Hi and welcome to our Pensions Age video interview. I’m Laura Blows, editor of Pensions Age, and joining me today to discuss active equities is James Harries, investment manager of global funds at Newton.

So, to start with, I was hoping you could talk me through just some of the themes affecting global equities? Both from a macro viewpoint and in terms of investor behaviour?

Yes certainly. So the first point is at Newton we invest according to themes, which we think are able to make us think a little longer term, work out which countries, companies and societies are in a favourable position and which aren’t.

The important themes we think of at the moment, the first one is debt burden. We think there is basically too much debt. It’s causing problems in the sense that at some point debt becomes a drag on economies rather than a stimulus. If savings is consumption deferred, then debt is consumption brought forward. We think that an awful lot of consumption activity is being brought forward and it can’t happen again.

The second one is Chinese influence. We are cautious about the Chinese economy. China should have had a slowdown in 2008. She didn’t because she essentially leant into her economy in a way the world has never really seen before. This has led to a recovery in the Chinese economy but we think precedes a somewhat more difficult period. And therefore those areas that has been beneficiaries of the Chinese boom we think are likely to suffer. 

The third one I would mention is state influence. We think that the state is interfering in markets – we can observe that states are interfering in markets in a way that they haven’t really done so before. We believe this is highly distortionary. It’s affecting asset prices, it’s making it quite difficult to find a great deal of value and we think therefore all in capital markets isn’t quite what it seems.  So they are the things we are worried about.

There are some things we like. Healthy demand relates to healthcare and all peripheral areas related to that. We like all areas of technology. Data is exploding to the upside in terms of its usage across networks, and we can invest in that as a theme. And finally construction and reconstruction. It’s highly likely that countries or companies at some point are going to start spending more money on infrastructure. We can invest in businesses that do that. In terms of investor behaviour it seems to us that it is distinctly possible at the moment to extrapolate what appears to be a benign backdrop in asset markets and believe that this is indicative of a very healthy underlying recovery, and we just don’t think that is necessarily the case. It seems to us that investors generally are pretty optimistic.

Going back to the themes that you mentioned, and ways to invest, you mentioned China. I’m curious as to whether you think it will have a soft landing? And perhaps, on the other side of that you have the American market. Do you think it will actually reach ‘escape velocity’?

So in terms of China it seems to us that the boom has been going on for a very long time and has been highly influential in a lot of different economies.  And in addition to that the sheer scale of the lending and the pace of the lending into the Chinese economy is  something that would seem to us to suggest that the way that capital is being allocated in that economy is unlikely to be optimal. And therefore in a good scenario we are just going to have a situation thereby the investments that have been made from that lending are likely to have a poor return on capital employed, which is not great. A bad scenario is that it will feed back into the Chinese banking system and we will have much more of a problem related to poor credit. So it may be that China will have a soft landing but I think after the extent of the boom that we have had any sort of landing is likely to be felt as not particularly positive by the rest of the global economy. China is a much bigger economy now than it used to be of course.

With regard to the US economy, we are sceptical with regard to the extent in which escape velocity - as it has been called-  will be reached. The recovery in the states is better than elsewhere but we still think it’s relatively lacklustre given the sheer scale of the stimulus that has been applied to the US economy. Rather than the raising up of asset process, leading to a self-sustained recovery, we think it is much more likely that returns are being front loaded and therefore the outlook is less optimistic with regard to the returns than perhaps would have been the case. Its notable also that two core areas of the US economy, both consumer spending and capital expenditure, have been somewhat lacklustre. What companies have been spending their money on however is share buybacks, but that’s a bit of a one-off in our view.

Another influencer would be of course what’s happening with interest rates.  Do you expect to see interest rates rise in the US market and elsewhere?

We think they would love to put interest rates up. It is pretty embarrassing that six years after  we still have no interest rates in many of the important economies around the world. Indeed bond markets have strengthened very substantially, both in the US and Germany and elsewhere. We think it’s likely therefore that in the absence of quantitative easing, economies may well look rather weaker than many believe them to be. That as they take the scaffolding down, the underlying economy may look less good than currently appears. It seems to us then that rising interest rates are not given. In fact we think it’s possible that as the underlying weakness of the economy becomes apparent that the authorities may have to go back and do further quantitative easing rather than raising interest rates. And we suspect that the journey to rising interest rates expectations to more quantitative easing  could well be consistent with wider volatility and equity markets.

And does this affect your view with regards to currency? For instance do you have a view on sterling, and do you implement currency hedging at Newton?

We do use currency hedging in our equity portfolios that I manage. We use it sparingly, and it’s usually in order to either reduce the risk of being in a currency you think will be weak or to hedge into a currency that we favour but that we haven’t found sufficient assets to fully reflect that in the portfolio. So today is a good example of that. We are relatively favourably disposed towards the US dollar. Yet finding sufficient assets and companies that we think are reasonable value and sufficient quality for us to invest in, has been reasonably challenging. So we are hedging a couple of currencies into US dollars to protect the portfolios from an ongoing rise in the value of that currency. 

Now our view has bene relatively positive on the dollar for two reasons. Either because of the relative vibrancy of the US economy relative to other economies around the world or because we have a more problematic period. In that sort of scenario people tend to move into the dollar. That has been right, the dollar has been pretty strong recently, but if you look at the dollar in various different ways it would appear that it still looks relatively inexpensive in a sense that the US economy is pretty competitive.

The only reason I hesitate is because that view, that one should be positive on the dollar, is pretty consensus, pretty widespread, and therefore I suspect positioning is pretty optimistic with regard to the dollar. So a counter-trend move whereby the overbought position of the US dollar retreats somewhat before it then surges anew could well happen, but I don’t know. But I think a strong favourable position towards the US dollar is probably going to be right for some time to come.

And finally on your question relating to sterling, we think it is highly likely that the government has managed to create some form of better economic backdrop which may be coincidental with the fact that we are about to have an election, and we wonder if the sustainability of the current strength in the UK economy should be questioned. UK currency tends to be fairly geared into financial optimism and finance in all its different guises. We remain pretty sceptical about the health of the UK’s banking system and banks generally, including the US.  And therefore as we move into a more difficult phase economically, we would expect the UK economy to weaken and we have begun to see that.

That’s quite interesting, because I believe the consensus was that the economic markets was going to strengthen next year, so I just wondered how that plays into your views, and also why bond markets are rising?

Well isn’t that interesting. One’s reminded that the back end of last year 100 per cent of the economists that were polled in something I read on Bloomberg thought that interest rates were going to rise and it was likely that bonds would sell-off.  And of course the opposite has happened.  Now that doesn’t come as any great surprise to us.

We felt the withdrawal from quantitative easing from the economy is not just a withdrawing of a buyer from the bond market but it is also a withdrawal of stimulus from the economy. So as stimulus becomes withdrawn it is likely that the economy looks weaker and bond markets actually strengthen. And that’s precisely what happened. That has happened each time they have tried to withdraw QE in the past and it’s happened again, so it’s no great surprise. And yet we’re told that we’re about to reaccelerate in terms of economic growth around the world next year, but we seem to be told this every year.

One of our views at Newton is the ability of the authorities to dampen and lengthen the business cycle by dropping interest rates and encouraging us all to borrow more in a post-credit crunch world is somewhat more constrained. Therefore one ought to expect shorter business cycles. I mentioned earlier that we are six years into this, and therefore it seemed to us that it was much more likely that toward the end of this particular economic cycle, so for that to be coincident with a strengthening in bond markets seems to be totally consistent. So it is highly possible that bond markets are beginning to price in unsustainability of the current boom. It is also possible that bond markets are currently pricing in a scenario that equity markets currently aren’t yet.  Therefore we think a relatively cautious view is warranted.

Bringing that information together, what at Newton do you see as the prospects for global equities, say over the next year or so?

Well it’s always very difficult to make forecasts over that sort of timescale. What we do know is that equity markets, notably in the US, which seems to be everybody’s favourite but is also highly valued, but to a degree elsewhere, is pretty fully valued. If you look upon a cyclically adjusted basis, equity markets are trending towards the top end of their historic range. Now that suggests nothing about what markets are going to do in the short term but it gives a pretty robust framework for what expected returns should be for an asset class. Given prevailing valuations, the expected returns are likely to be low. It relates to the point I made earlier about returns having been front-loaded. So the outlook is actually less attractive than many believe. We do think there are pockets of the market where you can still find value, where you can invest, where you can still expect to make a reasonable return, but you have to work quite hard at it, and it is within the context of us believing that overall equity markets are pretty fully valued.

You said about having to find value within equities, and you mentioned the US market at the start. Is that an area where you can see a place to be able to generate income from equities or are there other markets that you are quite excited by?

So we invest on a global basis and we find ideas in many different parts of the world. Our view relating to China means that we are currently structurally pretty cautious on China and related areas, including that broader Asian market. We are conversely relatively pretty positive on the US, but because it is the most expensive market we have to be careful with regard to valuation.

 So we have a broad spread of investments across the world. We have for the past few years been allocating further capital to the US market, but as I mentioned we are beginning to find value hard to come by.  We have a number of businesses in Europe which we think are sensibly valued and we think will make decent returns from. And it is always possible to find something that is out of favour for whatever reason.

So for instance Microsoft as a business is quite a substantial business within our portfolio, but even within the context of a pretty optimistic outlook for the US economy, and for technology, and the US dollar, not very long ago, 12-18 months ago, Microsoft was deeply out of favour as a number of their consumer products hadn’t done particularly well and it was deemed to be a business that has slightly lost its way. Now we took a very different view, we felt that Microsoft had durable and resilient high returns on capital on their core enterprise business, and that peripheral stuff was depressing the share price to a degree that was unwarranted. And therefore we were able to invest in that business at what we felt was a very attractive valuation. It was a very good example when within the context of a lacklustre outlook, the combination of elevated outlooks and not brilliant economies, you can still find areas of opportunities to drive returns.

Thank you James, and thank you for watching this Pensions Age video interview.