The prospect of monetary tightening by central bankers in the coming months could help bottom-up stock pickers, according to Liontrust Asset Management’s Samantha Gleave.
In recent months, expectations of rate hikes and the withdrawal of quantitative easing (QE) measures by central banks have risen among investors and economists.
The Bank of England has so far failed to tackle strengthening inflation and low wage growth, while the European Central Bank (ECB) has not yet raised interest rates despite stronger economic growth in the eurozone.
Base rates since December 2006
Source: OECD
Gleave, who co-manages the five FE Crown-rated Liontrust European Growth fund alongside James Inglis-Jones, said although central bankers have yet to take significant action there are signs that this could be about to change.
She said: “The Bank of England has yet to reverse its post-referendum rate cut and quantitative easing, expectations of the next US Federal Reserve hike are slipping back to 2018, and the ECB has not announced the taper of its own QE programme.
“We are therefore still a long way short of being able to declare that monetary policy normalisation is substantially underway on a global basis.
“However, with the Bank of England hinting at a rate rise in November and the ECB expected to finally announce its taper at its October meeting, we are seeing some incremental signs of a shift or inflexion point.
“In fact, we think this shift could develop into a regime change – resulting in a more benign environment for stock pickers.”
She said central bankers’ actions such as QE – while shoring up the financial system – had distorted stock valuations more recently, impacting some active strategies.
Gleave said: “We apply a rigorous bottom-up investment process and our inclination would be to shut out as much macro ‘noise’ as possible, especially when it concerns the actions of central bankers.
“There is, however, no denying the extent to which the top-down impact of monetary policy has distorted the bottom-up pricing of securities in recent years.”
Equity markets have remained resilient since the global crisis of 2007/2008 caused a loss of confidence among investors concerned about a collapse of the financial system.
More recently equity markets have shrugged off concerns over Brexit and the election of Donald Trump as US president, although growth has slowed.
Performance of major indices over 2yrs
Source: FE Analytics
The resilience of equity markets has also fuelled the growth of the passive investment management industry, most notably through low-cost, index-tracking exchange traded funds. The flood of money into passive vehicles has also helped to drive up valuations, some active managers have warned.
With central bank stimulus and passive money boosting equity markets, the wrong companies have benefited in some circumstances, warned Gleave.
“The phrase ‘a rising tide lifts all boats’ has been used to describe the inflationary effect of QE and ultra-low interest rates on asset prices in recent years, but it was often actually the case that the least seaworthy boats were lifted the most,” she explained.
“In the wake of the global financial crisis, near-zero interest rates and massive money printing programmes effectively bailed out the most troubled companies.
“This ‘dash for trash’ effect led to bouts of valuation compression which meant that high-quality companies were not afforded the rating premium over poor-quality companies that their superior balance sheets and growth prospects would demand in more ‘normal’ times.”
The manager said she hoped that the winding up of QE programmes and the rising of rates would help normalise company valuations and lead to a better environment for active managers.
She explained: “Any development which increases the extent to which share prices are connected to company fundamentals should be welcomed, and we are hopeful that the gradual withdrawal of stimulus will lead to a concomitant reduction in its distortionary effect on markets.
“Financial markets could therefore potentially be on the verge of a regime shift if this central bank tapering triggers a move from narrow dispersion (amongst stocks) to wider dispersion in markets,” she said.
“In this environment the pay-off for active managers is typically higher.”
However, Gleave said any such regime shift was likely to be a “long and gradual process” with the next milestone likely to come at the ECB’s 26 October meeting.
Gleave joined Liontrust in 2012 and is also a co-manager on the Liontrust Global Income and Liontrust GF European Strategic Equity funds.
The Liontrust European Growth fund invests primarily in European equities, excluding the UK, and follows the firm’s Cashflow Solution process
The process is based on the managers’ belief that the most important determinant of shareholder returns is company cash flows. The managers target companies generating significant free cash flows from their asset base and are lowly valued.
Over three years, the fund has returned 52.18 per cent, slightly ahead of a 43.61 per cent gain for the average IA Europe Excluding UK sector fund and a 37.09 per cent rise in the MSCI Europe ex UK benchmark.
Performance of fund vs sector & benchmark over 3yrs
Source: FE Analytics
The fund has an ongoing charges figure (OCF) of 1.05 per cent.