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.
What drove markets during the third quarter?
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 went on during the quarter, but from beginning to end markets were relatively flat, particularly equity markets. Hidden within that, however, was a lot of rotation.
The AI story continued to dominate, but the focus shifted. Rather than asking how much the sector would grow and who would buy which semiconductors, investors began asking how all this investment would be funded. You could feel market sentiment starting to change, partly because bond yields were rising.
As bond yields and inflation continued to rise, with inflation 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. There was a wall of money chasing the AI story. It was seen as a multiyear, multidecade growth opportunity, with investors assuming companies could borrow, invest and generate returns.
During the third quarter, investors started to question that assumption. If borrowing costs are rising and many large companies are investing substantial amounts of money, what will the returns be? These companies were not only borrowing more through the bond markets but also issuing more equity.
The market moved away from the excitement and liquidity we saw in the first half of the year and returned to the fundamentals. Ultimately, we invest because we want to see a return on that investment. What we saw during the third quarter, and what has continued into the fourth quarter, was a return to the real world.
One of the questions we have been asking within the team is how equity markets can continue to rise on such a positive, bullish outlook while bond yields are also rising. Something does not make sense.
I think that is why we have been seeing significant daily rotations and volatility in individual company share prices. You might not see it if you only compare the fund’s unit price at the beginning and end of the quarter, but the period in between was quite tumultuous. That has continued into the fourth quarter.
Fund performance and the changing AI trade
Olivia: Let’s turn to the Rathbone Multi-Asset Charity Growth and Income Fund. The third quarter was a more challenging period for bonds, while equities continued to be supported by the AI build-out and generally resilient corporate earnings.
What were the main contributors and detractors during the quarter, and how did the fund perform overall?
David: It was quite mixed. Performance was mostly driven by individual stocks and the rotations I mentioned.
Semiconductor companies are part of the AI trade. For those who may be less familiar with them, these businesses manufacture the chips used in AI computing.
We have been moving from AI training, where models and agents are trained, towards AI use cases. This is known as inference. The question has therefore moved from how AI is trained to how it will be used and what chips will be needed to support those applications.
During the first half of the year, there was an explosion in earnings and demand for memory chips because there was a shortage. Companies such as SK Hynix, Samsung and Micron performed very well. These businesses were not necessarily on many investors’ radars because they did not always appear to have a distinct technological advantage. They produced relatively standard chips, but benefited from a classic imbalance between supply and demand.
One reason the fund underperformed during the first six months was that we did not have much exposure to those companies.
During the second half of the year, some of those stocks fell significantly, in some cases by as much as 50%. We remained underweight those companies, which benefited us. That change has been a key driver of the market.
As I mentioned earlier, semiconductor and AI stocks started to underperform during the quarter and the market began to broaden. It was not a linear or one-way trade, however. Performance continued to fluctuate daily.
Why equities remained resilient
Olivia: Much of the equity market, aside from some particularly volatile parts of the AI complex, performed relatively well during the third quarter despite rising bond yields. What do you attribute that resilience to?
David: That is the $64,000 question. Ordinarily, rising bond yields and central banks increasing interest rates in response to inflation should be negative for equities.
AI, however, was viewed as a non-cyclical, multiyear structural growth story. The earnings of AI-related companies were therefore seen as being less dependent on the economic cycle, consumer demand, inflation or discretionary spending.
For much of the year, the equity market was driven by companies perceived to offer multiyear growth and to be relatively insensitive to interest rates.
That narrative began to change during the third quarter because the cost of capital had risen. The market now wanted to see a return on that investment. We saw an initial public offering pulled in Korea, some data centres struggle to secure funding and a data centre real estate investment trust face borrowing costs of up to 15%.
Those higher yields were finally having an impact. Until then, the market had largely ignored them.
Outside the AI growth trade, equity markets performed quite poorly during the year. The index looked positive, but the average or median stock was broadly flat or lower.
There is still room for equity markets to rise if interest rates come down. However, I think the one-way bet on growth, AI and yields is now over. That was the significant change during the third quarter.
Portfolio changes during the quarter
Olivia: Against that backdrop, where did you have the conviction to add to the fund’s equity holdings?
David: We did not add a great deal and did not introduce many new names. We probably sold more than we bought during the third quarter.
As some AI stocks sold off, we added to existing positions when they weakened, just as we had added to some laggards during the first quarter. That is good portfolio discipline. If you have long-term conviction in a company and the market is behaving irrationally in the short term, that can create an opportunity to add to an underperforming holding.
Most of our additions were therefore to existing names whose valuations had moved back towards us. The businesses we sold were probably more interesting. For example, we sold Netflix earlier in the quarter after it announced that it would try to complete the Warner deal, which it ultimately lost to Paramount.
We felt that this represented a significant change in the company’s strategy and we had not anticipated it. Our interpretation was that Netflix was less confident in its content. Until then, it had dominated the streaming market, although we were already concerned about increasing competition from Disney and Apple. With Paramount and Warner potentially forming a much larger competitor, we felt the investment story for Netflix had changed, so we sold the position.
Similarly, we sold Aptiv, an automotive parts company principally involved in connectors and sensors for vehicles. It had been viewed as a long-term play on the transition to electric vehicles and the increasing number of electronic systems in cars.
It was a long-term structural investment idea within the portfolio, but management increasingly told the market that it lacked clarity and visibility over future growth. The market punished the company and Aptiv disappointed.
To some extent, we sympathised with the company because the automotive industry has faced considerable political uncertainty. Questions remain over whether petrol cars will be phased out by 2028, 2030 or 2035, depending on the political party and jurisdiction involved.
It has been a difficult period for the automotive industry. We did not necessarily blame Aptiv’s management for the lack of visibility and clarity, but the outcome for the investment was the same. The investment thesis had changed, so we exited the position.
Connecting immediate pressures with long-term sustainability
Olivia: I’d like to bring Kate into the discussion from a 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 many positive and negative feedback loops between the different factors.
Consider climate change and food security, for example. We know that the extreme heat experienced over the summer, which was exacerbated by climate change, resulted in lower crop yields and made it more difficult to transport food around the world. These are interconnected issues.
When considering trade-offs at an individual company level, it is important that we do not expect perfection. I would challenge anyone to find a company that has no negative impact anywhere in its operations or value chain. In 20 years in the industry, I have not found one.
Instead, we need to make sure that companies understand where 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 specialist teams within those organisations. It helps us develop a fuller picture that can feed into our investment analysis and decision-making. It can also help identify and address areas of weakness, encourage positive change and promote best practice.
Engagement, voting and escalation
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 roadmap we follow. We cannot begin an engagement project and assume that we will take a prescribed action by the third month.
The process is much more flexible. We need to consider the nature of the engagement, the maturity of the issue and, sometimes, the asset class and the tools available to us based on the type of investment.
An escalation framework might begin with informal dialogue with specialists within the business. We might then collaborate with other investors and our peers in the market to amplify our voice with the company.
We may move to discussions with more senior managers or the company’s board. Other options include voting at annual general meetings, attending those meetings and asking questions. All these tools are available to us.
As part of our ongoing engagement, oversight and planning, we assess which projects are on track and delivering the results we want to see. We also identify those that are not progressing at the desired pace and determine which combination of levers is most likely to achieve the change we are seeking.
Questions for charity trustees
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: I would encourage charity trustees to ask their managers for evidence showing how policies and statements of practice are implemented in reality. These examples can be particularly compelling when they are placed in context.
As much as we all love spreadsheets and data, stories can sometimes provide a much more compelling illustration.
Trustees should ask for examples of where environmental, social and governance considerations have affected an investment decision. That does not necessarily mean deciding not to invest. They should also ask how those considerations were incorporated into the investment case for a particular company.
Ask for examples of engagement activity. It is also worth looking for cases where things did not go according to plan. Even with well-developed and well-executed ESG integration, engagement and stewardship processes, there will be occasions when an activity does not produce the results that were anticipated.
From globalisation to security and resilience
Olivia: For our final discussion, I’d like to look beyond the quarter at some of the structural changes 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.
The US is playing a central role through policies introduced under the current administration. David, how significant are these bigger-picture developments for investors?
David: They are extremely significant. I do not think they relate only to the current administration. The trend has clearly accelerated, but this increasingly national approach to policymaking is unlikely to disappear when an administration changes.
Even if the Democrats were to win the White House in two years, I think protectionism would remain with us for some time.
Whether we are considering the West’s relationship with China or relationships within Europe, countries are increasingly focused on food and energy security. That includes renewables, fossil fuels and nuclear energy. All these options are back on the table and remain the subject of active debate.
The same applies to technology. AI is increasingly viewed as critical to military and defence capabilities, as well as to commerce.
The US has taken a strategic stake in Intel, for example, because it wants certain chips to be sourced and manufactured domestically rather than relying on Taiwan.
I think we will see more government intervention and more subsidies. Globalisation will continue to contract compared with the position before the COVID-19 pandemic. The genie is out of the bottle.
Investment opportunities in a more fragmented world
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 certain industries, we are becoming less cost-conscious. Another potential benefit of capital goods companies, which are industrial businesses that manufacture physical products, is that they may be less vulnerable to disruption from AI. They can be more defensive than sectors such as software or platform businesses, including holiday platforms and other online services, which may be more exposed to disruption from AI and new, more sophisticated search engines.
Companies that manufacture physical products and can use robotics and AI to improve productivity may be among the sectors enabled by AI to increase their margins. As with globalisation, I do not think we will return fully to a market dominated by asset-light businesses.
Responsible investment risks in strategic supply chains
Olivia: Kate, from a responsible investment perspective, what tensions might arise when governments prioritise areas such as supply chains and domestic production?
Kate: As with anything in sustainability, the landscape is much more complicated than choosing between route A and route B.
Consider the growth of clean energy and how it relates to energy security and the desire to build more secure domestic energy sources.
That has clear environmental benefits because it can reduce reliance on fossil fuels. However, it also introduces additional risks, because it will increase demand for critical minerals and create associated supply-chain risks.
It is therefore important to consider these issues as a whole rather than viewing 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 available to charities.
The response is not simply to make a single geopolitical bet. It is 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.
