02 Aug 2021
Mike Fox, Head of Sustainable Investments
Bond markets are signalling The Great Rotation is over. After falling to 77bps on November 5 2020, the 10-year US treasury yield saw an increase to 177bps on the 31 March 2021.
This was driven by the expectation of a reopening of major economies after positive vaccine news, proposed new stimulus plans from the US government and concerns over inflation with central banks being behind the curve. At the end of March consensus was expecting a further increase in yields, perhaps significantly so. As of the 7 of July the 10-year US treasury yield has declined to 136bps. Why?
Markets only make sense after the event. In March 2020, at the time of lockdown and the pandemic, equity markets started to rally vigorously, and have continued ever since. This made no sense to anyone reading the news of the day, but in hindsight it reflected a correct view that both scientifically and economically we would get through this pandemic. Today bond markets seem to be ignoring the news of the day regarding inflation. What could they be saying? The most obvious explanation is that they believe inflation is transitory and not permanent. They could also be saying that growth is going to disappoint versus expectations in the coming months, as stimulus measures are withdrawn and some of the scarring of the economy by the pandemic becomes clearer. Within equity markets, growth has started to outperform value again. In Q2 the MSCI World Growth Index returned 10.9% versus 4.9% for the MSCI World Value Index. Again, maybe this is saying that economic growth will disappoint going forward, a key driver for the value trade, and growth stocks will once again become more valuable.
Time will tell of course, but as we have said previously 2021 is shaping up in a similar way to 2010, in the same way 2020 resembled 2009 during the financial crisis. In 2010 the market started off being value/cyclical biased due to inflation concerns and a rapid economic recovery, but as the year progressed inflation and growth normalised. For the next decade, business outcomes drove investment outcomes, something which benefitted key sectors such as technology over commodities, and growth over value. We think there is a reasonable chance history will repeat itself.
One of the stranger things about the value versus growth debate is how separate it is from what is going on in the real world. ‘Value’ and ‘growth’ are often presented (sometimes by us!) as quite nebulous entities, benefited, or impacted by, things such and bond yields and inflation. In reality, growth and value are buckets and aggregations of stocks that sit in discrete parts of the global economy. Value tends to represent industries such as oil, retail, tobacco and banking. Growth tends to represent areas such as technology, healthcare and engineering. Value will only outperform growth in the long run if those companies and industries in the value bucket deliver better financial performance than those in the growth category. We think this is unlikely.
There is no doubt that the macro environment is complex and hard to forecast. No one truly knows what will happen in a post pandemic world from an inflation and economic growth perspective. Indeed, the last 18 months and the recent decrease in bond yields highlight the risk of being too fixated on one particular economic issue. Despite this macro uncertainty, the micro and industry outlook are perhaps as clear as they ever have been. We believe the winners and losers of the next decade are in plain sight.
One example of this is the way the digital world continues to eat the physical. The previous model of boarding a physical train to get to a physical office has been replaced with Teams and Zoom. Work has gone digital, for better or for worse. We have seen this trend many times before in the music industry (CDs to Spotify), and retail (high street stores to websites), and is accelerating rapidly in the general economy. This is great news for certain sectors and bad for others. Add into this mix decarbonisation and the need for higher healthcare standards and all of a sudden the ‘growth’ bucket looks significantly more attractive than investing in those industries impacted by these trends, the ‘value’ bucket.
As can be seen between November and March (and maybe again in the future) anything can happen over a short time horizon. But run a marathon and you want to be Mo Farah not Usain Bolt. Over the long-term, which really should be the horizon for any investor, the delivery of investment returns is a marathon not a sprint. Growth investing is Mo, steady and relentless over long distances. Value investing is Usain, explosive but ultimately short in effectiveness.
The performance of our sustainable funds was some way below benchmarks and peer groups (including non-sustainable funds) during The Great Rotation. This wasn’t a surprise to us, even if we don’t like or accept it. Between November and March, the lowest quality businesses on sustainable and financial metrics performed the best, beating their more sustainable and better quality peers hands down. This is completely opposite to our view on where long-term investment returns will come from and typically happens in periods of hyper growth coming out of a recession. In the last three months, between April and June, this has completely reversed with our funds outperforming, some of them materially. Most, and in some cases all, of the underperformance of Q1 2021 has been regained. We can’t claim any expertise or wisdom in making this happen; they are largely the same portfolios as when they were underperforming. The consistent thread through all of this has been the strong operational performance of the businesses we own, many themselves beneficiaries of the trend towards sustainability. Of course, we make no prediction as to future short-term performance, but it seems likely to us economic growth will slow from here, as will inflation concerns. Would this prove to be correct we would be optimistic about what the rest of the year holds for the funds.
This is the title of a book by Jerry Muller, an academic running a university department who became interested in both the rise of metrics in judging how well he managed his area and their adverse and unintended consequences. I know how he feels as metrics become a more prominent part of sustainable investing.
Being able to measure something is inherently neither positive nor negative. In all cases its usefulness is context dependent. Measurement does create some general issues to be aware of, however. First is that it creates a bias towards increasing the importance of things that can be measured versus those that can’t. In school, reading, writing and arithmetic can be measured so are targeted. Wellbeing, confidence and happiness cannot be measured so are not typically targeted as goals of education, but are equally important life attributes to learn. Measuring something, and incentivising around it, can also result in the system being gamed. For example, if a country was to target an increase in students going to university, lowering the standards of the grading system to allow more people to meet requirements would be one way of doing this with bad consequences. Measuring and incentivising correctly is of course the foundation of our corporate governance work.
An illustration of this in the sustainable world is carbon footprinting. Most funds, ours included, are rightly carbon footprinted allowing us to demonstrate how they perform against benchmarks and peer groups. At a high level there is nothing wrong with this, and we score well. Look into the detail and it becomes less clear. The two most critical companies in the UK for delivering the Net Zero agenda are National Grid and SSE. Between them they develop, operate, and connect renewable energy to our homes. Without them the UK cannot achieve Net Zero. They are also two of the most carbon intensive businesses we own. Electricity networks, both transmission and distribution, are energy intensive to operate. Both companies also own other forms of power generation, such as gas, which emit carbon but are needed until renewables reach scale and can meet the demand for electricity. So, if we were to target the measurable metric of carbon, we should really sell them to improve our footprint. In the end though this would mean we would have less chance of meeting Net Zero. The Tyranny of Metrics indeed.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.