Karyn West is the managing director of Apostle Funds Management. As of June 2022, the fund holds more than $5 billion in funds under management. West shares her thoughts on the trends she’s watching and the broader global economic climate.
Are there any trends you’re currently watching?
We follow megatrends such as the global aging population, the need for companies and countries to decarbonise, and the need for clean water, food, and renewable energy. The increased demands for health and well-being and the impact of AI and robotics to solve a shortage of labour.
How do you define impact investing at Apostle, and how are impact funds performing right now?
Impact investing is defined by us as avoiding the bad and participating in the good for both people and the planet. This means having an impact framework that intentionally allocates our investments to sdgs 3,5,7,13 which are good health and wellbeing, gender equality, affordable and clean energy and climate action. We intentionally exclude investing counter to these SDGS. We do this across all asset classes in equities, credit, property alternatives etc. Additionally to create impact for investing we need to be mindful in Australia of regulatory requirements such as your future, your super benchmarks that many of our clients are required to report against. These benchmarks are traditional benchmarks and have no ESG or ethical bias. Therefore, where we are excluding investments in areas such as fossil fuels it creates a tracking order against these benchmarks. We have undertaken a significant amount of research over a number of years to find impactful impact correlating investments to reduce this tracking error. One of these areas as an example is to invest in carbon credits, as a commodity, to close the tracking error gap relative to fossil fuels. As a result of these substitute investments our funds have performed in line to traditional benchmarks, this is particularly pleasing given that oil, gas and coal have had extremely strong returns during 2020.
How is the rising interest rate environment impacting investments right now, particularly bonds?
There has been a significant readjustment in the bonds market this year which holds true across investment grade and sub-investment grade credit. Credit spreads have come from very expensive levels, and interest rates from very low levels, re-positioning bonds as an attractive asset class in the current environment. The combination of rising interest rates and wider credit spreads is clearly very challenging for fixed rate bonds, but floating rate securities have performed far better. U.S. Bank Loans, for example, have returned -0.94% YTD – that compares to –9.98% for High Yield Corporate bonds, -11.31% for Treasuries and -14.20% for U.S Investment Grade Corporate bonds – as the negative impact of higher interest rates has been greater than the impact of credit spreads. Thankfully, it would appear that most of the pain in interest rates is now behind us and with a peak in rate hikes now on the horizon, fixed income is well positioned to deliver more stable, positive returns in the year ahead. The difference is that now you can get exposure to US high yield credit at yields around 8.50% compared to < 4.50% at the end of 2021.
In the U.S., markets are pricing in a peak in the Fed Funds rate at around 5% and around 45 basis points of rate cuts at the back end of 2023 – reflecting an environment where the Federal Reserve raises interest rates to a level that pushes the economy into a deep slowdown, if not a recession, forcing them to ease monetary policy to support the economy in the coming months. Long end bond yields are reflecting this and we have seen 10 year US Treasuries as well as Australian Government bond yields fall over the past couple of months which has been positive for longer dated, fixed rate bonds. The short end of the curve, particularly in the U.S., has remained relatively elevated as the peak in interest rates there remains less certain. We think that this makes short duration bonds attractive. With 2-3 year duration you should expect far less interest rate-related volatility, and you are getting around 6.50-7.00% for BB rated bonds which, with a short timeframe to maturity and low default risk, looks appealing, especially as forward looking market pricing currently reflects a sharp fall in short end interest rates relative to long end interest rates.
Looking ahead, companies are going to face some challenges. Corporate earnings are likely to feel the squeeze in 2023 as financial conditions remain restrictive and ensuring that we are investing in sectors and issuers that are well positioned to withstand a downturn is important. Being higher up in the capital structure in bonds instead of equities is a good place to hang out in this environment. In our fixed income or credit allocations, we focus on areas such as infrastructure debt, purpose property such as retirement living, multifamily living and student accommodation, and green and sustainable bonds. These areas are more impacted by demographic trends which are in their favour. Within our portfolios we are also seeing a general move away from cyclical sectors and companies with high leverage. We also have to remain cognisant of our duration positioning and we predominantly manage our interest rate duration by investing in floating rate investments – these views and decisions are constructed through our asset allocation committee and applied through our asset allocation framework – where we closely monitor duration and default risk to optimise our portfolios.
What’s the strategy to get around the current pressures?
There are several secular changes occurring across the globe – some sparked by COVID-19 and worsened by the Russia-Ukraine war, others larger global megatrends that are becoming increasingly hard to ignore. These are creating several challenges that are presenting themselves through higher inflation and interest rates (and the result is likely to be a significant slowdown, if not recession), declining sectors and growing sectors of the economy, and a changing political and demographical landscape. This creates a number of challenges that need to be considered when considering asset allocation within our portfolios, but they also create opportunities. For example:
1. Decarbonisation
The clean energy transition is critical and the trend of moving away from fossil fuels and into renewable sources of energy is set to accelerate. But this process will take time and may lead to higher inflation, at least in the short term, as input costs increase. There are several challenges to consider, but over the long term, this also offers attractive investment opportunities – particularly in green infrastructure, projects that are focused on the reduction of carbon in the atmosphere, carbon credit markets, and minerals that are critical to the clean energy transition such as copper, lithium, aluminium, nickel, and cobalt (CLANCs).
2. Deglobalization
The shift away from the free flow of goods and capital around the world is taking place. This is something that started before Covid-19 – the U.S. is a good example where we saw a surge in populist politics that led to growing opposition to global economies and institutions. This was made worse by COVID-19, which in itself brought on new challenges across supply chains, encouraging companies to reconsider their offshoring strategies. We have seen a trend of companies to look for opportunities to onshore and source materials and manufacture goods domestically. As economies look inward for solutions, there will inevitably be opportunities that emerge as previously smaller industries grow, and new ones emerge within a country. If this continues, construction and engineering firms, railroads, and consumer discretionary firms are likely to benefit.
3. Changing demographics
An aging global population is set to continue to create pressure on various parts of the economy, including healthcare services, retirement living facilities and the labour force. In addition to that, COVID-19 led the shift to remote working, reducing the need for workers to be based close to their place of work. This has had implications on property prices within major cities, but also in nearby towns where the cost of living is more affordable, and workers have been able to change their lifestyles by moving out of overpopulated major cities – bringing business with them. All of these factors provide opportunities in infrastructure and real estate.
When looking at how asset allocation fits into this, we continue to employ a traditional asset allocation approach – where we solve for issues such as rising interest rates and inflation and a worsening economic outlook but we compliment that by thinking in terms of these broader themes when considering allocation within our portfolios. We also favour a mix of public and private markets in our portfolios. For example, we include alternative forms of defensive assets such as timberland investments, impact housing, thematic venture capital and purpose property such as multifamily housing, student accommodation and retirement living.
What are your thoughts on the current global economic climate?
The current economic climate has been built on the foundations of low-interest rates for too long which were engineered post the GFC and then extended through covid. Interest rates too low for too long have created bubbles in the economy which are now going through a reversal. Layered on top of this issue is the destruction of economic value through fires and floods, which has damaged both corporate profitability as well as personal wealth. The increasing requirement of governments and corporations to manage decarbonisation creates both future opportunities and current costs. We are all experiencing an increased cost of energy through oil prices and energy and electricity prices which Is continuing to fuel inflationary pressures. There are a couple of parallels we can look at in the past for solutions to the cost of polluting. During the 70s and 80s, there was a well-known example of acid rain affecting north America and Canada where polluting industries were sending sulphur through evaporation and rainfall into forests and lakes. This well-known problem took decades for regulators to address but was finally managed via a cap-and-trade system to make it cost-prohibitive for major industries to pollute. This is a great example of a market mechanism being applied to change the way corporations behave as global citizens. We expect the current carbon credit markets globally to drive the same type of changes to help decarbonise the world on a mission to keep emissions at or below 1 and a half degrees by 2050.
Are fears of a recession both here and in the US justified? And if so, how severe do you think this downturn may be?
The case for a recession in the US is strong as it is likely to take some time for inflation to back towards levels in line with the FOMC’s target. We expect that this creates an environment where the Fed is forced to keep interest rates higher for longer with the effects of that gradually flowing through to tip the economy into a mild recession, driving the Fed to start to ease monetary policy at the back end of 2023. A key component to this outlook is the labour market and the Feds ability to walk a path where they loosen the labour market just enough to ease wage pressures and ensure inflation moderates, but not too much that it creates an environment where the economy is driven into a more prolonged recession. The Fed will be acutely aware that they are walking a tightrope to manage inflation effectively without placing too much pressure on household expenditure and corporate profits.
The path for the RBA to deliver a soft landing, on the face of it, appears slightly less narrow. We have already seen a significant repricing of the housing market and whilst inflation remains uncomfortably high and the labour market tighter than what the RBA would like in this environment, we haven’t seen the same pressure on wages inflation here as we have seen in the U.S., and because of the housing markets heightened sensitivity to interest rates in Australia, the wealth effect should be larger. We also expect to see a gradual pick up in immigration which should provide some relief to the current labour market shortage. In Australia we expect a slowdown but not a recession.
Being forward looking is extremely challenging at the moment given the myriad of risks out there, and a number of secular changes occurring where changes will evolve over a longer period of time, and the path to the eventual outcome may be volatile and pose unforeseen risks, and opportunities. However, over the first half of next year, and assuming no escalation in geo-political risks, we expect the downturn to negatively impact corporate profitability and for there to be a mild uptick in corporate default rates in the US – but this comes from historically low levels to what is expected to be more in line with longer term averages of around 3-4%. We believe may create attractive entry points. If we assume this remains an inflation driven downturn, or possibly recession, then the impact on asset prices should be less severe than we have seen in recent recessions – broadly speaking the US housing and financial markets are far better positioned than they were previously, household savings buffers are large, and the labour market is robust. Eventually we will need to see the Fed start to ease financial conditions again and when it feels it is able to do that without risking inflation once again accelerating is going to be a critical inflection point, but one where if it gets it right will provide a strong stimulus for financial markets in the year ahead.
What are the most promising sectors both in Australia and globally?
Promising sectors in Australia and globally will be in the megatrends over the longer terms that input into a transitioning world away from fossil fuels and older energy industries into renewables, battery production, electric vehicles, AI and robotics. In our portfolios, we have allocated into CLANC [Copper, lithium, aluminium, nickel and cobalt] stocks for mining, which are all elements required for renewable technologies such as battery and solar. We also allocate into renewable energy companies. Given the global energy crisis which highlights a need for energy security, a renewables-based electricity system may be more cost effective and stable than a fossil fuels-based system this not only accelerates the transition to a low-carbon energy system, it makes investing in renewables more appealing.
When you look at individual companies, what should investors be looking at or looking for? What are you looking for?
We incorporate ESG factors into our investment process to evaluate the companies we invest in, by doing this we are able to achieve long-term sustainable performance. ESG risks and opportunities such as gender diversity, human capital management and the impact of climate change can pose very real long-term risks to our investment returns. Pricing-in the long-term potential, creates a more stable investment portfolio with less turnover, this should reduce our transactional costs and deliver more sustainable returns.
Share prices do not effectively price a company’s potential long-term value and can swing around due to shifts in investor sentiment. Aside from assessing the underlying fundamentals using accounting metrics, other factors to look at when considering long-term value creation include a company’s purpose & vision, its internal culture and how resilient the company is to disruption. Getting insight into a company’s culture from the outside may seem difficult but we have found some key qualitative data points to be helpful, these include reviewing customer surveys, staff turnover or engagement scores and long-term incentives in executive remuneration structures.
As mentioned previously, we also put a lot of emphasis on global megatrends where the need for investment into addressing these changes is obvious. Focusing on these themes and investing in companies that are leading the way in addressing them, and incorporating thorough ESG considerations into our process is how we believe we can achieve outsized, long term returns in our portfolios.
This is an edited version of the conversation.
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