London-based Hughes manages $17.5 billion in global equities. He recently met with FinanceAsia amid a worldwide series of meetings with institutional clients.

You've been travelling around the world. What's your message?

The theme we're pursuing is not one specific to 2006. We're making the case to institutional investors that for the past 15 years, the world has enjoyed the most stable set of economic conditions ever recorded. We haven't had this economic growth and stable inflation since the 1880s.

That has resulted in the convergence of bond markets, of valuations in equities, and a lengthy period where volatility in both markets declined. But the factors that have led to this stability are the same ones now taking us into a period of instability.

What are those factors?

First, capital mobility, or in other words, globalization. Nonetheless investors have retained a domestic bias, which is illogical. As this fades, capital will seek out the highest returns or the lowest risks, which is increasing differences among markets.
Second, everyone has been fighting inflation with monetary policy. This has become a global phenomenon, and monetary policy is determined globally, not locally - which begs the question of what central banks end up doing. So it is not surprising that bond yields have converged, because policies targeting inflation have also converged.

We detect, however, changes in these macro policies. Europe's central bank is holding rates down, while Japan is attempting to stimulate its economy and the United States is seeking stability, given its indebtedness. So this has led yield curves to change shape as interest rates rise in many markets, which indicates the economy faces more headwinds than tailwinds.

Why should macro policies now diverge?

We've enjoyed over 10 years of strong innovation that has created a business cycle based on information technology. History suggests that innovation breakthroughs last for 20-25 years, so we're only halfway there. But there is a big difference between those halves. The first stage sees this brave new world of technology come online, and this continues to have an positive impact on economic growth.

In the second stage, this technology is taken up by everyone, so life becomes more competitive and difficult. The trend remains one of economic growth but the deviations around that get bigger, and you have more periods of contracting economic activity.

More volatility, in other words.

Yes. And as volatility of economic growth increases, so does the volatility of corporate earnings, so that requires a larger risk premium.

How do you respond to this as a portfolio manager?

We're a big buyer of volatility. We take bigger asset-allocation bets and the scope for diversification gets easier. The top-down story becomes more relevant.

What does this imply for investors?

Some may need to change their attitude toward risk, and therefore their mandate objectives. Pension fund trustees should be asking managers to deliver 4-5% above cash, as opposed to asking for 1-2% above an equities index. Fund management companies need more products that let us control risk and that deliver absolute returns.

So more hedge funds?

We've introduced four long/short fund since 2004. But there is a healthy, growing scepticism about hedge funds among investors. They assume that the good managers in the US are closed, so they need hedge funds or funds of hedge funds in emerging markets. The best thing investors can do is reduce their domestic bias, but this takes time. It's sometimes an emotional thing.

The hedge funds we've introduced cover China, Japan, European small caps, and Eastern Europe and the Middle East. These will probably be the only ones we launch; there's no point now in large-cap hedge funds for the US or European markets, which are too efficient.

Does portfolio modelling remain the same?
Yes, although at the screen level, quality factors may count for more: return on equity, the strength of the balance sheet, a company's industry dominance, its credit rating. We're looking more for quality and lower risk in our stock-picking.

How do equities stack up against bonds today?
Everything favours equities without exception. Bond markets have overshot, which is a concern. At the long end of the curve in the US and UK, we're seeing 50-year inflation-linked notes issued that yield under 50 basis points. There's no value in that. Pension schemes are buying these simply to match their liabilities, because companies want to take away their pensions' investment risk. But trustees must ask themselves whether they will be able to honour their pension commitments in the years to come. Many of these schemes will need to change their asset allocation and let the pension scheme take risk.

But they face certain realities in accounting.

It's not just that. The higher that bond yields get, the higher the implied pension liabilities, which just adds to risk and makes schemes buy even more bonds. It's a vicious cycle that we've seen occur in the UK and is now developing in the States.

Does this environment change the risk equation for equities versus bonds as well?

The relationship between them depends on the inflation environment. In this low-inflation situation, the risk in fixed income is the creditworthiness of governments. America's debt exceeds 1929 levels, but not from corporate borrowers. The problem is the growth of public debt. And the current level of borrowing doesn't account for retirement liabilities or future healthcare costs.

Inflation-fighting central banks face a dilemma: if interest rates go above economic growth rates, the country will add debt faster than it can repay it. But independent central bankers may want to raise rates for a period of time, so the consequences build up. Governments will issue more inflation-linked notes to keep their current funding costs down. Issuing TIPS with a 2% coupon is cheaper than issuing regular bonds at 4%, at least in the short term. It's a very unstable state of affairs and there's no political vision to raise taxes to deal with this. So the intrinsic guarantee of a government guarantee is lower than we'd like.

So corporate bonds should have a lower yield than a government bond?

You can argue that. We're not getting paid for governments' credit risks. And because governments are the bigger part of market issuance, the overall risk/return profile for fixed income is deteriorating. Most of these government bonds will redeem at par, which is below their current prices.

What are the risks in the equities market?

Not being sufficiently diversified.

What are the stories you like now?
We identify sectors that have strong earnings momentum, like energy and commodities.

Aren't these stocks expensive?

Valuations aren't nearly high enough. Valuations on Australian mining stocks in the 1960s, which enjoyed strong demand due to the rebuilding of Japan's economy, were the same as internet stocks in 1999. But not today. You can still have a strong conviction about energy prices.

There's a debate over US consumer stocks but I like pharmaceuticals. There's a whole series of epidemics and scares, which is good for their business. It's not just avian flu, but things like tuberculosis: the UK now has the highest rates of TB in 40 years.

Internet themes are also interesting, as non-internet companies use it to revise their business models. Stores with internet sites couldn't handle the demand over Christmas because they had run out of stock. You see the impact of the internet on the high street, where more restaurants and pubs are replacing shops.

What don't you like?
Financial stocks in the US and Europe. The changing shape of yield curves has hurt hedge funds, many of which depended on that positive cost of carry and low yields at the short end. Now their major source of returns has disappeared, and this could have a knock-on effect on prime brokers. A large part of investment bank revenues now derive from prime broking, which makes me worry about them.