What keeps Hamish Douglass up at night?

The Magellan Financial Group CIO Hamish Douglass and his team clearly spend many hours weighing risks. And he seems to have a knack for tuning out the market noise that has been such a key feature of the last 18 months. It was the same when I interviewed him in March 2020, just after coronavirus had broken China’s borders. At the time, he believed the market selloff was overdone and that the world economy wasn’t broken. And ultimately, he was proven correct - many developed world markets now sit level with, or beyond, their pre-COVID levels.

When fronting cameras again yesterday during an investor webinar, Douglass spoke broadly about geopolitical and other macro risks and how the Magellan Global Fund is positioned to face them. Spending the first 20 minutes quizzing ex-CIA director Michael Morrell, they canvassed the potential of war with China; cybersecurity and Russian hackers; and domestic politics.

Morrell, a special adviser to Magellan, isn’t hugely concerned about the prospect of war. “The Chinese are unlikely, unprovoked, to move against Taiwan. China doesn’t want war because they understand the significant downside of going to war with Taiwan, of the significant price they would pay around the world.”

On the topic of cybersecurity, the pair discussed the rising frequency of ransomware attacks that recently paralysed around 200 US companies, Morell suggesting such events are going to “explode” in the years ahead. Having generated about US$25 billion for attackers in 2020 alone, the rate of attacks is growing at 30% a year and will continue at that level into at least 2030, Morrell said.

Many of these large-scale attacks have been traced to Russia, Morrell suggesting that while they’re not sponsored by the state, Russian President Vladimir Putin is in no rush to stop them. Morrell suggests Putin is allowing them to happen because he supports any actions that harm the US or its Western allies. “And the organised crime bosses who run these hacker networks are some of his political supporters, so it would be difficult politically to shut them down,” Morrell says.

“The people who do the hacking often work for Russian national intelligence during the day and then in the evening they work for Russian organised crime.”

This is why US President Biden recently met with Putin and delivered a message about the need for greater state cooperation to shut down such activity. On the back of this, Morrell expects US companies will tighten their protections. And if Putin fails to crack down on Russian hackers, he suggests the US would likely respond via renewed sanctions.

“The thing that worries me most is my own country”

Despite the global uncertainties, Morrell believes the biggest risk is right under his nose.

“US politics hasn’t got any better since President Trump left office. The thing that worries me the most is my own country and our very ugly politics here,” Morrell said.

“The elections in 2022 and 2024 are going to be very nasty, heavily contested with two extremes fighting each other.

“The pull that Trump has over Republicans here remains strong, and as long as we are struggling politically it’s going to be very difficult for us to make the right decisions about our economy and American leadership in the world," he said.

Escaped mutants, inflation, bubbles: How is Magellan positioned?

The second half of the webinar saw Douglass in the hot seat, being interviewed by The Australian business editor Ticky Fullerton. Speaking ahead of his latest investor letter titled The Importance of Being Rational, Douglass gave his views on the inflation outlook, the vaccine-led recovery and what bubbles he’s most concerned about.

Despite the risks, he’s buoyed by the “historic” levels of fiscal stimulus that are supporting economic recovery. “But there’s also the real risk of a material market correction, and that’s the virus itself. And it’s a little bit of a wake-up call here in Australia right now,” Douglass said.

Alluding to the current local outbreak, which has seen the Delta variant spread in some of Australia’s largest cities, Douglass said: “The risk is we get an escaped mutant from this virus, we haven’t yet seen that happen.”

As for inflation ...

On inflation, Douglass expects the upward pressures we’re seeing now will prove to be transitory and that there won’t be an abrupt end to stimulus. “Monetary policy is likely to be tightened but only gradually,” he said.

Referring to sentiment indicators such as used car prices, building supplies and housing prices, he believes many of these things that are driving inflation will pull back. Beyond this, he believes the more important question is “what happens if it isn’t transitory?”

“Higher interest rates and a recession would be very problematic for equity investors around the world.” The complexity here lies in the fact that the type of assets you hold will be completely different whether you believe one scenario or the other will occur.

How should investors be positioned?

“You don’t want to be overconfident in believing that inflation is transitory,” he said.

He suggests that many risks aren’t priced into markets at the moment: “We’re not that worried about asset bubbles, per se, but we do look at other assets that might be in bubble territory very closely."

“Not because we’ll be owning those assets if they collapse in price but because of the contagion effect and what it could do to investor confidence across the board if some of these bubbles burst," Douglass said.

Among some areas he’s most worried about are what he terms, “marginal investment-grade credit,” assets that are rated around BBB-minus.”

“There’s an enormous amount of corporate debt that’s been taken on in the last three to five years and much of it has leveraged up and credit ratings have gone down,” Douglass said.

“And there’s been the huge resurgence of speculative, junk-grade credit out there and people have been chasing them in reaching for yield.”

He suggested an uplift in inflation prompted by central bank actions around the world could lead to many investors being caught out: “As Warren Buffett said, only when the tide goes out do you see those who have been swimming naked.”

“That could cause a lot of pain for people just because of the extent of the participation and how much is held throughout the financial system.”

Cryptocurrency is another area he emphasises here, again because of the contagions risk and the impact on investor sentiment when the crash – which he regards as inevitable – arrives. In the context of these things, Douglass is concerned about investors who are exposed to these areas. They also support Magellan’s strong weighting to defensive stocks, with around 50% of the portfolio held in the likes of Nestle, Procter & Gamble, PepsiCo, McDonald's and utility companies.

“We want to go to sleep at night not worrying that if something blows up so will our portfolio.

While conceding that a big proportion of his portfolio “effectively went nowhere from November to Feb even as the market went up 20%,” Douglass makes no apologies for its positioning.

“Am I worried that we have this defensive side? No. I could’ve done a bit better in September and October and could’ve weighted the portfolio to some more cyclicals and put a bit more risk on.”

But looking forward, what are his thoughts? “I think you have to have a very balanced approach.”

“You want to be somewhat conservative here and if some of these downside events happen our portfolio has naturally got a lot of defensive bias,” said Douglass.

“And if markets continue to do well, we’re among the most fully invested we’ve been in a long time and we should do okay in that environment.”

He’s not convinced by the risk-reward outlook for cyclicals at the moment, so he's content to sit on the sidelines. And looking out further over the next three to five years, he believes the portfolio is ideally positioned.

Hamish Douglass

Chairman, CIO and Lead Portfolio Manager

Magellan

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Managed Fund

Magellan Global Fund

Global Shares

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