Capital Gearing Trust p.l.c (CGT) Earnings Call Transcript & Summary

[Audio Gap] Well, this feels like one of those COVID presentations. Next slide, please.

Next slide. So at the same time, as we have the supply constrained economy, what we've also seen is yields rise considerably, and financial conditions are now very tight. So as we all know, the Federal Reserve has responded to this surge of inflation by increasing interest rates by 525 basis points over the course of the tightening cycle and the latest Fed dot plot suggests that most of the FOMC expect one more rate rise before this year ends, and rates higher for longer after that period. In the FOMC's own language, they consider this policy stance to be restrictive. But financial conditions are also restrictive relative to what's called a neutral policy stance. So the green line on the chart shows R star which is the theoretical policy rate at which the economy is fully employed and inflation is kept a target at 2% levels. And what you can see in the pink line is that the real interest rate that currently exists in the market more than double the our start rate. And this implies a level of tightness that if it's sustained, is far more than what is needed to bring down inflation and bring up unemployment. So if we can go to the next slide, thank you. So the news flow about a potential government shutdown has sort of brought front of mind the U.S. fiscal position as an issue for market participants. Now the U.S. has been running sustained primary budget deficits for some time, and U.S. government debt is now about 130% of GDP. The effect of this, obviously, is to increase the supply of government bonds because the U.S. government has to issue treasuries to finance the deficit. Exacerbating the situation is that at the same time, the Federal Reserve is decreasing the size of its balance sheet, and this is also increasing the supply of U.S. government bonds into the market, and all of this pushes up on yields, and these higher yields then go on to affect the sustainability of the U.S. government's debt position. So you can see in the chart on the right, this shows the difference between the real interest rate that the U.S. government is paying on its debt versus the trend growth rate that the U.S. economy has actually seen. When this differential is negative, which it has been for some time, the economy can effectively grow itself out of its debt position. But what we've seen happen recently is that the real interest rate is not higher than the country's trend growth rate. And what this means is even if the U.S. ran a balanced budget which is not -- does not really seem to be on the cards. But even if it did, the stock of debt would continue to grow. And this is important because it's an example of the broader problem that the U.S. faces, which is that the economy is highly indebted across the household sector, the corporate sector and the government sector. And this indebtedness makes the U.S. economy extremely fragile, and the high interest rates and tight financial conditions that we are starting to see will begin to act as a catalyst to this fragility. Next slide, please. Thank you. So this is the kind of so what point. So what does this mean for where the economy ends up. So for those who are watching at the beginning of this year, Chris showed you a slide very similar to this one, and although a lot happened over the course of the year, our fundamental views haven't changed on this. There continues to be a very large chorus of voices. Those include Janet Yellen, they include Larry Summers, they include Paul Krugman, expressing optimism for a soft landing. I think our view accords more with the Niall Ferguson strapline that the U.S. economy is not a plane, and it won't land softly. That said, it's worth acknowledging that there is a wide range of uncertainties facing the U.S. economy. And so the funnel of outcomes is actually very wide. But a lot of these uncertainties are definitely uncertainties to the downside. And these are things like what is the impact of the resumption of student loan repayments on the American households? What will be the extent and the outcomes of the United Auto Workers strike and then the all important question of when the American consumer actually runs out of their pandemic savings. And we have the latest estimates from the Federal Reserve Bank of San Francisco, which suggests that this is starting to happen about now. Given this very wide funnel of uncertainty, we think the 2 most likely outcomes are the 2 in the bottom quadrants. These are either a hard landing situation where financial conditions continue to tighten into a painful recession where something breaks, and this ends up bringing inflation back to target. The other likely outcome is stagflation where financial conditions continue to tighten, but not quite enough. The U.S. economy continues to limp along and inflation remains above target. So neither of these landings is a situation that we expect to be comfortable, and it's also very difficult to try and predict what the timing of this will be and what the exact source will be. But the good news, at least for investors and TIPS, for example, is that either of these situations, stagflation or recession, we would expect to see real yields fall. In a recession, this would happen as a result of falling nominal interest rates where the Central Bank has to cut policy rates in response to a recession. In stagflation, we would see this mechanism act through increasing inflation expectations while nominal interest rates remain effectively capped. So with all of that, I will leave you here and turn to Chris to talk about how that impacts our positioning.

Thank you very much, Emma. That is excellent. And actually, before I get into that, I forgot to say at the outset. [Operator Instructions] And just coming back, before I move on to returns and positioning, I saw an absolutely lovely chart on the subject of soft landing, which was the prevalence of stories by -- within Bloomberg, which have the word soft landing in them. And you'll see that there is a monumental spike in the number of stories referring to soft landing in 1999 and then in late 2007 and early 2008. And now we're seeing them again. So I guess all we would say is that soft landings are things that are often conjectured but we haven't really seen one yet. Right. Returns and positioning, let's get cracking. So the asset allocation hasn't changed materially over the last quarter. So we've got 14% in cash and treasury bills. Those treasury bills in the U.K. are yielding about 5.5% today. We've got 12% in corporate credit. The duration of that corporate credit is sub-2 years. And that's reflective of the fact that while we can find value in individual credits, we are concerned that credit spreads as a whole are pretty tight, particularly if you're expecting a hard landing of at least one of our central cases for the near future. That portfolio is yielding about 6.6% today. But actually, that's probably a little bit misleading because we've got a number of index-linked credits in there. So the effective yield, I would judge is rather higher perhaps approaching 7%, and it's got a BBB+ composite rating. On the index-linked bonds side, that has ticked up slightly, 44% of the portfolio. That's made up of 23% in U.K. linkers with a duration of about 4 and a bit years. And then just short 16% in U.S. TIPS with yields of -- sorry, with a duration of 9.5 years. The yields there are -- we have to say very attractive. And clearly, I'm sure you've all noticed that the nominal yield curve, particularly in the U.S., has been selling off very dramatically over the past couple of weeks. And that has been -- has flowed through to the real curve. And that has been a headwind to our performance over the last couple of weeks. But the yields as things stand today is about [ 1.7 real ] overall, and that's made up of 1.5% in the U.K. and 2.8% in the U.S. I think it's worth pausing for a second there, just to think about what that means. Alistair was reminding me yesterday that there's a lot of sort of a typical defensive mandate would be, CPI plus 2%. A balanced mandate, you'd probably say with CPI plus 3%. And then your average, say, Oxford or Cambridge endowment targets a return of CPI plus 4%. So in that context, the fact that you can generate around 2.5% in U.S. TIPS, above 2.5% either at the very short end or at the 20 year, which is where we're focused. It means that you can fulfill substantially all of the objectives of somewhere between a conservative and a balanced mandate simply by investing in government bonds. As Alistair, I think, is going to suggest in his quarterly letter, you could just buy TIPS and go off and play golf for the next 20 years. Now as it happens, I hate golf. So that really isn't an option for me. But I think it does just served to show how values have dramatically changed and how prospective returns for our portfolio is so much more attractive than they have been at any point and certainly to the last 10 years and probably the last 15 years. And then we've got on the risk asset side, 30% of the portfolio in risk assets, and I'll come onto those in a little more detail. So you can see all parts of the portfolio contributed positively over the quarter to 1.2% overall return with corporate bonds and risk assets providing the biggest return. So if we turn into the risk assets in more detail, a little over 50% of those risk assets is in what you would call conventional equities and the single largest positions within those are Japanese equities which are about 4.4% of the portfolio and energy stocks which are about 4% of the portfolio. You can see that the one negative spot over the quarter were our infrastructure assets, which made a negative contribution. And all that we would say on the infrastructure, is that -- and as you know, we've got about 6% of the portfolio in infrastructure, divided roughly half between conventional infrastructure, so social infrastructure, utilities, those sorts of things and then the other half is in renewable infrastructure. And before this morning, I was just revising our return assumptions on those. And if you say, renewable infrastructure using pretty conservative forecast for power prices, pretty conservative forecast for inflation and those sorts of things, are looking like generating real returns of around 7%. And then our social and physical infrastructure is looking to return around 6%. Both of those are real. And if you think about that in the context of the long-term real return on equities being 6.5% in the U.S. since 1880. And we firmly believe that the prospective returns from U.S. equities are far lower than that. These are fantastic returns for low-risk assets. So while that's been somewhat painful over the last quarter, we are adding to those names modestly at present. I thought it was worth touching on 2 of the largest positions within the risk assets. So as I mentioned, we've got about 4.4% of the portfolio in Japanese equities. The single largest position is in the ETF that you see here, which is an MSCI Japan ESG screened ETF, and that's returned 6.4% year-to-date in sterling terms. Similarly, within our 4% allocation to Energy Equities, the single largest position is in the MSCI Europe Energy ETF, whose 3 largest constituents are Shell, BP and Total, and that has returned in sterling terms, 7.2% year-to-date. We've been trimming those positions as they have grown relative to the rest of the portfolio and reinvesting into some of the other things. So for example, into the infrastructure space. Here on this slide, you can see the portfolio of our equities and the portfolio of our bonds relative to -- for equities investment trust index, and the MSCI U.K. Index. And as you can see, over the last quarter, we certainly outperformed the investment trust index. And again, our bonds continue to outperform sterling aggregate. And that's even allowing for the headwinds that we've been having on our U.S. TIPS position. And you can see that over -- this is the performance of CG Absolute Return since inception. And we continue to think that we've delivered good risk-adjusted returns relative to a number of firms that we would consider to be our competitors or compared to the PIMFA conservative mandate, which is, I guess, a sort of a simple benchmark against which we would measure ourselves. And then finally, I think I've touched on this, but this just shows you numerically, the prospective returns on the portfolio and really just shows that our overall portfolio yield is 5.3% on unchanged capital values. And that's really so much more attractive than anything that we've seen for the last 10 to 15 years. And so we're cautiously optimistic that our portfolio can deliver good returns and especially in light of the fact that it is defensively positioned coming into what may be a tough time in equity markets if Emma's analysis for the macro outlook is correct. I think I'm going to stop there and take any questions that you have. So I'll stop sharing my screen with any luck. Hopefully, that doesn't mean that I loom too large on your screens. And I'm going to turn to questions.

So yes, question number one, anonymous attendee. "I think we can see Chris' bedroom." Bert, yes, you're absolutely right. There it is. So thank you very much for that. And yes, as you can see, I'm working from home today. I also have my mother staring over my shoulder which I think is always a good thing when one is doing fund management since I substantially all of our savings are in Capital Gearing Trust. Right. Next question. Lyndon Gill, many thanks for the update. Is it possible to give some background as to the type of help the data analysts will provide the team? Yes. So the main thing -- well, I mean, there's a number of things that Sasaan is doing, but actually what he is doing at the moment is building essentially an investment management piece of software that allows us to record all of our interactions with all of our companies, all of the analysis we do, all of the engagement that we do, and so that for any individual situation, we're able to very quickly go back and review all of the work that we've done on it, all of the investment decisions buy target, sell targets and so on and so forth. And it's really -- it's a fantastic innovation which is that we're able to build ourselves using Microsoft Power BI and -- whereas historically, there's sort of been a bespoke piece of programming that would have cost us hundreds of thousands of pounds to do. We're able to completely customizable and a relatively modest cost. A question for Ian Ling. What do you estimate the yield is on the CG portfolio? And what percentage of its income does the fund pay out. So hopefully, that answer from the previous slide, which was a 5.3% yield on the portfolio. Obviously, you need to deduct costs from that. Our open-ended funds pay out 100% of their income, in the annual dividend. And as you know, they're coming up, they go ex-dividend at the end of this month, and it gets paid in November. Obviously, yields have been rising. So I would guess that the actual yield this year would be -- wouldn't quite be that high. And of course, some of our funds, so CG portfolio has a higher proportion of 0 dividend preference shares. And there, that yield rolls up as capital rather than getting paid out. But the sort of on an ongoing basis, 5.3% less costs, certainly for CG Absolute Return Fund should give you a good idea. Richard Neville, good morning. The pressure on U.S. treasuries appears to the upside on the 10-year and beyond. What would push the 10-year beyond 5%, towards 6% and are bond vigilantes back? Emma, do you have any thoughts on that?

Sure. I mean, I think first thing I would say is, I step back from providing any forecast of what the yield on the 10-year will actually look like. But I guess some of the dynamics going on at the front end of the U.S. yield curve, we think of rates as essentially being a function of expectations for the Federal Reserve's policy rate. At the longer end of the yield curve, we think of it as essentially being supply-demand driven. And as we talked about a little bit earlier, there are obviously -- there's supply coming from the U.S. government's fiscal position and needing to issue new bonds, that's pushing up on yields. The Fed's QT is pushing up on yields. And beyond that, there's definitely now a market sentiment around rising yields, which adds to that, and that's sort of been after the Fed dot plot higher for longer government shutdown issues. And then also rising oil prices have sort of peaked inflation expectations somewhat. I think from here, the question then becomes, well, what would cause that to stop? And I think absent any change in the government's fiscal position, there's sort of 1 of 2 things. One is yields get concerningly high for the Fed, and they then may take some precautionary action. I think the chances of that are fairly low, given that they've communicated publicly that they expect policy to remain restrictive. And then beyond that, it sort of becomes a question of, at what point does something break? And obviously, the timing of that and the little that, that happens is difficult. I think those are some of the dynamics that are in play around that question. Chris, I don't know if you had anything to add on that.

No, I think, so -- and on the one hand, we've been concerned that the nominal curve would steepen and for some time, driven by a range of factors, most of which Emma has touched upon. And that all else being equal, we know that the yield -- that the real yield curve tends to move with the -- in sympathy with the nominal curve. And so given all of that, we've had a concern that TIPS would be weak and sure enough, that's what's happened. And now you might well ask, well, why would you do that? And given that then means that you're going to lose money? Well, we also recognize that our TIPS Holding is the single biggest portfolio protector, the single biggest thing that we think can perform well in the event of a hard landing. And so that's why we've wanted to retain that protection. I think the one -- there's a couple of things. One is that we now are starting to see the emergence of a term premium in U.S. nominal bonds. So the term premium has been resolutely negative for certainly the last 5 years and probably going back to 2015. And based on both the Fed models of term premium and our own estimates of term premium, we're starting to see some term premium there. So that just kind of says, okay, well, at least these things are starting to look like they're reasonable value. And then the final thing is that at some point, if you go back to Emma's analysis of R minus G, at some point, some combination of the Treasury and the Federal Reserve have to grasp ahold of these interest rates and bring them under control by hook or by crook because if they don't, the U.S. debt position becomes entirely unsustainable. So I think -- and so in answer to your question, what would push the 10-year beyond 5% and towards 6%? I suspect that probably the single biggest trigger of that would be a radical shift in monetary policy in Japan. Japanese investors have been one of the largest swing buyers of U.S. treasuries on a hedged basis over the last few years. And so if you were to see a large shift in Japanese monetary policy, you'll probably see quite a large repatriation of that trade. And so that would push yields higher. The flip side, of course, is that you would expect the yen to be very strong. And that's one of the reasons why we've got a near 10% position in the yen is that we hope that it should provide some protection against rising nominal yields in the U.S. treasury market, though I would note that it is not notably done so yet. Next question, Michael Shore. How are you managing FX risk on U.S. TIPS? The answer is that we don't manage the FX risk. We run that unhedged. And our logic for that is that, again, the U.S. TIPS are there to provide some portfolio protection. And part of that portfolio protection comes from the fact that the dollar tends to find a bid in a risk-off environment. And also, as you'll note, we've got -- we also, the other way that we're managing that risk is effectively by not having it, which is to say that we've got a larger allocation to U.K. linkers than we do to U.S. TIPS. Andrew Lister asked the question, does the move up in yields and markets imply that much more of CGT's total returns will be received in income versus capital growth? And does the trust, therefore, become more of an income stock at least now than it has been in the past? Now first thing I've got to say before responding to that is obviously that I'm not qualified to give tax advice. However, one of the features, as I understand it, of the investment trust regime is that the capital appreciation, which arises from index-linked bonds from the inflation accretion of the principal, that is treated as an increase in capital that's not -- that doesn't form part of the income that gets paid out. And so given that a very large portion of the portfolio is in indexing bonds. And then given that a large portion of that return comes from the inflation accrual, that goes some way towards reducing the amount of income that we will be paying out. But I think it's a fair comment that at least for the time being, we would expect that the dividends will be higher than they have been in the past. Of course, what we hope is that the market is going to reprice some of the very attractive income streams that the trust owns and that, therefore, those returns will ultimately get turned into capital rather than being received as income. Next question from Aiden Butler. Is there anything that would prompt you to lengthen your TIPS duration from here? Emma I was going to say, would you have any comment on that?

Sure. So I mean we are constantly looking at the real yields on TIPS. Our current portfolio duration is 10 years. And obviously, we're now in the situation where real yields available on TIPS to sort of at the highest level they've been for some time and much higher than R star. Obviously, in terms of extending the duration on TIPS, it becomes a balancing act between, on one hand, wanting to lengthen into better values, higher yields to sort of achieve this portfolio insurance role that TIPS plays as insurance against a downturn whilst also bearing in mind that essentially, it's very hard to predict the timing of a crisis. And therefore, as yields continue to rise, you're likely to take some pain for some time before that happens on a longer duration. So part of -- it's a trade-off between those things, and we're looking for evidence over time for when that market capitulation is coming close to let them lengthen into these better values. Chris, would you have anything to add to that?

No, I think, I think that's very good. I mean the bottom line is that we think the real yields are incredibly attractive, both measured against history, both versus R Star and versus prospective return from, certainly from U.S. equities. But against that, there is a powerful momentum moving in the opposite direction. Question from Mark Hamstead, I'm trying to get a feel for the direction of the dividend, given the higher portfolio yields, can we expect a material increase for Capital Gearing? Yes, tempered by my earlier comments about the proportion. Obviously, Capital Gearing does own a certain number of 0 dividend preference shares, although there's a rather smaller and the index linked inflation accretion. I guess this question has come up a couple of times. What we will do is what we will attempt to calculate it with a bit more detail and then share it in some of our commentary. It will obviously be an estimate. And so it will not be a forecast because we are not allowed to do that. A question here, why bother with U.K. index-linked rather than sticking it all into U.S. TIPS? That's a very good question. There's 2 elements to this. The first is the difference in yield of, say, 1.5% on our U.K. portfolio versus 2.8% on the U.S. portfolio. That obviously masks the RPI, CPI difference. So as you know, U.K. linkers payout an RPI. And RPI is structurally higher than CPI by probably it's been as sort of as high as 2% over the last 12 months or so, probably over the long term, it's about 0.8%, 0.85% possibly over the coming years, it will be a little lower because house prices form part of the RPI index. And there, we expect them to be weak. But nevertheless, there's that wedge. And so some of that yield difference is illusory. And then the other thing to say is just simply that because we don't hedge our government bond exposure, TIPS do carry that additional currency risk. And so we partly mitigate that by just owning U.K. linkers. Question. What has surprised you over the last year, 2 years? And is there anything that you would have done differently with the benefit of hindsight? I think we've talked in the past about on a 2-year view that we held on to too much of our property exposure. And obviously, we would have done that differently with hindsight. I think certainly, another surprise has been the continued weakness of currencies that we view to be extremely attractive. And so we would put the Swedish krona and the Japanese Yen into that. And so clearly, with the benefit of hindsight, we moved too rapidly into those. Is there anything, Emma, that you think I've missed?

I mean, I think the thing from a macro perspective that's been surprising also is actually the real resilience of some of the major economies, portfolios invested to higher interest rates. So particularly in the U.S., we started lengthening our TIPS duration some time ago on the basis that actually these economies wouldn't be able to withstand much higher interest rates. They continue to -- as we've discussed, real yields continue to rise. I think what this has been a sort of a function of this sort of lower for longer interest rate environment has changed the structure of the monetary policy transmission mechanism. Mortgage is a much longer duration, particularly in the United States, a lot of corporates issue debt for long term and sort of 2021 at much lower levels. So pass-through has been much slower. And I think that's one of the things that's also been a surprise.

And I think ally to that -- I think that we underestimated the amount of fiscal support to the economy. I think we were too focused on the monetary backdrop. And so when you combine those 2 factors of the fact that the transition mechanism is less powerful than I have been in the past with the fiscal support. That's what's explained the economic resilience. And then in turn, that then is caused yields to continue to rise longer than we would have expected. A question from William Pittman. How do you see the interplay of currency movements? And how do you position yourselves accordingly? It's a good question. I suppose the first thing to say is that unlike a lot of current conventional wisdom, current conventional wisdom says that you should hedge your overseas government bond exposure. We think that that's generally a mistake. And the reason is that currencies and yields tend to be mirror images of one another. So as interest rates rise, and therefore, the price of government bonds falls. So you also see the currency strengthening and that provides an offsetting balance to the weakness in the bonds. And so certainly, we've seen, I think, a small amount of that happening over the last month or so with the dollar generally being strong against other currencies and certainly against Sterling. And that's partially insulated us from rising TIPS yields, that's, I suppose, one thing -- one way we think about it. Another way that we think about it is that we are fundamental long-term bears of Sterling. So Sterling, if you go back 100 years, the [indiscernible] rate was 4:1. It's now 1.2-ish:1. We see no reason that should change -- that trend should change over the next 100 years. Similarly, in the beginning of the 1970s, Swiss Franc was GBP 1 bought you CHF 12. As you know, the figure is rather lower today. So therefore, over the -- we, therefore, tend to have around 50% of the portfolio in overseas currencies. That varies from around 40% to 60% from time to time, but roughly 50%. And that's a kind of a long-term position. We like to have -- always have a decent slug in the dollar, partly because it's a global reserve currency and partly because it finds a bid in tough times. And then sort of, we are nervous about the construct of the Euro, and we are nervous about the kind of -- the economic prospects for the Eurozone. So if you put those together, we tend to be somewhat underweight the Euro relative to its share of global GDP. And then we're always on the hunt for currencies that we think, look, particularly good value, and that takes us to the Swedish krona and the Yen. Next question. Higher real yields have impacted infrastructure and REITs. What would be the catalyst to add more aggressively to infrastructure REITs, given your comments on the prospective returns? I think I would probably phrase it slightly differently also answer it slightly and directly by saying that we have constrained appetite to own risk assets, set against two observations. One is that if we think that a hard landing is one of our core -- one of our sort of central thesis, then we would expect risk assets generally to perform poorly in that environment. And we would expect that notwithstanding that these assets are very attractive that they would probably suffer with everything else in a hard landing. So that kind of caps out our overall appetite for the asset class. And that's especially true when in the context that we think that there is essentially, depending on how you measure it, whether you take current year earnings yield versus the T-bill rate or current year earnings yield versus the corporate bond rates or the Shiller Cape yield versus the 10-year real rate, whichever way you look at it, the equity risk premium in the U.S. looks very, very low. And therefore, we can see a relatively high likelihood of a large setback to U.S. equities, as we know when those -- when you see a large setback to U.S. equities substantially all risk assets will go with them. So that is what is really constraining our appetite to infrastructure, notwithstanding the fact that we think that the returns are very, very attractive. Just keeping going down. There's a question from Bruce Lockwood. Why not extend your duration for the Linker portfolio? Is there a level of real yield or steepness that would lead you to do so? The answer to that has to be yes. And at the moment, the thing that stops us is a combination of momentum and supply/demand dynamics. We are looking for opportunities to get longer because as we say, we think these yields are attractive. So what I would say, what we were doing over the summer was we were lengthening our U.K. holdings, not very aggressively, but we were selling the U.K. 24s and lengthening into the 27s, 28s, 29s when the yields on those were above 1% in the kind of 1% to 1.25% range. And they have now fallen back to about the sort of high 60s. So that was a good trade. And we're kind of on the lookout to do more of the same. Another question about dividend yields, which I think just reinforces the fact that we need to spend a little bit of time thinking about that and responding to that. Do you believe that the issues in China real estate and local government debt could have an impact locally? Emma, do you have any thoughts on that?