QIF 3Q: Macro Uncertainty and the Role of Corporate Engagement in Driving Portfolio Outcomes

September 13, 2022

Macro Outlook

Evan Brown, Portfolio Manager and Head of Multi-Asset Allocation Strategy

  • The macro backdrop is still highly uncertain. The combination of slowing growth and sticky inflation suggests market volatility should persist.
  • We ascribe roughly equal odds to the market pricing in recession, stagflation, or a soft landing as the dominant regime at year end. The market implications of these scenarios vary widely. As such, we are focusing on efficient relative value expressions within asset classes over directional bets that might only work in one regime.
  • In our view, the key facet of the economic environment is that inflation is too high. Some of the pandemic and war-impacted components of inflation are decelerating, but stickier items (rents and core services inflation) are picking up.
  • Activity is decelerating. Higher rates have weighed on residential investment, and manufacturing is slowing on a shift of spending from goods to services and a large inventory overhang outside of the automotive sector.
  • Even though growth is slowing, central banks are hard-pressed to pivot because inflation is so hot and, in some economies like the US and UK, the labor market is so tight, too. We believe that the Federal Reserve in particular is unlikely to have confidence that inflation will move and stay lower until wage pressures subside materially, and therefore an extended period of restrictive monetary policy is likely.
  • Europe has done an impressive job building up natural gas reserves, which reduces the potential severity of worst-case economic scenarios heading into the winter. But much of Europe’s business model is grounded upon cheap Russian gas for industrial use to develop large trade surpluses – and the days of cheap energy are gone. In our view, Europe is going to need to support demand in another fashion, or risk another prolonged stretch of lackluster activity. Importantly, European governments are taking a more proactive fiscal stance. Last cycle, European fiscal policy was in retrenchment, and so far is doing the reverse: running cyclically-adjusted budget deficits to boost spending on decarbonization and energy security. Importantly, Europe is no longer exporting its savings to the rest of the world, a structural shift that implies higher global yields.
  • For China, the policy priority right now is stability. High-frequency indicators show that growth has a stop/start pattern due to zero COVID-19 measures, which we expect will persist well into next year. Beijing also wants to rein in excesses in the property sector, which should be in structural decline as a growth driver. Infrastructure spending is providing an offset, but with big construction booms likely a thing of the past, it is unlikely that China will be the catalyst for broad cyclical lifts in global activity.
  • Given this backdrop, we believe that stocks are likely to remain in a volatile range. The Federal Reserve’s desire to tighten financial conditions and slow activity caps the upside, but the floor is underpinned by resiliency in earnings and bearish positioning. Historically, when sentiment is at such low levels, forward returns are positive – but ultimately, macroeconomic conditions will dominate. Expectations for the Federal Reserve’s terminal rate have been revised aggressively to the upside in September, and risk assets need yields and the US dollar to peak for sustained upside.
  • The good news is that the year-to-date selloff in bonds amid central bank tightening has made bonds and cash much more attractive investment destinations. And on a forward looking basis, this should make for a much more positive environment for diversified 60/40 portfolios.

The Role of Engagement in Delivering Portfolio Outcomes

Lucy Thomas, Head of Sustainable Investing

Hans-Christoph Hirt, Head of Impact Engagement

A challenge for asset managers who seek to implement sustainable investing strategies – and have large, index-oriented exposures – is what to do with underperforming companies. We believe that the optimal approach is to augment these indexed positions with concentrated, active and activist portfolios staffed by teams that have the capability to engage with companies to unlock value and achieve better real-world outcomes. In our view, this is a much better option than divesting laggards – particularly with regard to index holdings, where this is not possible. This is the case even though effective engagement is resource intensive and requires dedicated resources.

We believe that there are five ingredients for successful, value-enhancing engagements with companies:

  1. Focus: concentrate engagement efforts on a small number of holdings and assemble a dedicated team with relevant experience and skills.
  2. A theory of change: formulate an engagement strategy – articulate what needs to change, how to drive that change, and why achieving the change will add value. Bring something to the table when interacting with companies and approach the interactions with companies as partnering.
  3. Engage-ability: identify a management/board that is willing to work with you, or a company in a crisis situation that has an incentive to collaborate with and listen to investors. The ownership structure and names on the share register are also important considerations. These may allow you the opportunity to build a larger base of support for potential changes, subject to point 5 below.
  4. Mastery of techniques: build capability to use the full range of engagement techniques and know when to use them as part of systematic escalation. On rare occasions – where private interactions and partnering fails – use more assertive means of engagement including around shareholder meetings.
  5. Knowledge of local markets: be conscious of the fact that engagement style and methods might vary due to the regulatory framework and culture in a specific market.

Leading a successful proxy fight can be important for smaller firms taking an activist approach, as it often enhances access and makes boards and management more receptive to partnering and constructive proposals in the future; as such, it increases their influence in engagement.

To unlock value and have a real word impact in engagement with companies, investors should bring something to the table – whether that is proprietary research, examples of best practice, benchmarking, or connections in the industry or value chain.

Engagement may also evolve beyond one-on-one interactions between an asset manager and a company. Instead, investors may look to bring multiple companies from the same sector or along a value chain together to tackle common challenges or connect companies to key stakeholders to effect greater change.

Christopher James, Founder and Executive Chairman of Engine No. 1

Note: His views are his own and do not necessarily reflect the views of UBS Asset Management.

I was inspired to use engagement as a tool to unlock value after many years on the buy side through my work in charitable endeavors, where I observed a lot of linkages between causation in social situations and outcomes. After reading more academic research on the movement towards ESG criteria, I realized there were linkages between some of these data and financial outcomes – and as an investor, that made me excited.

We use a total value framework, and try to put dollar values on the impacts corporate activities and all of their externalities have. You can look at carbon, water use, biodiversity, and put dollar values on those, and look at the relationship with that and the profitability of the business. This allows us to focus on what was really important, and have this information which could be used as a tool to drive change to cause value creation.

In our view, sustainable investing means answering the question, “Does a company earn the cost of capital net of all impacts/externalities?” The direction of travel between impacts in relation to profitability is, to us, what’s most important. Is the company borrowing from the future to maximize profitability now, or is there a long-term strategy for success?

In automobile manufacturing for instance, decarbonization will allow companies to drop Scope 3 emissions from roughly 320-330 million tons a year to 50-60 million. The profitability dwarfs negative cost impacts, even assuming a low social cost of carbon.

As auto firms carry this out, you should see, and I think we will see, the multiples of these stocks expand. And multiples are shorthand for the terminal value of the business, that tell us about the resilience, duration, and durability of the business model. We believe that is a function of the total social value of the business.

If we don’t find linkages between ESG and operating outcomes, we don’t focus on them. We haven’t utilized the “S” in ESG too much because we haven’t found those linkages. If we find data that supports their utilization, we’ll go down that path.

There is, at times, a tension in that management is in place for a limited time, so their incentive may be to borrow from the future to profit in the present. We’ve been living through this lately, with regards to supply chains. Many companies moved supply chains to Asia to maximize short-term profitability, and are starting to see the impact of this strategy. Negative impacts are not just through vulnerabilities of single-sourcing, but also by not having engineering and manufacturing in the same place. There is detailed information out of private companies linking market share gains by keeping these two business operations in the same place. For a time, corporates are penalized on margins and cost-disadvantaged versus peers, but the product continues to get better and that pays off in the longer term. We walk through case studies to explain this to people in the C-Suites. Offshoring has been going on for long enough that executives get it – they have paid a price for low-cost manufacturing. Long-term competitiveness is an issue that CEOs do care about. It takes a lot of explaining to get there, but it’s easier to have this conversation post-COVID-19 than it was 5 years ago, because vulnerabilities have been more exposed.

Geopolitics Q&A

Andrew Bishop, Senior Partner and Head of Policy Research at Signum Global Advisors

Note: His views are his own and do not necessarily reflect the views of UBS Asset Management.

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