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, and Kate Elliot, Head of Responsible Investment Centre of Excellence, to discuss what this means for long-term charity investors.

 

David, if you had to sum up the third quarter for a charity investor, what were the main forces driving markets?

 

David: A lot went on during the quarter, but actually, end to end, markets were relatively flat, particularly in the equity market. Hidden within that was a lot of rotation.

 

The AI story has continued to dominate, but it switched from simply asking how much it was going to grow and who was going to buy which semiconductors, to how we are going to fund this. You could feel market sentiment starting to change, partially due to the bond market and yields rising. As bond yields continue to rise and inflation continues to rise, not helped by the situation in Iran, the cost of capital starts to rise. In the first half of the year, the market largely ignored this. We had this wall of money chasing the AI story. It was seen as a multi-year, multi-decade growth story: don’t worry about how much is borrowed, just borrow, invest and you’ll get the returns. What we started to see creep into the third quarter was: hang on a second. If your borrowing costs are going up and there’s a lot of competition here, with a lot of big companies investing large amounts of money, what does that mean? Not only were companies borrowing more in the bond markets, they were also issuing more equity.

 

I think the markets, as they always do, moved away from that real excitement and wall of liquidity we had in the first half, and went back to the fundamentals. Why do we invest? We want to see a return on our investment. I think what we’ve seen, and this has actually carried on into the fourth quarter, is that we’re back in the real world again.

 

One of the things we’ve been asking ourselves and the team is: how can equity markets continue to rise with this super-positive, bullish outlook when bond yields are also rising at the same time? Something doesn’t make sense. I think this is why we’re seeing these big rotations on a daily basis and huge volatility in individual company share price performance.

 

You may not see it if you simply look at our fund unit price at the beginning and end of the quarter, but within that period it’s been quite tumultuous, and that has carried on into the fourth quarter.

 

Olivia: Turning now to the Rathbones Active Income and Growth Fund, the market backdrop again tested that balance between growth, income and resilience. David, without focusing on short-term market moves, how did the fund’s diversified structure and set-up help it navigate the quarter?

 

David: The beauty of this fund is that it has an income yield target, and that means it tends to have a tilt towards financials. With interest rates rising, that tends to be quite good for banks.

 

Why is that? When interest rates are higher, banks can take a bigger margin between what they pay on deposits and what they charge customers. When interest rates are 1%, there’s not much room to manoeuvre in terms of how much margin they can take, whereas when interest rates are 3%, 4% or 5%, they can take a bigger margin. Rising rates can therefore be quite good for banks. We’ve been in something of a sweet spot for banks for a couple of years now, and banks have really revalued. I have to put a caveat here, because we’ve been trimming. There is a sweet spot. If interest rates become too high, banks get less demand for credit and borrowing, so they get less growth. They may also see more non-performing loans, or bad credit where they don’t get paid back. For banks, it’s a classic Goldilocks situation. You don’t want interest rates too low because they don’t make enough money, but if interest rates are too high, that causes other problems. You need them around what is called a neutral rate, and that’s roughly where we’ve been for the past couple of years. This fund has therefore had more in financials. We’ve also had more high-yielding companies. In fact, we sold two during the quarter: Legal & General and M&G. They had revalued and become quite expensive. We bought M&G when its yield was around 9% or 10%, and that’s come right down to about 6%. We’ve seen some really strong performance, particularly from the UK market in the first quarter. UK yielding stocks have done very well this year and, in our view, they’ve gone about as far as they can in the short term. So there are very different drivers in an income strategy compared with a total return strategy.

 

Olivia: From that income perspective, where are you currently finding the most attractive opportunities, balancing the need for income with quality and resilience?

 

David: We’re in a very different situation from where I think we’ve been for nearly 20 years.

 

If you look at the UK market, everyone cites it as being a high-yielding equity market. It’s now yielding only around 3%. Yields have come down substantially. Yet you can get around 5.4% from a 10-year government bond and, even with inflation around 3.6% or 3.7%, you’re getting a real yield of about 2% from government bonds, and maybe even higher from corporate bonds.

 

The valuation differential, or return differential, between bonds and equities has gone back to something closer to where we were 25 years ago. Since the global financial crisis, we’ve had very low yields and interest rates.

 

To me, that dynamic has shifted, so we have been taking equities down overall in the fund and increasing our fixed-income exposure.

There’s a big caveat in that we’re still slightly nervous about deficits. Government deficits aren’t great and interest rates are rising, all of which I accept. But you’re now getting paid around 5.5%. Bond markets have to fall a long way before you actually lose money, and bonds can act as a really good diversifier against equities from here.

 

I think the risk-return trade-off for bonds versus equities is about as compelling as it’s been for a couple of decades.

 

Olivia: I’d like to bring Kate in on the responsible investment perspective. The quarter has 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: I think it’s really important that people don’t view them as competing priorities, but in fact as closely interrelated, because there are significant positive and negative feedback loops between those different factors.

 

If we think about climate change and food security, for instance, we know the impacts of the extreme heat we’ve seen over the summer, which have been exacerbated by climate change, have fed through into lower crop yields and greater difficulty transporting those crops around the world. These are very much interlinked issues. When we’re considering those trade-offs at a company-specific level, it’s really important that we’re not expecting perfection. I would challenge anyone to bring me a company that has no negative impact anywhere in its value chain, because in 20 years in the industry I’ve not yet found one. It’s about making sure that companies have an awareness of where those risks and trade-offs might arise, that they’ve got appropriate governance and oversight of how to manage them, and that those plans are executed in reality. That’s somewhere engagement and stewardship activity can play a really critical role. It often involves dialogue with company management and the expert teams working within those organisations, both to understand and get a fuller picture that can feed back into our investment analysis and decision-making, and to identify areas of weakness, encourage positive change and promote best practice.

 

Olivia: When engagement isn’t producing enough progress, how do voting and escalation become part of what we do next?

 

Kate: We talk about engagement with consequences. In reality, there isn’t one clear roadmap that we follow where we start an engagement project knowing that, by month three, we’ll be doing a particular thing. It’s much more flexible.

 

We need to consider the nature of the engagement, the maturity of the issue and, sometimes, even the asset class and the tools that we have available, depending on what investment we’re making and how. Typically, we might think about an escalation framework that moves from informal dialogue with experts within a business to collaboration with other investors and our peers in the marketplace, amplifying the voice we have with those companies. It could then move to dialogue with more senior managers within those organisations, discussions with their boards, AGM voting or attending AGMs to ask questions. All of these are tools at our disposal. It’s part of our ongoing engagement oversight and planning to work out which engagement projects are on track and yielding the results we want to see, which aren’t moving at the pace we would like, and what the most effective levers are that we can pull to bring about the change we want to see.

 

Olivia: What should charity trustees be asking their investment manager to understand whether responsible investment is genuinely integrated into what they do, rather than being more of a reporting function?

 

Kate: Very similarly to the questions I would ask company management teams, I’d encourage charity trustees to ask their managers for evidence of how policies and statements of practice are implemented in reality. Often, I find that quite compelling if it can be put into context with examples. As much as we all love spreadsheets and data, I do think stories can sometimes illustrate the point much more compellingly. Ask for examples where ESG, or environmental, social and governance considerations, have affected an investment decision. It might not mean that the decision was not to invest. How has it been built into the investment case for that company?

Ask for examples of engagement activity. Also look for examples where things haven’t quite gone to plan, because even with the most well-developed and well-executed ESG integration, engagement and stewardship activities, we can all think of times when they haven’t yielded the results we anticipated.

 

Olivia: For our final discussion, we’d like to look beyond the quarter to the more structural shifts that are affecting markets. We’re moving from globalisation built mainly around efficiency 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 some of its policies under the current administration, David, how significant are these bigger-picture issues for investors?

 

David: Extremely significant. And, by the way, I don’t think it’s just this administration. Clearly it’s accelerated, but I think this move towards countries putting themselves first doesn’t go away with a change in administration. Even if the Democrats were to win the White House in two years’ time, I think this protectionism is here for some time. Whether it’s the West versus China, or even within Europe, you’re seeing countries thinking about food security and energy security, whether through renewables, fossil fuels or nuclear. All of these are back on the table. You only have to look at technology, where increasingly AI is seen as critical in military and defence applications, not just commerce. We’re going to see more intervention by governments and more subsidies. I’m afraid globalisation will continue to contract compared with where we were before COVID. The genie is out of the bottle.

 

Olivia: For investors, does this create a broader opportunity set beyond the sort of asset-light growth models that potentially dominated markets in the previous decade?

 

David: I think that’s right. We’ve seen this with the build-out of data centres, for example. It may be cheaper to build a data centre elsewhere than on the West Coast of the US, but ultimately this is now not just about cost. It’s about securing supply lines and supply chains. I think we’re less cost-conscious in some respects and in certain industries. Another potential benefit of capital goods companies, by which I mean industrial companies that make things, is that they may be less likely to be disrupted by AI.

 

They may be more defensive than some sectors such as software or platform businesses, which could be more exposed to disruption by AI and new, more complex search engines. Companies that make things and can use robotics and AI to improve productivity could be among the sectors enabled by AI to grow margins. So I don’t think we return wholly to the days of asset-light businesses dominating the market.

 

Olivia: Kate, from a responsible investment perspective, what tensions might arise when governments are prioritising things such as supply chains and domestic production?

 

Kate: As with anything in the realm of sustainability, it’s a much more complicated landscape than simply route A or route B.

Even if we think about growth in clean energy and how that links back to energy security and people wanting to build more domestic, secure energy sources, there are environmental benefits because we’re reducing reliance on fossil fuels as an energy source.

But it brings additional risks because it will increase demand for critical minerals, for instance, and the associated supply-chain risks. So it’s really important that we consider these issues in the whole rather than looking through a narrow lens at particular factors.

 

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 isn’t simply 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 that come with this transition.

 

Thank you very much for listening.