Rathbones Group Plc (RAT) Earnings Call Transcript & Summary

Welcome, everyone. My name is Ian Dembinski from Rathbones, and it's my pleasure to be hosting today's 30-minute First Quarter Investment Insights program. I'm joined by Ed Smith, who is Co-Chief Investment Officer of Rathbones, our resident wise out and deep thinker on all matters to do with world economies. We're also joined by a new star in the Rathbones' Research firmament, our new Director of Fixed Income, Shilen Shah. Despite massive progress in artificial intelligence, you'll be relieved to know that we've not yet replaced Ed and Shilen with Alexa, although it would be interesting to try the next time around to see if she has any different views. Wow, it's been an action-packed first quarter of 2025. It's been dominated by the election of President Trump and his first salvos of tariffs against his biggest trading partners and possible retaliatory steps in response. Will this trigger a trade war with obvious impacts on inflation? Or has he escalated immediately only to de-escalate and meet somewhere in the middle. If inflation resumes an upward slant, could it all halt the pace of interest rate cuts in the U.S. and the Rest of the World. And by my reckoning, there is another 205 weeks to go of the Trump presidency, I'm exhausted already. For those of you who missed it, we also saw the announcement about a generative artificial intelligence model created by DeepSeek, which has been found to perform at comparable level to Western AI models built at a fraction of the price. This raises questions about the future of AI and the investment plans of the major U.S. tech companies. That had a potential knock-on effect in NVIDIA as the world's most powerful producer of chips used for AI computing power. And we've already seen a major move downwards in its share price, albeit from very high levels. Is the hype all overblown and will AI actually deliver its much wanted productivities gains, which have not been evident so far. So I will be asking Ed to get us inside the mind of the Donald. A tough ask, I know and pick out a few key insights from recent events, not least here in the U.K. I will also turn to Shilen to update us on bond markets and interest rates. So before we begin, please do write your questions on the chat function, and I'll pick these up as we go along on my trustee iPad. We're also very interested in your views on whether you like this format and approach. So please write some feedback so that we can continue to improve how we communicate with our community.

So Ed, turning to you for the moment. Let's begin with the EU this time. It's been a pretty serious time for its growth problems. Can we see the economy grow this year?

Well, some of its growth problem is structural. And by that we mean it's quite deeply embedded. It's got pretty poor demographics. It's got relatively weak productivity growth, and it suffered a hit to the competitiveness of its industrial heartlands, particularly Germany, as electricity costs have surged since the Ukraine war. That leaves the economy a little more fragile, a little more susceptible to cyclical downturns, downturns in the business cycle as a result in falling consumer confidence, for example, and we've seen some of that recently, and that's been compounded also by a major slump in one of Europe's biggest customers, China. So Europe over the last 2 years has delivered growth of just 1.4%. Now that's twice the rate of the U.K. in that time, but that's not a particularly high bar to clear. The EU is different to the U.K. It has low growth, but it also has lower inflationary pressures and lower interest rates. Interest rates were already 2.75%, likely heading lower. So a lesser financial conditions and a little bit of an increase in inflation adjusted wage growth should see some growth this year. But there is a risk from the politics, it's 2 biggest countries, Germany and France, don't have functional governments at the moment. France hasn't had one since last July. Now when you have a hiatus in the political leadership, uncertainty creeps in, that delays businesses, investment projects, and that's not good for the economy. It also means that it may inhibit the EU from amounting -- from mounting a convincing strategic response to U.S. protectionism.

So let's turn to the U.S. for a moment. We've seen some pretty robust growth. What's driven that? And can you imagine that carrying on under the new Trump administration?

So there's been a few factors that have caused U.S. growth to really outperform most of its peers. One of these is a very robust household balance sheets as a result of enormous amounts of stimulus during COVID and after, and the long running aftereffects of that. It's also had very good wage growth and employment growth. It's had a booming stock market. And in the U.S., you have very high rates of household ownership in stock markets in contrast to Europe. So that's helped a lot as well. You've also had the margins, influxes of government money causing increases in green investment spending and in spending on data centers, although all of that stuff actually -- although that last point actually hasn't had a huge effect, it's not that big an effect, not that big a part of the economy. So the fact that some of those green stimulus measures might be taken away or likely to be taken underway under the Trump leadership isn't too concerning. Now there's a lot of momentum in the U.S. economy. But we do think that it is slowing down. In fact, we've already seen it start down towards the end of last year to more normal levels, still decent, still better than Europe, better than the U.K., but more normal levels. We've also seen that business spending excluding spending on data centers has actually now started contracting again. And that could be partly in response to the uncertainty of what Donald Trump is going to do. And the longer that we don't know exactly what Donald Trump's industrial policy is, what is administration's position on taxes are, and what is positioned on tariffs are. And by that, I mean not just a threat of tariffs, but our tariffs is going to be in place 1 month, 3 months, 6 months, 12 months from here because that really, really matters. And that's the thing about Mr. Trump. You don't really know what you were going to get even his advisers in Washington are saying some different things at the moment. So investors shouldn't try an second guess the mind of Mr. Trump. There isn't much evidence that investors are very good at predicting politics. So what we're doing at Rathbones is keeping our head down, looking for companies that have a track record of delivering strong return on invested capital through a variety of different economic or political situations.

But is it inflationary if he does go ahead with tariffs? You even announced yesterday, steel tariffs at 25%. Imagine for a moment, he does go ahead with it. Could that upset the apple cart in terms of downward trajectory of inflation?

Sure. It is likely that it will cause an inflationary response. And actually, if you went to the extreme and we had those 25% tariffs on Mexico and Canada, the increase in tariffs on China and the 10% tariff on everyone else, then that would -- could be exert a very profound inflationary impulse possibly up to 1.5% on inflation in year 1. Now there is uncertainty over the modeling because you've got to make some assumptions, how much does the dollar go up how much the goods that are targeted with tariffs, can you easily substitute cheaper goods from other countries or from your own domestic base, all of that makes modeling it a little uncertain. But we know from last time when there were actually relatively small tariffs compared to what's threatened this time, but there were inflationary consequences.

So the other news is obviously a new government in the U.K., a budget since we were last on air. A lot of business leaders saying it's anti-growth, national insurance contributions hurting a hiring and employment. What's your view on the U.K. economy?

So the U.K. like Europe has also delivered a very weak growth that it's been slightly worse. Over the last 2.5 years, the U.K. economy has barely grown at all. And actually, if we look at GDP per capita and per person, which is a much better indicator of true economic performance. The economy has actually shrunk, but GDP per capital has shrunk by 1% over that time. In other words, if it wasn't for inward immigration, the whole total size of the U.K. economic pot would have gotten smaller. Now there's been a few reasons for that. One of the big one's last year, which actually isn't really spoken about very much is a big hit to net trade. So exports continued -- sorry, imports continue to grow, but exports took a big hit. The -- now one of the reasons for that is that British exporters are still struggling with a loss of competitiveness in the post-Brexit environment. And that's not likely to be fixed anytime soon. So we may see continued volatility in net trade. And actually, last year, there's a lot of gloom around the U.K. economy at the moment, but in the middle of the year, we had 2 pretty good quarters, business investment and household consumption wasn't too shabby. And if it wasn't that hit to net trade actually, the economy would have grown by just above 1.5% or so. So there is some reason to be optimistic. Unfortunately, Rachel Reeves budget was not the budget for growth. It was touted to be, and unfortunately, that triple whammy of widespread public sector wage increases, a hike in the minimum wage and the increase in employee's national insurance contributions does pose some risk to inflation at a time when we really need the Bank of England continue to cut rates.

Now there's a question here because the much-unfenced U.K. stock market had a bit of a cracker in January, didn't it outperforming both Europe and the U.S. And the question is do we see that continue because it's reach record levels? Or do you see that pulling back from this point of view?

Yes. So it's a good question after a question about the U.K. economy because actually, the U.K. stock market just isn't the U.K. economy, 70% to 80% of revenues come from overseas. Now we do like the U.K., especially for a couple of reasons. When we look at our long-term total return projections, the U.K. is up there. It doesn't have sexy fast-growing companies. The contribution to that total return doesn't come from so much profit growth, but there is this big dividends that you get, and a lot of them are quite stable. You've also had this irrational valuation discount in the U.K. And by a rational, I mean you cannot explain this discount that the U.K. has traded at. By looking at industry composition, the fact that the U.K. doesn't have a big tech sector, you can't explain it by long-term growth expectations for profits, you can't explain it by other markers of quality and fundamentals. And that is starting to come back. You never saw that discount before 2050. You never saw in decades past. That's starting to come back potentially that will narrow through M&A or private equity, acquisitions. And then finally, quickly, we also like the U.K. because our larger exposure is to the U.S., and we particularly like U.S. technology companies. But of course, there is a big risk to U.S. technology companies because they trade at very high valuations. And if we get another inflation or interest rate shock, like you saw in 2022, then that could cause a real hit to those valuations. Now that the U.K. equity market has a very low sensitivity or lower sensitivity U.S. yields and other parts of the equity market. So it's a nice hedge against a hit to U.S. technology.

Thank you for that. Now Shilen, turning to you, the Bank of England lowered its rates last week, and we even saw one of the hawks even suggesting that maybe they should have cut by 50 basis points. What's your view on whether that will continue?

I do think we're going to see further interest rate cuts this year. I think the key question is how many and how fast the split vote suggests actually the Bank of England is uncertain. And I think a key assumption they have is higher near-term inflation is going to wash out of the data. And I think that's partly driven by energy prices and gas prices. We've all seen utility bills, energy and gas and utility bills go up. The forecast to sort of the base effects come off that. And the second point probably to note is that the labor market continues to weaken. I think server indicator continues to be weak around that. Business confidence in the near term, somewhat weaker. So I do think potentially, I think market at the beginning of last year was potentially looking at 4 rate cuts for this year, potentially fewer than that, but it remains very data dependent.

Now let's turn to the Federal Reserve. Do you think the increase in trade tensions actually potentially delay further cuts in the U.S?

Notwithstanding what Ed is saying actually because I think that's really probably the key point to note. If we do see rational policymaking in the U.S., interest rates in the U.S. should fall down on a gradual path, much slower than what we're seeing in Eurozone and U.K. However, if you look at core inflation and the key components, housing, equivalent components, they are on a downward trend. It's huge to see that. But the sort of tightening of the labor market potential due to immigration leaving the economy and also tariffs could delay any sort of rate-cutting cycle.

And if inflation stays higher for longer, our inflation-linked bonds offering value during a period of increased market volatility, was that -- would that be interesting?

I think it does. I think it does. I think the interesting point to increase tariff concerns, geopolitical concerns have meant that inflation-linked bonds have outperformed sort of conventional government bonds. Now the valuations are looking probably close to fair value, but they do offer some form of insurance if we do get increased trade tensions or global tensions really versus conventional bonds.

Now Ed turning back to you, we've got some questions around this. U.S. equities powered ahead by AI-related stories and then we see DeepSeek. Do you think some of the heat will come out of that story?

So -- the -- just talk about the Magnificent 7, the 7 large technology companies that have been particularly linked to the AI story since the release of that ChatGPT at the end 2022. Now their ability to lead the stock market has actually already come into question. Since last July, they haven't led the U.S. stock market higher. The smaller capitalization companies have started to edge ahead. Now those Magnificent 7, they are formidable and prodigious producers of free cash flow, cash flow that accrues to shareholders. But they have also become prodigious expenders on capital. Now that's quite a departure from the very capital-light business models that these companies pursued to get them where they are today. Historically, we know that markets tend to penalize companies that are hugely increasing their capital expenditure, especially while their cash flow margins are starting to shrink. Those technology companies, the Magnificent 7 have been given a free pass by investors so far, perhaps because the level of cash flow margins was so high to begin with. But as more and more questions are coming into investors' minds about what the return on that capital expenditure is going to be, their -- as I said, their ability to lead the U.S. stock market is more challenged. And that DeepSeek revelation that you mentioned, which will just caveat with the fact that it's not 100% clear exactly what the cost of this model was, there are some questions about how -- what the true cost of the training and inference was. But looking like, let's say, substantially cheaper. That just adds to that uncertainty. So use cases for AI, real big ones are slow to come through. People aren't sure exactly what they are. And now people are questioning, well, actually can companies wanting to use AI do more with less. So look, we still like a lot of these companies. We don't think the DeepSeek revelation completely blows the investment case out of the water, but we do think a more diversified approach than just replicating the U.S. index is sensible.

Shilen, turning back to you, we've seen quite a rally in investment grade or corporate bonds relative to govern bonds. So there isn't as much of a premium as they used to be. Do you still see value in the corporate bond market?

Yes. So I think long-term, there continues to value. I think the macro backdrop is actually quite benign for the sector. So interest rates coming down, moderate growth, inflation concerns, are continue to be okay. But I think the key question is on valuations. Valuations on the headline level, at least in sterling, that's a sterling market. Credit spreads is circa around 1%, below 1% over government bonds. So you are getting compensated for the sort of long-term sort of risks around investment grade because the default risks are very, very low. But I think probably valuations and concerns on potential movement in credit spreads, probably look for shorter duration credit to provide some protection against interest rate risk.

And there's a question here about whether or not you see relative value between U.S. treasuries and U.K. gilts, after all, U.S. Treasury is the largest reserve currency bond market in the world, U.K. could be viewed as in an interesting funding position at the moment.

Yes. So I think the U.S. has much more ability to borrow money. And I think if you look at the deficit levels in the U.S., it's significantly wider, obviously, faster growth. But I think the ability and the sort of borrowing from global investors it's much, much better than the U.K. either the U.K. deficit forecast, if you believe the OBR and the new -- and the chancellor potentially likely to fall back in the next 12 to 18 months. The U.S. we're not sure. I think the tax cutting may become permanent, and we don't know whether that's sort of getting rid of federal spending is possible really. So I think there's valuation in both sectors actually. But clearly, at the beginning of this year, lots of new stories about the U.K. gilt markets. I think broadly, I think some of that was exaggerated. But clearly, it's -- it's potentially fighting the government to be more sensible on borrowing in the U.K.

So let's widen out to more questions from the floor. And Ed, on Japan, can we comment on research indicating that the average net cash to market capitalization remains over 50%. In other words, there's a lot of cash in these Japanese companies does that underscore the potential for greater shareholder returns, do you think?

Yes. So we still like the Japanese stock market. It's one of our favorite overweights. And one of the reasons for that is this quite long running structural reform story now that is seeing more and more -- a greater percentage of the Japanese stock market actually run in the interest of shareholders. If you speak to Japanese fund managers who are around in 90s, they would say that 1/3 of the index was uninvestable because it just wasn't really running in the interest of shareholders. Reforms by the Tokyo Stock Exchange and the government in Tokyo have really started to change that, particularly unwinding some of the big cross-family holdings that these large conglomerates can have in each other. And general reforms just to raise the rate of return on equity. Now one of the consequences of this is we're seeing a lot of share buybacks and a lot of that cash that outsized cash balances that we personally asked the question referred to being put to work. You're seeing record levels of buybacks, even dividends being increased as well. There is -- we have somewhat reduced our overweight. We remain overweight a little less say than we were because last year, you saw a big knee-jerk reaction when the Bank of Japan raised interest rates for the first meaningful time. That caught the market off guard, we saw a much larger hit to the yen and to the Tokyo stock market than would have historically been explained by that level of monetary policy change or movement in the exchange rate. And so that just means that we think Japanese equities might be more volatile than they have been going forward. So because of that, we don't want to expend as much of our risk budget on such a volatile area, but we still like the story, and that cash -- those cash balances are part of it.

Another question here is around ESG sector. We've seen some record outflows in 2024. Do you see that investment offering evolving? Or are we pessimistic about that sector.

So I mean how you define that sector is obviously is very wide, yes. So I mean we've obviously seen some money come out of that space tactically in response to a change of government in the U.S. buy them through a lot of fiscal weight behind sponsoring ESG environmental projects, decarbonization projects. Trump is a little more skeptical of climate change, right? So that follows through into policy. However, a lot of that expenditure went into red states, right, Republican states. The sunny states tend to be red. And market forces will continue to see investment here, right? Because on a very sunny day or a very windy day, these are the cheapest forms of electricity that you can produce and you want to produce cheap energy, right? The whole economy is energy transported, right? So I think the story isn't out of the -- blown out of the water, but there has been some tactical money coming out. Well, broadly, look, ESG it's still a sensible thing to incorporate into anyone's investment process regardless of the sort of moral or human or environmental consequences, right? Because we know that environmental, social and governance factors are -- can bit pose financially material risks to certain companies in certain sectors. So you want to understand all of the financially material risk when you make your investment decision.

So Shilen, there's a question here about the U.K. economy and Rachel Reeves wiggle room for maneuver in terms of her headroom, which seems to be evaporating. Can you see her having to either raise taxes again or cut spending?

So I think she's been very strong indicator. She's not looking to increase taxes at least during this year. And I think they're looking at potentially cutting spending. I think the big, big area they're looking at social security spending. There's been a big increase on that and maybe squeezing some spending on public sector. I think they have to have a trade-off here because a big concern for the U.K. economy has been the cutting of public sector investment, which has meant, as Ed had mentioned, the U.K. economy has been very weak growing. So I think it really does come back to the OBR when it comes out with his forecast. I think later next few months really. The fall in interest rates and especially the 10-year to 20-year interest rates in the U.K. has potentially reduced some of the concerns at the beginning of the year. But it's going to be touch and go really, and potentially driven by what's going to happen in the U.S. given the correlation between U.S. and U.K. 10-year yields.

And Ed, there's a few questions coming across from the issue around China. Do you think given the tensions between China and the U.S. that actually, in a way, China is a no-go area for investment?

It certainly doesn't help the case for the Chinese stock market, which there are large weightings given to significant exporters. Last time around, a lot of Chinese manufacturing, we're able to get around the tariffs by rerouting their trade through other regional hubs, Vietnam, for example, just look at the increase in trade places not because Vietnam suddenly started manufacturing so much more than they used to, right? And you can see that from satellite, clever satellite tracking imagery that trade economists can use these days. But if Trump is going to put a tariff on everything, then that rerouting trade, redirecting trade buyer a middle person, a middle country is harder to achieve. So it might hurt a little more. The main reason, though, why we're still fairly negative on China, and we've been long-term bears for quite some time, even when it was quite unfashionable to be bearish on China when they emerge out of COVID. It's because the country is undergoing a profoundly disinflationary slump and aftermath of a property boom gone wrong. The property sector in China and related activities to real estate got to 1/3 of the country's annual economic output. Now you've only ever seen countries get to that level before in Spain at the end of -- at the beginning -- end of the 2010s and in Japan in the late '80s. And the aftermath of that was pretty horrific, right? Big disinflation rebus. China is working its way through that. It's a controlled economy, so it's not so much of a sharp drop, but it's -- the impact is profound. Now Beijing may have just about done enough to put a floor under the property market, and we might start to see a bit of confidence coming back. But these things take a lot of time to work their way out, and we think a major catalyst for the Chinese economy and its stock markets to persistently start to outperform is lacking.

We've got an overflow great questions, but we've got 2 minutes left. And could you just comment on one question around real estate investments, particularly commercial where a lot of people withdrawn from working from home, interest rates are still high. Do you see that sector is still problematic or recovering?

So the global real estate sector got very beaten up over the last few years and quite rightly say, we had this perfect storm of high vacancy rates, particularly in offices, and very high interest rates on deals that were very levered. And cash flow in real estate sector took a sharp hit is looking like a floor has been found, but it is still a risky sector, particularly as Shilen was outlining, there are still uncertainties around what U.S. rates are likely to do.

And then finally, Rachel Reeves tried to announce some growth initiatives, which will probably take 10 to 15 years to come through. Is there anything on the horizon, any button she can push to get growth going?

Planning reform might help sooner rather than later. It won't be an immediate effect, but it won't be 10 years. The Harrington review into what is stopping foreign companies investing more in the U.K., revealed the sclerotic planning system was a major impediment to foreign direct investment. Sort that out, make planning more rules-based then maybe you'll get a bit of a bigger hit from business.

And perhaps increased trade a bit with Europe. If they can do that?

It couldn't hurt.

It couldn't hurt. Great. Well, look, thank you very much. Sadly, we have run out of time, and there are so many great questions, and I wish we could answer them all. But unfortunately, we've run out of time. So please do register for our next webinar on the 29th of April and leave any comments on any areas of improvement for these sessions and the content that we cover. We would love to hear your feedback and wishing you a great afternoon, and thank you very much.