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

Well, good morning, everybody. Happy New Year, and welcome to CG Asset Management Q4 webinar and update on the year as a whole. I'm delighted to say that accompanying me today is Hassan, who I think will be appearing in any second now. And we also have online, silent for the moment, but here to take your questions toward the end of the webinar, Jean Matterson, who is Chairman of Capital Gearing Trust. Now I know that you might be screaming that this is a change from the billing and that you're expecting to see Peter Spiller, and instead, you're going to have to make do with the understudy. And so I apologize for that. Peter has had a -- came off worse in a fight between him and a date and consequently has had to go to the dentist as a matter of urgency. And that's why you get I instead. Hassan is making some strange noises and yet visually we can't see him. So I don't quite know what's going on there.

Let me to host it so that everyone can see me.

Do I need -- what you're saying is that I need to allow you to be seen, Hassan, is that what you're telling me?

Please, if you could.

Well, I don't even know how to do that. That's an interesting question. There you go. Is that -- sorry, everybody. I'm afraid to say that just by way of background, Zoom has rolled out a whole series of updates to how Zoom works, which are frankly deeply counterintuitive and deeply unhelpful in terms of making the whole thing work. So I now have to work out on the fly how to do this. If I fail in doing that, then probably what we'll just to -- you just have to hear lovely Hassan and not be able to see him. But let me see if I can do it. Hassan, I can hear you. Can you give me a bright idea as to how to turn on your video?

As a solution, why don't you start and then make me the host. And then I'm sure I will have the powers to switch myself on.

That's a good idea. Now tell me Hassan -- you obviously know -- how do I make you the host? That's my next question.

Participants.

Hide nonparticipants -- Put on hold. Change panelist appearance. It's going to do that? No.

It says, make host for Hassan.

Sorry, Lydia, are you saying that I should be receiving a sign to say, make host to Hassan?

If you click participants and then it should happen. It says panelists or attendees.

If I click participants, panelist or attendees, oh, perfect. There we go.

Make host to Hassan.

Make host. There you go. Make him host and...

[indiscernible]

Right, everybody. Sorry about that. That's all deeply incompetent of us. But here, we have Hassan. Excellent. And sorry for the delay. Right, let's get cracking after that in slides. As I'm afraid I've got to go through the disclaimer. The prices of investments can go up as well as down. Past performance is not a guide to future performance. You need to decide whether or not an investment in our funds is right for you. And if you can't decide, you should take advice but nothing that Hassan or I or Jean for that matter, say, over the course of this webinar should be construed as investment advice and certainly not to buy a security, including whether or not to buy investments in our own funds. There we go. That is out of the way. Before I hand over to Hassan, I'm just going to touch on the discount. As Jean, we have the Board of Capital Gearing Trust here in the form of Jean, and she will be able to tell you in the Q&A our level of commitment to the discount control policy. I'm sure that most of you are aware that we ran into an issue in Capital Gearing Trust, which is frankly very embarrassing, where we're close to running out of distributable reserves which are the reserves which we need to use to make purchases to buy back stock. And in consequence, the discount control policy had to be throttled while that was being fixed. As you can see, the discount has crept out and is currently standing a little over 3% when I last checked. I understand that there is a court date next week in Northern Ireland, where Capital Gearing Trust is domiciled. And to hear about the capital reduction and that there are -- after that, there's a number of administrative processes that need to be gone through before we are able to resume the discount policy with full vigor. But I guess that all I would say is that, so far, it is proceeding smoothly and we have every reason to believe that it will be resolved soon. Right. With that, Hassan, I'm going to hand over to you. Oh, I'm sorry. And I will be continuing in my Chris-witty role. So -- of moving the slides. So Hassan, you tell me when you want me to move slide. But you are on mute, Hassan.

Thanks, Chris. Could you give me the slide. Thank you very much. So I will discuss a few things, positioning, why we think risk assets look interesting and why we think prospective returns look good from here. So really, the 2 biggest things that have changed over the last year have included index-linked bonds, U.K. index-linked bonds in particular, and some repositioning in our equities. As you can see, the biggest change by far has been the 9% that we've added to U.K. index-linked. And really, that reflects the phenomenal change in value that we've seen in these assets. So for instance, less than 18 months ago, if you had to invest -- if you wanted to get back GBP 1,000, you would have had to invest GBP 1,400. And today, if you want to get back GBP 1,000 in real term, you would have to invest only GBP 730. So that's an astonishing change in value from having to invest GBP 1,400 to only GBP 730 to get your money back in 20 years in real terms. And so interesting is the opportunity actually that in the last quarter, we've launched the U.K. indexing [indiscernible], our first launch in quite some time. And -- we've spent the past few webinars discussing the opportunity in U.K. index-linked, and I'm sure we will continue to do so in the future. But I'm intending to spend a little bit more time on the risk assets today. But if you have any specific questions, we can certainly answer them in the Q&A. I should say that we are hosting a webinar dedicated to U.K. index-linked at the Numis Auditorium on the 25th of January, aptly absolute titled, everything you need to know about indexing bonds, but we're afraid to ask. So please do come along to that. Next slide, please, Chris. Thank you. Performance. So performance, as you can see, of the quarter has been good. And over the year, all assets have delivered positive returns. If you look to the chart on your right, you can see corporate credit has made a significant contribution to that. And really, the story here is that we went into the year with 17% in corporate credit. Now partly, that was a consequence of the credit spreads widening following the LDI crisis, in which we took the opportunity to increase our credit weight. But by the sort of middle of the first quarter this year, credit spreads have narrowed substantially, and we began to sell into that. And I would say by the end of the quarter in April, our credit weight was 9%. So we were able to respond to values in the credit portfolio. Today, the credit portfolio was approximately 13%. And I would say that it's quite an attractive position in the credit portfolio as well. The composite credit rating is the same as a sterling aggregate. And -- but it also -- the CG portfolio, credit portfolio offers a substantially higher credit yield of 6.7% versus 5.4% for the sterling aggregate whilst taking substantially less duration risk of 2.5 years versus 6 years for the sterling aggregate. So the credit portfolio has been an important contributor to performance, and we think it's still positioned to deliver good returns going forward. The other interesting story has been in risk assets. Now there -- there's been a twofold impact. Infrastructure was a drag on performance and conventional equities outperformed. Now let's zoom into why. Chris, could you move to the next slide? Now that's -- the chart to your left is really quite something. It's been a fascinating year in investment companies. It has been the first year since the financial crisis that discounts have persistently been in double-digit territories throughout the entire year, reaching a trough of 17% in October. And in October, in fact, we reduced our energy equities at their 10-year peak and put some of those profits to work in the investment trust market and modestly in infrastructure as well. Some of these examples include Smithson, where we delivered 10% return, before split where we delivered a 10% return, and AVI where we delivered near 20%. It's also been a very busy quarter for shareholder activism. In the investment company sector saw 8 liquidations, 8 managers being replaced and 8 mergers being announced by the end of the year. And we, too, have increased the number and intensity of our engagement. So for example, this year saw us exit our position in European Opportunities Trust, which was subject to a hostile campaign by a U.S. activist investor. That delivered us 9%. We also built a few modest major arbitrage positions, the most recent of which was in Ediston Properties, where we established ourselves as one of the largest shareholders ahead of a planned liquidation this month. And we also largely have exited our position in Fidelity Japan, where we engaged with the Board to remind them of their commitment to a single-digit discount policy, and that position has delivered us approximately 12%. So it's been a busy year for engagement. I would say within commercial equities overall then, we've delivered approximately north of 7% overall. And that's been ahead of the FTSE 100, the 250 and the All-Share and the Investment Trust Index. But arguably, we would say we've delivered those returns on a better risk-adjusted basis as well. On your right, you can see infrastructure assets. And there, this is an estimate of our implied real returns from that space. And I think we can agree that returns look attractive on a fundamental basis. But so what? I think the real change crucially has been that there's been a change in the zeitgeist to how capital allocation is perceived. Historically, poor asset level liquidity was cited as a barrier to buybacks. And over the last 2 years, we've seen an astonishing and unrestrained issuance of capital in the sector, more so than relative -- there is a relative demand for. And what that means is that if companies don't preempt an internal solution to the capital allocation problem, then a hostile party potentially will or they may find that the potential income investors whose lived experience of the discount volatility they've seen doesn't match up with what they signed up for. And we too have over the last 12 months been holding dozens of meetings with management teams, their boards and some shareholders -- with Octopus Renewables recent hostile approach to Aquila, with NextEnergy and Foresight having continuation votes coming up, I think there's some real dynamism in the sector to continue our engagement on behalf of our investors with companies who are arguably more receptive to improving capital allocation, and we would encourage shareholders to query these matters as well and exercise their rights as they see fit to protect shareholder value as well. Next slide, please. This is a slide of our prospective attend. And if you take a step back and you think about the funnel of outcomes, whether you believe that we can execute a soft landing or whether we will have a bumpy recession or hang on for a little longer somewhere in between, there are multiple workhorses in the portfolio to continue to deliver positive real yields. At the shorthand, you have the credit portfolio and the cash portfolio, which set an exciting threshold for equities to exceed. In the medium term, had a duration of 4.6 years, you have in the U.K., primarily U.K. index-linked bonds protecting you from unexpected inflation. At the long end, you have TIPS, which are very powerful protectors against a recession. And as you've seen on the risk assets, a substantial portion of them deliver real return somewhere between 5% and 8%. And the balance in conventional equities, we think we can continue to outperform as there are increasing opportunities at attractive discounts to become the catalyst and drive those in. So I would say in conclusion, we are more optimistic than we have been in a long time about the prospective returns in this portfolio going forward.

Thanks very much, Hassan. That's really fantastic. And hopefully, I will be able to tie in this allocation that you see in front of you to some of our macroeconomic thinking, which is what I will start with now. So I suppose, as ever, we are spending a lot of time thinking about debt and the fiscal position in the U.S., but around the world troubles us very greatly. And as you can see, the fiscal deficit was projected to be 5.8% in the U.S. in 2023. And those deficits are projected to only increase. And indeed, if you go to the CBO's estimates, they suggest that the fiscal deficit will be 6.3% by 2033, 8.1% by 2043 and 10% by 2053. And many people would say that the CBO's estimates of deficits in the U.S. are optimistic because of the fact that they assume that a bunch of historic tax cuts that were enacted, which were time-limited are allowed to lapse, and history suggests that, that isn't what's going to happen. And so what this means is that the fiscal path in the U.S. is completely unsustainable. So by 2033, mandatory expenses to social security and health care and these sorts of things plus interest expenses will be greater than 100% of government revenues. So that's to say that the entire discretionary federal budget defends the environment. Anything else I forgot to mention will be deficit financed. This is a truly extraordinary state of affairs. Now this was much less of a problem in recent years when, as you can see on the right, the real interest rates was less than the real growth rate in the U.S., which meant that, all else being equal, deficits were sort of self-financing, I guess you could say. And now that situation has stopped. We saw a little flash of this in the autumn where there was for a brief period of time real concerns in the bond market about the deteriorating fiscal position of the U.S. Now the result was that the Fed wheeled out a lot of very dovish commentary and said, "No, no, no, don't worry. Interest rates will be kept low," and so on and so forth. And then the Treasury in its financing report said, "What we'll do is we'll cut issuance at the long end." And both the combination of those factors helped bring bond markets back under control. But we are nervous that we could see those fears rise again. And indeed, actually, as it happens, that was the front page article on The Financial Times yesterday. And it's not just the U.S. where this is happening, although the U.S. is probably the most extreme example. I think you all know about the fiscal position in the U.K. So I won't bore you with that. We've seen deficits in -- of over 5% in France in 2023, 5.4% in Italy. Germany, relatively prudent as ever at 2.4%. And obviously, we've got the issues there rounding the Schuldenbremse, the debt brake. And interestingly, the EU has borrowed EUR 458 billion over the last 3 years. And as far as I'm aware, that borrowing doesn't appear in the national accounts of any of the member states despite the fact that the EU has yet doesn't have tax raising powers of its own. So really, that EUR 458 billion ought to be included, at least to my view. Now this picture has been -- so how is it that this debt has not yet caused problems? Well, part of it is that we've seen a transfer from the balance sheets of households and corporates into the public sector, and the public sector is much better able to withstand high levels of indebtedness than the private sector. That's the first thing. The second thing is that the private sector and the corporate sector have done a fantastic job of terming out their debt. And therefore, the impact of monetary policy tightening is felt much less acutely. But nevertheless, we are in a situation where private credit in the U.S. is now at $1.3 trillion, and that's essentially financing private equity-backed companies that are junk-rated. And as we know that there haven't really been any problems that have arisen in those markets yet. But it's a feature of private credit, the lenders are able to enter into constructive discussions with their borrowers. And to some extent, we can see that, that's a good thing. But on the other hand, it also means that they're engaged in effectively an extend and pretend. What that means is that the reckoning for these very large debt levels when they come is likely to be worse than it would have been had they come sooner. However, so while the debt outlook is very troubling to us, the economic outlook has remained very good. And really, I think, what we would say was the surprise of 2023 was how well the economy has held up. And I think that was in very large part due to the very large fiscal stimulus that we have seen, particularly through some of the things like the Inflation Reduction Act that have resulted in very high levels of investment taking place in the U.S. economy. And so we've seen the economy hold up very well on the one hand and inflation has fallen very rapidly on the other. And that's led to a very strong consensus emerging, which is that of a soft landing. And we remain skeptical -- while we completely accept the funnel of outcomes is very wide and that a soft landing is possible, we think that navigating a path to a soft landing is akin to tightrope walking. And that what is more likely is either that inflation is not brought under control or that we go into a hard landing. And let's just think for a couple of reasons why that might be the case. Let's turn to the possibility of recession. So the first thing to say is that monetary tightening hasn't yet been fully transmitted into the real economy. We have heard from Bloomberg economists the effect of the transmission through to the real economy comes in stages and that initially it is felt in the manufacturing sectors of the economy. And indeed, that's consistent with our observation which is that manufacturing economy -- the manufacturing sector appears to be in recession pretty much around the whole world, including in the U.S. But the transmission into credit and households takes much longer. So that's the first thing. And certainly, also, it would appear that the European Union is probably in recession at the moment. And we don't really need to touch on the very serious [indiscernible] of the Chinese economy at present. But the other issue is around the savings rate. Now the savings rate at present is artificially depressed and that's because the stimulus checks are still being spent. And this isn't something that's confounded frankly everyone. We've been being told continuously that, "Gosh, they're just about to run out." And they haven't run out just yet. In the decade running up to the COVID pandemic, the U.S. savings rate sat at 6.2% on average. At present, it stands at 4.1%. Assuming it rises back to that average, well then, that is a 2% increase. And as you know, consumption is around 2/3 of GDP in the U.S., so that implies cutting the growth rate by something of the order of 1.4% were that to happen on top of the impact of delayed tightening. So that's what makes us nervous the calls for a soft landing seem unreasonable. Similarly, we've seen in recent months, team transitory, as you might call it, perhaps the 2 biggest cheerleaders of team transitory would be Claudia Sahm and Adam Tooze, essentially taking victory laps, saying that inflation is under control and coming back down to target. And indeed, where there's to be a recession, that would be our central case that will happen. However, the idea that we can have a soft landing and inflation will come down to target seems pretty unlikely to us. Why is that? Well, core inflation, year-over-year core inflation in the U.S. is still at 4% or 3.3% if you take the last quarter and annualize it. And that is not inflation down to its target. And so -- and if you think about the 2 largest long-term components of inflation, they are housing costs and wages. And as well, I'll just flip back onto that previous chart. As you can see, the Atlanta Fed wage tracker at around 5%, that is simply not consistent. Even if you allow for productivity growth of 1.5%, that is simply not consistent with wages being at a level of core inflation coming down to 2%. The U.S. has got a housing shortage. It's nowhere near as severe as in the U.K. But when you -- so when you combine a housing shortage with these elevated levels of wages, we would also say that rents are unlikely to come down to 2%. So the soft landing, combined with inflation coming to target, seems highly unlikely. And of course, this consensus view of a soft landing and inflation to coming back to target rapidly flows through all asset classes. And so that is -- you see that in the elevated equity prices and you see that in relatively subdued nominal bond yields. And that gives us a large pause thought. Just before I come on to currency, which is going to be the final area that I touched on. There is a -- this creates a real circularity -- sorry, Bloomberg alert just popped up on my screen here. This creates a real circularity, which is that part of the reason that the savings rate is so low at the moment is because Americans feel very rich. And the reason that they feel very rich is because they are very rich. Equity prices are very high and housing prices are very high. And so this becomes -- this is a self-fulfilling prophesy until it ceases to be. And so at some point, perhaps as confidence in the American consumers starts to teeter slightly, the saving rate ticks up growth falls. And that then, in turn, will flow through to the equity prices, and then it will become a self-fulfilling spiral on the downside rather than on the upside. And that's something that concerns us very considerably. Right, that's enough on the U.S. economy. Turning to currency. The big story over recent years was that the U.S. dollar was the [indiscernible] of the currency world, that's to say, reassuringly expensive, expensive but with very good reason. It became incredibly expensive in 2022. And frankly, it's a relief to us you hold U.S. dollar assets that it's fallen back and it's now just back in the [indiscernible] territory rather than, and forgive me for mixing my math, for the LVMH territory, which is perhaps where it was in 2022. So what are we to do about that? Well, what we are also doing is seeking refuge in currencies that we think are very cheaply valued. One of the particular reasons for doing this is that, as I suggested, we're concerned about what could happen in bond markets if investors come to believe that the fiscal path is unsustainable. And then on top of which, one of the largest participants in the U.S. treasury market has been Japanese investors. And essentially, that's because of the negatory returns that they've been getting on their domestic bonds. Now we fully expect that yield curve control in Japan is likely to come off at some point over the next 6 months. And so that could have 2 effects: one is that it could cause the yen to appreciate very rapidly, but also it could cause a weakness in all global bond markets, but particularly the U.S. bond market as Japanese investors seek to repatriate back and earn better yields in Japan than may have been able to up until now. So we see -- so we believe that the Japanese yen and the Swedish krona, which are 2 currencies where we have outsized exposure relative to their position in global reserves, and we believe that they are very, very cheap. One way of measuring that is on consumer PPP. Consumer PPP would suggest that sterling is 42% overvalued relative to the Swedish krona, 50% overvalued relative to the Japanese yen. So these look like real stores of value. We think that both the Swedish economy and the Japanese economy are in good shape. Why has the Swedish krona been so weak that's given that it has a good current account position, good budget position at a strong and productive economy? Well, the answer is that they've had a real estate crisis. But it appears that, that real estate crisis is being resolved. Why is the Japanese yen so cheap? Well, we attribute that largely to Japanese monetary policy. But as we've discussed, we think that, that monetary policy is likely to change and certainly that the interest rate differentials between Japan and the U.S. are going to change pretty dramatically. So we think that these are both currencies that have catalysts to perform very well and are starting off from a very cheap position. And this is one way -- one area of our portfolio where we think that we are able to provide protection against downside risks, which we see in both highly valued equity markets and bond markets that are going to be struggling to contain the supply of bonds. I think the other thing that I -- the final thing that I would say is that if you go back to Hassan's chart where he was showing the different bucket -- duration buckets of our portfolio, that is -- why do we have those different buckets? They are there to reflect the fact that the funnel of outcomes, macroeconomic outcomes is very wide. As you know, we would still say that our central case is either that a recession is going to be coming in the not-too-distant future, or alternatively, that inflation is going to prove very much stickier than the consensus, if you would have it. But nevertheless, we've got to accept that there is a reasonable chance that we will be wrong and the soft landing that Tooze and Sahm and much of the media are calling for could indeed come to [ pause ]. And so we have medium duration bonds and our risk assets are there to protect against the soft landing. Our long TIPS are there to protect against a hard landing. And we have cash that is -- and short-dated credit that's offering very attractive yields that's sitting there on the sidelines in case value crops up either in long-term bond prices or in equity prices in the meantime. I think that is everything that I wanted to say. I'm going to stop there and take questions. I'm also going to get Jean on the screen as well so that if you've got any questions for Jean, the Chairman of Capital Gearing Trust, you can ask them of her. As ever, in terms of format, feel free to use the Q&A chat box to ask any questions that you've got. Alternatively, if you raise your hand, assuming that I can use Zoom, which is not based off the beginning of this webinar an assumption that we should put full faith in, but anyway, if you raise your hand, I might be able to unmute you, enable you to ask your question directly, and we'll see how the technology goes. Right. Let me see if I can just -- Jean is unmuted, and I'm going to try and get a video, allow her video, but I'm not quite sure how to do that. So that may not -- maybe I'm unsuccessful in that regard. Jean, can we hear you?