Fund Manager Quarterly Commentaries
Read the latest fund manager commentaries for the quarter ending 30 June 2017.
Over the quarter the portfolio returned 1.31% outperforming the benchmark by 0.80%. From a sector perspective, the portfolio was negatively impacted by its lack of exposure to healthcare. While the goal of reducing high drug prices in the US remains, changing legislation is proving to be difficult.
The focus on speeding up FDA approvals to boost competition, rather than outright price controls, may be more realistic. More specifically, several healthcare companies, filtered out by the screening process, rallied strongly on the back of good quarterly results. Another key difference at the sector level was the portfolio’s lack of exposure to tobacco stocks, which outperformed during the period.
The IT sector added value relative to the benchmark, for both the Ethical fund and the unscreened fund. However, the portfolio suffered due to excluding its position in Korean-based Samsung Electronics. Its stock price rose following strong demand for its memory chips and display panels. Good performance from the holding in Swiss application software specialist Temenos, offset this to some extent.
The other main divergence at the sector level was in financials. The portfolio benefitted from having more exposure to this outperforming sector.
In addition to financials, the portfolio continues to have greater exposure to the industrial and telecommunications sectors, whilst being comparatively underweight to consumer goods, particularly tobacco, and the health care sectors, as a result of its screens.
In the face of rising interest rates, falling oil prices, a major global cyber-attack and a dysfunctional political environment, US markets continued perform positively. During the quarter, corporate earnings exceeded expectations and continued to improve investor sentiment.
The portfolio performed in line with the S&P 500 Index and ahead of the Russell 1000 Value Index. The information technology sector ended in positive territory has a heavier weighting in the S&P 500 Index than in the portfolio. On the other hand, the energy sector, which has a larger weighting in the Russell 1000 Value Index, underperformed.
The portfolio’s allocation in these two important sectors fell in between the two benchmarks. From a stock-specific standpoint, PayPal performed well. The business now has more than 200 million active users of their digital payment platform. PayPal now allows customers to use both Visa and MasterCard as payment options, significantly adding to their user base. Also, its peer-to-peer payment subsidiary, Venmo, continues to show double-digit growth.
Detracting from performance was food retailer Kroger. Kroger was hit with back-to-back difficult news. First, the company reported that margins were down in the first quarter and that same-store sales were weak. Food retailers are hit with food cost increases from time to time. Secondly, retailers carry very little inventory, they need to raise prices immediately in response to food price increases, which is difficult to do. This combination depresses margins. However, we expect this to be a cyclical process that will reverse over time.
Another consideration was the announcement that Amazon will purchase Whole Foods. While Whole Foods only competes with Kroger in a fraction of their markets and on a fraction of their products, we shall monitor the situation closely.
While markets can move in response to the geopolitical and economic news of the day, business values move much slower and require a dedicated, disciplined bottom-up approach. As always, going forward, we will continue to focus our analytical attention on business values.
UK & International Income
In recent times the UK equity market has treated unexpected outcomes with composure however, the general election was an outcome too far and the FTSE All-Share index fell back as a result, but still registered a return of 1.4% over the period.
There are many market commentators that suggest a negative outlook for the UK is ‘in the price’. They may be right, but often these individuals have only ever seen governments that veer towards free-market economics washed down with a glass of fiscal prudence. Our sense is that, for now, governments see no mileage in exercising fair play when it comes to business and whatever makes sense on the spreadsheet plays out less well at the ballot box.
In addition, businesses have benefitted from minimal increases in labour costs for some time and given the uncertainly around immigration and the desire of politicians to ‘promise what it takes’. There is a risk that this variable will trouble companies at a time when recouping higher costs through price is an avenue closed by companies such as Amazon.
Consequently, our view on the UK economic outlook has cooled however, we are cognisant that a more moderate Brexit would ease these concerns. This has led to a slight reduction in our domestic exposure for instance; BT, Persimmon, Centrica, Royal Mail – some of the companies we acquired in the aftermath of Brexit.
Conversely, we made some additions to our international weighting, subscribing for the IPO of Allied Irish Bank, purchasing Kion which equips e-commerce distribution centres, Galicia Sante (Swiss pharmacy) and Nordea Bank.
Over the period, the portfolio return improved versus the benchmark, with 3i leading the charge. In addition, the mining and oil sectors (where we are less exposed) were subdued, as were consumer staples where our exposure is light. On the latter, we continue to believe performance is less about bond yields and more to do with fundamentals, and we think that collectively these combines will struggle to meet the sales expectations embedded in their high valuations.
Global and Worldwide Opportunities
Global stocks performed positively over the second quarter in local currency terms but were just flat in sterling terms as a stronger pound weighed on results. Developed markets led, cheered in part by the outcome of the French presidential election and the UK’s snap election, which seemed to indicate a moderating political environment. Emerging markets stocks were also nicely positive, while the stronger pound diminished returns from US-listed holdings.
Among the top contributors were Samsung and the ING Group. While Samsung has suffered a challenging news cycle over the past year or so, its core semiconductor business is the market leader and enjoys significant capital, technological and scale advantages. That business is currently benefiting from strong memory chip demand combined with disciplined pricing. The company also recently released its latest smartphone, the Galaxy S8, to very good reviews.
During the quarter, Netherlands-based bank ING reported continued solid results with high single-digit revenue growth and even stronger increases in profitability as a result of good execution on cost controls.
The largest detractors were Cisco and Telefonica Brasil. Cisco, a leader in network equipment, reported mixed first quarter results. Profit growth was strong as a recent restructuring has improved the cost structure. However, orders were weak, and management guidance for the upcoming quarter forecast negative mid-single-digit revenue growth.
Brazil’s leading provider of mobile phone services Telefonica Brasil was pressured on how an unfolding political scandal in Brazil might impact macroeconomic conditions, but otherwise continues executing well. We purchased global vehicle parts manufacturer Delphi Automotive and exited Direct Line Insurance Group and Electronic Arts in favour of more attractive opportunities
Global equities markets delivered a positive performance in the second quarter. The global index was marginally up in sterling due to the dollar and the yen losing ground versus the euro and sterling. German bunds and gilts moved lower as central banks in developed economies are talking up prospects of monetary tightening.
Oil prices continued downwards. Within equities, emerging markets (outside of Russia and Brazil) and Japan were the strongest regions. Sector wise, energy performed unsurprisingly negatively while technology, healthcare and financials ranked top of the league. However, the technology sector went through several short-lived, yet sharp, sell-offs.
While political risk in the eurozone abated with French President Macron winning a parliamentary majority, the snap election in the UK led to a hung parliament. UK economic data points to mounting headwinds to consumer spending. In the US, the Federal Reserve raised its fund rate a second time as expected. The initial soft first quarter GDP print was revised up to 1.4%. The first quarter’s corporate earnings season finished on a strong note with most regions coming ahead of expectations.
The portfolio slightly underperformed its peer group over the second quarter. We saw strong outperformance in Japan and developed Asia. We also had a good relative performance in the emerging markets and in the US. This was somewhat offset by slightly lower relative performance in our European and UK equities’ sleeves.
AXA Investment Managers made no significant change to asset allocation within the portfolio, maintaining a large position in cash and commensurate underweighting in bonds and duration. When compared with our peer group, we own no alternative assets and are overweight in listed equities as a result.
Market valuations look only fair rather than compelling. Continued positive earnings revisions will be required to sustain share prices. Brexit negotiations present a potential headwind particularly to the UK economy. The start of an unprecedented unwinding of monetary stimulus and its impact on the global economy bear watching. Concerns about the Trump administration’s legislative agenda also remain. Nevertheless, with a reasonable global growth outlook we are comfortable with our bias towards equities rather than bonds.
Elections in the UK and France produced contrasting results. The Conservatives failure to produce an outright majority caused uncertainty while the French result has bolstered confidence at the core of Europe leading to strength in the Euro.
The oil price was weak during the period with a rally starting just before the quarter end. This weakness helped to lower any inflationary pressure, with bond prices being strong until the latter weeks of the quarter when coordinated talk of interest rate rises by central bankers caused a reverse.
The UK equity market made market progress despite weakness in the oil majors. In contrast HSBC was strong as all the major US banks passed stress tests enabling higher levels of dividends payments.
Reflecting the uncertainties in the UK economy, stocks with a domestic bias were weaker with the portfolio being affected via holdings in DFS Group, ITV, Pendragon and Topps Tiles. In addition, Vectura underperformed as one of their generic drugs failed to achieve approval at their first attempt. Continued strength in IQE was helpful to performance as was strength in Hilton Food, Low & Bonar and SIG Group.
During the second quarter, a holding in Rio Tinto was re-established and new holdings were bought in Forterra, Hollywood Bowl and PRS Reit. The holdings of Gattaca and GLI Finance were sold and after strength some profits were taken in Conviviality and IQE.
Central Bankers are indicating that the era of quantitative easing and rock-bottom interest rates could be coming to an end. They are likely to be very cautious in their approach needing to see that economic growth is well established. Within the UK the uncertainty caused by the general election is likely to slow the economy and with the inflationary pressures from the fall in sterling last year abating any increase will be very muted. Against this background, income producing assets should continue to be sought by investors.
UK Absolute Return
The surprise election outcome in the UK failed to derail the relative calm, as equity markets grinded higher over the quarter. Market volatility has also remained benign despite hopes around substantial fiscal action from the US fading a little further. Helped by a market-friendly outcome in the French election, the European economic rebound has brought greater balance to the global recovery story.
The portfolio made positive gains in the second quarter driven by the long side of the portfolio with financials positioning making the most notable sector contribution. The top performer was defensive and international business RELX (consumer services) where business trends so far in 2017 support further revenue and profit growth. 3i Group saw momentum continue, with strong full year results being reported by the private equity group. Within consumer services, ITV was a detractor as the latest trading update included advertising revenues being weaker than consensus expectations. On the short side, a position in a UK challenger bank detracted following strong deposit growth.
Brexit uncertainty remains a significant threat to the UK economy. With international businesses making up a number of core holdings however, the portfolio's overall exposure to the UK economy is modest and structured in such a way that performance should predominantly be driven stock-specific preferences. While the Federal Reserve moved away from quantitative easing, early Italian elections and the US debt ceiling debate could yet undo the benign volatility that has accompanied the grind higher in risk assets.
Global markets rallied in April after business-friendly, pro-European Emmanuel Macron became the clear front-runner for French president with his first-round win. Bullish sentiment sparked a sell-off in safe-haven assets. Despite a short-lived rebound after the strikes in Syria, oil prices declined sharply toward the end of the month as oil production increased and inventories rose unexpectedly.
The continued global reflation theme, albeit with softer inflation expectations, pushed equities and other risk assets higher in May. Emerging market equities topped asset class returns, buoyed by continued dollar depreciation. Despite political turmoil in the US and the spike in volatility mid-month, the leading US volatility index remains below its long-term average, supported by the steady economic environment and global expansion.
Geopolitical tensions and the attack in Manchester drove a bid for safe-haven assets, and nominals outperformed their inflation-linked counterparts. However, the inflation-linked bonds still delivered a positive return as yield curves flattened and the dollar index hit its lowest level since November.
Emerging markets continued to deliver positive returns through the quarter. The risk of trade wars declined, as the US did not name China a currency manipulator and the White House softened its stance toward the North American Free Trade Agreement (NAFTA).
The market reaction to Brazil’s presidential corruption scandal was largely contained and President Trump’s comments that the dollar is “too strong” were also supportive. The MSCI ACWI hit another record high, improved by tech stocks but also by greater breadth across emerging markets. Emerging sovereign debt modestly underperformed developed sovereign debt.
Losses in commodities offset some of these gains in other asset classes. Oil prices dropped as OPEC’s decision to extend its output cut for nine months fell short of hopes for even deeper cuts.
Through the quarter, global water, global infrastructure and inflation linked debt contributed the most to returns, whilst commodities detracted.
Index Linked Gilts
Despite higher inflation, gilt yields fell over the period with the 10-year down 0.11% and the 30-year falling 0.05%, as concern around the patchy nature of the UK’s economic growth and slowing retail figures raised concerns that the economy’s post-Brexit resilience may be waning, lessening pressure on the Bank of England (BoE) to raise interest rates.
Brexit dominated the tone over the period. Prime Minster Theresa May called a snap general election in a bid to strengthen in her hand in Brexit negotiations. However, the gamble backfired spectacularly with the Conservatives losing their slim parliamentary majority due to manifesto and policy concerns.
For the first time in two-and-a-half years, wages fell behind consumer price inflation (CPI), which is running well above target. The rise in CPI was due to an increase in airfares, electricity price hikes and transport insurance.
Despite tepid wages, the employment landscape remained strong with the percentage of people unemployed over the three months to April at its lowest level (4.6%) in more than forty years. Meanwhile, the employment rate (the proportion of people aged from 16 to 64 in work) stands at 74.9%, the highest since records began in 1971.
The second estimate for GDP growth (a measure of all goods and services produced) in the first three months of the year came in at 0.2%, a sharp slowdown from the 0.7% in the final quarter of last year. Since the first estimate, revised data on industrial production and construction in March disappointed. Services sector output growth was also revised down, which pulled the headline number lower. The portfolio has generally been positioned in line with the benchmark over the period.
Prior to the quarter, there was a great deal to give investors concern on the political front, with the Trump administration launching air strikes in Syria, bombing ISIL targets in Afghanistan and sending an aircraft carrier to discourage Kim Jong-un of North Korea from nuclear testing, together with political uncertainty ahead of elections in the UK and France.
In response to these uncertainties, the traditional safe investment havens, such as gold and US Treasury bills, gained. Europe was one of the strongest-performing regions over the month whilst, in Asia and emerging markets, equities made gains. May saw Emmanuel Macron elected as president in France, quelling fears that the country would swing to the right by electing Marine Le Pen.
French stocks and the euro rose strongly on the result, with indicators pointing to the highest levels of consumer confidence in the eurozone for a decade. In the US, the Federal Reserve opted to keep interest rates on hold at its monthly meeting. Boosted by this news, equities gained new ground early in the month. The Bank of England left interest rates on hold; only a ‘smooth Brexit’ would allow interest rates to rise over the next three years, according to the bank.
In Asia, encouraging news about the region’s growth prospects came from the International Monetary Fund, as it revised its growth forecast up to 5.5% for the year ahead. June saw a shock election result in the UK with the previous Conservative party majority wiped out in the national elections, resulting in a hung Parliament.
UK & General Progressive
The UK equity market extended positive returns despite a surprise result of no overall majority from the snap UK general election, whilst in France the election of President Macron was viewed positively by investors.
In the portfolio, we look to identify businesses we want to own through the cycle and consideration of both the upside and downside risks to investments has enabled the portfolio to navigate periods of market uncertainty.
We have been reassured by the number of holdings that have reported excellent results in recent months as we expect earnings growth to drive share prices over the medium term, whilst transient factors such as currency moves and political influences are not sustained. Corporate results from RELX, BAT, Wolseley, Merlin, Melrose and Compass have been in line with or exceeded our expectations.
Recent detractors to returns have included Shire after a competitor received approval to launch a generic version of Shire’s Lialda drug six months earlier than expected. Barclays reported weaker revenues at its investment bank, whilst the UK business remains stronger. Overall, the bank continues to trade at discount to its book value, whilst management seek to improve returns from its investment bank.
A number of the portfolio’s largest positions are international companies within the media, travel & leisure and tobacco sectors that are exposed to business and consumer spending. We continue to see a broadly supportive global macro-economic environment despite the US Federal Reserve gradually tightening policy, but a need to be selective within UK domestic exposure due to political-led uncertainty.
The second quarter saw a continuation of the strong performance of the emerging market (EM) high yield corporate bond market for the three months to end June 2017. This strong asset class performance came despite a pull-back in commodities prices, oil and iron ore in particular, as well as a general uptick in market volatility in a number of key countries in EM.
The main headline over the quarter came in Brazil, where audio tapes allegedly linking President Michel Temer to illegal “hush money” payments were leaked to the press and led to a widespread uptick in volatility in Brazilian assets. We also saw a resurgence of geopolitical tensions in the Middle East and in the Korean peninsula, as well as a general deterioration in the social and political landscape in Venezuela.
Against this backdrop, the portfolio still delivered positive absolute returns over the quarter. The main source of our relative underperformance came from our overweight positioning in Brazil, a trade which we have had a lot of conviction in over the past year and has been one of the top performing trades for us over the life of the mandate. But given the unexpected resurgence in political noise, this did lead to some negative returns for the portfolio, in particular in the distressed names we held such as CSN, Samarco, Andrade, and Odebrecht Drilling.
Aside from Brazil, we gave back some performance from our exposure in Noble Group in Singapore, who released a profit warning in advance of some poor first quarter results. On the positive side, our overweight positioning in Jamaica (Digicell) and Venezuela (PDVSA) and Argentina all added alpha for the portfolio.
Looking forward into the second half of the year, we maintain a constructive outlook for the EM high yield corporate market, underpinned by our high conviction bottom-up view of a benign default environment and improving corporate fundamentals. We retain our constructive view on Brazil, and on Latin America in general as it is the place where we feel there is the most value on offer given the risks.
Over the coming months we wait to get a further steer from the Federal Reserve over the likely pace of interest rate hikes, which should lay the foundations for the performance of risk assets for the remainder of the year, while in EM specifically, we continue to monitor developments in Brazil (indeed Brazil is the destination for the team’s next research trip).
High yield posted three consecutive months of positive performance during the second quarter and has had five months of positive performance during 2017. Spreads, which have compressed since last quarter, have remained range-bound during the second quarter. BB and CCC rated bonds were the top performers while C rated bonds suffered the most during the quarter.
A position in Valeant Pharmaceuticals was a top contributor during the quarter. The company has continued to make progress with its previously announced asset divestiture program, which has driven significant debt reduction. Additionally, recent prescription trends seem to suggest some early success with Valeant’s efforts to rebuild momentum in key brands.
A convertible bond position in Liberty Interactive increased its return over the quarter.
Brigade expects the credit to continue to tighten into the expected close of the General Communication acquisition in the first quarter of 2018. Finally, a position in Digicel Investments Ltd. added 0.11% to performance. The bond position has outperformed during the quarter following the refinancing of the company’s bank debt.
The largest detractor was a hedge via Iboxx High Yield total return swaps, which took away 0.13% due to the rally in high yield. A position in Noble, a leading offshore drilling contractor, hit the quarterly performance.
Although signs of the extended credit cycle continue to spark concerns of market weakness ahead, we continue to uncover compelling investment ideas in several sectors, including technology, chemicals, and healthcare. Considering corporate fundamentals, we believe that the risk of a US recession is relatively low over the next six to twelve months.
As such, we expect default rates to remain relatively contained over this same timeframe. While constructive on fundamentals, we are appreciative of the market valuations and the sharp move credit has experienced over the past 15 months. Therefore, we continue to rotate the portfolio, reducing lower quality credit as names reach price targets, and when adding new ideas to the portfolio, we are generally favouring higher-rated or senior secured opportunities.
Greater European Progressive
Burgundy had a positive return this quarter, ahead of the European market. Our top performing stocks were Heineken, Nestle and Sage and detractors included Imperial Brands, UBM and Roche.
This quarter provided a good example of our value investment philosophy because we reduced the portfolio weights of some of our top performers and increased the weights of some of our underperformers. For example, we added to Imperial Brands and Roche, which had among our weakest stock price performances and most attractive valuation multiples.
We trimmed Heineken and SAP, from among our largest weights down to normal-sized weights, after their strong stock price performance and lower margin of safety estimates (i.e. the discount of the stock price compared to our estimate of intrinsic value).
SAP is an enterprise software company. Its flagship product, SAP ERP (Enterprise Resource Planning), is used by some of the largest multinational companies to run their businesses. We think one of the many positive attributes is that switching costs are high.
Over the past 10 years, the software industry has experienced a tectonic shift. Enabled by improvements in internet-based technologies such as Amazon Web Services – a new breed of “cloud software” providers are challenging the incumbents. SAP has not been immune to these threats. However, the company has weathered the storm extremely well, so far. Its revenue and adjusted profits have more than doubled over the past 10 years while making painful but necessary investments.
Unfortunately, the market is becoming just as enthusiastic as we are about the future of the company and the management team. SAP trades at 22 times earnings, even after adjusting for share compensation expenses, making it one of the most expensive companies in our portfolio.
While Burgundy believes the future is bright for the business, the lower margin of safety at the current share price led us to reduce its weight within the portfolio.
Burgundy remains cautious, as valuation multiples of most good businesses are at elevated levels. We continue to position the portfolio in companies that meet both our quality and valuation criteria.
Portfolio returns were modest this quarter and in line with global indices. Our top performing stocks were Heineken, Nestle, and Canon. Our worst performing stocks were Cenovus, Autozone and Walgreens Boots, and we added to the latter two.
This quarter we capitalised on some developments in the market to improve the value and margin of safety in the portfolio. We sold our positions in Unicharm, Canon and significantly reduced our position in Philip Morris International. We added two new positions, Colruyt and a company that is still under accumulation.
Colruyt is among the highest quality grocers that we have come across in the world, and has been a long-term holding in our European portfolio that we manage for St. James’s Place. It has low costs and low prices for consumers, attractive profit margins and returns on capital, and a pristine balance sheet with net cash equivalent to almost 8% of market capitalisation and it owns approximately 90% of its stores. One of the many company executive meetings we had this quarter was an informative one with the CFO of Colruyt. As a family-controlled company, we remain confident that they are making investments for the long-term to remain well positioned competitively.
For example, they are thinking deeply about and investing to ensure that they are well positioned online in preparation for potential competitors like Amazon. This quarter, Amazon announced its intention to acquire Whole Foods in the US, which led to a sell-off of many retail stocks. Given the level of extra investments that Colruyt has been making, we think its current profits likely understate long-term earnings power. Colruyt has also historically been savvy about the timing of buying back their own shares, and they have been stepping up their buybacks lately.
We will continue to position our concentrated 15-25 stock portfolio in companies that we think best meet both our quality and value criteria, notwithstanding the challenging equity markets that are generally expensive.
International Corporate Bond
Returns over the second quarter were positive and much in line with the index; despite a more defensive allocation in a strong market, while at the same time experiencing some headwinds from interest rates.
The increase in interest rates in Europe detracted from performance of the portfolio which has a European bias as long-dated portfolio holdings especially within European Media and Telecom traded down across the board.
On the other hand, there was a strong contribution from security selection both from over and underweights and based on a broad number of credits. The largest single name positive contribution was due to an underweight as bonds of UK fashion retailer New Look traded down during the month due to continued concerns about decreasing sales and profit. Another large single name contributor was the overweight in data storage and service provider Veritas which are experiencing positive momentum on the back of improved financials.
During the quarter, the portfolio participated in 15 new issues. We saw a number of existing portfolio companies coming to the market such as the UK budget hotel operator Travelodge who refinanced existing notes with a senior secured floating-rate note which priced at an attractive spread.
We also saw new portfolio names such as Swedish financial services company Intrum Justitia coming with two EUR BB-rated bonds to finance the merger with Lindorff. Both bonds have an estimated equity cushion of more than 50%. Another new name was UK energy producer Drax, which came with two senior secured bond deals (a fixed-rated bond and a floating-rate bond) to repay an existing bridge facility and term debt.
Our short to medium-term outlook remains positive with healthy fundamentals and expected low default rates going forward. Nevertheless, we continue to focus on downside protection with a more defensive portfolio, which we would expect it to outperform in case of upcoming weakness.
Over the quarter, the top UK portfolio performers included Electrocomponents, 3i and WS Atkins. The latter rose sharply after becoming the target of a takeover bid in April.
Internationally, the Bank of China Hong Kong rallied on hopes that the Chinese government would announce supportive measures for the territory’s financial industry. Victoria’s Secret owner L Brands traded higher in early April after an expected fall in monthly sales was milder than investors had feared.
Laggards included Cisco Systems, which declined sharply after announcing a fall in its sales to the US government, and Occidental Petroleum, which was dragged down by falling oil prices. New positions included Manulife, an insurer well placed to increase its core return on equity in coming years; this seems underappreciated by the market and should drive the stock’s re-rating from current inexpensive levels.
Other new positions included PacWest, based on its share price weakness year-to-date, and Siam Commercial Bank, which looked attractively valued, particularly with the potential for a pick-up in its loan growth.
Over the period, we exited Six Flags Entertainment and Daimler, among others. For theme park operator Six Flags, we lost conviction in the stock’s growth potential. We sold automaker Daimler due to management’s inconsistent messages over capital expenditure. In the UK, we topped up positions in Centrica, Cobham and Johnson Matthey. We also exited National Grid and trimmed our position in Atkins.
Within fixed income markets, higher quality bonds currently offer better relative value, and additions included the Beckton Dickinson, Qualcomm and BPCE new issues. We increased our exposure to GKN, Centrica and Aviva, but cut back on Citigroup and exited HP Enterprise.
The Federal Reserve’s plans to continue with interest-rate rises suggest that prospects for the US economy remain broadly positive. Though mixed messages on trade prevail, recent rhetoric indicates a more pragmatic streak than earlier in the Trump presidency.
Improving data from Europe provides grounds for optimism however, much will depend on French president Emmanuel Macron’s ability to deliver far-reaching reform. Additionally, while any increases in interest rates in the eurozone and even the UK might indicate a move back towards a more “normal” monetary policy, they could certainly generate headwinds for the global economy in the near term.
The portfolio outperformed the wider global equity market in the second quarter. Major contributors to performance were found in the consumer staples, healthcare and industrial sectors – Shiseido, Alere, Anthem, Aena, SA and CSX respectively.
No sector detracted from performance overall, although WESCO International weighed most significantly on investment results. WESCO’s shares declined in price along with other industrial stocks in the market. There was nothing company-specific that triggered the drop. We sold our long-term investment Alere during the quarter due to the finalised takeover agreement with Abbott Laboratories. Japanese pharmaceutical company Shionogi & Co. and Japanese automaker Subaru were added during the period.
As bottom-up fundamental stock pickers we look to invest in businesses with growth potential where we aren’t asked to pay for that growth. In other words, we try to invest in businesses where the current market price trades at a suitable discount to our assessment of intrinsic value.
An additional criterion for making an investment is that we‘re looking for businesses that aren’t fragile – companies that have the potential to emerge stronger, from an economic downturn. This doesn’t mean that the share price won’t suffer in the short term during a downturn, although we would welcome the opportunity to buy a good company at a reasonable price.
An example of a non-fragile company is Affiliated Managers Group, a relatively recent addition to the portfolio. If capital markets perform poorly over the short term, Affiliated Managers Group share price will suffer. However, we believe they could be stronger when the recovery takes hold. To understand why, we need to consider the characteristics that make a business fragile. One trait of a fragile business is too much debt. The company’s debt-to-free cash flow is extremely low at roughly 0.5 times, meaning they could pay off their debts in only six months. Another characteristic is being a single product company with low barriers to entry.
While we avoid making top-down, macro predictions, we strive to own non-fragile businesses that can weather the inevitable economic storms and come through a downturn stronger than when they went in.
The portfolio performed well over the quarter. Adding to performance, HDFC Bank shrugged off India’s demonetisation disruption last November to report an increase in net profits, driven by strong asset growth and better than expected net-interest income.
Taiwan Semiconductor (TSMC) continued to benefit from the ramp up in sales of the Apple iPhone. Though the company has guided for lower growth in 2017, we believe this is still one of the best companies to own in this space and valuations remain reasonable.
On the negative side, Newcrest Mining declined, after an earthquake struck close to its flagship Cadia mine. No workers were injured; however, the company suspended operations at Cadia to assess the damage (though it reopened again fairly quickly). Meanwhile, Infosys disappointed, as revenues were again below expectations. The IT services company has struggled in the face of a continued challenging environment for banks, its major customer group.
We initiated a position in Ctrip, China’s leading online travel portal. We believe Ctrip’s near 80% market share puts it in a dominant position that could be difficult to challenge. The company benefits from China’s growing tourism industry, which we believe should provide decent long-term growth due to rising incomes and consumption upgrades. We bought Midea Group, a home appliances manufacturer in China which has decent growth prospects and has been increasing market share.
We divested Mediatek, as earnings has been weak due to rising competition in the smartphones chips space. Due to its earnings cut, its valuation is not as attractive as before; we believe the downside risk here outweighs its potential recovery.
We remain cautiously positioned as equity markets continue to be buffeted by geopolitical events. The status quo in Western democracies has, unsurprisingly, been challenged due to rising levels of global income inequality and public discontent. Although there have been positive signs of a revival in world trade growth in general and Asian exports in particular, we maintain our concerns around populism and the backlash against globalisation. Meanwhile, softer inflationary concerns coupled with an overly tightening bias from central banks has the potential to stamp out what little recovery there is.
However, as bottom-up investors, our focus remains on finding high-quality management teams and businesses that have, over time, delivered predictable and sustainable returns comfortably in excess of the cost of capital, despite the prevailing headwinds. We believe that finding and investing in these companies and holding for the long-term is the most important foundation for compounding financial value over time.
Global Emerging Markets
The portfolio underperformed during the quarter, underperforming the relevant MSCI benchmark. However, over the past 12 months, the portfolio produced a strong absolute return, rising 19.6%.
During the quarter, Greece, Turkey and Hungary were the strongest markets, while Qatar, Russia and Brazil were the weakest. The portfolio’s underperformance during this period has been related in part to the lack of exposure to the information technology sector, including Chinese internet companies such as Alibaba and Tencent. We continue to add value and generate positive returns in other sectors and geographical regions.
After conducting a review of our IT services holdings, we have made a number of changes. We have completely sold the holdings in Tech Mahindra and Infosys and bought a new position in Tata Consulting Services.
The rationale for selling Tech Mahindra is fuelled by concerns that management incentives are not aligned with that of minority shareholders. The firm’s acquisition of Pininfarina, an Italian car design agency has also eroded our confidence in the capital allocation discipline of this group.
In contrast, Tata Consulting Services deliberately makes fewer acquisitions than its competitors. It is a ‘fast follower’ that provides opportunities for its most talented employees to be more entrepreneurial.
The portfolio’s positioning has not changed dramatically since last quarter and continues to have a bias towards companies listed in markets that bore the brunt of commodity price declines, such as Brazil, Chile and South Africa. The resulting economic shock resulted in weaker currencies, more attractive valuations and the tantalising possibility of improving national governance.
Enthusiasm for the emerging markets equity opportunity continues to increase resulting in strong flows into the asset class. While positive in the near-term, this does increase our level of overall caution. However, with a long-term perspective, 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 portfolio benefitted from positive performance across a broad range of sectors. The largest contribution came from our allocation to subordinated financials. Duration was a slight negative following the spike higher in yields at the end of the month. However, given our overall low level of interest rate risk in the fund losses were limited.
European high yield bond markets delivered a positive return over the three months to 30 June. Helping to influence returns was the positive economic data showing the strength and depth of the economic recovery in the eurozone and a reduction in political risk following the election of pro-market candidate Emmanuel Macron to the office of French President.
Toward the end of the quarter, there was a shift in the rhetoric from central banks that led to speculation about when the European Central Bank will begin reducing its current level of economic stimulus. Bund yields rose strongly as a result. However, for the high yield bond sector this was offset by the higher income such bonds pay.
The portfolio’s high yield exposure is focused on higher quality companies that we considered have a lower risk of default. We also have significant holdings in non-traditional parts of the high yield bond market. This includes bonds within the financial sector and junior non-financial bonds with equity-like characteristics known as corporate hybrids. We also have some exposure to US corporate bonds, which due in part to the divergence of US and European monetary policy can pay a higher level of income.
Performance was positive with contributions spread across a wide range of ideas. We prefer French equities to German and Italian equities and this boosted returns as French equities rallied following the result of the first round of the presidential elections and the ultimately convincing victory for President Emmanuel Macron.
At the same time, our equity and credit ideas were broadly positive despite a pull back towards the quarter end as global equities continued to test all-time highs. Our ‘Equity – Selective Asia’ idea was a standout as Asian equity markets benefited from a more benign outlook for global growth and our ‘Equity – UK’ and ‘Equity – Global’ ideas were also significant contributors during the quarter. Similarly, our ideas giving exposure to corporate credit ‘Credit – US High Yield’ and the Europe-focused ‘Credit – Selective Credit’ idea also helped fund performance, even if the rallies appeared to be losing some momentum towards quarter end.
On the downside, the potential for a pro-European French president sent the euro higher against the US dollar, which detracted from performance in our ‘Currency – US Dollar vs Euro’ idea. This theme continued through the quarter as, increasingly, the US lost its monopoly on economic optimism and the Trump rally continued to unwind. Despite a hawkish Fed, stronger economic data and suggestions of an upcoming rate hike in Canada alongside the European Central Bank’s shift in tone, caused both the Canadian dollar and the euro to appreciate relative to the US dollar.
Two new ideas were added to the portfolio, three were removed and there were significant changes to the implementation of five ideas. Our ‘Equity – Dispersion’ idea hopes to take advantage of the continued low correlation between S&P 500 constituents and the index itself and our ‘Commodity – Short’ idea uses derivative indices to express a negative view against an index of energy and base metals. We closed our interest rates ideas in both Japan and Europe. We also closed our ‘Currency – Long Sterling’ idea, which derived an income from selling options, this implementation looked less attractive after an appreciation in the UK pound and lower volatility.
Global equities enjoyed another strong quarter, with emerging markets continuing their recent trend of outperforming developed markets. Central banks featured prominently over the quarter; as expected the US Federal Reserve raised interest rates in June, while the European Central Bank and Bank of England hinted that the prospect of higher rates may be closer than previously expected.
Geopolitical risk was fairly subdued, although the unexpected tightness in the UK general election did see UK equities underperform. The portfolio delivered a positive absolute return and outperformed the benchmark index.
Within the portfolio, our zero-weighting to energy stocks was the largest contributor to returns relative to the benchmark. The second quarter proved to be another volatile one for energy markets, with the oil price finishing down 9.3% for the period.
Consumer goods company Nestlé was our top performing stock over the quarter, aided by news that activist hedge fund investors Third Point had taken a small position in the stock. Our position in IT services company Amadeus was also a strong contributor to relative returns. Its reservation system, used as a point of access for booking airline seats, continued to show better-than-expected growth.
Elsewhere, positions in elevator manufacturer Kone and pharma giant Novartis also proved profitable. More negatively, tobacco company Imperial Brands was the worst performing stock in the portfolio due to weaker half-year profit and revenue figures.
During the quarter, we initiated a position in global healthcare company Abbott Laboratories. We believe this is an attractively valued high-quality business with a strong outlook for both income and capital growth, and where capital allocation is increasingly being directed to its higher-margin, faster-growing, more differentiated platforms. Elsewhere, we added to our existing position in British American Tobacco, AB InBev and Japan Tobacco, on short-term weakness.
Despite the seemingly positive noises coming from the global economy, and a backdrop of more hawkish monetary policy in key developed economies, we continue to believe that the economic recovery remains uncertain. Yet despite this uncertainty, we still believe there are opportunities to make money in global equities, following a quality income approach.
The portfolio outperformed during the quarter. There was a number of positive contributors, notably Capita, Safran, Sugi Holdings and Japan Tobacco. Capita, a UK business processing company, has been a major detractor in recent quarters, so it was pleasing to see the company confirm the disposals required to strengthen its balance sheet.
Further dollar weakness was a drag on performance, both directly in the cash balance and also in the relative performance of domestically-focused US distributors: TJX Companies, O’Reilly and Advance Auto Parts. The latter two stocks were added to the portfolio during the quarter, as we took advantage of share price declines following some weak trading updates. The shares continued to fall after our purchase, and we have been adding steadily since, as we believe that the trading weakness is temporary and not the result of a structural challenge from Amazon.
We have also taken advantage of recent commodity price weakness to add a third oil producer, Royal Dutch Shell, as well as two mining stocks, Rio Tinto and Norilsk Nickel. Both miners meet our quality criteria, being best in class, low cost producers of iron ore and nickel respectively, with strong balance sheets and sensible dividend policies. Of course, their short-term earnings and share prices are sensitive to movements in commodity prices but their ability to generate cash even at the trough allows us to look through short-term volatility and focus on the long-term franchise value.
Despite increasing the number of stocks during the quarter from 32 to 35, the cash balance remains close to its limit of 20% because we have reduced the weight of quite a number of positions where the risk/reward equation looks less attractive. In most cases, this is because of strong stock price performance – for example Oracle, SAP, Cognizant, Wolters Kluwer, RELX, Unilever, Wartsila (sold to zero), Edison International, and Ain Holdings. We have also sold Japan Tobacco at a modest profit, as we are uncomfortable with what is becoming a binary risk on the success of their t-vapour product, Ploomtech. We prefer to monitor this situation from the sidelines.
UK General and Progressive
The UK general election was a reminder that political risk is now a prominent feature of the investment landscape. After the electorate effectively decided to vote for "none of the above", the short-term political outlook for the UK is unclear ,as the Brexit negotiations start in earnest. A minority Conservative government propped up by the tiny Democratic Unionist Party and led by a prime minister shorn of all authority is a terrible starting point for these challenging talks.
The wider story, though, is that the UK (along with the US) has lost confidence in the benefits of free markets and free trade. We saw this in the Conservative party's campaign manifesto, which was a far cry from the Thatcherite worship of market forces as deliverer of the best outcomes for consumers, and in the election result itself, with a far better than expected showing for Jeremy Corbyn's Labour party and its heavily left-wing agenda. Political attitudes seem to be shifting leftwards, particularly amongst the young.
With faith in market forces fading, the risks of greater state intervention become more acute. High-earning sectors (e.g. technology) or monopolies should be wary of the government stepping in to re-distribute profits deemed to be excessively high. And with the public seemingly exhausted by the perceived austerity policies of the past seven years, the balance between cutting public spending and raising taxes could well be moving in favour of the latter.
Since the global financial crisis, the central bankers have called the shots. Their actions – extreme monetary policy, including quantitative easing – substantially inflated the wealth of the asset-rich but did little for large swathes of the population. The backlash is now well under way; we have already seen that in the Brexit vote and Trump's election. The omnipotence of the central bankers has reached its limits as politicians reassert themselves with populist, redistributive agendas. Investors would be wise to heed this shift in the political tectonic plates.
Investment Grade Corporate Bond
Corporate credit continued to outpace government bonds due to healthy profits and strong investor demand. As a result, our corporate credit positioning was a strong contributor to outperformance, especially within the financial sector. Overweight allocations to banking and insurance were quite positive, as were holdings in the communications sector.
In particular, allocations to BBB-rated and high yield corporate bonds within these segments lifted results, as they generally outpaced higher-grade names during the quarter. The overweight to the energy sector detracted as the decline in global oil prices sparked a fear of another squeeze on industry profit margins. An underweight allocation to the US dollar pay technology sector also detracted as it was one of the best performing industries during the period.
Security-specific selections aided performance. Selection among UK and French banks performed well. Select issuer decisions within capital goods and emerging markets also contributed positively. Bond selections within the consumer non-cyclical, consumer cyclical, and REITS (real estate investment trust) sectors detracted slightly as issuers held in the portfolio lagged comparable bonds.
Market participants face a long list of global risks. Uncertain global tax and trade policies, geopolitics and potentially higher real yields in developed markets could all serve as catalysts to dampen investor risk appetite. For now, we believe cautious, measured changes in monetary policy, and improving growth and earnings should provide a favourable environment for corporate and other fixed income credit sectors to outperform.
We expect the Fed to raise rates four more times through the end of 2018, though the timing of these hikes is still uncertain due to the potential for fiscal stimulus and further acceleration in wage pressures. We continue to see relatively accommodative monetary policy from other central banks, though we expect the European Central Bank, Bank of England and other Commonwealth banks to shift away from easy policy slowly and gradually. In emerging markets, disinflationary pressure in many constituent economies should allow for generally more accommodative policy and bond market outperformance.
Global stocks set record highs in the June quarter after US companies posted better-than-expected earnings, readings showed the US economy was expanding sufficiently, and the Federal Reserve reconfirmed that monetary policy would only be tightened gradually. Gains were capped when higher bond yields and the Conservative Party’s unexpected loss of its parliamentary majority in the UK election undermined European stocks.
The portfolio recorded a positive return in the quarter. At a stock level, the best performers included PayPal, McDonald’s and Nestlé. PayPal gained 25% after it announced a US$5 billion share repurchase program, and as better-than-expected first-quarter earnings allowed the company to boost annual guidance. McDonald’s jumped 19% after first-quarter same-store sales growth beat expectations due to pleasing growth in the US, where the company’s more focused execution is winning customers. Nestlé rose 12% in anticipation that cost-saving measures will boost profit margins.
Stocks that lagged included investments in Lowe’s and Apple. Lowe’s fell 5.4% after the US home-improvement chain posted first-quarter comparable-store growth that was below that of The Home Depot. Apple rose 0.6% but a drop in the US dollar turned this small gain into a detraction in pounds.
Over the quarter, the manager sold a position in Qualcomm due to the uncertainty surrounding legal challenges by Apple and the US Federal Trade Commission over royalty rates tied to Qualcomm’s licensing business – the business accounts for most of the US chipmaker’s profits. There were no other significant trades.
We are cautious about the outlook. Abnormally loose monetary policies have distorted asset markets, particularly equities that are sensitive to changes in longer-term interest rates. Developments in North Korea and in Sino-US trade and diplomatic relations need to be watched.
Notwithstanding this uncertainty, we are confident about the long-term outlook for the stocks in the portfolio because they are favourably positioned towards growth in consumer technology platforms, the shift in enterprise expenditure to cloud computing, ageing populations, and the move towards a cashless society.
UK Growth and UK & General Progressive
The portfolio returned 0.3% over the quarter, slightly underperforming the FTSE All-Share index return of 1.4%.
There was an apparently coordinated move by central banks to announce collective intentions to set off down the path of monetary policy normalisation. Against this backdrop, we continued to shift the portfolio to a more defensive shape. By doing so, we have positioned the fund in stocks and sectors that offer support from both low valuation and depressed expectation. As such, short term performance has been weighed down by these moves, but our conviction in the validity of these moves has actually hardened.
Markets are at a critical juncture. Valuations are rich, and labour markets across the G7 are tight. Corporates are levered, so too hedge funds. Volatility has been crushed and complacency abounds. Distortions from passive and smart beta products have pushed stock prices to levels that are, in some sectors, increasingly dislocated from fundamentals.
The central banks see risks in the system. Policy has inflated financial assets, leaving many workers feeling isolated and frustrated with stagnant pay packets. There is a concern, though, that if they don’t tighten now, it will be too late. Inflation has been thus far absent but could rise, leaving them with little option but to raise rates aggressively.
We believe that markets are likely to be challenged by this normalisation and that the risk of policy error is high. And all this at a time when we are beginning to see evidence of stress in pockets of the economy, in areas such as auto finance and credit cards – hence our move to a more cautious footing.
The shares of Tesco weighed on performance over the period. Despite evidence of ongoing operational recovery, the market fretted over the implications of Amazon’s purchase of US listed Whole Foods. We believe that Tesco is on track to hit its margin targets and that, with an inflationary tail wind, the share price will re-rate. Anglo American gave back some of last year’s gains as the commodity complex came under pressure, and Barclays drifted lower as the investor appetite for the sector remained subdued. On the positive tack, our holdings in Electrocomponents, Ryanair and Rentokil performed well.
The portfolio returned 2.4% over the quarter, outperforming the 1.4% return of the FTSE All-Share index by 1%.
Politics, mixed economic data and high profile comments from central bankers continued to colour the vista during the period. Whilst keeping a keen eye on these developments, we continue to focus on stock fundamentals and on identifying those companies with the potential for operational change.
It was pleasing to see a number of long-held names continuing to drive performance over the quarter, as the operational change our analysis had identified came through. In terms of individual stocks, Legal & General continued its strong post-Brexit recovery, posting some strong results and improved balance sheet. IAG, the parent company of British Airways, has also done well, supported by the fall in the oil price.
On the negative side, our energy holdings were weighed down by weakness in the oil price, as stubbornly high inventories in the US more than offset what is a robust demand backdrop. This has not been a surprise, hence our holding in IAG, but we expect the current surplus to clear, leading to a tighter supply-demand dynamic in 2018. Our Exploration and Production (i.e. upstream) holdings, continue to offer us attractive upside in such a scenario.
We remain optimistic about the portfolio, with many names now delivering an operational upgrade that is coming through in the numbers. And the market is starting to reward these companies. Our two biggest positions remain in financials and oil & gas. Financials are beginning to see a bit of a revenue tailwind in terms of interest rate rises, and we remain constructive on the oil price into next year. At this point in the cycle we see opportunity in the big UK-listed large cap stocks and it is here where we have been recently allocating our capital.
Global Equity Income
Global equity markets advanced over the quarter, ensuring a strong first half of 2017. A recovery in corporate earnings, as well as continued accommodative monetary policy from most central banks, supported share prices. Europe was the strongest-performing region as the economic and political outlook improved. The US Federal Reserve Board (“Fed”) raised interest rates in June and gave an optimistic outlook for the US economy. Energy was the worst-performing sector, as a result of volatility in the price of oil, which in turn stemmed from an increase in global supply.
Stock selections in the IT and industrial sectors contributed to the strategy’s performance. Individual contributors included Oracle, Nestlé and Heineken.
Stock selections in the healthcare and telecoms sectors detracted from performance. Individual detractors included Koninklijke Ahold Delhaize (“Royal Ahold”), Roche Holding and Total.
During the quarter, we added Affiliated Manager’s Group, KDDI and Johnson Controls International to the strategy. We sold the strategy’s positions in Macy’s and Ralph Lauren.
We believe global markets should continue to fare well in 2017. However, deflation continues to be a risk, as does persistent political uncertainty – not just in the US, but also in relation to the upcoming German and Italian elections and Brexit negotiations. That said, we believe political risks in the eurozone have subsided, leading to a lower probability that the euro will fall sharply. With this renewed stability, we have removed the strategy’s currency hedges.
We believe markets are currently in a valuation-rich environment. Against this backdrop, we will focus on companies that have enduring businesses, strong management teams with solid track records of effective capital allocation, strong balance sheets, and sustainable yield with free cash flow. We continue to view the US financials sector positively, although we remain cautious towards the European financial sector. We also continue to favor sustainable, quality franchises within the consumer staples sector. We maintain a negative view of the utilities sector as a result of high valuations.
Despite the recent oil commodity weakness, the broader high yield bonds market has held up well, ending the second quarter up 2.06%. Energy, broadcasting, utilities and retail were the main laggards in the high yield market in the second quarter, while healthcare was a notable outperformer.
The portfolio outperformed the broader market over the quarter, finishing up 2.67% in sterling terms. This performance was primarily driven by strong name selection and an underweight towards the energy sector. Performance across the top 10 winners was fairly balanced. On the losing side, detractors were fairly modest with only one issuer (Albertson’s) detracting by more than 0.01%.
We initiated several new positions this quarter, while also reducing exposure to a number of positions that we believed no longer offered attractive yields. Some of the larger positions initiated included Tempo Acquisition and Bumble Bee Foods. With respect to Tempo, a human resources services company, we believed the 6.75% bonds offered good relative value from a very stable company. As for Bumble Bee, the company is currently refinancing the capital structure, which enabled us to establish a position in the pre-existing high-coupon bonds that we believe offer an attractive yield to call. Looking ahead, we believe the book has a number of positions that offer an attractive combination of yield and total return potential.
Other than further energy weakness, we believe political headlines around the passage of a healthcare bill (and the implications for potential near-term tax reform) may prove to be the biggest factor for high yield total returns in the second half of the year. The default rate in high yield has been very low at 2.7% (1.5% ex-energy), and we expect this to continue, as capital markets have been open for companies to refinance. We expect muted volatility in the coming months.
In the face of these market conditions, our focus remains on finding positions that offer an attractive combination of yield and total return potential, and we remain poised to opportunistically trade into positions that we believe offer the potential for attractive returns should Fed- or commodity-related volatility increase.
International Corporate Bond
Investors were in a bullish mood in the second quarter, buoyed by a relatively resilient US economy and low interest rates around the globe. While equities couldn’t match their phenomenal first quarter return, the S&P 500 still gained 3.1%.
High yield bonds extended their rally during the quarter. Notably, however, performance was front loaded, with the asset class barely eking out a positive return in June following a strong start to the period. The major culprit was declining oil prices. After booming in 2016, the energy sector weakened during the period. In fact, the oil and gas producers and oil equipment providers, the stars of 2016, both ended the quarter in negative territory.
The portfolio benefited from credit selection in several different sectors. In particular, holdings in the satellite, metals and mining industries added value.
Credit conditions in the high yield bond market were sound during the second quarter, and we expect the default environment to remain benign for the balance of the year. We may see a pick-up in bankruptcies in the retail space and the energy sector is vulnerable to any slide in oil prices, but we wouldn’t be surprised if the 2017 market default rate is in the 2% range, about half last year’s rate.
While the Fed appears poised to raise rates, reflecting confidence in the state of the US economy, we don’t believe high yield bonds will be singled out. Their moderate duration makes them less sensitive to rising interest rates than longer-duration investment grade securities.
Our priority continues to be to earn our coupon, avoid defaults and minimise credit losses. Over the more than thirty years we’ve been managing high yield bonds, we’ve found that’s the best approach to adding value over the long-term.
It is hard this early to assess the impact from the 2017 general election on the property market, but so far not much seems to have changed. Interest rates continue to remain low, although with inflation now rising, an increase in the Bank of England base rate now seems more likely this year than it did only recently. Compared to the ten-year gilt rate, property yields remain higher than longer term averages and, on that relative basis, are better value now than perhaps ten years ago.
The trend of muted investment volumes in the UK commercial property market continues primarily due to a lack of good quality stock rather than lack of investor demand. Indeed, the level of overseas and UK institutional capital targeting UK commercial property remains close to a historical high.
Against that backdrop, we have acquired two assets during the quarter with a total investment value of £54.1m. These were both newly refurbished central London offices: the first in Hatton Garden, an improving mid-town location set to benefit from the nearby Farringdon Crossrail station, and the second in Camden, an office property that has seen significant improvements. Both offer flexible space attractive to a broad range of potential tenants at rents discounted to prime City and West End rents. Both properties are multi-let and should provide solid income with good prospects for rental growth.
Occupational demand remains strong across the portfolio, with occupancy levels in excess of 95%. We have seen an encouraging level of new lettings and lease renewals, particularly in the office and industrial sectors. Over the quarter, we have signed new lease commitments for some £2.9 million of rent over approximately 185,000 square feet of space.
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, they are well placed to deliver sustainable income with scope for growth. The income-dominated style of return from commercial property continues to make the sector a valid component of a diversified multi-asset portfolio.
Global Smaller Companies
In the second quarter of 2017, Western Europe again drove benchmark returns, rising roughly 10% in dollar terms. Japan was another strong geography, whereas the US and most other markets generally rose more modestly. A resurgent pound reduced global dollar returns of over 4% to less than 0.5% as measured in sterling terms. The fund outperformed in every major geography during the quarter, led by strong results out of the UK and US.
We’ve seen some wind come out of America’s sails as first quarter GDP came up short, and signs mounted that the US auto cycle is peaking. The euphoria of the early months of the Trump administration has given way to a more measured outlook for private/public investment, and for consumer spending. In Europe, output continued to rise at a relatively brisk pace, albeit with some deceleration in June. The fund remains significantly overweight Europe, and particularly the UK, where we find valuations most compelling.
Top contributors for the period were Equiniti (UK), Havas (France), and Novanta (US). Business process services provider Equiniti rose early in the quarter on a solid trading update, and rose further following the sale of a competitor to a strategic buyer. Ad agency Havas received a takeover offer from Vivendi, which shares a common controlling shareholder. Photonics specialist Novanta reported very strong first quarter results, including double-digit organic revenue growth.
The largest detractors were Pioneer Foods (South Africa), Eastman Kodak (US), and ON Semiconductor (US). Pioneer Foods suffered due to weak earnings and increased restructuring costs, as well as the end of talks with a potential strategic acquirer. Imaging specialist Kodak disappointed investors with both its 2017 guidance and the aborted sale of a division. ON Semiconductor traded down on the weakening North American auto sector. We remain encouraged by the company’s opportunities to expand its content per vehicle thanks to a number of trends, including vehicle electrification, autonomous driving, and in-vehicle networking.
Diversified Bond and Multi Asset
Financial markets marched higher through most of the second quarter, before taking respite at the end of June. The Federal Reserve’s fourth interest rate hike since its tightening cycle began was largely anticipated, but the plans it announced for winding down the balance sheet had a more pronounced impact on the market.
On the political front, President Trump faced continued delays in implementing his plans for tax cuts, deregulation, and infrastructure spending. In the UK, the prime minister’s snap parliamentary election backfired as her party lost its parliamentary majority, which weakened her position ahead of Brexit negotiations.
Increases in European consumer confidence and business expectations helped the euro reach a 52-week high at the end of June after ECB President Mario Draghi declared that ‘deflationary forces’ had been mitigated, spiking tapering fears and driving yields on European sovereign debt higher. Despite the bear market in oil, risk markets remained well-bid and had positive total returns on the quarter.
The portfolio remained structured to limit interest rate sensitivity as we continued to invest in a diversified mix of fixed income sectors including corporate, mortgage-backed and asset-backed securities. Given the high global demand for corporate credit, we remained active in the primary market in order to optimize security selection. The core income component benefitted from the positive tone in risk asset markets and from credit spreads tightening through the quarter.
The portfolio’s selection of legacy non-agency mortgage-based securities and government-sponsored enterprise risk-sharing deals was the top contributor on the quarter as these sectors remained insulated from the interest rate volatility. The emerging market and high yield allocations also added to performance as the coupon advantage offset the slight widening of spreads due to the weakness in commodity prices.
Currency positioning also benefitted performance, notably the short positions in the euro versus the Norwegian krone and the Australian dollar versus the Japanese yen. Our tactical positions in the credit markets contributed to performance, as credit premiums compressed relative to government bonds. Trades aimed at capturing potentially higher volatility detracted modestly, as volatility remained subdued.
The UK equity market has made steady if unspectacular progress in the first six months of the year, as fears of a sharp Brexit-induced slowdown in the UK economy have so far been largely confounded, although more recently there have been signs that consumer confidence is weakening and that the economy is slowing.
The strong equity returns enjoyed in the last few years have been largely prompted by the extraordinary actions of the world’s central banks who, through quantitative easing, have suppressed interest rates and ensured abundant liquidity. In the last few weeks, however, there has been a change in tone from some of the central banks, suggesting an increased resolve to return interest rates to more normal levels sooner than had been expected.
The portfolio marginally outperformed the wider market in the three months to the end of June. Investment returns were helped by good performances from financials HSBC and Legal & General – both banks would benefit from a moderate pick up in interest rates. Rolls Royce rose as the management team reiterated its long-term targets to restore the company’s profits and cash flows from low levels.
Conversely, Tesco declined on the news that Amazon will be buying Whole Foods of the US. Whilst the move underlines Amazon’s determination to move into the grocery sector, we believe that the dynamics of the grocery market are different from those of non-food retailing, and that the established food retailers can continue to make acceptable levels of profit in a competitive but orderly market.
Crude oil prices were notably weak in June as stockpiles continued to rise. So far, the agreed OPEC production cuts don’t seem to be offsetting production increases elsewhere, whilst demand remains lacklustre. Whilst the big oil companies have surprised in their ability to cut costs and restore profitability in a low oil price environment, this latest leg down in the oil price led to the underperformance of their share prices over the period.
Whilst it is not possible to know how stock markets will fare over the coming months, we recognise that it is the extraordinary actions of the world’s central banks that have pushed stock valuations to high levels. History has shown quite conclusively that high starting valuations have a strong and inverse correlation to future investment returns and, accordingly, we think it is in the unit holders’ long-term interests to remain cautiously positioned and have cash on hand, in order to take advantage of the better stock opportunities that are likely to arise in the future.
Continental European and Greater European Progressive
We marginally underperformed the market over the quarter. On the positive side, we benefitted from strong returns in SEB, Commerzbank, Intesa, Eurofins and AP Moeller . On the negative side, we were hurt by weakness in Banco Popular, Vallourec, STM, Yara and Nokian.
The European economic outlook continues to improve. Most notably, the German Ifo – the business sentiment indicator – reached its highest level since reunification in 1991, prompting the president of the think-tank to describe the mood in the business community as “euphoric”. The Eurozone Purchasing Managers Index (PMI), furthermore, rose from 56.7 in April to 56.8 in May. Interestingly, the euro has also risen by 7% year-to-date against the dollar.
The outlook for the British economy, however, appears less certain. Whilst the economy so far appears largely unaffected by the Brexit vote, we will only begin to have some idea of the real impact of the vote as negotiations gain momentum over the summer.
The outline of a possible deal with the EU may well only really emerge in 2018, and perhaps even later. The victory of Emmanuel Macron in the French presidential election has confirmed our view that the European project rests on stronger foundations than many believe. For most Europeans, the European Union is seen as something much more than a mere trade agreement; rather, it is seen as a way of bringing together countries which have warred with each other for centuries. For many, it is a single voice that can negotiate in all fields of political life with a strong America, China and Russia. It is also seen as a guardian of liberal values.
The election cycle following Brexit has amply supported our analysis. While some argued that Brexit would lead to the immediate collapse of the eurozone, the reality has proved very different. European markets are good value compared to the US, trading at an unusually large 36% discount to the US – many domestically-orientated companies trade at even heftier 50%+ discounts.
For the quarter ended June 30, 2017, the portfolio advanced 6% (in sterling terms) versus an advance of 0.4 percent for the MSCI All Country World Index. The IT and consumer discretionary sectors were the top contributors to relative investment results. The technology sector’s strength continued in the second quarter, as positive investor sentiment and solid business results from the sector buoyed share prices globally. No sectors detracted from results during the quarter. On a regional basis, the US/Canada and Emerging Asia contributed most to relative results, while Western Europe was the sole detractor.
On a relative basis, the top individual contributors to investment results were Alibaba, Whole Foods Market, Regeneron Pharmaceuticals, Edwards Lifesciences, and Maruti Suzuki. The top relative detractors from investment results were Biogen, Galapagos, ASML Holding, UCB and ASOS.
During the quarter, we purchased Galapagos and Incyte, and sold Biogen, Ono Pharmaceutical, and UCB.
A series of de-risking factors contributed to strong performance in European equity shares, which lagged US-domiciled companies since 2009. In the second quarter, Emmanuel Macron’s victory in the French presidential election was perceived as stemming the populist sentiment sweeping Europe, leading to gains in stocks and in the euro. Improving data — including Eurozone nominal GDP growth, purchasing managers’ index readings, and a strengthening German business environment — further supported gains in shares. These developments likely contributed to a renewed interest in European equities, as seen in financial news headlines and record flows into equity funds.
While we acknowledge these developments as positive, we maintain our melancholy view on the region, given persistent tail risks. We still believe the risk of eurozone and EU dissolution is a legitimate concern. In our view, a strong external tailwind is required for EU countries to grow under a common currency, given their vast structural differences. This disconnect in productivity may lead to heightened political tension, which could be exacerbated by other factors such as Brexit execution, European central bank policy, and the refugee crisis.
We believe other risks include an appreciating euro, ageing EU populations, banking sector problems, and the impediments to continued French economic momentum. Despite nascent improvements in economic data and sentiment, we believe these interrelated risks continue to create a high bar for businesses domiciled in the EU and UK – or those that simply generate a substantial portion of their revenues.
The portfolio continued to deliver on its income objective through a combination of dividends from the global equity portfolio and the sale of equity upside potential (the call overwriting programme).
Global equities advanced again in the second quarter in local currency terms with higher-yielding stocks underperforming the broader market. The investment strategy was adjusted in June to reflect the implementation of foreign exchange (FX) hedging. The portfolio posted negative returns as the FX impact during first two months of the quarter outweighed that of equity market moves.
The net dividend yield realised over the last 12 months for the global income basket was approximately 4.2%, exceeding the target of close to 4%, as determined by the basket. The equity portfolio returned around -1.5% in sterling terms over the quarter.
Weak returns can be attributed to the weak stock performance in consumer sectors, the United States and Australian banks, all of which offset positive relative returns from Switzerland, Germany and industrials. Furthermore, prior to implementation of the FX hedging programme, the relative strength of sterling weighed on returns, to the tune of 2.0%.
The recent global bond sell-off can be considered as evidence of rising investor concern that accommodative monetary policy will reduce, and that interest rates may rise. Higher-yielding stocks may underperform broader equity markets in such an environment. Our preference for higher quality companies, which are more likely to maintain or grow their dividends, should protect the yield of the basket as a whole.
The portfolio generated a rolling 12-month yield of around 2.7% from the call overwriting programme. Volatility in the global equity basket remained low and below the risk budget available, thus the systematic downside risk management mechanism was not activated over the period.
Over the quarter, the portfolio continued to provide investors with access to equity returns with embedded risk controls to reduce the likelihood of material loss. The portfolio delivered significantly positive performance as global equity markets advanced strongly in a low volatility environment.
Global equities rose again in the second quarter, with a number of key markets carried past historic highs by a strong earnings season and benign economic data. Political risk eased during the quarter, following the market-friendly outcomes of the Dutch and French elections.
The S&P 500 recorded a gain of 3.1% in US dollar terms over the quarter. US equities advanced despite some mixed macro-economic data and amid political uncertainty over the ability of the US administration to push through its fiscally expansive policies.
Eurozone equities advanced in the second quarter in euro terms. Reduced political risk, a positive economic backdrop and improved corporate earnings all helped to support share prices. However, the end of the quarter saw a pullback over concerns that economic stimulus measures would soon be withdrawn.
In the UK, the FTSE All-Share index rose 1.4% over what was a volatile quarter. Having failed to make progress in April, the market performed very well over May before lagging in June.
In Japan, after posting losses early in the period, equities climbed rapidly, ensuring very strong net quarterly performance in local currency terms.
The US dollar depreciated versus major global currencies, boosting returns on the MSCI World in dollar terms.
Volatility stayed low over the period as global equity markets continued their bull trend. Despite fleeting periods of relatively higher volatility, it was consistently below the target level and exposure to global equity markets remained high. This resulted in the volatility-targeted equity exposure delivering strong positive returns.
The put option overlay fell in value over the quarter as the underlying volatility target index rose. This detracted from returns over the period. On balance the risk control techniques in place both reduced the likelihood of large losses and delivered strong equity driven returns for the portfolio.
Global equities advanced in the second quarter, with a number of key markets carried past historical highs. US equities generated positive absolute returns despite some mixed macroeconomic data and amid political uncertainty over the ability of the US administration to push through its fiscal policies. In the UK, the FTSE All-Share index advanced over what was a volatile quarter.
In the fund’s UK equity portfolio, the holdings in diversified mining groups Anglo American and South32 underperformed the FTSE All-Share index against the backdrop of weaker industrial metal prices. Platinum miner Lonmin also fell amid fears about its balance sheet. Meanwhile, Barclays declined on the back of disappointing first quarter results and Centrica, the integrated energy company and owner of British Gas, underperformed as political uncertainty weighed on sentiment.
On the positive side, education business Pearson bounced back following the publication of a reassuring first quarter trading update and plans for further cost savings. Royal Bank of Scotland also performed well after delivering first-quarter profits well ahead of market expectations. Meanwhile, bank note printer De La Rue outperformed, after reporting better-than-forecast full-year results.
The Fund established a new position in bookmaker William Hill. The share price has fallen some 40% since the 2013 peak. William Hill is cash-generative and has a reasonably strong balance sheet. Its pension scheme is well provided for and its betting shops have a relatively short average lease length of three years – shorter leases are lower-risk. The dividend is prudently covered and it yields 5%. These characteristics, combined with its low valuation, warrant its position in the Fund.
We cannot forecast exactly when the market will recognise the intrinsic value of our selected holdings. However, we believe the portfolio is well-positioned to capture both the capital returns generated by lowly-valued companies improving, and the significant income such companies produce through paying growing dividends over time.
Following the long disappointment over the pace of global GDP recovery, we are increasingly encouraged by the acceleration in economic data and leading indicators we see in certain parts of the globe. The eurozone recovery is particularly noteworthy, and increasingly at odds with an ECB monetary policy consistent with depression.
Political risk in Europe is not disappearing any time soon, and there will always be another election to worry about – Italy in May 2018 is the next that could threaten the eurozone. However, with France’s benign result, this year’s biggest hurdle has been cleared.
We continue to believe that markets are significantly underestimating the costs and disruption to the UK from Brexit. With his self-professed penchant for unpredictability, President Trump is likely to remain the biggest “known unknown.” But we have seen little sign of destructive protectionism on trade policy or progress on tax reform and infrastructure spend.
We continue to scratch our heads that global equity markets, which were manipulated higher by central banks forcing down interest rates and bond yields, have extended their gains even as rates have begun to increase. International valuations look relatively attractive against a US market buoyed since November by high expectations for deregulation, fiscal stimulus and tax cuts – expectations which may not be met. The broad US equity market multiples toward the higher end of what we typically like to pay.
In the second quarter of 2017, the portfolio returned +2.9% on a net basis versus a +0.4% MSCI All Country World Index (sterling) return. The largest contributors in the quarter included a retailer of natural and organic foods, which rallied on the announcement that it would be acquired by a large online retailer; Asia’s oldest and largest life insurer; and a manufacturer of aerospace components for original equipment manufacturers and the aftermarket.
The largest detractors in the quarter were Japan’s largest advertising agency; the largest US specialty jewellery retailer with a significant UK presence; and a multi-channel specialty retailer of products for the home. Cash ended the quarter at 9.5%, a slight increase from 7.8% at the end of March. During the quarter, we added 10 new positions to the fund and divested 10 positions. One of these new positions is a provider of systems and equipment for aerospace, defense and security companies that, we believe, has strong long-term growth prospects.
Geopolitical events threatened markets in the second quarter of 2017. In the US, President Trump failure to repeal Obamacare, and the threat of impeachment over the saga of FBI Director Comey, resulted in a 350-point decline in the Dow. In Europe, concern ahead of the French presidential election spooked markets as far-left candidate Jean-Luc Mélenchon and the right-wing Marine Le Pen threatened to upset the status-quo. While that ultimately ended well with a Macron victory, here in the UK the inconclusive election result merely added to pre-existing uncertainty over the Brexit negotiations.
Politics aside, the focus remains on central bank activity. The Fed announced its third hike in six months and, although the data was relatively mixed, the US Treasury curve edged higher towards the end of the period. Mario Draghi spooked euro markets by saying “reflationary dynamics were slowly taking hold”. Despite the noise from government markets, credit spreads were benign as the strong technical backdrop continued to support the market.
The portfolio was positioned for a continuation of the technical rally although, being conscious of the geo-political risks, the portfolio managers kept a reasonable allocation of cash and ultra-short dated government bonds to allow some flexibility in the event of a short-term market sell-off. There were no significant changes to sector allocations, however the portfolio managers did revisit the Australian government trade, taking advantage of a recent jump in yields.
Every sector of the portfolio contributed to performance in the quarter, which generated a gross total return of 2.55%; most notably bank capital returned 1.1% over the period and the insurance sector 0.62%. Worth noting was the lack of contagion from the restructuring of three major European banks during the period, none of which were held in the fund.
Looking ahead to the second half of 2017, the portfolio managers are more circumspect about market conditions, and expect performance of the credit market over the next few months to be more benign than it was in earlier in the year. As a consequence, the portfolio managers feel a more balanced portfolio is likely to be maintained over the medium term.
The portfolio was positioned to take advantage of a continuation of credit spread tightening, specifically the current ‘Brexit premium’ and the technical support that exists in the European Asset-Backed Security sector and the Additional Tier 1 sector of bank capital. Encouragingly, the restructuring of three European banks during the period was correctly viewed as idiosyncratic events and there was no contagion across the wider sector.
Every sector of the portfolio contributed to performance in the quarter, which generated a gross total return in excess of 3%. The portfolio managers’ two most favoured sectors of banks and ABS generated total returns of 1.32% and 0.76% respectively.
Looking ahead to the second half of 2017, the portfolio managers are more circumspect about the market conditions. However, the relatively attractive yield generated by the portfolio (gross 5.69%) compared to the relatively short average duration (2.8-year) does mitigate the risk posed by higher rates. Given the strong start to 2017, the portfolio managers are expected to maintain a more balanced portfolio over the medium term, which will continue to generate a reasonable level of income but focus on capital preservation.
Emerging Markets Equity
One of the countries we’ll be watching especially closely in coming quarters is China. China is not only home to approximately one quarter of the emerging market universe; it also serves as an engine of growth through its purchases of raw materials and finished goods from other emerging markets. Imports to China rose 24% year-on-year during the first quarter of 2017, as the country’s economy grew 6.9%, which was faster than expected.
Increased government spending and an unrelenting real estate boom helped fuel the pickup in activity. Along with China’s surging economy has come increased uncertainty – both for China and its trading partners. In April, President Xi Jinping called for stepped-up efforts to deflate asset bubbles and reduce other financial risks that threaten to derail the world’s second-largest economy if not addressed.
Toward those ends, China’s central bank has raised key interest rates in the money market, and bank regulators have taken measures designed to cool asset prices and curb unrestrained lending in the country’s shadow-banking system. In seeking to rein in speculative investment and manage systemic risks – while simultaneously maintaining robust economic growth – China’s leaders must walk a narrow and difficult path. Given China’s prominent role in the modern world, a single misstep could significantly impact the global economy.
Most developed market sovereign yields rose over the period, led in particular by the front (short-dated) end. Having slipped in the first half of the quarter due to heightened political risk and uncertainty, rates rose once more later in the quarter. The prospect of a presidential win for Marine Le Pen, and her far right, anti-euro party, in the French elections was a significant threat to the EU. Moreover, confidence in Trump-era reflation faded, marked by political turmoil within his administration, and softer data releases.
A surprise rate cut by the Riksbank also served to push yields downwards. While Macron’s eventual election as the president of France was anticipated, and appreciated by markets, Theresa May’s snap election was less successful. Yields fell as the vote deviated significantly from initial expectations and saw the Conservative government lose its majority (despite retaining the most seats).
In the final weeks of the quarter, however, yields – particularly front-end yields – reversed their trajectory to end the period higher. This was largely triggered by several global central banks (including the Bank of China, the ECB, the BoE and Norges Bank) making decidedly hawkish statements, while the Fed raised rates again.
During the second quarter, the portfolio outperformed the benchmark, returning -0.63% while the benchmark returned -0.65%.
The general election resulted in weaker political leadership and has heightened political risks as the country enters complex Brexit negotiations. The UK may still seek “the greatest possible access” to the EU market through a comprehensive free trade agreement, but there is little incentive for EU countries to offer favorable terms.
The UK is unstable structurally, as productivity and debt worsen, and furthermore faces downside cyclical risks. We expect headline wage growth to slow to 1.8%, down from 2.1%, although by contrast employment numbers remain firm. However, the steepest decline in consumer spending in four years’ points to declining domestic demand. UK purchasing managers’ index figures remain at a good level, but are losing momentum as new orders are slowing. Despite recent hawkish overtones, we expect the BoE to remain on hold for now.
UK High Income
Despite a sell-off towards the end of the period, the UK equity market performed well over the second quarter. There was some better economic data to support this, primarily in Europe, but we don’t believe the recent signs of stronger growth are a forerunner of significantly better fundamentals. The UK stock market’s strength has resulted in part from a benign global equity environment, despite heightened domestic uncertainty around the UK’s general election and talk of a hard Brexit.
Against this backdrop, the portfolios delivered a positive return and outperformed the broader market. Top performers included Capita, which announced a positive trading update as it looks to put a disappointing 2016 behind it. AstraZeneca also rose, after reporting very promising results from a Phase III trial for Imfinzi, its potential treatment for non-small-cell lung cancer.
On a less positive note, shares in Provident Financial declined after it announced a one-off profit warning relating to its consumer credit division. Although this part of the business is very cash-generative, it isn’t one of the company’s real growth drivers and we remain attracted to the long-term investment case.
In contrast to an increasingly bearish consensus, we continue to warm to the prospects for the domestic economy. In this regard, we added two new holdings in housing-related companies - Countryside Properties and Kingfisher – and increased the portfolios’ positions in a number of domestic cyclicals, such as RBS and Barratt Developments. To fund these purchases, we sold the holdings in GlaxoSmithKline and Compass, and trimmed the positon in British American Tobacco.
Looking forward, we remain cautious on the outlook for the global economy despite the market’s lingering optimism on growth. Meanwhile, the UK election result doesn’t change the fundamentally positive backdrop for the UK economy, in our view. Indeed, with its implications for looser fiscal policy and a softer Brexit, the UK economic outlook appears to have improved still further and the portfolios are well-positioned to benefit from this outcome over the long-term.
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 information contained herein represents the views and opinions of our fund managers and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers of St. James’s Place Wealth Management.
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