Fund Manager Quarterly Commentaries
Read the latest fund manager commentaries for the quarter ending 31 December 2017.
Over the quarter the fund performed positively. The screening metrics applied to the fund also had a positive impact.
The contribution from North America suffered shortly however, a smaller US weighting acted as a drag. On the other hand, the absence of CVS Health and the inclusion of Jones Lang LaSalle were beneficial. Pharmacy benefits manager and drug store CVS Health was weak on Amazon competition fears and uncertainty surrounding plans to buy health insurer Aetna, while real estate company Jones Lang LaSalle was boosted by strong results.
The fund had better performance in Europe. Not holding pharmaceutical companies Roche and Novartis was beneficial as they declined in line with peers. The absence of Henkel, the adhesives and household products company was also positive. The inclusion of banking software specialist Temenos in the fund added value following strong results and raised guidance.
Conversely, the fund had weaker performance in Japan. The screen prevented the fund from holding material stocks such as Sysmex and Shin-Etsu Chemical, which were the top two positive contributors in the Japanese materials sector. The inclusion of snack producer Calbee also hurt the performance due to a broker downgrade during the quarter.
A strong global economy and robust corporate profits pushed US equities further into record territory during the quarter. The US economy is in its ninth year of expansion, and the bull market that began in March 2009 is officially the second-longest on record.
For the fourth quarter of 2017, the fund performed well. Performance was the result of both security selection and sector allocation. Security selection was strongest in consumer discretionary and information technology. An overweight exposure in information technology also benefited returns. By contrast, relative performance was hurt by security selection in health care and industrials. An underweight in the healthcare sector also detracted from relative results.
Shares of Kroger reversed much of the losses they experienced earlier in the year, after reporting strong quarterly results. The supermarket operator saw an increase in store traffic, market share gains and gross margin expansion, despite the competitive environment. “Our goal is to continue generating shareholder value even as we make strategic investments to grow our business,” said Mike Schlotman, Kroger’s Executive Vice President and CFO.
Shares of General Electric declined after the company announced the elimination of 12,000 jobs in their global power division, part of their stated desire to reduce expenses by $1 billion. The action is in response to systemic changes in the global power production marketplace; as rival Siemens recently noted, producers’ annual technical manufacturing capacity for gas turbines (generating more than 100 megawatts) is approximately 400, while global demand has declined to about 110. While painful in the short-run, General Electric’s action is necessary.
Our work is focused on individual companies. Where broader issues are relevant, we take a long-term view, attempting to minimize the distractions of what may be on others’ minds. We will persist in our quest to add value through in-depth company research, focusing on what we perceive to be high-quality businesses with an attractive valuation and catalysts we believe will materialise in a three- to five-year timeline.
UK & International Income
The UK equity market finished the year strongly registering a gain of 5% over the quarter. Having lagged other equity markets since Brexit, on this occasion the return was more in keeping. In part, this was down to ‘progress’ in Brexit and chimed with our view that it would take only a little good news to help the UK market out of its relative malaise.
In terms of detractors, the most notable was a disappointing statement from Saga, the insurance and travel business. The poor trading can be attributed to missteps by management, and the fact that earlier in the year management had sought to portray the company as a stock market ‘steady Eddie’.
In 2016, large sectors exercised a degree of benchmark tyranny over the active manager and the challenge from the strength of both mining and oils was acute. In 2017, it was just mining and having less than the benchmark cost us 0.8%. For perspective, at the end of December these commodity sectors combined represented 19.4% of the UK benchmark. Were we to be index weighted then it would likely account for about 25% of the fund ’s income, an exposure that we would find uncomfortable.
We started 2 new holdings. Anglo American is a more diversified mining company than Rio and trades on a cheaper valuation and so we part funded our purchase with a reduction in Rio. The valuation disparity stems, in part, from the proportion of assets in South Africa and the associated political risk.
Vivendi, the French conglomerate, owns a number of businesses that would not be near the top of our ‘to die for’ investment list e.g. the advertising agency and a broadcaster, Canal Plus. However, it does own Universal Music with a catalogue of a third of the world’s recorded music. This industry is growing rapidly on the back of streamed music (Spotify et al).
We stand by our previous comment that the UK market contains plenty to admire but has lagged due to Brexit and politics. Predicting sunnier times for both these issues would take courage, nevertheless it wouldn’t take much for UK equities to extend the outperformance seen in December.
Global stocks ended the year on a strong note – a solid fourth quarter added to double-digit returns for the year, though an appreciating pound was again a modest headwind for GBP-based investors. Developed markets were broadly positive, though they trailed emerging markets for the quarter and the year. Stock returns in general were aided by solid corporate profitability and a generally improving economic backdrop.
Among our top contributors were Qualcomm, Microsoft and Tesco. Share prices of Qualcomm, a leader in mobile phone technology and equipment, had been pressured due to a series of outstanding legal actions against it, including a royalty dispute with Apple, its largest customer.
During the fourth quarter, Qualcomm rejected an unsolicited bid from Broadcom that many viewed as undervalued, which may have helped renew confidence in Qualcomm’s long-term value. Microsoft announced solid earnings over the quarter with top-line growth bolstered by margin expansion, aided by strength in its cloud-based business. The turnaround story for UK grocery retailer Tesco continues to gain traction, as the company is seeing fairly consistent comparable sales growth in its volume-led recovery.
The largest detractors included Arch Capital Group, Baidu and Telefonica Brasil. Insurer Arch Capital Group announced disappointing quarterly results with greater-than-expected losses. Chinese Internet firm Baidu reported respectable results—revenue growth was as expected and margins exceeded consensus estimates. However, investors seemed disappointed by management’s near-term, somewhat tempered outlook. Brazil’s leading provider of mobile phone services, Telefonica Brasil, traded down largely in sympathy with a weak Brazilian stock market.
We purchased Chinese Internet retailer JD.com and French telecom company Vivendi. We sold contract caterer Compass Group as it approached our estimate of intrinsic value.
Markets concluded one of their stronger recent years with a solid fourth quarter. US led stocks in the quarter, on the ongoing strength of corporate earnings and investor enthusiasm for forthcoming corporate tax cuts. Emerging markets led global markets for the quarter and year, tied particularly to strength among Chinese stocks.
European markets, though positive, trailed in the quarter but modestly beat global stocks for the year. Notably absent in 2017 was much volatility, perhaps thanks to relatively few exogenous shocks which can commonly trigger near-term corrections.
Among our largest detractors were Genmab, Boston Scientific and Regeneron. Genmab has faced moderately higher competitive pressures for its anti-cancer drug, Darzalex – though we maintain our conviction in Genmab and its pipeline. Ongoing operation issues with Boston Scientific’s Lotus’s heart valve have led it to indefinitely delay the US launch, in turn pressuring shares—though it remains a meaningful position based on our longer-term confidence. Shares of Regeneron were pressured by competitive data from Novartis, which raised questions about future market-share trends for Eylea. We are evaluating the likelihood that the profit cycle will reaccelerate from here.
Among our top contributors were Temenos, James Hardie and LKQ. Temenos, which develops core banking software systems, has picked up meaningful steam among both large and regional banks globally. We believe it is well positioned to drive a long and compelling profit cycle. James Hardie is showing signs the majority of its largely self-inflicted issues are behind it as the steps management took to solve some manufacturing issues are showing signs of remediating the company’s supply issues. LKQ has weathered a challenging macroeconomic backdrop well, integrating recent acquisitions while scaling its business both in North America and Europe. We have been impressed by its ability to maintain margin growth, despite ongoing acquisitions.
We added to logistic systems producer Daifuku and global travel industry IT services provider Amadeus IT Group. Conversely, we trimmed several positions in accordance with our valuation discipline—including Alphabet, Treasury Wine Estates and Keyence.
2017 has been a good vintage for most asset classes. By year-end a number of domestic stock exchanges reached record highs, including the S&P500. For the first time since the onset of the great financial crisis, most major regions in the world experienced a synchronised economic upswing. Forward indicators point to this persisting into 2018.
Central banks have begun their tightening cycle with the Fed and BOE both raising interest rates during the fourth quarter. The ECB is also expected to start reducing its asset purchases in 2018. Central bank actions have been moderate and delayed so far by the lack of inflation. Should this change, we could see the US yield curve invert and liquidity tensions. The year was more politically stable than initially feared. In the last quarter, although Merkel struggled to form a new government, the US Congress passed the much-awaited tax reform and the UK made some progress in its exit negotiations with the EU. As a result, sterling rose against the USD and JPY.
Global equities delivered strong performance during the fourth quarter. The strongest regions were Japan, emerging market s and the US while Europe lagged. Growth outperformed value. The strongest sectors were IT as well as cyclical sectors (materials, consumer discretionary and energy). The weakest were the more defensive sectors utilities, health care and telecommunications.
The strongest performing equity sleeves were Asia Pacific and Emerging Markets; the weakest was continental Europe. In the UK, BBA Aviation was a strong performer after a good trading update. TUI AG also performed well as it rationalised its business within the travel sector.
Sector wise, the underweight in utilities contributed positively to performance whereas the underweight in materials was detrimental. Mid cap holdings RWS Holdings and Homeserve PLC were added to the fund . We exited WPP and Inmarsat. In Europe, we introduced Kingspan, Linde, Iliad and Essilor, and sold Fresenius SE, Orange, ProSieben and Anheuser-Busch Inbev.
We made no significant changes to asset allocation. The large overweight to overseas equities and cash versus the peer group was maintained. We remain underweight bonds as we believe this asset class is too richly valued though maintain the position as a hedge.
The UK market continued to make good progress mainly driven by strength in the oil & gas and basic material sectors. This strength was largely seen in the run up to the end of the year. Commodity prices were supportive with steady global growth and some supply disruptions helping sentiment. The higher oil price enabled Shell to cancel their scrip dividend policy while BP commenced a buyback to neutralise the dilution from their scrip dividend.
The fund slightly underperformed during the quarter, with a fall in Low & Bonar following a profit warning being the main cause. Weakness was also seen in Eurocell, Pendragon and Senior. A lack of holdings in Diageo, Glencore and BHP Billion was also detrimental to performance. On a positive note both Hilton Foods and Intermediate Capital were strong with both being among the larger active positions in the fund.
New holdings were acquired in Palace Capital and Sabre Insurance. In addition, the holdings of GlaxsoSmithKline, Regional Reit and Rio Tinto were increased. The holdings in St. Ives was sold and the holdings of FDM Group, Hilton Foods, IQE, New River Retail and Sirius Real Estate were reduced.
Global growth appears to be well set with even the UK seeing some optimism following the agreement to move Brexit talks onto trade matters. This means that there are likely to be further interest rate increases in both the US and UK. With the European Central Bank still buying bonds there is likely to be pressure for this to cease.
UK Absolute Return
A breakthrough in Brexit negotiations and increased hope for US tax reform was seen in the fourth quarter. The Bank of England and the US Federal Reserve both raised interest rates while the European Central Bank extended its bond purchase programme at a reduced pace. Central Banks are responding to positive and widespread global economic growth expecting inflation to trend higher. The UK is an exception in that we have seen stronger import-led inflation due to currency weakness.
The fund made modest progress driven by the long book with the short book a modest detractor despite protecting capital in November’s falling market. Consumer services positioning was the notable contributor with gains from both the long and short side. Telecoms was the largest detractor at the sector level.
Core holdings RELX and BAT contributed to returns though food and drink operator SSP Group was the top performer, as ongoing self-help saw earnings ahead of expectations and guidance raised. US growth and the European recovery remain in place but building supplier CRH fell as their earnings forecast fell short of expectations. Serco also fell back as sentiment reacted negatively to potentially large contracts failing to materialise for the professional outsourcer.
While the healthier growth outlook and supportive liquidity conditions have boosted financial markets through the year, our primary focus remains on stock selection while maintaining only moderate market exposure. Into 2018, our stock preferences leave us constructive on more internationally facing businesses alongside a more cautious view on the domestic economy.
Politics dominated headlines at the beginning of the quarter as both global risk assets and select bond markets climbed higher. Steady economic expansion, easy financial conditions and strong corporate earnings boosted US and Eurozone equities. Global risk assets and bond markets continued their positive run in November as investors headed into the holiday season. Solid economic data supported sustained, above-trend global growth, while a flattening US yield curve and accommodative central banks outside the US buoyed bond prices. Eurozone PMIs topped consensus forecasts to hit seven-year highs, showing a broad-based recovery deepening across the region. Positive developments on Brexit drove the British pound to a two-month high versus the dollar in November.
Inflation-linked bond markets positively contributed to returns. US Treasury Inflation-Protected Securities were broadly flat and lagged other markets, as minutes from the Federal Reserve’s September meeting revealed mixed sentiment, whilst Canadian inflation-linked bonds were a strong contributor. Developed sovereign debt underperformed inflation-linked debt as inflation breakevens modestly widened.
Credit spreads have tightened throughout the year as investors’ search for yield has driven rates to historical lows. US credit spreads relative to government bonds approached 17-year lows In November, supporting attractive returns. Emerging markets underperformed developed markets in November, illustrated across both the credit and infrastructure spectrum.
Developed equities continued to climb higher; Eurozone stocks hit a nine-year high as the European Central Bank delivered a dovish quantitative easing plan, while strong earnings reports continued to support US stocks. A more synchronised global expansion also helped commodities. Commodity-exporting countries have benefitted from rising commodities prices and a weaker US dollar, and overall global expansion has supported all markets. The OPEC and Russia agreed to extend oil production cuts until the end of 2018, driving energy commodities higher. However, other parts of the commodity complex did not fare so well as some real asset classes, such as clean energy, underperformed their more traditional counterparts through the period.
Through the quarter to the end of November, asset classes were broadly positive with water and timber the best performing in the cross-section. However, emerging market infrastructure detracted from returns.
Index Linked Gilts
Yields fell over the period with the 10-year falling from 1.33% to 1.19%, while the 30-year fell from 1.88% to 1.76%. 30-year breakeven inflation ended very slightly lower at 3.41%.
Yields broadly declined throughout the quarter with sentiment dominated by the Bank of England. Yields fell in October when comments by two members of the BoE’s Monetary Policy Committee (MPC) suggested a split decision on rates at the November meeting with implications for interest rate trajectory through next year i.e. the likely speed of increases may be slower than previously expected.
The BoE raised for the first time in a decade in November taking the benchmark interest rate from 0.25% to 0.50%. While the increase was widely anticipated and fully priced in, yields fell sharply on the announcement due to the dovish post-meeting commentary, which indicated a modest rate of further tightening. Closing out the quarter, yields hit a three-month low in December amid a global sell-off in sovereign bonds. Rising speculation ahead of the US Senate passing its long-awaited fiscal reform bill in December, as well as optimism for the global economy, both contributed.
Brexit negotiations picked up speed, with UK reaching a deal with the EU on 8 December on the three remaining main Brexit issues of citizens' rights, the financial settlement and a commitment to avoid a hard border in Ireland. At the EU Summit in December the EU-27 leaders agreed that talks had made "sufficient progress" to enter the second phase on the future EU/UK relationship.
Economic data was mixed but predominately positive with unemployment remaining at decade-long lows, private sector wages up, retail sales rebounding and manufacturing strong. The Office for National Statistics (ONS) confirmed third quarter growth of 0.4%, slightly higher than the 0.3% recorded in each of the first two quarters.
Unemployment remained at decade lows (4.3%) throughout the quarter. However, employment fell by 56,000 in the three months to October, echoing the trend in the three months to September, the first time in a year that the number of people in work had dropped. ONS data showed that growth in private sector hourly wages (2.8% year-on-year in the three months to September) was solid, with weakness in the first quarter dragging down the stronger recent growth of around 3%.
Retail sales were mixed, experiencing their first annual fall in October (-0.3% in volume terms) before a pick-up in November saw the biggest rise in seven months (1.6% year-on-year) according to ONS figures. Sales of electrical household appliances did particularly well. The manufacturing purchasing managers index hit a four-and-a-half year high in November. Although the dominant services sector remained in growth territory throughout, it experienced a slowdown in November as business activity fell off its six-month high, while increases in volumes of new work eased.
Less positively, consumer price inflation remained elevated throughout and surged to a six-year high (3.1%) in November driven by computer games and food, as well as slower falls in airfares compared with last year.
Chancellor Philip Hammond presented his autumn budget in November, the most striking feature of which was the Office of Budget Responsibility's downgrade to its UK gross domestic product growth forecast from 2.5% annual average over the next five years to a little over 1.4%, necessitating an extra £59bn in debt issuance.
Global equities climbed higher in October, with the MSCI All-Country World index hitting an all-time high at the end of the month. Emerging markets generally outperformed developed markets, with Turkey, South Africa and India particularly strong. Central bank activity was in the spotlight, with the ECB announcing the details of how it will scale down quantitative easing, and the US Federal Fed beginning to unwind the massive asset purchase programme that followed the global financial crisis.
The International Monetary Fund revised its forecast for global economic growth upwards to 3.6% for 2017 and 3.7% for 2018, with higher growth estimates for Europe, Japan, China and Russia outweighing reduced growth forecasts for the US, UK and India. November was another positive month for global equities, with the MSCI All Country World index hitting several record highs.
Key market drivers included strong corporate earnings, a healthy global economy and, towards the end of the month, anticipation of the US tax reforms being passed. US President Trump toured Asia, and although he had dismantled the Trans-Pacific Partnership trade agreement on taking office, he offered ‘bilateral trade agreements’ with countries ready to make ‘fair and reciprocal trade’.
Meanwhile, the North Atlantic Free Trade Association talks restarted, with Mexico and Canada back at the table to consider whether the US proposal to apply a five-year ‘sunset clause’ to any agreement was acceptable. In the UK, the Bank of England made a 0.25% interest-rate rise at the start of November in a bid to dampen inflation. In December, UK Prime Minister Theresa May reached a last-minute agreement with the EU in order to move Brexit discussions onto the next phase.
UK & General Progressive
The fourth quarter has seen the Bank of England raise interest rates to 0.5%, reversing last year’s cut, whilst the US Federal Reserve continued to increase rates and the European Central Bank extended the duration but scaled back its monthly bond purchase programme. Central banks are responding to positive and widespread global economic growth where they see the risk of inflation picking up from the low levels seen in recent years. The UK is an exception in that we have seen stronger import-led inflation due to currency weakness. As investors, we continue to see this global growth as a supportive backdrop for corporate earnings growth and for stock markets.
The fund lagged the stock market’s rise due to our underweight exposure to the banks and resources sectors. We expect profit growth to prove more challenging for these sectors due to respectively, ongoing regulatory headwinds and rising capital expenditure. We firmly believe that our fundamental investment approach, where our scale allows us to meet, research and identify advantaged companies, enables us to focus on the long-term winners that are disrupting existing markets and growing earnings over the next three to five years and to avoid those companies that fail to deliver.
The impact from disruption in an industry can provide opportunities for active fund managers. In the UK take away market, Just Eat has managed to secure a dominant position that now presents a significant barrier to potential competition with a highly profitable business model. Within the airline industry, low cost airlines have disrupted a market previously dominated by the legacy carriers with easyJet’s cost advantage enabling it to benefit as other business models fail. Within the tobacco industry, British American Tobacco has invested in the development of e-cigarettes and vaping and has built a dominant position in this new area of growth.
Risk assets continued their strong run into year-end. emerging market high yield corporate debt was no exception and continued to deliver positive returns. Central to this strong absolute performance was a generally supportive macro backdrop, with higher commodities prices and despite an uptick in geopolitical headlines, generally positive sentiment towards emerging markets.
News flow was more mixed on the quarter both in the developed world and emerging market. From a bottom-up corporate perspective, although we did see an uptick in individual credit name volatility, for the most part it was positive to see the deleverage theme continue to play out and hence we witnessed a big year-on-year decline in default rates. For context, the emerging market high yield corporate default rate ended the year at 2%, which was significantly lower than the 2016 rate of 5.1% and lower than market expectations.
Central to performance was our decision to run the fund with a ‘risk-on’ tilt, with more exposure to higher-beta country segments of the Latin American market, such as Brazil and Argentina. In addition, we held exposure to some more esoteric markets like Ukraine and Nigeria, which were among the best performers of 2017.
We retain our constructive stance on the asset class. That is not to say that there will not be challenges ahead, as the extremely low volatility environment of 2017 is unlikely to be repeated. There are a number of key areas that we will be watching, not least global growth and inflation dynamics and the resultant impact on global monetary policy, a busy emerging market election calendar (Russia, South Africa, Colombia, Venezuela, Mexico, and Brazil to name a few), rising geopolitical tensions in a number of emerging market destinations, and of course, China’s ongoing growth transition.
That said, we feel that the favorable dynamics that have provided the foundation for the strong performance of EM assets in 2017 should continue into 2018, albeit punctuated with bouts of heightened volatility that we will look to take advantage of over the year ahead.
The high yield market closed out 2017 on a positive note, returning 0.41% for the quarter, according to Bank of America Merrill Lynch (BofAML). Sector dispersion was apparent during the final quarter of 2017 and lower quality credits outperformed higher quality credits overall.
Yield-to-worst levels increased, ending the quarter at 5.84%, while spreads closed the quarter at 3.63%. The average price of the high yield bond index decreased to $100.59. The par-weighted US high yield default rate closed the year at 1.45%, according to JP Morgan.
The largest detractor during the quarter was Puerto Rico General Obligation (GO) bonds, which fell following a comment made by President Trump about wiping out Puerto Rico’s debt. The bonds were also down after the oversight board announced a five-year plan that showed little to no debt service. We have sold out of our GO exposure.
Cenveo detracted from performance due to technical pressure as the company works towards a restructuring. The company also announced its third quarter earnings and guidance that were viewed as below expectations. Lastly, iHeartCommunications traded down as the company continues to be pressured by a lack of progress with senior creditors on a restructuring deal.
The largest contributor during the quarter was a position in New Albertsons. The company monetised some of its real estate by executing a sale. They will use the proceeds of the sale to pay down debt or re-invest in the business. In addition, negative sentiment on the grocery industry has abated following Amazon’s acquisition of Whole Foods. Kindred Healthcare added to performance upon rumours that certain private equity firms will buy Kindred and will take over Kindred’s long-term acute care hospitals and rehabilitation facilities and jointly own Kindred’s home health operation. Lastly, CII Carbon was a contributor as market demand and supply dynamics are strong for aluminium and company fundamentals continue to be robust.
Greater European Progressive
The fund generated a good return this quarter, in comparison to the wider European equity market. The calendar-year return was also decent, although lagged the European equity market this year.
Our companies with the worst stock returns this quarter were down modestly (i.e. Unilever, Publicis, and Henkel) and not based upon anything that we think is material to our long-term theses. Our companies with the best stock returns this quarter were Sage, Brenntag, and UBM. We added to Brenntag in August and UBM in September, at depressed valuations that we thought were compelling, and the market has started to recognise this.
Our only transaction during the quarter was increasing the size of our position in Colruyt upon share price weakness. Colruyt is a grocery retailer in Belgium with significant cost advantages that we have owned for many years and discussed in previous letters.
We remain ready to upgrade the value and quality in the fund when compelling opportunities present themselves. An important part of being ready to act is staying current with the managements of the companies in our fund and on our ‘dream team’ list. We conducted more than 80 company meetings since mid-September, and more than 80% of them were with top management.
We continue to own companies that provide good value within the universe of companies that meet our quality criteria. While the average P/E ratio of our fund in the mid-17s (based upon estimated earnings for the next 12 months) is reasonably high in absolute terms, it is considerably less expensive than our ‘dream team’ list, which has an average P/E ratio of more than 22 times.
The fund generated a good return this quarter. Our companies with the worst stock returns were Cenovus Energy, Philip Morris International, and Walgreens Boots, although not based upon any developments that we think makes our investment theses invalid. Our companies with the best stock returns this quarter were AutoZone, Union Pacific and CisIn 2017, the disruptive force of Amazon has captured the stock market’s imagination. While we highly respect Amazon and the digital transformation within retail that it has unleashed, the disruption fear has created indiscriminate selling across the retail industry. Such indiscriminate actions can create bargains and investment opportunities if our research can determine what may have been overlooked in the panic of overzealous selling.
Burgundy currently owns Walgreens Boots (one of the largest pharmacy chains in the US and the UK) and AutoZone (one of the largest auto parts retailers in the US). We continue to believe both companies have unique value propositions, and we added to our AutoZone position earlier in the year before its recent share price recovery. Our only transactions during this quarter are still currently in progress and we look forward to reporting upon them when they are complete.
We think that our fund companies have the strength (in quality of product/service offering, business model, competitive position, balance sheet and management) to successfully manage and adapt to uncertainties better than many companies around the world. These uncertainties would include such things as material changes in interest rates, currencies or raw material costs, recessions, geopolitical tensions, trade protectionism, the risk of disruption by Amazon or other attackers, etc. Some of these strengths show up in financial attributes. For example, our fund companies, on average, earn returns on equity that are almost double that of the Global index averages, but with roughly half the financial leverage.
We also think the fund provides better value than the market with an average P/E ratio of 18.6 compared to 20.6 for the Global index.
International Corporate Bond
The fund had a positive final quarter in 2017. However, we did see some volatility in the market that we did not experience in the first three quarters of the year. The negative sentiment in the market peaked during the middle of November before recovering by the end of the year as investors regained some confidence.
The fund managed to provide decent returns and significantly outperform the market in what was a relatively weak quarter despite some headwind from geographical allocation effects and only had two sectors (telecom and media) with negative returns. The performance was primarily due to security selection.
Within media, the fund ’s underweight in Altice and SFR contributed positively to performance as bonds traded significantly down in price due to concerns of the performance of the businesses in the Altice Group structure which is run with fairly high leverage. Within retail the fund benefitted from overweight exposure to Hema that continue to perform well, as well as Pizza Express which rebounded during the quarter after a period of sub-par performance.
Within healthcare, relative performance was positively affected due to the underweight in US hospital operators such as HCA and Tenet Healthcare which continue to struggle. We expect low default rates for 2018 as fundamentals within European high yield continue to look healthy with high interest rate cover ratios and leverage remaining at overall healthy levels. Our short to medium-term outlook remains positive and we continue to focus on downside protection with a defensive fund, which we would expect it to outperform in case of upcoming weakness.
We are likely to see continued high level of new issue volumes and we expect 2018 to be a coupon-clipping year with volatility sources likely to be rates and exogenous shocks (geopolitical, China, US). We also believe that there is high potential for an active return from high new issue activities – where we can create returns from coupons and capital appreciation).
Furthermore, there is upside return potential from rating upgrades (late cycle dynamics in credit markets) either within the high yield rating categories or from high yield to investment grade. At the same time, there is also significant return potential from the IG companies that have been downgraded. Such situations can offer interesting investment opportunities as management focus typically shifts from equity upside to focus on sustainability of debt structure.
Global equities benefited from optimism over the global economy, strong corporate results and the promise of US tax reform. Bonds lagged in a quarter which saw key central banks make further moves towards normalising policy.
Investment grade bonds performed steadily as expected but the US high yield segment underperformed. Equities on a global scale also lagged due to unfavourable security selection. In the former, Centrica and Cobham detracted most while Pearson and Booker led outperformers. PG&E and Deutsche Telekom were among the key laggards but L Brands and Valero Energy performed positively.
In the UK, we focused on topping up existing positions, chiefly BT and Electrocomponents. New additions to the fund included Telekomunikasi Indonesia, Anta Sports and Erste Bank. We sold DowDuPont, Givaudan, Cypress Semiconductor and AstraZeneca, following strong runs, and also exited General Electric.
Within investment grade, new issue purchases included Nestle, RCI Banque, Nisource Finance and Severn Trent Utilities Finance. In the secondary market, we bought QBE Insurance, Thames Water, InterContinental Hotels, SSE and Arion and added to some existing holdings while reducing GKN and Commonwealth Bank of Australia, among others.
Markets remain buoyant in light of the Trump administration’s progress in enacting market-friendly reforms, as well as broader synchronised accelerations in economic growth – though ongoing uncertainties including Brexit, the US mid-term elections in 2018 and slowing Chinese growth remain in the spotlight. Further monetary tightening may also generate some nearer-term headwinds for the global economy. Ultimately however, we believe that seeking a combination of income and growth lends itself to companies which can generate outperformance on a longer-term view.
The macro growth environment and strong earnings are benefiting investment grade markets more than balance sheets. Given the late stage of the credit cycle, we are also cautious about increased leverage and more merger and acquisition activity. Spread valuations are now at long-run averages, so we do not consider it advisable to be aggressive with overall credit risk.
The top contributor during the quarter was Shiseido which led consumer staples holdings. On a sector basis, information technology (Ubiquiti Networks and TE Connectivity) and industrial (WESCO International and Generac Holdings) holdings were the strongest contributors. The largest individual detractor was Realogy Holdings Corp. and the largest detractor on a sector basis was the consumer discretionary space where Subaru Corp. acted as a drag on investment results.
One of our main reasons for investing in a business is the quality of its management team. Our investment in CSX began in January 2017 following the announcement that an activist investor wanted to install Hunter Harrison as the company’s new CEO. We saw a strong leader in Harrison based on his experience turning around three other railroads through cost-cutting and cultural changes. When combined with CSX’s real estate holdings and strong urban freight presence, we believed CSX was an attractive opportunity.
In December 2017, Harrison sadly passed away, though he managed to implement enough of his policies to lay down the tracks for the company’s future. It’s important to remember that the board that selected Harrison remains in place. Company management is only one of the criteria we use to gauge the fitness of a business for investment. We think that the CSX remains a fundamentally sound investment based on our analysis and deserves to remain among the fund ’s top ten holdings.
India was the best performing market over the quarter, driven by a rally in state-owned banks as the cabinet announced a recapitalisation plan to the order of US$32 billion. South Korea was boosted by an improvement in relations with China, following a year-long diplomatic spat over South Korea’s deployment of the US Terminal High Altitude Area Defence system.
Pakistan was the worst performing market, as continued political turmoil impacted the stock market. Taiwan increased but lagged the broader market as its technology sector suffered from profit-taking. LG Household & Health Care was boosted by the resumption of cordial relations between China and South Korea. A significant proportion of its sales are from Chinese customers, both onshore and in the offshore duty-free market. Meanwhile, Midea Group reported better than expected revenue growth based on its strong book of legacy business, double digit ASP growth and market share gains. On the negative side, Ctrip.com faced concerns around greater competition in the online travel agency market, while Delta Electronics was lower due to weak legacy business and rising operating costs. Over the past few years, the group has been in transition from component supplier to solutions provider; though there are some early signs of success, progress has been slow.
Due to the lifting of restrictions, we bought a number of Indian stocks over the quarter. These included HDFC Bank and Kotak Mahindra Bank – two of the better quality private sector banks in India that have been aggressively taking market share from the inefficient and poorly-managed state banks. With over half of India’s population unbanked, we believe the longer-term opportunity is significant.
We divested Amorepacific Corp on expensive valuations and sold LG Corp on concerns around the large discount to net asset value. Although LG Corp’s valuation is cheap, we believe the passive holding company structure does little for value creation.
Our generally cautious stance, as well as overall fund positioning has not changed very much in the last 12 months. Stock markets in Asia and globally have shot through previous highs, as investors remain sanguine on the prospect of the global economic recovery continuing into 2018. Weak inflationary pressures have called into question the need for tightening measures, which has added to the market’s bullish sentiment. However, history and our experience suggest that such benign conditions do not endure; though we do not know what or when the catalyst will be, we are mindful of a potential reversal in fortunes and – at current heady valuations – the growing risks to capital preservation. On the other hand, our longer-term time horizon means that we can look past the short-term noise.
While there is much to worry about on a macro level, there are still plenty of opportunities for the bottom-up investor. We have added to quality companies in our fund and continue to prefer exporters and US dollar earners as being amongst Asia’s more competitive companies.
Global Emerging Markets
Emerging market equities rose in sterling terms in the final quarter of 2017. The fund produced a strong positive return of 7.41%. The markets of South Africa and India were among the strongest while Mexico, Pakistan and United Arab Emirates were the weakest.
We initiated a new position in Femsa, a Mexican multinational retail and beverage company. The business has evolved over the last decade from being a Mexican-focused brewer and Coca-Cola bottling franchise to now being dominated by OXXO, a convenience store chain. OXXO is one of the best run and fastest growing retail franchises across the emerging markets.
The overall business, however, has been impacted by downward pressure on returns generated by Coca-Cola Femsa, which in turn has been affected by a number of recent bottling operation acquisitions that require restructuring. This has brought the stock back down to an attractive valuation for investors with a genuine long-term time horizon. We believe that returns at the bottling business will improve and the retail business should continue to experience robust growth.
The fund continues to have a bias towards companies listed in markets that bore the brunt of commodity declines such as Brazil and South Africa. The resulting economic shock resulted in weaker currencies, more attractive valuations and the tantalising possibility of improving national governance. To paraphrase Winston Churchill, we are hopeful that “a good crisis doesn’t go to waste”. During 2016 emerging middle class voters in South Africa delivered a message to the ruling African National Congress (ANC) party, demanding less corruption and more focus on improving living standards.
The recent election of Cyril Ramaphosa as leader of the ANC demonstrates that the majority of its delegates see the peril that numerous corruption scandals bring to their shores. It remains to be seen whether the day-to-day reality for business and investment can be improved significantly, but this is a step in the right direction. In Brazil, ongoing political scandals appear to have delayed the implementation of some market-friendly reforms. More positively though, the fact that corrupt politicians are being held to account demonstrates an institutional credibility in the country, something lacking in so many parts of the developing world.
There is a risk that we sound like a broken record but the past 12 months have seen continued enthusiasm for risky assets. Demand for the emerging markets asset class has also continued to increase. A number of low quality and cyclical equities appear to be pricing in a continuation of strong economic conditions and favourable monetary conditions for a significant period. Financial markets are at risk of being overly optimistic and in the face of this complacency we continue to believe that it is important to stick to our belief not to compromise on quality, to maintain a long-term approach and to apply a strict valuation discipline.
With a long-term perspective, however, we are positive about the prospects that emerging markets offer equity investors. This is due to the opportunity to gain exposure to the structural trend of rising living standards in some parts of the developing world.
The fund achieved a positive return in what was a mixed quarter for bond markets. All the main areas of the fund’s corporate bond allocation (including allocations to financial names) added to fund performance, with the largest contribution coming from our holdings in subordinated financials. Despite the Bank of England hiking UK interest rates for the first time since 2007, fund duration was also a positive for performance.
A key reason for this was that the dovish rhetoric that accompanied the hike pushed out expectations of any further hikes in 2018. The UK government’s agreement with European Union to move onto phase two of the Brexit negotiations provided a further boost to sentiment in sterling bond markets.
The broad shape of the fund was unchanged over the quarter. 33% of the fund is held in non-financial high yield bonds. This exposure is focused on higher quality companies that we consider have a lower risk of default. The subordinated bonds of companies within the financial sector are currently our preferred area of the corporate bond market. These are junior bonds within a company’s capital structure that may have some equity-like characteristics. We also see some opportunities in subordinated bonds within the wider corporate bond market. Given the high yields available in the US, we also have some exposure in the fund to the US corporate bond market.
Looking ahead, the low level of yields means we are cautious. That said, we continue to find some selective investment opportunities and position the portfolio to capture them. The key challenge facing bond markets over the coming year is the speed at which central banks withdraw their current levels of support. Given the low level of inflation, our central scenario is that any change will continue to be gradual and is unlikely to result in substantially higher yields.
Fund performance was broadly flat over the quarter driven by a broad range of asset classes. On the upside, some of our directional equity investments did well. The main contributors were our selective Asian equities, which benefited from the rising equity markets in the region and, similarly, our long approach to Japanese equities.
The fund benefitted from our preference for US large caps vs small caps as investors started to question the historically high valuation of US small caps. Our ‘Interest Rates – Australia vs US’ idea was also a strong performer as the differential between Australian and US interest rates narrowed – this was triggered as expectations for any rate hikes in Australia were pushed further into the future by lacklustre inflation numbers, at the same time, the US economy remained comparatively ebullient.
Another positive was our preference for the Chilean and Mexican pesos against the Australian and New Zealand dollars, this was partially down to the strong performance of the Chilean peso, which benefited from a higher copper price and stronger economic data.
The two main detractors were the ‘Japanese Yen vs Korean Won’ and ‘Inflation – Short Real Yields and Inflation’. ‘Japanese Yen vs Korean Won’ was impacted by a convincing election victory for Prime Minister Shinzo Abe in Japan, which was seen as supportive for the continuation of the country’s ultra-accommodative monetary policy. Our ‘Inflation – Short Real Yields and Inflation’ idea was hurt by gradually rising medium-term inflation in Europe counting against performance during the period.
Other less impactful ideas were ‘Commodity – Short’ and ‘Currency – Long emerging market Carry’. Our short commodity strategy lost ground as commodities had a strong end to the year while an interest rate cut in Brazil, combined with stronger equity markets there, meant the emerging market carry idea was also in negative territory.
During the quarter, the team added the Japanese yen, which we believe is measurably cheap, to the Swiss franc. Changes included removing Hungarian exposure from our emerging market debt idea, removing the US leg from our ‘Interest Rates – Swap Spreads’ idea and moving to a more directional implementation of US dollar vs Canadian dollar following US dollar weakness.
The final quarter of 2017 was a positive one for global markets, rounding off another strong year for global equities. The best performing assets over the fourth quarter were oil, followed by Japanese equities, emerging markets and then US equities. Quality sectors of the market, including the consumer sectors and IT, enjoyed a more upbeat quarter, as did more economically-sensitive sectors such as energy, materials and financials.
The portfolio delivered a positive absolute return. Our exposure to consumer staples did contribute positively to absolute returns over the quarter. However, our overweight in tobacco stocks and our holding in global brewer Anheuser-Busch InBev (ABI) hurt relative performance.
Tobacco stocks have been under pressure since July, when the US Federal Drug Authority announced that it intends to reduce the nicotine in cigarettes to non-addictive levels. This trend continued into the final quarter, but there was some reprieve in December, in particular for the US-exposed producers which benefited from US tax reforms. Our holdings in Philip Morris, Imperial Brands and Japan Tobacco were among the worst performers. While the investment landscape for the tobacco industry is undergoing change, we feel the current valuations and dividends of these tobacco stocks remain compelling.
ABI is feeling the pain from weak sales in the US for staple brands like Budweiser and Bud Light, amid continued strength in craft and imported beer. The brewer recently appointed a new North American Zone President to turn things around, a move we support and will continue to monitor closely.
More positively, our exposure to media company Twenty-First Century Fox supported performance over the quarter. The company benefited from ongoing talks with Disney, which resulted in an agreement to sell certain media assets, including the movie studio, television content and certain international operations, such as Star India and a stake in Sky.
Other pockets of strong individual performance included software giant Microsoft and clothing retailer Nike. Microsoft has performed well thanks to sustained growth in revenues for its cloud business, Azure, while Nike rallied on strong quarterly results, driven by impressive growth in China, Europe, the Middle East and Africa.
It is fair to say that 2017 was not a helpful environment for our investment strategy, since markets rose relentlessly and volatility fell. The MSCI AC World Index rose every single month last year, even excluding dividends. As a result, our cash balance remained a drag on relative performance. The upward momentum was led by technology and emerging markets, two areas where we tend to be underrepresented, and so we also suffered an allocation headwind.
Although we have enjoyed very positive returns from a variety of names – in particular European stocks such as Wolters Kluwer, ENEL and Safran – we suffered absolute losses in a small number. Most are suffering operational headwinds which we believe to be temporary. In general, we have used share price weakness as an opportunity to buy more shares, but they have clearly been a drag on relative performance in the short term.
During the quarter, we sold our position in Woodward on valuation grounds. It has doubled in the last two years and now prices in a very good outcome for both sides of the business (aerospace and industrial). Elsewhere, we started a position in healthcare company Roche. The shares have de-rated substantially and we feel we are paying very little now for a world class innovator with a very strong balance sheet. News flow on both existing and new drugs has started to improve, so we expect cash flows to improve.
We also established a position in Pepsi – a very solid business whose value is underpinned by its savoury snacks business in the US, Frito-Lay. This is an increasingly rare asset at a time when plenty of other staples businesses are losing pricing power.
Looking forward, we accept that equity markets can continue their upward momentum but remain convinced that it is appropriate to tread carefully. Real world data is encouraging but there is only ever a tenuous link between economic growth and investment returns – after all, markets have been very strong for years in the face of lacklustre growth, so it is quite possible that strong growth and rising inflation is negative, not positive, for equity investors.
Investment Grade Corporate Bond
Our overweight stance to select credit sectors and issuers, including an allocation to US high yield bonds, was a strong source of positive performance during the fourth quarter, as corporate credit spreads narrowed. Strong investor demand for higher-yielding securities continued (as an alternative to global treasuries), which drove spreads tighter. (The price of a barrel of Brent crude rose from around $55 to more than $65 over the course of the quarter). Solid econometrics, stronger oil prices, and the US republican tax plan contributed to the risk-on tone. Corporate profits, stable and synchronized global economic conditions, and low interest rates helped to create a supportive environment for credit market performance.
The fund’s risk-adjusted overweight positioning to the insurance and banking sectors were quite positive during the period. Specifically, euro pay subordinated insurance and banking holdings led the way due to attractive spread levels, improving balance sheets, and the positive impact of expected higher rates. The fund’s off-benchmark allocation to high yield energy also proved beneficial, particularly among independent energy producers. However, allocation to some of the more defensive sectors, such as consumer products and pharmaceuticals, detracted, as these segments underperformed during the period. An underweight to the technology sector also weighed on relative returns.
We expect the combination of continued technical support and healthy fundamentals to provide a positive backdrop as we head into 2018. We believe the primary risks to the credit markets include the pace of global growth, the pace and timing of Fed tightening, inflationary pressures, shareholder-friendly activity and commodity price volatility. We also consider geopolitical dynamics to be an important variable to monitor in coming months.
Global equity indices set record highs, rising for a seventh straight quarter as US companies posted higher-than-expected average earnings; the internet giants surged on strong results and their upbeat outlooks; US Congress slashed the corporate tax rate; the Federal Reserve projected that it would only tighten US monetary policy slowly; and the world’s major economies grew in unison for the first time in about a decade. European stocks, however, slid on political uncertainty. Ten of the eleven industry classifications within the MSCI World index rose in US-dollar terms over the quarter. IT and materials were the best-performing sectors while utilities fell.
The portfolio recorded a positive return in the quarter. At stock level, the best performers included Lowe’s, Apple and Microsoft. Lowe’s gained after announcing higher-than-expected earnings growth for the third quarter; the US’s second-largest home-improvement chain is a major beneficiary of lower corporate taxes because it sources all its revenue in the US. Apple rose after its higher-than-expected quarterly revenue and profit results showed iPhones remained popular, aided by the 10-year anniversary launch of the iPhone X, while its services and wearables businesses performed well. Microsoft gained after margin expansion in its server software and personal computers businesses meant quarterly earnings beat consensus.
Stocks that lagged included Sanofi and eBay. Sanofi fell amid ongoing disputes regarding patent protections of its diabetes products and after third-quarter revenue missed estimates due to pressure on drug prices in the US. eBay fell when the owner of the online auction site marginally downgraded full-year earnings-per-share guidance due to issues at its StubHub ticket-selling site.
Over the quarter, the manager exited a position in PayPal on valuation grounds – our view of the company’s business prospects has not diminished.
Abnormally loose monetary policies have created distortions in asset markets, particularly in what we would call bond-proxy equities, which are sensitive to movements in longer-term interest rates. We are cautious about the outlook for these stocks.
UK Growth and UK & General Progressive
In the fourth quarter of 2017, the fund returned 2.3%.On the negative tack, Centrica’s share price was weakened by a profit warning, which reflected problems in its North American business. However, one of Centrica’s attractive characteristics is its sizeable dividend, and in this area the company was able to provide reassurance.
Saga warned that profits will be below expectations, citing tough trading conditions in home insurance, and a hit from the collapse of Monarch Airlines. The shares traded down significantly, which reflected not only the profit warning for 2018, but also the fact that the profit benefit carried over from last year will unwind over the course of 2018-19. We still believe Saga can leverage its brand across services to people approaching and in retirement. WM Morrison was also weak, as industry research found it had given up some market share for the 12 weeks to early December when compared to a year ago. We maintain our valuation discipline whilst some others focus on companies that pursue growth at any price.
Tesco was the largest positive contributor during the quarter. There was more evidence of strong operational progress, and the Booker acquisition was unconditionally cleared by the Competition and Markets Authority. BP exceeded expectations, and doubled third-quarter profits. It also announced a share buyback programme, which should give confidence in the dividend (which is unchanged). Elsewhere, Ladbrokes Coral, the UK’s biggest high street bookmaker, saw its share price rise when it agreed to a takeover by GVC, thus creating one of the world’s biggest gambling groups.
We took further profits from miners such as KAZ Minerals and Anglo America, as we became a little more cautious about China. We established a new holding in Associated British Foods, which has a collection of strong businesses. In addition, we bought shares in QinetiQ, a business that looks well placed to leverage its UK operations and expertise into international markets, and that has secured Ministry of Defence contracts for critical support operations.
We continue to back Darwinian winners and favour the restructured food retailing and telecoms markets. We also have a material position in oil and oil Services companies, where the oil supply-demand balance continues to improve, and where restructuring is leading to greater returns and cash generation from the stronger companies.
In the fourth quarter of 2017, the fund returned 2.3%. The stock that detracted the most from performance was Saga, who warned that profits will be below expectations, citing tough trading conditions in home insurance, and a hit from the collapse of Monarch Airlines. The shares traded down significantly, which reflected not only the profit warning for 2018, but the forthcoming unwinding of last year’s profit benefit. We had a call with management and still believe Saga can leverage its brand across services for both those approaching retirement and those already there.
A profit warning at Centrica, following problems in its North American business, weakened the share price, but it provided reassurance on its sizeable dividend. Scheduling problems and conflict with cockpit personnel contributed to a falling share price for Ryanair, but industrial relations issues looked brighter by quarter-end. Elsewhere, Serco stepped away from the tendering process for £2.5 billion of rail contracts in the Middle East, which wasn’t taken well by the market.
On the positive side, good winter trading boosted Pearson’s share price while, in food retail, Tesco’s acquisition of Booker was unconditionally cleared by the Competition and Markets Authority. Lundin Mining, a diversified base metals mining company, benefited from the rally in commodity prices while Ashmore Group, the specialist emerging markets investment manager, benefited from strong trading and inflows.
We have invested in some Darwinian winners that will continue to strengthen their competitive position and in companies that exhibit attractive capital and income growth prospects. We have also added to some of the defensive positions in the fund, given the UK is in the late stages of an economic cycle, and given the political and Brexit uncertainties. We continue to favour the oil sector due to the growing supply tightness, better demand outlook and the increasing cash generation, following years of much-reduced capital expenditure.
Global Equity Income
Global equity markets advanced in the fourth quarter as we continued to see improving global economic growth. Japan performed well on strong company earnings, increased political stability and an expanding economy. Emerging markets outperformed developed markets on improving company earnings and a weakening US dollar. In the US, consumer confidence rose to a near 17-year high, unemployment reached a 17-year low and wage growth accelerated.
The late-month passing of the US administration’s tax reform bill also contributed to the market rally. Consumer discretionary and IT were the best-performing sectors, while the utilities and healthcare sectors lagged. The materials sector was also among the top performers due to continued strength in metals, particularly copper and aluminum. The energy sector performed well on the back of a rising oil price, which ended 2017 at its highest level in nearly two years due to a combination of production cuts by Opec and to increased global demand.
Stock selection in the financial sector and an underweight position in the utilities sector contributed positively to performance. Contributors included Wolters Kluwer, Wells Fargo & Company and Cisco Systems. Stock selection in the consumer discretionary, healthcare and materials sectors detracted from performance. Detractors included Koninklijke Philips, Sanofi and Whirlpool Corp.
During the quarter, we added Airbus, Medtronic, Direct Line Insurance and Compagnie Générale des Établissements Michelin to the strategy. We sold our positions in Bridgestone, Honeywell, HSBC, PNC Financial and SES.
Most equity price/earnings ratios are at elevated levels not seen since the early 2000s. Our analysis shows that leverage levels have risen, even as profit margins appear to be near peak levels. The biggest risks we see result from high global valuations and high debt levels. We focus on companies that have enduring businesses, strong balance sheets, sustainable free cash flow, and management teams with a strong track record of effective capital allocation. We view US financials and sustainable quality franchises within the consumer staples sector positively.
The fund was up in the fourth quarter. Performance was driven primarily by positive name selection, with particularly advantageous trading activity in November supporting these gains.
High yield spreads were relatively unchanged during the fourth quarter with a modest 0.11% of tightening. High yield market volatility was muted, except for the brief period of heightened volatility observed in November. High yield bonds returned +0.01% in November, but this flat performance masks an otherwise volatile month.
Weakness in the telecoms, consumer and retail sectors caused the high yield market to decline by 1.22% mid-month before ultimately rebounding to finish flat. Due to the passage of tax reform and another 0.25% hike by the Federal Reserve in December, 5-year US Treasury yields jumped 0.27% during the quarter to 2.25% - close to a 7-year high. But the rate rise tempered gains.
We initiated several new positions during the fourth quarter, particularly during November’s intra-month market sell off, and but also reduced some exposures. The fund bought $227 million - $80 million of it during the volatile period – and sold $146 million in November.
We believe these opportunistic mid-November purchases added around five points of potential upside based on where these bonds were trading at the end of October. One example is Envision Healthcare, a leading provider of outsourced physician staffing and an operator of ambulatory surgery centres. November volatility and disappointing earnings results caused the bonds to trade down sharply, so we opportunistically built up our position in mid-November and the bonds have since traded up at quarter-end.ahead, while valuations appear extended, an improving global macroeconomic outlook could see high yield spreads continuing to grind tighter as riskier appetites drive equity benchmarks to new records.
There is the potential for increased volatility if inflation picks up materially and overshoots what the Federal Reserve and ECB are forecasting. In this environment, strong security selection should provide an opportunity to outperform on a risk-adjusted basis as volatility is reintroduced back into the market.
Between the fund launch on 6 November to the end of 2017, the Tokyo Stock Price Index (TOPIX) declined 0.2% (in sterling terms), following a strong market rally from September to early November. This rally was attributed to the victory of Japan’s ruling party in the snap general election in late October and the announcement of the US tax reform plan. Also, growing expectations for an improvement in the semi-annual earnings of many Japanese companies supported the markets in general.
Yet fund performance was aided by stock selection. The top contributor during the period was Kyowa Exeo, a leading telecoms and IT-related construction company. Kyowa Exeo benefited from the recent rising demand for mobile network construction projects as well as from redevelopment projects in the Tokyo metropolitan area.
The largest detractor was Nippon Seiki, a world-leading manufacturer of display products for motorcycles and automobiles. The company recently suffered an earnings decline as a result of weak sales of its profitable automotive display products in North America, caused by poor auto sales at a major customer. We believe that the company’s earnings will rebound as its North American business recovers along with the growth of global automobile and motorcycle production.
The major positions Nippon added during the period were Kato Works (a construction machinery manufacturer); Iida Group Holdings (a house construction company); and Taihei Dengyo Kaisha (a power plant construction subcontractor). Major sales during the period were Asahi Diamond Industrial (an industrial diamond tool manufacturer); Kyowa Exeo (discussed above); and Sumitomo Metal Mining (a non-ferrous mineral resource company).
The ultimate objective of Nippon’s investment program is to maximize the intrinsic value of the portfolio over time by investing in attractively valued companies relative to their quality without regard to short-term market conditions or macroeconomic and political issues. We will stay focused on stock selection and portfolio management, based on our value-oriented investment philosophy and bottom-up approach.
International Corporate Bond
Stocks were the star performers in the fourth quarter, as a range of leading global indices struck new record highs. Bolstered by the Trump administration’s pro-growth tax cut package and by an improving economic outlook, the S&P 500 gained 6.6%. The rise in corporate earnings over the course of the year was also a significant contributor to rising investor confidence. In this pro-risk environment, traditional fixed income couldn’t keep pace, and the 10-year Treasury note lost 0.3%. High yield bonds also lagged equities in the fourth quarter, although the asset class managed to finish the quarter in positive territory.
Within the broader high yield bond market, oil & gas producers performed strongly, lifted by rallying oil prices. (The price of a barrel of Brent crude rose to above $65 by the end of the quarter, having begun the year below $55.) At the same time, satellite and diversified telecom companies trailed their peers.
In the fourth quarter, the portfolio benefited from credit selection in retail – the food & drugs and metals & mining sectors. However, our avoidance of the strongly-performing home builders sector and credit selection in the retail stores sector detracted from results.
High yield bonds are off to a good start in 2018, and we expect that the default environment will continue to be benign. Supporting this view is the small percentage of the market currently trading at or below 70% of par (an indicator of perceived credit weakness). As always, there are plenty of threats on the horizon, not least in the US. In addition to the potential for higher interest rates to put downward pressure on bond prices, there is continued uncertainty related to President Trump’s policies, which can create volatility on markets. Offsetting these risks is a growing US economy and also stable credit fundamentals.
The UK real estate market continues to perform well, delivering an attractive level of income together with modest levels of capital and rental appreciation. Economic growth, whilst slower than a year ago, remains positive, and record levels of employment and very low interest rates are underpinning demand for real estate from both occupiers and investors.
Fears over the impact of Brexit appear to have receded for the moment, as the government appears to have agreed the initial issues of the exit bill and is now moving on to start the far more complex negotiations over the shape of the future trade relationship. Thus a significant amount of uncertainty remains.
Despite the high level of employment, real wage growth remains restrained, especially in light of recent rising inflation. This has curtailed the growth in consumer spending, adding to the widely reported challenges facing parts of the retail market. That said, the internet retail subsector continues to grow at double-digit rates, fuelling robust demand for industrial and logistics properties, particularly those in the supply-constrained London and South-East markets.
Occupational demand remains strong across the portfolio, with occupancy levels remaining above 95%. During the quarter, we completed leasing transactions involving nearly £5 million of annual rent across over 500,000 square feet of commercial property space. This continued demand for good quality space is leading to some rental growth and during the quarter we have settled a number of rent reviews at levels ahead of expectation.
The St. James’s Place property funds are invested in over 100 quality assets with more than 900 tenants. Notwithstanding the political and economic uncertainties that lie ahead, the funds are well placed to deliver sustainable income, with scope for growth in that income, which continues to make the sector a valid component of a diversified multi asset portfolio.
Global Smaller Companies
Global small caps wrapped up a stellar year with an additional 4.8% return (in sterling terms) in the fourth quarter. Against this favorable market backdrop, our portfolio delivered positive performance, yet lagged the benchmark. Our underweight position in the US was a headwind despite above-market performance for our selections. Emerging markets and Western Europe, where we are overweight, were additional sources of underperformance.
The US had a strong quarter driven by continued favorable economic news as well as the successful signing of a tax reform bill. The reduction in corporate tax will benefit near-term profitability and, more importantly, could spur growth in investment spending as after-tax returns on projects will be more attractive for domestic businesses. It is not just US holdings that will benefit, as both US subsidiaries of foreign firms and US-facing exporters stand to profit from reduced taxes and increased US spending.
Top contributors for the quarter included KLX (US), Pioneer Foods (South Africa), and Ferroglobe (UK). Hardware distributor KLX took off late in the quarter after the company announced a process to explore strategic alternatives for one or both of its aerospace and oil & gas divisions. Pioneer Foods Group, a leading manufacturer of breakfast cereal, rose on news of its acquisition of UK-based Lizi’s. Lizi’s provides an entry into the high-growth granola market and bolsters Pioneer’s leading consumer brand portfolio. Similarly, Ferroglobe, a leading producer of unique, metal-based alloys, rose after announcing an acquisition of additional manganese alloy capacity on top of reporting favorable third quarter results.
Material detractors for the quarter were Eastman Kodak (US) and Eros (India). Kodak declined following a disappointing earnings release as competitive pressure and rising raw material prices negatively impacted the company’s commercial printing business. Kodak is in “advanced negotiations” to monetize technology and IP, but these developments are progressing slowly. Eros addressed concerns around its balance sheet by issuing a convertible bond, but equity investors were disappointed in the terms the company secured.
Diversified Bond and Multi Asset
Persistent economic tailwinds prevailed in the fourth quarter as unemployment and economic growth numbers continued to improve around the globe. In addition, long-awaited fiscal progress was made in the US as the Trump administration delivered tax reform legislation. These key ingredients resulted in a positive tone across the markets, with equities continuing to set record highs and corporate risk premiums narrowing. With plenty of economic support, the Federal Reserve raised interest rates for the third time in 2017, driving the two-year Treasury yield to 1.88%, its highest level since 2008, while the ten-year note finished the year little changed at 2.41%.
Other central banks around the world followed suit, as the Bank of England and People’s Bank of China hiked rates, while the European Central Bank reiterated its intention to curtail asset purchases. Consequently, interest rates moved higher around the globe, but subdued volatility persisted as investors searched for yield.
We continued to hold a diversified mix of fixed income sectors including corporate, mortgage-backed and asset-backed securities. These sectors generated positive returns over the quarter, as robust global economic data and high levels of investor confidence continued to support the credit markets. The top contributor to performance was the non-agency mortgage-backed securities sector, which benefited from the strength of the US housing market, together with the GSE risk-sharing deals sector, which was supported by lower supply volumes.
Currency trades contributed to performance, particularly a short position in the US dollar versus a basket of emerging market currencies. Our tactical trades aimed at capturing the mispricing in the front-end of the US Treasury yield curve also contributed to the positive performance this quarter.
In the coming year, we anticipate further monetary tightening from central banks, including further reductions in the European Central Bank’s asset purchasing programme, as well as three to four rate hikes from the Federal Reserve. We remain cautious of a potential rise in inflation as labour market conditions are likely to continue tightening around the globe.
The UK market delivered further strong returns in the fourth quarter of 2017, propelled higher by evidence of strong global economic growth and a belief that, whilst interest rates are likely to rise from current levels, the increases will be gradual and not enough to derail the economy Although there are signs that the UK is suffering from the uncertainties surrounding Brexit, the economy is making some progress and certainly hasn’t (as yet) turned down in the way that some had feared at the time of the referendum vote eighteen months ago.
The portfolio underperformed the market over the period, with positive contributions from BP, Royal Dutch Shell and Tesco more than offset by negative contributions from Centrica, Next and Serco. The oil companies have benefited from firmness in the oil price and the aggressive steps that the management teams have taken to ensure that the companies are able to pay their generous dividends out of internally-generated cash flows, even in the event of lower oil prices.
Tesco continues to make good progress with its recovery and, whilst profit margins are unlikely to return to historic levels, they should recover to a level that more than justifies today’s share price. Centrica downgraded profit expectations by around 15% in the three months on the back of falling margins in its US and UK business, Next fell on fears of poor trading over the Christmas period and Serco fell on signs that the UK outsourcing market has seen a slowdown in recent months. Next has since confirmed that trading was resilient over the Christmas period and, in each case, we believe that the valuation case is intact and that continued investment is warranted.
Following a long period of rising share prices, stock market valuations are at elevated levels and as a result many shares offer the prospect of relatively meagre returns. Whilst there are a number of good opportunities, investors need to be selective in what they hold, focusing on those companies where valuations are reasonable and the bar of expectation is reasonably set.
We outperformed the market over the quarter. On the positive side, we benefited from strong performance in Axel Springer, VW, STM, Commerzbank and Amadeus. On the negative side, we were hurt by weakness in Intesa, Maersk and Assa Abloy.
The outlook for European equities remains very positive. The Christmas break brought more evidence of a buoyant European economy. Most notably, the eurozone manufacturing purchasing managers’ index reached a breathtaking 60.6 in December, the highest level since the survey began over 20 years ago. Perhaps more importantly, our company visiting programme suggests a corporate sector recovery that continues to outpace more cautious market expectations. The political backdrop also continues to improve, with President Macron beginning to make real progress with his various economic reforms. Germany, furthermore, appears to be close to agreeing a CDU/SDP coalition, which would be very supportive for the European project.
The overall shape of the fund remains broadly unchanged. Some 59% of the portfolio is made up of companies with an above-average sensitivity to the business cycle. Within this group, the majority are comprised of more traditionally labelled cyclicals, such as the Spanish homebuilder Neinor. Special situations, such as SOITEC, STMicroelectronics and Dassault Aviation constitute a little more than a quarter of the same cycle-sensitive group. Finally, amongst these more business cycle sensitive investments, banks constitute a further 10% of the group. We believe that the market has failed to appreciate the benefits of stable financial margins coupled with draconian cost cutting and easing regulatory pressures.
The remaining 41% of the fund is built up of our growth company investments. We have invested in a broad range of businesses, from the German media group Axel Springer to the food and drug tester Eurofins. We have focused on companies with strong secular growth drivers, generally avoiding businesses whose future prospects are predicated on continuing economic growth in the emerging world. We have been especially wary of bubble-priced ‘no-growth growth stocks’, such as the consumer staples.
Greater European Progressive
We outperformed over the quarter. On the positive side, we benefited from strength in Axel Springer, VW, STM, Commerzbank and IAG. On the negative side, we were hurt by weakness in Assa Abloy, Intesa and Maersk.
The outlook for European equities remains very positive. The Christmas break brought more evidence of a buoyant European economy. Most notably, the Eurozone manufacturing purchasing managers’ index reached a breath-taking 60.6 in December, the highest level since the survey began over 20 years ago. More importantly perhaps, our company visiting programme indicates a corporate sector recovery that continues to outpace more cautious market expectations.
The political backdrop also continues to improve, with President Macron beginning to make real progress with his various economic reforms. Germany, furthermore, appears to be close to securing a CDU/SDP coalition, which would be very supportive for the European project. The outlook for the British economy, however, remains very challenging. The economy is suffering from a squeeze in real incomes, with the collapse in sterling pushing up the cost of imported goods. Investment spending growth, furthermore, has begun to slow down rapidly, with many in the business world fearing that a trade deal with Europe may not be possible.
The overall shape of the fund remains broadly unchanged. Some 54% of the portfolio is made up of companies with an above-average sensitivity to the business cycle. Within this group, half of our investments are comprised of more traditionally labelled cyclicals, such as the airline group IAG and the shipping conglomerate Maersk. Special situations, such as SOITEC, STMicroelectronics and Dassault Aviation constitute more than a quarter of the group.
The remaining part of the portfolio is built up of our growth company investments. We have invested in a broad range of businesses ranging from the French consumer appliances group SEB to the food and drug tester Eurofins. We have focused on companies with strong secular growth drivers, generally avoiding businesses whose future prospects are predicated on continuing economic growth in the emerging world.
For the quarter ending 31 December 2017, the fund posted a healthy return. The consumer discretionary and consumer staples sectors were the top contributors to relative investment results, while information technology and health care were the top relative detractors. On a regional basis, emerging Asia and the Middle East & Africa contributed most to relative results, while the US/Canada and Western Europe were the top relative detractors.
The IT sector posted another quarter of strong returns, bolstered by the prospect of US tax reform and by solid economic data and business results. Key beneficiaries included several large, slower-growing benchmark constituents. Three US IT companies—not owned by the Global Growth strategy—were responsible for over 30 percent of the sector’s contribution to the overall index return, an exceptionally outsized proportion of total gains. Despite the sector’s detraction from the fund’s overall relative results in the fourth quarter of the year, we continue to believe that the IT businesses we own possess longer-lasting and higher-quality growth potential.
IT businesses continue to drive large secular trends that appear to be gaining momentum in the current business environment. For example, we are observing larger transformational enterprise software transactions, a material shift of advertising dollars to digital from traditional advertising channels, and greater-than-expected semiconductor demand, given the need to analyse data and connect new devices to networks. We expect these secular trends to persist for the foreseeable future, and believe that owning the leading businesses with strong competitive advantages is the best strategy for adding value over the long term.
On a relative basis, the top individual contributors to investment results were Maruti Suzuki, Titan, Naspers, Charles Schwab, and Amazon. The top relative detractors from investment results were Regeneron Pharmaceuticals, Incyte, Genmab, Shopify, and Medidata. We purchased Zalando during the quarter, and there were no sales.
The portfolio continued to generate a high income in line with its objective and delivered positive performance over the fourth quarter of 2017 as global equities capped off a strong year. The yield was generated through the portfolio’s strategy of combining a basket of high-yielding stocks with the sale of some uncertain upside equity market potential in exchange for regular upfront payments.
The net dividend yield realised over the last 12 months for the global income basket stood at c. 4.3% at the end of December. The global income basket returned 2.8% in sterling terms over the quarter while the policy to hedge foreign currency exposure added to returns as sterling appreciated during the quarter. The overall hedged equity exposure returned around 3.5% over the quarter.
Once again, there were positive contributions from all regions in the portfolio as global equities finished off the year in robust fashion. However, there were signs of weakness in some markets. Eurozone equities lagged amidst profit taking and heightening political risks in Spain. Disparity in sector returns was more pronounced, with materials comfortably leading the way on the back of rising commodity prices, while utilities experienced losses in an environment of rising interest rates.
Over the quarter, bond yields have continued to rise as global central banks proceed along a path of gradual interest rate increases. Following up from guidance issued in October, the Bank of England hiked rates in November and the US Federal Reserve (Fed) raised the Fed Funds rate by another 0.25% to 1.5% in December. Retaining an exposure to high yielding stocks with strong quality characteristics should ensure the basket continues to produce a suitable yield and keeps pace with the market.
The portfolio’s programme of selling some uncertain upside potential generated a regular stream of income. Global equity markets performed well, particularly in October. As a result a number of markets rose above the level of upside that was sold and detracted from the portfolio’s returns in exchange for the additional yield. Reflecting the portfolio’s positive performance, the systematic downside risk management mechanism was not activated.
The fund produced a strong return in the last quarter of 2017, as global equities capped off a strong year amid continued low volatility. The MSCI World recorded a fourth quarter gain of 5.5% in US dollars while the portfolio returned around 7.4% in sterling terms.
In the US, the S&P 500 ended a strong year with a fourth-quarter gain of 6.6% in dollar terms. Two Republican defeats in Senate contests in Alabama and Virginia spurred House and Senate Republicans into action and the long-awaited tax reform bill was agreed. Markets rallied on the news.
Eurozone equities saw negative returns amid profit-taking following strong gains earlier in the year. Simmering political risk was a further drag after Catalonia’s independence referendum in October. However, the earnings season was generally encouraging and the region’s economic recovery continued.
The FTSE All-Share Index rose more than 5% in sterling terms to close out the year with record highs. UK equities made significant gains in December, more than reversing a decline in the prior month. Resources-related stocks performed well, as commodity prices rose strongly and progress in Brexit negotiations provided a broadly supportive backdrop.
Japanese equities enjoyed strong gains with the Topix returning 8.7% in yen terms. Investors reacted positively to Prime Minister Abe’s victory in the October general election. The period also saw a robust earnings season, with the majority of companies again exceeding expectations.
Equity market volatility remained low over the quarter and was accompanied by positive performance. This environment was beneficial for the portfolio which retained an equity exposure at its maximum level over the full quarter. The volatility target strategy made strong gains, and the protection in place therefore fell in value. On balance, the risk management in place provided ongoing downside protection and contributed positively to the returns over the quarter.
Global equities capped off a strong year with a fourth quarter gain. US equities performed well as lawmakers agreed on tax cuts. Two recent Republican defeats in Senate contests spurred House and Senate Republicans into action. Fearing the defeats are a sign of things to come in the 2018 mid-term elections, they agreed the long-awaited tax reform bill.
The FTSE All-Share index performed very well over the period amid further evidence of a sustained recovery in the global economy, including the US where GDP expanded at a significantly better-than-expected rate of 3.2% (annualised) in the third quarter. This was as eurozone growth gained pace and Chinese output advanced by a steady 6.8% (year-on-year). The UK market was led higher by the resources sectors, against the backdrop of strong performance in both industrial metal prices and crude oil.
Amongst the fund’s UK equity holdings, education business Pearson performed well after it released a trading statement showing good progress over the last nine months. Mining group Anglo American performed well against the backdrop of stronger industrial metal prices. Gaming group William Hill was another top contributor on following a reassuring trading update, renewed industry consolidation and hopes regulatory change around fixed-odds betting terminals would be manageable.
Tesco performed well after the Competition and Markets Authority provisionally cleared its acquisition of wholesaler Booker and industry data revealed its grocery volume growth has continued to exceed peers by a significant margin. On the negative side, Centrica and power group Drax performed poorly amid regulatory uncertainty in the wake of the Conservative Party conference. Centrica was also negatively impacted following a profit warning. UK retailer Debenhams came under further pressure as sentiment towards the high street and clothing deteriorated.
In the fourth quarter of 2017, the fund saw a positive return. The largest contributors in the quarter included emerging Asia’s oldest life insurer; a provider of payroll services to small businesses, which reported solid quarterly results driven by growth in the HR Services segment; and a consumer products company in South Korea.
The largest detractors in the quarter were a media company in the Spanish-speaking world; the dominant mid-market jewellery retailer in North America and the UK; and a global manufacturer of branded athletic footwear and apparel. Cash ended the quarter at 10.2%, a decrease from 12.2% at the end of September.
Growth expectations are rising throughout the eurozone, Japan, China and emerging Europe, while concerns have mounted regarding the UK and its deteriorating prospects, caused by uncertainty over the timing and outcome of Brexit. However, the enthusiasm with which global investors have extrapolated the cyclical recovery (even in the face of unchanged structural obstacles) has caused even UK stocks to post absolute gains.
Meanwhile, in the US, tax reform may drive accelerated US GDP growth in an economy already characterised by high levels of consumer confidence, relatively clean household balance sheets and unemployment rates nearing record lows with an almost equal ratio of job openings to job seekers. We also expect accelerated wage growth in the US, and as a result we believe the Fed will elevate interest rates steadily in response to inflationary pressures.
The current equity market environment is beginning to resemble a “melt-up” rally that buoys shares in most listed businesses—particularly those for which greater risk appetite is required to merit enthusiasm—despite generally high valuations for the market overall. We own businesses that we are confident can grow long-term earnings power meaningfully, even if the broader macroeconomic environment proves more challenging than expected. We also believe the share prices of our holdings represent attractive discounts to our estimates of their intrinsic values, providing downside protection in the event that an external shock dampens sentiment for equities.
The final quarter of the year continued much in the same vein as the rest of the year, as market conditions continued to be positive for risk assets, driven by the strong technical factors of supportive central bank policies and high cash balances. Only a slight softening in late November and early December gave a pause in the rally.
The big event for markets in October was the decision by the ECB on its Asset Purchase Programme, which was tapered to €30 billion per month but extended until at least September 2018, and was accompanied by a dovish statement that helped credit spreads to tighten further.
In the UK, the emergency rate cut that followed the UK referendum on EU membership was reversed by the Bank of England in November and Governor Carney also stated that “two more 0.25% rate hikes will be needed over the next three years”, which surprised markets given the uncertainty surrounding the Brexit negotiations.
In the US, following what was widely viewed as a very successful term, Janet Yellen announced that she would be stepping down from the Board of Governors in February 2018, when the new Chair Jerome Powell would take over. The Fed also increased rates in December, taking the total to three hikes in 2017; another three are forecast for 2018. The US markets also got a boost at year-end when President Trump’s tax reform plan was finally passed, helping him to end a very difficult year on a positive note.
With the US buoyed by the new tax reforms and the first round of Brexit talks ending on a positive note, the market starts 2018 in reasonably good shape for credit. Valuations are clearly approaching end-of-cycle levels but the supportive backdrop and positive technicals point to a continuation of the rally in credit spread products. That said, 2018 will present new challenges and, given the stretched valuations, the portfolio managers will adopt a slightly more prudent approach to start the year.
The final quarter of the year continued much in the same vein as most of the year, as market conditions continued to be positive for risk assets, driven by the strong technical factors of supportive central bank policies and high cash balances, with only a slight softening in late November/early December giving a pause in the rally.
The big event for markets in October was the decision by the ECB on its Asset Purchase Programme, which was tapered to €30 billion per month but extended until at least September 2018, and was accompanied by a dovish statement that helped credit spreads to tighten further.
In the UK, the emergency rate cut that followed the UK referendum on EU membership was reversed by the Bank of England in November. Governor Carney also stated that “two more 0.25% rate hikes will be needed over the next three years”, which surprised markets, given uncertainty surrounding the Brexit negotiations.
In the US, following what was widely viewed as a very successful term, Janet Yellen announced that she would be stepping down from the Board of Governors in February 2018, when the new Chair Jerome Powell will take over. The Fed also increased rates in December, taking the total to three hikes in 2017; another three are forecast for 2018. The US markets also got a boost at year-end when President Trump’s tax reform plan was finally passed, helping him to end a very difficult year on a positive note.
With the US buoyed by the new tax reforms, and the first round of Brexit talks ending on a positive note, the market starts 2018 in reasonably good shape for credit. Valuations are clearly approaching end-of-cycle levels but the supportive backdrop and positive technicals point to a continuation of the rally in credit spread products. That said, 2018 will present new challenges and given the stretched valuations, the portfolio managers will adopt a slightly more prudent approach to start the year.
Emerging Markets Equity
Stronger global growth prospects and higher prices for oil and other raw materials underpinned investor sentiment toward emerging markets during the fourth quarter. Initial concerns about rising US interest rates and a stronger dollar seemed to dissipate as the quarter unfolded. The benchmark MSCI Emerging Markets Index rose 6.55% for the quarter. India and Mexico were the largest sources of fund underperformance. Shares in India’s private lenders lost ground after the government unveiled a plan to recapitalize state-owned competitors. In Mexico, a travel warning from the US State Department impacted portfolio holdings with exposure to tourism, while uncertainty over the future of the North American Free Trade Agreement (NAFTA) weighed on the peso.
Brazil and South Africa were key sources of fund strength against. Brazil’s economy appears to be on the mend following its worst downturn on record. In South Africa, Cyril Ramaphosa’s election as president of the African National Congress (ANC) sparked an upturn in sentiment.
The strongest contributor to portfolio performance was Naspers. A global internet and entertainment group based in South Africa, Naspers has achieved rapid growth driven by the continued expansion of digital media and e-commerce. The greatest detractor from performance for the quarter was Ctrip.com. The company operates a leading online travel agency in China. Investors remained sceptical about Ctrip’s expansion into low-tier cities. However, we think the company’s enlarged presence leaves it well-positioned to capture a greater share of China’s growing travel market.
Substantially higher market valuations in India have triggered a thorough review of the portfolio’s Indian investments, especially in financials. We’re redoubling our research efforts in China, which thus far has been a difficult market for stock-picking. While the portfolio has typically focused on secular growth stories driven by domestic consumer
demand, technology and the internet have become increasingly intertwined with everyday life. Given the growing importance and rapid pace of technological change, we think a broad reassessment of the IT sector is appropriate as well.
Global fixed income markets once again generated positive total returns in the fourth quarter. Optimism over US tax reform and further central bank policy normalisation were balanced by ongoing geopolitical tensions and persistently subdued inflation data. Strong global economic growth, positive earnings trends, and continued demand for yield-producing assets supported credit markets and spreads tightened further. The US dollar finished the quarter stronger against most major currencies. The greenback ebbed and flowed, pushed around by news developments related to the Russia investigations and the likely passage of tax reform. The fund posted a positive return over the quarter.
Global monetary policy continued along a less accommodative path. The Fed hiked rates in December and projected three additional hikes in 2018. At its October meeting, the ECB announced it would start to reduce its monthly asset purchases from to 30 billion euros from 60 billion euros in January, but extended the purchase programme’s endpoint to September 2018. The Bank of England hiked interest rates for the first time in ten years but struck a dovish note in the accompanying press conference, as the governor noted that future rate hikes would depend on the stability of the Brexit transition.
US GDP growth was revised up to a 3.2% annualized rate during the third quarter, robust housing market data continued, and both consumer and small business sentiment surged. Eurozone unemployment and consumer confidence data rose to post-crisis highs, while the manufacturing Purchasing Manager’s Index (PMI) expanded to a record level on strong gains in output, orders, and employment. Japanese GDP grew at an annualized 2.5% pace in the third quarter and manufacturing improved to the highest level in almost four years during December, led by new orders. Chinese industrial production slowed, imports and exports both jumped, and the country’s official manufacturing and non-manufacturing PMIs both rose. Inflation data across most developed market economies failed to engage meaningfully higher – and remained well below central bank targets – despite continued labor market improvement.
UK High Income
Nine years into this bull market, the evidence increasingly suggests that it has moved into its late stages, with momentum replacing fundamentals as the primary driver of share prices. Valuations across a wide range of assets have increased significantly as markets have risen and, as a result, there is considerable risk.
Such an environment is always likely to prove challenging for a fundamentals-driven investment approach such as ours. The final quarter of 2017 was no exception, and the portfolio delivered a positive return, but failed to keep up with the broader market.
The bulk of positive contributions to performance came from the portfolio’s healthcare holdings, with AbbVie, BTG and Alkermes in particular delivering strong returns. In Alkermes’ case, the company announced that its potential therapy for multiple sclerosis will be commercialised by Biogen, under an agreement from which Alkermes will receive an upfront payment and milestone payments along with a royalty stream.
Meanwhile, Next and Babcock International were amongst the poor performers. Both businesses released slightly downbeat trading updates during the quarter, but their share-price performance was, in our view, primarily a result of the market’s narrow focus over the quarter and its ongoing dislike of UK-focused businesses – a dislike we certainly do not share.
In the long run, fundamentals are all that matter in determining the performance of financial assets. That is why they are central to our investment approach. There are always pockets of value, and when a bull market becomes long in the tooth, as this one is now, the stretch between the cheap and expensive stocks can become extreme.
We have positioned the portfolio towards those areas of the market where valuations look attractive. This is a deeply unpopular strategy at the moment because the market excitement has been taking place elsewhere. However, when fundamentals reassert themselves, as they inevitably will, the fund is poised to deliver very attractive returns against a backdrop of a more challenging broad market environment.
Past performance refers to the past and is not a reliable indicator of future results. The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.
The opinions contained herein represents are those of our fund managers and are subject to change at any time due to changes in market or economic conditions. This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell securities or to adopt any strategy. The views are not necessarily shared by other investment managers or St. James's Place Wealth Management.
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