Border to Coast's Joe McDonnell on why now's the time to approach investments with caution

Aggressive monetary tightening by central banks, stifled consumer spending and risks relating to the tightening U.S. money supply call for a cautious stance in the coming months, said Joe McDonnell, CIO at Border to Coast Pensions Partnership.

“We have only recently turned more cautious on the backdrop of a very strong performance in risk assets as markets are entrenched in this perfect Goldilocks scenario,” he said in emailed answers to questions from Pensions & Investments. “However, we continue to see downside risks to global growth as tighter liquidity begins to weigh more heavily on both consumer and corporate spending.”

And that’s certainly the case in Europe, which McDonnell said is “arguably already in a form of recession, especially in the more manufacturing-based economies such as Germany.”

The Leeds, England-based pool for 11 local authority pension funds that have a total about £60 billion ($77.1 billion) in assets, was responsible for £40.3 billion in assets as of March 31, 2023, invested across equities, debt and private markets for more than 1 million participants.

Markets are primarily occupied with interest rates, but the U.S. money supply amid Federal Reserve tightening is another risk on the horizon, he said. Although there is plenty of dollar liquidity in absolute terms, tightening is likely to negatively impact GDP for developed economies, which have become increasingly dependent on upping their money supply to fuel growth, McDonnell wrote.

“Our biggest concern with the money supply is the rapid depletion of excess savings,” he said, citing a Fed research report that found that most advanced economies will have largely depleted their accumulated excess savings from the COVID-19 pandemic. “This is quite important when considering that in 2023 the economic resilience was largely driven by very strong consumer spending,” he said.

With many corporations taking the opportunity afforded by excess spending to increase prices to grow profits, “any sort of weakness in the consumption impulse and it will have huge ramifications on business margins.”

Due to the downside risks, portfolios have been tilted away from cyclicals and into higher quality defensive assets, he said. Investment executives are “vigilant with our stock selection in our internal equity portfolios and try to invest in companies with clear competitive advantage that can weather a potential economic slowdown,” McDonnell said.

And the same applies across the fixed-income portfolios, “where selectivity is key in this sector, particularly following the sharp rally in the last weeks of 2023.”

If consumer spending falls and refinancing becomes challenging for some issuers given tighter bank-lending standards, “vulnerabilities in lower-rate credit are likely to be exposed,” he said. Plus, the “dilution of covenant protections in recent years” means recovery rates are likely to fall should default rates rise.

“That said, we think that episodes of distress are more likely to be idiosyncratic rather than widespread as default rates could rise above long-term averages,” McDonnell added.

For fixed income, McDonnell and the investment team continues to believe that long duration is the “most prudent allocation, given the current economic climate.”

The team likes government bonds, “as they are an obvious beneficiary of inflation peaking” and offer a degree of diversification, “which will be useful should equity markets begin to suffer. This also extends to emerging market debt, where proactive monetary policy over the past two years has been of net benefit to local economies,” McDonnell said.

As of March 31, 2023, assets under Border to Coast’s management were invested across equities (£20 billion,) fixed income including multiasset credit (£8.3 billion), and private markets at £12 billion. Infrastructure carried the highest commitments at £4.3 billion, followed by private credit at £3.3 billion, private equity at £3 billion and climate opportunities at £1.4 billion.

Although equities made gains last year, much of the momentum came from the so-called Magnificent Seven stocks — Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. These companies gained over 100% in 2023, vs. a 24% return for the overall S&P 500.

That concentration is something Border to Coast is aware of, and that it was “buoyed by the artificial intelligence boom that captured investors’ attention,” McDonnell said.

While the Magnificent Seven stocks have room to run, executives are also mindful of the expectations that are embedded in the current prices, and so are looking at AI carefully.

“Our overseas developed equity fund has benefited from the explosion of the AI theme, particularly our overweight position to Nvidia,” he said. That fund had £6.2 billion in assets as of March 31. “We are cognizant of the fact that lofty expectations are embedded in the price and are somewhat concerned in the short term with a potential correction in the buildup of excess inventories among the cloud customers that account for more than half of data center sales. Given our short-term concerns, we are treading carefully and have taken the opportunity to crystalize some of the profits through our positioning,” McDonnell said.

However, the AI theme is disruptive over the long term, and executives are already starting to look — carefully — at companies that may benefit from early adaptation to improve their operational efficiencies. “Notwithstanding, this is a gradual process, and it will take time to evaluate the ability for companies to monetize on this opportunity. We are therefore very careful to separate the hype from the opportunity and ensure that we invest our partner fund capital in the best quality operators in their respective fields.”

Executives are also looking to Asia for equity exposure, to China and Japan specifically.

The Nikkei 225 gained 28% in 2023 — one of the top-performing markets last year, and the Bank of Japan grew more assertive in addressing weakness in the yen. With that in mind, Border to Coast executives prefer domestic companies with the potential to enhance shareholder value by improving governance and capital allocation, McDonnell said.

The Tokyo Stock Exchange introduced the Corporate Governance Code in 2015, which was subsequently revised to include stricter requirements, he said. “These efforts have accelerated this year as the Japan Exchange Group adopted a name-and-shame policy to push companies to improve shareholder value and improve communication with the market,” McDonnell said.

But improved governance is not the only reason why Border to Coast is bullish on Japan, with the macro environment also playing a key role since “Japan is essentially a net beneficiary of the inflationary pressures most developed markets have experienced. Following decades of stagnation, we are seeing the first signs of sustained wage growth in Japan that would likely kindle more robust consumer demand. This will also help support the case for the BOJ to increase rates and in effect help with the reshoring of capital from global corporate and financial institutions,” he said.

Regarding China, McDonnell acknowledged that investor sentiment is at “extreme low levels as the property drags continue to affect consumers’ willingness to spend.”

But there are some positive signs that give executives some comfort that the worst may be over: “The piecemeal stimulus thus far has failed to ignite a significant rally but has managed to stamp out risks to the financial stability,” he said. Chinese authorities have made a number of moves to stimulate the economy and stem outflows from stock markets.

“Furthermore, policymakers are clearly focused on supporting new growth drivers through innovation in areas such as digital economy, advanced manufacturing and green technologies. These are sectors that are very important to the global supply chain that are difficult to replicate given China’s infrastructure and low-cost access to skilled labor,” McDonnell added.

That’s “also aligned with how external China managers are positioned as they are looking for companies with global dominant positions and ongoing commitment to innovation and technological advancement,” he said, citing the pool’s holding in solar company Sungrow as an example of this. The company has invested heavily in research and development, allowing it to offer advanced inverter products that are more efficient and reliable than that of the competition, he said. “This clear advantage is the reason why we believe that Sungrow is a very important player to the global energy transition especially given our commitment to be climate-neutral by 2050,” McDonnell added.