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 second quarter investment insights program. I'm joined by Ed Smith, who is Co-Chief Investment Officer of Rathbones. We're also joined by a fellow star in the research firmament, Sanjiv Tumkur, who is Head of Equities. They've both been very busy juggling the stresses of market volatility, portfolio rebalancing, risk management and providing a calming voice in a period of great change. And yet here they are both still smiling, and I think, looking pretty sharp. Remarkable. Goodness me, when I hosted the first quarter webinar, I thought that was volatile. The second quarter has been no different. And as Lenin once said, "There are decades where nothing happens and there are weeks where decades happen." Even before he has reached his first 100 days, President Trump has launched a trade war. He then rowed back partially from it, but not in the case of China. We've seen the U.S. treasury market and dollar both take big hits and U.S. equity suffering more than other markets. President Trump's approval ratings are down. And meanwhile, the Ukrainian conflict remains unresolved with the U.S. threatening to lose interest in the process. What does this all mean for markets going forward, inflation, interest rates and our day-to-day lives? To help me answer some of those questions, I'll be interviewing Ed and Sanjiv who are here to remind us to take a long-term view of investment and not get overwhelmed by shorter-term crisis. As Warren Buffett once said, "Our favorite holding period is forever," to emphasize his commitment to the long game. [Operator Instructions] We're also very interested in your views and whether you like this format and approach, so please do also write some feedback so that we can continue to improve how we communicate with our community.

Goodness me, Ed, will the Trump moves and administration actually cause us a global recession?

Well, I think that's far from guaranteed. Now sure, on the one hand, we've had one hell of a trade shock. Even if the current rollback of tariffs that we've got in place for 90 days becomes permanent, that's still going to be the sharpest increase in the effective tariff rate on U.S. imports since the 1860s. But that alone doesn't guarantee a recession. The effects of tariffs per se via higher cost, lower demand don't necessarily get us there because 75% of the U.S. economy isn't tradeable. To get us to a recession, we would need to see something happen via 4 different channels, and it's worth running through them. The first could be contractionary fiscal policy. Now the federal government is cutting staff and there are some threats to benefits payments. So that's a risk factor. We're a little less concerned than most given some of the political and judicial constraints. But what's really important with this one is to remember that we're just 100 days into the Trump presidency. We are looking at a decidedly incomplete picture of what U.S. policy is going to look like over the next 4 years. And the tariff is a bit like a tax hike. And when we analyze a tax hike, we don't just look at the impact of the tax hike itself, but the net effect the tax hike relative to the impact of where the revenues raised from that tax are spent. Now it's important to note that in the last few weeks, the Senate and the House of Representatives have both passed highly expansionary budget resolutions. And if they become law perhaps in the early summer, then that's quite a big offset. Second channel is consumer sentiment falling back, resulting in more precautionary saving, less spending by households. And surveys of consumer sentiment have tanked. But since 2016, there has actually been no statistically significant relationship between these survey measures of consumer sentiment and actual spending. Part of the reason for that is because more and more of the spending is being done by the richest quintile of Americans and their wealth has soared over the last few years. They now own a record 73% of total household wealth. And unless we get a very big wealth shock, which could be maybe like a 30% peak-to-trough fall in equities, that's probably not going impart a negative wealth effect on spending. So we're not there yet. Third channel, a greater market route could raise the cost of borrowing for firms and raise the cost of growth capital for firms and that could cause retrenchment. The fourth channel is the uncertainty effect on business investment. And that is the most likely, out of anything, to get us to a recession if one were to happen. So we know from corporate boardroom intelligence that boardrooms are pretty shocked about what's going on. Uncertainty is through the roof that delays investment spending, delays some hiring. And there have been plenty of examples of recessions where actually household spending hasn't contracted, but the economy has fallen into recession because business investment has fallen back so much. But tying everything together, we have a 45% chance of the U.S. entering recession over the next 12 months. That, of course, also takes into account the possibility that tariffs could be rolled back further. So it's not more likely than not at the moment.

So Sanjiv, translate that into what companies are saying for the outlook for their businesses and how will they deal with the tariffs?

Right. It's very interesting the point we're in right now, we're just starting the first quarter results season for U.S. companies. Something like 40% of the S&P 500, the main U.S. stock market index, are reporting this week. So I think we'll know a lot more by the end of this week. We've had relatively few companies reporting so far. But the ones that have, have sort of talked about -- well, they've been quite circumspect about the outlook. And I think that's absolutely understandable because the tariff situation, the potential trade wars changing on a daily basis. We saw the rollback of the initial April 2 tariffs. And the pause, that pause might be unpaused. So I think companies are recognizing they can't make any long-term plans based on the current state of affairs. They are talking about quantifying what the potential impact of tariffs could be on their sales, for example. But what they're not doing is making big claims about being able to completely offset that. They've talked about the mechanisms by which they can try to mitigate the impact of tariffs on their business. And I'd say there's probably 5 kind of main areas they are looking to do that in. First is kind of front-loading inventory, so getting stock into the U.S. ahead of things potentially tightening up. We've already seen quite a lot of evidence of consumers kind of buying ahead of certain items, which are dependent on being imported into the U.S. We've got companies talking about sharing the pain of the tariffs with their supplier base, that's been quite a recurring theme. Where companies have flexible manufacturing, they're talking about relocating manufacturing back to the U.S. Now we've heard a lot of big claims, particularly from sectors like the pharmaceutical sector. Say, for example, Swiss companies, Roche and Novartis, have laid out sort of $50 billion investment plans to increase their manufacturing in the U.S. In some cases, that's already incorporating plans that were already existing, but they're kind of packaging them up and putting them in a bow. But for a lot of companies, their manufacturing isn't that flexible. They need to make really long-term CapEx plans, and they're just not doing that at the moment because they don't know how long the tariff situation, the tariff threat, could last.

Those are not physically possible. You take the Apple phone, 2,700 components made in 128 countries, most of them in Asia. You can't just overnight build an Apple factory even if they wanted to.

Absolutely, it's going to take 3 or 4 years. There are some estimates that the cost of building an Apple iPhone in China is about $1,000. If you try to do that in America, it would be more like $3,000 and the consumer just isn't able to bear that. So yes, I think the longer-term offshoring -- sorry, onshoring from offshoring that the Republican government is looking to achieve will take a lot of time and a bit more clarity. The fourth thing the companies are talking a lot about is trying to generate cost efficiencies if tariffs prove enduring, and they'll vary in their ability to do that and how quickly they can do that. And then the fifth thing is, most importantly, pricing. So ultimately if tariffs are here to stay at the levels that Trump was talking about on April 2, companies will seek to pass that on to consumers, to business customers whether they put a specific kind of tariff surcharge to sort of make it clear that this is not just inflation, this is related to specifically the tariff issue. How much of that they can pass on depends on their pricing power. So how important is their service or product to their customers. How easy is it for their customers to substitute from companies, for example, which are less reliant on China for their manufacturing. So yes, it's a combination of different things, but everyone is just sort of biding their time until they get more clarity about what the ultimate shape of the trade and tariff situation is going to be.

Okay. So Ed, let's just look at the downside from it, the dark side. If a recession does occur, what will it look like? And how long could it last?

Well, it might not last very long at all. So the longest recessions and the longest recoveries from recession occur when there is a financial crisis. Now we've got this big dashboard of indicators that help us monitor for signs of a financial crisis. And nothing is flashing red on that dashboard at the moment. The short-term funding markets, the lifeblood of the catalyst system that enables banks and businesses to balance their books at the end of each week, that stayed completely calm. There is -- even on the most extreme days earlier in April when you had really big moves in markets. There's no sign that any major U.S. or global financial institution is tapping central banks emergency liquidity lines, which are there for when things got really wrong. And even in the more sort of bankruptcy-sensitive end of corporate borrowing markets, the high-yield end, they remained pretty remarkably calm throughout all of this. Now if this continue -- if a recession were to happen, would that continue? We think that's quite likely because the precursor to a financial crisis is invariably a very rapid accumulation of debt in some sector more broadly, and we just don't see that. So I think a very long recession, long recovery is ruled out. Whether it's short or moderate in length really depends on whether the extent to which companies shed jobs and then maybe reticent to hire them back. Companies at the moment are still reporting skills shortages and they're scarred from their experience in 2020 to 2023 when they shed a bunch of jobs and then found it very difficult to rehire when the economy really got going again without offering those staff big wage increases, and that was one of the reasons for inflation. So there may be a reticence to shed staff this time that could shorten the length of a recession. And then finally, the extent to which the Central Bank, the Federal Reserve can stimulate the economy is an important factor. And that will depend on whether the inflationary impacts of tariffs, which will certainly be significant for a short period of time gives way and proves short-lived and then the sort of demand effects on growth will lead inflation lower. So the bottom line is we think actually the recession is likely. If it does arrive, remember, we've only got a 45% chance of it, it's likely to be relatively short, relatively rapid recovery, which markets would move well ahead of.

So just to be clear, compared to 2008, which was a bank crisis, this is not a bank crisis. The banks are much better capitalized than they were before?

Yes, absolutely. There are so many things that are different and that's why that financial crisis dashboard is just looking nice and green. And we all have a -- we're human. We have a tendency to anchor our expectations about future events to something in the past. 2008 was really the last proper recession, right, because the COVID one was so unusual and so short-lived. But that is a financial crisis. That's not a regular recession.

So Sanjiv, if you were talking to our guests who are listening today, which parts of the equity market are expected to be more sheltered in the current environment?

Yes. So typically, the more defensive areas are sectors like health care, so pharmaceuticals and medical equipment; consumer staples, so things that people buy every day like toothpaste and soap; utilities where they've got very fixed returns that they make and electricity demand doesn't tend to vary that much through the cycle. But we're in a slightly unusual position because of the tariff uncertainty. So for example, health care is generally exempted from tariffs and it was last time around under the first Trump presidency. This time, it doesn't seem to be. So medical devices are not exempt. And while pharmaceuticals are so far not covered, Trump's very clearly said he wants pharmaceutical tariffs to come into play. He wants a lot more manufacturing pharmaceuticals used in the U.S. to be made in the U.S. So there is an element of uncertainty. That said, the end demand for pharmaceutical drugs is very defensive. So we still think that should be a pretty decent sector. Consumer staples, again, we think should be fairly sheltered. One thing to bear in mind is if tariffs prove to be quite inflationary. When consumer staples went through the sort of 2022-'23 inflation period, they didn't necessarily cope that well with it. Yes, they put up prices because they've got the brand power to be able to do so, but they saw volumes being hurt. And it's interesting, Procter & Gamble, which is a very well-managed U.S. consumer staples company, has noted that in terms of its 2025 outlook, that the U.S. consumer is looking a little bit less rosy and that will in part be due to the uncertainty. I suppose another area to call out as being relatively defensive is within technology. So technology as a whole has defensive and cyclical elements. The hardware element, so things like phones; other kind of hardware equipment, PCs, et cetera, is notoriously quite cyclical. But the software side is actually a lot more defensive, particularly as the business model evolves to be more of a subscription. So a business might buy a piece of software -- might rent a piece of software for a monthly amount of money. And if that software is critical to the business that's buying it, then it has to keep renting it no matter what's happening with the economy. So that section of the economy should be quite defensive. The other area that would be interesting to see and we'll know more about at the end of this week is the Internet stocks. So we had Alphabet, which owns Google and YouTube reporting last week, and that actually was reporting pretty decent trading. One area that we're nervous about is advertising and the fact that Chinese sellers of goods, be they like sort of SHEIN or Temu, have grown to be quite a large segment of Internet advertising on platforms like Instagram, so it may be that they impact some of the other Internet companies reporting later a little bit more. But we'll know more about whether that area is defensive. In general, I'd say U.S. exporters are probably going to benefit from the weaker dollar unless we eventually see retaliatory measures from other trading partners. And U.S. companies with significant overseas earnings that are generated in those countries will be translating that back to dollars at a weaker dollar price. So that could be an offsetting benefit for some more internationally focused U.S. companies. I mean, the other thing we haven't talked about is Europe. And Europe is really kind of getting together...

Europe has outperformed the U.S. market.

Absolutely, absolutely. So we saw some unprecedented changes happening in Europe as a response to what Trump was saying about defense. So European countries targeting much higher defense budgets. And also we saw Germany relax its so-called fiscal brake and actually earmarked huge amounts of money for domestic infrastructure, which is quite sort of [ quaking at the scene ]. So there is actually quite an interesting emerging opportunity, we think, sort of happening in Europe potentially and some really good companies to play there.

Great. So Ed, we also saw the dollar depreciating. We saw the U.S. treasury market being very volatile. And indeed, in many ways, it was the treasury market that perhaps persuaded Trump to row back a little bit on the tariffs rather than the equity market. Are we really witnessing the end of the U.S. dollar and its hegemony and its bond market as a world haven?

Well, to answer that question, I'm going to transport you back to the early 1970s, right? So in the early '70s, we had these big, boisterous arguments in America about how American manufacturing needed to be shielded from unfair trade practices in Europe and Asia. We had arguments that European and Asian currencies were deliberately undervalued. And we had arguments that the U.S. should stop supporting Europe militarily. Sounds pretty familiar, right? So what happened? We had the Nixon shock. President Nixon did a 10% universal tariff. He put price controls and wage controls in place in the American economy. And he ended the dollar's convertibility to gold, which was a really big thing at that time. In fact, those 3 things, I would say, were more radical than Trump's agenda today or at least what we've seen of Trump's agenda. "Other countries don't like it, so what?" Said John Connally, Nixon's Treasury Secretary. He was just a sort of rhetorically belligerent as a lot of people in Trump's camp today. Really credible voices, many credible serious voices said the days of the dollar being the world's international currency back in the '70s are done. But of course, 50 years since, that prophecy did not come true. In fact, far from it, the dollar has just become more and more embedded. And I tell that story because the role of the dollar is not really linked to how good an international diplomacy America is. It's not even really linked to the wisdom of American policymakers, at least not in the short term. And it's not linked to U.S. economic growth. It's linked to the fact that most international debt, most international bank loans, most global trade financing and most global trade invoicing are denominated in dollars even when -- mostly when the U.S. is on neither side of transaction itself. And the dollar acts as a safe haven because when the economy gets into trouble and firms and investors need to meet their liabilities more quickly, they've got to sell other things and buy some dollars to pay things down. And that functions whether the dollar is weak or whether the dollar is strong. It's really important to differentiate between the dollar's role as that sort of safe haven and the strength of the currency because they're not the same. So look, we think it's actually really quite inconceivable that over the short term the dollar will suddenly stop being that -- playing that role. Sure, over the next few decades, quite possibly we could see a transition. But it's inconceivable that could happen so quickly. Now all that said, we do think and have thought for quite a while and have said for quite a while that the dollar is overvalued. That's built into our 10-year assumptions, has been for a long time. And if global equity investors start to reposition from U.S. equities into other global equity markets, we may see a period like we did in the early 2000s after the dot-com crash where the dollar weakens because U.S. equity markets are falling out of favor. But that will be relatively short-lived. That doesn't mean that the whole role of the U.S. dollar as the world's international currency is over. And we do think over the long term, it will still play that safe haven role. U.S. treasuries, also deeply embedded. And no major holder of U.S. treasuries has an incentive to really tank that market. But that said, we have thought for quite some time since last year, actually, we announced that we are strategically shortening the duration, the sensitivity to interest rates, the maturity profile of the bonds we hold in our portfolios to guard against some of these political, geopolitical and inflation risks.

So let's get to how quickly could equity market recovery take place because we talk about invest for the long term, don't get overwhelmed by short-term crisis, but how quickly could we see that recovery happen?

Yes. Okay. Well, to answer that question, I'm just going to jump up to the video wall and bring up a couple of slides. And let's think back over the last few years, right? So this chart here starts in 2018 and the gray shaded areas here are the peak-to-trough falls over that period of time. And this is a chart of global equity markets and in 2018, 2020 and 2022, we had more than 10% corrections. Now if these was a chart of U.S. equities, these gray areas would actually be even bigger than the drawdown that we suffered this year. And 2 those periods of equity market falls were the pandemic and then in 2022, after the Ukraine war. They were very profound economic disruptions, right? The pandemic, obviously, and then the permanent remapping of global energy supplies after Russia invaded Ukraine. And yet despite all of that volatility, all the profound dislocation, the blue line here, which is just simply global equity markets total returns aligned to the right-hand axis is pretty steadily going up all through that period. And I put this on the screen because it's really important to note that equity markets are extraordinarily resilient even to periods of profound disruption. Just give them a little bit of clarity, markets and the firms that constitute them can really get on with things. And so if we bring up another slide that just has a few statistics, so they're really helpful to bear in mind at the moment. Let's start on the right-hand side. We're looking at equity market returns since the Second World War. In 73% of 1-year periods, they delivered a positive return. 84% of 5-year periods all the way to rolling 15-year periods since the Second World War 100% of them gave positive returns. And that's despite the fact that pretty often we get major corrections sometimes associated with big changes in the global economy or global politics. A 10% fall in markets happened in just over 1 in 2 calendar years since 1964. We've switched to 1964 because we're using daily data now to properly look at those peak to trough losses. And in about 1 in 5 calendar years, a 20% peak-to-trough correction takes place. Equity markets are extraordinarily resilient. We have a tendency as human beings to think that this time is always more uncertain than the last, it's more profound than the last. That's often not quite true. Equity markets are resilient, please bear that in mind. And we think that, especially if we don't get a recession, the bounce back could be quite quick, which is why we remain invested. Most investors don't think for the long term, the average holding period for a stock these days is 1 minute, but our clients tend to have long-term goals. We think like them, we focus on the long term.

So there are a few questions coming in from our audience, and that's all very well, Ed, to talk about those recoveries. But one question here is what's going to happen at the end of Trump's 90-day tariff pause? I mean, are things just going to go haywire again? Or do you think he's actually learned his lesson?

I'm going to say, I don't know and I think that's really important. So you may remember in our sort of 2 or 3 webinars ago when we were talking about Trump about to start his presidency, I was saying I was dismayed by how when I was on TV or on panels, how many of sort of like fellow CIOs were saying, I know Trump is going to do that. I know Trump is going to do this. No, you don't. And that's okay. We don't have to know everything. In fact, some humility is really important as an investor because there are so many uncertainties. So I think it's probably unlikely we're going to -- suddenly, this is going to go away like tariffs are -- Trump has been talking about them since the '80s, if you listen to some of his close confidants. But the -- I suspect, to an extent they're here to stay, but the extent to which they get rolled back or extend, I don't know. So what do we do with that as investors? What's our investment strategy? Well, we continue to focus on a really core part of our equity research process led by Sanjiv that is look for quality companies. Companies that -- and by quality, we mean companies that have high degrees of profitability relative to their sector that can maintain that profitability through a variety of different economic environments, through thick and thin essentially. It doesn't mean that they're going to be completely immune, but they should do relatively better than less good quality companies. And that sounds really obvious, right? But actually, that quality factor has been routinely underappreciated by investors for decades.

And Sanjiv, turning to the U.K. equity market. There's some room to be a bit optimistic isn't there in terms of quality and defensive nature of that market?

Yes. I mean, the U.K. market is shown to be relatively defensive one. We've got a lot of really good global companies with great business models. I mean, if you look at the business information sector just alone, you've got companies like RELX, Reed Elsevier. Experian, which started off as credit bureau, now does a huge amount of different data analytics. We've got world-leading pharmaceutical companies like AstraZeneca. We've got world-leading consumer staples companies. They're listed in the U.K., but they are achieving great things globally. And yes, I mean, I think the story over the last 3 to 4 years has been very much U.S.-focused. And I think as global investors start to pan away from that and maybe because of this uncertainty, they might actually pay a bit more attention to some of the good things that are going on in the U.K.

And could you drill down also one particular sector you mentioned en passant, which was the defense sector and stocks there because some of our viewers are interested in that.

Yes. Well, I mean, so very much the sort of the last 90 days has been the U.S. slightly sort of retrenching from some of the defense commitments to Europe, and Europe, realizing that they need to spend more on their own defense. Europe has been kind of quite reliant on U.S. defense suppliers. And while I think it will probably always maintain very close links with the U.S. defense establishment, there's going to be a lot more reliance on internal champions. And we've got some of them in the U.K., for example, BAE Systems. And there's also some really interesting ones in Europe as well, which are going to face a lot more investment as more platforms become European sort of based rather than U.S. or global.

So we are coming up towards the end, but we've got so many great questions. I think we're going to go over half an hour a little bit. And one of the questions that just come in at is that there were a lot of people very overly confident in the guess view about the U.S. and had overly invested in U.S. and U.S. tech. do you think we're shifting our allocations to be more European focused in response to that? In other words, did we get caught cold a bit by all of this?

Yes. I mean, so look, we have always thought that for a sterling-based investor that non-U.S. investments have a bigger role to play than what you would get if you just outsourced your asset allocation to the FTSE World Index or the MSCI World Index. We like a lot of U.S. tech, particularly software, Software as a Service, as Sanjiv has said. But there are risks associated with that sector. They are more -- they can be quite sensitive to U.S. bond yields, which, of course, could -- what we saw earlier this month, as you said, really pressured Trump into a reversal, who knows how that may pan out. So we want to look for assets that complement that, that diversify away some of the risks to those really great U.S. companies. And the U.K. is actually a part of the market that is the least sensitive to higher U.S. bond yields. So there are really good reasons that we are being reminded of this year more than ever for why you don't want to put all your eggs in one basket. That said, U.S. equities are still going to be the lion's share of equity portfolios both for us and for other investors, in part because they just have a really great and varied base of these high-quality companies that I referenced earlier. There are more high return on invested capital companies in the U.S. than in many other markets. But we may have gone through a period where that just got a bit over extended, that idea of U.S. exceptionalism which we never bought into just got too in -- people got carried away with that, and we may be going through a bit of a rotation that lasts.

I think there's time for one more, and there's a few questions here about U.K. interest rates with the decision coming up in May. Does the Bank of England tell itself a story that inflation is rising, so rates need to stay high? Or does the Bank of England tell itself a story that growth is stuttering, so the economy needs to be stimulated. These counter-pressures, how do you feel about that?

Yes. So I mean U.K. inflation has been stubborn. It's a little bit difficult to pinpoint exactly why because some of the labor market data, the wage data is a bit deficient at the moment. There are problems at the Office for National Statistics and the way that, that data is being collected. But there is this -- there are parts of the inflation basket that are heading in the wrong direction. So it is unusual, though not unprecedented for the Bank of England to cut rates during an environment like that. But what would lead them to do that is that actually a lot of the growth indicators are not doing too well. Now if this tariff shock from America takes hold and growth -- there is a global growth slowdown, even if it doesn't result in recession but there is a significant slowdown, then that's going to hurt the U.K. economy as well. And in the U.K., that is disinflationary, particularly if China reroutes some of the exports it used to sell to America and puts them into other markets at a cheaper price. The U.S. would have a lower growth, a much bigger hit to growth than anywhere else because it's doing a tariff on everything all at once. But there, the impact is inflationary. So there is more scope for the Bank of England or the European Central Bank or other places to respond with lower rates. And we think that there will be a few more cuts coming this year.

Goodness me, there are so many more questions we could answer. Unfortunately, we've run out of time, so we can't take any more questions. Would be interested in all of your views about whether this webinar should be 30 minutes or maybe 45, we have a lot of debate about that. So do let us know. And please do register for our next webinar on the 1st of July using the link provided within the webinar platform and leave any comments, any areas for improvement for these sessions and the content that we cover. We'd love to hear from you, and I'm wishing you a great afternoon.