Global financial markets have bounced higher over the past few months, in eager anticipation of cuts to interest rates. However, they may be glossing over longer-term trends in bond yields that could prove destabilising. It is an environment that warrants caution and that may reward a different type of company.

Until 2008, bond markets were priced by the market. Investors decided the risk premium to be placed on individual bonds and a real yield of 2-3% was normal. That all changed as central banks started printing money in response to the global financial crisis. With central banks acting as the buyer of last resort, any risk premium was eroded, and negative yields became commonplace.

Central banks are now withdrawing that support from the market. There is no longer a buyer of last resort and therefore price discovery once again falls to the market. If this pricing follows historic norms, investors might expect a real yield of 2-3%. If inflation is 3-4%, that implies a government bond yield of 5-6% rather than its current level of 4%. Given stock market sensitivity to bond yields, this represents a risk.

Yet equity markets remain chirpily optimistic. They currently assume that there will be rate cuts, that any recession will be a short-lived and inflation will be well-behaved. This may be wishful thinking. Many of the stock market gains of the past decade have come from the expansion of valuation multiples, rather than being driven by fundamental factors such as earnings or dividends. It is difficult to see this continuing if bond yields spike higher.

However, the right kind of company can and will thrive in this type of environment. They will need to have tangible drivers for growth, sound financial management, and clear cash generation.

Growth dynamics

To do that, they will need to be exposed to areas of long-term, sectoral growth. For example, we see real strength in companies in Mexico. The country is benefiting from the reshoring trend, as global companies move supply chains out of China. This is driving foreign direct investment and supporting economic growth. We take exposure through groups such as Walmex (Walmart’s central America division) and airport operator ASUR. This is an example of a trend that will happen regardless of what is happening in broader markets.

It is the same for businesses such as TSMC or BE Semiconductor. These companies are supported by structural trends in demand for semiconductors, but also have strong balance sheets, no debt and a long pathway of reliable growth. This helps deliver the mandate for Murray International: to grow the dividend and capital ahead of inflation.

Value

A good company can be a bad investment if the price isn’t right. There are parts of the market that have gathered too much investor attention over the past 12 months and look expensive. The market deals increasingly harshly with companies that do not meet expectations, as the recent experience of Tesla shows. Being part of the ‘magnificent’ seven counts for little in the face of operational weakness.

That leads us to hunt in areas that have been overlooked. More recently, this has included parts of the consumer staples sector. It had a tough year in 2023, which left valuations looking interesting. We have taken positions in Pernod and Diageo, both of which have a suite of strong brands, and a pipeline of growth.

For the time being, that does not extend to the UK market. While it is cheap, we find few UK stocks that bring something unique to the portfolio. Often, we can find something better elsewhere. It is also worth noting that over the past 20 years, the UK has only been the best-performing market twice.

Diversification

Another important factor in the current environment will be diversification. Markets have been narrowly focused on a handful of companies for much of the past 12 months. Yet over the past decade the highest market annual returns have come from a variety of regions: the United States, Latin America, Japan, and Asia Pacific ex-Japan.

We are always looking for companies that can bring a new and diversifying strand of growth to the portfolio. We can roam the world to look for this growth, but we don’t have to own any individual area. We have no exposure to Japan, for example, because there are generally better equivalent opportunities elsewhere and the currency exerts a significant drag on returns.

The geographic allocation is only ever a function of the stock picking. Nevertheless, we will adjust it if necessary. For example, a high weighting to Taiwan contributed to our decision to sell Taiwan Mobile, having held it for 19 years. We were also concerned that its dividend growth had stagnated, and debt had picked up.

Financial markets need to adjust to a new inflation and monetary policy environment. Inflation is unlikely to return consistently to central bank target levels because to do so would risk decimating the economy. This environment is not unusual in an historic context, but it will be very different to the past decade – and it is likely to reward a different type of company.

Important information

Risk factors you should consider prior to investing:

• The value of investments and the income from them can fall and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
• Movements in exchange rates will impact on both the level of income received and the capital value of your investment.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• The Company invests in emerging markets which tend to be more volatile than mature markets and the value of your investment could move sharply up or down.
• Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
• With funds investing in bonds there is a risk that interest rate fluctuations could affect the capital value of investments. Where long term interest rates rise, the capital value of shares is likely to fall, and vice versa. In addition to the interest rate risk, bond investments are also exposed to credit risk reflecting the ability of the borrower (i.e. bond issuer) to meet its obligations (i.e. pay the interest on a bond and return the capital on the redemption date). The risk of this happening is usually higher with bonds classified as ‘sub-investment grade’. These may produce a higher level of income but at a higher risk than investments in ‘investment grade’ bonds. In turn, this may have an adverse impact on funds that invest in such bonds.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends with match or exceed historic dividends and certain investors may be subject to further tax on dividends.

Other important information:

Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

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