The Investment Trusts Handbook 2025 – John Baron’s Chapter
Image source: Harriman House
The following chapter by John Baron in the recently published ‘Investment Trust Handbook 2025’ explains why he believes markets will continue to climb the wall of worry, and the importance of maintaining diversification relative to remit.
My chapter in last year’s Handbook (The Darkest Hour?) referenced why our portfolios had been defensively positioned in order to reflect the new investment landscape and why, with sentiment poor relative to outlook, our portfolios were now increasing their equity exposure within the perimeters of the new regime. One year on, we remain positive about the outlook for markets. However, given expected volatility, adequate diversification relative to portfolio remit is now more important than ever. Travelling with some insurance is never a bad idea, if only for peace of mind, and particularly so if approaching financial goals.
Climbing the wall of worry
Equities are enjoying a good run of late with even the much-maligned UK market doing well. This is confounding many investment strategists, while year-end forecasts are being revised up as previous estimates become redundant. Despite the many economic and geopolitical challenges facing policymakers, markets are climbing the wall of worry. The question is whether this can continue? All-time highs often make investors nervous. Yet, while accepting volatility will be a constant companion, there are good reasons to believe progress is sustainable.
The geopolitical challenges are well-rehearsed. The war in Ukraine may be edging in Russia’s favour and many eastern European countries are understandably nervous. Diplomacy and strategic alliances are also having to contend with China’s intentions regarding Taiwan and a widening conflict in the Middle East. The current demise of Western influence is perhaps illustrated by the UN vote on Ukraine last year, which saw governments representing more than half of the world’s population refusing to condemn Russia’s invasion. Meanwhile, wars exist elsewhere, particularly in Africa.
Economic concerns abound. At time of writing, despite markets recognising interest rate cuts are part of the equation, interest on cash and government bond yields still present a headwind for equities – higher yields elsewhere offer greater competition for investors’ funds. Meanwhile, geo-political events and conflict in the Middle East risk sending oil prices higher, while the gold price is reflecting wider uncertainty and some aggressive central bank buying.
There are also market concerns about the extent of budget deficits and debt levels. The situation is not helped by economic growth slowing globally as productivity has stalled in recent decades. The exception is the US, despite productivity there remaining below its long-term average. Productivity has levelled off in the UK and EU, and the gap with the US has therefore widened. It is no surprise economic growth has outpaced that of Europe, and this is reflected in their respective unemployment rates. The UK has done better on this measure though.
At least part of the divergence between the US and Europe can be accounted for by their different approaches to risk and concomitant attitudes to regulation. While governments must ensure a ‘safety net’ for the vulnerable, they must also encourage growth. Yet Europe abounds in regulations. In the UK, overzealous regulation and guidance (now finally removed) has previously made investment trusts look unduly expensive, so hindering investment into sectors such as infrastructure, renewable energy and so on. In Europe generally, MiFID rules are hindering bank lending to smaller companies. Far fewer government regulations on AI have been passed by the US when compared with Europe. The list goes on.
Reasons to be positive
Yet there are reasons to remain positive about markets. The recent graph (below) from Montanaro Asset Management shows the correlation in direction between the US economy and global equity markets over the last 25 years or so. While no correlation is perfect, it does highlight the importance of the US economy in providing markets with a sense of direction. This is rational given its size, transparency and dynamism. And given the usually long economic cycles, the current juncture suggests further equity gains, despite markets being close to all-time highs.
A common refrain is that terminology such as ‘all-time high’ can spell danger, in that prices are higher than ever before and so buyers should beware. Yet logic suggests that for markets to advance, they must break through previous highs, otherwise no progress can be made. A journey consists of an increasing number of steps. Indeed, recent research regarding the S&P 500 index has shown that investing solely at all-time highs would still have produced returns close to the index average over the last half century or so. All-time highs are very common. The greater danger is missing out on the best market days, which is why investors should remain invested relative to remit.
Of course, volatility will be a constant companion as markets digest the various challenges. And the gradient of the market’s rise will depend on several factors, particularly the extent and timing of interest rate cuts. For reasons I first cited in the spring of 2021, there has been a long-term structural shift in inflation. Three per cent has now become the new two per cent. This is helping to shape a new market landscape. Yet overall, the backdrop continues to be supportive of equities over the short to medium term.
However, this narrative should not encourage complacency. Having turned positive on equity markets in the spring of 2023, my Investor Chronicle columns at the time and since have highlighted market and sector preferences when increasing exposure. Our portfolios are underweight the US in favour of the UK, Japan and emerging markets. Portfolio holdings for these markets include Pershing Square Holdings (PSH), Edinburgh Investment Trust (EDIN) and Utilico Emerging Markets (UEM). Favoured international generalists include JPMorgan Global Growth & Income (JGGI) and AVI Global Trust (AGT).
At a more granular level, we favour smaller companies given this point in the cycle. Holdings here include JPMorgan UK Small Cap Growth & Income (JUGI), Montanaro UK Smaller Companies (MTU), Scottish Oriental Smaller Companies (SST), Smithson Investment Trust (SSON) and Herald Investment Trust (HRI). Private equity is another attractive sector given track records and discounts. Holdings include Patria Private Equity Trust (PPET), Pantheon International (PIN), HarbourVest Global Private Equity (HVPE) and CT Private Equity Trust (CTPE).
Positive on the UK
Within the portfolios’ increased equity exposure, the UK has been assuming greater importance given it continues to languish at a 40% discount to global markets. Commentators and investors alike have all but thrown in the towel. Even some of the MSCI PIMFA benchmarks used as a long-term reference for the portfolios have recently reduced their UK weighting. Yet, I dare to suggest there is hope. Catalysts for a re-rating lurk in the shadows.
Explanations as to why the UK market remains cheap are well rehearsed. An overweight exposure to ‘old economy’ sectors (at the expense of more highly rated technology companies), five prime ministers in eight years and the concurrent political challenges, onerous listing rules and obligations seeing many companies move to the US, a huge divestment in recent decades by pension funds of equities in general and the UK in particular, and a perception economic growth has been relatively pedestrian – these have all contributed to the malaise. Any good news has paled into insignificance.
Certainly, in contrast to the perception created in certain circles, economic growth has been among the fastest across the continent since Brexit, as evidenced by an unemployment rate remaining well below the EU average and inward investment continuing to compare well. The corporate sector is in good shape with company balance sheets strong and investment gathering pace. Personal taxes are higher than liked, but one of the most generous furlough schemes and energy support packages ensured no one was left behind. Meanwhile, interest rates are now on the turn even though the Bank of England again risks being behind the curve in responding to the short-term inflation outlook.
Perhaps another misconception should be tamed. This is the view that the UK market is bereft of technology. It is true the UK, like many other countries, is not home to the likes of the US’ magnificent seven companies. For some the jury is still out as to whether the lofty ratings afforded these companies are justified. Regardless, many large British companies are busy embracing technology and the application of digital tools, including AI. Examples include London Stock Exchange, Sage, Experian and RELX – and the price tags for these stocks are disproportionately cheaper.
What of possible catalysts?
In an increasingly uncertain world, the UK offers political stability. The election of a Labour Government contrasts starkly with far-right parties gaining political influence on the continent. Our Parliamentary system was always more robust and responsive than its detractors believe, but first past the post ensures the minority of extremists in our society, whether left or right, find it difficult to break into the political mainstream. By contrast, proportional representation has sadly conjured an ill wind on the Continent. This is being acknowledged by international investors, who are also encouraged by the continued thawing in relations between the UK and EU.
The drive by City regulators to relax London’s listing rules, and so help stem the flow of companies moving to international rivals, offers hope. In the biggest shakeup in decades, rule changes simplify the process for companies coming to market, including the elimination of the two-tier system of standard and premium listings, relax the restrictions on dual class shares that confer more voting rights for founders, remove the need for firms to provide a three-year financial record and reduce shareholders’ rights regarding M&A decisions. Despite the governance concerns of some, the rule changes bring London more in line with international competitors. The regulation of the graveyard has little future.
In addition to proposed pension fund reforms encouraging greater investment in domestic equities and infrastructure assets, perhaps there is another factor worth mentioning. Current headlines focus on inflation falling and the speed of interest rate falls. Yet, as highlighted previously, the structural shift in inflation over the medium to long-term has implications for discount rates, which will be high enough for questions to be asked regarding the lofty ratings afforded the larger US technology companies. Once the penny drops, investors will have another reason to look at the UK market.
The portfolios’ increased UK exposure has been courtesy of seven companies which promise to outperform their respective benchmarks as the UK plays catchup. These ‘magnificent seven’ companies are Temple Bar Investment Trust (TMPL), Finsbury Growth & Income (FGT), Henderson High Income (HHI), The Merchants Trust (MRCH), Fidelity Special Values (FSV), The Mercantile Trust (MRC) and Montanaro UK Smaller Companies (MTU).
Stay diversified
However, while remaining positive if not selective about markets, it is important to maintain investment discipline to ensure portfolio balance is retained and diversification is adequate to remit. This is particularly so when financial goals are nearing. Rising markets can sometimes be seductive and so distract from the task at hand. The journey is better enjoyed if an element of insurance is in place, should things go wrong. Of course, those assets helping with diversification can also be themselves good investments.
There is a minority view that diversification is second best to putting all of one’s eggs into the basket but watching that basket very closely. I tend to disagree. I have always considered diversification an important investment discipline, yet one which is often overlooked, particularly when markets are rising. Investors can underestimate just how risk averse they are until a market correction takes place. Better then, as time passes, to increasingly diversify a portfolio away from equities toward other ‘alternatives’, meaning uncorrelated assets which tend not to move in the same direction as equities, over the same period.
While few investments will escape a major market correction unscathed, adequate diversification will help to reduce losses and so protect past gains, while providing firepower for opportunities that usually avail themselves when markets are volatile. Assets used by the portfolios include bonds, infrastructure, renewable energy, commercial property, gold, commodities and capital preservation companies. Some of these assets also help portfolios achieve a high and growing income, which may become increasingly important to investors as time passes.
There are no fixed rules as to the pace and extent of diversification. An investor’s income requirement, investment risk profile (influenced by portfolio size relative to other assets), financial objectives and proximity to goals, are key factors.
Disclaimer: The information contained in this article does not constitute investment advice or a personal recommendation and it is not an invitation or inducement to engage in investment activity You should seek independent financial advice as to the suitability of any investment decision. Past performance is not a guide to future performance. The value of investment company shares, and the income from them, can fall as well as rise. You may not get back the full amount invested and, in some cases, nothing at all.
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