Introduction
Olivia: Hello and welcome to our latest quarterly market update for charities. The third quarter brought another shift in the investment backdrop, with equity markets continuing to advance even as bond yields rose, energy prices remained elevated and expectations for interest rates moved higher.
I’m joined by David Coombs, Head of Multi-Asset Investments at Rathbones Asset Management, and Kate Elliot, Head of the Responsible Investment Centre of Excellence at Rathbones, to discuss what this means for long-term charity investors.
Market performance and the changing AI investment story
Olivia: David, if you had to sum up the third quarter for a charity investor, what were the main forces driving markets?
David: A lot happened during the quarter, but from beginning to end, markets were relatively flat. Hidden within that, however, was a great deal of rotation.
The AI story continued to dominate, but the focus shifted. The question was no longer simply how much AI would grow or who would buy which semiconductors. It became: how are we going to fund this? You could feel market sentiment beginning to change, partly because bond yields were rising.
As bond yields and inflation continued to rise, not helped by the situation in Iran, the cost of capital also increased. During the first half of the year, the market largely ignored this. We had a wall of money chasing the AI story. It was viewed as a multi-year, multi-decade growth opportunity, with investors paying little attention to how much companies would need to borrow. The prevailing view was simply: borrow, invest and the returns will follow.
During the third quarter, investors began to reconsider that view. If borrowing costs are rising and there is significant competition, with many large companies investing substantial amounts of money, the return on that investment becomes increasingly important. These companies were not only borrowing more in the bond markets but also issuing more equity.
Markets moved away from the excitement and abundant liquidity we saw in the first half of the year and returned to the fundamentals. Why do we invest? We want to see a return on our investment.
That shift has continued into the fourth quarter. We are back in the real world again. One question our team has been asking is how equity markets can continue to rise on such a positive, bullish outlook while bond yields are rising at the same time. Something does not add up.
That is why we are seeing significant rotations on a daily basis and considerable volatility in individual companies’ share prices. You may not see it if you compare only a fund’s unit price at the beginning and end of the quarter, but the period in between has been quite tumultuous. That has continued into the fourth quarter.
Connecting immediate pressures with long-term sustainability
Olivia: I’d like to bring Kate in for the responsible investment perspective. The quarter highlighted tensions between immediate pressures, including energy security, inflation and geopolitics, and longer-term challenges such as climate change, nature, human rights and governance.
Kate, how should investors hold these priorities together?
Kate: It is important not to view them as competing priorities. They are closely interrelated, with substantial positive and negative feedback loops between the different factors.
Consider climate change and food security, for example. We know that the extreme heat we saw over the summer, exacerbated by climate change, contributed to lower crop yields and made it more difficult to transport those crops around the world. These issues are very much interconnected.
When considering the trade-offs at an individual company level, it is important not to expect perfection. I would challenge anyone to find a company that has no negative impact anywhere in its value chain. In 20 years in the industry, I have not found one. Instead, we need to ensure companies understand where the risks and trade-offs may arise, have appropriate governance and oversight in place to manage them, and put their plans into practice.
Engagement and stewardship can play a critical role. This often involves dialogue with company management and the expert teams working within those organisations. It helps us develop a fuller picture that can feed back into our investment analysis and decision-making. It may also help companies identify and address areas of weakness, encouraging positive change and best practice.
Escalating engagement when progress is limited
Olivia: When engagement is not producing enough progress, how do voting and escalation become part of what we do next?
Kate: We talk about “engagement with consequences”. In practice, there is no single, clearly defined roadmap that applies to every engagement.
We cannot start an engagement project knowing that, by month three, we will always take a particular action. The approach needs to be more flexible. We must consider the nature of the engagement, the maturity of the issue and, sometimes, the asset class and the tools available to us based on what type of investment we are making and how we are making it.
An escalation framework might begin with informal dialogue with experts within a business. We might then collaborate with other investors and peers in the market to amplify our voice with the company.
The next steps could include dialogue with more senior managers or the board, voting at the annual general meeting, attending the AGM and asking questions. All these tools are at our disposal.
As part of our ongoing engagement, oversight and planning, we assess which projects are on track and producing the results we want to see, and which are not progressing at the pace we would like. We then consider the most effective levers we can use to achieve the change we want to see.
Questions charity trustees should ask investment managers
Olivia: What should charity trustees ask their investment manager to understand whether responsible investment is genuinely integrated into the investment process, rather than being primarily a reporting function?
Kate: Similar to the questions I would ask a company’s management team, I would encourage charity trustees to ask their investment managers for evidence showing how policies and statements of practice are implemented in reality.
It can be particularly compelling when this evidence is placed in context through examples. As much as we all love spreadsheets and data, stories can sometimes illustrate the point more effectively.
Trustees could ask for examples of where environmental, social and governance considerations have influenced an investment decision. That does not necessarily mean a decision was made not to invest. The question could be how those considerations were incorporated into the investment case for a particular company.
They should also ask for examples of engagement activity, including occasions when things have not gone to plan. Even with the most well-developed and well-executed ESG integration, engagement and stewardship activities, there will be times when the work does not produce the results initially anticipated.
From globalisation to security and resilience
Olivia: For our final discussion, we’d like to look beyond the quarter at some of the structural shifts affecting markets.
We are moving away from a model of globalisation built mainly around efficiency and towards a world increasingly shaped by security and resilience. Food, energy, technology and critical supply chains are therefore becoming strategic priorities. While the US is playing a central role through policies introduced by the current administration, David, how significant are these bigger-picture developments for investors?
David: They are extremely significant. I do not think this is solely about the current US administration. The trend has clearly accelerated, but this move towards countries prioritising their own interests is unlikely to disappear with a change of administration.
Even if the Democrats were to win the White House in two years’ time, I think protectionism is here to stay for some time. Whether it is the West versus China or developments within Europe, countries are thinking more seriously about food and energy security.
That includes renewable energy, fossil fuels and nuclear power. All these options are back on the table and are part of an active debate.
The same applies to technology. AI is increasingly viewed as strategically important to the military and defence sectors, not only to commerce. The US has taken a strategic stake in Intel, for example, because it wants those chips to be sourced and manufactured in the US rather than relying on Taiwan.
I believe we will see more government intervention and more subsidies. Globalisation will continue to contract compared with where it was before Covid. The genie is out of the bottle.
Investment opportunities beyond asset-light businesses
Olivia: Does this create a broader opportunity set for investors beyond the asset-light growth models that potentially dominated markets during the previous decade?
David: I think it does. We have seen this with the development of data centres, for example. It may be cheaper to build a data centre in the East than on the West Coast of the US, but this is no longer only about cost. It is also about securing supply lines and supply chains and protecting citizens.
In some industries, we are becoming less cost-conscious. One of the benefits of capital goods companies, which are industrial businesses that make physical products, is that they may be less vulnerable to disruption by AI.
They could prove more defensive than sectors such as software or platform businesses, including holiday platforms and other types of digital platform that may be disrupted by AI or new, more sophisticated search engines.
Companies that manufacture products and can use robotics and AI to improve productivity may be among the sectors enabled by AI to grow their margins.
I do not think we will return fully to a market dominated by asset-light businesses. As with globalisation, the investment landscape has changed.
Responsible investment in a more fragmented world
Olivia: Kate, from a responsible investment perspective, what tensions might arise when governments prioritise issues such as supply chains and domestic production?
Kate: As with anything in sustainability, the landscape is more complicated than simply choosing route A or route B.
Consider the growth of clean energy and how that relates to energy security and the desire to build more secure domestic energy sources. That clearly has environmental benefits because it reduces reliance on fossil fuels.
However, it also introduces additional risks because it will increase demand for critical minerals, along with the associated supply-chain risks. It is important to consider the whole picture rather than looking at individual factors through a narrow lens.
Closing remarks
Olivia: Thank you both.
A more fragmented world may create greater uncertainty, but it also broadens the range of long-term investment themes.
For charities, the response is not to make a single geopolitical bet, but to build diversified portfolios with exposure to resilient businesses, essential infrastructure and multiple sources of return, while remaining clear about the environmental and social risks associated with this transition.
Thank you very much for listening.
