Artemis Global Income Fund update

Source for all information: Artemis as at 31 December 2023, unless otherwise stated.

Review: In the final quarter of 2023, markets rushed to embrace ‘Goldilocks’

The defining event of the fourth quarter was the market’s embrace of a comforting fairytale: Goldilocks. Investors seized upon below-expected inflation readings and dovish signals from the Fed as evidence that the US central bank would cut interest rates aggressively in 2024 - and by more than implied its own ‘dot plot’. By the end of 2023, markets were pricing in six cuts to interest rates in 2024 while simultaneously holding out hopes there would be a soft landing in the US economy.

In time, this ‘Goldilocks’ scenario, in which economic growth is ‘just right’ (hot enough to avoid recession but not hot enough to fuel inflation) may prove to be wishful thinking. But, towards the end of last year, it was a story many investors were eager to believe – and sufficiently convincing to trigger a strong rally.

The Magnificent Seven and debt-dependent companies led; the energy sector fell

The quarter presented a mirror image to 2022: assets that performed best in 2022 tended to be some of Q4’s worst performers and vice versa. So, the gains for global indices over the quarter were led by the so-called ‘Magnificent Seven’ US technology stocks (over 2023 as a whole, these stocks collectively added an astonishing $5.2 trillion in market cap). In tandem, hopes that rate cuts would reduce funding costs for leveraged companies saw a rebound in some of those areas that had come under the greatest pressure during the summer, such as real estate.

At the other end of the performance spectrum, energy stocks fell. By the end of 2023, oil prices had fallen by almost a quarter from their late-September peak despite the threat of regional escalation in the Middle East and its potential effect on energy supplies.

Performance: The fund gave back some – but not – all of its third-quarter gains

In this environment, the fund’s zero allocation to the Magnificent Seven (their lack of meaningful dividends makes them unsuitable holdings for a fund designed to produce income), its limited allocation to levered companies and its exposure to the energy sector resulted in it lagging gains in the wider market.

Over the quarter, the fund returned 4.2% versus 6.3% return from MSCI AC World Index and 5.5% from its IA peer group. It thereby relinquished some of the significant relative outperformance it amassed over the previous quarter – but not all. With a gain of 11.5%, it remained firmly ahead of both the index (up 7.0%) and its peer group average (up 5.9%) over the second half of the year.

Contributors

Rheinmetall (3.5% position) and BAE Systems (4% of the fund) added 18% and 13% respectively over the quarter. In part, this was a response to the terrible violence engulfing the Middle East. Meanwhile, the war in Ukraine continues to grind on. Governments worldwide are starting to address significant shortfalls in defence spending. This results in improved pricing power for defence companies and reduced uncertainty around their future earnings. Our exposure to the sector – through holdings in Rheinmetall, BAE and Mitsubishi Heavy Industries – currently amounts to around 10% of the portfolio.

Broadcom (4.2% position) rallied strongly in reaction to robust fourth-quarter results and guidance that suggested its AI-related earnings could double to $8 billion in 2024. With a 2% dividend yield, it is one of few technology companies that we find attractive. Growth in its dividend has been strong (up 20% over the last five years) and has been firmly underpinned by 17% compound annual growth in free cashflows since 2019.

CRH delivered total returns of 25% (sterling) to its shareholders last year. And while its recent share-price performance has been strong, cash returns have – through a combination of dividends and share buybacks – been attractive for a number of years. The company bought back some $3 billion of stock last year; another $300 million is due to be retired by the end of February. Since CRH began buying back shares in 2018, it has returned $7 billion to its shareholders. Add in dividends and it has returned $12 billion in cash over the last five years, roughly a quarter of its current market capitalization. Owning CRH gives us exposure to the manufacturing boom in the US that was triggered by the Inflation Reduction and CHIPS Acts. Even after last year’s strong performance, the shares still offer a 7% dividend yield and trade on a price-to-earnings ratio of 15x, meaning CRH trades on a material discount to its US peers.

Detractors

Energy was the market’s weakest performer over the quarter, with the MSCI AC World Energy Index down 4%. In part, that was a reaction to the oil price falling by almost a quarter from its late September peak. The other factor was that energy stocks are regarded as short-duration assets and are therefore among the areas of the market that benefitted least from hopes of lower rates. Although we have trimmed our allocation to the sector (the overweight was much larger in 2022) 12% of the fund is still invested here, reflecting the attractive cash returns the sector produces. Through a combination of dividends and share buybacks, cash returns from oil & gas producers are in the high single-digits or even low double-digits.

With a return of 100% in sterling terms, Exxon made one of the biggest positive contributions to the fund’s outperformance in 2022. In the final quarter of last year, however, it was the single biggest detractor, falling by 18% in sterling terms. On a stock-specific level, meanwhile, Exxon changed the investment ‘story’ around its shares by paying $60 billion for Pioneer Natural Resources, a domestic shale energy business. That seemed to signal a new emphasis on securing long-term supplies of domestic energy. While that may be a sensible strategy, for investors who hold energy stocks for shorter-term cash returns, it represented an unwelcome change.

Komatsu fell by 8% over the quarter. Cautious comments from the company on capital expenditure by US mining companies were poorly received. This, however, is at odds with plans by Glencore and Antofagasta to increase capital expenditure by 20% in the near term. Komatsu offers a dividend yield of more than 4%, analysts are upgrading their earnings expectations and its balance sheet is rock solid. Unless global demand is on the brink of contracting sharply – which we don’t think it is – Komatsu appears to offer attractive balance between risk and reward.

Insurer Marsh & McLennan fell by 5% as investors rotated away from high-quality financials in the expectation of interest rate cuts and falling bond yields. Marsh is currently one of the lower yielders in the portfolio (1.5% dividend yield) but its dividends per share have doubled since 2018. It is well run, with strong pricing power, and could see margins expanding as it integrates the various businesses it has acquired in recent years.

Activity

We marginally increased our allocation to the fund’s ‘core’ bucket, which is composed of ‘classic’ income sectors, such as real estate, utilities and pharmaceuticals. At 28%, however, our allocation to the fund’s ‘core’ bucket remains well below its long-term average of 40%.

As part of our efforts to hedge the portfolio against falling interest rates, we added AGNC, a mortgage REIT. At the end of December, its shares yielded 15%, a level of payout we believe is sustainable in a world in which US interest rates have peaked.

We added a new holding in Verizon. After performing poorly for much of 2023 due to its high debt levels, we think some value has begun to emerge in the telecoms sector. Verizon trades on 8x earnings and offers a double-digit free cashflow yield. Unusually, with a dividend yield of 7% Verizon’s shares currently yield more than its bonds.

We bought BlackRock. As the world’s largest fixed-income manager, it is a clear beneficiary of the rally in the bond market. It also gives the portfolio some upside exposure should the remarkable run by the Magnificent Seven continue (they increasingly dominate returns from its index funds) while paying us a c.3% dividend yield.

Outlook

Look beyond the US and equities are not unduly expensive

Pockets of value are apparent if we look beyond the Magnificent Seven and US technology stocks more broadly. In fact, some areas of the global market – UK and European equities being the most glaring examples – now look cheap.

Has the Fed has really been able to push rates up from 0% to 5% without triggering a recession?

If that ‘Goldilocks’ story is real, it would clearly be hugely positive for equity markets. But it may yet prove to be wishful thinking. The vast cash transfers from governments to consumers during the pandemic helped to support demand for longer than anticipated. That may explain why the lagged effects of tightening are taking longer to play out than in previous cycles.

Inflationary pressures have yet to be vanquished

Global freight rates have lurched higher in recent weeks and oil prices have ticked higher. The recent escalation of violence in the Middle East, particularly in the Red Sea – a crucial shipping lane through which 15% of global trade passes – surely represents a significant upside risk to inflation. Strong data on the US labour market and a rise in inflationary pressures in the Eurozone (it ticked back up to 2.9% in December after six consecutive months of declines) call into question the magnitude of interest rate cuts the market began to price in towards the end of 2023. If that view comes to be more widely accepted, it could put the share prices of some of 2023’s winners under pressure.

Leverage is something investors should remain wary of

Bond yields came back a little towards the end of last year, with the 10-year US Treasury yield falling from almost 5% to under 4%. But for companies tapping the high-yield market, funding rates are still hovering at around 8%. That is clearly a very different financing environment to the pre-pandemic world of near-zero rates.

We therefore continue to avoid some of the more highly geared names in our investment universe. These includes tobacco companies, consumer staples, real estate and some infrastructure stocks. That share prices of some of these companies rallied so sharply towards the end of last year was not helpful for our (relative) performance. But we suspect the process of flushing out unprofitable, levered companies – the relics of the QE era – has only just begun. We simply believe these businesses have the wrong capital structures to thrive in the new economic and monetary regime.

We don’t believe that investing (y)our capital in the expectation of six cuts to US interest rates in 2024 is wise.

Our core view is that the market may be in danger of getting ahead of itself by expecting the Fed to cut rates aggressively from here. And while rates may have peaked for this cycle we’re not going back to a world of zero rates and quantitative easing. The next stage in the battle to bring inflation back towards its target could prove to be hard going. ‘Base effects’ will provide much less support than was the case for much of 2023: getting inflation down from 3% to 2% is likely to be much more challenging than it was to cut inflation of 8% in half.

Meanwhile, the world still needs massive investment in the physical economy – in areas such as oil, defence and food production. So we believe your capital is better deployed in areas such as these, where there is objective, measurable scarcity, than it is in interest-rate sensitive technology companies and concept stocks or in most highly leveraged names among ‘classic’ income stocks.