assets.
Energy and utility stocks tend to do well as inflation rises and demand continues. Financials tend to underperform as the yield curve flattens reflecting the slowing growth outlook as do consumer discretionary stocks as inflation forces an adjustment in household budgets toward consumer staples. Cash has also tended to outperform bonds in late cycle and bonds tend to outperform credit.
Table 3: The business cycle and sector performance
Early Cycle: There is a clear divide between the winners and losers. Directional tactical asset allocation tends to perform well. The more cyclically sensitive sectors such as consumer discretionary, financials, materials, industrials and real estate tend to perform best. Defensive sectors such as health care, energy and utilities tend to perform worst.
Mid-Cycle: The divide between the winners and losers is less clear so fewer tactical asset allocation opportunities. The focus should be on making slight portfolio allocation changes to protect the downside and quality manager selection within active funds.
Late Cycle and Recession: Directionality returns as does opportunities to add value from tactical asset allocation. Defensive and inflation-protected sectors tend to do better.
Global Equities Model
As we have moved from early to mid to late cycle we have progressively become more defensive in our manager selection. Since September last year we have:
– removed entirely from the model our allocation to small cap funds;
– we have increased the weight to real assets such as infrastructure to hedge against inflation; and
– we have reduced our growth style bias and increased the weight toward style agnostic or neutral funds.
The current model is presented below.
Chart 1: Global equities CIO model of managed funds
Chart 2: Global equity model health check
We are happy with our 53% weight to North America. In our view, the regions most at risk of a recession over the coming 12-18 months are Europe and the UK. Where we do have exposure to these regions it is mainly in materials, such as Anglo American, or utilities, such as National Grid and Iberdrola. Both sectors tend to do well in late cycle. Since the start of the year the US S&P500 is down 20% versus -4.5% for Iberdrola, -1.5% for National Grid and +13% for Anglo American.
From a geographic perspective, one of the largest changes over the past 12 months is the reduction in emerging markets exposure, particularly to emerging Asia (from 11.9% to 6%). We are happy with this given the impact the strength in the US dollar tends to have on emerging markets. Emerging markets also tend to struggle in late cycle as growth eases.
This decline in weight to emerging markets is mostly due to our reduced weighting to the Franklin Global Growth Fund and WCM Global Growth. This has had the effect of reducing our top ten exposure to emerging market risk. In particular, HDFC Bank (a financial stock in India) and Mercado Libre have fallen out of the top ten. TSMC, the Taiwan semiconductor manufacturer, is still the number one holding for Fidelity Asia but has also fallen out of the top ten holdings.
In the past 12 months we have made some significant changes in our manager line-up to build in resiliency into the model to navigate a late cycle environment. This is best reflected in the changes in our sector weights.
Our exposure has increased to:
– Utilities, (from 0.3% to 12.9%),
– Consumer Staples (from 4.8% to 5.2%),
– Materials (from 4.1% to 7.1%), and
– Energy (from 0.5% to 3.7%).
Our exposure has decreased to:
– Information Technology (from 22.4% to 17.4%), and
– Consumer Discretionary (from 11.2% to 7.5%).
The total weight to technology stocks in our top ten is now just 1.7% in a single stock (Microsoft) compared to 3.5% across three stocks (Shopify, TSCM, Synopsys) 12 months ago.
Though being challenged in the current climate, Microsoft has a very strong balance sheet with $105 billion in cash and equivalents. It’s cloud unit, Azure, is growing by more 40% annually and it is expanding its margins. Azure generates $19 billion in revenue (responsible for 38% of Microsoft’s total revenue). Azure has several tailwinds given the heightened need for cybersecurity protocols and the increasing prevalence of remote work. Azure is growing across every industry, region, and type of customer. Microsoft has knocked Visa from its number one position in our top 10 holdings despite it being the stock most widely held by our model fund managers.
Visa derives its revenue from client services, data processing, cross-border transactions and value-added services, such as licensing fees. It does not issue credit cards and does not bear risk tied to the interest or fees paid by cardholders. The key tailwinds supporting Visa is the opening up of economies and the resurgence in travel and the intensification of the shift to digital payments. Visa is also disrupting the payments industry with its Visa Acceptance Cloud (VAC). VAC expands its “Tap to Phone” payment solution, allowing almost any device to be transformed into a cloud-connected payment terminal
New to our top ten is National Grid – a UK utility stock held by our newly appointed Royal London Global Equities fund. With a yield of around 5%, the stock is seen as a safe hedge against inflation given its revenues (which are up by 16%) are tied to inflation. The shift to electricity should also mean faster growth in the future, as electric consumption replaces gas usage. This should translate into faster earnings growth, supporting higher dividends.
Table 4: Top 10 positions
Table 5: Top holding in each sector