Defying Volatility Through Strategic Foresight

The year 2023 was marked by robust growth and strategic reliance for Merill SICAV, which saw its Net Asset Value increase to €153 million amid tough market conditions, we sit down with the Merill Investment Committee executive chairman and Fund manager Dr. Mark Azzopardi to learn more about the strategy behind this success.

We saw the year start off with a strong rally after a positive but volatile 2023. What’s your reading of the markets?

2023 was volatile, but it unfolded in line with our expectations. Market movements were primarily influenced by how the Federal Reserve (FED) was expected to increase interest rates. Although there was a risk of recession if interest rates rose too aggressively, so far, central banks managed to avoid this. Inflation was brought under control in most developed economies, though rates remain above the preferred 2% target. Given persistent inflation, it is likely that these targets will be adjusted to a higher norm, either officially or unofficially. At the end of the day central banks have a dual mandate – price stability and growth.

The U.S. economy was resilient in 2023 and continues to show resilience, with low unemployment and growth exceeding expectations, while Europe also managed to avoid falling into recession, albeit with much more modest growth. As things stand now, the European Central Bank (ECB) might prioritise growth and actually move to cut interest rates before the FED.

And how has this influence the Merill Fund portfolio composition?

We maintained most of our equity positions in 2023 but adopted a defensive strategy. We definitely held onto our information technology investments due to their long-term potential, especially those with exposure to AI, which we’ve been talking about for quite some time now.

The year did pose challenges, however, mainly due to the volatility as I’ve already mentioned. If you remember in the first half of the year, we had the regional bank crisis in the US, and this was eventually turned around by the AI hype. That said, we anticipated a market cooldown by September, and it occurred. Then November came along and the FED’s unexpected announcement that there would be up to three rate cuts in 2024.

This led to a very strong rally at the end of the year, too strong a rally I would say. The market’s reaction reflected an expectation that these cuts would come early in 2024 but this was never realistic. The FED will want a plateau to gauge the impact of past hikes before completely shifting policy. We will probably get two to three cuts in the latter half of the year, and only if there are no surprises.

So, to go back to Merill, throughout the latter part of 2023 and the first quarter of 2024 we concentrated on securing yields and preparing for market shifts. While we’ve held onto major investments like Microsoft, we’ve taken profits where possible and moved towards more defensive sectors and those which haven’t really rebounded. Healthcare is one example, where we have companies priced at half their 2021 peak like Pfizer.

What about the potential impact of new weight-loss drugs on the pharmaceutical industry?

New breakthrough drugs like Novo Nordisk’s Ozempic, show how certain medications can redefine market dynamics. If these become more affordable and available, they could significantly alter the pharmaceutical landscape by reducing the demand for other medications. As we’re seeing with AI, however, when technologies come with big promises of revolution, they are also prone to hype. We were lucky to have taken up a position before the Ozempic hype, purely based on the company’s valuation and their market dominance as a leading provider of diabetes-care products. The current market valuation aligns with our projections, but we don’t foresee explosive growth beyond what’s anticipated. The company has first-mover advantage so much will depend on how it plays its cards going forward.

Looking back over the past twelve months what do you consider having been your biggest win?

Two relative trades. The first was increasing our position in Microsoft over Apple. Thanks to that decision we had significantly more exposure to the AI rally given that Microsoft was one of the first companies to monetize from it. Another strategic move was investing in Toyota instead of purely EV-focused companies. The decision was prescient as we’re now seeing a cool-off in EV enthusiasm with some governments even having withdrawn subsidies. We gained further momentum from Warren Buffett publicising the Japanese market some weeks later, so it was a move that worked out well for us.

How has your strategy towards the bond market change, if at all?

In 2023, we focused on the shorter end of the yield curve, anticipating more interest rate hikes. This approach marked a shift from 2022’s strategy, where high cash levels acted as a buffer against market downturns. Early in the year, we transitioned to investing mainly in short-term bonds. Throughout Q3 and Q4 of 2023, we focused on gradually increasing the duration of our bond investments, maintaining a laddered portfolio approach without extending durations beyond the ten-year mark. The idea is to slowly shift to normalisation. Our current bond durations are closely aligned with market benchmarks, around 4 years, which is strategically underweight. This positioning allows us to capitalise on potential rate hikes while finding value at the shorter end of the yield curve.

How do you manage the timing of these adjustments, especially with uncertainty about when rate cuts will come?

Timing is crucial. Volatility will likely persist in the bond market until around June, creating opportunities for strategic investments during yield spikes. We’re disciplined in reallocating excess cash and adjusting our bond holdings to maximise yield, either through purchasing low-coupon bonds at high discounts, thus higher convexity or securing high-coupon bonds for stable income. On the high yield side, we’re focusing on higher quality issuers to manage the increased cost of capital as we anticipate higher default rates. If interest rates remain high for longer, more leveraged companies will feel the impact significantly, typically within a year.

Is fixed income where you see the most opportunity currently?

Yes, the current market dynamics and potential rate changes suggest significant opportunities in fixed income. This area could be pivotal in the coming years, especially given the past decade’s low-interest rates, making it an essential focus for investors looking to capitalize on these shifts.

What changes might affect these strategies?

Key disruptors include uncontrollable spikes in inflation and geopolitical tensions, particularly in the Middle East, which could impact investment strategies significantly. An unexpected spike in inflation could stifle economic growth as companies reduce investments, potentially leading to a downturn that favours safer assets like sovereign bonds while negatively affecting equities. High yield bonds face particular risks, as inflation could increase defaults and curtail growth, especially impacting highly leveraged companies. Indeed, geopolitical events, especially those affecting crucial shipping lanes like the Red Sea, can greatly impact economic costs and global inflation. In such a volatile environment, fixed income offers substantial opportunities, particularly as active management can leverage shifts in the yield curve and manage credit quality.

This interview is issued by Jesmond Mizzi Financial Advisors Limited and does not intend to give investment advice and the contents therein should not be construed as such. Dr. Mark Azzopardi is a director at Jesmond Mizzi Financial Advisors, the fund Manager of Merill SICAV plc. The Company is licensed to conduct investment services by the MFSA, under the Investment Services Act. Merill SICAV plc is incorporated and licenced as an open-ended collective investment scheme, registered in Malta, qualifying as a Maltese UCITS in terms of the UCITS Directive with effect from the 16th of October 2015. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 21224410, or email [email protected]