T.Bailey Quarterly Update Q3 2023

The last two years will certainly go down in history. After more than a decade of low interest rates and low inflation, the world turned on its head in January 2022 as we entered a period of soaring inflation and a new investment regime that central banks, in hindsight, did not address early enough. Subsequently, interest rates have increased at the fastest pace in history in a bid to try and keep inflation at bay.

What remains unknown is whether central bankers have done enough by taking the heat out of the economy to defeat rising inflation or if they have done too much, which could result in a deep recession. They hope to land in the sweet spot somewhere in the middle, fully aware that this is a difficult yardstick to achieve. This unknown outcome is understandably causing much market uncertainty and volatility.

With this backdrop, the third quarter of 2023 remained challenging for investors. A tough stance from the US, UK, and European Central Banks, indicating that interest rates are likely to stay higher for longer, weighed on investor sentiment towards the end of the quarter. This is despite the Bank of England opting to pause hiking interest rates and inflation starting to fall in the UK and the US. Strong economic data from the US and rising oil prices over the last few months have added to wage pressure, resulting in central banks’ hesitancy to declare that they’ve won the battle with inflation. We now find ourselves in a strange environment where signs of a strong economy, a healthy employment picture and increasing wage pressure are negative for investment markets as the threat of further interest rate rises strengthens.

The ‘Magnificent Seven’ stocks (recognised as Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta) that powered equity indices in 2023 subsided in September. Rising yields took their toll on equities across the board and caused havoc in bond markets, and the prospect of ‘higher rates for longer’ also impacted gold, leaving few hiding places.

Within the multi-asset funds, exposure to US Treasury bonds was hurt as bond yields rose. These have been bought opportunistically over the quarter as they are expected to add protection in a recessionary environment; bond yields should reverse in a crisis. Additionally, while the managers have had some exposure to the US Dollar, much of this has been hedged back to Sterling, which is felt to be undervalued. This negatively impacted performance, given how strong the US dollar fared over the period.

Within the equity book, recent months have seen a narrow breadth to global equities, with the broad market’s performance being driven by the largest US-domiciled companies. As a thematic investment house, T. Bailey has not had exposure in this space. Healthcare and energy transition—two key themes—have disappointed in the ‘higher rates for a longer’ environment. Healthcare is held for its defensive characteristics but has been more volatile than expected, and the energy transition has been impacted by short-term sentiment, which has caused increasing volatility. Nevertheless, the managers still strongly believe in the long-term story and that initiatives such as Biden’s Inflation Reduction Act will support these themes.

Lastly, Nickel, introduced towards the start of the year, has been a disappointment. For now, supply of the resource has expanded faster than the accelerating demand from EV battery manufacturers. The managers continue to hold positions, believing that this supply-versus-demand balance will not be sustainable for long. Copper fared better and was a positive contributor over the quarter.

There has been significant activity within the funds over the quarter. The managers have become more concerned over a liquidity squeeze as higher interest rates start having more of an impact; as such, they have taken a more defensive stance.

They have sold funds that might suffer from tightening liquidity conditions or further macro headwinds; for example, Chelverton UK Equity Growth, Baillie Gifford Health Innovation, and more recently Tufton Oceanic and Baillie Gifford Pacific Funds. They have also sold the First Trust Indxx Innovative Transaction and Process Fund, which provided exposure to blockchain technology. Despite it doing well, the managers felt their position in this fund had become too large. They also sold Tellworth UK Select at the beginning of the quarter, due to the departure of the main fund manager as they felt it changed the investment thesis.

The proceeds have mainly been invested in US Treasuries and UK Gilts in order to support a deflationary scenario. Capital has also been deployed to the Polar Capital Global Insurance Fund following a recent meeting with the managers which highlighted strong earning potential for the underlying companies. The cash weighting is now also higher at c. 10% across the funds. This reflects a more cautious positioning entering the year’s fourth quarter. During Q3 the managers also reduced gold exposure, following a surprisingly resilient period given higher interest rates.

The traditional thematic growth strategy is not having its moment in the sun. The ‘future earnings potential’ which funds are valued against becomes less attractive when interest rates are higher. Nevertheless, the T. Bailey managers maintain that holding quality, growth and cash-generative businesses that don’t need to re-finance will reap rewards. Holding companies at the right valuation is paramount; once confidence around peak interest rates improves and future rate and inflation expectations normalise, these companies have the potential to deliver good returns.

Go well,

Featherstone