Latest / On The Money / Why investors overexposed to the US should think twice

Transcript

Why investors overexposed to the US should think twice · On The Money

0:03
Kyle Caldwell: Hello, and welcome to on the money, a weekly look how to get the best out of your savings and investments. In this episode, I've interviewed a global equity income fund manager who holds less in The US than the wider global stock market. The fund manager is James Harries of the SCS Global Income and Growth Investment Trust. James explains reasons to be cautious about the outlook for The US stock market as a whole. However, he is still finding opportunities within The US stock market, and he outlines some of his ideas.
0:40
James also explains why he is viewing UK shares as an opportunity, and he also explains how he moves to take advantage of the stock market sell off that plays out early this year in response to US president Donald Trump's tariff policies. So, James, to kick off, could you explain why you are booking the wider trends in running a global funds or having around 20% less in US shares versus the global stock market, the MSCI World Index. Has this been a long standing underweight position versus the index, or have you been reducing exposure to The US in more recent times?
1:25
James Harries: Well, so there's a couple of things to be said about that. The first is, obviously, we run a global income and growth fund. And there are, of course, high quality yielding businesses in The US, but there are some very large businesses that don't have much of a yield and and sometimes called the Magnificent Seven, but there are others. Plus, can say at the moment that the weighting of The US market within the global index is at a very high level relative to history, 70 ish percent. And so in some respect, both of those things count towards us being underweight that country.
1:53
I guess second point to make is if you looked at an MSCI high yield high dividend yield index, it would have a lower US weighting anyway, and so our weighting is probably a bit closer to that. But having said all of that, we are underweight The US. Yes. We observed that The US is a higher proportion of the global market. It's been for a very long period of time.
2:11
It is very fully valued on long term valuation measures such as a Shiller Cape or market capitalization to GDP or or similar measures. And therefore, it seems to us that you are facing a market that has pretty extreme valuation and pretty extreme concentration because so much of the index is in these very large nonyielding companies. And so putting all that together for us to be fulfilling our mandate, we think being the under weight US is a relatively sensible thing to be. I would also say it is quite a long standing position. We haven't been consciously reducing The US recently.
2:45
Indeed, I think because we're in a unusual situation here currently where the US dollar is weakening for lots of reasons, and we can talk about that. Even at a time when markets have been a bit weaker, that suggests to us that there's a change of trend in the US dollar. And it may be that we get an opportunity at some point in the future to buy the best businesses, which tend to be in The US, in the best economy, which tends to be The US, in now a cheap currency and a really competitive economy. And that's a prize to to be ready to take advantage of at some point in the future.
3:16
Kyle Caldwell: You mentioned the approach. You're looking to grow capital and also provide growing income as well. You touched on this, but does this mean you are then less wedded to having a big position in The US? Do you have sympathy for a global manager that they typically do tend to have The US as their biggest country allocation and many of them have around the index level of 70%?
3:38
James Harries: Well, it's very interesting because if you go back in history, I wasn't particularly that concerned about which benchmark one would use. If you looked at the MSCI World or the MSCI ACWI or the MSCI high dividend yield, they sort of tracked each other. Recently, this phenomena of whereby the main index has has has run away from other indices, particularly the high yield high dividend yield index is actually quite remarkable and is a function of the fact, of course, that we have these I mentioned again, these very large companies who have done particularly well, but which are now very large part of the index, in some cases, really very fully valued. So I think there is some sense anyway to diversifying somewhat away from that. I would also say that at Troy, we are not particularly benchmark driven.
4:21
We want to be building a portfolio of high quality global franchises independent of a benchmark with an absolute return mindset. And we are trying to provide a particular return stream, if you like, for a particular cohort of investors. And what we observe or what we believe at Troy is that our investors tend to be those who have irreplaceable capital, and that tends to come in retirement, and in our case, are in need of income because people should, in my view, at least cover a proportion of their liabilities from income from their investments so that when times are more difficult, they don't have to dip into their capital at a time when they don't want to. So you put all of that together, and that means that we aren't forced, if you like, to chase the index weightings in the way that others might be. It does also mean, of course, that we have had a tough time in the last couple of years and particularly since the technology companies have been doing so well.
5:12
But it would also mean on the flip side of that, if we do see a bit of weakness in that area, then we will do relatively pretty well as well as fulfilling our mandate.
5:19
Kyle Caldwell: And how challenging is it to look very differently from the index? Is there an element of career risk? Of course, if you look very different from the index, then in theory, you're not gonna match it. You're gonna either outperform or underperform quite significantly either way potentially.
5:34
James Harries: Yes. And that gets back to the point about, we like to think at Troy that we have a particular process process and a particular way of doing things. We are known for investing in a conservative manner, for being very focused on valuation and quality, and on particular bits of the market that we think have sustainably high returns on capital employed and that are fairly predictable businesses that you can say something sensible about on a three, five, seven, ten year view. You're quite right. That does mean that you look one looks pretty different from the index on occasion and that one's performance can diverge quite markedly.
6:06
But we like to think, and, of course, time will tell, and that's where career risk comes in, that people understand that and that they have in their portfolios, they have lots of people who are doing the sort of investing that you're talking about. But they tend to hold Troy in that corner of their portfolio, which, you know, they're not we're not gonna make you rich, but we're gonna keep you rich. And we should do well when times are more difficult and we have a particular type of return profile.
6:29
Kyle Caldwell: For a number of years now, the valuations attached to The US stock market have been at a pretty high premium compared to other regions. How do you assess valuations at the moment, and is this one of the reasons why you do have this underweight position due to the valuations looking potentially too rich?
6:47
James Harries: The short answer is yes. Absolutely. So we observe, as I mentioned, that The US market is really very expensive. Not just quite expensive. It's very expensive by historical standards relative to its own, history.
6:59
It's also worth remembering that interest rates have gone up a lot. So the market doesn't just look expensive relative to its own history. It looks extremely expensive relative to bonds, relative to other asset classes. And therefore, we do think that it is potentially a time for caution. There's there's a broader point here also, that investors have done phenomenally well over, what, fifteen years, seventeen years, a really long period of time now.
7:21
And once again, for a certain cohort of investors, it might maybe really quite a sensible thing to do to take some of those, you might say, excess or supernormal gains and secure secure for yourself a robust and growing income stream from a global income and growth fund. We would certainly advocate that not for all of your capital, but a proportion of your capital that might be a very sensible thing to do. It is also the case, however, that there are other parts of the world that are not as expensive, and I would pick out The UK, oddly enough, as as part of that. So we are underweight The US, as you say, but we're actually overweight The UK. I I would just mention that if you look at indices and markets on underlying and our portfolio, on underlying revenue basis, the difference isn't nearly a stock.
8:06
They all have about 50% in The US. We have about 50%. They all have about 20% in Europe. We have about 20%, and so on and so forth. So at an underlying revenue basis, which is where companies actually make money is where we think you how you should think about it, we're actually much less extreme as it would appear relative to the benchmark and much more spread globally for a sensibly managed global income global income fund.
8:27
But and we don't particularly, on that basis, invest geographically. We think about or we don't think about so much where a company is listed. We think about where it makes money. But The UK is a bit of an exception because The UK has been in what you might describe as the capital markets doghouse for really quite a long period of time for all the reasons we know, Brexit particularly, but for for lots of other reasons. And therefore, it does oddly, geographically, idiosyncratically look cheap.
8:52
It is also the case that The UK has had a history of playing decent dividends. You could argue in some respects that that's been overemphasized at some points in the past, but it is the case that there are a number of high quality global businesses listed in The UK, which have a nice return profile balance between capital and income, and which look idiosyncratically cheap. And therefore, we have been taking advantage of that.
9:13
Kyle Caldwell: How much overall exposure does the investment trust have to The UK at the moment? And could you highlight some stock examples?
9:20
James Harries: Yeah. So we have about 30% in The UK. But once again, on an underlying revenue basis, we have about 6% in The UK. So it's really quite a dramatic difference in terms of the listing exposure relative to the underlying exposure, if you like. But we have a number of businesses that many people would be familiar with.
9:38
So we have an investment in Unilever. We have a an investment in Wrecket Bank Visa, which has been had a troubled few years and therefore looks looks very inexpensive to us. We have an investment in Admiral Insurance. Admiral Group is, we think, a very special business. It is probably the only proper UK UK business we own.
9:57
But because they're extremely good underwriters and they tend to be extremely adept at at managing the insurance cycle, they make money in terms of underwriting. It might come as a surprise to many investors that most insurance companies don't actually. That enables them to then hand off some of their insurance risk to a much bigger company called Munich Re and retain the profitability. So we think for lots of reasons, it's a really special business. So there there will be three good examples of global businesses listed in The UK.
10:22
Well, the first two are global businesses, but three companies listed in The UK that look really good value to us.
10:27
Kyle Caldwell: And your investment style is seeking out quality growth companies. And, of course, you're also looking for good income growth as well. Could you outline the key characteristics that you're looking for when sizing up a new investment?
10:41
James Harries: Yes. So we at Troy like to concentrate on particular businesses and particular sectors, and we like companies in which we invest to have identifiable and sustainable competitive advantages. And they relate to such things as brands to distribution capability, possibly to being the lowest cost, having potentially a regulatory arbitrage, whatever it might be, there are a number of of nodes. Scale advantages is a is a is an important one, which enables companies to earn a better return than otherwise would be the case for a long period of time. That's a critical point.
11:12
You know, within capitalism, as as many know, if you earn high returns, then then competition will come in and try and diminish them. Now these competitive advantages enable you to to at least repulse that competitive threat for a period of time. So we want sustainable and unidentified high competitive advantages, which leads to high returns on capital employed and then to a degree of growth. Now the point about that is and this is an interesting point. In recent years, growth companies and growth styles have done really well relative to income styles.
11:41
But, actually, if you look through history, it's often the case that investors have a tendency to overpay for growth. And the reason is because they're the most exciting dynamic companies. They've got the newest mousetrap or the most exciting business model. But, of course, the return you generate from an investment isn't simply a function of how fast a company grows. It's how fast a company grows relative to expectations.
12:02
And it is often the case that people get overexcited about growth companies. Whereas the sort of businesses we like that grow grow persistently, but may may not be the fastest growers, actually through time can produce a decent return without being the fastest grower. So we want high quality, good competitive advantages, and element of growth, but we don't have to have the growthiest companies.
12:22
Kyle Caldwell: We, of course, had earlier in the year a pickup in stock market volatility as the market become very wary about Donald Trump's tariff policies. During that period, did you use that as an opportunity to take a good look at the portfolio and to take a good look at your watch list and then consider which companies have now become cheaper in terms of their valuations? And, of course, the share prices may have also fallen as well.
12:47
James Harries: Well, that's exactly what we did. And we do some of the businesses that had held up particularly well, and we added to some of the businesses that, for whatever reason, had done relatively poorly, and actually, that that's reversed fully now. So they that was a good decision. We did also take advantage of the sell off to establish a new position in Nike, which was right in the crosshairs of what was going on at that point because Nike, of course, effectively sells trainers in, the developed market and makes them in developing market, particularly in Vietnam. And Vietnam had particularly, for whatever reason, punitive tariffs placed upon it or were suggested that it might.
13:22
Now this is after a couple of years, a period of time when Nike's had some quite serious strategic missteps. Effectively, put it very simplistically, people were buying lots of footwear online during COVID, and Nike took that as a signal that people would be much more engaged digitally and much more less much less likely to buy their trainers in a shop. In fact, it turns out people like to try on trainers when they buy them, and then that was a bit of a a strategic misstep. And what it enabled competitors to come to do is to come into their retail footprint and establish more of a presentness than they had before. So you've got a combination of some strategic missteps, a particular specific risk from tariffs, which meant that Nike was down over 70% from the high.
14:03
But this is Nike. This is one of the great global sports wear franchises. It has no debt. It is a a fantastic brand. And we think that either by putting up prices to offset the tariffs, potentially moving some of the production elsewhere geographically to maybe circumvent some of the tariffs, but also get back to being the premier global sports led branded apparel business, footwear and apparel business, is just a fantastic opportunity.
14:31
And so that was what we did.
14:32
Kyle Caldwell: We've seen US and global stock markets recover their poise over the past couple of months. Those markets both made steep losses early this year due to tariff uncertainty. However, those losses have now been recovered. Now at the time of this recording in late July, the S and P 500 index is year to date up nearly 9% in US dollar terms. However, UK investors will have not received that level of return due to the weakness of the US dollar, which has the effect of reducing returns for UK investors.
15:11
An S and P 500 index fund or ETF is up around 2% year to date for a UK investor. And that, of course, is notably lower than the 9% return for the S and P 500 index in US dollars. James, you earlier touched on US dollar weakness. Could you talk us through it? And do you think the US dollar will continue to weaken from current levels?
15:38
James Harries: It's a very interesting question on the basis that and it relates to the whole the tariff question as well. The proximate cause of recent volatility has been the tariff announcement by the US administration, but, of course, it should be put in context of a much broader picture. And we've been describing this as as a reverse Berlin Wall moment. What I mean by that is when the Berlin Wall came down back in '89, it set up a whole chain of events which was very benign for the global economy, for capital markets, and so on. What I mean by that is, effectively, the iron curtain came down.
16:10
You had a huge flood of much less expensive labor coming to the global workforce. That meant there was structural downward pressure on inflation, structural downward pressure on bond yields. It meant that companies could optimize their cost base by sending manufacturing to a lower cost area, and countries could optimize their comparative advantage, which is after all the classic sort of economic idea, which led to fantastic returns all around and good growth and and and very little inflation. Of course, that was sent into overdrive post the global financial crisis when not only did we have a very benign structural backdrop, but we also had interest rates go to zero and quantitative easing put in place. And that's led to these wonderful returns.
16:50
We would argue all of that at the margin. Nearly all of that is going to reverse. So globalization, although we will still have a global economy, it's quite clear that the global economy is is bifurcating into a Chinese sphere of influence and a US sphere of influence. It's clear that policy can't be as supportive in the future as it can be in the past because interest rates are now no longer at zero, and fiscal policy is at some level constrained by the fact that government debt's GDP is much higher across the board virtually than it was before that. Inflation is more an issue.
17:20
It's a much less secure world, so we're gonna have to spend more money on defense. So there's lots of factors that mean that and, actually, you could say tariffs. That's what tariffs are about. That's encouraging countries around the world to say, are you with us or are you against us? That's one one element of the whole tariff regime, if you like.
17:36
So we've had a number of things that have been the case for a long, long time that are going to reverse, and one of those is the dollar. Traditionally, The US has seen the US dollar as an exorbitant privilege. It's the world's reserve currency that gives The US, frankly, slightly structurally lower interest rates than otherwise it would have, and real power within the global economy. But more recently, they've seen it more as a burden and viewed it as effectively a cost to The US and means it comes with it responsibilities to the rest of the world, both in terms of trade, but also in terms of security, which they are now not apparently, slightly less willing to, stand behind. So that does mean plus, of course, The US financial position is far less strong than it used to be.
18:23
Its international investment position is weaker. Its fiscal position is weaker, and so on. So people are beginning to question whether or not the dollar is quite the thing that it used to be. And, therefore, I think it is possible, even probable, that the days of a strong dollar structurally may well be behind us. Now that doesn't mean that we won't have periods of dollar strength.
18:42
It just means that the trend from here, a bit like the trend of The US being north of 70% of the global markets probably peaked and on a structural decline, the US dollar probably also is in structural decline relative to other currencies.
18:54
Kyle Caldwell: So in terms of headwinds for The US stock market, there's, of course, the weakness in the US dollar, which you've just explained, the fact that valuations looking pretty rich, and also Donald Trump's tariff policies, which of the three do you think is most concerning?
19:10
James Harries: Well, the dollar of two investors is a is a headwind, as you say, to a sterling investor. If the dollar is declining, then you'll make losses. But, actually, to The US economy as a whole, a weakening currency can lend greater competitiveness. So I wouldn't say that necessarily. I think the question marks over whether or not the dollar's strength is what it was in the past are interesting and structural, and that is a bit of a risk.
19:30
I think tariffs are much more of an issue. And the reason I say this is this. It goes back to the point that we've had amazing returns for a very long period of time. We haven't really had a recession. We haven't really had a recession since February.
19:42
We haven't had one for twenty five years because the global financial crisis was about leverage and banking, and that obviously had very dramatic consequences. But it wasn't really an orthodox normal recession. It was a banking crisis. And then we had COVID, which, of course, is you know, COVID was COVID. It was a very different sort of thing.
20:00
But an orthodox classical economic cycle whereby you have a little bit too much inflation, so you put up interest rates to quell that inflation, which leads to a slowdown in the economy, which leads to a, usually, a credit cycle, and therefore, reordering, and then we all go on for a lower level. That looks pretty likely on the basis that we haven't had one for so long, and there's lots of these headwinds, which I've been describing, that have been building up. So I think you could say anyway that The US was both the expansion was long in the tooth, the economic expansion, and valuations were very full. So you've got a fragile environment anyway, arguably, but then you come along and hit it with a hammer, which is tariffs. And it's usually an exogenous shock, which often pushes economies from a slowdown into a recession.
20:42
Now I'm not saying it's going to happen. I'm just saying the risks are definitely there. And it strikes me that it's so interesting, you know, that that the US administration's policies have there's an irony within them, if you like, or at least there's there's there's a plot. There are positives and there negatives. The positives are that they are pursuing a deregulation agenda.
21:00
They're pursuing a tax cutting agenda, which whatever you you know, unless it becomes a real fiscal issue, and we've talked about that a little bit, ought to inject some further growth into the economy. But then against that, they have this protectionist and and and tariff policy as well as being a harsher treatment of migrants, which means that the inward flow of people will be lower, which has a has a economic cost to it too. And it seems that the market is vacillating between concentrating one on the other. At one point, it's looking at the tariffs, and that's why we had the big sell off, and then another is looking at tax cuts from the big beautiful bill, has a bit of a recovery. And so we're gonna see this oscillation between the two, I think.
21:37
But overall, this combination of being late cycle, very fully valued, and having exogenous factors, which aren't particularly helpful, is a bit of a, is not a fantastic cocktail, if you like.
21:49
Kyle Caldwell: And putting all that together, would you say that over the next decade, the returns for The US stock market will likely be lower than it has been the previous decade?
21:58
James Harries: Well, the maths would suggest that absolutely. So it's always you know, it's ironic. It's interesting in a way that the the the market feels most optimistic when it's most fully valued. But, of course, high valuations imply low returns as as night follows day. And so given where we are in terms of valuations in The US market, returns are extremely likely to be much lower in the next ten years than have been in the last ten years.
22:20
Yes.
22:20
Kyle Caldwell: My thanks to James, and thank you for listening to this episode of On the Money. If you enjoyed it, please follow the show in your podcast app and do tell a friend about it. And if you get a chance, please leave us a review or a rating in your podcast app too. We love to hear from you. You can get in touch by emailing otm@ii.co.uk.
22:40
And in the meantime, you can find more information and practical pointers on how to get the most out of your investments on the interactive investor website, ii.co.uk. And I'll see you next week.